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? " CHRG-111shrg57709--207 Mr. Wolin," No question about it. Absolutely, Senator. Senator Menendez. And finally, Mr. Chairman, you have said, Mr. Chairman, that there is, quote, ``not a shred of evidence that financial innovation has improved our economy,'' and, in fact, that innovative financial products, quote, ``took us right to the brink of disaster.'' Why do you believe that financial innovation got so out of control, and can regulators, as the Chairman and the Committee deal with financial regulatory reform, can regulators ever be in a position to keep pace with innovation? And if not, are there steps we should take to make banking an innovation, you know, subject to the ability to ensure that it doesn't get out of control? " 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. " FinancialCrisisInquiry--76 And I’ve said this to Chairman Bernanke, and I’ve also said it to Barney Frank when I visited with him. I think we do need to look at complexity. It continues to jump higher and higher and, of course, with innovation and computers and very smart people, you can continue to make it complex. So I think one of the things that the regulatory framework needs to focus on is complexity. THOMPSON: So can the regulatory framework adapt or adjust fast enough given the pace of innovation in the industry? MACK: Well, I think, again, I’ve said it, and my colleagues on this panel have said it. We do need a regulator who has more resources and more—bigger budget to focus on that and to attract people into that arena to focus on it. But, yes, they can do that. But it needs— again, we have many different regulators. I would like to see some consolidation. I would like to see a kind of a head regulator, not just here in the U.S. but tied to other regulators across the world in a global economy. And I think if you had the super-regulator—and, again, it’s a new experience for Morgan Stanley to be reporting to the Fed, but I’ve got to tell you, the amount of questions that we’re asked—and Mr. Blankfein said earlier— that every day people from the Fed are in his building; the same at Morgan Stanley. MACK: I find that very helpful. It’s a great check-and-balance. And certain things that we think we can do, they say, “Well, if you do, let us tell you how we’re going to look at it.” Now re-think it. FinancialCrisisInquiry--75 BLANKFEIN: Well, I think there’s always—the answer is: It does. And the question is what is the— how do you moderate the risk or how do you cover the risk or how do you—you know— let’s apply the word “excessive” to prudence instead of excessive risk. How do you take such prudence that you can allow for risk, but you’ve built safeguards and conditions and liquidity and a lot of capital around it because you don’t want to—it’s the age-old problem. You don’t want to fail to innovate on the one hand. And on the other hand, you don’t want to bear the consequences of innovation that goes poorly. And so that is a balance that has to be reached, and you’d like to reach the best balance, again, before the hundred-year storm, not the day after the hundred-year storm. But that, I think, is going to be one of the most important uses of the information that’s gleaned from this—from the work of this commission is how do we reset the balance but, also, making sure we don’t go so far that we so delever the system, if you will, or so take no risk that we lose a lot of the engines that drive growth in the economy. It’s a challenge. THOMPSON: So, Mr. Mack, you indicated that you’ve had a 40-year career in this industry. How would you suggest, going forward, we think about innovation and managing the risks associated with innovation because you’ve seen a great deal in your time? MACK: Commissioner, I think it’s—in many ways, it’s very simple. I think our regulators and the industry have to focus on complexity. Instruments today can be so complex that even though—let’s assume I am a salesperson at Morgan Stanley and you run a pension fund or insurance company. You and I understand what you are buying. And then a year later, you move up. I move over to a different role. Someone else takes your job. How difficult is it to get into the structure of that instrument? Now, clearly, people are qualified and smart enough to do that, the question is does it happen. CHRG-111shrg57709--209 Mr. Wolin," Senator, thank you. You know, I think financial innovation is incredibly important to our economy and to people in businesses across the country. The critical question from our perspective is that that innovation happen within a robust framework of consumer protection, firstly, and that, second, that the taxpayer is not on the hook for when those innovations go sideways, that the funds themselves bear the downside risk of, in effect, failed innovation. So we want to make sure we have a system in which we have lots of innovation in this sector. That is hugely important, I think, to our entire country and to our economy, but incredibly important that it be done within those two critical frameworks. Senator Menendez. So innovation in which the innovator bears the risk? " CHRG-111hhrg52261--133 Chairwoman Velazquez," Okay. Mr. Moloney, up until the financial crisis, the economy experienced a decade of relatively solid growth, and during this time we saw an explosion of financial innovation and all of the products that went with it. Are you concerned that the proposed regulation might reverse this trend of financial innovation? " CHRG-111shrg54789--89 Mr. Barr," But competition based on financial innovation for price and quality, transparency to consumers, that kind of financial innovation we will see more of, not less. Senator Schumer. Right. Let me ask you this. What about the FTC? Some have said, well, the FTC can do these kinds of things. Has the FTC done at all a decent job in regulating financial products in the last decade? " CHRG-111hhrg55811--20 AND FINANCIAL INNOVATION, U.S. SECURITIES AND EXCHANGE CHRG-110hhrg46591--41 Mr. Stiglitz," Okay. Let me just say that there is also an international dimension, that we can redesign our financial system to actually encourage innovation. We have had bad innovation. The agenda for regulatory reform is large. It will not be completed overnight. But we will not begin to restore confidence in our financial system until and unless we begin serious reform. Let me submit my whole statement for the record. " CHRG-111hhrg53245--212 Mr. Johnson," Do we really have an efficient system at this point? Mr. Bernanke gave a speech recently where he talked about financial innovation and the value of it, he did not name a single innovation since the 1970's in the financial system, okay. We did not get that much efficiency, I think we need to apply the brakes. I do not think you can go back to where we were before. You cannot ``unring'' the bell as you said, but I think applying the brakes is absolutely critical. " CHRG-111hhrg55811--179 Mr. Hu," The standard process of modern financial innovation involves the OTC derivatives market as being the hothouse for financial innovation. The weird products basically appear there first, the newest products, and they migrate. They get standardized. So right now interest rate swaps are highly, highly commoditized. Back in the 1980's, hardly so. You sometimes still had to argue about documentation. There is a process. " CHRG-111shrg54789--23 Mr. Barr," Sir, I think that risk and innovation are central to our financial system. Senator Shelby. We benefit from it, don't we? " CHRG-110shrg46629--45 Chairman Bernanke," No, I think the market will find solutions. They already are finding some. For example, even if the individual instruments are not particularly liquid, there are indices that are based on the payments from CDOs or CLOs which are traded and therefore give some sense of the market valuation of these underlying assets. So this is a market innovation. Sometimes there are bumps associated with a market innovation. I think we just have to sit and see how it works out. There are very strong incentives in the market to change the structure of these instruments as needed to make them attractive to investors. Senator Reed. Let me change gears just slightly. You alluded to it, not the CDOs but the CLOs, the collateralized loan obligations, essentially derivatives of corporate debt. There has been a lot of discussion that it is very easy now to go out in this market and to prop up companies that do not have the ability to borrow directly. And that the underwriting standards have slipped a bit because the banks who typically do the underwriting do not hold the product. They move them out very quickly in these complex secondary markets. First, can you comment on the underwriting standards for the corporate borrowing? Are they loosening to a degree that could-- " CHRG-111shrg51290--29 Chairman Dodd," Thank you, Senator, very much. Senator Bennet? Senator Bennet. Thank you, Mr. Chairman. I appreciate it. Ms. Seidman, you mentioned earlier in passing that even good products are complex or can be complex, which is true in these markets, and good products being ones that actually are collateralized, that actually have some value. When we are thinking about how to create a regulatory structure and a bureaucratic structure that makes sense, on the one hand, there is the issue of wanting the capital markets to be inventive, wanting to be able to lower costs for people that are in their homes and borrowing money or other kinds of things, and on the other hand we find ourselves in a place where we securitized--we didn't, but all these loans were securitized. The bad products became very complex as well as good products and it inspired lots of, or incentivized a lot of behavior that probably wouldn't have happened otherwise because the market in some sense was insatiable and people started to say, well, we don't need to do 70 percent loan to value anymore, let us do 100 percent, just to create a take-up, or a product for that take-up. And I wonder what the implications of all of that are for thinking about the bureaucratic design here so that we can allow the markets to continue to invent, on the one hand, but on the other hand say, is there a degree of complexity that we simply can't sustain or that the regulators will never catch up to, or--I am sorry for the long-winded question--or does it imply something about who needs to be in the room to pass on whether these structures actually make sense or not, these structures being these products? Ms. Seidman. I think that this current situation is really forcing us to take another look at the question of whether innovation and complexity in consumer financial products is something that we ought to value. It is not to say that everybody should have a 30-year fixed-rate mortgage. There are certainly situations in which a 30-year fixed-rate mortgage is not the best instrument for the consumer. And it is not to say that some good products like savings bonds aren't inherently complex. They are. They are extremely complex. But I do think that the notion that allowing continuous redesign and complexity is a good thing needs to be reevaluated. I do think that there are some suggestions that have been made recently about how to sort of come in the middle. The default product suggestion that I mentioned in my testimony is one of them. There would be a standard, relatively simple product that was the product that needed to be offered first in all situations, to avoid the situation that Pat's broker tried to get her into. If a consumer nevertheless decided to buy one of the non-default products, the seller's ability to enforce the contract would be subject to the seller having to prove that whatever disclosures they made initially were understandable to a reasonable man, which is your classic legal standard. I would prefer a system of standardized contracts, but I think that at least in certain areas like mortgages, we probably need multiple standardized contracts in order to cover the waterfront. Senator Bennet. Does anybody else have a comment on that? " CHRG-111shrg54789--78 Mr. Barr," I think, Senator Johnson, that we will see lots of financial innovation in the future, lots of choice in the future in financial products. This agency will enable choice cross the financial services sector, enable financial innovation across the financial services sector based on a level playing field with high standards. Senator Johnson. I can probably say that most mortgages are originated within the terms of 30-year fixed-rate mortgages. These products work for most of my constituents. That said, sometimes there are other products that are not plain vanilla that work for a consumer. Your proposal seems to create many hurdles for both banks that offer these types of products and consumers that use them. Do you think your proposal creates a disincentive for institutions to offer different products? Do you think that fewer products will reduce consumer choice? Could this indirectly increase the cost of credit? " CHRG-111hhrg53238--23 The Chairman," The gentlewoman from Kansas for 2 minutes. Ms. Jenkins. Thank you, Mr. Chairman. For months now, this body has been attempting to relieve the pain felt by our constituents because of today's economic turmoil. However, politicians should not use the current financial crisis as a convenient excuse for a massive overreach of government intervention into our free markets. Smart and lean regulation can be effective, allow free markets to innovate, and balance consumer protection. Innovation is the base of American economic strength. Killing innovation, whether through overregulating or by allowing only plain vanilla products, could hinder access by individuals and businesses to sound, yet creative, financial products. Plus, many of the proposals before us may not address the real faults in the system. The regulatory compliance costs alone may severely impact smaller financial institutions at a time when many of these institutions in Kansas are already struggling. I am eager to hear this week about how we can best reform our system, protect consumers, and allow for vibrant growth. Regulatory restructuring is not to be taken lightly. I urge my colleagues to proceed with caution, taking into account unintended consequences these reforms may have on the financial industry and the consumer. Thank you, Mr. Chairman. I yield back the remainder of my time. " CHRG-111shrg54789--87 Chairman Dodd," Thank you very much, Senator. Senator Schumer. Senator Schumer. Thank you, Mr. Chairman, and we appreciate your being here, Under Secretary Barr. Sorry I couldn't be here the whole time. We have the Judiciary hearings. That is why I am in the back here. But I am very much for a Consumer Financial Protection Agency. In fact, Senator Durbin, Senator Kennedy, and I introduced legislation quite along the lines of this a while back and I am glad that the Chairman has made this an important hearing, an important part of our bill, and I am glad that the White House has supported it. The bottom line is that the present regulatory structure has been an abject failure. I worked with the Fed on, for instance, credit card interest rates for 15 years. The progress was slow, it was muted, and way behind what the credit card issuers would come out with. And so to have an agency whose sole focus is on protecting consumers when the Fed has so many other responsibilities, and we are considering giving them even more responsibility, makes sense. Having the FTC do it, again, they are all across the board. And look, let us face it, the kinds of deceptive practices that, for instance, occurred in the mortgage industry brought down the whole economy, and it is amazing to me that people say we don't need stronger regulation given that that has happened. It is just amazing. And as for this idea, and I want to ask you about this, stifling innovation--some of the critics have said this--yes, it will. It will stifle innovation, clever ways to dupe the consumer, to sell people mortgages that they shouldn't have, to issue people more credit card debt than they can pay for. You bet, it is going to stifle that kind of innovation. But will it stifle a new product, as long as it is fully disclosed, that the consumer or mortgagor needs? No. So please, we have had such a sorry history in the regulation of consumer financial products--sorry history, despite the efforts of you, Mr. Chairman, and others on this Committee on both sides of the aisle--that I would argue that if we don't include this in our financial regulation bill, there will be a gaping hole. But I want to ask you the question about innovation, Mr. Barr. What about the argument that this new agency will stifle innovation of new products and things? " CHRG-111shrg54589--128 PREPARED STATEMENT OF HENRY T. C. HU Allan Shivers Chair in the Law of Banking and Finance, University of Texas Law School June 22, 2009The Modern Process of Financial Innovation and the Regulation of OTC Derivatives *Introduction Mr. Chairman and Members of the Subcommittee, thank you for the invitation of June 15 to testify. My name is Henry Hu and I hold the Allan Shivers Chair in the Law of Banking and Finance at the University of Texas Law School. In the interest of full disclosure, I recently agreed to begin working soon at the Securities and Exchange Commission. I emphasize that I am currently a full-time academic, have been so for more than two decades, and, after this forthcoming government service, will return to my normal academic duties. My testimony reflects solely my preliminary personal views and does not reflect the views of the SEC or any other entity. The below testimony has not been discussed with, or reviewed by, the SEC or any other entity. I ask that this written testimony also be included in the record.--------------------------------------------------------------------------- * Copyright 2009 by Henry T. C. Hu. All rights reserved.--------------------------------------------------------------------------- This is a seminal time as to the regulation of credit default swaps and other over-the-counter derivatives. \1\ Speaking on March 26, Treasury Secretary Timothy Geithner stated that the markets for OTC derivatives will be regulated ``for the first time.'' Last Wednesday, as a key element in a ``new foundation for sustained economic growth,'' President Barrack Obama proposed the ``comprehensive regulation of credit default swaps and other derivatives that have threatened the entire financial system.'' All OTC derivatives dealers and other firms whose activities create large exposures would be subject to ``robust'' prudential supervision. ``Standardized'' OTC derivatives would be required to be cleared through regulated central counterparties. Record keeping and reporting requirements would apply to both ``standardized'' and ``customized'' OTC derivatives. New steps to better ensure that OTC derivatives are not marketed inappropriately to unsophisticated parties would be adopted. Regulated financial institutions would be encouraged to make greater use of regulated exchange-traded derivatives.--------------------------------------------------------------------------- \1\ As Subcommittee Members are already aware, a ``derivative,'' at least in the classical sense, is an agreement that allows or obligates at least one of the parties to buy or sell an asset. Fluctuations in the asset's value would affect the agreement's value: the agreement's value derives from the asset's value, whether the asset is a stock, commodity, or something else. Many derivatives trade on organized exchanges; people using such ``exchange-traded derivatives'' generally need not worry about who is on the other side of the transaction. The exchange's ``clearinghouse'' is effectively the buyer to every seller and the seller to every buyer. These products typically have standardized contractual terms and exchange-traded derivatives markets have been active in the U.S. since the 19th century. In contrast, the market for ``OTC derivatives'' arose in the late 1970s. These agreements are individually negotiated, such as between financial institutions or between financial institutions and their corporate, hedge fund, or other institutional customers. In the 1970s, a conceptual revolution in finance helped financial institutions to price derivatives, hedge associated risks, and develop new products. At least in the past, there were generally no clearinghouse arrangements. Each participant relies on the creditworthiness (and sometimes the collateral) of the party it deals with. ``Credit default swaps'' are one kind of OTC derivative. At their simplest, they involve bets between two parties on the fortunes of a third party. A protection buyer might, for instance, have lent money to the third party and be concerned about repayment. For a fee (or stream of fees), the protection seller will pay the protection buyer cash upon a specified misfortune befalling the third party. A derivatives dealer enters into such bets with its customers, as well as with other dealers. For more background, see, e.g., Henry T. C. Hu, ``Swaps, the Modern Process of Financial Innovation and the Vulnerability of a Regulatory Paradigm'', 138 University of Pennsylvania Law Review 333 (1989) [hereinafter Hu, ``Modern Process'']; Henry T. C. Hu, ``Misunderstood Derivatives: The Causes of Informational Failure and the Promise of Regulatory Incrementalism'', 102 Yale Law Journal 1457 (1993) [hereinafter Hu, ``Misunderstood Derivatives''].--------------------------------------------------------------------------- Key government officials central to developing the President's proposal are testifying today. It is my understanding that the Subcommittee thought that, rather than similarly discussing the specific components of the proposal, I might offer a more general perspective on the regulation of OTC derivatives, based on some of my past writings. In this context, perhaps the four questions set forth in the Subcommittee's June 15 invitation revolve around a basic issue: what's special about regulating OTC derivatives, in terms of transparency, risk, international coordination, or other matters? In this respect, I am reminded of something that Woody Allen once said: ``I took a speed reading course and read War and Peace in twenty minutes. It involves Russia.'' OTC derivatives are no less complex that Napoleonic Russia. In the next few minutes, I will try to offer some thoughts on how to frame the regulatory task that lies ahead. Because I have had to review the Administration proposal and prepare this testimony in the space of only a few days, these thoughts are preliminary and incomplete. I suggest that it would be useful to consider not just the characteristics of individual OTC derivatives, but also the underlying process of modern financial innovation through which products are invented, introduced to the marketplace, and diffused. This process perspective may further the identification of some issues that are important as a regulatory matter. I start with two contrasting visions that have animated regulatory attitudes ever since the emergence of the modern financial innovation process in the late 1970s. (Part II) This may help ensure that, as the Administration's proposal is reviewed or fine-tuned with respect to such matters as ``encouraging'' a migration to exchange-traded derivatives and distinguishing ``standardized'' from ``customized'' OTC derivatives, consideration is given not only to the private and social costs of OTC derivatives, but to their private and social benefits as well. I will then turn to how the financial innovation process results in decision-making errors, even at the biggest financial institutions. (Part III.A) In a Yale Law Journal article published in 1993, I suggested that, because of compensation structure, cognitive bias, human capital, ``inappropriability,'' and other factors characteristic of that innovation process, ``sophisticated'' financial institutions can misunderstand--or act as if they misunderstand--the risks of derivatives and other complex financial products. \2\ Analyzing how these errors occur may be helpful as the Administration seeks to undertake, for instance, the prudential supervision of derivatives dealers and reforms relating to compensation disclosures and practices, internal controls, and other corporate governance matters, at such dealers and perhaps at publicly held corporations generally.--------------------------------------------------------------------------- \2\ Hu, ``Misunderstood Derivatives'', supra note 1.--------------------------------------------------------------------------- The innovation process also leads to informational complexities well beyond the usual ``transparency'' issues, and to related difficulties. \3\ (Part III.B) Regulator-dealer informational asymmetries can be extraordinary--e.g, regulators may not even be aware of the existence of certain derivatives, much less how they are modeled or used. These asymmetries are especially troubling because of the ease with which the financial innovation process allows for the gaming of traditional classification-based legal rules (e.g., ``cubbyholes''). Responding to these complexities is difficult. As an example, beginning in 1993, I have argued for the establishment of a centralized, continuously maintained, informational clearinghouse as to all OTC derivatives activities and outlined some of the key questions that must be answered in creating such an informational clearinghouse. Especially in the wake of the disasters in 2008, regulators have begun working vigorously with derivatives dealers and others to establish data-gathering systems with respect to credit default swaps and other OTC derivatives.--------------------------------------------------------------------------- \3\ As to the issues outlined in this paragraph, see Hu, ``Modern Process'', supra note 1; Hu, ``Misunderstood Derivatives'', supra note 2; cf. Matthew Leising, ``Wall Street to Clear Client Credit Swaps by Dec. 15'', Bloomberg, June 2, 2009 (on recent interactions between the Federal Reserve Bank of New York and financial institutions).--------------------------------------------------------------------------- Finally, I turn briefly to a particular example of the financial innovation process, one that can help shape governmental responses to credit default swaps (CDS) and securitized products, another financial innovation that is sometimes also considered a derivative. (Part IV) The process of what can be called ``decoupling'' or, more specifically, its ``debt decoupling'' form, can undermine the ability of individual corporations to stay out of bankruptcy and can contribute to systemic risk. I discuss ``empty creditor'' and ``hidden noninterest'' issues. I will leave aside ``empty voter'' and ``hidden (morphable) ownership'' issues on the ``equity decoupling'' side. \4\--------------------------------------------------------------------------- \4\ As to the issues outlined in this paragraph, see, e.g., Henry T. C. Hu & Jay Westbrook, ``Abolition of the Corporate Duty to Creditors'', 107 Columbia Law Review 1321, 1402 (2007); Henry T. C. Hu & Bernard Black, ``Equity and Debt Decoupling and Empty Voting II: Importance and Extensions'', 156 University of Pennsylvania Law Review 625, 728-735 (2008); Henry T. C. Hu & Bernard Black, Debt, ``Equity and Hybrid Decoupling: Governance and Systemic Risk Implications'', 14 European Financial Management 663, 663-66, 679-94 (2008), draft available at http://ssrn.com/abstract=1084075; Henry T. C. Hu, `` `Empty Creditors' and the Crisis'', Wall Street Journal, April 10, 2009, at A13; ``CDSs and Bankruptcy--No Empty Threat'', The Economist, June 18, 2009.---------------------------------------------------------------------------Two Contrasting Visions of the Financial Innovation Process From the beginning of the explosive growth of the derivatives market in the early 1980s, two visions have animated the debate over the regulation of derivatives and new financial products generally. The first vision is that of science run amok, of a financial Jurassic Park. In the face of relentless competition and capital market disintermediation, big financial institutions have hired financial scientists to develop new financial products. Typically operating in an international wholesale market open only to major corporate and sovereign entities--a loosely regulated paradise hidden from public view--these scientists push the frontier, relying on powerful computers and an array of esoteric models laden with incomprehensible Greek letters. But danger lurks. As financial creatures are invented, introduced, and then evolve and mutate, exotic risks and uncertainties arise. In its most fevered imagining, not only do the trillions of mutant creatures destroy their creators in the wholesale capital market, but they escape and wreak havoc in the retail market and in economies worldwide. This first vision, that of Jurassic Park, focuses on the chaos that is presumed to result from financial science. This chaos is at the level of the entire financial system--think of the motivation for Federal Reserve's intervention as to Long-Term Capital Management (perhaps inappropriately named) in 1998 or as to American International Group in 2008--or at the level of individual participants--the bankruptcy of Orange County in 1994 or the derivatives losses at Procter & Gamble (perhaps appropriately named) in 1994. The second vision is the converse of the first vision. The focus is on the order--the sanctuary from an otherwise chaotic universe--made possible by financial science. The notion is this: corporations are subject to volatile financial and commodities markets. Derivatives, by offering hedges against almost any kind of price risk, allow corporations to operate in a more ordered world. As the innovation process goes on, the ``derivative reality'' that corporations can buy becomes ever richer in detail. If the first vision is that of a Jurassic Park gone awry, the second vision is of the soothing, perfect hedges found in a formal English or Oriental garden. There are certainly private and social costs associated with derivatives besides the chaos derivatives sometimes bring. Similarly, there are private and social benefits beyond the risk management possibilities of derivatives. \5\--------------------------------------------------------------------------- \5\ As to some of the other benefits of derivatives, see Darrell Duffie and Henry T. C. Hu, ``Competing for a Share of Global Derivatives Markets: Trends and Policy Choices for the United States,'' preliminary June 8, 2008, draft available at http://ssrn.com/abstract=1140869 (the views in said draft are solely those of the authors and do not reflect those of anyone else). Similarly, beyond OTC derivatives and looking at the regulation of capital markets and institutions overall, the minimization of systemic risk, short- or long-term, should not be the sole touchstone for regulatory policy. In the interests of the proper allocation of resources and long-term American economic growth, care must be taken that our capital markets not only remain firmly rooted in full and fair disclosure, but are perceived to be so rooted by investors worldwide.--------------------------------------------------------------------------- I make a basic point here. In a financial crisis, especially one with deep derivatives roots, it is too easy to focus solely on the dark side of OTC derivatives. Directly encouraging regulated financial institutions to migrate to exchange-traded derivatives has benefits as well as costs. Similarly, the differing regulatory regimes for ``standardized'' and ``customized'' OTC derivatives will trigger differing burdens. As to these and other decisions, careful consideration of the net impact of regulatory efforts will be necessary.The Financial Innovation Process: Decision-Making Errors and Informational ComplexitiesDecision-Making Errors Financial institutions focused solely on shareholder interests would generally take on more risk than would be socially optimal. At least in the past, governments typically constrained risk-taking at financial institutions, but not elsewhere. But as for financial institution decision making with respect to derivatives, much more than a gap between shareholder- and social-optimality is involved. There is a repeated pattern of outright mistakes, harmful to shareholders and societies alike, even at ``sophisticated'' entities. Why? In the 1993 ``Misunderstood Derivatives'' article, I argued that several of the factors stemmed from the underlying process of modern financial innovation. These factors may cause even the best financial institutions and rocket scientists to misunderstand (or behave as if they misunderstand) derivatives. I also offered some possible responses, both in terms of disclosure (including enhanced compensation disclosure) and in terms of substantive measures (including measures to encourage proper consideration of legal risks). One factor is cognitive bias in the derivatives modeling process. Humans often rely on cognitive shortcuts to solve complex problems; sometimes these shortcuts are irrational. For instance, one of the cognitive biases undermining derivatives models is the tendency to ignore low probability-catastrophic events. Psychologists theorize that individuals do not worry about an event unless the probability of the event is perceived to be above some critical threshold. The effect may be caused by individuals' inability to comprehend and evaluate extreme probabilities, or by a lack of any direct experience. This effect manifests itself in attitudes towards tornados, safety belts, and earthquake insurance. My 1993 article indicated that in the derivatives context, financial rocket scientists are sometimes affirmatively encouraged, as a matter of model design, to ignore low probability states of the world. I also showed how this tendency, along with other cognitive biases, may cause risks of a legal nature to be ignored. Certain public AIG statements are arguably consistent with the operation of this cognitive bias, though they do not necessarily prove the existence of the bias. For example, in August 2007, the head of the AIG unit responsible for credit default swaps stated: It is hard for us, without being flippant, to even see a scenario within any kind of realm of reason that would see us losing one dollar in any of those [credit default swap] transactions. \6\--------------------------------------------------------------------------- \6\ Gretchen Morgenson, ``Behind Insurer's Crisis, Blind Eye to a Web of Risks,'' N.Y. Times, Sept. 28, 2008, at A1.Then again, perhaps he was right. AIG didn't lose one dollar; it lost billions. Similarly, AIG's Form 10-K for 2006 stated: The threshold amount of credit losses that must be realized before AIGFP has any payment obligation is negotiated by AIGFP for each transaction to provide that the likelihood of any payment obligation by AIGFP under each transaction is remote, even in severe recessionary market scenarios. Another factor flows from the inability of financial institutions to capture--to ``appropriate''--all the benefits of their financial research and development. This ``inappropriability'' can lead to the failure to devote enough resources to fully understand the risks and returns of these products. (This has implications for responding to securitization that have not been considered. As to asset-backed securities, inappropriability may well have contributed to the sacrificing of due diligence in favor of excessive reliance on ratings agencies.) One of the other factors flows from the incentive structures in the innovation process. In the derivatives industry, the incentive structure can be highly asymmetric. True success--or the perception by superiors of success--can lead to enormous wealth. Failure or perceived failure may normally result, at most, in job and reputational losses. Thus, there may be serious temptations for the rocket scientist to emphasize the rewards and downplay the risks of particular derivatives activities to superiors, especially since the superiors may sometimes not be as financially sophisticated (and loathe to admit this). Moreover, the material risk exposures on certain derivatives can sometimes occur years after entering into the transaction--given the turnover in the derivatives industry, the ``negatives'' may arise long after the rocket scientist is gone. The rocket scientist may have an especially short-term view of the risks and returns of his activities. I do not know if any of AIG's current or past employees succumbed to any such behavior, by reason of the incentive structure or otherwise. That said, it is a matter that would be worth looking into. According to the testimony of Martin Sullivan, the former CEO of AIG, until 2007, many employees at AIG Financial Products (AIGFP) (the subsidiary generating the losses leading to the AIG bailout) were being paid higher bonuses than he was. The head of AIGFP, Joseph Cassano, apparently made $280 million over 8 years. And when Mr. Cassano left AIG in February 2008, he was given, among other things, a contract to consult for AIG at $1 million a month--at least, if memory serves, until a pertinent Congressional hearing came along. The foregoing factors characteristic of the modern financial innovation process should be considered with respect to regulatory reforms. This applies not only with respect to how the Administration should engage in the prudential supervision of derivatives dealers but perhaps as well to such matters as the Federal role as to compensation disclosure and practices at publicly held corporations generally. These issues are quite complex, perhaps especially with respect to substantive (as opposed to disclosure) aspects of compensation: questions abound for any particular dealer or corporation, as well as for the proper role of the Federal Government in respect to those questions. How and when should ``profits'' on trades be calculated? What are the proper models for valuing complex derivatives and determining profits? How are risks and returns on particular types of instruments to be quantified? How should compensation be risk-adjusted?Informational Complexities and the Creation of an Informational Clearinghouse As noted earlier, a variety of informational complexities stem from the financial innovation process. One of the complexities stems from the fact that, historically, neither the introduction of new OTC derivative products nor individual OTC derivative transactions were required to be disclosed to any regulator. The informational predicate for effective regulation is absent. In ``Misunderstood Derivatives,'' I suggested the creation of an informational clearinghouse involving the centralized and continuous gathering of product information and outlined some of the key questions as to nature and scope that would need to be answered in actual implementation. Market participants would provide specified transaction-specific data in computerized form. Although providing actual market prices (transactional terms) may be sensitive, providing theoretical pricing models are sometimes likely to be far more so. The models the derivatives dealers use can be complex and proprietary. And market prices may depart substantially from valuations predicted by models. Especially after the CDS-related AIG debacle in September 2008, regulators have been moving aggressively to work with derivatives dealers and others to improve OTC derivatives data-gathering, particularly as to CDS. Perhaps there is a possibility of a fully centralized informational clearinghouse. This would necessitate international coordination well beyond the U.S.-U.K.-centric process that culminated in the pioneering 1988 Basel Accord for capital adequacy. A properly designed centralized informational clearinghouse must consider the extent to which proprietary information should really be required and, if or when required, reflect extensive safeguards. Moreover, complicated decisions lie ahead as to what information provided to regulators should be made available to the public.The ``Decoupling'' Process I now turn briefly to a particular example of the financial innovation process, consideration of which should help guide policy decisions with respect to CDS, securitized products, and other derivatives. Certain issues relating to CDS and to securitizations have become quite familiar. For example, everyone is by now aware of how American International Group's CDS activities helped cause AIG's near-collapse in September 2008. And, especially with President Obama's Wednesday speech and its reference to the need for ``skin in the game,'' most of us are familiar with the moral hazard, ratings agency, principal-agent, and other issues which cause securitized products to be mispriced or missold. And, in Part III.A, I have discussed how ``inappropriability'' issues in the financial R&D process should begin to be considered with respect to such matters as the inadequate due diligence done (and excessive reliance on ratings agencies) in connection with securitizations. Instead, I will focus here on the process that can be called ``debt decoupling.'' In August 2007, I began suggesting that the separation of control rights and economic interest with respect to corporate debt through swaps can cause a variety of substantive and disclosure problems, problems that become especially troublesome when economic times are bad. This debt decoupling analysis has been further developed and I rely on this analysis to illustrate these issues. Ownership of debt usually conveys a package of economic rights (to receive payment or principal and interest), contractual control rights (to enforce, waive, or modify the terms of the debt contract), other legal rights (including the rights to participate in bankruptcy proceedings), and sometimes disclosure obligations. Traditionally, law and real world practice assume that the elements of this package are generally bundled together. One key assumption is that creditors generally want to keep a solvent firm out of bankruptcy and (apart from intercreditor matters) want to maximize the value of an insolvent firm. These assumptions can no longer be relied on. Credit default swaps and other credit derivatives now permit formal ownership of debt claims to be ``decoupled'' from economic exposure to the risk of default or credit deterioration. But formal ownership usually still conveys control rights under the debt agreement and legal rights under bankruptcy and other laws. There could, for instance, be a situation involving what, in 2007, I termed an ``empty creditor'': a creditor may have the control rights flowing from the debt contract but, by simultaneously holding credit default swaps, have little or no economic exposure to the debtor. The creditor would have weakened incentives to work with a troubled corporation for the latter to avoid bankruptcy. And if this empty creditor status is undisclosed, the troubled corporation will not know the true incentives of its creditor as the corporation attempts to seek relief in order to avoid bankruptcy. Indeed, if a creditor holds enough credit default swaps, it may simultaneously have control rights and a negative economic exposure. With such an extreme version of the empty creditor situation, the creditor would actually have incentives to cause the firm's value to fall. Debt decoupling could also cause substantive (empty creditor) and disclosure (hidden noninterest and hidden interest) complications for bankruptcy proceedings. Have CDS-based empty creditor situations actually happened in the real world? Yes. On September 16, 2008, as AIG was being bailed out, Goldman Sachs said its exposure to AIG was ``not material.'' But on March 15, 2009, AIG disclosed it had turned over to Goldman $7 billion of the Federal bailout funds AIG received. Perhaps this could be referred to as ``The Curious Incident of the Bank That Didn't Bark.'' As I suggested in an op-ed in the April 10 Wall Street Journal, one reason Goldman Sachs did not express alarm in September is that it was an empty creditor. Having hedged its economic exposure to AIG with credit default swaps from ``large financial institutions,'' Goldman had lessened concerns over the fate of AIG. Yet Goldman had the control rights associated with the contracts that it had entered into with AIG (including rights to demand collateral). Perhaps not surprisingly, Goldman was apparently aggressive in calling for collateral from AIG. (I do not in any way suggest that Goldman did anything improper. Moreover, Goldman had obligations to its own shareholders.) Debt decoupling issues relating to multiple borrowers can also affect the economy. In the securitization context, servicing agents have little or no economic interest in the debt (and limited rights to agree to loan modifications) while senior tranche holders typically have most of the control rights (but, in contrast to junior tranche holders, little incentive to agree to modifications). As a result, the relationships between debtors and creditors tend to be ``frozen'': difficulties in modifying the debtor-creditor relationship can contribute to systemic risk. Front page headlines suggest the importance of loan modification difficulties in the securitization context; analyzing how debt decoupling contributes to these difficulties may be helpful in considering governmental policies as to asset-backed securities. The foregoing involves ``debt decoupling.'' ``Equity decoupling'' also occurs. Ownership of shares traditionally conveys a package (economic, voting, and other rights) and obligations (including disclosure). Law and contracting practice assumed that the elements of this equity package are generally bundled together. But outside investors and others can now decouple this link between voting (as well as other) rights on shares and economic interest in those shares. Financial innovations like equity derivatives and familiar tools like share borrowing used for decoupling purposes have affected core substantive and disclosure mechanisms of corporate governance. But today, I will leave aside analysis of ``empty voting,'' ``hidden (morphable) ownership,'' and related matters.Conclusion The President's proposal appears to offer a good starting point for review, with respect to OTC derivatives and otherwise. I make a modest claim: considering the special nature of the modern process of financial innovation can be helpful in the road ahead. Thank you. ______ FOMC20050630meeting--141 139,MR. MOSKOW.," But you can’t really associate it with the degree of financial innovation that we’ve had in the United States because of this great variability? Is that what you’re saying, Karen?" CHRG-111hhrg55811--176 Mr. Hu," The financial innovation process is critical not only for this country, but the financial services industry and the social wellbeing. This bill does not stop that; it controls it. It tries to confine it so that the externalities of these kind of activities are severely limited. " 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-111hhrg52406--8 The Chairman," Next, the prime sponsor of the bill here on the committee, the gentleman from North Carolina, Mr. Miller, for 2 minutes. Mr. Miller of North Carolina. Thank you, Mr. Chairman. One of the issues arising from the financial crisis that this committee must address is how compensation in the financial industry created incentives for taking immediate profits while ignoring only slightly less immediate risk. We will consider how to adjust compensation to ally the long-term interests of companies with the interest of those who work for them. The issue before us today is more difficult and more important, how to ally the interests of the financial industry with those of society. The financial industry has defended every consumer credit practice, regardless of how predatory the practice appeared to those unsophisticated in finance, like me, as an innovation that made it possible to extend needed credit to those who were excluded from traditional lending. And the industry's innovations resulted in inflating the housing bubble, evading existing consumer protections, trapping the middle class in unsustainable debt, and creating risk for financial companies that were dimly understood by regulators, by investors, and even by the investors and CEOs of the companies that created them. And it plunged the country and the world into the worst recession since the Great Depression. The regulatory system we are considering is less restrictive than the regulation of many industries that have done much less damage. At bottom, the question is this: Are consumer lending practices that the industry celebrates as innovation actually useful to society, or are they just a way to make more and more money by betraying the trust of the American people? Other regulators don't just take the regulated industry's word for it that their products are beneficial, and neither should the regulation of the financial industry. I yield back my time. " CHRG-110shrg38109--125 Chairman Bernanke," I agree that derivatives are an incredibly important part of our expanding financial market, part of financial innovation, and I would like to see the United States remain competitive in those areas. Senator Crapo. So you think it would be appropriate for us to focus in this Congress on things that we can do or not do to assure that we remain competitive or that we become more competitive in those arenas? " FOMC20050630meeting--153 151,MR. STOCKTON.," Let me make one other point on the reasons why there may have been an increase in the equilibrium price-rent ratio, because I certainly agree with you and President Yellen that there are some good reasons. Those reasons could well include financial innovation, changes in capital gains taxation, and supply constraints. However, lots of asset price misalignments start out with situations where there are good reasons why those prices are rising rapidly. Productivity innovation and changes in business models, and so forth, were I think probably valid explanations for the increase in stock market prices, but that doesn’t mean—" CHRG-111hhrg55811--19 The Chairman," Thank you. Mr. Hu is the Director of the SEC's new Division of Risk, Strategy, and Financial Innovation. Mr. Hu? STATEMENT OF HENRY HU, DIRECTOR, DIVISION OF RISK, STRATEGY, CHRG-111shrg54789--24 Mr. Barr," We at times benefit from it and at times have costs from it, and on balance, financial innovation and risk taking are central to our system. What we are talking about here is not eliminating risk, certainly not eliminating financial innovation. Quite the contrary. I think those are central concepts. But we have to see that happen on a level playing field with high standards so that people are competing based on price and quality and not consumer confusion. Senator Shelby. The board of the consumer--the composition of the board, the proposal of the Consumer Financial Protection Agency would include the Director of the National Bank Supervisors and four members of the President's choosing. There is no limit on the number of members who are from the same political party. This contrasts, as you well know, with the limits on the composition of both the Securities and Exchange Commission and the Consumer Product Safety Commission. Why did you choose such a politically biased construct at this point knowing that would raise red flags for some? " CHRG-111shrg53085--51 Mr. Whalen," Well, I think it is a failure born out of distraction. The Fed, as I mentioned before, the senior levels are populated by academic economists primarily. We occasionally let a banker in there or a generalist, but it has primarily become a place for patronage appointments of economists. And frankly, if you look at the history of financial economics, the development of innovation, as we call it, derivatives, et cetera, these are all the intellectual playthings of the economists. So they promoted all of this innovation that we have heard from the other witnesses that is, in fact, now killing the little banks who weren't involved in it in the first place. Senator Shelby. Promoted the consolidation of the whole banking system, didn't it. " CHRG-110hhrg34673--178 Mr. Bernanke," That is an issue that has received a lot of attention. It is a good puzzle why we have gotten differential results. I think the answer is the interaction of the technologies and the economic system. To go back to themes we have already addressed today, technology creates change, and the system has to be able to adapt to change in order to make full use of the technology, and in the United States the combination of very deep capital markets which have been able to fund new start-up firms or venture capital support for entrepreneurial activities and a flexible labor market which has allowed for changes in the way people work and the distribution of workers across industries and across occupations has allowed these new innovations, these technological innovations and information communication technologies not only to lead to increased productivity within the narrow sphere of high technology industries but to spread out through the whole economy and to increase productivity in financial services, in retailing, in wholesaling, and in manufacturing. As firms have been able to apply effectively these technological innovations, in some countries there is a great deal of rigidity in the structure of labor and product markets, and those rigidities have prevented the technological innovations from being applied as effectively or as quickly as in the United States. " CHRG-111hhrg53240--114 Mr. Carr," It is a frivolous argument, the idea that somehow every single consumer is different from one another. There is a difference to offering one product to every single consumer in the market as opposed to having standard products that are based on individuals' income, their wealth, and certain other types of financial circumstances to create classes of standard products. And one can be very nimble, very innovative, with standard products. In fact, there are a lot of them that actually exist. The problem was they could not compete with the reckless subprime loans that were actually priced at a much higher premium by the investment banks. So the idea that somehow you lose innovation because you introduce standards is a frivolous argument. " CHRG-111shrg54533--6 Secretary Geithner," Mr. Chairman, Ranking Member Shelby, and Members of the Committee, it is a pleasure to be here. I welcome this debate. This is a critically important debate for our country, and I think it is time we get to it. Over the past 2 years, our Nation has faced the most severe financial crisis since the Great Depression. Our financial system failed to perform its critical functions. The system magnified risks. Some of the largest institutions in the world failed. The resulting damage affected the country as a whole, affecting virtually every American. Millions have lost their jobs and their homes. Hundreds and thousands of small businesses have shut down. Students have deferred college and education, and workers have had to shelve their retirement plans. American families are making essential changes in response to this crisis. It is our responsibility to do the same, to make our Government work better. And that is why yesterday President Obama unveiled a sweeping set of regulatory reforms to lay the foundation for a safer, more stable financial system, one that can deliver the benefits of market-driven financial innovation even as it guards against the dangers of market-driven excesses. Every financial crisis of the last generation has sparked some effort at reform, but past efforts have been begun too late, often after the will to act has subsided. We cannot let this happen this time. We may disagree about the details, and we will have to work through these issues. But ordinary Americans have suffered too much. Trust in our financial system has been too shaken, and our economy was brought too close to the brink for us to let this moment pass. In crafting our plan, the administration has sought input from all sources. We consulted extensively with Members of Congress, regulators, consumer advocates, business leaders, academics, and the broader public. And we looked at a range of proposals made by a number of bodies here in the United States over the last several months. We considered a full range of options, and we made the judgment that now was the time to pursue the essential reforms, those that address the core causes of the crisis and those that will help prevent or contain future crises. I want to be clear. Our plan does not address and does not seek to address every problem in our financial system. That is not our intent, and we do not propose reforms that, while desirable, would not move us toward achieving those core objectives of creating a more stable system and addressing those vulnerabilities that are critical to our capacity to prevent future crises. We have laid out the details of our proposals in public, so I just want to spend a few minutes explaining some of the broad principles that guided our proposals. First, if this crisis has taught us anything, it is that risks to our system can come from almost any quarter. We must be able to look in every corner and across the horizon for dangers, and our system was not able to do that. While many of the firms and markets at the center of the crisis were under some form of Federal regulation, that supervision did not prevent the emergence of large concentrations of risk. A patchwork of supervisory responsibility, loopholes that allowed some institutions to shop for the weakest regulator, and the rise of new institutions and instruments that were almost entirely outside the Government's supervisory framework left regulators largely blind to emerging dangers. And regulators were ill equipped to spot systemwide threats because each was assigned to protect the safety and soundness of individual institutions under their watch. None was assigned to look out for the broader system as a whole. That is why we propose establishing a Financial Services Oversight Council to bring together the heads of all the major Federal financial regulatory agencies, and this council will help ensure that we fill gaps in the regulatory structure where they exist and where they emerge. It will improve coordination of policy and help us resolve disputes across agencies. And, most importantly, it will have the power to gather information from any firm or market to help identify and help the underlying regulators respond to emerging risks. The council will not have the responsibility for supervising the largest, most complex, interconnected institutions, and the reason for that is simple. That is a highly specialized, complicated task, and it requires tremendous institutional capacity and organizational accountability. Nor would the council be an appropriate first responder in a financial emergency. You cannot convene a committee to put out a fire. The Federal Reserve is the best positioned to play that role. It already supervises and regulates bank holding companies, including all major U.S. commercial and investment banks. Our plan is to give it a carefully designed, modest amount of additional authority, and clearer accountability for the Fed to carry out that mission, but we also take some important authority and responsibilities away from the Federal Reserve. Specifically, we propose removing from the Federal Reserve and other bank regulators oversight responsibility for consumers. Historically in those agencies, consumer interests were often perceived to be in conflict with the broader mandate of the institutions to protect safety and soundness. That brings me to our second key priority: consolidating protection for consumers and ensuring they understand the risks and rewards associated with financial products sold directly to them. Before this crisis, many Federal and State regulators had authority to protect consumers, but few viewed it as their primary mission. As abusive practices spread, particularly in the market for subprime and nontraditional mortgages, our regulatory framework proved inadequate. And this lack of oversight, as the Chairman said, led millions of Americans to make bad financial decisions that emerged as a core part, a core cause of this crisis. Consumer protection is not just about individuals, but it is also about safeguarding the system as a whole. Now, this Committee, the Congress, and the administration have already taken important steps to address consumer problems in two key markets--those for credit cards and the beginning mortgages--and our view is that those are a sound foundation on which to build more comprehensive reform. We propose the establishment of a Consumer Financial Protection Agency to serve as the primary Federal agency looking out for the interests of consumers of credit, savings, payments, and other financial products. This agency will be able to write rules that promote transparency, simplicity, and fairness, including standards for standardized, simple, plain vanilla products that have straightforward pricing. Our third priority is to make sure that reform, while discouraging abuse, encourages financial innovation. The United States remains the world's most vibrant and most flexible economy in large measure because our financial markets create a continuous flow of new products, services, and capital. That makes it easier for the innovator to turn a new idea into a growing company. Our core challenge, though, is to design a system which has a proper balance between innovation and efficiency on the one hand and stability and protection on the other. We did not get that balance right, and that requires substantial reform. We think the best way to keep the system safe for innovation is to have stronger protections against risk with stronger capital buffers, to have greater disclosure so that investors and consumers can make more informed financial decisions, and a system that is better able to evolve as innovation advances and the structure of our financial system changes in the future. Now, I know that some suggest we need to ban or prohibit specific types of financial instruments as too dangerous, and we are proposing to strengthen consumer protections and investor protections and enforcement by, among other things, prohibiting a range of abusive practices, such as paying brokers for pushing consumers into higher-priced loans or penalties for earlier repayment of mortgages. In general, however, we do not believe you can build a system based on--a more stable system based on an approach of banning on a periodic basis individual products because those risks will simply emerge quickly in new forms. Our approach is to let new products develop, but to bring them into a regulatory framework with the necessary safeguards in place. Our tradition of innovation in the financial sector has been central to our prosperity as a country, so our reforms are designed to strengthen our markets by restoring confidence and accountability. Finally, Mr. Chairman, a fourth priority is to address the basic vulnerabilities and our capacity to manage future crises. We came into this crisis without an adequate set of tools to confront and deal with the potential failures of large, complex financial institutions. That left the Government with extremely limited choices when faced with the failure of the largest insurance company in the world and some of the world's largest investment banks. And that is why, in addition to addressing the root causes of this crisis, putting in place a better framework for crisis prevention in the future, we have to act to give the Government better tools to manage future crises. At the center of this, we propose a new resolution authority modeled on the existing authority of the FDIC to manage the failure of weak thrifts and banks, and that will give us more options in the future that we should have had going into this crisis. This will help reduce moral hazard by allowing the Government to resolve failing institutions in ways that impose costs on owners, creditors, and counterparties, making them more vigilant and prudent. Now, we have to also minimize moral hazard created by institutions that emerge with a scale and size that could threaten stability. No one should assume that the Government in the future will step in to bail these institutions out if they fail. We will do this by making sure financial firms follow the example of families across the country and build bigger protections, bigger cushions, bigger safeguards as a precaution against bad times. We will require all firms to keep more capital and more liquidity on hand as a greater cushion against future losses and risks, and the biggest, most interconnected firms will be required to keep larger cushions, larger shock absorbers against future shocks. Now, the critical test of our reforms will be whether we make the system strong enough to withstand the stress of future recessions and strong enough to withstand the failure of large institutions in the future. These are our basic objectives. We want to make the system safer for failure and safer for innovation. We cannot afford inaction. As both the Chairman and Ranking Member said, I do not think we can afford a situation where we leave in place vulnerabilities that will sow the seeds for future crises, so we look forward to working with this Committee in the weeks and months ahead to put in place a stronger foundation for a more stable financial system in the future. Thank you very much, Mr. Chairman. " 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. " FinancialCrisisInquiry--408 CHAIRMAN ANGELIDES: Thank you, Mr. Vice Chairman. I was going to hold all my questions until the end, but I want to ask one now so I don’t forget. And that is, one thing you seem to be saying is, in a world of rapid innovation, rapid change, expansion of new industries, there’s an argument, at least for the core financial sector, to have perhaps even greater stability as opposed to, for example, all the entities out there who can take greater risk without consequence to the taxpayers. January 13, 2010 But you seem to be saying that the price of greater innovation, greater volatility in the larger economic world may be having a stronger core. Am I hearing you correctly? CHRG-111shrg50815--3 STATEMENT OF SENATOR SHELBY Senator Shelby. Thank you, Chairman Dodd. Although problems with mortgage-related assets have taken center stage in our ongoing financial crisis, credit card lending has also rapidly declined as our economy has deteriorated. The securitization market, a key vehicle for financing credit card transactions, remains severely constrained, at its best. The absence of a robust secondary market has deprived many financial institutions of the financing needed to support credit card-based lending. Unable to securitize their credit card portfolios, many banks have been forced to cut back their customers' credit limits or even terminate their customers' credit cards altogether. In the midst of these challenging market conditions, the Federal Reserve, along with the Office of Thrift Supervision and the National Credit Union Administration, finalized new rules last December that will drastically alter the credit card industry. The rules prohibit a variety of business practices and impose a new layer of complex regulation. They also update and enhance certain consumer protections. The new rules will be implemented over the next year and a half, but already, financial institutions are drastically altering their credit card practices, as they should. Recent reports suggest that the new rules will cause a substantial contraction in consumer credit. While I believe that there are many credit card practices that need reforming, as Senator Dodd mentioned, I also believe that regulators need to be especially careful in this time of financial stress not to take actions that unduly restrict the availability of credit. Limiting the ability of consumers of low and moderate means to obtain credit could have unfortunate consequences. If they can't get credit from regulated banks, they may seek it outside the banking system. Regulators must exercise caution to ensure that the appropriate balance is struck between adequately safeguarding consumers, which is important to all of us, while not eliminating access to credit for millions of American families. Regulators also need to make sure that they do not stifle innovation or unduly restrict consumer choice. Many innovative products that have been demanded by and have benefited consumers, including zero percent financing, may be eliminated or severely curtailed because of the recent regulatory rule changes. We can all agree that abusive products should be addressed, and soon, but we should also be careful not to eliminate legitimate products in doing that. An overly broad approach risks giving consumers a false sense of security. Too often, consumers fail to consider whether a particular financial product is right for them because they believe that Federal regulators have already determined which products are safe and which are dangerous. Yet in many cases, whether a financial product is appropriate for a consumer depends on the consumer's own financial position. If the financial crisis has taught us anything, it is that all sectors of our economy, from big commercial banks to retail consumers, need to do more due diligence before they enter into financial transactions. No regulator can protect a consumer as much as they can protect themselves if they have the necessary information, which is why clear, complete, and understandable disclosure, as Senator Dodd has pushed for years, is so critical. Several bills have been introduced that seek to codify the recent rule changes, and in several instances would go beyond those rules to enact even more severe regulations. I believe before we legislate in this area, I think we should be careful. I would prefer that we give regulators the necessary time to implement the rule changes and then we can evaluate how those rules have worked and what changes are needed. In this time of economic turmoil, we need to proceed carefully, but we do need to proceed. We need to be especially careful not to undermine the ability of our financial system to accurately price risk. The advent of risk-based pricing has helped our financial institutions expand the availability of credit. Undermining the ability of banks to employ risk-based pricing could reverse this very positive development. As this Committee begins to consider regulatory reform, I believe it is important to keep in mind the need to balance carefully our strong desire to protect consumers and the absolute necessity of preserving an innovative and diverse marketplace. These are not mutually exclusive concepts and it is our job--our obligation--to craft a regulatory structure that can accommodate them both, and I hope we will. Senator Johnson. [Presiding.] The Chairman has stepped out momentarily to confer with Secretary Geithner and Mr. Summers. Does anyone want to comment briefly before we get to the panelists? Senator Reed? Senator Reed. I will pass, Mr. Chairman, and defer to my colleagues if they would like to speak. Senator Johnson. Anybody? CHRG-110hhrg44900--7 Mr. Kanjorski," Mr. Chairman, this hearing comes at a critical juncture. As the economy reels from a widespread, far-reaching financial crisis that continues to wreak havoc on everything from the housing market to student loans, while we remain focused on many current economic difficulties average Americans face, we must simultaneously look to the future to determine how to prevent or at least mitigate future crises. Financial innovation and the proliferation of complex and exotic financial instruments are probably inevitably going to occur under our capitalist system. But we must develop innovative, regulatory and oversight responses to keep pace as these market transactions evolve. One such proposal worth considering is the Systemic Risk Reduction Act of 2008 put forth by the Financial Services Roundtable. This bill seeks to make regulation more efficient by closing gaps in our regulatory structure and by promoting consolidation and cooperation among regulatory agencies. Their proposal includes a provision of particular interest to me; namely, it proposes establishing a bureau similar in concept to the Office of Insurance Information which passed the Capital Markets Subcommittee yesterday. Without a Federal repository to collect and analyze information on insurance issues, we cannot fully understand and control systemic risk. The Roundtable proposal would also expand the authority of the Federal Reserve so that investment banks who borrow from the Fed's discount window in various facilities do not get a free pass. No one else can borrow money without conditions, and the American people do not expect that the investment bank be allowed to do so. Chairman Bernanke spoke 2 days ago and raised many of these issues and offered ideas for consideration, noting that the financial turmoil since August underscores the need to find ways to make the financial system more resilient and more stable. I whole-heartedly agree. He further stated that the Fed's powers and responsibilities should be commensurate. It is the job of Congress to strike that proper balance. While many concur that the Federal Reserve's move to bail out Bear Stearns in March of this year was necessary to prevent a financial meltdown, most also agree that we should be concerned about setting precedents with broad ramifications down the road. Taxpayers cannot be asked to bail out financial institutions, and we should look for ways to prevent such dire situations from arising in the future. Another area germane to today's discussion is speculation. Specifically, we must determine to what extent speculation in commodities futures has hurt American consumers by artificially inflating the price of oil, energy, and other goods. I appreciate the ongoing debate on speculation with economists, traders, pundits, and politicians staking out various positions on the issue. To the extent that we can glean further insight from our panelists today, that would be of tremendous help, for it is true that speculators bear blame. Then congressional action in the form of increased oversight in authority is warranted. on a related note, I am very interested in consolidating the regulation of our securities and commodities markets. While the CFTC currently has jurisdiction of this market, the Treasury's recommendation to merge SEC and FCTC seems a sensible course of action for Congress. We need to take this action now and I look forward to working with the Administration. " CHRG-111shrg50564--191 STATEMENT OF SENATOR CHARLES SCHUMER First, I'd like to thank Chairman Dodd for holding the first of what I'm sure will be many hearings on financial regulatory reform. For decades, America generally, and New York in particular, have been the financial capitals of the world. Our markets have been the deepest, most liquid and safest. Our dominant position was built not only on our talent, ingenuity and expertise, but also on a foundation of strong but efficient regulation, and a reputation for fairness, that demonstrated to investors that they would be protected from fraud and financial recklessness here. The events of past 24 months have destroyed our reputation as the system has been gripped by a financial crisis that resulted from years of regulatory neglect at all levels. Eight years of the Bush Administration's one-sided, laissez-faire, deregulatory ideology have helped cripple our financial system, and an outdated and overmatched regulatory system in this country compounded their failure. Even former Federal Reserve Chairman Alan Greenspan, once an ardent defender of deregulation and the free market, recently acknowledged that there was a ``flaw'' in his belief that markets could and would regulate themselves. I hope that we've learned that as appealing as deregulation may seem in good times, the price we ultimately pay will be far higher than had we exercised the good judgment and restraint imposed by responsible regulation. Designing a regulatory system is a complicated and difficult task. Regulation must strike a delicate balance--providing a sense of safety and security for investors, without snuffing out the flame of entrepreneurial vigor and financial innovation that drives economic growth. It's easy, and even tempting, to go to the ideological extremes on either end of the spectrum. But threading this needle correctly is an essential component of restoring confidence and long-term stability to the financial system. For many years, the United States had struck that balance very well. However, new factors, including technology, globalization, and industry consolidation and evolution have left our regulatory infrastructure too far behind the reality of today's global financial system. Where does this leave us? Well, it leaves us needing significant reform. As we go forward, I believe there are a number of clear principles that we must adhere to. I've discussed these principles before, but I think they're worth repeating now as we begin the discussion of regulatory reform under a new Administration. 1.) We must focus on controlling systemic risk and ensuring stability. In increasingly complex markets, even the most sophisticated financial institutions don't always understand the risks their decisions involve. Smaller institutions like some hedge funds and private equity firms, can also create systemic risk in today's world and cannot escape regulation, particularly when it comes to transparency. We need regulation that looks at risk systemically and above all, we need to ensure that whatever may happen to any individual financial actor, we can be confident that the financial system itself will remain strong and stable. 2.) We need to look closely at unifying and simplifying our regulatory structure. In this era of global markets and global actors, we cannot maintain the older model of separate businesses with separate regulators. Right now there are too many regulators at the Federal level with overlapping authority. This creates a regulatory ``race to the bottom'' as less responsible firms are able to play the regulators off one another in their efforts to operate with as little oversight and as few restrictions as possible. 3.) It is clear that we must figure out how to regulate currently unregulated parts of the financial markets and opaque and complex financial instruments. There are too many vital players and products in the financial markets that operate beyond the scope of Federal regulators, yet have the ability to put the system at risk. We must create an effective regulatory framework for those actors and for more exotic financial instruments like complex derivatives and even the relatively plain vanilla credit-default swaps, which have grown into a multi-trillion dollar part of the financial system. 4.) We must recognize that a global financial world requires global solutions. In this era of global finance, while we have international markets, we still have national regulations. The danger is that there is often a rush to the place where regulation is lightest and least effective. This may be our toughest challenge. 5.) Increased transparency must be a central goal. We must continue to emphasize transparency among all market participants. The ability of investors, lenders and especially regulators to evaluate the quality of holdings and borrowings is essential for restoring confidence. A complete overhaul of this nation's financial regulatory system will be difficult, complex and time consuming. I look forward to working with President Obama, and under the leadership of Chairman Dodd to advance this process so that as we begin to recover from the current financial crisis in the coming months, we have a system in place to prevent its repetition. ______ CHRG-110hhrg44900--63 Secretary Paulson," Congresswoman Maloney, that's an important question. There is no doubt that our financial system has grown. It has become much more complex. We have seen a complexity of financial instruments, and a lot has taken place between the last stress we had in the market in 1998 and this current period. And so we are seeing how a number of these institutions and securities are performing under stress for the first time. I do agree with you that large, complex financial institutions are difficult to manage. So I agree with you there. I would also say, though, that a lot of the diversity in our financial system, and Chairman Bernanke commented about it, you know, the so-called hedge funds where people were saying is that going to be a major problem? And yet those risks, so far we have managed through those pretty well. I believe that the biggest problems we are dealing with is not the diversification of these organizations but it is the amount of risk that was taken on, and the amount of leverage, much greater than was understood, because a lot of it was taken on through complex products that were difficult to understand. And that's why it's taking so long to work through this. So I believe the big part of the answer here is going to be the de-leveraging and going forward enhancing liquidity practices, risk management practices, and getting our arms around some of these complex products. " CHRG-111hhrg55811--138 Mr. Hu," Congressman, you raise excellent questions. The SEC has historically emphasized very much the public utility model as to clearinghouses so that we actually expect fair representation of people who use these clearinghouses so that there is active involvement in terms of making sure that the fees are not exorbitant, that they don't unfairly burden people. And we have set up this model to prevent exchanges from controlling clearinghouses. We believe that is an essential element as well. In terms of innovation, competition, the discussion draft Treasury proposal recognized both the benefits of financial innovation and some of the costs. And in terms of this balance, these are issues that the CFTC and the SEC, together with this committee and other committees, will work closely on. " CHRG-111shrg54589--64 Mr. Hu," Mr. Chairman and distinguished Members of the Subcommittee, thank you for this opportunity. My name is Henry Hu. I teach at the University of Texas Law School and my testimony reflects my preliminary views as an academic. In the interest of full disclosure, I recently agreed to begin working soon at the Securities and Exchange Commission. I emphasize that I am currently a full-time academic, have been so for over two decades, and after this forthcoming government service will return to my normal academic duties. What I will say today does not reflect the views of the SEC and has not been discussed with, or reviewed by, the SEC. I have submitted written testimony. I ask that it also be included in the record. This is a seminal time for the regulation of over-the-counter derivatives. My understanding is that the Subcommittee wanted me to offer a broad perspective as to undertaking this task instead of analyzing specific elements of the President's proposal. Almost from the beginning of the OTC derivatives markets in the late 1970s, two overarching visions have animated the regulatory debate. The first vision is that of science run amok, of a financial Jurassic Park. In the face of relentless competition and capital market disintermediation, big financial institutions have hired financial scientists to develop new financial products. Often operating in an international wholesale market open only to major corporate and sovereign entities--a loosely regulated paradise hidden from public view--these scientists push the frontier, relying on powerful computers and esoteric models laden with incomprehensible Greek letters. But danger lurks. As these financial creatures are created, evolved, and mutate, exotic risks arise. Not only do the trillions of mutant creatures destroy the creators in the wholesale capital market, they escape to cause havoc in the retail market and economies worldwide. This first vision focuses on the chaos that is presumed to result from the innovation process. The chaos could be at the level of the entire financial system. This motivated, of course, the Federal Reserve's intervention in 1998 of Long-Term Capital Management--perhaps they should have called this hedge fund something else--and the intervention in 2008 as to AIG. There could also be chaos at the level of individual market participants. Witness the bankruptcy of Orange County in 1994, and also in 1994, the huge derivatives losses at Proctor and Gamble--but perhaps that company's name was appropriate. But there is also a second vision, one that is the converse of the first vision. Here, the focus is on the order, the sanctuary from an otherwise chaotic universe made possible by the innovation process. The notion is this. Corporations and others are subject to volatile financial and commodities markets. Derivatives, especially OTC derivatives, can allow corporations to hedge against almost any kind of risk. This allows corporations to operate in a more ordered world. If the first vision is that of a Jurassic Park gone awry, the second vision is that of the soothing, perfect, hedges found in formal English and Oriental gardens. While the first vision focuses on the private and social costs of derivatives, the second vision emphasizes the private and social benefits of OTC derivatives. In fact, there are elements of truth to both visions and the essential task ahead is to try to reduce the costs of such derivatives without losing their benefits. Now, that is easily said. How can we actually accomplish this? Well, in my academic articles on this matter, I stress one theme. We must not just focus on the characteristics of individual OTC derivatives, but also on the underlying process of financial innovation through which products are invented, introduced to the marketplace, and diffused. That is, the financial innovation process itself, not just individual derivatives, has regulatory significance. Because of time limitations, I simply refer to two or three examples, and only very briefly. First, the innovation process can lead to chaos by causing important market participants to make big mistakes. In an article published in 1993 in the Yale Law Journal entitled ``Misunderstood Derivatives,'' I argued that the particular characteristics of the modern financial innovation process will cause even the most sophisticated financial institutions to make big mistakes as to derivatives. Second, the gaps in information as to this innovation process between the regulators and the regulated are extraordinary. Regulators may not even be aware of the existence of certain derivatives, much less how they are modeled or used. And so beginning in 1993, I have urged the creation of a centralized informational clearinghouse as to OTC derivatives. Third, let's focus on one particular example of the innovation process, the so-called ``decoupling'' process. I have--beginning in 2006--been the lead or sole author as to a series of articles suggesting that this decoupling process can affect the core disclosure and substantive mechanisms of our economic system. In the initial 2006 articles, the focus was on the equity side. Those articles showed how you could have an ``empty voter'' phenomenon. For instance, the person holding the highest number of votes in a company could be somebody with no economic interest or a negative economic interest. And similarly, there is a ``hidden morphable ownership'' issue. Those 2006 articles showed how some hedge funds and others have used cash-settled equity swaps in efforts to try to avoid making disclosures under Section 13(d) of the Securities Exchange Act of 1934. In 2007, it suddenly occurred to me that the same kind of decoupling process can work on the debt side. For instance, using credit default swaps, you could have creditors who are ``empty creditors.'' With this empty creditor situation, these creditors might often have weaker incentives than traditionally to make sure that their borrowers stay out of bankruptcy. Indeed, if they hold enough credit default swaps, they might benefit from their borrowers going into bankruptcy. In these times, this is deeply troubling. Let me conclude. Three econometricians went hunting in the wilds of Canada. They were getting hungry and they suddenly see a deer. One econometrician shoots and misses three feet to the right. The second econometrician shoots and misses three feet to the left. The third econometrician doesn't shoot but shouts, ``We got it! We got it!'' It is very difficult to come up with a good model, much less one that would actually put food on the table. The task of coming up with a good model for regulating derivatives is no less difficult, and we now all know that this task is essential to making sure that food is indeed on the table for everyone. Thank you very much. " CHRG-110shrg38109--124 Chairman Dodd," Thank you, Mr. Chairman, very much. Senator Crapo. Senator Crapo. Thank you very much, Mr. Chairman. And Chairman Bernanke, we appreciate you being here with us. I want to return to the global competitiveness issue for a minute. I know that others have spoken to you about this already. First and foremost, I want to commend Senator Schumer for working with Mayor Bloomberg for the McKenzie report. There is also, as you know, the new interim report of the Committee on Capital Markets Regulation, and both of those reports I think add significantly to this debate and to the issue. I am working on a resolution, and talking with Senator Schumer about it as well, and hope to be working with him on a resolution to help highlight this and to express the sense of the Senate about what steps we need to take in terms of better dealing with our global competitiveness. Now what I want to focus my questioning on with you is derivatives and hedge funds. I will start by noting that in the McKenzie report this following quote occurs. London already enjoys clear leadership in the fast-growing and innovative over-the-counter derivatives market. This is significant because of the trading flow that surrounds derivative markets and because of the innovation these markets drive, both of which are key competitive factors for financial centers. Dealers and investors increasingly see derivatives and cash markets as interchangeable, and are therefore combining trading operations for both products. Indeed, the derivatives markets can be more liquid than the underlying cash markets. Therefore, as London takes the global lead in derivatives, America's competitiveness in both cash and derivatives flow trading is at risk, as is its position as a center for financial innovation. Would you agree with that portion of the McKenzie report? " CHRG-111shrg53085--105 Mr. Whalen," Nobody does not want to get paid. But Lehman Brothers to me is a classic example of why the good people in the U.S. Federal Bankruptcy Court should be the first folks you talk to about this. You do not need another layer of politics to deal with holding companies, because once the bank is gone, what do you have? You have a Delaware corporation that belongs in front of the U.S. Bankruptcy Court. The moment the FDIC becomes receiver of the banks, it is no longer a regulated entity. They are gone. The deposits are gone. The loans are gone. That is the point. Senator Warner. Let me come at this from a different way, and I am going to thank the Chairman for giving me a little more time. We look at size, we look at complexity. Another approach which I have been thinking about for some time is on the financial products end. Again, my premise is--and I would like to hear from a number of you, if you want to comment. And I spent 20 years around financing more in the venture capital end, but, you know, under the guise of innovation, it appears to me that over the last 10 years we have created a whole series of financial products that at some level have been argued that they have been about better pricing risk. I think on reflection it may be the marginal societal value of better pricing risk versus the type of systemic exposure that it has created and that many of these financial products may have been more about short-term fee generation than they have been about long-term value to the system. But if we were to--and I know Senator Schumer has mentioned an approach he has taken, and I would love to see what would be the--what kind of thinking any of you have done in terms of the criteria of how we might on a going-forward basis evaluate financial products. Is there an underlying theory? Is it just the risk they bring to the system? Would there be some effort to try to make an evaluation of a macrolevel societal value added for these new financial products? How do you do that, and how do you--you know, I am a little bit afraid that we closed the door on certain products from the last crisis, but with the amount of intellectual fire power going into financial engineering, how are we going to preclude the next generation of financial products kind of getting beyond our control or oversight? Ms. Hillebrand, or anyone else on that comment. Ms. Hillebrand. Thank you, Senator Warner. I think there are two things. One is the Financial Product Safety Commission would be charged not with minimizing all risk but with minimizing undue risk to consumers, including keeping up with those new practices and those new products, so that the consumer who overdraws by 85 cents does not face $126 in bank fees, as happened to a consumer who we talked to earlier this month, and keeping up, looking at the practices. This is not to say banks cannot charge fees, cannot do anything, but to try to watch the practices and to outlaw those products that just do not fit with the nature of the product. Your checking account should be a service you pay for and not a fee machine for the bank. We need to get back to that kind of common sense. We think a Financial Product Safety Commission could do it on the consumer financial product side. In the mortgage and credit area, we also need to create accountability structures so that everybody who has a piece of that loan has responsibility going forward. That means a suitability requirement for those who are selling, a fiduciary requirement for those who are advising, and as people talk about ``skin in the game,'' a responsibility going forward if there are later problems with that loan. That is a beginning. Senator Warner. Well, my time has expired. I know Senator Menendez--but I would like to hear from others, perhaps, if you could get back to us on what would be that--I still did not hear what would be the underlying theory of how we would evaluate financial products on a going-forward basis. We do not want to stem innovation and, clearly, some level of responsibility and higher minimum investment requires qualified investor criteria and other things I get. But what would be the underlying theory of how we should regulate or evaluate financial products. Thank you for allowing me a little additional time, Mr. Chairman. " FinancialCrisisReport--19 Over the last ten years, some U.S. financial institutions have not only grown larger and more complex, but have also engaged in higher risk activities. The last decade has witnessed an explosion of so-called “innovative” financial products with embedded risks that are difficult to analyze and predict, including collateralized debt obligations, credit default swaps, exchange traded funds, commodity and swap indices, and more. Financial engineering produced these financial instruments which typically had little or no performance record to use for risk management purposes. Some U.S. financial institutions became major participants in the development of these financial products, designing, selling, and trading them in U.S. and global markets. In addition, most major U.S. financial institutions began devoting increasing resources to so-called “proprietary trading,” in which the firm’s personnel used the firm’s capital to gain investment returns for the firm itself rather than for its clients. Traditionally, U.S. banks, broker- dealers, and investment banks had offered investment advice and services to their clients, and did well when their clients did well. Over the last ten years, however, some firms began referring to their clients, not as customers, but as counterparties. In addition, some firms at times developed and used financial products in transactions in which the firm did well only when its clients, or counterparties, lost money. Some U.S. banks also sponsored affiliated hedge funds, provided them with billions of dollars in client and bank funds, and allowed the hedge funds to make high risk investments on the bank’s behalf, seeking greater returns. By 2005, as U.S. financial institutions reached unprecedented size and made increasing use of complex, high risk financial products, government oversight and regulation was increasingly incoherent and misguided. B. High Risk Mortgage Lending The U.S. mortgage market reflected many of the trends affecting the U.S. financial system as a whole. Prior to the early 1970s, families wishing to buy a home typically went to a local bank or mortgage company, applied for a loan and, after providing detailed financial information and a down payment, qualified for a 30-year fixed rate mortgage. The local bank or mortgage company then typically kept that mortgage until the homeowner paid it off, earning its profit from the interest rates and fees paid by the borrower. Lenders were required to keep a certain amount of capital for each loan they issued, which effectively limited the number of loans one bank could have on its books. To increase their capital, some lenders began selling the loans on their books to other financial institutions that wanted to service the loans over time, and then used the profits to make new loans to prospective borrowers. Lenders began to make money, not from holding onto the loans they originated and collecting mortgage payments over the years, but from the relatively short term fees associated with originating and selling the loans. (8/28/2009). Those banks plus Citigroup also issued one out of every two mortgages and two out of every three credit cards. Id. FOMC20050630meeting--168 166,MR. GALLIN.," I do not, certainly not with respect to the rents. I would like to say also that I agree with the comments that financial innovations could very well be a justifiable reason for house prices to be higher than usual relative to other prices. I do think some things are different. But I don’t see anything to suggest that we have to be worried about rental inflation and, as a result, overall inflation." CHRG-111hhrg74090--89 Mr. Barr," With respect, sir, our strong view is that it does not. It continues to provide for financial innovation. Consumers can get access to whatever products and services providers want to offer. Our basic approach is to improve disclosure, reduce regulatory burden, for example, by merging authorities so you can have one simple mortgage form at the time of disclosure, improve---- " CHRG-111shrg54789--88 Mr. Barr," Senator Schumer, I think that the agency will enable financial innovation to occur based on a level playing field with high standards. It will prevent the kind of competition that we have seen in the past based on--competition based on who can provide the most confusing terms and the most hidden fees. Senator Schumer. Right. " CHRG-111shrg50564--183 Mr. Dodaro," I definitely think that the systemic regulator that we are talking about would fulfill that function, or at least that could be one of the functions they fulfill, is to assess the risk level, and there have to be tolerances put in place and balances and decisions made on a case-by-case basis as to whether the risk--you know, assuming you have these clear goals of consumer protection as one of your goals, along with, you know, allowing innovation and capital formation. But, I mean, all those things have to be balanced. But I think you definitely need that in place. I agree with what you are saying, that, you know, disclosure, transparency alone are not going to be enough. I think you need to have it sort of from one end to the other. One is the regulators need to be protecting the consumers as well as allowing for innovation, all the way through transparency, disclosure, down to educating people more to make them more financially literate. Senator Warner. I had a family member who I warned time and again do not get into this adjustable rate mortgage. All the warnings in the world, all the transparency in the world, would not have precluded her from taking a bad long-term action. I was able to bail her out, but now we are looking to a national Uncle Sam bailing everybody out because at some point people with information may still not be making good financial judgments here. " CHRG-111hhrg53241--4 The Chairman," The gentlewoman from California, Ms. Speier, for 2\1/2\ minutes. Ms. Speier. Thank you, Mr. Chairman, and thank you for having the backbone to continue this fight to make sure consumers in America have a choice. The taxpayers have spent more than $2 trillion to turn around an economic crisis that had its foundation in the insatiable appetite of Wall Street for the high yields provided by mortgage-backed securities and the fees that went with them. We got liar loans and no-doc loans and pick-a-payment loans that had no relation to the borrower's ability to pay. It didn't matter, because the loans were cut up into pieces and bundled and rated triple A. Lots of people got rich, and the foundation of this economy crumbled. Today, we are going to talk about what we can do for the consumers of America now that we have taken care of Wall Street. We heard yesterday from the banks, both big and small, about how they weren't responsible for the current financial crisis and consumer protection should be left with the existing regulators. Well, the existing regulators have had 14 years, and what have they done in 14 years to fix the problem? Sixty percent of the subprime borrowers would have qualified for cheaper mortgages, but they didn't get them. They talked about how the consumers must have choice and access to innovative financial products, about how a Consumer Financial Protection Agency is somehow going to shut down access to credit for consumers or drive the price of credit sky high, about how they will be subject to 50 standards. These arguments are scare tactics intended to delay action until the economy starts to recover, as it inevitably will, and the political will for bold reform will fade. The choice and innovation argument only works when the parties involved are on an equal negotiating level. Furthermore, what is wrong with plain vanilla? Innovative products have equaled paying for the consumers and ripoffs to the taxpayers. You can't tell me that a kindergarten teacher buying her first home or a firefighter who has been offered a teaser rate to transfer a large balance from one credit card to another is on an even playing field with the phalanx of lawyers deployed by Citibank or Bank of America or Wells Fargo who write 30 pages of legalese in print so small that even triple-strength reading glasses aren't enough to reveal the real terms. A Consumer Financial Protection Agency will not limit creative or innovative products. It will, however, limit the ability to run roughshod over the consumers. Terms will have to be clear and fully disclosed, and the consumer may have to opt in. And although opt in seems to be a dirty word to those in the financial industry, it simply means that the consumer will actually have to affirmatively agree to the terms. I yield back. " CHRG-111hhrg53021Oth--292 Secretary Geithner," Congressman, as you know, you and I are going to disagree very fundamentally on where you began your question, which is the appropriate response of a country facing a crisis like we inherited. But on the question you are raising, which is about the benefits of hedging and how we get the balance right between stability, innovation, and the future, I suspect that our differences are much narrower, again, because, as I have said many times here today, we trying to preserve the capacity for hedging. We are trying to make it better, more possible for our country to have both a more stable, more resilient system, and preserve the capacity of people that hedge against these risks. We are basically committed to that. We are trying to make sure that innovation, which is a great strength of our financial system, can proceed in the future with less risk of catastrophic damage. But I suspect that we don't--our differences are not as great. They are probably very great where you began your question. And I would be happy to talk about that at any time. " CHRG-111hhrg53021--292 Secretary Geithner," Congressman, as you know, you and I are going to disagree very fundamentally on where you began your question, which is the appropriate response of a country facing a crisis like we inherited. But on the question you are raising, which is about the benefits of hedging and how we get the balance right between stability, innovation, and the future, I suspect that our differences are much narrower, again, because, as I have said many times here today, we trying to preserve the capacity for hedging. We are trying to make it better, more possible for our country to have both a more stable, more resilient system, and preserve the capacity of people that hedge against these risks. We are basically committed to that. We are trying to make sure that innovation, which is a great strength of our financial system, can proceed in the future with less risk of catastrophic damage. But I suspect that we don't--our differences are not as great. They are probably very great where you began your question. And I would be happy to talk about that at any time. " FOMC20050630meeting--137 135,MR. MOSKOW.," Thank you, Mr. Chairman. I wanted to make a few comments and then ask a question. First, I’d say that with all of the concerns about froth in housing markets, I found these presentations to be very informative, and I want to congratulate the people who spent a lot of time preparing them. I thought they were all very good presentations. But I also found the information comforting. We’ve all talked about the possibility of local housing bubbles and regional housing bubbles, and clearly there are some in the United States. But we never really looked at it on a national basis before. The net result for me was that I come away from the analysis not feeling any worse than I did before and probably a little better. First, I thought it was very helpful to see quantified—I think this was in Josh’s memo—the size of the potential bubble. He talked about a 20 percent drop in housing prices. But that was equal to only about 30 percent of GDP as compared to the drop in equity prices we had, which was more than twice that. Also, I had the feeling that appropriate monetary policy, as John said, could mitigate much of the distress that might occur. Moreover, the credit risk associated with home mortgages seems to be spread out across many institutions. Governor Bies said that a lot of analysis is being done now, and we’ll want to see the results of the analysis that the Board and the Comptroller are doing. But on the whole, the financial institutions seem to be in pretty good shape. The role of securitizing mortgages is to lay off risks to parties who are willing and able to bear the risks. Capital levels of the financial institutions are relatively high, so it appears that these markets are performing their roles well. And in the event of a sharp drop in housing prices, the odds of a spillover to financial institutions seem limited. And as I mentioned, it was helpful to hear the June 29-30, 2005 48 of 234 housing prices. So I come away somewhat less concerned about the size and consequences of a housing bubble than I was before. The question I had relates to what Governor Yellen was asking about—financial innovation. I was going to make a similar point. The fact is that there has been a great deal of financial innovation in housing markets in the United States. The average person can borrow very easily on his home these days. And I was wondering if there have been—or if it is possible to do—any international comparisons on this. I wondered whether the price-rent ratios in other countries that may not have had the same degree of financial innovation we’ve had differ substantially from ours." FOMC20081216meeting--503 501,MR. ROSENGREN.," The loss of the securitization market is really important, so I think this facility is a very important innovation. My question is, How important were the conduits to this market, and how confident are we that there will be structures to bring back the securitization market? Or are we basically bridging to these things going on bank balance sheets or other types of financial intermediaries? How do you see this? I guess the question is, From your perspective, what is this a bridge to? " CHRG-111hhrg52397--90 Mr. Lynch," Thank you, Mr. Chairman. At the outset, I would just like to say if we cannot fix this system, given the experience we have had with this, if we cannot fix it and allow all investors and institutions to I think readily rely on a derivatives system, it is probably better that it go overseas rather than put the stamp of this country and the full faith and credit of this Nation behind such a system if we do not think it is really sound. Now, I have heard that argument before from other firms within the financial services industry that if we regulate this industry, it will go overseas. Well, there are probably some folks over in London who sort of wish that type of dynamic had not been created. Now, a couple of observations that I want to make. Dimitris Chorafas wrote that, ``Compared to horse-and-buggy classical bonds and equities, complex derivatives are supersonic engines.'' And I just want to bring to mind the power of derivatives. I will readily admit there is some advantage to be had from their use, but I am very concerned about the idea that there would be customized derivatives outside of a regulatory system because I think there is a certain attraction to firms, such as 3M and others, to have a derivative customized to their very specific situation. I understand the attraction of that. I also understand that where AIG and some others got into some tough situations in terms of the derivatives they were holding is that they were not fungible. They were so uniquely crafted that no one could determine what the value of those derivatives were and there were just no buyers on the market, so it seized up. So there were advantages but it also created problems. Let me ask you this question: If we allow a customized derivative industry to operate outside of--just over-the-counter, without anybody knowing the details and the dynamic of those customized derivatives, and frankly stability has always been gained at some cost to innovation. That is just the way it operates. But if we are going to allow that to happen in this opaque and complex system, customized derivatives to be traded over-the-counter, how do the regulators protect the American system here, our financial system, if we do not know what is going on out there, the only limit is the creativity of some of those folks over at MIT, some of whom live in my district, how do we allow that to operate when all the good that your industry might do, you also have the ability to destroy the economy and bring the economy down, how do we balance that? Mr. Don Thompson. Well, I would like to address that. I think that the framework that we have been working on with the Fed and the other regulators provides a paradigm here where you have clear transactions between major dealers that are standardized being given up to a clearinghouse. And then with respect to transactions that are not cleared, you have central trade repositories, which contain all of the trade information of those non-cleared transactions, whether they be not cleared because of their degree of customization or because of the counterparties to the transaction, which are accessible to regulators in whatever form and as frequently as they want it. " 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-111hhrg53021--10 Mr. Lucas," Thank you, Mr. Chairman and thank you to both Chairmen for holding this joint hearing to hear the Treasury's proposal to regulate over-the-counter derivatives, as well as examine the legislation that the House Agriculture Committee passed a few months ago. I, as Ranking Member of the House Agriculture Committee and senior Member of the Financial Services Committee, I would like for this occasion to examine the issue from two different perspectives. The Agriculture Committee has been very active in exploring the role derivatives play in the marketplace, and in the overall economy. The Committee has held numerous hearings to gain further information and insight into the complex nature of credit default swaps and how they should be regulated. In February of this year, as the Chairman noted, the Agriculture Committee passed H.R. 977, the Derivatives Markets Transparency and Accountability Act. No one can argue that the concepts of transparency and accountability are wrong, but we must make certain that our actions call for an appropriate level of regulation that will respect the nature of the marketplace and encourage product innovation and economic growth. Derivatives do serve a valid purpose in the marketplace when used with judgment. They are essential for managing risk. We must consider that there are numerous industries that have legitimate price risk and there must be a way to mitigate that. Derivatives provide a legitimate means for managing that risk. The financial problems that we have seen recently are not the result of merely the existence of derivatives, but rather because there are problems in measuring their true performance, or knowing with certainty the depth and breadth of the over-the-counter market, or knowing with confidence the creditworthiness of the counterparty. Simply put, the marketplace can be protected from market failures if regulators are fully aware of the threat. Ignorance of this relatively new financial instrument caused much of the financial failures. We now know that these complex markets need better models and methods for oversight and transparency. However, we must be careful not to overreach and force businesses into very expensive clearing operations that cost capital that they do not have, or force them out of risk mitigation all together. Business will then be forced to manage risk with higher prices, which will ultimately be passed on to consumers. The need to avoid artificial costs for business was the reason I opposed the clearing requirement in H.R. 977. There is considerable concern that section 13, as currently drafted, which relates to the clearing requirement will stifle invasion in the over-the-counter market. CFTC needs more authority to waive the clearing requirements in section 13 so new and safer products can get to the market in a timely fashion. This would recognize the fact that not all contracts can be cleared and that there is a need for customized contracts. These are just a few of the concerns I have on my part as we move forward today. Again, I thank you for the opportunity to discuss the issues regarding these important financial institutions. And Secretary Geithner, I look forward to your testimony and the answers to the questions posed by the panel. Thank you, Chairman. " CHRG-111hhrg53021Oth--10 Mr. Lucas," Thank you, Mr. Chairman and thank you to both Chairmen for holding this joint hearing to hear the Treasury's proposal to regulate over-the-counter derivatives, as well as examine the legislation that the House Agriculture Committee passed a few months ago. I, as Ranking Member of the House Agriculture Committee and senior Member of the Financial Services Committee, I would like for this occasion to examine the issue from two different perspectives. The Agriculture Committee has been very active in exploring the role derivatives play in the marketplace, and in the overall economy. The Committee has held numerous hearings to gain further information and insight into the complex nature of credit default swaps and how they should be regulated. In February of this year, as the Chairman noted, the Agriculture Committee passed H.R. 977, the Derivatives Markets Transparency and Accountability Act. No one can argue that the concepts of transparency and accountability are wrong, but we must make certain that our actions call for an appropriate level of regulation that will respect the nature of the marketplace and encourage product innovation and economic growth. Derivatives do serve a valid purpose in the marketplace when used with judgment. They are essential for managing risk. We must consider that there are numerous industries that have legitimate price risk and there must be a way to mitigate that. Derivatives provide a legitimate means for managing that risk. The financial problems that we have seen recently are not the result of merely the existence of derivatives, but rather because there are problems in measuring their true performance, or knowing with certainty the depth and breadth of the over-the-counter market, or knowing with confidence the creditworthiness of the counterparty. Simply put, the marketplace can be protected from market failures if regulators are fully aware of the threat. Ignorance of this relatively new financial instrument caused much of the financial failures. We now know that these complex markets need better models and methods for oversight and transparency. However, we must be careful not to overreach and force businesses into very expensive clearing operations that cost capital that they do not have, or force them out of risk mitigation all together. Business will then be forced to manage risk with higher prices, which will ultimately be passed on to consumers. The need to avoid artificial costs for business was the reason I opposed the clearing requirement in H.R. 977. There is considerable concern that section 13, as currently drafted, which relates to the clearing requirement will stifle invasion in the over-the-counter market. CFTC needs more authority to waive the clearing requirements in section 13 so new and safer products can get to the market in a timely fashion. This would recognize the fact that not all contracts can be cleared and that there is a need for customized contracts. These are just a few of the concerns I have on my part as we move forward today. Again, I thank you for the opportunity to discuss the issues regarding these important financial institutions. And Secretary Geithner, I look forward to your testimony and the answers to the questions posed by the panel. Thank you, Chairman. " CHRG-111hhrg52407--3 Mr. Paulsen," Thank you, Mr. Chairman. I appreciate it. I also strongly believe that we must increase the financial literacy of our citizens. This is a basic life skill that, unfortunately, many in our country truly lack. This is really a family and a financial security issue. What concerns me is that nowhere in the Administration's proposal that we have now begun hearings on are the words ``financial literacy'' mentioned. The plan doesn't do anything to encourage individuals, from what I can see, to empower themselves or help people better understand personal finance and the decisions that they have to make on a daily basis. Instead, what I see is that, is one of my chief concerns, that it actually takes away the ability of individual choice and decisions from individuals. And rather than seeking to increase financial literacy, the underlying legislation creates this panel that potentially will take away choices from consumers out of a fear that things will be too complicated for them to understand. In other words, someone else is going to make decisions about what is best for you. And I think that is the wrong approach. Congress should not be taking away choices from the American people. Congress shouldn't be stifling innovation at a time when we need innovation. Instead, I think Congress should be helping these individuals understand what options are available so that they can make the right decisions for themselves. And I sincerely hope that this committee can work in a bipartisan way to improve upon the Administration's proposal as we go forward in crafting really some commonsense legislation that is needed to make sure that ultimately we are empowering all Americans to make sound and educated judgements with regard to their own personal finances. And I yield back. " CHRG-111shrg54789--125 Mr. Wallison," Thank you, Mr. Chairman and Ranking Member Shelby, Members of the Committee. I must say candidly that I was shocked when I realized how this legislation will actually work. For me, it raised the following questions. Are consumers protected when they cannot buy products and services that are available to others? Is that what consumers want? Does it matter what they want? These questions occur because the Administration's proposal for a Consumer Financial Protection Agency, the CFPA, results in the Government, I believe, essentially deciding which Americans will have access to certain financial products and which will not. Traditionally, consumer protection in the United States has focused on disclosure. It has always been assumed that with adequate disclosure, all consumers at whatever level of education or sophistication could make rational purchase decisions. Consumer protection under these circumstances focused on fraud and deception and could take account of differences in consumer sophistication. But the Administration's plan is based on an entirely different idea. That idea is that many consumers should not be allowed to have particular products or services because they are not sophisticated, educated, and perhaps intelligent enough to understand what they have been offered. It is clear that in the Administration's plan, disclosure, no matter how complete, is not enough. The white paper that the Administration circulated before submitting its legislation contains the following language: ``Even if disclosures are fully tested and all communications are properly balanced, product complexity itself can lead consumers to make costly errors.'' As a result, under the proposed legislation, every provider of a financial service, and that term, incidentally, includes everything from banks to check cashing services, and from furniture rental companies to Western Union, every one of these institutions--not including, incidentally, securities firms or insurance companies, which are also involved in financial activity--is required to offer a plain-vanilla product or service to be defined and approved by the CFPA that will be simpler and entail, ``lower risks'' for consumers. This raises, to me, the obvious question. Once the CFPA has prescribed a simpler and lower-risk mortgage, who will be eligible to buy the more complex product that is tailored to a consumer's particular needs? In effect, this question places on the provider the burden of deciding which of his customers is qualified for the more complex or riskier product. Going beyond the plain-vanilla product will entail risks for the provider, who could face an enforcement proceeding and a fine from the CFPA, action by a State Attorney General or a State Consumer Protection Agency also to enforce the CFPA's regulations, and a class action by disgruntled consumers who claim they did not understand the risks associated with the nonplain-vanilla product. As the white paper states, the CFPA should be authorized to use a variety of measures to help ensure that nonplain-vanilla mortgages were obtained only by consumers who understood the risks and could manage them. How would a provider determine whether a product with more features than the plain-vanilla product is suitable for a particular consumer? The white paper suggests that the CFPA could, ``require providers to have applicants fill out financial experience questionnaires.'' This will be a humiliating experience for anyone, especially a consumer whose credit record up to that point has been completely unblemished. It is not a question of what he can afford, but what he can understand, a much more difficult question. These elements are troubling enough, but this regime will be bad for all consumers. Product innovation will be stymied. Product variety will be diminished. Costs of credit will rise, and many small credit providers, small stores, finance companies, and others will have to leave the market. This will reduce competition and in some cases eliminate the only sources of credit for some consumers. So those who will be able to get these more complex plain-vanilla products--more products than are plain vanilla--who are these people? Not ordinary Americans, in my view, whose lack of demonstrable financial sophistication will make the risks of selling to them very difficult for most providers. The more complex products, the ones with useful features, will be offered only to the more sophisticated and the better educated, in other words, to the Nation's elites. In this way and for the first time in our history, it will be Government policy to deny products and services to a large proportion of the population, not because the products and services are inherently dangerous, like drugs or explosives, but because this Administration apparently believes that no amount of disclosure can make some Americans capable of understanding what they are buying. Thank you. Senator Reed. Thank you, Mr. Wallison. Professor. STATEMENT OF SENDHIL MULLAINATHAN, PROFESSOR OF ECONOMICS, CHRG-111hhrg74090--202 Mr. Cox," Thank you, Ranking Member Radanovich. I will respond to that by also responding to Mr. Stinebert's earlier comment, that we all agree that the regulation that was there was an enforcement problem. We don't all agree on that, and here is--the problem had two parts to it if you want to break it into its grossest problem. The first part was the type of products that were being sold. They were simply way too high risk, way too complex and way too aggressively sold for average consumers to work through all the problems and understand all the costs and consequences and the context of these mortgages. For instance, held up at the time as the great financial innovation, the payment option ARM, it was sold so aggressively on its benefits but its risks were not clear to the average consumer, to my aunt. You know, it was the kind of thing I could have sold her on if I was an evil person without informing her of the risks. So there is a product regulation problem that existed here. The Fed, if you read the Fed's papers during this time and you put them right next to the industry's papers, you could change the titles and you couldn't tell the difference. There was one type of thinking. That needs to change. The second problem was a fraud problem. The fraud problem got so far out of control, I have never seen anything like it. You know, if you were talking to the people and you saw this going on, if you talked to the ex-workers in these agencies, et cetera, in these companies that were selling these things, fraud was so rampant in this industry that, you know, that was almost a separate problem from the product regulation problem, and so we also had a lack of enforcement, particularly at the federal level, you know, on fraud but we fundamentally had a product regulation problem. I hope that responds. " CHRG-111shrg50815--91 Mr. Zywicki," Thank you for that. First, Senator Tester is leaving. I will just note that with respect to the cost of credit card operations, the cost of funds are about 30 to 40 percent of total costs. Charge-offs are about 30 to 40 percent, and operating costs are about 20 to 30 percent. So the reason we don't is exactly as Mr. Clayton was saying. The reason is when charge-offs go up and risk goes up, the amount that goes obviously to charge-offs goes up and so that dampens any interest-rate effect. So I just thought that would be some facts to put on the record. And I appreciate your question, Senator, because I think it is the most important question here and one that is worth focusing on. This is about complexity, right? These are very complex products. They do have a lot of price points that can confuse consumers. But the reason they are complex is precisely because consumers use these in so many different ways. They use an auto loan to buy a car. They use a mortgage to buy a house. They use a credit card to do a cash advance, to make a purchase, to revolve debt, to travel to Europe, to do all the different sorts of things that they do with it. So there are a lot of price points, but it is precisely because of the myriad different ways in which consumers use these products. We do need a better way of dealing with this. The market is already ahead of us. There is a new Web site called Cardhub.com. I have nothing to do with Cardhub.com. What Cardhub.com is is a Web site you can go to and you can basically get tailormade disclosures. You could say, I am interested in a card that has no annual fee, low transaction fees for travel to Europe, and gas benefits when I use my card, and they have about 1,000 credit cards in their system and you can basically create a tailormade disclosure for exactly the fees that you are looking for. What I get concerned about this is that we take a one-size-fits-all proposal and put it on top of a market where consumers are using cards for all myriad sorts of things. So regulation, I hope, can encourage and be a mechanism for encouraging further innovation, development in these cards, and allowing consumers to get what they want. If I could just add one last fact---- Senator Merkley. One quick point. Go ahead. " CHRG-111hhrg53241--2 The Chairman," The hearing will come to order. We are here today for the second day of hearings on the Administration's proposal for a change in the regulatory structure, and in particular today, we have advocacy groups of various sorts that have focused on consumer civil rights and community economic concerns. All of the issues that are embodied in this are before us. As was the case yesterday, I think we probably have some particular interest among many of the witnesses today in the proposed consumer agency, but, as I said, all of the various aspects of that are before us. I will begin. We will have 10 minutes of opening statements on each side and then proceed with our panel. The need for regulation seems clear, and I think we should understand that this is, to a great extent, part of a historical pattern. We have a private sector economy in which the private sector generates wealth, and we are all supportive of that. There is constant innovation in the private sector, as there should be. At certain points in history, the level of innovation reaches a point where there is almost a qualitative change in the way in which certain institutions function. Now we should be very clear. None of these institutions, none of these new approaches, would survive if they did not add significant value in the society because they are voluntary. And if they did not add value, nobody would participate and provide any funds for them. The problem comes when they innovate, provide a great deal of benefit, but precisely because they are innovative, occur in a regulatory vacuum. There are no rules, and the free market clearly needs rules to function well. Rules to give investors, the people who will be making the money available, some confidence. Rules to protect the great majority of people in the business who want to be honest and follow all the rules from those who don't. We had a situation in the late 19th Century where the innovation was large industrial enterprises. If you looked at the structure of American enterprise in the 1880's and 1890's, it was very different than it was in the 1940's and 1950's. It was larger. Those large enterprises were good, because you could not have had the degree of industrialization and wealth creation that we have had without them. But they operated in a regulatory vacuum. So after the creation of the large enterprises in the latter part of the 19th Century, you had Woodrow Wilson and Theodore Roosevelt, in reverse order, adopting rules, the Federal Trade Commission, the Federal Reserve system, antitrust acts to try to preserve the benefit of those large institutions without much of the harm. That worked pretty well but it, in turn, led to another situation where the newest innovation in terms of its impact was the stock market, because with large enterprises, you could not have individually financed entities or family financed entities. You needed a stock market. The stock market, obviously, did a lot of good, but it caused a lot of problems because there were no regulations. So in the New Deal you saw regulations both in the banking industry and of the equity industry. That worked for a long period of time. Beginning in the 1980's, into the 1990's, and culminating in this past decade, a new round of innovations came up. Banks became less important, because there were ways for people to aggregate the money and lend it out outside of banks. So bank regulation covered less and less of the activity. Securitization came into being, which meant that the discipline that came from the lender/borrower relationship eroded. Derivatives were created without an adequate regulatory structure. I think we are in the third of those periods that I just mentioned, where innovation that essentially does a lot of good outstripped regulation by definition. And our job is to try to fashion regulations with regard to derivatives; with regard to excessive leverage; with regard to loan originations by people who have no economic interest in their being repaid; with regard to the model in which so many mortgages--such a large part of the economy--are held in a split fashion, where there are those with ownership interest and those with the control of the instrument and they are not always able to work together. And it is not that we have had innovations that are bad. It is that innovations by definition are unregulated. The lack of regulation I believe has caused serious problems. And our job is, as it was for Woodrow Wilson, Franklin Roosevelt, and Theodore Roosevelt, to come up with rules that minimize the damage while maximizing the benefit. Now I know--let me say in closing--there were those who tell us we will be killing off the innovations by doing this. I can save them the time. They don't have to write these speeches. They can go back to 1902 and 1903 and dig out what people said about Theodore Roosevelt and then later about Woodrow Wilson, and they can go back to 1933 and 1934 and be right here in the Congressional Record, and they can get all the speeches about how regulation will inherently kill off these activities. Yes, excessive regulation and incompetent regulation and foolish regulation can do that, but well-done regulation, as it did under Theodore Roosevelt and Woodrow Wilson and as it did under Franklin Roosevelt, can help, and that is what we intend to try to do today. The gentleman from California is recognized for 4 minutes. " CHRG-111hhrg51698--120 Mr. Duffy," I didn't have a chance to answer the Congressman. I think it is important for the record that I do so, right, because he talked about not having credit default swaps around or anywhere else as of 10 or 11 years ago, and that is absolutely true. But you also have to remember that product innovation in financial services is as critical as it is to research and development of any other business. So in order for economies to grow, we need to have new products that people can manage their risk properly with that to help us continue to grow and bring us into new centuries. So, that is really important for product innovation to move forward. And as far as rampant speculation, when you look at regulated exchanges with limits proposed on their trading, spending a big part of a portion of their own budgets--we are public companies--to make certain that we don't have rampant speculation that could turn into manipulation, it is critically important to the success of any publicly traded company such as CME Group. So, no, we don't condone excessive speculation or rampant speculation, as you put it, sir, but we do believe that there is a buyer for every seller, a seller for every buyer. The more liquidity there is, the better price the person that is trying to hedge their risk will get for the product. Thank you, Mr. Chairman. " CHRG-111hhrg52406--173 Mr. Paulsen," And just to follow up. One of the concerns I have, and I just spoke yesterday to a community banker in my district, and he said he is going through an audit process right now. And the folks who are in his building are looking at--just a small community bank. I thought maybe he would have 3 or 4 regulators who are going through the books and the audit; 17 people are in there going through the books from top to bottom. And that is a huge drain on resources. Obviously regulation is important, but 17 people. And to think that we potentially are going to add another layer on top of that is of a concern to me. And I guess it is important to focus again on safety and soundness, but at a time I think in the market right now we need innovative products, we need to allow the financial community to provide for innovation, I am really concerned that this may hamstring that ability. Ms. Seidman. Can I raise an issue? I don't think anybody would create our bank regulatory system if they were starting from scratch for many of the reasons you just described. But Mr. Yingling listed all of the different rules that you have to go through with respect to account opening. Those rules are generated by a whole bunch of different agencies. One of the points of this proposal is to have them generated by one agency. " 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-111shrg55117--75 Mr. Bernanke," By the private sector. But we would have to be also careful to make sure that that didn't eliminate or create a regulatory danger in some sense to legitimate products that are not the basic product but still have appropriate features that are good for some borrowers. So we don't want to--we want to make sure that simple, straightforward products are available, but we don't--on the other hand, we certainly don't want to roll back all of the innovation in financial markets that has taken place over the past three decades or so. Senator Corker. A very tactful answer, but the fact is, you believe that that should reside in the private sector and not be administered through the public sector? " CHRG-111hhrg53248--97 Secretary Geithner," We are again--we are pretty clear in the language we put out in our draft proposal. And again we are happy to--obviously we are happy to look for ways to make that clear and better. But we are largely going to rely on disclosure and penalties against fraud to provide the protections against the risks that future innovation in these areas imperils the system. But I think that in this area we very much share your objective in trying to make sure we are preserving the capacity for competition of products and for innovation in products. That is very important to us. This is one of the great strengths of our system. We just let it get a little too far away from any basic sense of gravity and we need to bring that balance back a little bit. But I very much share the objective of preserving competition and product innovation but within a better framework of protection against fraud and predation. " CHRG-110hhrg46593--64 Mrs. Maloney," Thank you, Mr. Chairman. First, I would like to thank all the panelists for your leadership in stabilizing our financial markets. And I congratulate Chairman Bair on an innovative program to help people stay in their homes, if it was expanded. She testified that 1.5 million people could be kept in their homes without a financial loss to this Nation, therefore helping to stabilize our economy, which is now our major concern. Chairman Bernanke, would you favor her program? Would you use TARP funds to expand FDIC's loan modification program to help stabilize our economy and help people stay in their homes? " CHRG-110hhrg41184--98 Mr. Bachus," Thank you. Chairman Bernanke, have the markets repriced risk? Where do we stand there? You know, we talked about the complex financial instruments. " CHRG-111shrg54789--40 Mr. Barr," You have to offer the standard product if you are going to offer the exotic product. Senator Corker. OK. Well, I think my time is up, but I think what you have just said, again, is that smaller innovative companies that want to enter a market, which is what our country is about as it relates to innovation--that is why we are the leader that we are in the world. You are basically saying that these entities, unless they offer other standard products, would not be able to be in business. That is a large departure from where we have been as a country, and I want to revisit that with you. And I thank you for your service and your testimony. " CHRG-111hhrg48867--227 Mr. Wallison," Because regulation imposes costs, it suppresses innovation, it reduces competition, all of the things which make our system work better. " CHRG-110hhrg46591--250 Mr. Ryan," The answer is yes. One comment: Clearly, from our perspective, financial engineering was taken to a level of complexity that was unsustainable. We know that 2 years from now, you are not going to have hearings where you are talking about CDOs and some of the other things that Ed talked about--SIVs and different off-balance-sheet vehicles. Clearly, the industry and the country and, in fact, the financial market participants around the globe have seen that the complexity is just too much, so we are all focused on what we can do that makes sense. We are all focused on the critical element in financial markets, which is confidence. Right now people lack confidence. That is what is reflected in the volatility in the markets, and we need to fix that. So we are very, very focused globally within this industry on fixing it. " CHRG-111hhrg53238--36 Mr. Courson," Thank you, Mr. Chairman. Let me say from the outset that MBA supports regulatory modernization and strengthening our consumer protections. Our country's economic crisis gives us a once-in-a-generation opportunity to really improve the regulation of our mortgage markets. These improvements to the financial regulatory structure will have a profound effect on the availability and affordability of mortgage financing. We believe they must be judiciously considered so reform is done right. Today's financial regulatory system is a patchwork of State and Federal laws. While MBA strongly supports the Congress' and the Administration's efforts to improve this system, having reviewed these proposals through the prism of our regulatory modernization principles, we do have some concerns. MBA's principles include that all parts of financial services regulation must be addressed comprehensively and regulatory changes should focus on substance, not form. Uniformity and oversight and interpretation of standards should also be promoted whenever possible. Collaboration among regulators and transparency should be required. Appropriate borrower protections must be balanced with the opportunities for the industry to compete and to innovate. Finally, attention must be given to ensure the continued availability and affordability of sustainable mortgage options. With these points to guide our analysis, MBA has the following concerns about the creation of a consumer financial protection agency. Establishing a new consumer protection regulator, while also maintaining the authority at existing regulators, may actually weaken consumer protections by disbursing regulatory power and removing consumer protection from the mainstream of the regulators' focus. In addition, CFPA may result in a worse patchwork of Federal and State laws as well as uneven protection and increased costs for consumers. To truly protect consumers, we need greater uniformity. Additionally, while the proposal suggests that HUD and the Federal Reserve work together to achieve a single combined RESPA/TILA of disclosure or have it become the responsibility of CFPA, the bill does not require such collaboration as this committee directed in the mortgage reform bill, which passed this House in May. And borrower protections offered in H.R. 3126 could stem competition and innovation. If saddled with responsibilities across the spectrum of financial products, CFPA could fail to give proper attention to the biggest asset most families purchase: a home. Because the new regulator would not be solely focused on mortgage regulation, there is a danger that mortgage products may not receive sufficient priority. To respond to these issues, MBA believes there are better alternatives for improving consumer protections. With our expertise in the mortgage markets, MBA has developed a groundbreaking proposal to protect consumers and improve the system that regulates mortgage finance. We call it the Mortgage Improvement and Regulation Act. It would provide uniform standards, consistent regulation for all mortgage lending. MIRA would improve the regulatory process to include more rigorous standards for lenders and investors and equally clear protections for consumers. Instead of adding duplicative regulation at the Federal level, it would fill gaps in regulation of nondepository lenders and mortgage brokers, providing them with a Federal regulator, streamline regulation, and would enhance enforcement. MIRA could easily be part of a more comprehensive regulatory modernization effort. More importantly, it would ensure that consumers are provided mortgage financing and protection from abuse. We hope the committee will consider our MIRA proposal as part of its regulatory modernization efforts. Mr. Chairman, MBA looks forward to working with the committee on new consumer protection and regulatory modernization legislation as these proposals develop. These are extremely complex and important issues, and we hope the committee will take all of the time it needs to do the right thing. Thank you for this opportunity to testify. [The prepared statement of Mr. Courson can be found on page 111 of the appendix.] " CHRG-111hhrg48873--54 Secretary Geithner," So AIG was able to, as a result of the intervention, to meet a full range of its obligations as a large, complex financial institution. " CHRG-111shrg55278--124 RESPONSES TO WRITTEN QUESTIONS OF SENATOR VITTER FROM MARY L. SCHAPIROQ.1. Ms. Schapiro, in recent months, you stated that the SEC is undertaking a comprehensive reexamination of rule 12b-1 fees. Can you please explain why, when the SEC has so many other important issues facing it, you are directing the SEC's resources to a review of these fees which exist to help millions of small investors have access to ongoing professional financial advice and service?A.1. I have directed the staff to undertake a comprehensive reexamination of rule 12b-1 to help the Commission better understand the impact the rule has on investors and funds and to make recommendations to the Commission regarding the rule. Rule 12b-1, which permits funds to use their assets to pay for distribution costs, was adopted 30 years ago and has not been substantively revised since that time. As a result, certain provisions of the rule likely are outdated and no longer relevant to the way the rule is used today. The amount of 12b-1 fees that shareholders pay through mutual funds has risen from a few million dollars per year in the early 1980s to over $13 billion in 2008. The expanded use and amount of the fees paid pursuant to rule 12b-1 have been a source of concern and controversy for many years. As you note, supporters of the rule argue that 12b-1 fees help small investors to access ongoing professional financial advice and services, and help spur innovation and fund growth. Others, however, have argued that the rule has, among other concerns, led to complex fee structures that make it difficult for investors to evaluate and compare overall costs and services. The results of the staff's reexamination of rule 12b-1 will better inform the Commission as it considers potential updating and reform of this rule that has a substantial impact on fund investors. ------ CHRG-110shrg46629--28 Chairman Bernanke," Senator, let me address the financial side. We have talked about this effect on homeowners. On the financial side, I am not sure there is anything essentially wrong with structured credit products, per se. But what we have learned since early this year is that a lot of the subprime mortgage paper is not as good as was thought originally. And there clearly are going to be significant financial losses associated with defaults and delinquencies on these mortgages. As a result, the credit quality of many of the structured projects that include in them substantial amounts of subprime mortgage paper is being downgraded. The one issue is that the structured credit products are quite complex. They include many different kinds of assets. Then the risks are divided up in different so-called ``tranches.'' So it takes quite a complex model or analysis to determine what the real value of these things is. Senator Shelby. But the value seems to be going down instead of up. " CHRG-110hhrg44900--22 Secretary Paulson," Mr. Chairman, let me respond by saying first of all, the role of the Fed as a macro stability regulator will take time to think through. It's a complex question. It's an important question. The authorities that will go with that, how that will work. That will clearly take some time to consider and to get the legislation through. Even more pressing is--which is again a complex issue which will take time--is the issue of the resolution process and procedures for complex financial institutions that aren't federally insured. We both talked about that. And so in terms of priorities, that should be even the higher priority in terms of time. But that will take some time. I think what you are getting at is even though our system may not optimal, the authorities may not be optimal, we have been able to work together to protect the system by communicating with Congress, and that's our plan and our expectation that we are going to need to keep doing that, and we are going to work in that way, recognizing that the requests we have made are not things that can be implemented immediately. " CHRG-111hhrg52406--3 Mr. Bachus," I thank the chairman. Mr. Chairman, today we are having a hearing on the creation of an independent consumer protection, or Consumer Financial Protection Agency. And there is no question that consumer protection is a legitimate government responsibility. However, there is and needs to be a serious dialogue over how that function should be properly undertaken to be effective. The proposal that was outlined in the Administration's White Paper proposes very fundamental and profound changes to the current financial regulatory regime. We have to ask ourselves whether those changes have the potential to reduce consumer choice, limit innovation, and exacerbate the credit crunch that consumers and small businesses are currently facing. When you tell people that they cannot make certain loans, then it always has the potential to restrict credit. The House Republicans have offered a consumer protection plan that closes gaps in the enforcement of our present consumer protection laws by consolidating the regulatory enforcement and consumer protection functions in a single agency and streamlining the complaint process for consumers and investors. It would also strengthen antifraud enforcement by giving regulators more investigative and enforcement tools. The Republican consumer protection proposal is built on the premise that the best way to protect consumers is not through creation of another bureaucracy accountable to no one, but by consolidating the regulatory system in place today and holding regulators accountable for both consumer protection and safety and soundness. Probably my main question early on is the wisdom of bifurcating consumer protection and safety and soundness regulation as is suggested in the Administration's proposal. I am not the only one who has raised these concerns. A Virginia Democrat, Mark Warner of the Senate Banking Committee said, ``I need some more convincing of the creation of this Consumer Protection Agency. Will this new consumer agency have the knowledge because it won't have the kind of day-to-day exposure to financial products or the industry if this agency was actually housed inside the day-to-day prudential regulator.'' Mr. Chairman, I look forward to working with you and the Administration to develop a consumer protection framework that fosters innovation in financial products, and benefits and protects consumers without creating unintended potentially adverse consequences for consumers and the financial services industry. I also thank Congressman Delahunt for his work on the issue. " CHRG-111hhrg53021--219 Secretary Geithner," Congressman, if we were proposing that, what you described, you would be right to be concerned and I would not support a proposal described as you did. What we are proposing to do is to take the basic framework that the Congress legislated to allow the country to deal with risks to the financial system posed by the failure of banks and thrifts, and to adapt that framework to give us similar authority to deal with a large complex financial institution. The absence of that framework and that authority was enormously damaging to this country. We are going to take a framework that was carefully designed by the Congress, with good checks and balances, lots of experience over time, and simply adapt that framework to give us similar tools to help manage the unwinding and the failure of large complex institutions. That is the proposal. Again, there is--the virtue of using the model we have, which is the FDIC resolution framework, is that that has been tested, people understand its merits and complexity, and gives us a little bit better basis for finding consensus on the right approach. " CHRG-111hhrg53021Oth--219 Secretary Geithner," Congressman, if we were proposing that, what you described, you would be right to be concerned and I would not support a proposal described as you did. What we are proposing to do is to take the basic framework that the Congress legislated to allow the country to deal with risks to the financial system posed by the failure of banks and thrifts, and to adapt that framework to give us similar authority to deal with a large complex financial institution. The absence of that framework and that authority was enormously damaging to this country. We are going to take a framework that was carefully designed by the Congress, with good checks and balances, lots of experience over time, and simply adapt that framework to give us similar tools to help manage the unwinding and the failure of large complex institutions. That is the proposal. Again, there is--the virtue of using the model we have, which is the FDIC resolution framework, is that that has been tested, people understand its merits and complexity, and gives us a little bit better basis for finding consensus on the right approach. " CHRG-111hhrg56766--64 Mr. Bernanke," One of the issues that we will have to address, for example, if the regulators agree there should be additional capital on systemically risky firms, then the question will be how to identify those firms. Presumably, we will look at things like their size, their complexity, their interconnectedness, and the kinds of services they provide to the financial system. We have not addressed that question. We do not have a list or anything like that. It is also possible we might want to do it in kind of a gradated way so that the bigger and more complex the firm, the more capital it needs to hold, as protection for the system, so we do not have the ``too-big-to-fail'' problem that Congressman Paul was talking about. " CHRG-110hhrg46591--242 Mr. Bartlett," Congresswoman, there is one lesson that we have studied a lot in the last 3 years from Europe and from FSA, the Financial Supervisory Authority, and that was to use guiding principles or principles for regulation in order to write your regulations. This does not eliminate regulations. The regulations are still there, but it is to create some uniform principles. When we looked at the roundtable, it is like the weather in Texas. Everybody wants to complain about it, but nobody wants to do anything about it. So everybody wants to talk about principles, and nobody wants to write them down. We wrote them down, and I will enter them into the record. Our conclusion was that there should be six, by statute, that this Congress should adopt as the guiding principles for regulations. They would include fair treatment for customers, stable and secure financial markets, competitive and innovative financial markets, proportionate risk-based regulation, prudential supervision, and responsible and accountable management. I would offer that had those been in place for the recent round prior to the crisis, things would have been a lot different and a lot better. " 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-111hhrg51698--52 Mr. Cota," Let me be very brief. These are very complex financial instruments; and, to the extent that they are complex, don't just give up and let it pass. It is the scale of these that are staggering. The estimate for the credit default swaps is somewhere between $40 and $60 trillion of value. If you add in the other derivatives that may apply under this regulation, it could be as high as $500 trillion, according to some news reports. Those are so many times the size of the U.S. GDP or even world GDP that it is so significant that it needs to be dealt with. And that is where my expertise ends. " CHRG-111hhrg48875--2 The Chairman," The Committee on Financial Services will now convene for the purpose of the hearing with Secretary Geithner. I have an announcement to make regarding the order on the Democratic side when Mr. Geithner and Mr. Bernanke were here the day before yesterday; and, I apologize for not having Mr. Geithner here on Wednesday, but sometimes we have to do other things. The following Members on the Democratic side were here at a time when he and Mr. Bernanke had to leave, and I said at the time that they would get priority in questioning. After myself and the chairman of the subcommittee, we would go to the following Democrats: Let me just read them in the normal, seniority order: Mr. Ellison; Mr. Scott; Mr. Green; Ms. Kilroy; Mr. Donnelly; Mr. Klein; and Mr. Grayson. They will be the first ones to ask questions. . We will now proceed to the opening statements using the rules for hearings with a Cabinet member. The rules are 5 minutes for the chair and the ranking member; 3 minutes for the chair and ranking members of the subcommittee, and I apologize for the disruption of the transition. We will now begin. I think the announcements are over. We have before us the job of dealing with whether or not there is existing in the Federal Government today sufficient authority to deal with systemic risk. There are several aspects to that. We talked considerably about one of them on Tuesday with the Chairman of the Federal Reserve and the Secretary of the Treasury; namely, the need to have somewhere in the Federal Government the ability to use the bankruptcy authority given by the U.S. Constitution to wind down an important, non-bank, financial institution. We have long had in our laws an adaptation to bankruptcy to wind down banks; and, when banks have failed, while it has been sometimes painful, it has not been as disruptive as when the non-bank financial institutions have failed. The two glaring examples are Lehman Brothers, where nothing was done, and AIG, where everything was done. I believe we are looking for an alternative method to avoid those two polar extremes. That is, a bankruptcy authority which can honor some and not honor others. It has some discretion. The question of compensation is part of that, as is the question of whether or not people should continue to be allowed to securitize 100 percent of loans. Today--although obviously members are free to bring up whatever they wish--our focus will be on whether we need to increase the authority of some entity or entities in the Federal Government to restrict excessive leverage. We are talking in the resolving authority about what happens when there is a failure on the part of an institution that is so heavily indebted to so many parties that simply allowing it to fail without intervention could cause magnifying, negative effects. But, obviously, the preferential situation would be to keep that from happening, and this subsumes a lot of other issues, whether or not people are too-big-to-fail, or too-interconnected-to-fail. The goal should be--and obviously no system is going to prevent all failures, because it would then be too restrictive--to minimize the likelihood that entities will get so heavily indebted, so heavily leveraged with inadequate resources in case there is a need to make the payments, that their lack of success threatens the whole system. I believe that we are in a third phase here of a set of phenomena we have seen in American economic history. It is a phenomenon in which the private sector innovates. Innovations which have no real value die of their own weight, but innovations that add value thrive as they should, because we are dependent on the dynamism of the private sector to increase our wealth. But, by definition, when this comes from significant innovation, there aren't rules that contained abuses. The goal of public policy is to come up with rules that set a fair playing field that constrains abuses, and that protects legitimate and responsible entities from irresponsible competition, that can draw them away from good practices, while having as little effect as possible on diminishing the value. Thus, in the late 19th Century, the trusts were created, and they were very important. We would not have industrialized without those large enterprises such as oil, coal, and steel, and a number of other areas. But because they were new, the operated without restraint, so Theodore Roosevelt and Woodrow Wilson were more help, I think, than they get credit for from William Howard Taft. Set rules, the Antitrust Act, the Federal Trade Commission, the creation of the Federal Reserve, those were rules that tried to preserve the large industrial enterprises. Indeed, they were people who tried to get Woodrow Wilson to break them up. And he said, ``No.'' They gave a valuator that we need, but we need rules. That led to a great increase in the importance of the stock market, because you now had enterprises that could not be financed individually. And the job of Franklin Roosevelt and his colleagues during the 1930's was to set rules that allowed us to get the benefit of the finance capitalism, the stock market, but curtailed some of the abuses. I believe that securitization and the great increase in the ability to send money around the world that comes from both the pools of liquidity and the technology, CDOs and credit default swaps, these are a set of innovations on a par with the earlier set, and they have had great value. Securitization, which allows money to be relent and relent and relent without it all having to be repaid, greatly magnifies the value of money; but, there are problems, as there were with the trusts or with the stock market when there are no rules. Our job is to craft rules as did Theodore Roosevelt, Woodrow Wilson and Franklin Roosevelt that allow the society to get the benefit of these wonderful, value-added financial innovations while curtailing some of the abuses. The gentleman from Alabama. " FOMC20080318meeting--45 43,MR. EVANS.," Dave, my question is basically about the influence of the financial stress on the outlook. I was talking to an official at the Bank of Canada last week, and she had an intriguing calibration by which she said that, since last August, they thought that financial stress for Canada was worth about 25 basis points of restraint at the outset and now they thought it was more like 50 basis points for their economy, which is doing quite well. I guess the impossible question is, Have you thought about that type of calculation and how it influences the way we think about interest rates for your forecast? The way that I am thinking about this and that President Lacker and others have thought about this is that we are trying to separate the effects of standard monetary policy and of the innovative policies. Any separation that affects financial markets directly helps us think about the more normal calibration of policy. But, of course, with financial stress we have these add-on effects. So that is why I think that would be interesting. " CHRG-111hhrg51698--160 Mr. Gooch," The insurance companies did historically for a long time sell debt insurance, but it is not a dynamic marketplace. You can get the debt insurance on an entire issue from an insurance company, but you don't have the ability, therefore, to tap additional pools of capital that are willing to effectively be synthetic lenders if you restrict it to just insurance companies. What I would say has occurred, in that respect, is that this is innovation in the marketplace. Throughout history we have had innovation. We had stock market crashes in the 1920s. We had the introduction of futures in the early 1970s. The over-the-counter markets are five times as big as the future markets. This is all innovation that has helped contribute to the prosperity of the free world. That is why I am a free marketeer. Now I do recognize that there is always the time in any free market where you will have certain speculative bubbles. I mean, I do agree with this Committee in looking to bring regulation and transparency to that market. We are totally, 100 percent, in support of transparency and also in order--not order limits but limits on the degree of risk-taking that entities are allowed to take subject to their balance sheets. " FinancialCrisisReport--48 Because of the complex nature of the financial crisis, this chapter concludes with a brief timeline of some key events from 2006 through 2008. The succeeding chapters provide more detailed examinations of the roles of high risk lending, federal regulators, credit ratings agencies, and investment banks in causing the financial crisis. CHRG-110shrg50415--6 STATEMENT OF SENATOR DANIEL AKAKA Senator Akaka. Thank you very much, Mr. Chairman. Thank you for conducting this hearing today. I am hopeful that this hearing will help clear up some misconceptions and help promote a greater understanding of the cause of this financial crisis as we work to reform the financial services regulatory structure. And I thank you for this opportunity, Mr. Chairman. I want to express some of my thoughts thus far on what has been happening. The uninformed have blamed much of the current financial crisis on the Community Reinvestment Act. That is simply not true. The CRA has helped empower individuals in low-income communities by promoting access to mainstream financial services and investment. Instead of finding excuses to stop Federal efforts to expand across to mainstream financial services, we must do more. Low- and moderate-income working families are much better off utilizing mainstream financial service providers rather than unregulated or fringe financial service providers. Working families would have been better off obtaining mortgages from their local financial institutions instead of obtaining mortgages through independent peddlers such as Countrywide. The majority of subprime mortgage lending was done by independent mortgage companies that are not subject to CRA requirements and lacked effective consumer protections. I have greatly appreciated the extraordinary leadership and judgment shown by the Chairman of the Federal Deposit Insurance Corporation, Sheila Bair, during her tenure. I also have highly valued Chairman Bair's efforts to promote financial literacy and address issues so important to working families. Under Chairman Bair's leadership, the FDIC is encouraging the development of affordable, small-dollar loans using CRA initiatives. Working families are exploited by predatory lenders who often charge triple-digit interest rates. As access to legitimate credit tightens, more working families will be susceptible to unscrupulous lenders. We must encourage consumers to utilize the credit unions and banks for affordable small loans. Banks and credit unions have the ability to improve lives of working families by helping them save, invest, and borrow at affordable rates. Repealing or weakening the CRA would be a mistake. Low- and moderate-income families must have greater access to regulated mainstream financial institutions, not less. Critics of the CRA seem to forget that it does not apply to investment banks. Investment banks bought securitized and sold subprime mortgages. The CRA does not apply to credit rating agencies. The CRA does not apply to the sale of derivatives or credit default swaps. These products have contributed significantly to the financial situation that we are in now. The causes of this crisis are complex and cannot simply be blamed on the CRA. Instead of repealing the CRA, we must overhaul and strengthen the regulation of financial services to better protect consumers, protect markets ability, and empower the regulators to be more forward-looking. Instead of just reacting to a crisis, regulators must quickly adapt to the financial service innovations. I thank the witnesses for appearing here today, and I look forward to their testimony, and thank you very much, Mr. Chairman. " 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-111shrg55739--106 Mr. Coffee," I think this is a case where innovation was corrupted. We had a much simpler kind of asset-backed securitization in the 1990s---- Senator Shelby. And it worked, didn't it? " CHRG-111hhrg52397--8 Mr. Bachus," Thank you, Mr. Chairman. Mr. Chairman, I would like to associate myself with the remarks by the subcommittee Chair. Derivatives do help companies manage risk, and I think they are a very valuable thing. Of course, the derivative market is valued notionally at $684 trillion, which is a tremendous amount. And the rapid growth of this market, coupled with the potential for widespread credit defaults and operational problems in the over-the-counter market have led many to conclude that derivatives pose a substantial systemic risks. Therefore, the Treasury released a comprehensive framework for over-the-counter derivatives. In that, they call for financial derivatives suitable for clearing by a federally regulated central counterparty to be placed on registered exchanges. I personally believe that most derivatives, if they are not too highly customized, should be placed in a clearinghouse situation. It helps you identify risk and define risk. And I think from talking to most financial institutions, they know what their risk is between two parties but they sometimes do not know what the party they are dealing with, what their risk with a third party is, and I think that is one of the values of a clearinghouse. You not only have to know what your exposure to each other is, but sometimes what the exposure they have to a third party. The idea I think the Treasury has proposed is really an over-simplification of the use of an exchange and simultaneously may give unsophisticated retail investors a false comfort that their products are now safe for purchase because they have somehow been approved for exchange trading by a government agency. Furthermore, in testimony before the committee in March, the GAO pointed out that some credit default swaps may be too complex or they would be highly tailored even for a clearing, and therefore placing them on an exchange to me would be almost impossible. And it is in those highly complex derivatives that we are going to particularly have a problem. As we move forward with regulatory reform proposals, we should make every effort to strike the right balance between protecting investors and preserving innovation. I think that is where Mr. Garrett and I really agree, that there are already private sector initiatives well underway to clear a standardized derivative contract. A part of that is a response to what we have seen in the last year or two. Some of what we have seen I do not think will take place again because the parties are demanding that. And I think that these are efforts to remind us that market-based solutions are capable of generating the information that investors and companies need to make informed decisions. The last thing Congress should do is prevent new entrance into the derivatives clearing marketplace. In closing, Mr. Chairman, any ban on over-the-counter derivatives would likely harm responsible and well-managed U.S. corporations that use derivatives to hedge against business risks. Restrictions on credit default swap contracts will also limit the ability of investors to appropriately calculate risks as it has become apparent that CDS spreads have become a more accurate reflection of credit risk than even credit ratings. And that is one thing that we have learned in all this is that credit rating agencies were way behind what we were seeing on some of the credit spreads themselves. I appreciate our witnesses testifying. I have some of your testimony and I look forward to, over the next few days, reading the rest of it if I do not hear it. Thank you. " CHRG-111shrg50564--46 Mr. Volcker," No question about that. Senator Warner. You do not want to stifle innovation, but it seems to me that some of these instruments recently were more about fee generation than they were about appropriately pricing risk? " 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. " 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-111shrg53085--199 Mr. Attridge," I agree. It is complex enough now without allowing commercial enterprises to intermingle with the financial institutions. I just think it adds an additional level of risk. I think they have experienced that in Japan and that was one of the problems. " FinancialCrisisInquiry--460 GEORGIOU: Thank you, gentlemen. You know, Mr. Mayo, you said that innovation always outpaces regulation. January 13, 2010 And, Mr. Solomon, you had almost 30 years at Lehman Brothers and sort of hearkened back to the days when all the partners sat in a room and listened to each other make commitments on behalf of the firm and on behalf of each other’s capital, effectively, and that you thought those days the market, in that the partners were unconditionally liable for the commitments that the firm made, was essentially the, you know, the safety valve that prevented people from over committing themselves and putting the whole financial system at risk. Given that today we don’t really have many of those firms that are in the upper levels of the financial marketplace, what can we do and what ought we to be thinking about doing to create market mechanisms that would replicate, if that’s possible, the discipline of the capital that was unconditionally an unlimited liability in the private marketplace? CHRG-111hhrg48875--121 Secretary Geithner," I know there are strong opinions on this issue, so I say this with some trepidation. My own sense is that banning naked default is not necessary and wouldn't help fundamentally in this case. It's too hard to distinguish what's a legitimate hedge that has some economic value from what people might just feel is a speculative bet on some future outcome. If we could find a way to separate those two types of transactions from each other, we could do that--we would have done that a long time ago across a whole range of financial innovations. But it is terribly hard to do, and--but we will listen carefully to any ideas in this area and understand why people feel so strongly about this. " CHRG-111hhrg48875--10 Secretary Geithner," Thank you, Mr. Chairman, Ranking Member Bachus, and other members of the committee. I am pleased to be here before you today, again, and to testify about this critical topic of financial regulatory reform. Now, over the past 18 months, we faced the most severe global financial crisis in generations. Some of the world's largest institutions have failed. Confidence in the overall system has eroded dramatically. As in any financial crisis, the damage falls principally on Main Street. It affects those who are conservative and responsible, not just those who took too much risk. Our system today is wrapped in extraordinary complexity, but beneath it all, financial systems serve an essential and basic function. Institutions and markets transform the earnings and savings of American workers into the loans that finance a first home, a new car, a college education, or a growing business. They exist to allocate savings and investment to their most productive uses. Our financial system still does this better than any financial system in the world, but still our system failed in basic fundamental ways. Compensation practices rewarded short-term profits over long-term return. Pervasive failures in consumer protection left many Americans with obligations they did not understand and could not sustain. The huge, apparent returns to financial activity attracted fraud on a dramatic scale. Market discipline failed to constrain dangerous levels of risk-taking throughout the system. New financial products were created to meet demand from investors, but the complexity out-matched the risk management capabilities of even the most sophisticated institutions in the world. Financial activity migrated outside the banking system, relying on the assumption that liquidity would always be available. Regulated institutions held too little capital relative to their exposure to risk. Supervision and regulation failed to prevent these problems. There were failures where regulation was extensive and failures where it was weak and absent. Now, while supervision and regulation failed to constrain the build-up in leverage and risk, the United States came into this crisis without adequate tools to manage it effectively; and, as I discussed before this committee on Tuesday, U.S. law left regulators without good options for managing the failure of systemically important, large, complex financial institutions. To address this will require comprehensive reform, not modest repairs at the margin, but new rules of the game. And the new rules must be simpler and more effectively enforced. They must produce a more stable system, one that protects consumers and investors, rewards innovation, and is able to adapt and evolve with changes in the structure of our financial system. Our system, the institutions, and the major centralized markets must be strong enough and resilient enough to withstand very sever shocks and withstand the effects of a failure of one or more of the largest institutions. Financial products in institutions should be regulated for the economic function they provide and the risks they present, not the legal form they take. We can't allow institutions to cherry-pick among competing regulators and shift risk to where it faces the lowest standards and weakest constraints. And we need to recognize that risk does not respect national borders. Markets are global and high standards at home need to be complemented by strong international standards enforced more evenly and fairly. Building on these principles, we want to work with Congress to create a more stable system with stronger tools to prevent and manage future crises. And, in this context, my objective today is to concentrate on the substance of reform, rather than the complex and sensitive question of who should be responsible for what. Now, our framework for reform will cover four broad areas: systemic risk; consumer investor protection; eliminating gaps and streamlining our regulatory framework; and international coordination. But today, I want to discuss in greater detail the need to create tools to identify and mitigate system risk, including tools to protect the financial system from the failure of large, complex, financial institutions. Before I go into that, though, I just want to briefly touch on the critical need to reform in these other areas. Weakness in consumer and investor protection harm individuals, undermine trust in our system, and can contribute to the kind of systemic crisis that shakes the foundations of the system. We are developing a strong plan for consumer and investor regulation to simplify financial decisions for households and to protect people much better from unfair and deceptive practices. We have to move to eliminate gaps in coverage, and end the practice of allowing banks and other finance companies to choose the regulator simply by changing their charters. Our regulatory structure must assign clear regulatory authority, resources, and accountability. As I said, we need a simpler, more streamlined, more consolidated, broader supervisory structure; and, to match these increasingly global markets, we must ensure that global standards for regulation are consistent with the highest standards we will be implementing here in the United States. And we have begun to work with our international counterparts to reform and strengthen the role of the financial stability forum and enhancing sound regulation, strong standards, strengthening transparency, and reinforcing the kind of cooperation and collaboration we need. In addition to this, we are going to launch a new initiative to address prudential supervision, tax savings, and money laundering issues in weekly regulated jurisdictions. President Obama will underscore in London on April 2nd at the leaders summit the imperative of raising standards globally and encouraging a race to the top, a race to higher standards, rather than a race to the bottom. Now, on systemic risk, I want to focus on this today, not just because of its obvious importance to our future economic performance, but also because these issues about systemic stability will be at the center of the G-20 summit agenda next week. This crisis has made clear that large, interconnected firms and markets need to be brought within a stronger and more conservative regulatory regime. These standards cannot simply address the soundness of individual institutions, but they must also focus on the stability of the system as a whole. The key elements of our program to reduce systemic risk in our system have six elements. I am going to summarize these briefly. My written statement goes into them in somewhat greater detail, and then I'll conclude and look forward to responding to your questions. Let me just go through these quickly, these six key points: First, we need to establish a single entity with responsibility for systemic stability over the major institutions and critical payment and settlement systems and activities. Second, we need to establish and enforce substantially more capital requirements for institutions that pose potential risk to the stability of the financial system that are designed to dampen rather than amplify financial cycles. Third, leveraged private investment funds with assets under-management over a certain threshold should be required to register with the SEC to provide greater capacity for protecting investors and market integrity. Fourth, we should establish a comprehensive framework of oversight, protections, and disclosure for the OTC derivatives market, moving the standardized parts of those markets to central clearinghouse, and encouraging further use of exchange-traded instruments. Fifth, the SEC should develop strong requirements for money market funds to reduce the risk of rapid withdrawals of funds that could pose greater risks to market functioning. And sixth, as we have all discussed, we need to establish a stronger resolution mechanism that gives the government tools to protect the financial system and the broader economy from the potential failure of large complex financial institutions. Let me just conclude by saying that these are very complicated, very consequential, very difficult sets of questions. You are absolutely right that we have to look at these together. Their interaction is important, and it is very important we have a comprehensive approach. The President has made it clear that we are going to do what is necessary to stabilize this system to get credit flowing again and restore the conditions for a strong economic recovery. And I look forward to working closely with the Congress to modernize our 20th Century regulatory system and put in place a system that meets the needs of our much more complicated, more risky 21st Century financial system. And, working together, I am confident that we have an opportunity we have not had in generations to put in place a stronger, more resilient system. Thank you, Mr. Chairman. [The prepared statement of Secretary Geithner can be found on page 49 of the appendix.] " CHRG-110hhrg46591--454 The Chairman," Well, you have to ask Mr. Greenspan, because he explicitly did. I mean look, this is a deep philosophical approach. Mr. Greenspan explicitly said in Mark Zandi's book, Greenspan's deregulatory failure, it is very clear there were fundamental philosophic issues here. And we are debating--and Mr. McCotter raised it, and Mr. Price raised it in very thoughtful ways. We are now discussing what the role is of regulation. But I agree, I think Mr. Ryan said it best in terms of--and others, and Mr. Yingling and Gramm-Leach-Bliley, this is not a case so much of deregulation as a case of not adopting appropriate new regulations to keep up with innovation. It is not that old rules were dismantled, it is that as the system innovated, appropriate new rules were not adopted. And that is what we need to do. But I do want to say on subprime we were looking at it from the systemic point of view as well as the consumer protection. " CHRG-110hhrg44903--162 Mr. Lynch," Thank you, Mr. Chairman. Let me go one step further, and this is sort of related to the chairman's question about investor protection. I agree that we need a strong regulator. But I also believe that some of these instruments, as you said in your opening statement, Mr. Geithner, that our current laws and regulations were put in place when we had a much different market. And they don't necessarily address the situation we have today. I think one of the fundamental needs of our reform system, and I wish it was in one of your lists, is basic understanding within the market, by the market, by the individual investor. And it is great to have a policeman in the background of a strong regulator. But the best protection would be allowing the investor to protect themselves. And I have to tell you, I think Warren Buffett was right. He calls some of these complex derivatives the financial weapons of mass destruction, and he predicted this whole fallout. These complex instruments, the CDOs, the credit default swaps, these complex derivatives, based on models are so complex, our own rating agencies couldn't figure out who owned what or how to value them. And when I asked Mr. Bernanke at our most recent hearing who was addressing this, he indicated that you were, Mr. Geithner. So I hope he wasn't throwing you under the bus. Can you tell me what we are doing to just equip the investor with the ability to make those smart determinations on their own? " CHRG-111shrg50564--58 Mr. Volcker," Well, we have got a lot of rhetoric in this report about the importance of risk management and trying to deal with the problem you have and the failures of risk management in our leading financial institutions--partly, and importantly, because the complexity became so great that we lost sight of how to measure the risk. Now, I have got a point of view on this, but the markets were taken over by financial engineers. They were mathematicians. They were not market people. They somehow thought that financial markets would follow the laws of physics or some natural law and everybody had a nice, normal distribution curve. And they kept being surprised by outlying events. Well, they seemed outlying if you thought of the world of a normal distribution curve, but that is not the world of finance that I know. Financial markets are affected today by what happened yesterday, and what is happening right now affects thinking and affects what happens tomorrow. So you get people going to extremes in both directions. And these financial engineers kind of thought that they had the answer to how to measure risk and take care of it. Things were very complex. When you mixed together these enormous compensation practices, the enormous gains possible, with obscure financial engineering, you had a recipe for extremes, I think, that kind of came back to haunt us. Senator Johanns. If I might just---- " FinancialCrisisInquiry--128 I’d say innovation always outpaces regulation, but in this case, it was just much further ahead. And, you know, you certainly need more capital for newer activities or more risky activities or other activities without a long enough track record. And you saw that. And, as Mr. Solomon said, we’ve had a lot of once-in-a-lifetime events. And you—you know, whether it’s Enron and WorldCom or Russia and Asia and Mexico or, you know, the tech bubble and then the real estate bubble. It seems as though these once-in-a- lifetime events happen every couple of years. So the idea of more capital overall makes a lot of sense for these once-in-a-lifetime events for these new activities. And as far as additional disclosure, no question. It would have been very helpful during the crisis and would still be helpful now especially with regard to problem loans at U.S. banks. I would make one point, though. We can’t be too pro-cyclical. If you try to correct all at once, then you’re going to kill the economy. So you have to do this in a balanced way. VICE CHAIRMAN THOMAS: A question to all of you, and it’s just from my previous job on Ways and Means and the tax code. Would it make a big difference, not much difference, if we had in the time of all of these once-in-a-lifetime events, a better understanding between equity and debt and the way in which major American corporations and even international corporations can utilize debt versus equity? And had we recognized it in the tax code, that, to a certain extent, the old cash-on-the-barrel head is, perhaps, a good way to see what’s going on, notwithstanding the complexity of the world today? FinancialCrisisInquiry--19 Morgan Stanley is also doing its part to get our economy moving again. We are working with businesses to raise capital to invest in job growth. We are working with families to modify mortgages we service so families can stay in their homes. By the end of November ‘09, Morgan Stanley’s loan servicing subsidiary had active trial modifications in place for 44 percent of borrowers who are over 60 days delinquent and eligible for the administration’s Home Affordable Modification Program. This was the highest percentage of any servicer participating in the HAMP program. We believe this is both business imperative and public important. The financial crisis laid bare the failures of risk management of individual firms across the industry and around the world, but also made clear that regulators simply don’t have the tools or the authority to protect the stability of the financial system as a whole. That’s why I believe we need a systemic risk regulator with the ability to ensure that excessive risk taking never again jeopardizes the entire financial system. We cannot and should not take risk out of the system. That’s what drives the engine of our capitalist economy. But no firm should be considered too-big-to-fail. The complexity of the financial markets, financial products exploded in recent years, but it’s clear that regulation and oversight have not kept pace. While many of these complex products were designed to spread out risk, they’ve often had just the opposite effect, obscuring where and to what degree that risk was concentrated. Regulators and investors need to have a fuller and clearer picture of the risk posed by increasingly complex products as well as their true value. We should also aim to make more financial products fungible to ensure they can be transferred from one exchange or electronic trading system to another. I believe we need to establish a federally regulated clearing house for derivatives or requiring reporting to a central repository. This will create truly efficient, effective, and competitive markets in futures and derivatives which would benefit investors and the industry as a whole. CHRG-111shrg53085--131 Mr. Patterson," I think that is a reasonable presumption and it obviously has---- Senator Menendez. Has not worked. " Mr. Patterson," ----the issues that it has created. Senator Menendez. Ms. Hillebrand, if you want to comment on this. I also want to ask you, much of our discussion of regulatory reform has talked about systemic risk. It has talked about complicated financial instruments that pose a threat to institutions and investors. But isn't it equally important to recognize that maybe the earliest and most fundamental failure that led to our current crisis in which--and it was a much simpler failure--is a lack of consumer protection. Ms. Hillebrand. Yes, Senator, absolutely. These bad mortgages--the bad practices in subprime were not new. They used to be called hard money loans. The theory was you could make money by loaning to someone who you had no reasonable expectation they would be able to repay. When that migrated into securitization, then it started to touch the whole economy, and we certainly saw it in nonprime with the no-doc loans. This little failure that first affected poor people and working class people and their neighborhoods suddenly kind of took off because it wasn't stamped out early. We don't know what the next little failure that could grow into a forest fire will be, but we know there will be one. Some innovation is toxic and early is the time when we need to address it. On the issue of have we already failed if an entity is too big to fail, I think the answer is yes and the question is what do we do from here. Part of it is we have to figure out how to make these entities whose complexity creates a risk for those of us who don't own them and are not their bond holders, but just taxpayers, to carry that risk themselves, to put that into their cost structure. If it is too expensive to internalize those risks, then that means that we need smaller institutions. And I am very intrigued by the ICBA suggestion that no further mergers be approved that involve institutions--involve or would create institutions--that are too big to fail. Senator Menendez. To some degree, in this present market that we are in, where we see one of the first things that happened in the first tranche of TARP was, in fact, the purchase of other institutions, and therefore more consolidation in the marketplace. Isn't that something that we should be concerned about as we look forward in terms of these set of circumstances. " CHRG-111hhrg55809--3 Mr. Bachus," Thank you, Mr. Chairman. First of all, Mr. Chairman, let me respond to say that we do not object to consumer protection being removed from the Federal Reserve. What we do object to and what we strenuously think would be a mistake is what you do with consumer protection, and that is you vest it in a new government agency and you give it tremendous power not only to protect the consumer, but you also give it power to design financial products. You give it power to dictate terms on financial agreements. You give it power to limit choice. You give it power to restrict competition. And by giving it the power to approve new products, you completely stifle innovation. America didn't get to be the largest economy in the world, 3 times bigger than the next biggest economy, by taking away individual choice, by stifling innovation, and by putting government in the business of managing financial services and making choices for both institutions and individuals. So I am sorry that we have had a miscommunication, but our objection is that you have a tremendous shift of responsibility from individuals and institutions to the government. We also object and, Chairman Bernanke, we have strenuously objected to something else, and that is vesting in the Federal Reserve the right to bail out individual non-bank financial institutions. We believe that the FDIC has the power to resolve banks through their statutory authority, but we think that is to protect depositors and not to protect the bank, its shareholders, or to protect it from risky investors. Now in the remaining time I have left, let me tell you something else that we have a great unease about. I believe it was in March of last year, not September, that I had conversations with you and Secretary Paulson; and at that time, you actually expressed tremendous concern about the overextension of debt and of leverage. And I think there was a real concern on the part of a lot of people, whether this deleveraging and constriction of debt could be done in an orderly way. So there was some forewarning of what we saw in September, I think, starting with Bear Stearns. But, I am not sure that even until this very day we have identified exactly what caused the events of last year and how to address it. Instead, we have had, almost with light speed, the Obama Administration propose a sweeping change in financial regulation, which includes and continues to include as late as this month the possibility that the Treasury would spend a trillion dollars to bail out another non-bank financial institution. Chairman Volcker--former Chairman Volcker--said he had extreme concern over that. He felt like it was a mistake; and we, as Republicans, do, too. We simply do not believe the government ought to be in the bailout business of nonfinancial--non-bank financial institutions. " CHRG-111hhrg56778--93 Mr. Greenlee," It is a concern more broadly about any firm that is large, complex, and has a lot of interconnections with other players in the financial system and in the marketplace. So an insurance company may have securities activities or engage in--not like AIG--derivative activity that would have some connections with other financial firms and could be a source of contagion to the rest of the finance system if there was a problem there. " CHRG-111hhrg53021Oth--20 Secretary Geithner," Thank you, Chairman Peterson, Chairman Frank, and Ranking Members Lucas and Bachus. I am grateful for the chance to come before you today. I want to compliment both of you and your colleagues for already doing so much thoughtful work in trying to lay the foundation for reform, and for bringing this basic spirit of pragmatic cooperation, transcending the classic institutional differences that have made it harder to make progress in these areas in the past. Before I get to the subject of this hearing, which is the important need to bring comprehensive oversight and regulation to the derivative markets, I just want to make a few broader points about the imperative of comprehensive reform. There are some who have suggested that we are trying to do too much too soon, that we should wait for a more opportune moment when the crisis has definitively receded. There are some who are beginning to suggest that we don't need comprehensive change, even though the cost of this crisis has been brutally damaging to millions of Americans to hundreds of thousands of businesses, to economies around the world, and to confidence in our financial system. And there are some who argue that by making regulations smarter and stronger will destroy innovation. And there are even some who argue that we should leave responsibility for consumer protection for mortgages and consumer credit products, largely, where it is today. Now, in my view, these voices are essentially arguing that we maintain the status quo, and that is not something we can accept. Now, it is not surprising that we are having this debate, it is the typical pattern of the past. As the crisis starts to recede, the impetus to reform tends to fade in the face of the complexity of the task, and with opposition by the economic and institutional interests that are affected. It is not surprising because the reforms proposed by the President, and the reforms that your two Committees are discussing, would: substantially alter the ability of financial institutions to choose their regulator; shape the content of future regulation; and to continue the financial practices that were lucrative for parts of the industry for a time, but did ultimately prove so damaging. But this is why we have to act and why we need to deliver very substantial change. Any regulatory reform of this 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. And we failed to get this balance right in the past. And if we do not achieve sufficient reform, we will leave ourselves weaker as a nation, weaker as an economy and more vulnerable to future crises. Now one of the most significant developments in our system during recent decades has been the very substantial growth and innovation in the market for derivatives, in particular the over-the-counter derivative market. Because of this enormous scale and the critical role these instruments play in our markets, establishing a comprehensive framework of oversight for derivatives is crucial. Although derivatives bring very important benefits to our economy by enabling companies to manage risk, they also pose very substantial challenges. Under our existing regulatory system, some types of financial institutions were allowed to sell very large amounts of protection against certain risks without adequate capital to back those commitments. The most conspicuous and the most damaging examples of this were the monoline insurance companies and AIG. Banks were able to reduce the amount of capital they held against risk by purchasing credit protection from thinly capitalized, special purpose insurers subject to little or no initial margin requirements. The complexity of the instruments overwhelm the checks and balances risk management and supervision, weaknesses that were magnified by very systematic failures in judgment by the credit rating agencies. These failures enabled a substantial increase in leverage both outside and within the banking system. Inadequate enforcement authority and information made the system more vulnerable to fraud and to market manipulation, and because of a lack of transparency in the OTC derivative markets the government and market participants did not have enough information about the location of risk exposures, or the extent of mutual interconnection among firms. And this lack of visibility, magnified contagion as the crisis intensified, causing a very damaging wave of deleveraging, and margin increases, the classic margin spiral, contributing to a general breakdown in credit markets. Now these problems in derivatives were not the sole or the principal cause of the crisis, but they made the crisis more damaging and they need to be addressed as part of the comprehensive reform. Our proposals for reform are designed to protect the stability of our financial system, to prevent market manipulation, fraud and other abuses, to provide greater transparency, and protect consumers and investors by restricting inappropriate marketing of these products to unsophisticated parties. This proposed plan will provide strong regulation and transparency for all OTC derivative products, both standardized and customized, and strong supervision and regulation for all OTC derivative dealers and other major market participants in these markets. And we propose to achieve these goals with the following broad steps. First, we propose to require that all standardized derivatives contracts be cleared through, well-regulated central counterparties and executed either on regulated exchanges or regulated electronic trade execution systems. Central clearing makes possible the substitution of a regulated clearinghouse between the original counterparties to a transaction. And with central clearing, the original counterparties no longer have credit exposure to each other. They place that credit exposure to a clearinghouse, backed by financial safeguards that are established through regulation. Second, we propose to encourage substantially greater use of standardized OTC derivatives, and thereby to facilitate a more substantial migration of these OTC derivatives onto central clearinghouses and exchanges. We will also require, and I want to underscore this, that regulators police any attempts by market participants to use spurious customization to avoid central clearing and exchanges. And in this context, we will impose higher capital and margin requirements for counterparties using customized and non centrally cleared derivative products to account for higher level of risk. Third, we propose to require that all OTC derivative dealers and all major market participants be subject to substantial supervision and regulation, including appropriately conservative capital margin requirements, and strong business conduct standards, to better ensure that dealers have the capital needed to make good on the protection they provide. Fourth, we propose steps to make OTC derivative markets fully transparent. Relevant regulators will have access, on a confidential basis, to all transactions and open positions of individual market participants. The public will have access to aggregated data on opening positions and trading volumes. To bring about this high level of transparency we require the SEC and CFTC to impose record-keeping and reporting requirements, including an audit trail on all OTC derivatives and trades, and to provide information on all OTC derivative trades to a regulated trade repository. Fifth, we propose to provide the SEC and the CFTC with clear unimpeded authority to take regulatory and civil action against fraud, market manipulation and other abuses in these markets. And we will work with the SEC and the CFTC to tighten the standards to govern who can participate in these markets. And finally we will continue to work closely with our international counterparts to help ensure that our regulatory regime is matched by similarly affected efforts in other countries, these are global markets and for these standards to be effective they have to be applied and enforced on a global basis. Now with these reforms we will bring protection that exists in other financial markets, protections that exists to prevent fraud and manipulation in other markets, and preserve market integrity of the OTC derivative markets. The SEC and CFTC will have full enforcement authority. Firms will no longer be able to use derivatives to make commitments with inadequate capital. No dealer in these markets will escape oversight, and we will bring the risk reducing and financial stability promoting benefits of central clearing to these important markets. Now turning these proposals into law will require complex, difficult judgments. And some of these judgments will involve assigning jurisdiction over particular transactions and particular participants to our regulatory agencies. I want to say we have been working closely as you have with the SEC and CFTC over the last few months to develop a sensible, pragmatic allocation of duties and have made very, very substantial progress in narrowing the issues. And I want to join the Chairman in complimenting Chairman Schapiro and Chairman Gensler for working so closely and productively together. As Congress moves to craft legislation, we are moving quickly, along with other relevant agencies, to advance the overall process of reform. Just as an example, we provided detailed legislative language for the establishment of the Consumer Financial Protection Agency to Congress just last week. The SEC is moving forward with new rules to govern and reform credit rating agencies. And the CFTC as you saw, announced hearings recently on whether to impose limits on speculation in energy derivatives in order to dampen price swings, and to require new disclosure by derivative traders. Those are just some examples of things we are doing as you move forward to consider legislation. Now we welcome the commitment of these Committees, and of the Congressional leadership, to move forward in legislation this year. This is an enormously complicated project and it is important we get it right. We share responsibility for fixing the system, and we can only do that with comprehensive reform. I look forward to answering your questions and talking through the range of important complex issues we face in the reform effort. Thank you, Mr. Chairman. [The prepared statement of Secretary Geithner follows:] Prepared Statement of Hon. Timothy F. Geithner, Secretary, U.S. Department of the Treasury, Washington, D.C. Chairman Frank, Ranking Member Bachus, Chairman Peterson, Ranking Member Lucas, Members of the Financial Services and Agriculture Committees, thank you for the opportunity to testify today about a key element of our financial regulatory reform package--a comprehensive regulatory framework for the over-the-counter (OTC) derivatives markets. Over the past 2 years, we have faced the most severe financial crisis in generations. Some of our largest financial institutions failed. Many of the securities markets that are critical to the flow of credit in our financial system broke down. Banks came under extraordinary pressure. And these forces magnified the overall downturn in the housing market and the broader economy. President Obama, working with the Congress, has taken extraordinary steps to stabilize the economy and to repair the damage to the financial system. As we continue to put in place conditions for economic recovery, we need to lay the foundation for a safer, more stable financial system in the future. This financial crisis has exposed a set of core problems with our financial system. The system permitted an excessive build-up of leverage, both outside the banking system and within the banking system. The shock absorbers that are critical to preserving the stability of the financial system--capital, margin, and liquidity cushions in particular--were inadequate to withstand the force of the global recession, and they left the system too weak to withstand the failure of major financial institutions. In addition, millions of Americans were left without adequate protection against financial predation, particularly in the mortgage and consumer finance areas. Many were unable to evaluate the risks associated with borrowing to support the purchase of a home or to sustain a higher level of consumption. The United States entered this crisis without an adequate set of tools to contain the risk of broader damage to the economy and to manage the failure of large, complex financial institutions. Many forces contributed to these problems. Household debt rose dramatically as a share of total income, financed by a willing supply of savings from around the world. Risk management practices at financial firms failed to keep abreast of the rising complexity of financial instruments. Compensation rose to exceptionally high levels in the financial sector, with rewards for executives unmoored from an assessment of long-term risk for the firm, thus mis-aligning the incentive structures in the system. Our framework of financial supervision and regulation, designed in a different era for a more simple bank-centered financial system, failed in its most basic responsibility to produce a stable and resilient system for providing credit and protecting consumers and investors. The Administration proposed in June a comprehensive set of reforms to address the problems in our financial system that were at the core of this crisis and to reduce the risk of future crises. We proposed to establish a new Consumer Financial Protection Agency with the power to establish and enforce protections for consumers on a wide array of financial products. We proposed to put in place more conservative constraints on risk taking and leverage through higher capital requirements for financial institutions and stronger cushions in the core market infrastructure. We proposed to extend the scope of regulation beyond the traditional banking sector to cover all firms who play a critical role in market functioning and the stability of the financial system. We proposed to put in place stronger tools for managing the failure of large, complex financial institutions by adapting the resolution process that now exists for banks and thrifts. We proposed to reduce the substantial opportunities for regulatory arbitrage that our system permitted by consolidating safety and soundness supervision for Federal depository institutions, eliminating loopholes in the Bank Holding Company Act, moving toward convergence of the regulatory frameworks that apply to securities and futures markets, and establishing more uniform standards and enforcement of standards for financial products and activities across the system. And we proposed to work with other countries to establish strong international standards, so the reforms we put in place here are matched and informed by similarly effective reforms elsewhere. 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. The reforms that we propose seek to shift the balance by creating a more resilient financial system that is less prone to periodic crises and credit and asset price bubbles, and better able to manage the risks that are inherent in innovation in a market-oriented financial system. We consulted widely with Members of Congress, consumer advocates, academic experts, and former regulators in shaping our recommendations. And we look forward to refining these recommendations through the legislative process. One of the most significant developments in our financial system during recent decades has been the substantial growth and innovation in the markets for derivatives, especially OTC derivatives. Because of their enormous scale and the critical role they play in our financial markets, establishing a comprehensive framework of oversight for the OTC derivative markets is crucial to laying the foundation for a safer, more stable financial system. A derivative is a financial instrument whose value is based on the value of an underlying ``reference'' asset. The reference asset could be a Treasury bond or a stock, a foreign currency or a commodity such as oil or copper or corn, a corporate loan or a mortgage-backed security. Derivatives are traded on regulated exchanges, and they are traded off-exchanges or over-the-counter. The OTC derivative markets grew explosively in the decade leading up to the financial crisis, with the notional amount or face value of the outstanding transactions rising more than six-fold to almost $700 trillion at the market peak in 2008. Over this same period, the gross market value of OTC derivatives rose to more than $20 trillion. Although derivatives bring substantial benefits to our economy by enabling companies to manage risks, they also pose very substantial challenges and risks. Under our existing regulatory system, some types of financial institutions were allowed to sell large amounts of protection against certain risks without adequate capital to back those commitments. The most conspicuous and most damaging examples of this were the monoline insurance companies and AIG. These firms and others sold huge amounts of credit protection on mortgage-backed securities and other more complex real-estate related securities without the capacity to meet their obligations in an economic downturn. Banks were able to get substantial regulatory capital relief from buying credit protection on mortgage-backed securities and other asset-backed securities from thinly capitalized, special purpose insurers subject to little or no initial margin requirements. The apparent ease with which derivatives permitted risk to be transferred and managed during a period of global expansion and ample liquidity led financial institutions and investors to take on larger amounts of risk than was prudent. The complexity of the instruments that emerged overwhelmed the checks and balances of risk management and supervision, weaknesses that were magnified by systematic failures in judgment by credit rating agencies. These failures enabled a substantial increase in leverage, outside and within the banking system. Because of a lack of transparency in the OTC derivatives and related markets, the government and market participants did not have enough information about the location of risk exposures in the system or the extent of the mutual interconnections among large firms. So, when the crisis began, regulators, financial firms, and investors had an insufficient basis for judging the degree to which trouble at one firm spelled trouble for another. This lack of visibility magnified contagion as the crisis intensified, causing a very damaging wave of deleveraging and margin increases, and contributing to a general breakdown in credit markets. Market participants and investors used derivatives to evade regulation, or to exploit gaps and differences in regulation, and to minimize the tax consequences of investment strategies. The lack of transparency in the OTC derivative markets combined with insufficient regulatory policing powers in those markets left our financial system more vulnerable to fraud and potentially to market manipulation. These problems were not the sole or the principal cause of the crisis, but they contributed to the crisis in important ways. They need to be addressed as part of comprehensive reform. And they cannot be adequately addressed within the present legislative or regulatory framework. In designing its proposed reforms for the OTC derivative markets, the Administration has attempted to achieve four broad objectives: Preventing activities in the OTC derivative markets from posing risk to the stability of the financial system; Promoting efficiency and transparency of the OTC derivative markets; Preventing market manipulation, fraud, and other abuses; and Protecting consumers and investors by ensuring that OTC derivatives are not marketed inappropriately to unsophisticated parties. Our proposals have been carefully designed to provide a comprehensive approach. The plan will provide for 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 propose to achieve this with the following broad steps: First, we propose to require that all standardized derivative contracts be cleared through well-regulated central counterparties and executed either on regulated exchanges or regulated electronic trade execution systems. Central clearing involves the substitution of a regulated clearinghouse between the original counterparties to a transaction. After central clearing, the original counterparties no longer have credit exposure to each other--instead they have credit exposure to the clearinghouse only. Central clearing of standardized OTC derivatives will reduce risks to those on both sides of a derivative contract and make the market more stable. With careful supervision and regulation of the margin and other risk management practices of central counterparties, central clearing of a substantial proportion of OTC derivatives should help to reduce risks arising from the web of bilateral interconnections among our major financial institutions. This should help to constrain threats to financial stability. Second, through capital requirements and other measures, we propose to encourage substantially greater use of standardized OTC derivatives and thereby to facilitate substantial migration of OTC derivatives onto central clearinghouses and exchanges. We will propose a broad definition of ``standardized'' OTC derivatives that will be capable of evolving with the markets and will be designed to be difficult to evade. We will employ a presumption that a derivative contract that is accepted for clearing by any central counterparty is standardized. Further attributes of a standardized contract will include a high volume of transactions in the contract and the absence of economically important differences between the terms of the contract and the terms of other contracts that are centrally cleared. We also will require that regulators carefully police any attempts by market participants to use spurious customization to avoid central clearing and exchanges. In addition, we will raise capital and margin requirements for counterparties to all customized and non-centrally cleared OTC derivatives. Given their higher levels of risk, capital requirements for derivative contracts that are not centrally cleared must be set substantially above those for contracts that are centrally cleared. Third, we propose to require all OTC derivative dealers, and all other major OTC derivative market participants, to be subject to substantial supervision and regulation, including conservative capital requirements; conservative margin requirements; and strong business conduct standards. Conservative capital and margin requirements for OTC derivatives will help ensure that dealers and other major market participants have the capital needed to make good on the protection they have sold. Fourth, we propose steps to make the OTC derivative markets fully transparent. Relevant regulators will have access on a confidential basis to the transactions and open positions of individual market participants. The public will have access to aggregated data on open positions and trading volumes. To bring about this high level of transparency, we will require the SEC and CFTC to impose record-keeping and reporting requirements (including an audit trail) on all OTC derivatives. We will require that OTC derivatives that are not centrally cleared be reported to a regulated trade repository on a timely basis. These reforms will bring OTC derivative trading into the open so that regulators and market participants have clear visibility into the market and a greater ability to assess risks in the market. Increased transparency will improve market discipline and regulatory discipline, and will make the OTC derivative markets more stable. Fifth, we propose to provide the SEC and CFTC with clear authority for civil enforcement and regulation of fraud, market manipulation, and other abuses in the OTC derivative markets. Sixth, we will work with the SEC and CFTC to tighten the standards that govern who can participate in the OTC derivative markets. We must zealously guard against the use of inappropriate marketing practices to sell derivatives to unsophisticated individuals, companies, and other parties. Finally, we will continue to work with our international counterparts to help ensure that our strict and comprehensive regulatory regime for OTC derivatives is matched by a similarly effective regime in other countries. Turning our proposals into law will require that a number of difficult judgments be made. Some of these judgments involve assigning jurisdiction over particular transactions or particular market participants to particular regulatory agencies. We have been working with the SEC and the CFTC over the past few months to develop a sensible allocation of duties. We have made great progress in narrowing the outstanding issues, and intend to send up draft legislation that will provide for a clear allocation of oversight authority between the SEC and CFTC. In making these decisions, we are striving to utilize each agency's expertise, eliminate gaps in regulation, eliminate uncertainty about which agency regulates which types of derivatives, and maximize consistency of the regulatory approach of the two agencies. Our plan will help prevent the OTC derivative markets from threatening the stability of the overall financial system. By requiring central clearing of all standardized derivatives and by requiring all OTC derivative dealers and all other significant OTC market participants to be strictly supervised by the Federal Government, to maintain substantial capital buffers to back up their obligations, and to comply with prudent initial margin requirements, the regulatory framework that we seek to put in place should help lower systemic risk. Our plan will help make the derivatives markets more efficient and transparent. By requiring all standardized derivatives to be cleared through regulated central counterparties and executed on regulated exchanges or through regulated electronic trade execution systems and by requiring that detailed information about all types of derivatives be readily available to regulators, our plan will help ensure that the government is not caught--as it was in this crisis--with insufficient visibility into market activity, risk concentrations, and connections between firms. Our plan will help prevent market manipulation, fraud and other abuses by providing full information to regulators about activity in the OTC derivative markets and by providing the SEC and the CFTC with full authority to police the markets. Finally, our plan will help protect investors by taking steps to prevent OTC derivatives from being marketed inappropriately to unsophisticated parties. As Congress moves to craft legislation to reform our financial system, we are moving quickly to advance the overall process. Following the release of our White Paper on financial regulatory reform in mid-June, we sent up detailed legislative language for the establishment of the Consumer Financial Protection Agency. We have used the President's Working Group on Financial Markets to pull together all government agencies that oversee elements of the financial system to begin the process of formulating more detailed proposals for implementing the comprehensive reforms outlined by the President. The SEC is moving forward to put in place new rules to govern credit-rating agencies, which failed to adequately assess the risks of mortgage-backed and other structured securities at the center of the crisis. The CFTC has announced hearings on whether to impose limits on speculation in energy derivatives in order to dampen price swings, and to require new disclosures by derivative traders. SEC Chairman Schapiro and CFTC Chairman Gensler were recently on Capitol Hill testifying together about progress in coordinating their agencies' approaches to derivatives and developing a reasonable division of labor in the oversight of these markets. We welcome the commitment of the Congressional leadership and of the key Committees to move forward with legislation this year. This is an enormously complex project. It is important that we get it right. And we need a comprehensive approach. This crisis caused enormous damage to trust and confidence in the U.S. financial system and to the American economy. We share responsibility for fixing the system and we can only do that with comprehensive reform. We look forward to working with you to achieve that objective. " CHRG-111hhrg53021--20 Secretary Geithner," Thank you, Chairman Peterson, Chairman Frank, and Ranking Members Lucas and Bachus. I am grateful for the chance to come before you today. I want to compliment both of you and your colleagues for already doing so much thoughtful work in trying to lay the foundation for reform, and for bringing this basic spirit of pragmatic cooperation, transcending the classic institutional differences that have made it harder to make progress in these areas in the past. Before I get to the subject of this hearing, which is the important need to bring comprehensive oversight and regulation to the derivative markets, I just want to make a few broader points about the imperative of comprehensive reform. There are some who have suggested that we are trying to do too much too soon, that we should wait for a more opportune moment when the crisis has definitively receded. There are some who are beginning to suggest that we don't need comprehensive change, even though the cost of this crisis has been brutally damaging to millions of Americans to hundreds of thousands of businesses, to economies around the world, and to confidence in our financial system. And there are some who argue that by making regulations smarter and stronger will destroy innovation. And there are even some who argue that we should leave responsibility for consumer protection for mortgages and consumer credit products, largely, where it is today. Now, in my view, these voices are essentially arguing that we maintain the status quo, and that is not something we can accept. Now, it is not surprising that we are having this debate, it is the typical pattern of the past. As the crisis starts to recede, the impetus to reform tends to fade in the face of the complexity of the task, and with opposition by the economic and institutional interests that are affected. It is not surprising because the reforms proposed by the President, and the reforms that your two Committees are discussing, would: substantially alter the ability of financial institutions to choose their regulator; shape the content of future regulation; and to continue the financial practices that were lucrative for parts of the industry for a time, but did ultimately prove so damaging. But this is why we have to act and why we need to deliver very substantial change. Any regulatory reform of this 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. And we failed to get this balance right in the past. And if we do not achieve sufficient reform, we will leave ourselves weaker as a nation, weaker as an economy and more vulnerable to future crises. Now one of the most significant developments in our system during recent decades has been the very substantial growth and innovation in the market for derivatives, in particular the over-the-counter derivative market. Because of this enormous scale and the critical role these instruments play in our markets, establishing a comprehensive framework of oversight for derivatives is crucial. Although derivatives bring very important benefits to our economy by enabling companies to manage risk, they also pose very substantial challenges. Under our existing regulatory system, some types of financial institutions were allowed to sell very large amounts of protection against certain risks without adequate capital to back those commitments. The most conspicuous and the most damaging examples of this were the monoline insurance companies and AIG. Banks were able to reduce the amount of capital they held against risk by purchasing credit protection from thinly capitalized, special purpose insurers subject to little or no initial margin requirements. The complexity of the instruments overwhelm the checks and balances risk management and supervision, weaknesses that were magnified by very systematic failures in judgment by the credit rating agencies. These failures enabled a substantial increase in leverage both outside and within the banking system. Inadequate enforcement authority and information made the system more vulnerable to fraud and to market manipulation, and because of a lack of transparency in the OTC derivative markets the government and market participants did not have enough information about the location of risk exposures, or the extent of mutual interconnection among firms. And this lack of visibility, magnified contagion as the crisis intensified, causing a very damaging wave of deleveraging, and margin increases, the classic margin spiral, contributing to a general breakdown in credit markets. Now these problems in derivatives were not the sole or the principal cause of the crisis, but they made the crisis more damaging and they need to be addressed as part of the comprehensive reform. Our proposals for reform are designed to protect the stability of our financial system, to prevent market manipulation, fraud and other abuses, to provide greater transparency, and protect consumers and investors by restricting inappropriate marketing of these products to unsophisticated parties. This proposed plan will provide strong regulation and transparency for all OTC derivative products, both standardized and customized, and strong supervision and regulation for all OTC derivative dealers and other major market participants in these markets. And we propose to achieve these goals with the following broad steps. First, we propose to require that all standardized derivatives contracts be cleared through, well-regulated central counterparties and executed either on regulated exchanges or regulated electronic trade execution systems. Central clearing makes possible the substitution of a regulated clearinghouse between the original counterparties to a transaction. And with central clearing, the original counterparties no longer have credit exposure to each other. They place that credit exposure to a clearinghouse, backed by financial safeguards that are established through regulation. Second, we propose to encourage substantially greater use of standardized OTC derivatives, and thereby to facilitate a more substantial migration of these OTC derivatives onto central clearinghouses and exchanges. We will also require, and I want to underscore this, that regulators police any attempts by market participants to use spurious customization to avoid central clearing and exchanges. And in this context, we will impose higher capital and margin requirements for counterparties using customized and non centrally cleared derivative products to account for higher level of risk. Third, we propose to require that all OTC derivative dealers and all major market participants be subject to substantial supervision and regulation, including appropriately conservative capital margin requirements, and strong business conduct standards, to better ensure that dealers have the capital needed to make good on the protection they provide. Fourth, we propose steps to make OTC derivative markets fully transparent. Relevant regulators will have access, on a confidential basis, to all transactions and open positions of individual market participants. The public will have access to aggregated data on opening positions and trading volumes. To bring about this high level of transparency we require the SEC and CFTC to impose record-keeping and reporting requirements, including an audit trail on all OTC derivatives and trades, and to provide information on all OTC derivative trades to a regulated trade repository. Fifth, we propose to provide the SEC and the CFTC with clear unimpeded authority to take regulatory and civil action against fraud, market manipulation and other abuses in these markets. And we will work with the SEC and the CFTC to tighten the standards to govern who can participate in these markets. And finally we will continue to work closely with our international counterparts to help ensure that our regulatory regime is matched by similarly affected efforts in other countries, these are global markets and for these standards to be effective they have to be applied and enforced on a global basis. Now with these reforms we will bring protection that exists in other financial markets, protections that exists to prevent fraud and manipulation in other markets, and preserve market integrity of the OTC derivative markets. The SEC and CFTC will have full enforcement authority. Firms will no longer be able to use derivatives to make commitments with inadequate capital. No dealer in these markets will escape oversight, and we will bring the risk reducing and financial stability promoting benefits of central clearing to these important markets. Now turning these proposals into law will require complex, difficult judgments. And some of these judgments will involve assigning jurisdiction over particular transactions and particular participants to our regulatory agencies. I want to say we have been working closely as you have with the SEC and CFTC over the last few months to develop a sensible, pragmatic allocation of duties and have made very, very substantial progress in narrowing the issues. And I want to join the Chairman in complimenting Chairman Schapiro and Chairman Gensler for working so closely and productively together. As Congress moves to craft legislation, we are moving quickly, along with other relevant agencies, to advance the overall process of reform. Just as an example, we provided detailed legislative language for the establishment of the Consumer Financial Protection Agency to Congress just last week. The SEC is moving forward with new rules to govern and reform credit rating agencies. And the CFTC as you saw, announced hearings recently on whether to impose limits on speculation in energy derivatives in order to dampen price swings, and to require new disclosure by derivative traders. Those are just some examples of things we are doing as you move forward to consider legislation. Now we welcome the commitment of these Committees, and of the Congressional leadership, to move forward in legislation this year. This is an enormously complicated project and it is important we get it right. We share responsibility for fixing the system, and we can only do that with comprehensive reform. I look forward to answering your questions and talking through the range of important complex issues we face in the reform effort. Thank you, Mr. Chairman. [The prepared statement of Secretary Geithner follows:] Prepared Statement of Hon. Timothy F. Geithner, Secretary, U.S. Department of the Treasury, Washington, D.C. Chairman Frank, Ranking Member Bachus, Chairman Peterson, Ranking Member Lucas, Members of the Financial Services and Agriculture Committees, thank you for the opportunity to testify today about a key element of our financial regulatory reform package--a comprehensive regulatory framework for the over-the-counter (OTC) derivatives markets. Over the past 2 years, we have faced the most severe financial crisis in generations. Some of our largest financial institutions failed. Many of the securities markets that are critical to the flow of credit in our financial system broke down. Banks came under extraordinary pressure. And these forces magnified the overall downturn in the housing market and the broader economy. President Obama, working with the Congress, has taken extraordinary steps to stabilize the economy and to repair the damage to the financial system. As we continue to put in place conditions for economic recovery, we need to lay the foundation for a safer, more stable financial system in the future. This financial crisis has exposed a set of core problems with our financial system. The system permitted an excessive build-up of leverage, both outside the banking system and within the banking system. The shock absorbers that are critical to preserving the stability of the financial system--capital, margin, and liquidity cushions in particular--were inadequate to withstand the force of the global recession, and they left the system too weak to withstand the failure of major financial institutions. In addition, millions of Americans were left without adequate protection against financial predation, particularly in the mortgage and consumer finance areas. Many were unable to evaluate the risks associated with borrowing to support the purchase of a home or to sustain a higher level of consumption. The United States entered this crisis without an adequate set of tools to contain the risk of broader damage to the economy and to manage the failure of large, complex financial institutions. Many forces contributed to these problems. Household debt rose dramatically as a share of total income, financed by a willing supply of savings from around the world. Risk management practices at financial firms failed to keep abreast of the rising complexity of financial instruments. Compensation rose to exceptionally high levels in the financial sector, with rewards for executives unmoored from an assessment of long-term risk for the firm, thus mis-aligning the incentive structures in the system. Our framework of financial supervision and regulation, designed in a different era for a more simple bank-centered financial system, failed in its most basic responsibility to produce a stable and resilient system for providing credit and protecting consumers and investors. The Administration proposed in June a comprehensive set of reforms to address the problems in our financial system that were at the core of this crisis and to reduce the risk of future crises. We proposed to establish a new Consumer Financial Protection Agency with the power to establish and enforce protections for consumers on a wide array of financial products. We proposed to put in place more conservative constraints on risk taking and leverage through higher capital requirements for financial institutions and stronger cushions in the core market infrastructure. We proposed to extend the scope of regulation beyond the traditional banking sector to cover all firms who play a critical role in market functioning and the stability of the financial system. We proposed to put in place stronger tools for managing the failure of large, complex financial institutions by adapting the resolution process that now exists for banks and thrifts. We proposed to reduce the substantial opportunities for regulatory arbitrage that our system permitted by consolidating safety and soundness supervision for Federal depository institutions, eliminating loopholes in the Bank Holding Company Act, moving toward convergence of the regulatory frameworks that apply to securities and futures markets, and establishing more uniform standards and enforcement of standards for financial products and activities across the system. And we proposed to work with other countries to establish strong international standards, so the reforms we put in place here are matched and informed by similarly effective reforms elsewhere. 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. The reforms that we propose seek to shift the balance by creating a more resilient financial system that is less prone to periodic crises and credit and asset price bubbles, and better able to manage the risks that are inherent in innovation in a market-oriented financial system. We consulted widely with Members of Congress, consumer advocates, academic experts, and former regulators in shaping our recommendations. And we look forward to refining these recommendations through the legislative process. One of the most significant developments in our financial system during recent decades has been the substantial growth and innovation in the markets for derivatives, especially OTC derivatives. Because of their enormous scale and the critical role they play in our financial markets, establishing a comprehensive framework of oversight for the OTC derivative markets is crucial to laying the foundation for a safer, more stable financial system. A derivative is a financial instrument whose value is based on the value of an underlying ``reference'' asset. The reference asset could be a Treasury bond or a stock, a foreign currency or a commodity such as oil or copper or corn, a corporate loan or a mortgage-backed security. Derivatives are traded on regulated exchanges, and they are traded off-exchanges or over-the-counter. The OTC derivative markets grew explosively in the decade leading up to the financial crisis, with the notional amount or face value of the outstanding transactions rising more than six-fold to almost $700 trillion at the market peak in 2008. Over this same period, the gross market value of OTC derivatives rose to more than $20 trillion. Although derivatives bring substantial benefits to our economy by enabling companies to manage risks, they also pose very substantial challenges and risks. Under our existing regulatory system, some types of financial institutions were allowed to sell large amounts of protection against certain risks without adequate capital to back those commitments. The most conspicuous and most damaging examples of this were the monoline insurance companies and AIG. These firms and others sold huge amounts of credit protection on mortgage-backed securities and other more complex real-estate related securities without the capacity to meet their obligations in an economic downturn. Banks were able to get substantial regulatory capital relief from buying credit protection on mortgage-backed securities and other asset-backed securities from thinly capitalized, special purpose insurers subject to little or no initial margin requirements. The apparent ease with which derivatives permitted risk to be transferred and managed during a period of global expansion and ample liquidity led financial institutions and investors to take on larger amounts of risk than was prudent. The complexity of the instruments that emerged overwhelmed the checks and balances of risk management and supervision, weaknesses that were magnified by systematic failures in judgment by credit rating agencies. These failures enabled a substantial increase in leverage, outside and within the banking system. Because of a lack of transparency in the OTC derivatives and related markets, the government and market participants did not have enough information about the location of risk exposures in the system or the extent of the mutual interconnections among large firms. So, when the crisis began, regulators, financial firms, and investors had an insufficient basis for judging the degree to which trouble at one firm spelled trouble for another. This lack of visibility magnified contagion as the crisis intensified, causing a very damaging wave of deleveraging and margin increases, and contributing to a general breakdown in credit markets. Market participants and investors used derivatives to evade regulation, or to exploit gaps and differences in regulation, and to minimize the tax consequences of investment strategies. The lack of transparency in the OTC derivative markets combined with insufficient regulatory policing powers in those markets left our financial system more vulnerable to fraud and potentially to market manipulation. These problems were not the sole or the principal cause of the crisis, but they contributed to the crisis in important ways. They need to be addressed as part of comprehensive reform. And they cannot be adequately addressed within the present legislative or regulatory framework. In designing its proposed reforms for the OTC derivative markets, the Administration has attempted to achieve four broad objectives: Preventing activities in the OTC derivative markets from posing risk to the stability of the financial system; Promoting efficiency and transparency of the OTC derivative markets; Preventing market manipulation, fraud, and other abuses; and Protecting consumers and investors by ensuring that OTC derivatives are not marketed inappropriately to unsophisticated parties. Our proposals have been carefully designed to provide a comprehensive approach. The plan will provide for 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 propose to achieve this with the following broad steps: First, we propose to require that all standardized derivative contracts be cleared through well-regulated central counterparties and executed either on regulated exchanges or regulated electronic trade execution systems. Central clearing involves the substitution of a regulated clearinghouse between the original counterparties to a transaction. After central clearing, the original counterparties no longer have credit exposure to each other--instead they have credit exposure to the clearinghouse only. Central clearing of standardized OTC derivatives will reduce risks to those on both sides of a derivative contract and make the market more stable. With careful supervision and regulation of the margin and other risk management practices of central counterparties, central clearing of a substantial proportion of OTC derivatives should help to reduce risks arising from the web of bilateral interconnections among our major financial institutions. This should help to constrain threats to financial stability. Second, through capital requirements and other measures, we propose to encourage substantially greater use of standardized OTC derivatives and thereby to facilitate substantial migration of OTC derivatives onto central clearinghouses and exchanges. We will propose a broad definition of ``standardized'' OTC derivatives that will be capable of evolving with the markets and will be designed to be difficult to evade. We will employ a presumption that a derivative contract that is accepted for clearing by any central counterparty is standardized. Further attributes of a standardized contract will include a high volume of transactions in the contract and the absence of economically important differences between the terms of the contract and the terms of other contracts that are centrally cleared. We also will require that regulators carefully police any attempts by market participants to use spurious customization to avoid central clearing and exchanges. In addition, we will raise capital and margin requirements for counterparties to all customized and non-centrally cleared OTC derivatives. Given their higher levels of risk, capital requirements for derivative contracts that are not centrally cleared must be set substantially above those for contracts that are centrally cleared. Third, we propose to require all OTC derivative dealers, and all other major OTC derivative market participants, to be subject to substantial supervision and regulation, including conservative capital requirements; conservative margin requirements; and strong business conduct standards. Conservative capital and margin requirements for OTC derivatives will help ensure that dealers and other major market participants have the capital needed to make good on the protection they have sold. Fourth, we propose steps to make the OTC derivative markets fully transparent. Relevant regulators will have access on a confidential basis to the transactions and open positions of individual market participants. The public will have access to aggregated data on open positions and trading volumes. To bring about this high level of transparency, we will require the SEC and CFTC to impose record-keeping and reporting requirements (including an audit trail) on all OTC derivatives. We will require that OTC derivatives that are not centrally cleared be reported to a regulated trade repository on a timely basis. These reforms will bring OTC derivative trading into the open so that regulators and market participants have clear visibility into the market and a greater ability to assess risks in the market. Increased transparency will improve market discipline and regulatory discipline, and will make the OTC derivative markets more stable. Fifth, we propose to provide the SEC and CFTC with clear authority for civil enforcement and regulation of fraud, market manipulation, and other abuses in the OTC derivative markets. Sixth, we will work with the SEC and CFTC to tighten the standards that govern who can participate in the OTC derivative markets. We must zealously guard against the use of inappropriate marketing practices to sell derivatives to unsophisticated individuals, companies, and other parties. Finally, we will continue to work with our international counterparts to help ensure that our strict and comprehensive regulatory regime for OTC derivatives is matched by a similarly effective regime in other countries. Turning our proposals into law will require that a number of difficult judgments be made. Some of these judgments involve assigning jurisdiction over particular transactions or particular market participants to particular regulatory agencies. We have been working with the SEC and the CFTC over the past few months to develop a sensible allocation of duties. We have made great progress in narrowing the outstanding issues, and intend to send up draft legislation that will provide for a clear allocation of oversight authority between the SEC and CFTC. In making these decisions, we are striving to utilize each agency's expertise, eliminate gaps in regulation, eliminate uncertainty about which agency regulates which types of derivatives, and maximize consistency of the regulatory approach of the two agencies. Our plan will help prevent the OTC derivative markets from threatening the stability of the overall financial system. By requiring central clearing of all standardized derivatives and by requiring all OTC derivative dealers and all other significant OTC market participants to be strictly supervised by the Federal Government, to maintain substantial capital buffers to back up their obligations, and to comply with prudent initial margin requirements, the regulatory framework that we seek to put in place should help lower systemic risk. Our plan will help make the derivatives markets more efficient and transparent. By requiring all standardized derivatives to be cleared through regulated central counterparties and executed on regulated exchanges or through regulated electronic trade execution systems and by requiring that detailed information about all types of derivatives be readily available to regulators, our plan will help ensure that the government is not caught--as it was in this crisis--with insufficient visibility into market activity, risk concentrations, and connections between firms. Our plan will help prevent market manipulation, fraud and other abuses by providing full information to regulators about activity in the OTC derivative markets and by providing the SEC and the CFTC with full authority to police the markets. Finally, our plan will help protect investors by taking steps to prevent OTC derivatives from being marketed inappropriately to unsophisticated parties. As Congress moves to craft legislation to reform our financial system, we are moving quickly to advance the overall process. Following the release of our White Paper on financial regulatory reform in mid-June, we sent up detailed legislative language for the establishment of the Consumer Financial Protection Agency. We have used the President's Working Group on Financial Markets to pull together all government agencies that oversee elements of the financial system to begin the process of formulating more detailed proposals for implementing the comprehensive reforms outlined by the President. The SEC is moving forward to put in place new rules to govern credit-rating agencies, which failed to adequately assess the risks of mortgage-backed and other structured securities at the center of the crisis. The CFTC has announced hearings on whether to impose limits on speculation in energy derivatives in order to dampen price swings, and to require new disclosures by derivative traders. SEC Chairman Schapiro and CFTC Chairman Gensler were recently on Capitol Hill testifying together about progress in coordinating their agencies' approaches to derivatives and developing a reasonable division of labor in the oversight of these markets. We welcome the commitment of the Congressional leadership and of the key Committees to move forward with legislation this year. This is an enormously complex project. It is important that we get it right. And we need a comprehensive approach. This crisis caused enormous damage to trust and confidence in the U.S. financial system and to the American economy. We share responsibility for fixing the system and we can only do that with comprehensive reform. We look forward to working with you to achieve that objective. " fcic_final_report_full--68 In , the Economic Growth and Regulatory Paperwork Reduction Act re- quired federal regulators to review their rules every decade and solicit comments on “outdated, unnecessary, or unduly burdensome” rules.  Some agencies responded with gusto. In , the Federal Deposit Insurance Corporation’s annual report in- cluded a photograph of the vice chairman, John Reich; the director of the Office of Thrift Supervision (OTS), James Gilleran; and three banking industry representa- tives using a chainsaw and pruning shears to cut the “red tape” binding a large stack of documents representing regulations. Less enthusiastic agencies felt heat. Former Securities and Exchange Commission chairman Arthur Levitt told the FCIC that once word of a proposed regulation got out, industry lobbyists would rush to complain to members of the congressional committee with jurisdiction over the financial activity at issue. According to Levitt, these members would then “harass” the SEC with frequent letters demanding an- swers to complex questions and appearances of officials before Congress. These re- quests consumed much of the agency’s time and discouraged it from making regulations. Levitt described it as “kind of a blood sport to make the particular agency look stupid or inept or venal.”  However, others said interference—at least from the executive branch—was mod- est. John Hawke, a former comptroller of the currency, told the FCIC he found the Treasury Department “exceedingly sensitive” to his agency’s independence. His suc- cessor, John Dugan, said “statutory firewalls” prevented interference from the execu- tive branch.  Deregulation went beyond dismantling regulations; its supporters were also disin- clined to adopt new regulations or challenge industry on the risks of innovations. Federal Reserve officials argued that financial institutions, with strong incentives to protect shareholders, would regulate themselves by carefully managing their own risks. In a  speech, Fed Vice Chairman Roger Ferguson praised “the truly im- pressive improvement in methods of risk measurement and management and the growing adoption of these technologies by mostly large banks and other financial in- termediaries.”  Likewise, Fed and other officials believed that markets would self-reg- ulate through the activities of analysts and investors. “It is critically important to recognize that no market is ever truly unregulated,” said Fed Chairman Alan Greenspan in . “The self-interest of market participants generates private market regulation. Thus, the real question is not whether a market should be regulated. 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-111hhrg74090--188 Mr. Stinebert," Well, I think when you go back, and there is plenty of history to point fingers at what was the cause of the subprime mortgage crisis and currently economic crisis but I don't think you would get anybody that would predict that whatever is done here today or by Congress that you can control every bubble that is going to occur in the future. Most economists would agree that yes, this bubble is a housing bubble, before it was a tech bubble, before that it was a savings and loan bubble. You cannot have government totally controlling financial markets unless they can totally control potential bubbles, unless you totally stymie innovation and all you have is a plain vanilla standard product out there, and I don't think that is good for the very consumers that we are trying to protect here. " CHRG-111shrg54789--90 Mr. Barr," Senator, I think that the FTC is a good agency with many good people in it. I think that it has not had the tools to do this kind of action. It is structurally not set up to supervise or examine the nonbank sector. It can only act long after the fact with enforcement when it is too late---- Senator Schumer. Right. " Mr. Barr," and that is just not enough. It can't act at all with respect to banks, and so we have a fractured system where everybody can point fingers and nobody gets the job done. Senator Schumer. Right. And let me just ask one more question of you, and that is this. Right now, one of the things that hamstrung us was the fact that there were unregulated areas. In other words, if a bank issued a mortgage, there was some degree of regulation--I would say not enough, but some. But if a mortgage broker got from a nonbank financial institution financing, there was virtually no regulation at the Federal level, and when you talked to the Fed about it, which I did, they would say, well, we don't have jurisdiction. Isn't another reason to have this financial product regulator, which regulates the product and not the specific institution that issues the product, a way when the next new innovation comes up that there won't be a hole in the regulatory structure, because right now, we regulate by the type of institution, not the type of product issued? " CHRG-111shrg54789--185 RESPONSES TO WRITTEN QUESTIONS OF CHAIRMAN DODD FROM MICHAEL S. BARRQ.1. Correcting Incentives--We have heard a number of reports of how financial sector employees are incentivized to push harmful financial products on to customers--sometimes to keep their jobs. For example, one Bank of America call-center worker claimed, ``the more money [she] sold [a customer] and the higher the rate, the more money [she] made. That's what the bank rewards--sales, not service.'' These products harmed not just customers but the entire U.S. economy. The President's plan recognizes that ``an important component of risk management involves properly aligning incentives, and that properly designed compensation practices for both executives and employees are a necessary part of ensuring safety and soundness in the financial sector.'' \1\ Secondly, it suggests the creation of a whistleblower fund, saying that ``financial firms and public companies should be accountable to their clients and investors by expanding protections for whistleblowers.'' \2\ This raises two questions:--------------------------------------------------------------------------- \1\ See http://www.financialstability.gov/docs/regs/FinalReport_web.pdf, p. 30. \2\ See http://www.financialstability.gov/docs/regs/FinalReport_web.pdf, pp. 15 and 72.--------------------------------------------------------------------------- How could a Consumer Financial Protection Agency ensure that employees are not provided with these incentives to push negative financial products onto customers?A.1. The Consumer Financial Protection Agency (CFPA) will have the authority and tools to address practices that harm consumers in the marketplace for consumer financial products and services. This authority would extend to business practices, including compensation practices that push consumers to purchase inappropriate products and services. The authority the CFPA would have to address harmful employee incentive practices includes, for example, the following: Under Section 1031, the CFPA could issue rules to restrict unfair, deceptive or abusive acts and practices. The CFPA will also have the authority, under Section 1033, to promulgate rules regarding sales practices, to ensure that consumer financial products and services are provided in a manner, setting and circumstances which ensure that the risks, costs, and benefits of the products or services are fully and accurately represented to consumers. In addition, under Section 1037, the CFPA will have the authority to prescribe rules imposing duties on a covered person, or an employee of a covered person, who deals directly with consumers in providing financial products and services, as the CFPA deems appropriate to ensure fair dealing with consumers. With this authority, the CFPA will be able to impose duties on salespeople and mortgage brokers to offer appropriate loans, take care with the financial advice they offer, and meet the duty of best execution. The CFPA also would be able to prevent lenders from paying higher commissions to brokers or salespeople (yield spread premiums) for selling loans to consumers with higher rates than consumers qualify for.Q.2. Would the Consumer Financial Protection Agency play any role in protecting whistleblowers who call attention to abuses against consumers, much like the whistleblower protections given to employees of contractors and State and local governments in this year's stimulus bill? \3\--------------------------------------------------------------------------- \3\ American Recovery & Reinvestment Act of 2009, Pub. L. No. 111-5, 1553.---------------------------------------------------------------------------A.2. Yes, the CFPA will play a role in protecting whistleblowers who call attention to abuses against consumers. Section 1057 provides protections for employees who, among other things, provide information to the Agency or testify in any proceeding resulting from the enforcement of the CFPA Act. Employees who believe they have been terminated or otherwise discriminated against because of the information they have provided have a right to review by the Agency of such action, including a right to a public hearing as part of the required investigation by the Agency. After investigation, the Agency has the authority to issue an order which provides for reinstating or rehiring the employee.Q.3. Senators Wyden and Whitehouse's Amendments From the Credit Card Bill--Earlier this year when the Credit Card Accountability, Responsibility and Disclosure Act was on the Senate floor, Senator Wyden and Senator Whitehouse each had an amendment that ultimately did not get incorporated into the final legislation. Senator Wyden's amendment would have established a five-star rating system for credit cards, and Senator Whitehouse's amendment would have overturned the Supreme Court's Marquette decision that allowed interest rates to be exported across State lines. How would your proposal deal with the issues that these two amendments sought to address? Would the proposal allow the Consumer Financial Protection Agency to set up some type of rating system for credit cards to the extent it determines necessary to protect cardholders? And what effects would your proposal have on the Marquette decision?A.3. The CFPA would have the authority to achieve the same ends as the proposed credit card rating system--fairness and transparency. It is given the mandate to ensure that consumers have the clear and accurate information they need to make responsible financial decisions. Ensuring that consumers have, reasonably can understand, and can use the information they need to make responsible decisions is the first of the CFPA's four objectives under Section 1021(b)(1). We do not propose to alter existing law under Marquette, which allows banks to charge the interest rate permitted by their chartering State.Q.4. In his testimony, Mr. Yingling cites the Treasury's plan as saying ``that 94 percent of high cost mortgages were made outside the traditional banking system,'' (p. 4). On the other hand, you testify that ``about one-half of the subprime originations in 2005 and 2006--the shoddy originations that set off the wave of foreclosures--were by banks and thrifts and their affiliates.'' Please explain the discrepancy.A.4. Mr. Yingling's assertion is incorrect. Here is the relevant paragraph from our white paper, Financial Regulatory Reform: A New Foundation (pp. 68-69). http://10.75.16.79:8080/docs/regs/FinalReport_web.pdf. See in particular the last sentence. Rigorous application of the Community Reinvestment Act (CRA) should be a core function of the CFPA. Some have attempted to blame the subprime meltdown and financial crisis on the CRA and have argued that the CRA must be weakened in order to restore financial stability. These claims and arguments are without any logical or evidentiary basis. It is not tenable that the CRA could suddenly have caused an explosion in bad subprime loans more than 25 years after its enactment. In fact, enforcement of CRA was weakened during the boom and the worst abuses were made by firms not covered by CRA. Moreover, the Federal Reserve has reported that only 6 percent of all the higher-priced loans were extended by the CRA-covered lenders to lower income borrowers or neighborhoods in the local areas that are the focus of CRA evaluations. The information from the last sentence is from an article by Federal Reserve economists and refers just to subprime loans made by a bank or thrift (a) to lower-income people or neighborhoods and (b) in a bank or thrift's CRA assessment area. See http://www.minneapolisfed.org/publications_papers/pub_display.cfm?id=4136. This statistic does not refer to the whole population of subprime loan originations. Of that population, banks and thrifts held a significant share. That fact is evident in Table 1 below (http://www.minneapolisfed.org/pubs/cd/09-2/table1.pdf.) from the same article. It shows that, in 2005, 36 percent of higher-priced loans were by depositories or their subsidiaries; in 2006 the figure rose to 41 percent. If you add in bank affiliates, in 2005, banks, their subsidiaries and affiliates made 48 percent of all higher-cost loans, and 54 percent in 2006.Q.5. Mr. Yingling claims that the creation of the CFPA will result in a ``potentially massive new regulatory burden.'' He then goes on to assert ``community banks will have greatly increased fees to fund a system that falls disproportionately on them.'' How do you respond?A.5. We believe that the Federal regulatory structure for consumer protection needs fundamental reform. We have proposed to consolidate rule-writing, supervision, and enforcement authority under one agency, with marketwide coverage over both nonbanks and banks that provide consumer financial products and services. With this consolidated authority and marketwide coverage, the CFPA will be able to regulate in a manner that is more streamlined and effective, not more burdensome. The authorities for rulemaking, supervision, and enforcement for consumer financial products and services are presently scattered among seven different Federal agencies, sometimes with overlapping authority. For example, the Federal Reserve Board (FRB) has jurisdiction over required mortgage disclosures under the Truth in Lending Act (TILA), while the Department of Housing and Urban Development has authority to require mortgage disclosure under the Real Estate and Settlement Protection Act (RESPA). As another example, the Federal Trade Commission (FTC) has authority to issue rules relating to mortgage loans in the nonbank sector, while the Federal Reserve has similar authority under the Home Ownership and Equity Protection Act to issue rules regarding the entire mortgage market. Such balkanization and overlap of regulatory authority does not make sense. With consolidated authority, the CFPA will, for example, be able to integrate the mortgage disclosures required under TILA and RESPA into one, integrated form. This simplification--and others like it--would decrease, not increase, the compliance burden, while improving protections for consumers. Moreover, with respect to regulations, the CFPA will be statutorily required to consider the potential costs and benefits to consumers and institutions, including the potential reduction in consumer access to financial products and services. The CFPA will be required to consult with safety and soundness regulators before issuing rules. As a result, the CFPA's rules and supervisory approach will be balanced and effective. It is simply not true under our proposal that community banks will pay higher fees to fund the CFPA. The Administration proposes to provide by statute that community banks will pay no more for Federal consumer protection supervision after the CFPA is created than they do today. Moreover, we believe that community banks will benefit from the CFPA in several ways. First, today, community banks have to compete against nonbank entities like mortgage brokers and mortgage companies, which, unlike banks, are not subject to Federal oversight. In recent years, nonbank firms won market share by lowering lending standards and offering irresponsible--and often deceptive--loans. Community banks were forced either to lower their own standards or to become uncompetitive. The CFPA will provide a level playing field, extending the reach of Federal oversight to all providers of consumer financial products and services, banks and nonbanks alike, for the first time. The CFPA will put an end to community banks' competitive disadvantage. Second, CFPA's marketwide coverage and consolidated authority for rule writing, supervision, and enforcement will enable it to choose the least-cost, most-effective tools. For example, it will be able to use ``supervisory guidance'' in place of new regulations. Supervisory guidance is less burdensome for financial institutions, but is not an effective consumer protection tool today because it requires coordination between numerous Federal and State agencies. With one Federal agency in charge, supervisory guidance can more often be used in place of new regulations. Finally, the CFPA will have a mandate to allocate more resources to those companies that pose more risks to consumers when providing consumer financial products and services. Community banks are close to their customers and have often provided simpler, easier-to-understand products with greater care and transparency than other segments of the market. Such banks will receive proportionally less oversight from the CFPA.Q.6. Mr. Yingling asserts that the CFPA is ``instructed to create its own products and mandate that banks offer them. . . . 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.'' This raises two questions: Would the Administration's proposal require the CFPA to create its own products? In the area of mortgages, for example, are the kinds of ``plain-vanilla'' mortgages that the plan would encourage similar to products that community banks currently offer, or do community banks tend to offer more exotic mortgages that might attract the additional scrutiny contemplated by the proposal? What about nonmortgage products such as credit cards, auto loans, and the like?A.6. The Administration's proposal would not require the CFPA to design products. The proposal would permit the CFPA only to identify a standard product that is commonly provided in the marketplace already, and that is proven, simple, and poses less risk to consumers. In the mortgage context, such standard products would likely include both 30-year, fixed rate mortgages and adjustable rate mortgage (ARM) products. Most community banks that offer residential mortgages, offer 30-year fixed rate and conventional ARM mortgage products. These loans would generally meet the definition of standard products. Some community banks certainly offered more exotic mortgages such as payment option ARMs or subprime loans with nontraditional features, but those institutions likely offered conventional loans too. The mortgage market has known standard products for years. The Agency would have the authority to determine if the concept would also apply in other contexts, such as credit cards and auto loans. Recently at least one major card issuer has offered a ``plain-vanilla'' credit card and it is possible that this practice would spread.Q.7. Had lenders been required to offer ``plain-vanilla'' mortgage products such as fixed-rate mortgages or traditional ARMs during the significant growth in subprime lending starting in 2003, what impact do you think it might have had on the crisis?A.7. Subprime mortgages grew extremely rapidly, reaching $600 billion in originations and 20 percent of the market by 2005. It is clear today that the rapid development of this segment of the market was disastrous; a Federal Reserve economist has projected that approximately 45 percent of subprime loans originated in 2006 and 2007 will end in foreclosure. A substantial proportion of subprime borrowers qualified for much safer conventional, standard mortgages, which had lower interest rates, stable payments, escrows for taxes and insurance, no barriers to exit such as prepayment penalties, and substantially lower default rates. The financial incentives for originators, however, were to steer borrowers into subprime loans even if borrowers qualified for conventional loans. A requirement to provide the consumer a comparison between these more complex products and simpler products might have made a difference. The banking agencies ultimately required lenders to disclose these comparisons, but the agencies took so long to agree on the disclosures that they made little difference.Q.8. Chairman Bernanke appeared before the Committee on July 23 to discuss monetary policy. At that hearing, he was asked about the requirement that consumers be offered ``plain-vanilla'' choices. Bernanke said ``there is some economic analysis which suggests that there might be benefits in some cases of having a basic product available, so-called `vanilla product'.'' He goes on to say, however, that the regulators would have to take care not to ``roll back all of the innovation in financial markets that has taken place over the past three decades or so.'' Do you have any observations to make regarding these comments by Chairman Bernanke?A.8. Chairman Bernanke's comments are well taken. Our specific proposal on ``plain vanilla'' is lighter touch regulation. A vanilla product would serve to provide a standard of comparison for borrowers, so they can make more informed choices about what loan product would be best for them. It is another tool besides disclosure, but less intrusive than outright banning contract terms that harm consumers (as Congress just did on credit cards). Our proposal would not dictate business plans or decide for consumers what products are right for them. The goal is to make it easier for consumers who want to choose simple products to make that choice, and to make sure consumers who choose more complicated products understand the risks they are taking. Here's an example. When the regulators put out a model disclosure on subprime mortgages in 2008, it required mortgage lenders to compare the payment schedule of a subprime mortgage--with a big jump in interest rates in the third or fourth year--to the payment schedule on a fixed-rate, 30-year mortgage. That's the sort of action this agency would take. Only, it would be able to act much faster--the regulators' disclosure came out after the subprime mortgage market had imploded. I also agree with Chairman Bernanke on innovation. Our proposals are designed to preserve the incentives and opportunities for innovation. Many of the consumer lending practices that led to this crisis gave innovation a bad name and served simply to hide costs in a deceptive manner. We need to create an agency that restores confidence of consumers in innovation. We also need to restore confidence of the financial investors who would fund innovation but have become wary of it. This is why preserving innovation and promoting access are key objectives of the agency. The agency will be required to measure every proposal against these objectives. Innovation has to be sustainable and respond to consumer preferences. That requires transparency and fairness. We are equipping the agency with the authority to ensure transparency and fairness so that sustainable innovations can thrive.Q.9. Mr. Wallison argued at the hearing that the Administration's proposal would require lenders to determine the ability of a potential customer to understand various products, which, he goes on to assert will lead to limitations on what they offer. How do you respond?A.9. The intent of the standard products provision is to provide a standard of comparison for borrowers, so they can make more informed choices about what loan product would be best for them. The Agency will also improve disclosures so that it will be easier for consumers to understand the loan products they are getting. It will remain the consumer's right and responsibility to make the choice.Q.10. Mr. Wallison said during the hearing that the liability faced by lenders for offering more complex products would effectively eliminate those options for consumers. How do you respond?A.10. A standard product would serve to provide a standard of comparison for borrowers, so they can make more informed choices about what loan product would be best for them. It's another tool besides disclosure, but less intrusive than outright banning complex contract terms (as Congress just did on credit cards). Since borrowers would be entirely free to select alternative, more complex products and many would do so, lenders would have substantial incentives to offer them.Q.11. Title X, section 1022(b)(2)(A) of the Administration's proposal describes special rulemaking requirements applicable to the Consumer Financial Products Agency (CFPA). These requirements state that when engaged in a rulemaking, the CFPA must ``consider the potential benefits and costs to consumers and covered persons, including the potential reduction of consumers' access to consumer financial products or services, resulting from such rule.'' Please explain the rationale for requiring the CFPA to conduct additional analysis beyond the typical notice and comment procedures required of agencies engaged in a rulemaking under the Administrative Procedures Act.A.11. The goal of the CFPA is not more regulation, but smarter regulation. There is no question that existing consumer protection statutes and rules were not protective enough of consumers, and we are all paying a price for that failure. Better rules are needed. An essential part of the solution is one agency, with marketwide reach, and consolidated authorities of rule writing, supervision, and enforcement. These rules must be balanced. Supervising and, when necessary, enforcing against banks and nonbanks will provide the new agency with essential information about which problems to address, as well as market realities in banks and credit unions that need to be respected. CFPA will consult with prudential supervisors before writing rules, and the national bank supervisor will be on the CFPA board. The CFPA proposal requires that the Agency weigh costs in addition to benefits, and consider impact on businesses as well as access to credit, in order to ensure that it is a balanced agency that acts in the most effective, prudent way possible. This requirement is consistent with the Agency's mission of not removing all risk from consumer financial products and services, but rather providing consumers with clear and unbiased information that permits them to make their own decisions and weigh their own costs and benefits in a reasoned manner. It is also the practice the Federal Reserve has followed in implementing the consumer financial protection statutes. ------ CHRG-111shrg51395--3 STATEMENT OF SENATOR RICHARD C. SHELBY Senator Shelby. Thank you, Chairman Dodd. I think the greatest challenge in dealing with this financial crisis is understanding its multiple, complex, and interrelated causes. This hearing provides us an opportunity to examine some of the causes that relate to our securities markets and securities regulation. Without presupposing the specific causes of the financial crisis, I think it is appropriate to conclude that a broad failure of risk management in the financial system led us to where we are today. It appears that everybody assumed that someone else was monitoring the risk. Regulators assumed that financial institutions had properly assessed the risk of their own activities or assumed that other regulators were watching what those entities were doing. Financial institutions failed to adequately monitor risks across business units and failed to thoroughly understand the risks associated with new financial products. They did not adequately assess either their exposures to or the health of their counterparties. Very sophisticated investors assumed that someone else had done their due diligence. Less sophisticated investors assumed, unreasonably, that asset prices would only climb. The excessive reliance on credit ratings and the failure of the market to develop a clearinghouse for credit default swaps are just two examples of this widespread market failure. The disastrous consequences of this nearly universal passing of the buck should serve as the guidepost for us and the SEC as we consider reforms. I think there should be clear lines of responsibility for regulators. Only then can Congress hold regulators accountable for their performance. It is also important not to make changes to the statutory and regulatory framework that would further lull market participants into believing that regulators or other market participants are doing their work for them. We cannot build a regulator big enough to be everywhere at all times. Market participants need to do their own due diligence before and after they make an investment decision. They need to bear the costs of an unwise investment, just as they reap the benefit of a wise investment. In the end, I believe our markets will be best served by the combined efforts of diligent regulators and responsible market participants working under rules that are clear and consistent. Uncertainty about the rules impedes the market from working as it should. Ad hoc Government actions lead private capital to sit on the sidelines because a change in rules can radically change a market participant's expected return. A consistent legal framework is an essential component of a competitive capital market. Investors will avoid a market if they believe the rules may change in the middle of the game. A clear example of this dynamic is the world of accounting where many are calling for the suspensions of mark-to-market because of the adverse impact that it is presently having on the books of so many companies. Accounting rules should be designed to ensure that a firm's disclosures reflect economic reality, however ugly that reality may be. Changing the accounting rules now will simply compound investors' wariness about investing in a market where many firms have bad or illiquid assets on their books. I will be interested in hearing from today's witnesses on this topic and how the SEC can improve its efforts to protect our securities markets while also facilitating continued innovation and responsible risk taking. Chairman Dodd, I thank you for calling this hearing. I think you are on to something here. " CHRG-111shrg55117--86 Chairman Dodd," That is a good point. We should. I think the point you make, it is the startup. It is also that mezzanine level which can be really difficult. You are right at that point of kind of going in one or two directions and the idea of being able to have someone sustaining that effort for you during those critical periods. That has been a great source of not only job creation, but tremendous innovation in the country in so many areas. So I think it is very worthwhile, because it is something, as I mentioned earlier, all of us hear about it every single day. We grapple with it every day, and we don't have very good answers yet on this and we should. So it is a very good suggestion. Thank you, Senator Warner. Senator Vitter. Senator Vitter. Thank you, Mr. Chairman, and thank you, Chairman Bernanke, for your work. I have questions in two areas. The first is the proposed Consumer Financial Protection Agency. Do you think it is a good idea to have a very powerful consumer issues-driven regulator structurally divorced from safety and soundness regulation? " CHRG-111shrg55739--144 PREPARED STATEMENT OF MICHAEL S. BARR Assistant Secretary for Financial Institutions, Department of the Treasury August 5, 2009 Chairman Dodd, Ranking Member Shelby, and Members of the Committee, thank you for the opportunity to testify before you today about the Administration's plan for financial regulatory reform. On June 17, President Obama unveiled a sweeping set of regulatory reforms to lay the foundation for a safer, more stable financial system; one that properly delivers the benefits of market-driven financial innovation while safeguarding against the dangers of market-driven excess. In the weeks since the release of those proposals, the Administration has worked with Congress in testimony and briefings with your staff to explain and refine our legislation. Today, I want to first speak in broad terms about the forces that led us into the current crisis and the key objectives of our reform proposal. I will then turn to discuss the role that third party credit ratings and rating agencies played in creating a system where risks built up without being accounted for or properly understood. And how these ratings contributed to a system that proved far too fragile in the face of changes in the economic outlook and uncertainty in financial markets. This Committee provided strong leadership to enact the first registration and regulation of rating agencies in 2006, and the proposals that I will discuss today build on that foundation.Where Our Economy Stands Today President Obama inherited an economic and financial crisis more serious than any President since Franklin Roosevelt. Over the last 7 months, the President has responded forcefully with a historic economic stimulus package, with a multiprong effort to stabilize our financial and housing sectors, and, in June, with a sweeping set of reforms to make the financial system more stable, more resilient, and safer for consumers and investors. We cannot be complacent; the history of major financial crises includes many false dawns and periods of optimism even in the midst of the worst downturns. But I think you will agree that the sense of free fall that surrounded the economic statistics earlier this spring has now abated. Even amidst much continued uncertainty, we must reflect on the extraordinary path our economy and financial system have taken over the past 2 years, and take this opportunity to restore confidence in the system through fundamental reform. We cannot afford to wait.Forces Leading to the Crisis At many turns in our history, we have seen a pattern of tremendous growth supported by financial innovation. As we consider financial reform, we need to be mindful of the fact that those markets with the most innovation and the fastest growth seemed to be at the center of the current crisis. But in this cycle, as in many cycles past, growth often hid key underlying risks, and innovation often outpaced the capacity of risk managers, boards of directors, regulators, rating agencies, and the market as a whole to understand and respond. Securitization helped banks move credit risk off of their books and supply more capital to housing markets. It also widened the gaps between borrowers, lenders, and investors--as lenders lowered underwriting standards since the securitized loans would be sold to others in the market, while market demand for securitized assets lowered the incentives for due diligence. Rapidly expanding markets for hedging and risk protection allowed for better management of corporate balance sheets, enabling businesses to focus on their core missions; credit protection allowed financial institutions to provide more capital to business and families that needed it, but a lack of transparency hid the movement of exposures. When the downturn suddenly exposed liquidity vulnerabilities and large unmanaged counterparty risks, the uncertainty disrupted even the most deeply liquid and highly collateralized markets at the center of our financial system. It is useful to think about our response to this crisis in terms of cycles of innovation. New products develop slowly while market participants are unsure of their value or their risks. As they grow, however, the excitement and enthusiasm can overwhelm normal risk management systems. Participants assume too soon that they really ``know how they work,'' and these new products, applied widely without thought to new contexts--and often carrying more risk--flood the market. The cycle turns, as this one did, with a vengeance, when that lack of understanding and that excess is exposed. But past experience shows that innovation survives and thrives again after reform of the regulatory infrastructure renews investor confidence. Innovation creates products that serve the needs of consumers, and growth brings new players into the system. But innovation demands a system of regulation that protects our financial system from catastrophic failure, protects consumers and investors from widespread harm and ensures that they have the information they need to make appropriate choices. Rather than focus on the old, ``more regulation'' versus ``less regulation'' debate, the questions we have asked are: why have certain types of innovation contributed in certain contexts to outsized risks? Why was our system ill-equipped to monitor, mitigate and respond to those risks? Our system failed to provide transparency in key markets, especially fast developing ones. Rapid growth hid misaligned incentives that people didn't recognize. Throughout our system we had inadequate capital and liquidity buffers--as both market participants and regulators failed to account for new risks appropriately. The apparent short-term rewards in new products and rapidly growing markets created incentives for risk-taking that overwhelmed private sector gatekeepers, and swamped those parts of the system that were supposed to mitigate risk. And households took on risks that they did not fully understand and could ill-afford. Our proposals identify sweeping reforms to the regulation of our financial system, to address an underlying crisis of confidence--for consumers and for market participants. We must create a financial system that is safer and fairer; more stable and more resilient.Protecting Consumers We need strong and consistent regulation and supervision of consumer financial services and investment markets to restore consumer confidence. In early July, we delivered the first major portion of our legislative proposals to the Congress, proposing to create a Consumer Financial Protection Agency (CFPA). We all aspire to the same objectives for consumer protection regulation: independence, accountability, effectiveness, and balance--a system that promotes financial inclusion and preserves choice. The question is how to achieve that. A successful regulatory structure for consumer protection requires mission focus, marketwide coverage, and consolidated authority. Today's system has none of these qualities. It fragments jurisdiction and authority for consumer protection over many Federal regulators, which have higher priorities than protecting consumers. Banks can choose the least restrictive supervisor among several different banking agencies. Nonbank providers avoid Federal supervision altogether; no Federal consumer compliance examiner ever lands at their doorsteps. Fragmentation of rule writing, supervision, and enforcement leads to finger-pointing in place of action and makes actions taken less effective. The President's proposal for one agency for one marketplace with one mission--protecting consumers--will resolve these problems. 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 market. It will support financial literacy for all Americans. It will prohibit misleading sales pitches and hidden traps, but there will be profits made on a level playing field where banks and nonbanks can compete on the basis of price and quality. If we create one Federal regulator with consolidated authority, then 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; preserves, not stifles, innovation; strengthens, not weakens, depository institutions; reduces, not increases, regulatory costs; empowers, not undermines, consumers; and increases, not reduces, national regulatory uniformity.Systemic Risk Much of the discussion of reform over the past 2 years--both in our proposals and among other commentators--has focused on both the nature of and proper response to systemic risk. To address these risks, our proposals focus on three major tasks: (1) providing an effective system for monitoring risks as they arise and coordinating a response; (2) creating a single point of accountability for tougher and more consistent supervision of the largest and most interconnected institutions; and (3) tailoring the system of regulation to cover the full range of risks and actors in the financial system, so that risks can no longer build up completely outside of supervision and monitoring. Many have asked whether we need a ``systemic risk regulator'' or a ``super regulator'' that can look out for new risks and immediately take action to address them or order other regulators to do so. That is not what we are proposing. We cannot have a system that depends on the foresight of a single institution or a single person to identify and prevent risks. That's why we have proposed that the critical role of monitoring for emerging risks and coordinating policy responses be vested in a Financial Services Oversight Council. At the same time, a council of independent regulators with divergent missions will not have operational coherence and cannot be held accountable for supervision of individual financial firms. That's why we propose an evolution in the Federal Reserve's power to provide consolidated supervision and regulation of any financial firm whose combination of size, leverage, and interconnectedness could pose a threat to financial stability if it failed. The financial crisis has demonstrated the crucial importance of having a consolidated supervisor and regulator for all ``Tier 1 Financial Holding Companies,'' with the regulator having the authority and responsibility to regulate these firms not just to protect their individual safety and soundness but to protect the entire financial system. This crisis has also clearly demonstrated that risks to the system can emerge from all corners of the financial markets and from any of our financial institutions. Our approach is to bring these institutions and markets into a comprehensive system of regulation, where risks are disclosed and monitored by regulators as necessary. Secretary Geithner has testified about the need to bring all over-the-counter derivatives markets into a comprehensive regulatory framework. In the next few days we will deliver legislative text to this Committee that would accomplish that goal. We have delivered proposed legislation that would strengthen the regulation of securitization markets, expand regulatory authority for clearing, payment, and settlement systems, and require registration of hedge funds.Basic Reform of Capital, Supervision, and Resolution Authority As Secretary Geithner has said, the three most important things to lower risk in the financial system are ``capital, capital, capital.'' We need to make our financial system safer and more resilient. We cannot rely on perfect foresight--whether of regulators or firms. Higher capital charges can insulate the system from the build-up of risk without limiting activities in the markets. That's why we have launched a review of the capital regime and have proposed raising capital and liquidity standards across the board, including higher standards for financial holding companies, and even higher standards for Tier 1 Financial Holding Companies--to account for the additional risk that the largest and most interconnected firms could pose to our system. Making the system safe for innovation means financial firms should raise the amount of capital that they hold as a buffer against potential future losses. It also means creating a more uniform system of regulation so that risks cannot build up due to inadequate regulatory oversight. To strengthen banking regulation, we propose removing the central source of arbitrage among depository institutions. Our proposed National Bank Supervisor would consolidate the Office of Thrift Supervision and the Office of the Comptroller of the Currency. We will also close loopholes in the Bank Holding Company Act that allow firms to own insured depository institutions yet escape consolidated supervision and regulation. Financial activity involves risk, and the fact is that we will not be able to identify all risks or prevent all future crises. We learned through painful experience that during times of great stress, the disorderly failure of a large, interconnected institution can threaten the stability of the entire financial system. While we have a tested and effective system for resolving failing banks, there is still no effective legal mechanism to resolve a nonbank financial institution or bank holding company. We have proposed to fill this gap in our legal framework with a mechanism modeled on our existing system under the We have proposed to fill this gap in our legal framework with a mechanism modeled on our existing system under the Federal Deposit Insurance Corporation (FDIC). Finally, both our financial system and this crisis have been global in scope. Our solutions have been and must continue to be global. International reforms must 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. We will not wait for the international community to act before we reform at home, but nor will we be satisfied with an international race to the bottom on regulatory standards.Credit Ratings and Fragility It's worthwhile to begin our discussion on credit ratings with a basic explanation of the role that they play in our economy. Rating agencies solve a basic market failure. In a market with borrowers and lenders, borrowers know more about their own financial prospects than lenders do. Especially in the capital markets, where a lender is likely purchasing just a small portion of the borrower's debt in the form of a bond or asset-backed security--it can be inefficient, difficult and costly for a lender to get all the information they need to evaluate the credit worthiness of the borrower. And therefore lenders will not lend as much as they could, especially to lesser known borrowers such as smaller municipalities; or lenders will offer higher rates to offset the uncertainty. Credit rating agencies provide a third party rating based on access to more information about the borrower than a lender may be able to access, and on accumulated experience in evaluating credit. By issuing a rating of the creditworthiness of a borrower, they can validate due diligence performed by lenders and enhance the ability of borrowers to raise funds. Further, the fact the credit rating agencies rate a wide variety of credit instruments and companies allowed debt investors to have the benefit of a consistent, relative assessment of credit risk across different potential investments. This role is critical to municipalities and companies to access the capital markets, and rating agencies have facilitated the growth of securitization markets, increasing the availability of mortgages, auto loans, and small business loans. Credit ratings also played an enabling role in the buildup of risk and contributed to the deep fragility that was exposed in the past 2 years. As I discussed before, the current crisis had many causes but a major theme in each was that risk--complex and often misunderstood--was allowed to build up in ways that the supervisors and regulators were unable to monitor, prevent or respond to effectively. Earnings from rapid growth driven by innovation overwhelmed the will or ability to maintain robust internal risk management systems. As the Members of this Committee know, the highest rating given by rating agencies is ``triple-A.'' An easy way to understand the importance of a triple-A rating for a borrower or an investor is that this label is the same one given to the U.S. Government. It means that the rating agency estimates that the probability of default--or the debt investor losing money--in the following year is extremely remote. The ``triple-A'' designation was therefore highly valued, but perversely, rather than preserve this designation for the few, the amount of securities and borrowers that were granted this designation became much more prevalent as borrowers and issuers were able to convince the rating agencies that innovation in the structured credit market allowed for the creation of nearly riskless credit investments. Market practices such as ``ratings shopping'' before contracting for a rating, and the creation of consulting relationships may have contributed to conflicts of interest and upward pressure on ratings. Rating agencies have a long track record evaluating the risks of corporate, municipal, and sovereign bonds. These ratings are based on the judgment of rating agencies about the credit worthiness of a borrower and are usually based on confidential information that is not generally available to the market, including an assessment of the borrower's income, ability to meet payments, and their track record for doing so. Evaluating a structured finance product is a fundamentally different type of analysis. Asset-backed securities represent a right to the cash flows from a large bundle of smaller assets. In this way an investor can finance a small portion of hundreds or thousands of loans, rather than directly lending to a single borrower. This structure diversifies the investor's risk with respect to a given borrower's default and averages out the performance of the investment to be equal to a more general class of borrowers. It also allows more investors to participate in the market, since the investor's capital no longer needs to be tied to the origination of a loan. Certain asset-backed securities also relied on a process of ``tranching''--slicing up the distribution of potential losses to further modify the return of the security to meet the needs of different investors. This process relied on quantitative models and therefore could produce any probability of default. Credit ratings lacked transparency with regard to the true risks that a rating measured, the core assumptions that informed the rating and the potential conflicts of interest in the generation of that rating. This was particularly acute for ratings on asset-backed securities, where the concentrated systematic risk of senior tranches and resecuritizations are quite different from the more idiosyncratic risks of corporate bonds. As we discovered in the past 2 years, the risks of asset-backed securities are much more highly correlated to general economic performance than other types of bonds. The more complicated products are also sensitive to the assumptions in the quantitative models used to create these products. Investors, as described earlier, relied on the rating agencies' ability to assess risk on a similar scale across instruments. They therefore saw highly rated instruments and borrowers as generally similar even though the investments themselves ranged from basic corporate bonds to highly complex bonds backed by loans or other asset-backed securities. Investors, and even regulatory bodies, rather than using ratings as one of many tools in their credit decisions, began to rely entirely on the ratings and performed little or no due diligence. Further, investors ventured into products they understood less and less because they carried the ``seal of approval'' from the rating agencies. This reliance gave the ratings agencies an extraordinary amount of influence over the fixed income markets and the stability of these markets came to depend, to a large degree, on the robustness of these ratings. Ultimately, this led to a toxic combination of overreliance on a system for rating credit that was not transparent and highly conflicted. Many of the initial ratings made during this period turned out to be overly optimistic. When it became clear that ``triple A'' securities were not as riskless as advertised, it caused a great amount of disruption in the fixed income markets. One of the central examples of these problems is in the market for Collateralized Debt Obligations or ``CDOs.'' These products are created by pooling a group of debt instruments, often mortgage loans, then slicing up the economic value of the cash flows to create tailored combinations of risk and return. The senior tranches would have the first right to payments, while the most junior tranche--often called the ``equity'' tranche--would not be paid until all others had been paid first. These new products were highly complex and difficult for most investors to evaluate on their own. Rating agencies stepped into this gap and provided validation for the sale of these products, because their quantitative models and assumptions often determined that the most senior tranches could be rated triple-A. Without this designation, many pension funds, insurance companies, mutual funds, and banks would never have been willing to invest. Many investors did not realize that the ratings were highly dependent on the economic cycle or that the ratings for many CDOs backed by subprime mortgage bonds assumed that there would never be a nationwide decline in housing prices. This complexity was often ignored as the quarterly issuance of CDOs more than quadrupled from 2004 to mid-2007, reaching $140 billion in the second quarter of 2007. \1\ But following a wave of CDO downgrades in July 2007, the market for CDOs dried up and new issuance collapsed as investors lost confidence in the rating agencies and investors realized they themselves did not understand these investments.--------------------------------------------------------------------------- \1\ SIFMA, CDO Global Issuance Data.--------------------------------------------------------------------------- The reforms proposed by this Administration recognize the market failure that the credit rating agencies help to remedy, but also address the deep problems caused by the manner in which these agencies operated and the overreliance on their judgments.Reform of the Credit Rating System This Committee, under the leadership of Senator Shelby, Senator Dodd, and others, took strong steps to improve regulation of rating agencies in 2006. That legislation succeeded in increasing competition in the industry, in giving much more explicit authority to the SEC to require agencies to manage and disclose conflicts of interest, and helping ensure the existence and compliance with internal controls by the agencies. This authority has already been used by the SEC over the past year to strengthen regulation and enforcement. The Administration strongly supports the actions that the SEC has taken and we will continue to work closely with the SEC to support strong regulation of credit rating agencies. But flaws and conflicts revealed in the current crisis highlight the need for us to go further as more needs to be done. Our legislative proposal directly addresses three primary problems in the role of credit rating agencies: lack of transparency, ratings shopping, and conflicts of interest. It also recognizes the problem of overreliance on credit ratings and calls for additional study on this matter as well as reducing the overreliance on ratings. While there were clear failures in credit rating agency methodologies, our proposals continue to endorse the divide established by this Committee in 2006: The Government should not be in the business of regulating or evaluating the methodologies themselves, or the performance of ratings. To do so would put the Government in the position of validating private sector actors and would likely exacerbate over-reliance on ratings. However, the Government should make sure that rating agencies perform the services that they claim to perform and our proposal authorizes the SEC to audit the rating agencies to make sure that they are complying with their own stated procedures.Lack of Transparency The lack of transparency in credit rating methodologies and risks weakened the ability of investors to perform due diligence, while broad acceptance of ratings as suitable guidelines for investment weakened the incentives to do so. These two trends contributed significantly to the fragility of the financial system. Our proposals address transparency both in the context of rating agency disclosure as well as stronger disclosure requirements in securitization markets more generally. An agency determines a rating with a proprietary risk model that takes account of a large number of factors. While we do not advocate the release of the proprietary models, we do believe that all rating agencies should be required to give investors a clear sense of the variety of risk factors considered and assumptions made. For instance, there are a number of ways to obtain a high rating for an asset-backed security that are not transparent to investors. First, there is the quality of the underlying assets--a bundle of prime mortgage loans will have higher credit worthiness than a bundle of subprime mortgage loans, all things being equal. Second, the rating agency could consider the quality and reliability of the data--fully documented mortgages or consumer credit instruments with a longer performance history (like auto loans) give greater certainty to the rating. Finally, if the security uses tranching or subordination, then giving a greater proportion of the economic value to a certain class of investors will raise the credit rating for that class. In the current system, there is no requirement that these factors be disclosed or compared for investors along with the credit rating. Our proposals would require far more transparency of both qualitative and quantitative information so that investors can carry out their own due diligence more effectively. To facilitate investor analysis, we will require that each rating be supported by a public report containing assessments of data reliability, the probability of default, the estimated severity of loss in the event of default, and the sensitivity of a rating to changes in assumptions. The format of this report will make it easy to compare these data across different securities and institutions. The reports will increase market discipline by providing clearer estimates of the risks posed by different investments. The history of rating agencies assessments in corporate, municipal, and sovereign bonds allowed them to expand their business models to evaluate structured finance products without proving that they had the necessary expertise to evaluate those products. The use of an identical rating system for corporate, sovereign, and structured securities allowed investors to purchase these products under their existing investment standards with respect to ratings. The identical rating systems also allowed regulators to use existing guidelines without the need to consider the different risks posed by these new financial instruments. Our proposals address the disparate risks directly by requiring that rating agencies use ratings symbols that distinguish between structured and unstructured financial products. It is our hope that this will cause supervisors and investors to examine carefully their guidelines to ensure that their investment strategy is appropriate and specific.Ratings Shopping Currently, an issuer may attempt to ``shop'' among rating agencies by soliciting ``preliminary ratings'' from multiple agencies and enlisting the agency that provides the highest preliminary rating. Consistently, this agency also provides a high final rating. A number of commentators have argued that either the existence or threat of such ``ratings shopping'' by issuers played an important role in structured products leading up to the crisis. A recent Harvard University study contains supporting evidence, finding that structured finance issues that were only rated by a single rating agency have been more likely to be downgraded than issues that were rated by two or more agencies. \2\ Our proposal would shed light on this practice by requiring an issuer to disclose all of the preliminary ratings it had received from different credit rating agencies so that investors could see how much the issuer had ``shopped'' and whether the final rating exceeded one or more preliminary ratings. The prospect of such disclosures should also deter ratings shopping in the first place. In addition, the SEC has proposed a beneficial rule that would require agencies to disclose the rating history--of upgrades and downgrades--so that the market can assess the long-term quality of ratings.--------------------------------------------------------------------------- \2\ Benmelech and Dlugosz 2009, ``The Credit Rating Crisis.''--------------------------------------------------------------------------- As an additional check against rating shopping, the Administration supports a proposed SEC rule that would require issuers to provide the same data they provide to one credit rating agency as the basis of a contracted rating to all other credit rating agencies. This will allow other credit rating agencies to provide additional, independent analyses of the issuer to the market. Such ``unsolicited'' ratings, have been ineffective because investors understand that these unsolicited ratings are not based on the same information as the fully contracted ratings, especially for structured products that are often complex and require detailed information to assess. By requiring full disclosure to all rating agencies, this rule would limit any potential benefit from rating shopping and should increase the amount of informed, but independent, research on credit instruments.Conflicts of Interest Our proposals include strong provisions to prevent and manage conflicts of interest, which we identify as a major problem of the current regime. Many of our proposals are aligned with specific provisions proposed by Senator Reed. Our approach is to solve these problems within the current framework rather than prohibiting specific models of rating agency compensation as some have advocated. Both issuer pay and investor pay models exist today and we do not believe it is the place of Government to prescribe allowable business models in the free market. Our proposal will make it simple for investors to understand the conflicts in any rating that they read and allow them to make their own judgment of its relevance to their investment decision. Most directly, we would ban rating agencies from providing consulting services to issuers that they also rate. While these consulting contracts do not currently form a huge proportion of the revenue of the top rating agencies, they are an undeniable source of conflict since they allow for issuers and raters to work closely together and develop economic ties that are not related to the direct rating of securities. For instance, today a rating agency may consult with an issuer on how to structure and evaluate asset-backed securities, and then separately be paid by the issuer to rate the same securities created. This Committee was at the center of a similar effort that banned these types of cross-relationships for audit firms in the passage of the Sarbanes-Oxley Act of 2002, which also required a study of issues with credit rating agencies. Today, we propose that these cross-relationships be simply prohibited. Our proposals also strengthen disclosure and management of conflicts of interest. The legislation will prohibit or require the management and disclosure of conflicts arising from the way a rating agency is paid, its business relationships, its affiliations, or other sources. Each rating will be required to include a disclosure of the fees paid for the particular rating, as well as the total fees paid to the rating agency by the issuer in the previous 2 years. This disclosure will give the market the information it needs to assess potential bias of the rating agency. The legislation also requires agencies to designate a compliance officer, with explicit requirements that this officer report directly to the board or the senior officer, and that the compliance officer have the authority to address any conflicts that arise within the agency. Rating agencies will be required to institute reviews of ratings in cases where their employees go work for issuers, to reduce potential conflicts from a ``revolving door.''Strengthen and Build on SEC Supervision Under the authority created by this Committee in 2006, the SEC has already begun to address many problems with rating agencies. The Treasury supports these actions and has included in our legislative proposal additional authority to strengthen and support SEC regulation of rating agencies. The Commission has allocated resources to establish a branch of examiners dedicated specifically to conducting examination oversight of credit rating agencies, which would conduct routine, special, and cause examinations. Our proposed legislation would strengthen this effort and create a dedicated office for supervision of rating agencies within the Commission. Under the legislation, the SEC will require each rating agency to establish and document its internal controls and processes--and will examine each rating agency for compliance. In line with the principle of consistent regulation and enforcement, our proposal will make registration mandatory for all credit rating agencies--ensuring that these firms cannot evade our efforts to strengthen regulation. In response to the credit market turmoil, in February the SEC took a series of actions with the goal of enhancing the usefulness of rating agencies' disclosures to investors, strengthening the integrity of the ratings process, and more effectively addressing the potential for conflicts of interest inherent in the ratings process for structured finance products. Specifically, the SEC adopted several measures designed to increase the transparency of the rating agencies' rating methodologies, strengthen the rating agencies' disclosure of ratings performance, prohibit the rating agencies from engaging in certain practices that create conflicts of interest, and enhance the rating agencies' recordkeeping and reporting obligations to assist the SEC in performing its regulatory and oversight functions. We support these measures.Conclusion In the weeks since we released our plan for reform, we have been criticized by some for going too far and by some for not going far enough. These charges are stuck in a debate that presumes that regulation--and efficient and innovative markets--are at odds. In fact, the opposite is true. Markets rely on faith and trust. We must restore honesty and integrity to our financial system. These proposals maintain space for growth, innovation, and change, but require that regulation and oversight adapt as well. Markets require clear rules of the road. Consumers' confidence is based on the trust and fair dealing of financial institutions. Regulation must be consistent, comprehensive, and accountable. The President's plan lays a new foundation for financial regulation that will once again help to make our markets vital and strong. Thank you very much. CHRG-110shrg46629--106 Chairman Bernanke," Sure. Senator Bayh. So you say in the past that the rewards to capital versus labor has tended to correct itself. If we are living in an era of more rapid rates of innovation, might that not lead it to correct perhaps not quite as quickly as in the past? " 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-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. " CHRG-110shrg50410--94 Secretary Paulson," The Chairman did such a great job, I am only going to underscore what he said and say, to really emphasize that I think of all of the recommendations that came out of the President's Working Group on Financial Markets after this turmoil, this was the most important one. That it is strengthening that infrastructure. We have too much complexity, not enough standardization. And getting the protocols right, getting these contracts so they know that they will perform under stress is just critical to having our financial system work the way we need it to work. Senator Dole. Mr. Chairman. " CHRG-111shrg51395--80 Chairman Dodd," Thank you, Senator, very much, and that is a question that many of us have raised, given the already full plate that the Fed has, in addition to roles they are taking on. The obvious problem is that if you move away from the Fed as the model, creating a whole new entity raises another whole set of issues and that is the quandary I find myself in. I don't disagree with Richard Shelby's point. We have all talked about it here at various other times. And then I quickly say to myself, so what is your alternative? And when I come to my alternative, I find myself almost in as much of a quandary. And so we find ourselves in this position of trying to make a choice between an existing structure in which I can see how this could fit--I think your point, as well--although you would have to make some changes in this thing, or trying to create something altogether new, which has also got its difficulties. But it is a very critical point, obviously, and one that we are talking about, obviously, at this point. Anyway, with that point, Senator Bennet, I thank you for your patience. Senator Bennet. Thank you, Mr. Chairman. I want to start broadly and then ask a couple of narrow questions. Professor Coffee talked about the difference between the culture of the banking regulator and the culture of the securities regulator, which has been a theme that we have heard about in this Committee, and in thinking about the new structure, we want to make sure that that culture shifts, I think, so that we get the kind of oversight that all of us will feel comfortable with. In addition to that, there is the issue of no matter what structure you have, the constant innovation that goes on in the market and having some assurance that the regulator is keeping up with that innovation, as well. We want the innovation but we also want to make sure we understand it. And then Mr. Turner's observation that what is really critical, as it is with all human institutions, is that you get the right people in the job, and unfortunately, neither he nor we have the magic wand that he called for. But I guess the question I have is, are there thoughts from you, Professor Coffee or others on the panel, about what we could do in this legislation to assure that we have the kind of attention to the changes in the market knowledge about approach and the right people so that we can really get the job done? " CHRG-111shrg49488--21 Mr. Nason," Thank you for having me. Chairman Lieberman, Ranking Member Collins, and Members of the Committee, thank you for inviting me to appear before you today on these important matters. As the United States begins to evaluate its financial regulatory framework, it is vital that it incorporate the lessons and experience from other countries' reform efforts.--------------------------------------------------------------------------- \1\ The prepared statement of Mr. Nason appears in the Appendix on page 334.--------------------------------------------------------------------------- I recently, as you just mentioned, finished a 3-year stint at the U.S. Department of the Treasury where I was honored to serve former Secretaries Jon Snow and Henry Paulson. And as the Assistant Secretary of the Treasury for Financial Institutions, I worked hand in hand with the government as they tried to respond to the financial crisis. More germane to this particular hearing is I am particularly proud to have led the team that researched and wrote the Treasury's ``Blueprint for a Modernized Financial Regulatory Structure,'' which was published in March 2008. And many of the issues that we evaluated in the writing of the Blueprint are before the Congress and the focus of this hearing. What seems clear as we think about this issue is that financial institutions play an essential role in a large part of our U.S. economy, and given the economic significance of the sector, it is important that we examine the structure of our regulatory framework as we think about the content of regulations. And this is all the more pressing as the United States begins to emerge from the current financial crisis. The root causes of the financial crisis are well documented. Benign economic conditions and plentiful market liquidity led to risk complacency, dramatic weakening of underwriting standards for U.S. mortgages, especially subprime mortgages, and a general loosening of credit terms of loans to households and businesses. The confluence of many events led to a significant credit contraction and a dramatic repricing of risk. We are still living through this process right now, and we have seen more government intervention in the financial markets than we have seen in decades. The focus of this hearing today is prospective, however, and the financial crisis has told us that regulatory structure is not merely an academic issue and that topics like regulatory arbitrage matter and have meaningful repercussions outside of the province of academia. Indeed, if we look for something positive in the aftermath of the crisis, it might be that it will give us the courage to make the hard choices and reform our financial regulatory architecture. We have learned all too well that our regulators and regulations were not well positioned to adapt to the rapid financial innovation driven by capital mobility, deep liquidity, and technology. Regulation alone and modernized architecture could not have prevented all of the problems from these developments. But we can do much better, and we can position ourselves better. Our current regulatory structure in the United States no longer reflects the complexity of our markets. This complexity and the severity of the financial crisis pressured the U.S. regulatory structure, exposing regulatory gaps as well as redundancies. Our system, much of it created over 70 years ago, is grappling to keep pace with market evolutions and facing increasing difficulties, at times, in preventing and anticipating financial crises. Largely incompatible with these market developments is our current system of functional regulation, which maintains separate regulatory agencies across segregated functional lines of financial services, such as banking, insurance, securities, and futures, with no single regulator possessing all of the information and authority necessary to monitor systemic risk. Moreover, our current system results in duplication of certain common activities across regulators. Now, while some degree of specialization might be important for the regulation of financial institutions, many aspects of financial regulation and consumer protection regulation have common themes. So as we consider the future construct of our U.S. financial regulation, we should first look to the experience of other countries, especially those that have conducted a thoughtful review recently, like we have heard today. As global financial markets integrate and accounting standards converge, it is only natural for regulatory practices to follow suit. There are two dominant forms of financial regulatory regimes that should be considered seriously in the United States as we rethink our regulatory model. I would like to focus on the consolidated regulator approach and the twin peaks approach. Under a single consolidated regulator approach, one regulator responsible for both financial and consumer protection regulation would regulate all financial institutions. The United Kingdom's consolidation of regulation within the FSA exemplifies this approach, although other countries such as Japan have moved in this direction. The general consolidated regulator approach eliminates the role of the central bank from financial institution regulation, but preserves its role in determining monetary policy and performing some functions related to overall financial market stability. A key advantage of the consolidated regulator approach that we should consider is enhanced efficiency from combining common functions undertaken by individual regulators into one entity. A consolidated regulator approach should allow for a better understanding of overall risks to the financial system. While the consolidated regulator approach benefits are clear, there are also potential problems that we should consider. For example, housing all regulatory functions related to financial and consumer regulation in one entity may lead to varying degrees of focus on these key functions. Also, the scale of operations necessary to establish a single consolidated regulator in the United States could make the model more difficult to implement in comparison to other jurisdictions. Another major approach, adopted mostly notably by our colleagues at the table in Australia and in the Netherlands, indeed, is the twin peaks model that emphasizes regulation by objectives. One regulatory body is responsible for prudential regulation of relevant financial institutions, and a separate and distinct agency is responsible for business conduct and consumer protection. The primary advantage of this model is that it maximizes regulatory focus by concentrating responsibility for correcting a single form of market failure--one agency, one objective. This consolidation reduces regulatory gaps, turf wars among regulators, and the opportunities for regulatory arbitrage by financial institutions, while unlocking natural synergies among agencies. And perhaps more importantly, it reflects the financial markets' extraordinary integration and complexity. It does pose a key problem in that effective lines of communication between the peaks are vital to success. There are several ideas in circulation in the United States. I would like to focus on some things that we focused on in the Treasury Blueprint in 2008 and some other relevant policymakers that are talking about other ideas. The March 2008 Blueprint proposes that the United States consider an objectives-based regulatory framework, similar to what Dr. Carmichael discussed, with three objectives: Market stability regulation, prudential regulation to address issues of limited market discipline, and business conduct regulation. Prudential regulation housed within one regulatory body in the United States can focus on the common elements of risk management across financial institutions, which is sorely lacking in the United States. Regulators focused on specific objectives can be more effective at enforcing market discipline by targeting of financial institutions for which prudential regulation is most appropriate. Secretary of the Treasury Geithner and FDIC Chair Bair addressed similar issues of importance in dealing with too-big-to-fail institutions and the necessity of providing systemic risk regulation. Senator Collins, you introduced legislation that recognizes the key aspects that need to be addressed in our system to deal with these difficult problems. So while there is an emerging consensus in the United States and among global financial regulators, market participants, and policymakers that systemic risk regulation and resolution authority must be a cornerstone of reform financial regulation, the exact details of the proposals need to be settled. These are very complicated and they require thoughtful debate and deliberation. One point, however, is clear: The U.S. regulatory system, in its current form, needs to be modernized and evolved. We should seize upon this opportunity to do this. To this end, the future American regulatory framework must be directed towards its proper objectives to maintain a stable, well-capitalized, and responsible financial sector. Thank you for inviting me. " CHRG-111shrg54789--166 PREPARED STATEMENT OF CHAIRMAN CHRISTOPHER J. DODD Good morning. Thank you all for being here today. This morning, we are taking an important step in our efforts to modernize our financial regulatory system. The failure of that system in recent years has left our economy in peril and caused real pain for hard-working Americans who did nothing wrong. The important work we do on this Committee is often complex and painstaking in its detail. And so, I'd like to start by reminding everyone that the work we do here, the details, matter to real people, the men and women in my home State of Connecticut and across America who work hard, play by the rules, and want nothing more than to make a better life for their families. These families are the foundation of our economy and the reason we're here in Washington working on this historic and critically important legislation. That's why the first piece of the Administration's comprehensive plan to rebuild our regulatory regime and our economy is something I have championed: an independent agency whose job it will be to ensure that American consumers are treated fairly and honestly. Think about the moments when Americans engage with financial service providers. I'm not talking about big-time investors or financial experts, just ordinary working people trying to secure their futures. They're opening checking accounts, taking out loans, building their credit, trying to build a foundation upon which their family's economic security can rest. These can be among the most important and stressful moments a family can face. Think of a young couple. They've carefully saved up for a down payment. It might be a modest house--but it'll be their home. Before they can move into their new home, however, they must sign on the dotted line for that first mortgage with its pages and pages of complex and confusing disclosures. Who's looking out for them? Think of a factory worker who drives 30 miles to and from work every day in an old car that's about to give out. He needs another one to make it through the winter, but his wages are stagnant and the family budget is stretched to the max. He's got no choice but to navigate the complicated world of auto loans. Who's looking out for him? Think of a single mother whose 17-year-old son just got into his top choice of colleges. She's overjoyed for him, but worried about how she'll pay the tuition. Financial aid might not be enough, and she knows that even as her son begins the next chapter in a life filled with promise, he might be saddled with debt. Who's looking out for them? These moments are the reason we have invested so much time and money to rebuild our financial sector even though some of the very same institutions the taxpayers have propped up are responsible for their own predicaments. These moments are the reason we serve on this Committee. And these moments are the reason I and many of my colleagues were enraged at the spectacular failure of consumer protection that destroyed the economic security of so many American families. In my home State of Connecticut and around the country, working men and women who did nothing wrong have watched this economy fall through the floor--taking with it jobs, homes, life savings, and the cherished promise of the American middle class. These folks are hurting, they are angry, they are worried. And they are wondering: Is anyone looking out for me? Since the very first hearing before this Committee on modernizing our financial regulatory structure, I have said that consumer protection must be a top priority. Stronger consumer protection could have stopped this crisis before it started. And where were the regulators? For 14 years, despite a clear directive from Congress, the Federal Reserve Board took no action to ban abusive home mortgages. Gaping holes in the regulatory fabric allowed mortgage brokers and bankers to make and sell predatory loans to Wall Street that turned into toxic securities and brought our economy to its knees. That is why I called for the creation of an independent consumer protection agency whose sole focus is the financial well-being of consumers; an agency whose goal is to put an end to unscrupulous lenders and practices that have ripped off far too many American families. And I'm pleased that the Administration has sent us a bold and thoughtful plan for that agency. You would think financial services companies would support protections that ensure the financial well-being of their customers--if not out of concern for their own bottom-lines, then out of simple common decency. But now I read that various industry groups are planning a major PR offensive in an effort to kill this consumer protection agency. To those who helped create this mess and now plan to flood the airwaves with misleading propaganda, I have just two words for you: Get real. The forces of the status quo can run as many ``Harry and Louise'' ads as they want. But Harry and Louise are exactly why we're moving forward on this proposal. We can't have a functioning economy if Harry and Louise can't safely invest and borrow without fear of being cheated by greedy banks and Wall Street firms. And we will not have a financial regulatory modernization bill that doesn't provide the protections American families need and deserve. An independent consumer protection agency can, and should, be good for business. It can, and should, protect the financial well-being of American consumers so that businesses can rely on a healthy customer base as they seek to build long-term profitability. It can, and should, eliminate the regulatory overlap and bureaucracy that comes from the current balkanized system of consumer protection regulation. It can, and should, level the playing field by applying a meaningful set of standards, not only to the highly regulated banks, but also to their nonbank competitors that have slipped under the regulatory radar screen. Financial services companies that want to make an honest living should welcome this effort to create a level playing field. Indeed, the good lenders are the most disadvantaged when fly-by-night brokers and finance companies set up shop down the street. Then we see bad lending pushing out the good. No Senator on this Committee wants to stifle product innovation, limit consumer choice, or create regulation that is unnecessary or unduly burdensome. And I welcome constructive input from those in the financial services sector who share our commitment to making sure that American families get a fair shake. But I do not view as constructive the opposition to the creation of this agency by some industry groups in order to, as Bloomberg News reported, ``protect their fees.'' We all want financial services companies to thrive and succeed, but they will have to make their money the old fashioned way--by developing innovative products, pricing competitively, providing excellent customer service, and engaging in fair competition on the open market. The days of profiting from misleading or predatory practices are over. The path to recovery of our financial services companies and our economy is based on the financial health of American consumers. We need a system that rewards products and firms that create wealth for American families, not one that rewards financial engineering that generates profits for financial firms by passing on hidden risks to investors and borrowers. The fact that the consumer protection agency is the first legislative item the Administration has sent to Congress since it released its white paper on regulatory reform last month tells me that our President's priorities are in the right order. I wish I could say the same for everyone in the industry. Nevertheless, with the backing of the Administration, with the support of many in the financial community who understand the importance of this reform, and, most of all, with a mandate from the American families who count on a fair and secure financial system, we will push forward. I thank you all for being here today. Now let's get to work. ______ CHRG-111shrg50564--189 Mr. Dodaro," I agree, Mr. Chairman, and we would be happy to follow up on our report and provide a follow-up activity report on how well they have implemented the recommendations to the Committee. Senator Akaka. Well, let me thank you for your January 2009 report, and I have seen parts of it, and your report states that: New and more complex products raise challenges for regulators in addressing financial literacy. Without sufficient financial literacy, individuals will not be able to effectively evaluate credit and investing opportunities or be able to cope with difficult economic situations.And we agree with that. My question to you is: How can we ensure that in a new regulatory structure financial literacy is effectively addressed? " CHRG-111shrg56376--117 PREPARED STATEMENT OF SENATOR TIM JOHNSON Thank you Chairman Dodd for holding today's hearing. As we all know, the regulatory structure overseeing U.S. financial markets has proven unable to keep pace with innovative, but risky, financial products; this has had disastrous consequences. Congress is now faced with the task of looking at the role and effectiveness of the current regulators and fashioning a more responsive system. To date, it appears one of the Committee's biggest challenges will be to create legislation that better protects consumers. I very much look forward to hearing from today's panels of current and former regulators to see if they believe a new agency is needed to better protect consumers, or if consumer protection should remain a function of the prudential regulator. I am also interested in hearing from the regulators their views on ways to make the regulatory system more effective. For example, does it make sense to eliminate any of the bank charters to streamline the system? Last, I would also like to know from the witnesses if they believe the regulatory gaps that caused our current crisis would be filled by the Administration's regulatory restructuring proposal. We must get this right, and the proposal we craft must target the most pressing problems in our financial regulatory system. As this Committee works through many issues to fashion what I hope will be a bipartisan proposal that creates an updated system of good, effective regulations that balance consumer protection and allow for sustainable economic growth, I will continue to advocate for increases in transparency, accountability, and consumer protection. ______ CHRG-111shrg57320--300 Mr. Doerr," Yes, we were. Senator Levin. So, Mr. Corston, we will have you go first, and then Mr. Doerr.TESTIMONY OF JOHN CORSTON,\1\ ACTING DEPUTY DIRECTOR, DIVISION OF SUPERVISION AND CONSUMER PROTECTION, COMPLEX FINANCIAL INSTITUTION BRANCH, FEDERAL DEPOSIT INSURANCE CORPORATION " CHRG-111hhrg52407--71 Mr. Scott," Thank you, Mr. Chairman. And thank you all for coming. I can't think of really any more important thing we can do than financial literacy to deal with what has happened in this financial crisis. Because, quite honestly, if we had had an informed, educated constituency consumer base, we wouldn't be in this situation we are in now, where we are literally having to spend trillions of dollars just to find our way back to shore. And education is important; K through 12 is important. But this financial system of ours is so complicated, it is so complex, and even as we are dealing with trying to fix it now, it is getting even more complex and more complicated, for the public not only lacks the education to understand how we got into this situation, they are lacking the education as to what we are doing to fix it. So financial literacy has to come front and center. And I am so glad, Mr. Chairman, that we are hosting this hearing. And I hope that we will be able to lift financial literacy up to the proper level it needs to be as a major component of our financial regulatory reform. So the question that we have to ask is, how can we incorporate financial literacy into our new financial regulatory system in a way that can certainly protect the consumer today, as they stand? And I don't see how we can do this without having some infrastructure and money and resources behind it connecting the Federal Government to this. By that, I mean this: I believe that we have to have something out there, right now, as a part of our reform, to have the consumer to say, ``Here is somewhere I can call to get information now.'' Our system is complex. There are credit cards coming, we have credit card reform; there is banking coming. Plus, we need a monitoring system to make these loan originators, these credit card companies behave themselves. Because if nobody is monitoring them, we are going to be right back in the situation that we have now. So I would like for us to give some thought to trying to come up with a monitoring system, a toll-free 1-800 number with human beings at the end of it anchored here in the government, at the Treasury Department, not a counseling program, but folks like the Urban League and the NAACP and ACORN and the senior citizens group, people who have a relationship with the most vulnerable out there. Because the damage is that these folks out there target people, and we need something that we have that targets them to give a help line. Therefore, we can have a way for people to call in and ask questions about what that situation is. And I am hopeful we can put something like that together and probably put it in Treasury in the reform. I know my time is up, Mr. Chairman, but I just wanted to say that, and commend everybody for coming, and I look forward to working on this going forward. " CHRG-110hhrg46591--383 Mr. Ryan," I am going to make a couple of comments. First, as to the general business of credit default swaps, they are risk mitigators and they serve a very useful purpose on a global basis. Some of the, I would say, concern that exists in today's marketplace and the reason for a lack of confidence is, as I said before, we have taken financial engineering to a level of complexity that people do not understand. Most of the problems, by the way, are not with credit default swaps, they are with other instruments where they were very very complex, and insurance was purchased around those securities, which are called credit default swaps. That is why this is implicated in the discussion right now. Ms. Moore of Wisconsin. Thank you. I yield back. " CHRG-111hhrg55811--174 Mr. Gensler," We believe that the legislation should cover all of the products, but allow for hedgers to hedge risk, and even if they are tailored in particular and customized, so that they would be able to innovate, and that is part of our important risk management in our economy. " CHRG-110hhrg38392--169 Mr. Bernanke," Well, on the first part of your comments, there are many issues that affect a consumer's budget: energy; health care; a whole variety of items. Each one of these things is a big and complex problem. There is not a single solution. We are just going to have to address them piece by piece. So we talked about energy, we talked about health care, we talked about other aspects of the cost of living. Let me turn, though, to your very good question about subprime. First, there always have been some concerns about these practices; you are correct about that. But there was a period that lasted perhaps less than a year--late 2005, early 2006--when there was just a tremendous sea change, a deterioration in underwriting and its standards. That came about because of the confluence of a number of different events, including this huge demand for high-yield mortgage securities from Wall Street, the expansion of lenders outside the banking system where they are closely regulated, financial innovation, new kinds of products. An important factor was the fact that with high house prices, people were stretching for affordability. All those things came together at the same time and underwriting standards really deteriorated pretty quickly. And we have seen that of mortgages written in 2006, with many of them the first payment doesn't get made; they get returned within a few months. So, something seems to have changed in late 2005 and early 2006. We were very active early on in providing guidance on best practices, on doing disclosure work, on doing fair lending reviews and so on. But it is clear, having seen some of these recent developments and asking my staff to do a top-to-bottom review, it does seem clear we need to take additional steps, which I have talked about today, and they include not just disclosure, but the rules. And among the rules we are considering are addressing low doc loans, escrow, some of these other prepayment penalties, and some of these other things you have mentioned. Some of these things have already appeared in our subprime mortgage guidance, which a lot of the States have adopted for their own, so a lot of these things are going to be put in place more quickly. But in terms of the rulemaking process, there are obviously some procedural steps that we have to take. We have to go through a full process of getting commentary and the like, and we can't go faster than that. Ms. Waters. Do you have any suggestions for legislation for us? We would move it a little bit faster if we understood it a little bit better and knew what to do. " CHRG-110shrg50415--14 Mr. Levitt," Thank you, Chairman Dodd and Senator Crapo, for the opportunity to appear before the Committee at this momentous time in the life of our markets. From where we stand at this moment in this deeply serious and destructive market crisis, we already know that there is plenty of blame to go around, but let me be clear about one point. We are here today not because of what happened this year or last, but because of at least two decades of societal and political adherence to a deregulatory approach to the explosive growth and expansion of America's major financial institutions. Furthermore, it is now readily apparent that our regulatory system failed to adapt to important, dynamic, and potentially lethal new financial instruments as the storm clouds gathered. The list of failures goes well beyond the Securities and Exchange Commission, but today I would like to focus my remarks on that agency. Right now, the key problem plaguing our markets is a total breakdown in trust, in investor confidence, in every institution that we have. Since 1934, a strong SEC--staffed by consummate professionals and led by independent-minded commissioners--has succeeded in maintaining investor confidence and helping to make our markets the envy of the world. Unhappily, over the past few years, the SEC has not lived up to this storied history. As the markets grew larger and more complex--in scope and in the products that they offered--the Commission simply failed to keep pace. As the markets needed more transparency, the SEC allowed opacity to reign. As an overheated market needed a strong referee to rein in dangerously risky behavior, the Commission too often remained on the sidelines. As this Committee examines the record, I believe it will find a lack of transparency, a lack of enforcement, and a lack of resources all played key roles. Allow me to highlight a few instances of these problems. After all the markets have undergone the past few weeks, we still do not know the full extent of the losses incurred by banks and other companies on mortgage-backed securities. A lack of information about where risk resides is keeping investors suspicious and out of the markets. One of the biggest steps we can take to bring to light a fuller picture of companies' financial health would be to expand fair value accounting to cover all financial instruments--the securities positions and the loan commitments--of all financial institutions. Yet in recent weeks, fair value accounting has been used as a scapegoat by the banking industry--the financial equivalent of shooting the messenger. If financial institutions were accurately marking the books, they would have seen the problems they are experiencing months in advance and could have made the necessary adjustments, and we might have diminished the current crisis. As the markets grew more complex, there was also a failure of oversight to keep up with growing and risky parts of it. The recent revelations about the CSE program are a glaring example of this problem. The last area where we have seen a deviation from decades of SEC history, tragically, has been the enforcement of the laws on the books. In part, this is the result of a lack of adequate resources. Budget and staffing levels have not kept pace with inflation or financial innovation. And recent procedural changes at the Commission have led to a lessening of the imposition of corporate penalties against egregious wrongdoers, a reduction in the corporate penalty in terms of penalty numbers over the past year and a demoralizing of the enforcement staff undermining their efficacy. Of course, resources alone will neither reinvigorate the SEC nor revive our markets. For the past 75 years, the Commission has been the crown jewel of the financial regulatory infrastructure and the administrative agencies because its leadership from both political parties--Chairmen like Kennedy and Douglas at its founding, and Ruder, Breeden, and Donaldson in recent times--understood the importance of public pronouncements and signals sent to the market, signals that were far more important than any rule that was passed or regulation that may have been considered. Recently, at critical moments and on critical issues, the SEC has been reactive at best or has shown no real willingness to stand up for investors. And it is these moments that weaken the power of the agency and investors' faith in the markets. Looking forward, restoring trust in our markets will require rejuvenating the SEC. It is the only agency with the history, the experience, and specific mission to be the investor's advocate--a history earned under the chairmanship of individuals from both political parties. Losing that legacy would be devastating to our ability to regulate the markets and restore investor confidence. And let me be clear: A restoration of the SEC to its position from before this current slide simply is not enough. At this moment, we need a dramatic rethinking of our financial regulatory architecture--the biggest since the New Deal. And the SEC will need to undergo changes and evolve to keep pace with a dynamic marketplace. As we move forward in the process, we must make sure that there is an agency that is independent of the White House, dedicated to mandating transparency with robust law enforcement powers, with the wherewithal and knowledge to oversee and, if necessary, guide risk management, and built around one mission: protecting the interests of investors. If we do, investors will know that they have someone in their corner, that the markets will be free and fair, and then they will invest with confidence. Thank you. " CHRG-111hhrg53021--156 Mr. Garrett," Mr. Secretary, thank you. Your opening comments were to the tune of those people who think that we are moving too soon or that we don't need change right now, or your third point was that smarter regulations might basically destroy innovation. Those people you said were---- " CHRG-111hhrg53021Oth--156 Mr. Garrett," Mr. Secretary, thank you. Your opening comments were to the tune of those people who think that we are moving too soon or that we don't need change right now, or your third point was that smarter regulations might basically destroy innovation. Those people you said were---- " FinancialCrisisInquiry--615 CHAIRMAN ANGELIDES: But did we see—last question—I said one question, but this is interesting—did we see the evolution of, I hate to use the word innovation, but did—you know, in the same way we saw a whole new set of products was it matched in those other sectors? CHRG-111hhrg48875--251 Secretary Geithner," Well, I think it is a very good question. I think that, you know, people will always innovate around what the government prohibits. And you will always be chasing the next thing which is designed to get around just that new piece of legislation designed to ban some particular product. So probably the more effective way to regulate, in some sense, is again to make sure the institutions are strong enough to survive a very bad storm, and that people are protected from predatory behavior, because the predation can come in all sorts of forms. People will be endlessly innovative in how to take advantage of people if they think there is some gain at stake. So I think that you need to have, you know, clearer standards regulated and enforced much more effectively across our country, and not allow people to come and get around those standards and offer people products that don't meet with those broad regulatory standards. But if you just do it by banning specific things, you will always be chasing the next innovation. Ms. Waters. Well, I am not so sure that we shouldn't look at opportunities to give more scrutiny to products before they come on the market, and really disclose to consumers that this is particular maybe as it relates to your economic health. So let me go to the next one on asset management. I started out the other day talking about the five firms that are indicated in the plan. I am concerned about women-owned and minority-owned businesses. You know, we are dumping a lot of money out into the economy, and we want everybody who has something to offer that is legitimate and competent to participate in all of this money that we are putting into the economy to create jobs and opportunities. Why can't we look at this a little bit closer and figure out how we can get more women and small firms and minority firms involved in this asset management, rather than having to go and knock on the doors and beg the five? " 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-111shrg53085--203 PREPARED STATEMENT OF SENATOR TIM JOHNSON Thank you Chairman Dodd and Ranking Member Shelby for holding today's hearing. As we now know, the regulatory structure overseeing U.S. financial markets has proven dangerously unable to keep pace with innovative, but risky, financial products; this has had disastrous consequences. Congress is now faced with the urgent task of looking at the role and effectiveness of the current regulators and fashioning a more responsive system. I share my colleagues' great interest in a systemic risk regulator. I am interested in how that entity would interact with existing bank regulators. I also think it is vitally important that we address the ``too big to fail'' issue. How do the regulators unwind these institutions without causing economic harm? In addition, I share the interest in proposals to enhance consumer protections--particularly whether this should include a separate regulatory body specifically designed to protect consumers. I look forward to hearing the views of today's witnesses on these topics and a variety of other topics that they believe we should consider as we look for solutions. I will continue working to fashion good, effective regulations that balance consumer protection and allow for sustainable economic growth. Today's hearing is an important piece in the development of proposals to modernize the bank regulatory structure. Any proposal must create the kind of transparency, accountability, and consumer protection that is lacking in our system of regulation. Thank you, Mr. Chairman. ______ 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. " 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. " fcic_final_report_full--421 Now  of the homes in the Hunts’ neighborhood are in default, are in the fore- closure process, or have been taken back by the bank.  Most of the other houses in the community are occupied by renters whose absentee landlords bought the houses when the homeowners lost their homes to their banks. The Hunts’ house has lost two-thirds of its value from the peak of the market. Nonetheless, even though the neighborhood is not as lovely as it used to be, Dawn Hunt told the FCIC, “I’m not leaving.”  COMMISSION CONCLUSIONS ON CHAPTER 22 The Commission concludes the unchecked increase in the complexity of mort- gages and securitization has made it more difficult to solve problems in the mortgage market. This complexity has created powerful competing interests, in- cluding those of the holders of first and second mortgages and of mortgage ser- vicers; has reduced transparency for policy makers, regulators, financial institutions, and homeowners; and has impeded mortgage modifications. The resulting disputes and inaction have caused pain largely borne by individual homeowners and created further uncertainty about the health of the housing market and financial institutions. CHRG-111shrg53822--2 Chairman Dodd," The Committee will come to order. Let me apologize to my colleagues and the witnesses as well. It was a late hour last night when we changed the schedule, but as I am sure my colleagues are aware, anyway, we are going to have about six votes beginning around 10:30 to try and finish up the housing bill. And, therefore, I thought we would try to move this up a half an hour so we could have at least a good hour and a half with you. I am going to ask my colleagues to restrain themselves, if they can, in opening statements so we can get right to the witnesses and hear their thoughts. Sheila, welcome. Nice to have you back before the Committee. Let me just share some opening comments. Senator Shelby has a meeting. He will be here shortly. He had something around 9:10, so he will be coming along. I am going to begin. Normally, of course, I would wait for my colleague from Alabama, but in light of the fact of the change in the time here, we are going to begin, anyway, on this. So let me share some opening thoughts on this subject matter, and then we will go right to the witnesses. This morning is the 13th in a series of hearings since January to identify causes of the financial crisis and specific responses that will guide the Committee's formulation of the new architecture for 21st century financial services regulation. I welcome all of our witnesses. This morning, we are going to discuss regulating and resolving institutions whose failure would pose a risk to the financial sector and our underlying economy. To be sure, we meet at a moment when many of these so-called ``too-big-to-fail'' institutions are under a microscope, and for good reason. Consider for a moment the following financial institutions: Bear Stearns, Fannie and Freddie, Lehman Brothers, AIG, Washington Mutual, Wachovia, Citigroup, Bank of America. Inside of 14 months, every one of these institutions either failed or posed a risk of failing absent Government intervention. Some were sold under duress; others failed outright. Many were saved because the Government resorted to an array of loans, guarantees, and capital injections to keep these large, complex financial firms afloat. But, regardless, the result of this turmoil is clear, with 20,000 layoffs and 10,000 homeowners entering into foreclosure each and every day. As this Committee works to modernize our financial architecture, I believe it is essential that we identify ways to give the Government the tools it needs to unwind troubled, systemically important institutions in an orderly way that will put adequate safeguards in place to prevent unwarranted risky behavior on the part of the largest market actors and puts our economy at risk. And I would commend the administration again for sharing my belief that the resolution authority be given to the FDIC, with whom the expertise of unwinding failed institutions clearly lies. To be sure, we have seen unprecedented consolidation in the banking industry over the last few decades. In 1992, the 25 largest insured depository institutions accounted for a quarter of banking industry assets. As of 2008, the top 25 held over 60 percent of industry assets. Four U.S. bank holding companies now have over $1 trillion each in banking assets. At the same time the industry became increasingly consolidated, the institutions themselves became more interconnected, and as many of these failures have illustrated, their relationships with one another even more complex. The growth of the largely unregulated credit derivatives market and the ability to process transactions with increasing speed added to the unprecedented level of complexity as well. But it was the performance of our regulators, in my view, that spun this all out of control, allowing these financial institutions to take on more and more risk, more and more leverage, with far too much autonomy and far too little accountability. Essentially, regulators took our largest financial institutions at their word that they understood what they were doing, and clearly they did not. In fact, some had no idea at all. The question before this Committee today is how to prevent this from happening again and how do we create an architecture to allow for wealth creation and for productivity to be restored. Some have looked at the failure of many large, complex financial firms to manage their risks and the failure of regulators to adequately supervise them. They concluded that we can no longer afford to let institutions grow to a point where they put our financial system at risk. As economist Joseph Stiglitz has put it, many of these institutions became not just ``too big to fail,'' but also too big to save and too big to manage. Some would strictly limit the size of balance sheets or restore some of the restrictions on business line affiliations lifted a decade ago. Another option would be to impose more stringent capital requirements, deposit insurance assessments, and other costs to provide disincentives to becoming either too big or to complex. And still others suggest that it is unrealistic to believe that we could somehow abolish large, complex financial organizations. They suggest designing a regulatory framework that would make sure that taxpayers are not on the hook each time one of these companies gets in trouble. That would mean finding ways to ensure that the creditors as well as the shareholders can suffer losses when these companies get in trouble. As Warren Buffett said last week, the key to ensuring large financial institutions are run well is not only proper incentives for success, but also severe disincentives for failure. The truth is, unlike the average family in my State or my colleagues' States who has no choice but to live within their means, the large institutions throughout the crisis were always able to borrow more, draw down more, and relax their underwriting standards as their regulators stood by. Whatever else we do, that has to stop, in my view. Large financial companies may well need a different set of capital rules to ensure that they will have sufficient funds to absorb large, unprecedented losses. They may need new disclosure and responding requirements that would enable regulators to close them in an orderly way if they become troubled. If the AIG contemporary mess that this Committee helped to expose has taught us anything, it is that regulators need a much clearer picture of the arrangement that these firms get themselves into, not only to regulate them better but to extricate them from those arrangements if need be. Each of these approaches that I have mentioned this morning has merit, and it is my hope that today's hearing will offer an opportunity to fully explore each of these options. I will say again that I believe there is a need for systemic risk regulation to ensure that we no longer need to treat any institution as ``too big to fail.'' It is my preference that that authority not lie in one body. We cannot afford to replace Citi-sized financial institutions with Citi-sized regulators. The goals of our financial modernization efforts must be more transparency, more accountability, and more checks and balances. Today's witnesses I think will help us become better informed as to these steps. With that, I thank again everyone for being here, and, Sheila, we will begin with you. CHRG-111hhrg52406--213 Mr. Bachus," Okay. Thank you. Mr. Miller of North Carolina. I like calling time on members who are much more senior than I am on this committee. We do need to try to get done before this series of votes. It is a real series of votes, not a temper tantrum of votes. For Ms. Keest and Mr. Plunkett, one series of questions, or one point repeatedly made today, is that consumer protection is a vague concept for which Congress should enact very bright line rules, which is somewhat contrary to the wisdom of previous generations. There was a famous 18th Century British case widely quoted in the United States that said that there should be no single, all-encompassing definition of ``fraud'' less the craft of men should find a way of committing fraud which might escape such a rule or definition. One of the principal functions of financial innovation in recent years appears to be to evade existing regulations. In your experience, Ms. Keest and Mr. Plunkett, how easy has it been to get legislation through Congress to protect consumers from financial practices? " CHRG-110shrg46629--122 STATEMENT OF SENATOR DANIEL K. AKAKA Senator Akaka. Thank you very much, Mr. Chairman. Mr. Bernanke, it is good to see you in person here. And I want to tell you my role here on the Banking Committee has come down to being very concerned about the consumers of America. Here I have looked upon this as trying to improve the quality of life for consumers, as well as to help them improve themselves. Consumer protection is important, and also equipping them with the skills and knowledge that will help them with their understandings and also to empower them with economic empowerment. So this area has been important to me. Our modern complex economy depends on the ability of consumers to make informed financial decisions. Without a sufficient understanding of economics and personal finance, individuals will not be able to appropriately manage their finances, evaluate credit opportunities, and successfully invest for long-term financial goals in an increasingly complex marketplace. Mr. Chairman, I really appreciate your personal involvement on the important issues of financial literacy. I also wanted to take the time to thank all of the Federal Reserve employees, and I want to include Sandy Bronstein in that, and all of those who have taken such an active role in helping improve the financial knowledge of consumers and evaluating the effectiveness of education programs. As you know, approximately 10 million households in the United States do not have accounts at mainstream financial institutions. Unfortunately, too many of these households depend on high cost fringe financial services. They miss out on opportunities for saving, borrowing, and lower cost remittances found at credit unions and banks. And so the unbanked has become one of my concerns. My question to you is what must be done to bring these households into mainstream financial institutions? " CHRG-111shrg57320--301 Mr. Corston," Thank you, Chairman Levin. I appreciate the opportunity to testify on my role with the FDIC regarding Washington Mutual Bank. On behalf of the Corporation, we have submitted to the Subcommittee a written statement that responds to specific issues that were requested by the Subcommittee. In addition, allow me to briefly introduce myself and my roles and responsibilities at the FDIC.--------------------------------------------------------------------------- \1\ The prepared statement of Mr. Corston appears in the Appendix on page 153.--------------------------------------------------------------------------- I am John Corston, Acting Deputy Director for the FDIC's Division of Supervision and Consumer Protection's Complex Financial Institution Branch in Washington, DC. I have had a leading role in this branch since 2005, after working in three different regions in various capacities related to bank supervision. I started as a field examiner with the FDIC in 1987. An element of my duties as Acting Deputy Director of Complex Financial Institutions is to oversee the Large Insured Depository Institution Program (LIDI). Broadly, the LIDI program provides forward-looking assessment of insured depository institutions over $10 billion, provides highly experienced technical experts to provide on-site support for the regions, operates continuous presence at the eight largest insured institutions, and assists in developing and recommending strategy to the Division Director and the Chairman regarding specific institutions. With regard to Washington Mutual, I worked with technical experts on my staff and coordinated with the region to evaluate CAMELS and LIDI ratings and supervisory strategy, including enforcement actions. While the region is primarily responsible for these areas, input from the Complex Financial Institutions Branch played a significant role in the decisionmaking process. I also worked with my Washington-based counterpart at the Office of Thrift Supervision on LIDIs, including Washington Mutual, to resolve issues regarding FDIC's actions or conclusions that were not resolved at the regional level. One of the roles of the FDIC's Complex Financial Institution Branch is to identify risks that impact large institutions, including high-risk lending strategies such as those that took place at Washington Mutual. To do this, we have technical experts on-site at institutions we have identified through the LIDI review process that are considered to possess higher levels of risk. For instance, we placed staff on-site at Countrywide, IndyMac, and Washington Mutual to identify high-risk activities and measure their impact on the financial condition. My branch's responsibility is to examine financial institutions and gain an awareness of the speed in which the institution could deteriorate, determine its sensitivity to market events, and analyze its exposure to loss so appropriate and timely responses can be developed. I thank you for the opportunity to testify today and I am pleased to answer any of your questions. Senator Levin. Thank you very much. Mr. Doerr.TESTIMONY OF J. GEORGE DOERR,\1\ DEPUTY REGIONAL DIRECTOR, SAN CHRG-111shrg52619--62 Chairman Dodd," Thanks very much. Senator Corker. Senator Corker. Thank you, Mr. Chairman, and I thank all of you for your testimony and your service. Ms. Bair, Chairman Bair, let me ask you this: Do you think that not having an entity that can do the overall resolution for complex entities is affecting the policies that we have in place right now as it relates to supporting them? Ms. Bair. It absolutely is. There is really no practical alternative to the course that has been set right now, because there is no flexibility for resolution. Senator Corker. So much of the actions that we are taking as a Congress and as an administration to support some of these entities have to do with the fact that we really do not have any way to unwind them in a logical way. Is that correct? Ms. Bair. I do agree with that. Senator Corker. I know the Chairman mentioned the potential of FDIC being the systemic regulator. What would be the things that the FDIC would need to do to move beyond bank resolution but into other complex entities like AIG, Lehman Brothers, and others? Ms. Bair. Right. Well, we think that if we had resolution authority, we actually should be separate from where we have the requirements for prudential supervision of systemic institutions. Those responsibilities are actually separated now, and I think it is a good check and balance to have the resolution authority with some back-up supervisory authority working in conjunction with the primary regulator who has responsibility for prudential supervision. In terms of resolution authority, I think that the current system--that we would like--if we were given it, is a good one. We can set up bridge banks, or conservatorships to provide for the orderly unwinding of institutions. There is a clear set of priorities, so investors and creditors know in advance what the imposition of loss will be. We do have the flexibility to deviate from that, but it is an extraordinary process that includes a super majority of the FDIC Board, the Federal Reserve Board, the concurrence of the Secretary of the Treasury and the President. So it is a very extraordinary procedure to deviate from the baseline requirement to minimize cost. So I think the model we have now is a good one and could be applied more broadly to complex financial organizations. Senator Corker. It sounds like in your opinion in a fairly easy way. Ms. Bair. Well, I think one easy step would be just to give us authority to resolve bank and thrift holding companies. I think that would be--I think there are going to be larger, more complex issues in terms of going beyond that category, what is systemic when you talk about insurance companies, hedge funds, other types of financial institutions. But, yes, I think that would be a relatively simple step that would give us all some additional flexibility, yes. Senator Corker. Thank you Mr. Dugan, you know, we talk about capital requirements and institutions, but regardless of the capital that any particular institution has, if they make really bad loans or make really bad decisions, it really does not matter how much they have, as we have seen, right? Are we focusing enough on minimum lending standards as we think about the overall regulation of financial institutions? " FinancialCrisisInquiry--74 Yes. THOMPSON: And many, many statutory changes were made to govern organizations to make sure that they didn’t do things like that again. How could that have occurred in such a massive scale this time? BLANKFEIN: I think in my written testimony when I cited that issue about off-balance-sheet risks, I said, post-Enron, that is amazing was the line I used because—not because these things haven’t happened before where people had risks that they weren’t showing—which, by the way, creates two problems. One, whether you have profits and losses in our own business and, two, an uncertainty of the people who deal with you about whether you’re solvent or whether anybody in the world is solvent, which froze the system. I think it’s quite a—it’s quite a big lapse that that happened. We, as a mark-to-market firm, because of our regimen, we are required to put everything through our P&L whether or not it’s on our balance sheet. If there is a risk, if we make a commitment before it’s even a security, we have to mark that commitment to market. And so our regimen that we were always under wouldn’t have allowed us to do that, but it created a lot of problems for some of the big banks and sponsoring institutions and for everybody else because not only, again, did it affect them, but it created this wave over the financial markets where there was insecurity about whether anybody could be trusted. THOMPSON: While it certainly would suggest that risk management might have lapsed, it also might suggest that corporate governance lapsed just a bit in terms of the interactions between the audit committee and the board and the voracity, if you will, of the work that was being done to determine exactly what the quality of the book was. So to what extent does financial innovation and the regulator or even organizations ability to keep up really put this economy at risk? CHRG-111shrg54789--2 Chairman Dodd," The Committee will come to order. I would like to welcome all here this morning for this morning's hearing on ``Creating a Consumer Financial Protection Agency: A Cornerstone of America's New Economic Foundation.'' We want to thank you, Mr. Barr, for joining us, and our other witnesses we will hear from after your testimony, and the Members of the Committee who are here this morning. And, obviously, my good friend and colleague Richard Shelby, former Chairman of the Committee, will be making some opening comments as well. So let me take a few minutes and share with you my thoughts on this question and then turn to Richard for any comments he has. And since only a few of us are here this morning, Bob, if you have got any opening comments you would like to make as well, I will turn to you, and then we will go to you, Mr. Barr, for your testimony. This morning we are taking an important step in our efforts to modernize our financial regulatory system. The failure of that system in recent years has left our economy in peril, as we all know, and caused real pain for many hard-working Americans who did nothing wrong themselves. And so I would like to start by reminding everyone that the work we do here matters to real people, men and women in my home State of Connecticut and all across our Nation who work hard every day, play by the rules, and want nothing more than to make a better life for themselves and their families. These families are the foundation, as all of us know, of our economy and the reason that we are here in Washington working on this historic and critically important legislation. That is why the first piece of the Administration's comprehensive plan to rebuild our regulatory regime and our economy is something that I have championed as well, and that is, an independent agency whose job it will be to ensure that American consumers are treated fairly and honestly. Think about the moments when Americans engaged with financial service providers. Now, I am not talking about big-time investors or financial experts. We know those people have a level of sophistication. I am talking about just ordinary citizens, working people trying to secure a stable future for themselves and their families. They are opening checking accounts. They are taking out loans. They are building their credit. They are trying to build a foundation upon which their families' economic security can rest for years to come. These can be among the most important and stressful moments a family can face. Think of younger people who have carefully saved up for that down payment on a home. It might be a modest house, but it will be their first home, a starter home. Before they can move into their new home, however, they must sign on the dotted line for that first mortgage, with its pages and pages of complex and confusing disclosures. Who is looking out for them in that process? Think of a factory worker who drives 30 miles to and from work every day and that old car that is about to give out. He or she needs another one to make it through the winter, but wages are stagnant and the family budget is stretched to the max. He has got no choice but to go to navigate the complicated world of an auto loan. Who is looking out for that person at that moment? Think of a single mother--and there are many in our country--whose 17-year-old son or daughter has just gotten into his or her first choice of going to college. She is overjoyed for him or her, but worried about how she is going to pay for that tuition, which grows every year astronomically. Financial aid might not be enough, and she knows that as her son or daughter begins the next chapter in their lives filled with promise, they may be saddled with overwhelming debt. Who is looking out for that family under those circumstances? These moments are the reason that we have invested so much of our time and money to rebuild our financial sector, even though some of the very institutions that the taxpayers have propped up are responsible for their own predicaments. These moments are the reason why we serve on this Committee and why I believe we have all come to the Senate to try and make a difference in the lives of the people we represent. And these moments are the reason that I and many of my colleagues were enraged by the spectacular failure of consumer protection that destroyed economic security for so many of our American families. In my home State of Connecticut and around the country, working men and women who did nothing wrong have watched this economy fall through the floor, taking with it their jobs, their homes, their life savings, and the cherished promise of the American middle class. These people are hurting. They are angry and they are worried, and they are wondering whether anyone is looking out for them. Since the very first hearings before this Committee on modernizing our financial regulatory structure, I have said that consumer protection should be a top priority in our deliberations. Stronger consumer protection could have stopped the crisis before it started, in my view. And where were the regulators in all of this? We know now that for 14 years, despite a clear directive from the U.S. Congress, the Federal Reserve Board took no action to ban abusive home mortgages. Gaping holes in the regulatory fabric allowed mortgage brokers and bankers to make and sell predatory loans to Wall Street that turned into toxic securities and brought our economy to its knees. That is why many of us call for the creation of an independent consumer protection agency whose sole focus is the financial well-being of consumers, an agency whose goal it is to put an end to lending practices that have ripped off far too many American families, and the Administration has sent us a very bold and I believe thoughtful plan for that agency. You would think financial services companies would support protections that ensure the financial well-being of their consumers. An independent consumer protection agency can and should be very good for business, not just for consumers. It can and should protect the financial well-being of American consumers so that businesses can rely on a healthy customer base as they seek to build long-term profitability. It can and should eliminate the regulatory overlap and bureaucracy that comes from the current Balkanized system of consumer protection regulation. It can and should level the playing field by applying a meaningful set of standards, not only to the highly regulated banks but also to their nonbank competitors that have slipped under the regulatory radar screen. Financial services companies that want to make an honest living should welcome this effort to create a level playing field. Indeed, the good lenders--and there are many--are the most disadvantaged when fly-by-night brokers and fly-by-night finance companies set up shop down the street. Then we see bad lending pushing out the good. No Senator on this Committee, Democrat or Republican, wants to stifle product innovation, limit consumer choice, or create regulation that is unnecessary or unduly burdensome. And I welcome the constructive input from those in the financial services sector--who share our commitment, by the way, to making sure that American families get a fair shake. We all want financial services companies to thrive and succeed, but they are going to have to make their money, in my view, the old-fashioned way: by developing innovative products, pricing competitively, providing excellent consumer service, and engaging in fair competition on the open market. The days of profiting from misleading or predatory practices need to be over with completely. The path to recovery of our financial services companies and our economy is based on the financial health of American consumers. I believe that very deeply. We need a system that rewards products and firms that create wealth for American families, not one that rewards financial engineering that generates profits for financial firms by passing on hidden risks to investors and borrowers. The fact that the consumer protection agency is the first legislative item the Administration has sent to Congress since it released its white paper on regulatory reform last month tells me that our President's priorities are in the right place. Nevertheless, with the backing of the Administration, with the support of many in the financial community who understand the importance of this reform, and, most of all, with a mandate from the American families I have discussed who count on a fair and secure financial system, I believe that we will push forward and succeed. I thank all of you for being with us here today as we move forward on this issue. Let me say, as I have said many times already in discussions both informally and formally, Richard Shelby, my partner in all of this, he and I are determined to work together on this to get this right. This is not one where we bring a lot of ideology to this debate but, rather, what works, what makes sense, what will restore the confidence and optimism of people all across this country--and, for that matter, around the world, who look to the United States as a safe and secure place and an innovative place to come and park their hard-earned dollars and hard-earned money. And so, with that, I thank again everyone for being here, and let me turn to Senator Shelby. CHRG-111hhrg48873--16 Secretary Geithner," Thank you, Mr. Chairman. As we have seen with AIG, distress at large, complex financial institutions can pose risks as dangerous as those that led the United States to establish a full framework of tools for dealing with banks. We need to extend those protections and authorities to cover the risks posed by our more diverse and complicated financial system today. And we are proposing legislation to provide those tools, and look forward to working with this committee and the Congress to pass such legislation as quickly as possible. The proposed resolution authority would allow the government to provide financial assistance to make loans to an institution, to purchase its obligations or assets, to assume or guarantee its liabilities, and to purchase an equity interest. The U.S. Government, as conservator or receiver, would have additional powers to sell or transfer the assets or liabilities of the institution in question, to renegotiate or repudiate the institutions' contracts, and to prevent certain financial contracts with the institution from being terminated on account of conservatorship or receivership. This proposed legislation would fill a significant void in the current financial services regulatory structure in respect to these large, complex institutions. And implementation would be modeled on the resolution authority that the FDIC has under current law with respect to banks. This an extraordinary time for our country, and your government has been forced to take extraordinary measures. We will do what is necessary to stabilize our financial system and, with the help of the Congress, develop the tools we need to make our economy more resilient and our financial system more stable and more just. We need to work together to create an environment where it is safe to save and invest and where all Americans can trust the rules governing their financial decisions. Thank you, Mr. Chairman. [The prepared statement of Secretary Geithner can be found on page 83 of the appendix.] " 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-111hhrg56241--38 Mr. Stiglitz," It is both a source of pleasure and sadness to testify before you today. I welcome this opportunity to testify on this important subject, but I am sorry that things have turned out so badly thus far. In this brief testimony I can only touch on a few key points, and many of these points I elaborate in my book, ``FreeFall,'' which was published just a few days ago. Our financial system failed to perform the key roles that it is supposed to perform in our society: managing risk; and allocating capital. A good financial system performs these functions at low transaction costs. Our financial system created risk and mismanaged capital, all the while generating huge transaction costs, as the sector garnered some 40 percent of all corporate profits in the years before the crisis. So deceptive were the systems of creative accounting the banks employed that, as the crisis evolved, they didn't even know their own balance sheet, so they knew that they couldn't know that of any other bank. We may congratulate ourselves that we have managed to pull back from the brink, but we should not forget that it was the financial sector that brought us to the brink of disaster. While the failures of the financial system that led the economy to the brink of ruin are by now obvious, the failings of our financial system were more pervasive. Small- and medium-sized enterprises found it difficult to get credit, even as the financial system was pushing credit on poor people beyond their ability to repay. Modern technology allows for the creation of an efficient low-cost electronic payment mechanism, but businesses pay 1 to 2 percent or more for fees for a transaction that should cost pennies or less. Our financial system not only mismanaged risk and created products that increased the risk faced by others, but they also failed to create financial products that could help ordinary Americans face the important risk they confronted, such as the risk of homeownership or the risk of inflation. Indeed, I am in total agreement with Paul Volcker. It is hard to find evidence of any real growth associated with many of the so-called innovations in our financial system, though it is easy to see the link between those innovations and the disaster that confronted our economy. Underlying all the failures a simple point seems to have been forgotten: Financial markets are a means to an end, not an end in themselves. We should remember, too, that this is not the first time our banks have been bailed out, saved from bearing the full consequences of their bad lending. Market economies work to produce growth and efficiency, but only when private rewards and social returns are aligned. Unfortunately, in the financial sector, both individual and institutional incentives were misaligned, which is why this discussion of incentives is so important. The consequences of the failures of the financial system are not borne by just those in the sector, but also by homeowners, retirees, workers, and taxpayers, and not just in this country but also around the world. The externalities, as economists refer to these impacts and others, are massive; and they are the reason why it is perfectly appropriate that Congress should be concerned. The presence of externalities is one of the reasons why the sector needs to be regulated. In previous testimony I have explained what kinds of regulations are required to reduce the risk of adverse externalities. I have also explained the danger of excessive risk-taking and how that can be curtailed. I have explained the dangers posed by underregulated derivative markets. I regret to say that so far, more than a year after the crisis peaked, too little has been done on either account. But too-big-to-fail banks create perverse incentives which also have a lot to do with what happened. I want to focus my remaining time on the issue of incentives and executive compensation. As I said, there are also key issues of organizational incentives, especially those that arise from institutions that are too-big-to-fail, too-big-to-be-resolved, or too-intertwined-to-fail. The one thing that economists agree upon is that incentives matter. Even a casual look at the conventional incentive structures, with payments focused on short-run performance and managers not bearing the full downside consequences of their mistakes, suggested that they would lead to shortsighted behavior and excessive risk-taking. And so they did. Let me try to summarize some of the general remarks that I make in my written testimony that I hope will be entered into the record. Flawed incentives played an important role, as I said before, in this and other failures of the financial system to perform its central roles. Not only do they encourage excessive risk-taking and shortsighted behavior, but they also encourage predatory behavior. Poorly designed incentive systems can lead to a deterioration of product quality, and this happened in the financial sector. This is not surprising, given the ample opportunities provided by creative accounting. Moreover, many of the compensation schemes actually provide incentives for deceptive accounting. Markets only allocate resources well when information is good. But the incentive structures encouraged the provision of distorted and misleading information. The design of the incentives system demonstrates a failure to understand risk and incentives and/or a deliberate attempt to deceive investors, exploiting deficiencies in our systems of corporate governance. I want to agree very much with Professor Bebchuk's view of the need for reforms in corporate governance. There are alternative compensation schemes that would provide better incentives, but few firms choose to implement such schemes. It is also the case that these perverse incentives failed to address adequately providing incentives for innovations that would have allowed for a better functioning of our economic system. [The prepared statement of Professor Stiglitz can be found on page 68 of the appendix.] " CHRG-111hhrg55809--36 Mr. Bernanke," Well, no doubt the failure of the auto companies would have been disruptive, particularly in the areas where employment is concentrated in that area; and it was particularly troublesome given the state of the general economy when these decisions were made. But I would draw a strong distinction I think between financial institutions, particularly large, complex, international, interdependent financial institutions and any other kind of firm. I think only those large financial institutions have the ability to bring down the entire global system. So the failure of Lehman Brothers affected not only the United States economy but every economy in the world. Now, clearly, damage would have been done by other kinds of firms, but I would personally--my focus is on financial firms. " CHRG-111hhrg53242--31 Mr. Nichols," Chairman Kanjorski, members of the committee, I would like to thank you as well as Chairman Frank and Ranking Member Bachus for the opportunity to participate in today's hearing and to share the Financial Services Forum's views on the Administration's proposal to reform and modernize our Nation's framework of financial supervision. The Forum, as many of you know, is a nonpartisan financial and economic policy organization comprised of the chief executives of 17 of the largest and most diversified financial institutions doing business in the United States. Our purpose is to promote policies that enhance savings and investment, and that ensure an open, competitive, and sound global financial services marketplace. Reform and modernization of our Nation's framework of financial supervision is overdue and needed. Our current framework is simply outdated. Our Nation needs a new supervisory framework that is effective, efficient, ensures institutional safety and soundness and systemic stability, promotes the competitive and innovative capacity of the U.S. capital markets and, quite importantly, protects the interests of depositors, investors, consumers, and policyholders. With this imperative in mind, we applaud the Administration's focus on reform and modernization and the ongoing hard work of this committee. We agree with much of the Administration's diagnosis of the deficiencies of our current framework, and we applaud the conceptual direction and many of the details of the Administration's reform proposal. I will briefly touch on a couple elements of that plan. Perhaps the most significant deficiency of our current supervisory framework is that it is highly balkanized, with agencies focused on specific industry sectors. This stovepipe structure has led to at least two major problems that created the opportunity for, and some would say exacerbated, the current financial crisis: one, gaps in oversight naturally developed between the silos of sector-specific regulation; and two, no agency is currently charged with assessing risks to the financial system as a whole. No one is looking at the big picture. A more seamless, consistent, and holistic approach to supervision is necessary to ensure systemic stability and the safety and soundness of all financial entities. We believe the cornerstone of such a modern framework is a systemic risk supervisor. Indeed, one of the reasons this crisis could take place is that while many agencies and regulators were responsible for overseeing individual financial firms and their subsidiaries, no one was responsible for protecting the whole system from the kinds of risks that tied these firms to one another. As President Obama rightly pointed out when he announced his plan just a few weeks ago, regulators were charged with seeing the trees, but not the forest. This proposal to have a regulator look not only at the safety and soundness of individual institutions, but also for the first time at the stability of the financial system as a whole, is essential. During Q&A, we could visit about who might be best suited to be a systemic risk supervisor and how you could make that entity accountable. Of the many unfortunate and objectionable aspects of the current financial crisis, and the subsequent policy response, perhaps none is more regrettable and evoking of a more passionate objection than too-big-to-fail. Failure is an all-American concept because the discipline of potential failure is necessary to ensure truly fair and competitive markets. No institution should be considered too big to fail. A critical aspect of regulatory reform and modernization, therefore, must be to provide the statutory authority and procedural protocol for resolving, in a controlled way that preserves public confidence and systemic integrity, the failure of any financial entity, no matter how large or complex. So while no institution should be considered too big to fail, there are some that are too big to fail uncontrollably. We think that putting in place safeguards to prevent the failure of large and interconnected financial firms, as well as a set of orderly procedures that will allow us to protect the economy if such a firm in fact does go under water, should go hand in hand. The Forum's insurance industry members agree that it is essential that there be increased national uniformity in the regulation of insurance. Congressman Kanjorski, you and I have had this discussion. And we are supportive of the creation of an Office of National Insurance within the Treasury Department. ONI will ensure that knowledge and expertise is established at the Federal level, which is critical to ensuring that insurance industry interests are represented in the context of international negotiations and regulatory harmonization efforts. Again, thank you for the opportunity to appear before you today. I look forward to your questions. [The prepared statement of Mr. Nichols can be found on page 84 of the appendix.] " CHRG-111shrg55739--8 Mr. Barr," Thank you very much, Chairman Dodd, Ranking Member Shelby. It is a pleasure to be back here today with you and the other Members of the Committee to talk about the Administration's plan for financial regulatory reform. As you know, on June 17th, President Obama unveiled a sweeping set of regulatory reforms to lay a foundation for a safer, more stable financial system. We have sent up draft legislation for your consideration in most of the areas covered by that proposal, and in the weeks since the release of those proposals, we have worked with you and your staffs on testimony and briefings on a bipartisan basis to explain and refine the legislation. Today, I would like to focus on credit ratings and credit rating agencies and the role that they played in creating a system where risks built up without being accounted for or properly understood, and how these ratings contributed to a system that proved far too fragile in the face of changes in the economic outlook and uncertainty in our financial markets. This Committee has provided strong leadership to enact the first registration and regulation of rating agencies in 2006 under Senator Shelby's leadership, and Chairman Dodd, Ranking Member Shelby, Senators Reed and Bunning have continued that tradition going forward. The proposals that I will discuss today build on that already strong foundation of this Committee's work. It is worthwhile to begin our discussion of credit ratings with a basic explanation of the role they play. Rating agencies solve a basic market failure. In a market with borrowers and lenders, borrowers know more about their own financial prospects than lenders do. And especially in the capital markets, where a lender is likely purchasing a small portion of the borrower's debt in the form of a bond or asset-backed security, it can be inefficient for all lenders to get the information they need to evaluate the creditworthiness of the borrower. Lenders will not lend as much as they otherwise might, especially to lesser known borrowers such as smaller municipalities, or they will offer significantly higher rates. Credit rating agencies provide a rating based on scale economies, access to information, and accumulated experience. At the same time, credit ratings played a key role, a key enabling role in the buildup of risk in our system and contributed to the deep fragility that was exposed in the past 2 years. The current crisis had many causes, but a major theme was that risk--complex and often misunderstood--built up in ways that supervisors, regulators, market participants did not, could not monitor, prevent, or respond to effectively. Rapid earnings from growth driven by innovation overwhelmed the will or the ability to maintain robust internal controls and risk management systems. Rating agencies have a long track record evaluating the risks bonds, but evaluating structured financial products is a fundamentally different type of analysis. Asset-backed securities represent a right to the cash-flows from a large bundle of smaller assets. Certain asset-backed securities also rely ``tranching''--the slicing up of potential losses--and this process relies on quantitative models that can produce and did produce any desired probability of default. Credit ratings lacked transparency with regard to the true risks that a rating measured and the core assumptions that informed the rating and the potential conflicts of interest in generating that rating. This was particularly acute for ratings on asset-backed securities, where the concentrated systemic risk are quite different from the more idiosyncratic risks of corporate bonds and are much more sensitive to the underlying assumptions. Investors relied on the rating agencies' assessment of risk across instruments, and they saw those risks as remarkably similar, despite the complex and different securities underlying the assets. Ultimately, this led to serious overreliance on a system for rating credit that was neither transparent nor free from conflict. And when it turned out that many of the ratings were overly optimistic, to say the least, it helped bring down our financial system during the financial crisis. We do need fundamental reform. The Administration's plan focuses on a series of additional measures in three key areas: transparency, reduction of rating shopping, and addressing conflicts of interest. It recognizes the problem of overreliance and calls for reducing the ratings usage wherever possible. With respect to transparency, we would call first for better transparency in the rating agency process itself as well as stronger disclosure requirements in securitization markets more broadly. We would require transparency with respect to qualitative and quantitative information underlying the ratings so that investors can carry out their own due diligence more effectively. Mr. Chairman, I see that my time is up. Would you mind if I take a couple more moments to outline the key proposals? " CHRG-111shrg55739--79 Mr. Gellert," Thank you. Senators, thank you for inviting us to join you today. Rapid Ratings is a subscriber-paid firm or otherwise known as an investor-paid firm. We utilize a proprietary software-based system to rate the financial health of thousands of public and private companies and financial institutions quarterly. We use only financial statements, no market inputs, no analysts, and have no contact in the rating process with issuers, with bankers, or with advisers. Our ratings far outperformed the traditional issuer-paid rating agencies in innumerable cases such as Enron, GM, Delphi, Pilgrim's Pride, the entire U.S. homebuilding industry, and others. Currently, we are not a NRSRO. We have not applied for the NRSRO status, and we do not have immediate plans to do so. At present, there are too many mixed messages coming from the SEC, Treasury, and Congress for me to recommend to our shareholders that the designation is in their best interests. Of course, the Treasury proposal's requirement that all ratings firms must register is an unwelcomed development. It runs counter to the goal of positive change for the industry, not to mention elements of the Credit Rating Agency Reform Act of 2006. We do believe that reform in our industry is necessary and must happen with a sense of urgency. But we caution that, if not done properly, this reform may have counterproductive and unintended consequences. We also believe that competition in this industry, and the level playing field for current and new players, is essential. Equivalent disclosure of information is needed. Rules that do not disproportionately penalize small players are needed. An environment where the new innovate and where the old can have their behavior modified is needed. All should be primary goals of legislation. The SEC has been wrestling with new rules and rule amendments and has made some headway in areas curbing the issuer-paid conflicts. We do not agree with all of the elements of the SEC's initiatives, but the Commission has taken some positive steps to stop the more egregious behavior of the issuer-paid agencies. As detailed in my written submission, our views on the new Treasury proposal are not quite as balanced. Together, the SEC and Treasury initiatives are positively addressing rating shopping, conflict and fee disclosure, transparency issues, and are at least flirting with removing the NRSRO designation from SEC regulations. For our complete comment on these, again, I would like to refer you to our written submission. On the critical side, the recent Treasury proposal, despite its positives, threatens to erect more hurdles to competition in this industry, further solidifying the entrenched position held by S&P, Moody's, and Fitch. A few items. Methodology disclosure: Rules in the Treasury proposal on transparency of ratings methodology could come dangerously close to meaning ratings firms would have no intellectual property protection. Ratings disclosure: Requiring subscriber-based rating agencies to disclose their history of ratings and ratings actions can undermine the subscriber-based business model, which is predicated on selling current and past ratings to investors. The Treasury proposal covers all types of rating agencies and for 100 percent of their ratings. This erects a major barrier for subscriber-paid firms by interfering with their revenue model. Requiring NRSRO registration: Requiring registration of all companies issuing ratings is perhaps the most counterproductive initiative of all. Not only does forcing registration run counter to the 2006 Act, it could create a flood of new NRSROs captured by the sweeping dragnet. Investors will not have the inclination to look at all of these firms and will tend to remain with the providers they know best, the Big Three. Further, registration would impose all of the increased direct and indirect costs on firms that would otherwise choose not to be an NRSRO. This will force some out of business, it will create disincentives for new entrants, and it will stifle potential innovation and positive competition. So the Treasury proposal would require firms to register, subject them to high compliance costs, put at risk some firms' intellectual property, and hinder their revenue-generating ability. All in all, regulatory protection for S&P, Moody's, and Fitch, and anything but a level playing field. The Big Three agencies have lobbied heavily to promote the notion that one-size-fits-all regulation is fair because all business models carry conflicts of interest and that theirs is no worse than any other. Can conflicts occur in other business models? Sure, theoretically. Have conflicts in subscriber-paid models contributed to any financial disasters? No. This red herring cannot drive new legislation. The problem is not the potential behavior of the subscriber-paid rating agencies. Rather, it is the misbehaviors of the issuer-paid rating agencies that have already occurred. Effective legislation and regulatory framework must focus on reforming the issuer-paid model and the model's most negative features, providing oversight of the NRSROs that prevent the self-interested behavior that contributed to the current financial crisis and creating an even playing field for competition. The latter has two major components, fostering, or at least not inhibiting, new players, methodologies, and innovation; and equivalent disclosure of data used by issuer-paid agencies. For true reform to have a fighting chance, these themes must be protected by the legislative framework for the ratings industry. We must be critically aware of how the unintended consequences of poorly implemented regulations can leave us with a broken system that has proven it is not so deserving of protection. Innovation and responsible alternatives to a status quo have been hallmarks of the American financial system. These should be fostered by those looking to return confidence and integrity to this industry. Thank you. Senator Reed. Thank you very much, Mr. Gellert. I would just take the opportunity that your comment about registration of all rating agencies is the Treasury proposal, it is not my proposal. " CHRG-111shrg54789--137 Mr. Wallison," Well, exactly. The effect of this, of course, is when a provider is confronted with the choice of whether to offer only the plain-vanilla product or the more complex product, he has to decide whether this particular consumer is going to be able to understand the product. And as I quoted in my testimony, the white paper says here that disclosure itself may not be enough. For some people, complexity itself is going to make it difficult for them to sign up for something that they may not understand. So the provider has to make this decision, and what the provider is mostly going to do is say, I am sticking with the plain-vanilla product because if I go any further with that, with this particular consumer, I could get in trouble, and that will reduce the products that are available to consumers, I am afraid. Senator Shelby. Financial institutions, as I understand the proposal, will no longer be primarily concerned with discerning and meeting the needs of their customers. Instead, they would be concerned with gaining regulatory approval and avoiding taking any steps that would lead to enforcement actions or, obviously, costly litigation down the road. Do you agree with that? " CHRG-111hhrg52406--17 Mr. Hensarling," I thank you, Mr. Chairman. The subject matter of today's hearing is disappointing to me. The goal should not be enhancing regulation; the goal ought to be enhancing consumer protection. The hearing title assumes that the magic elixir to our Nation's economic woes is simply more regulation and more regulators. Regulators who now apparently will be given sweeping powers to decide which financial products are best for ourselves and our families. The underlying legislation essentially says that when it comes to financial products if we will only yield our freedoms, if we will only yield our consumer choices, if we will only yield our market-driven innovations to a group of unelected philosopher kings, they will undoubtedly rule us with wisdom and justice. Forgive me, but I do not buy it. The way to protect consumers is to ensure competitive markets, effective disclosure, consumer choice, innovation, and a modicum of personal responsibility. Now, the underlying legislation tells us that this unelected group of people to form this Commission will have full powers to unilaterally and subjectively ban a product from the market that it deems unfair or anti-consumer. Unelected bureaucrats will now decide for us what mortgages we can have, they will decide what bank accounts we can open, they may even decide whether or not we can be trusted with a credit card. To that I say, if you do not know the Rodriguez family of Mesquite, Texas, do not presume to choose their bank account for them. If you do not know the Laird family of Athens, Texas, do not believe that you can decide what mortgage is best for them. If you don't know the Shane family of Coffman County, Texas, please don't deign to decide whether or not they can use a credit card to meet their family's needs to find their version of the American dream. Now, to those who say the Administration's financial reform plan lacked any originality, they are clearly wrong. To functionally create a commission of consumer punishment, not consumer protection, this is an original idea, it is an originally bad idea. And for those who say that, well, we have an economic crisis therefore we must act, you cannot point to any other consumer product but a subprime mortgage as having anything connected to the economic crisis, yet the Federal Reserve has acted, Congress has acted. You can also not point to any lack of regulatory authority. You may not believe that the regulatory authority was exercised properly, maybe not aggressively, it is not a lack of regulatory authority. We need better enforcement, smarter enforcement, but we must preserve economic liberty and consumer choice, and I yield back the balance of my time. " CHRG-111hhrg48875--120 Mr. Donnelly," When the chairman gave his opening statement, one of the things he said was that we want to have innovations with value added. We saw naked credit default swaps cause extraordinary devastation to our economy. And I know regulation is coming. Do these naked credit default swaps provide any value added, or is this simply just gambling? " CHRG-111hhrg48867--2 The Chairman," The hearing will come to order. The purpose of this hearing is to continue to focus even more on a very broad question, the importance of an effect that has been undermined by recent events and by the considerably larger crowd we will have here tomorrow when we deal with the apparently three most fearsome letters in the English language: ``AIG.'' We will deal with that tomorrow. But what we need to do is to figure out how we avoid ever again being in this situation. ``Ever again'' overstates it. How do we make it much less likely that we are not again in this situation? So this begins a set of hearings that we are going to be having on what, if anything, should be done at the legislative level and then carrying through obviously to the executive level to prevent some of the problems that we are now dealing with from recurring. There will be a series of hearings. As you know, the Secretary of the Treasury will be testifying at our hearing on March 26th. But we want to hear from a wide range of people on the consumer side, on the labor side, and on the financial industry side, former regulators, other commentators, and people in the industry. We will have a series of hearings on this. We have several hearings planned between now and the break. We will resume and continue the hearings, and it is my hope that we will be able to begin the drafting of legislation sometime in early May. That is when we come back and have a couple more weeks of hearings. I urge people to be thinking seriously about what we are doing. This will be a lengthy process. It will go through all of the regular order. The Senate also is engaged in this. The White House and the Treasury are engaged in it. It is a very important task, and we will be addressing it with great seriousness and with full input. I am not at this point going to get into anything substantive because I really hope that we will have a full and unfettered conversation with a variety of people about this, and I would hope people would feel totally free to make whatever recommendations they may have. Everyone who is here will, I am sure, be asked again to comment on this, but you don't have to wait to be asked. We have as important a task as we have had in this general area, I believe, since the 1930's. But I will just say briefly what seems to me to be the situation. We are a society that understands the value of free enterprise in a capitalist system in creating wealth. Some political rhetoric to the contrary, that is not in question now, and won't be in question in the future. No one is seriously talking about diminishing the role of the private sector as the wealth creator, and for this committee's jurisdiction of the financial services industry as the intermediary, as the entity that helps accumulate wealth from a wide variety of sources and makes it available for those who will be taking the lead in the productive activity, that is the intermediation function, and it is a very important one. From time to time in economic life, the private sector, which is constantly innovating, but achieves the level of innovation that is almost a qualitative change when a very new set of activities comes forward. Now, by definition, if those activities do not provide value to the society, they die of their own weight. Only those that are in fact genuinely adding significant value thrive. But also by definition because they are innovative, as they thrive they do a lot of good, but there is some damage because they are operating without rules, they are new, and that is why I think the problem here is not deregulation, but nonregulation. It is not that rules that had been in place were dismantled, it is that as new activities come forward there need to be new rules that are put in place that to the maximum extent possible provide a structure in which the value of these innovations can continue but some of the abuses are restricted. I will give two examples where it seems to me we went through that process. In the late 19th Century, the formation of the large industrial enterprises, then called trusts. This country could not have industrialized. The wealth could not have spread to the extent that it has here or elsewhere without large enterprises. But because they were new, there were not rules. So while they were formed and thrived in the late 19th Century and on into the next century, the presidencies of Theodore Roosevelt and Woodrow Wilson were aimed at preserving the value while containing the damage that could be done. The antitrust acts, the Federal Trade Act, even the Federal Reserve Act itself came out of that situation. Because you had the large enterprises you then had the stock market become so important, because you had now gone beyond what individuals could finance. And the stock market obviously provided an important means of support for this process, but with some abuses. So in the New Deal period and then after we had rules adopted that gave us the benefits of this finance capitalism but tried to restrain some of the abuses, the SEC and other factors. I believe that securitization, the ability to use pools of money not contributed by depositors, and are therefore relatively unrestricted, to finance activities and to sell the right to be repaid, obviously has a lot of advantages. If mortgage loans can be made, securitized, and remade, that money can support a lot more activities. Securitization greatly increases the ability to use the money. But like these other innovations it comes in an area without regulation. And our job now I believe is in some ways comparable to what happened under Franklin D. Roosevelt or Theodore Roosevelt and Woodrow Wilson, to come up with a set of rules that create a context in which a powerful, valuable tool can go forward in its contributions but with some restriction on the negative side. And that is never easy to do and you never do it 100 percent. I regard it, by the way, as very much a pro-market enterprise, because one of the problems we have now is an unwillingness on the part of many who have the money to make it available. We have investors who are reluctant to get involved. That is a great problem. It is nice from the standpoint of calculating our interest costs to have Treasuries be so popular. But it is not healthy for the economy for Treasuries to be disproportionately the investment people want to make. One of the advantages of this being done properly is to get a set of rules that will tell investors that it is safe to get back into the business of investing. So we regard this again as very pro-market, of taking a market-driven innovation, in this case securitization, and trying to preserve its value while limiting some of the harm that comes when it acts in a totally unregulated atmosphere and in a manner that will give a great deal of confidence to investors so that we can resume this function of intermediation of gathering up resources and making them available for productive uses. The gentleman from Alabama. " CHRG-111hhrg53238--91 Mr. Neugebauer," Thank you, Mr. Chairman. One of the things that I heard, a common theme was coordination, innovation, and the fact that with two different regulators there could be conflicts. And one of the things that I think about from my lending days is many times when people came in to borrow money, sometimes we had to tailor financial products to meet the consumer's need. And I think this hearing today is about the consumers to a great degree. And everybody here, I believe, believes that they ought to be treated fairly and appropriately and with integrity. But what I am concerned about under the proposal that the Administration and the chairman have laid out is that this is really not a consumer protection bill but a products regulation bill. And there is a difference between product regulation and consumer protection. And I think I would just kind of like to go down the line there and get your perspective of--you know, one is about a behavior, and when people try to defraud or misrepresent something to someone, that is a behavioral issue and not a product issue--but get your reflections on the implications of the Federal Government being very prescriptive about the products that you would be providing and how that might impact the people that we are talking about here, and that is the consumer. Mr. Bartlett? " CHRG-109hhrg23738--170 Mr. Greenspan," Yes. Congressman, I am not sure I agree with you, and let me tell you why. What we do know is that the cutting edge of this economy is basically new companies which start from scratch, small business. Most of them fail. Those that really make it, do well. Now, it may very well be the case that after they make it, the entrepreneurs move to the big city. That may be true. But the real growth in this country is in the peripheral areas, where technology and innovation is the most pronounced. We do have an extraordinary advance that has occurred in the financial system in the United States in the last decade, which essentially has meant that we have carried technologies that would develop not in Manhattan Island, but they are most obviously applied to Manhattan, so that the value added, in a good part of Manhattan, is quite significant and growing, but the source of it is not fundamentally there. And I think what is so extraordinary about this country is the flexibility and the mobility. People move all the time. I mean, I think something like 20 percent of our households move every year. " CHRG-111hhrg53242--13 Mr. McHenry," Thank you, Mr. Chairman. Thank you all for being here today. This is by far one of the most wide-ranging panels that we have had representing the financial markets, and I am glad you are here. My concern is for my constituents and average Americans to have options for investments, have options for the type of savings accounts they have, the type of investment vehicles they have. And my additional concern is about the credit rating agencies. But beyond that, when you look at CFPA and the idea of creating another bureaucracy by which you have to jump through hoops, will that limit options for my constituents to have products that they can invest in? Will it basically make vanilla bean products, will it limit innovation in the marketplace? Will it hamstring our capacity and my constituents' capacity to get the lending that they need to grow this economy? The fact is that in this severe downturn, capital is hard to come by for average Americans. Will this proposal further restrict capital? And what are your firms and the people that you represent doing in anticipation of this massive regulatory reregulation, overregulation? So what are they doing right now? Are your firms holding more capital in anticipation of regulatory changes? Are we further limiting options because Congress is talking about completely changing financial regulations? That is a concern that I have, and I would hope that the panel would touch on that today as well. Thank you, Mr. Chairman. " 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-109shrg21981--138 Chairman Shelby," Hurry. Senator Bayh. Very quickly. I want to ask you about our comparative advantage looking forward, Mr. Chairman. You have been a long-time observer of our economy. Here shortly you are going to be liberated from the burdens of public responsibility and might have a chance to reflect at greater length. But I was struck in December when my wife and I were in India, in Bangalore, and visited General Electric, who employs 6,000 people in our State. One of their worldwide innovation centers was located in Bangalore. There is a biotech company there that heretofore has been only engaged in generic production but is now getting into proprietary discover. Our economy--and my State is a good example. A hundred years ago, most people were employed in agriculture. We transitioned into manufacturing, which peaked in the 1950's. We then transitioned into a service sector economy. As succinctly as you can, how would you define, looking forward, our comparative advantage in a world in which our competitors--India, China, and the others--are rapidly moving up the innovation curve? " CHRG-111hhrg56778--58 Mr. Royce," What transpired at the time, though, in this case, is that we did not have commissioners who took a look at the health of this holding company, and, given its very varied non-insurance holdings and the fact that its financial position could harm the insurance company in the system, this turned out to be problematic, especially, when you consider that the Securities Lending Division, which has taken up roughly half of the tax dollars that have been pumped into AIG was using money directly from the AIG insurance subsidiaries, and all of those were State-regulated. So I would ask Ms. Gardineer. Would you care to comment? Certainly, OTS had some authority over AIG. Do you agree that the various State insurance commissioners could have taken steps early on to prevent some of the damage caused by AIG? Ms. Gardineer. Congressman, I do recognize that with the speed that AIG Financial Products collapsed, and then ultimately the problem surfaced with regard to the securities lending subsidiaries, there were problems, as you indicated earlier, across all parts of the organization of those that are functionally regulated by the State commissioners as well as the parts that were not functionally regulated and fell to OTS for examination. It imposes a very interesting dynamic as far as all of the complexities of a company of that size when you have so many regulators who are looking into trying to figure out very complex structures of unregulated products. " CHRG-111hhrg53248--80 Secretary Geithner," Again, as I said, we want to have a strong agency with the right balance between innovation and protection, and we would be happy to work with you and your colleagues on how best to achieve that. " Mr. Kanjorski," [presiding] The gentlelady's time has expired. The Chair now recognizes Mr. Neugebauer for 5 minutes. " CHRG-111hhrg58044--224 Mr. Snyder," What we do support is reasonable regulation and their ability to innovate and compete in the market. Ms. Waters. Mr. McRaith, you represent the National Association of Insurance Commissioners. You must hear from commissioners all over the country about the problems they have with whatever regulation they may be responsible for in their States. Have you heard any of your commissioners complaining about loops or gaps in their oversight responsibilities-- " CHRG-111shrg54789--79 Mr. Barr," Thank you, Senator. Our judgment is that the new agency will have the ability to set high standard across the financial services marketplace, including for mortgages, that we will continue to see innovation in the mortgage sector, but that if firms want to offer products that are difficult for consumers to understand, there will be a higher burden on them to explain those products and services. And I think that we have seen the consequences of a system in which there is inadequate supervision of those kinds of practices. So I do think we are going to see a rebalancing, if you will, where it is a much lighter regulatory burden even than we have today with respect to straightforward products. So you can do things like combine the Truth in Lending Form and the Real Estate Settlement Practices Form into one simple Mortgage Disclosure Form everybody can use. That is easy under the new approach, very hard under the current approach. It is a way of reducing regulatory burden for banks, improving disclosure for consumers. We can see a lot of that happening in this space with the new agency. Senator Johnson. My time is up. " CHRG-111hhrg52406--122 Mr. Posey," I heard that. My question to you was, you said that some of these products are very complicated, and so obviously, the disclosure of them is going to be very complicated. Oftentimes, you can't simplify a disclosure of a complex equation. And so my point is, were you talking about disallowing the complex items themselves or the complex-- " CHRG-111hhrg52397--92 Mr. Lynch," I appreciate your attempt there but having looked at these derivatives and how complex they are, and if they are all carved out individually, customized to these firms and their situations, I do not think there is any systemic regulator who is going to be able to make that determination based on the instrument itself. These are very, very complex, it is mind-numbing how complex these things are, and I just do not think that is a realistic expectation. I think I have exhausted my time, Mr. Chairman. I appreciate your attempt to address that, and I appreciate the attendance of all the witnesses. Thank you. " CHRG-111shrg52619--177 PREPARED STATEMENT OF GEORGE REYNOLDS Chairman, National Association of State Credit Union Supervisors, and Senior Deputy Commissioner, Georgia Department of Banking and Finance March 19, 2009NASCUS History and Purpose Good morning, Chairman Dodd, and distinguished Members of the Senate Committee on Banking, Housing, and Urban Affairs. I am George Reynolds, Senior Deputy Commissioner of Georgia Department of Banking and Finance and chairman of the National Association of State Credit Union Supervisors (NASCUS). \1\ I appear today on behalf of NASCUS, the professional association of state credit union regulators.--------------------------------------------------------------------------- \1\ NASCUS is the professional association of the 47 state credit union regulatory agencies that charter and supervise the nation's 3,300 state-chartered credit unions.--------------------------------------------------------------------------- The mission of NASCUS is to enhance state credit union supervision and advocate for a safe and sound state credit union system. We achieve our mission by serving as an advocate for the dual chartering system, a system that recognizes the traditional and essential role of state governments in the national system of depository financial institutions. Thank you for holding this important hearing today to explore modernizing financial institution supervision and regulation. The regulatory structure in this country has been a topic of discussion for many years. The debate began when our country's founders held healthy dialogue about how to protect the power of the states. More recently, commissions have been created to study the issue and several administrations have devoted further time to examine the financial regulatory system. Most would agree that if the regulatory system were created by design, the current system may not have been deliberately engineered; however, one cannot overlook the benefits offered by the current system. It has provided innovation, competition and diversity to our nation's financial institutions and consumers. In light of our country's economic distress, many suggest that regulatory reform efforts should focus, in part, on improving the structure of the regulatory framework. However, I suggest that it is not the structure of our regulatory system that has failed our country, but rather the functionality and accountability within the regulatory system. A financial regulatory system, regardless of its structure, must delineate clear lines of responsibility and provide the necessary authority to take action. Accountability and transparency must also be inherent in our financial system. This system must meet these requirements while remaining sufficiently competitive and responsive to the evolving financial service needs of American consumers and our economy. Credit union members and the American taxpayer are demanding each of these qualities be present in the nation's business operations and they must be present in a modernized financial regulatory system. These regulatory principles must exist in a revised regulatory system. This is accomplished by an active system of federalism, a system in which the power to govern is shared between national and state governments allowing for clear communication and coordination between state and federal regulators. Further, this system provides checks and balances and the necessary accountability for a strong regulatory system. I detail more about this system in my comments.NASCUS Priorities for Regulatory Restructuring NASCUS' priorities for regulatory restructuring focus on reforms that strengthen the state system of credit union supervision and enhance the capabilities of state-chartered credit unions. The ultimate goal is to meet the financial needs of consumer members while assuring that the state system is operating in a safe and sound manner. This provides consumer confidence and contributes to a sound national and global financial system. In this testimony, I discuss the following philosophies that we believe Congress must address in developing a revised financial regulatory system. These philosophies are vital to the future growth and safety and soundness of state-chartered credit unions. Preserve Charter Choice and Dual Chartering Preserve States' Role in Financial Regulation Modernize the Capital System for Credit Unions Maintain Strong Consumer Protections, which often Originate at the State Level My comments today will focus solely on the credit union regulatory system; I will highlight successful aspects and areas Congress should carefully consider for refinement.Preserving Charter Choice and Dual Chartering The goal of prudential regulation is to ensure safety and soundness of depositors' funds, creating both consumer confidence and stability within the financial regulatory system. Today's regulatory system is structured so that states and the federal government act independently to charter and supervise financial institutions. The dual chartering system for financial institutions has successfully functioned for more than 140 years, since the National Bank Act was passed in 1863, allowing the option of chartering banks nationally. It is important that Congress continue to recognize the distinct roles played by state and federal regulatory agencies. Dual chartering remains viable in the financial marketplace because of the distinct benefits provided by charter choice and due to the interaction between state and federal regulatory agencies. This structure works effectively and creates the confidence and stability needed for the national credit union system.Importance of Dual Chartering The first credit union in the United States was chartered in New Hampshire in 1909. State chartering remained the sole means for establishing credit unions for the next 25 years, until Congress passed the Federal Credit Union Act (FCUA) in 1934. Dual chartering allows an institution to select its primary regulator. For credit unions, it is either the state agency that regulates state-chartered credit unions in a particular state or the National Credit Union Administration (NCUA) that regulates federal credit unions. Forty-seven states have laws that permit state-chartered credit unions, as does the U.S. territory of Puerto Rico. Any modernized regulatory restructuring must recognize charter choice. The fact that laws differ for governing state and federal credit unions is positive for credit unions and consumers. A key feature of the dual chartering system is that individual institutions can select the charter that will benefit their members or consumers the most. Credit union boards of directors and CEOs have the ability to examine the advantages of each charter and determine which charter matches the goals of the institution and its members. Congress intended state and federal credit union regulators to work closely together, as delineated in the FCUA. Section 201 of the FCUA states, `` . . . examinations conducted by State regulatory agencies shall be utilized by the Board for such purposes to the maximum extent feasible.'' \2\ NCUA accepts examinations conducted by state regulatory agencies, demonstrating the symbiotic relationship between state and federal regulators.--------------------------------------------------------------------------- \2\ 12 U.S. Code 1781(b)(1).--------------------------------------------------------------------------- Congress must continue to recognize and to affirm the distinct roles played by state and federal regulatory agencies. The U.S. regulatory structure must enable state credit union regulators to retain regulatory authority over state-chartered credit unions. This system is tried and it has worked for the state credit union system for 100 years. It has been successful because dual chartering for credit unions provides a system of ``consultation and cooperation'' between state and federal regulators. \3\ This system creates the appropriate balance of power between state and federal credit union regulators.--------------------------------------------------------------------------- \3\ The Consultation and Cooperation With State Credit Union Supervisors provision contained in The Federal Credit Union Act, 12 U.S. Code 1757a(e) and 12 U.S. Code 1790d(l).--------------------------------------------------------------------------- A recent example of state and federal credit union examiners working together and sharing information is the bimonthly teleconferences held since October of 2008 to discuss liquidity in the credit union system. Further, state regulators and the NCUA meet in-person several times a year to discuss national policy issues. The intent of Congress was that these regulators share information and work together and in practice, we do work together. Another exclusive aspect of the credit union system is that both state and federal credit unions have access to the National Credit Union Share Insurance Fund (NCUSIF). Federally insured credit unions capitalize this fund by depositing one percent of their shares into the fund. This concept is unique to credit unions and it minimizes taxpayer exposure. Any modernized regulatory system should recognize the NCUSIF. The deposit insurance system has been funded by the credit union industry and has worked well for credit unions. We believe that credit unions should have access to this separate and distinct deposit insurance fund. A separate federal regulator for credit unions has also worked well and effectively since the FCUA was passed in 1934. NASCUS and others are concerned about any proposal to consolidate regulators and state and federal credit union charters. Charter choice also creates healthy competition and provides an incentive for regulators (both state and federal) to maximize efficiency in their examinations and reduce costs. It allows regulators to take innovative approaches to regulation while maintaining high standards for safety and soundness. The dual chartering system is threatened by the preemption of state laws and the push for a more uniform regulatory system. As new challenges arise, it is critical that the benefits of each charter are recognized. As Congress discusses regulatory modernization, it is important that new policies do not squelch the innovation and enhanced regulatory structure provided by the dual chartering system. As I stated previously, dual chartering benefits consumers, provides enhanced regulation and allows for innovation in our nation's credit unions. Ideally, the best of each charter should be recognized and enhanced to allow competition in the marketplace. NASCUS believes dual chartering is an essential component to the balance of power and authority in the regulatory structure. The strength and health of the credit union system, both state and federal, rely on the preservation of the principles of the dual chartering system.Strengths of the State System State-chartered credit unions make many contributions to the economic vitality of consumers in individual states. Our current regulatory system benefits citizens and provides consumer confidence. To begin, one of the strengths of the state system is that states operate as the ``laboratories'' of financial innovation. Many consumer protection programs were designed by state legislators and state regulators to recognize choice and innovation. The successes of state programs have been recognized at the federal level, when like programs are introduced to benefit consumers at the federal level. It is crucial that state legislatures maintain the primary authority to enact consumer protection statutes for residents in their states and to promulgate and enforce state consumer protection regulations, without the threat of federal preemption. We caution Congress about putting too much power in the hands of the federal regulatory structure. Dual chartering allows power to be distributed throughout the system and it provides a system of checks and balances between state and federal authorities. A system where the primary regulatory authority is given to the federal government may not provide what is in the best interest of consumers.Preserve States' Role in Financial Regulation The dual chartering system is predicated on the rights of states to authorize varying powers for their credit unions. NASCUS supports state authority to empower credit unions to engage in activities under state-specific rules, deemed beneficial in a particular state. States should continue to have the authority to create and to maintain appropriate credit union powers in any new regulatory reform structure debated by Congress. However, we are cognizant that our state systems are continuously challenged by modernization, globalization and new technologies. We believe that any regulatory structure considered by Congress should not limit state regulatory authority and innovation. Preemption of state laws and the push for more uniform regulatory systems will negatively impact our nation's financial services industry, and ultimately consumers. Congress should ensure that states have the authority to supervise state credit unions and that supervision is tailored to the size, scope and complexity of the credit union and the risk they may pose to their members. Further, Congress should reaffirm state legislatures' role as the primary authority to enact consumer protection statutes in their states. Added consumer protections at the state level can better serve and better protect the consumer and provide greater influence on public policy than they can at the federal level. This has proved true with data security and mortgage lending laws, to name a few. It is crucial that states maintain authority to pursue enforcement actions for state-chartered credit unions. Congress' regulatory restructuring efforts should expand the states' high standards of consumer protection. Recently, Chairman Barney Frank (D, Mass.) of the House Financial Services Committee, said, ``States do a better job,'' when referring to consumer protection. NASCUS firmly believes this, too.Comprehensive Capital Reform for Credit Unions The third principle I want to highlight is modernizing the capital system for credit unions. Congress should recognize capital reform as part of regulatory modernization. Capital sustains the viability of financial institutions. It is necessary for their survival. NASCUS has long supported comprehensive capital reform for credit unions. Credit unions need access to supplemental credit union capital and risk-based capital requirements; these related but distinctly different concepts are not mutually exclusive. The current economic environment necessitates that now is the time for capital reform for credit unions.Access to Supplemental Capital State credit union regulators are committed to protecting credit union safety and soundness. Allowing credit unions access to supplemental capital would protect the safety and soundness of the credit union system and provide a tool to use if a credit union faces declining net worth or liquidity needs. A simple fix to the FCUA would authorize state and federal regulators the discretion, when appropriate, to allow credit unions to use supplemental capital. NASCUS follows several guiding principles in our quest for supplemental capital for credit unions. First, a capital instrument must preserve the not-for-profit, mutual, member-owned and cooperative structure of credit unions. Next, it must preserve credit unions' tax-exempt status. \4\ Finally, regulatory approval would be required before a credit union could access supplemental capital. We realize that supplemental capital will not be allowed for every credit union, nor would every credit union need access to supplemental capital.--------------------------------------------------------------------------- \4\ State-chartered credit unions are exempt from federal income taxes under Section 501(c)(14) of the Internal Revenue Code, which requires that (a) credit union cannot access capital stock; (b) they are organized/operated for mutual purposes; and without profit. The NASCUS white paper, ``Alternative Capital for Credit Unions . . . Why Not?'' addresses Section 501(c)(14).--------------------------------------------------------------------------- Access to supplemental capital will enhance the safety and soundness of credit unions and provide further stability in this unpredictable market. Further, supplemental capital will provide an additional layer of protection to the NCUSIF thereby maintaining credit unions' independence from the federal government and taxpayers. Allowing credit unions access to supplemental capital with regulatory approval and oversight will enhance their ability to react to market conditions, grow safely into the future, serve their nearly 87 million members and provide further stability for the credit union system. We feel strongly that now is the time to permit this important change. Unlike other financial institutions, credit union access to capital is limited to reserves and retained earnings from net income. Since net income is not easily increased in a fast-changing environment, state regulators recommend additional capital-raising capabilities for credit unions. Access to supplemental capital will enable credit unions to respond proactively to changing market conditions, enhancing their future viability and strengthening their safety and soundness. Supplemental capital is not new to the credit union system; several models are already in use. Low-income credit unions are authorized to raise uninsured secondary capital. Corporate credit unions have access, too; they have both membership capital shares and permanent capital accounts, known as paid-in capital. These models work and could be adjusted for natural-person credit unions.Risk-Based Capital for Credit Unions Today, every insured depository institution, with the exception of credit unions, uses risk-based capital requirements to build and to monitor capital levels. Risk-based capital requirements enable financial institutions to better measure capital adequacy and to avoid excessive risk on their balance sheets. A risk-based capital system acknowledges the diversity and complexity between financial institutions. It requires increased capital levels for financial institutions that choose to maintain a more complex balance sheet, while reducing the burden of capital requirements for institutions holding assets with lower levels or risk. This system recognizes that a one-size-fits-all capital system does not work. The financial community continues to refine risk-based capital measures as a logical and an important part of evaluating and quantifying capital adequacy. Credit unions are the only insured depository institutions not allowed to use risk-based capital measures as presented in the Basel Accord of 1988 in determining required levels or regulatory capital. A risk-based capital regime would require credit unions to more effectively monitor risks in their balance sheets. It makes sense that credit unions should have access to risk-based capital; it is a practical and necessary step in addressing capital reform for credit unions.Systemic Risk Regulation The Committee asked for comment regarding the need for systemic risk regulation. Certainly, the evolution of the financial services industry and the expansion of risk outside of the more regulated depository financial institutions into the secondary market, investment banks and hedge funds reflect that further consideration needs to be given to having expanded systemic risk supervision. Many suggest that the Federal Reserve System due to its structural role in the financial services industry might be well suited to be assigned an expanded role in this area.The Role of Proper Risk Management During this period of economic disruption, Congress should consider regulatory restructuring and also areas where risk management procedures might need to be strengthened or revised to enhance systemic, concentration and credit risk in the financial services industry. Congress needs to address the reliance on credit rating agencies and credit enhancement features in the securitization of mortgage-backed securities in the secondary market. These features were used to enhance the marketability of securities backed by subprime mortgages. Reliance on more comprehensive structural analysis of such securities and expanded stress testing would have provided more accurate and transparent information to market analysts and investors. Further, there is a debate occurring about the impact of ``mark-to-market'' accounting on the financial services industry as the secondary market for certain investment products has been adversely impacted by market forces. While this area deserves further consideration, we urge Congress to approach this issue carefully in order to maintain appropriate transparency and loss recognition in the financial services industry. Finally, consideration needs to be given to compensation practices that occurred in the financial services industry, particularly in the secondary market for mortgage-backed securities. Georgia requires depository financial institutions that are in Denovo status or subject to supervisory actions that use bonus features in their management compensation structure not to simply pay bonuses based on production or sales, but also to include an asset quality component. Such a feature will ``claw back'' bonuses if production or sales result in excessive volumes of problematic or nonperforming assets. If such a feature were used in the compensation structure for the marketing of asset-backed securities, perhaps this would have been a deterrent to the excessive risk taking that occurred in this industry and resulted in greater market discipline.Conclusion Modernizing our financial regulatory system is a continuous process, one that will need to be fine-tuned over time. It will take careful study and foresight to ensure a safe and sound regulatory structure that allows enhanced products and services while ensuring consumer protections. NASCUS recognizes this is not an easy process. To protect state-chartered credit unions in a modernized regulatory system, we encourage Congress to consider the following points: Enhancing consumer choice provides a stronger financial regulatory system; therefore charter choice and dual chartering must be preserved. Preserve states' role in financial regulation. Modernize the capital system for credit unions to protect safety and soundness. Maintain strong consumer protections, which often originate at the state level. It is important that Congress take the needed time to scrutinize proposed financial regulatory systems. NASCUS appreciates the opportunity to testify today and share our priorities for a modernized credit union regulatory framework. We urge this Committee to be watchful of federal preemption and to remember the importance of dual chartering and charter choice in regulatory modernization. We welcome questions from Committee Members. Thank you. FOMC20051101meeting--195 193,CHAIRMAN GREENSPAN.," I can’t speak for the rest of the Committee in that respect, but we’ll all be vetting the minutes so we can try to do our best in conveying our thoughts. My only concern is not to introduce a new uncertainty in the process since we’ve done exceptionally well for so long. Being innovative has less value than I think we’ve realized." FinancialCrisisInquiry--131 But you seem to be saying that the price of greater innovation, greater volatility in the larger economic world may be having a stronger core. Am I hearing you correctly? SOLOMON: Yes. CHAIRMAN ANGELIDES: OK. Well, if it’s all yes, then unless you want to... MAYO: Well, I would say not completely. CHAIRMAN ANGELIDES: OK. MAYO: So and it’s partly—the source of a lot of the losses were detailed by Mr. Bass and Mr. Solomon. And a lot of the companies they named were outside of the core banking industry. SOLOMON: The activities were. MAYO: And the companies were, too, to a certain degree. I mean, the story is not over yet for the U.S. banks, but big losses you’ve seen were outside the core part of the U.S. banking industry. So I’d make that point to start off. The second point I would make is, to some degree, it’s management over model. So you can go down the whole laundry list of the types of financial firms. You have big conglomerates; some did well, some did poorly. You have brokerage firms; some did well, some did poorly. So I don’t want to overstate the point that you’re making here. CHRG-111hhrg52261--10 Mr. Loy," Thank you, Chairman Velazquez, Ranking Member Graves, and members of the committee. Thank you for the opportunity to be part of this important discussion today. I would like to begin by talking about risk and the difference between entrepreneurial risk and systemic financial risk. Entrepreneurial risk involves making calculated and informed bets on people and innovation and is critical to building small businesses. Systemic financial risk involves a series of complex financial interdependencies between parties and counterparties operating in the public markets. The venture industry and the small business community are heavily dependent on embracing entrepreneurial risk, but we have virtually no involvement in systemic risk. Let me explain why. The venture capital industry is simple. We invest in privately held small businesses created and run by entrepreneurs. These entrepreneurs grow the business using their own personal funds as well as the capital from ourselves and our outside investors, known as LPs or limited partners. We invest cash in these small businesses to purchase equity, i.e., stock, and we then work closely alongside the entrepreneurs on a weekly basis for 5 to 10 years until the company is sold or goes public. When the company has grown enough so that it can be sold or taken public, the VC exits our investment in the company and the proceeds are distributed back to our investors in our funds. When we are not successful, we lose the money we invested, but that loss does not extend to anyone else beyond our investors. Even when we lose money on investments, it does not happen suddenly or unexpectedly. It takes us several years to lose money and the investors in our funds all understand that time frame and the risk when they sign up. Debt, known as leverage, which contributed to the financial meltdown, is not part of our equation. We work simply with cash and with equity. We do not use debt to make investments or to increase the capacity of the fund. Without debt or derivatives or securitization or swaps or other complex financial instruments, we don't expose any party to losses in excess of their committed capital. In our world, the total potential loss from a million dollar investment is limited to a million dollars. There is no multiplier effect because there are no side bets, unmonitored securities, or derivatives traded, based on our transactions. There are no counterparties tied to our investments. Nor are venture firms interdependent with the world's financial system. We do not trade in the public markets and our investors cannot withdraw capital during the 10-year life of a fund, nor can they publicly trade their partnership interest in the fund. The venture capital industry is also much smaller than most people realize. In 2008, U.S. venture capital funds held approximately $200 billion in aggregate assets and invested just $28 billion into start-up companies. That is less than 0.2 percent of the U.S. gross domestic product. Yet, over 40 years, this model has been a tremendous force in U.S. economic growth, building industries like biotech, semiconductor and software. Now we are increasingly helping to build renewable energy and other green-tech sectors. Companies that were started with venture capital since 1970 today account for 12.1 million jobs and $2.9 trillion in revenues in the U.S. That is nearly 21 percent of the U.S. GDP, but it grew from our investments of less than 0.2 percent of GDP. My main point, therefore, is that harming our industry will prevent a major part of the future American economy from growing out of businesses that are today's small businesses; and that is the risk that you should be concerned about. Now, we do recognize the legitimate need for transparency and we simply ask that you customize the regulatory approach to fit what we do. Today, VCs already provide information to the SEC. That information, submitted on what is called Form D, should already be sufficient to determine the lack of systemic risk from venture capital firms. This filing process could easily be enhanced to include information that would provide greater comfort to our regulators. An enhanced Form D--let's call it Form D-2, could answer questions on our use of leverage, trading positions, and counterparty obligations, allowing regulators to then exempt from additional regulatory burdens firms like ours that don't engage in those activities and, therefore, don't pose systemic risks. In contrast, formally registering as investment advisers under the current act, as the current proposals require, has significant burdens without any additional benefits. And let me be clear, registering as an advisor with the SEC is far from simple, and it is not just filling out a form. The word ""registration"" in that context might sound like registering your vehicle, telling the motor vehicle department what kind of car it is and who you are and where you live. It might conjure up images of things like smog checks and our proposal for the Form D-2 is equivalent to that. But actually the word ""registration"" in the SEC context comes with a lot of other requirements. To continue my analogy with your car, it is equivalent to having to hire a full-time driver, plus a compliance officer who rides in the front seat to make sure that driver is operating the car correctly, plus a mechanic who lives at your house to fix the car and works only on your car, plus providing the government with information about every place you drive. Moving back to the actual world of SEC registration involving examinations, complex programs overseen by a mandatory compliance officer, it will demand significant resources which promise to be costly from both a financial and human resources perspective. My own firm believes it will be one-third of our entire annual budget. Your support has not gone unnoticed by us and we appreciate it. We cannot afford another situation where the unintended consequences of well-intentioned regulation harms small businesses and the economic growth that we drive. We look forward to working with the committee on that goal. " CHRG-111shrg56376--99 Mr. Tarullo," Sure. Some of the regulatory requirements are for all institutions and the FDIC has to decide whether to grant insurance to each depository institution, no matter by whom chartered, that wants to be insured. There is a way to contain that kind of arbitrage while permitting the useful, innovative kinds of experimentation that States have engaged in, such as allowing creation of NOW accounts, for example. Senator Warner. Mr. Dugan, Mr. Bowman, do you want to---- " CHRG-111shrg61651--111 Mr. Johnson," Absolutely. Senator Shelby. OK. Now, as we wrestle with this, we all know, and you know because you spend your life in this as either a professor or consultant or a banker, it is very complex, and as Senator Dodd said, there always--when we raise a question, then it begets another one to deal with. But do you know--do any of you know of any institution, financial institution, that has been well capitalized--we talked about capital here earlier--well capitalized, well managed, Mr. Reed, and well regulated that has failed? Do you? [Witnesses shaking heads.] Senator Shelby. I don't, either. Thank you, Mr. Chairman. " CHRG-111shrg61513--108 Mr. Bernanke," We have worked together on it. The Federal Reserve has had concerns for a long time, and you were a supporter of very good, strong regulatory oversight of Fannie and Freddie. And unfortunately, you know, we know how it turned out, that they did not have enough capital. You know, I think the current situation is worrisome. It obviously is a costly situation. And it also generates a certain amount of uncertainty in markets as people try to anticipate, you know, what the U.S. housing financial situation is going to be in the future. Housing policy is a very big part of our financial policy in this country, and the lack of clarity about that is an issue. Now, again, let me just say I sympathize with Secretary Geithner in that there is an awful lot going on and financial reform is complex. But I do hope we will be thinking about where we want to take Fannie and Freddie soon so that we can at least provide some clarity to the markets and to the public about, you know, where we think this ought to be. Senator Shelby. Thank you, Mr. Chairman. Senator Reed. Senator Menendez. Senator Menendez. Thank you, Mr. Chairman. Chairman Bernanke, welcome and congratulations on your confirmation. " 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-110hhrg44903--5 Mr. Kanjorski," Thank you very much, Mr. Chairman. Today we continue our review of a systemic risk in financial markets. Although we passed the housing reform package yesterday, tremendous economic anxiety and uncertainty remain. Finding an effective regulatory regime to keep pace with increasingly complex financial products and markets remains our goal. Striking an appropriate balance to enhance protection against systemic risk is also a difficult task. For just as the markets continually change and evolve, so must regulation. The explosive growth of complex financial instruments is well-documented. Credit default swaps and collateralized debt obligations are just two examples of comparatively new exotic products flooding our markets. Warren Buffett famously labeled credit derivatives as ``financial weapons of mass destruction.'' Some may view his characterization as extreme. But allowing these risky creations to thrive in a thinly regulated or unregulated market is a recipe for disaster. So, in order to better understand these instruments, I sent 2 days ago a request to the Government Accountability Office that it begin a study on structured financial products. This study will examine the nature of these instruments and the degree of transparency and market regulation surrounding them. From this study, we should obtain a clearer picture of how to improve regulation in the sector of our financial system. Another area of regulation we should consider is the consolidation of regulation of our securities and commodities markets. The Treasury's recommendation to merge the Securities Exchange Commission and the Commodity Futures Trading Commission is something that ought to be discussed today. Such a merger illustrates the kind of streamlined regulatory system to which we should aspire. Additionally, last week's emergency order on naked short selling has received much attention. This committee is due an explanation as to the reason for the order, the effect to date on the market, its possible extension, and whether it will be expanded to broader market segments. I dare say it is something that the Commission should be commended for. I have seen the results and they seem to be quite clear that they aid the free flow of the market. Even to those of us who view short selling as a necessary provider of liquidity and market efficiency, naked short selling is worthy of closer scrutiny. People enter into trades with the expectation to complete them. In closing, both the Commission and the New York Federal Reserve have played crucial roles throughout the current financial crisis. I very much appreciate Chairman Cox and Mr. Geithner being here today, and I look forward to their testimony. " CHRG-110hhrg46591--11 Mr. Neugebauer," Thank you, Mr. Chairman. One thing we know about Congress is that we do not necessarily do our best work in a crisis environment. We get a lot of pressure to just do something and to do something quickly. As a result, Congress can tend to overreact. Our financial markets are not functioning normally, and our Federal Government has gone to some unprecedented steps to intervene in these markets. Certainly, we need to consider some regulatory improvements. This committee started regulatory hearings this year, and the industry and the Treasury and others have put forward regulatory proposals. Before Congress rushes to overhaul regulations, we need to do a complete autopsy of the current problems so that we know exactly what went wrong and what changes could help prevent this from happening again. We also need to understand the outcomes of these problems on the structure of our financial services sector. Much focus has been on institutions that are too big or too interconnected to fail, but now it seems that more institutions fall into these categories. Expanding regulation to new entities also brings expectations of future government help. Now, this debate isn't simply about having more regulation or about having less regulation; it is about having effective regulation. Effective regulation allows market discipline to drive decisionmaking, and it minimizes moral hazard. Effective regulation keeps the U.S. capital markets competitive with others around the world. Effective regulation protects investors and consumers and rewards innovation and responsible risk-taking. We must also look at how the Federal Government plans to work its way out of these interventions. While some of these interventions are still being implemented, at some point the Federal Government will need to pull back. We need a bona fide exit strategy. This strategy needs to be a part of our discussion as we talk about regulatory changes. Moving forward, we need to work together across this committee aisle to come up with the right solution so we can leave America's financial system and economy stronger. " CHRG-111shrg382--27 Mr. Tarullo," Senator, I think that you will have complexities with or without the mechanism, but they will be of a somewhat different sort, and my instinct would be that the complexities with the mechanism in place here will be more manageable than under the status quo. Senator Corker. Where they actually go out of business? " CHRG-110hhrg46593--266 Mr. Findlay," I think the way we view this, Congresswoman, is that the fundamental problem in the marketplace right now is a lack of reliable information on the value of assets and indeed a sort of panic that sets in when you don't have reliable information. You don't want to be the last person holding a troubled asset. And all these financial institutions have on their books assets that they had valued a certain way in August, and it is a fraction of that value today. We are fairly confident that the fire sale price at which assets are being held today is not the intrinsic value of the asset, and it wouldn't be a good thing to require institutions to mark assets down to that value. So what we have tried to do is come up with an innovative way to take the panic out of the marketplace, and allow information to get into the marketplace, so we can determine what these assets' values are and essentially give a little breathing space to the market over the next year or two to bring these assets back to their intrinsic values, which we know they are not at today. " CHRG-111shrg55739--87 Mr. White," Again, it is understandable they want to do something, but I think the efforts go in the wrong direction and the dangers are substantial because they are going to raise barriers to entry and reduce innovation, reduce the possibility of new ideas. Something that is especially dangerous is something that Mr. Gellert mentioned a few minutes ago: the requirement that all credit rating agencies, whether you are just an independent guy offering some advice to a hedge fund or whether you are a fixed-income analyst at a financial services firm, must register as an NRSRO. This strikes me as something that is going to discourage entry, discourage those new ideas, and that can't be a direction we want to go. So let me just say again that the proposals really are wrong-headed and that we really do have a superior route to go, which is a greater reliance on the market for information which an institutional bond market can use and use effectively. Thank you for this opportunity, and I will be happy to answer any questions. Senator Reed. Thank you. " Mr. Froeba," STATEMENT OF MARK FROEBA, J.D., PRINCIPAL, PF2 SECURITIES CHRG-111shrg56376--164 Mr. Baily," Well, I agree with you very much, Senator, that simply creating a single prudential regulator is not going to solve all our problems. The deficiencies of our system are greater than that, and there were a lot of private failures. We need to try to improve private incentives so that people do not get to play with other people's money and they take on the risk if the risk is there. So I agree with you completely. This is not by any means going to solve all our problems. I think it does help, though, because it allows for the kind of consolidated regulation that can, if necessary, stand up to the big banks and make sure that they are following the right rules. It can respond, it has got the resources and the stature to respond to innovation because one of the problems with regulation is you are always sort of one step behind what the private market is trying to do. And we want to encourage that innovation, but at the same time, we do not want it to be in the direction of making things less safe. So on the procyclicality side, we need to get rid of that. First of all, I think we need higher capital requirements so that in good times there is plenty of capital, and in bad times we can sort of cushion that shock. So that needs to be part of the reform, too, is how we deal with cyclicality, and there are some proposals there for so-called ``contingent capital'' or ``convertible capital'' that allow you to do that. So I think that should be an important part of the regulatory changes. I just think also on the diversity of views, the way I would put it is that we need to make sure that our prudential regulator is accountable. I mean, there are a lot of people--again, I do not want to impugn anybody in particular, but some regulators made some very bad decisions in this process. And, you know, do they still have jobs? Maybe they should not. We need to set up this structure in a way that preserves accountability whether it is a single prudential regulator or more than one. " CHRG-111hhrg54872--5 Mr. Bachus," Yes, we do have some English speakers who will be speaking later on. I thank you for having today's hearing, Mr. Chairman, and I look forward to hearing the perspectives from our witnesses on the merits or possible demerits of creating the Consumer Financial Protection Agency. And I think we can do a better job of protecting the consumer. I think we all agree on that and we should. However, the Administration's proposal, I think, is conceptually flawed. Since the Treasury Department submitted the legislative language to Congress 3 months ago, we have heard from a host of community bankers, credit unions, accountants, small business owners, and Federal financial regulators that this, what could prove to be a massive new regulatory bureaucracy, will create more confusion for our consumers, more government spending, but, more importantly, less innovation and less creation of credit and less consumer protection. I know some of our witnesses today have said some of that credit has been a bad thing, but I think ultimately that choice should be left to the individual as long as it is under acceptable terms. In deference to this widespread public and official opposition, I do commend Chairman Frank for releasing, last Friday, a new working draft that attempts to narrow the scope of an overly broad proposal by the Obama Administration. However, I think that what his proposal does is basically tinkering around the margins of a fundamentally flawed proposal, and it is not a solution. What is needed is an entirely different approach. " 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-111hhrg54873--172 Mr. Gellert," Everyone is looking at me. It is clearly an impediment, it is clearly a disincentive to enter the space, and without question, it further solidifies the market share that the three largest players have, without a doubt. I cannot speak for the other NRSROs that are smaller and outside of that Big 3, but without a question. it does. The more you have entrenched--the more you have entrenched oligopoly and less competition, the more likely it is that you will have stable ratings. But they won't necessarily be accurate ratings because they won't necessarily have the competitive and innovation-- " fcic_final_report_full--60 A sset - Ba ck ed Se cu r i t i es Ou tstand i ng In the 1990s, many kinds of loans were packaged into asset-backed securities. IN BILLIONS OF DOLLARS $1 , 000 Other 800 Student l oans 600 M anufactured hous i ng 4 00 200 0 Eq u i pment H ome e q u i ty and other res i dent i a l Cred i t card A utomob il e ’ 85 ’ 86 ’ 88 ’ 89 ’ 91 ’ 92 ’ 93 ’ 95 ’ 9 7 ’ 99 NO TE: Res i dent i a l l oans do not i nc l ude l oans secur i t iz ed by government - sponsored enterpr i ses . SOURC E: Secur i t i es I ndustry and Fi nanc i a l M arkets A ssoc i at i on Figure . these instruments became increasingly complex, regulators increasingly relied on the banks to police their own risks. “It was all tied up in the hubris of financial engineers, but the greater hubris let markets take care of themselves,” Volcker said.  Vincent Reinhart, a former director of the Fed’s Division of Monetary Affairs, told the Com- mission that he and other regulators failed to appreciate the complexity of the new fi- nancial instruments and the difficulties that complexity posed in assessing risk.  Securitization “was diversifying the risk,” said Lindsey, the former Fed governor. “But it wasn’t reducing the risk. . . . You as an individual can diversify your risk. The sys- tem as a whole, though, cannot reduce the risk. And that’s where the confusion lies.”  THE GROWTH OF DERIVATIVES: “BY FAR THE MOST SIGNIFICANT EVENT IN FINANCE DURING THE PAST DECADE ” During the financial crisis, leverage and complexity became closely identified with one element of the story: derivatives. Derivatives are financial contracts whose prices are determined by, or “derived” from, the value of some underlying asset, rate, index, or event. They are not used for capital formation or investment, as are securities; rather, they are instruments for hedging business risk or for speculating on changes in prices, interest rates, and the like. Derivatives come in many forms; the most com- mon are over-the-counter-swaps and exchange-traded futures and options.  They may be based on commodities (including agricultural products, metals, and energy products), interest rates, currency rates, stocks and indexes, and credit risk. They can even be tied to events such as hurricanes or announcements of government figures. Many financial and commercial firms use such derivatives. A firm may hedge its price risk by entering into a derivatives contract that offsets the effect of price move- ments. Losses suffered because of price movements can be recouped through gains on the derivatives contract. Institutional investors that are risk-averse sometimes use interest rate swaps to reduce the risk to their investment portfolios of inflation and rising interest rates by trading fixed interest payments for floating payments with risk-taking entities, such as hedge funds. Hedge funds may use these swaps for the purpose of speculating, in hopes of profiting on the rise or fall of a price or interest rate. CHRG-111shrg51395--101 Mr. Doe," Senator Warner, if I could just offer an example, I like Mr. Silvers' comment about the subject of regulation being routine, because I think that brings vigilance. Let me give you just a quick example of why when I hear you ask the question about products, why I think that is so important. After the Lehman bankruptcy in September, on the Wednesday following there was a liquidation, an unannounced liquidation by a money market fund of substantial holdings of cash-equivalent securities which had been created in the municipal market through leverage programs and which were used--essentially synthetics securities, so derivatives. The liquidation, unannounced--again, a trying time in the market in mid-September--resulted in the following day of there being no liquidity in the municipal secondary market, where one transaction that occurred in a distressed situation resulted in the repricing of the entire holdings of investors that were in mutual funds that were in individual holdings. We estimated that, in a back-of-the-envelope kind of way, about $5.5 billion were lost on that September 18th, solely because an illiquid market, because of liquidation of a cash security that was synthetic in order to fulfill the needs of having short-term investments for these money market funds, is that created a crisis in confidence that--and a confusion among investors as to what was the security of the credits of the States, of the towns that were, you know, issuing municipal debt. And that type of concern--and that lasted through September and October, and municipal issuers who were trying to come to market and raise important funds for capital projects and for operations were really inhibited by extraordinarily penal rates. So here we had this, you know, single event and this cascaded, touching upon cash securities, derivative securities, and then also tied to the supposedly the most secure cash equivalents in these money market funds. The other thing I think is really important and not to be lost here, as we are talking about cash securities, we are talking about derivatives, and a lot has been talked about credit default swaps, the municipal market, predominantly it is interest rate swaps. Here, again, there is not transparency. And yet these are linked intimately with cash transactions. And when we talk about, gee, the taxpayer is coming in and helping to bail out the various transgressions that have occurred in the banking system or in the financial system is that here we have taxpayers--and I think, Senator Shelby, you had some instances with some derivatives in your State that are getting a lot of headlines. And taxpayers are on the hook most directly right there. And I would argue and suggest to you the notion of really examining this opportunity that we have in our U.S. municipal bond market, where all these products have come to roost, and the credit default swap market is emerging. It is in its nascent stage in the municipal bond market. Yet it is there, and it is creating perhaps a thinness or an illiquid market that those derivative products is maybe creating misconceptions about the soundness of our States and our towns and our counties. And so I think that when we start looking at how do we gain transparency on these securities that are now part of the risk management of our municipalities and how do we help so we can understand them, so we can see them, so investors that are putting their--are facilitating the borrowing by buying these securities, they can see what is going on, and we can also help to protect these issuers who, as Mr. Turner was saying--well, as we were talking about broadly in this financial regulation of the separation of risk management and operation, is that here we have these--our States and our towns and counties that are serving--wearing both hats and using complex securities that they may not have fully understood. So I guess when I hear you talk about products, I applaud that, because I think that it just cannot be the people involved. We have to look at what is being used, but also being--the word has been used--``nimble'' so that we can adapt regulation and be flexible so that as new innovations come in that can be very positive but also can be seen and understood. Senator Warner. And I think our time has expired, and my only last comment would just be that I think we will get to some stance where we will have some level of regulatory oversight. My hope is that we will adhere to Mr. Turner's suggestion that it is a nimble and well-funded regulator. But I would say from the industry, we are going to need your help on setting standards not just retrospectively but prospectively. With the complexity and financial engineering that goes on, I just do not want to be here 5 years later looking at what the next round of new products would be and say, ``Why didn't we see that ahead of time?'' and helping us see what those standards--so that you do not end up with having to pre-clear every new product at some regulator. You know, you are going to have to really step up on this one and give us some assistance. Thank you, Mr. Chairman. " CHRG-111hhrg51698--410 Mr. Short," I think transparency to regulators is key here. I think we have moved beyond the days where people can argue that transparency to appropriate regulatory bodies isn't good. I am not sure I would go as far as to suggest that something needs to be preapproved to be traded. For example, that could lead to a lot of gridlock and maybe hamper product innovation. But certainly transparency would be appropriate to give the regulator the view about whether something needed to be cleared, or whether additional steps needed to be taken. Ms. Herseth Sandlin. And you would be comfortable with the CFTC making those decisions? " CHRG-110hhrg45625--61 Secretary Paulson," As we have dealt with some of the other situations and we have dealt with them and we have gone over them on a case-by-case basis and we dealt with failure either to prevent failure or to deal with failure. And what we want to do here is deal with it systemically and get ahead. And so this program that we are proposing is not one that is aimed just at big financial institutions. We could--you could design programs that would come in and deal with big financial institutions and take a lot of assets off their balance sheets at prices that were very helpful and, of course, when you do that, then you have other measures that go with it. But what we are looking at doing here and which we think is very important is to get price discovery and transparency and price discovery with very complex mortgage and mortgage related assets. And we think the way to do that is design a process where you get hundreds, even thousands of institutions for some of these asset classes and mortgage represented securities to participate. And there are different programs that will be used. There are reverse auctions. There are different-- " CHRG-111shrg51395--95 Chairman Dodd," I agree. Senator Warner. And I appreciate your asking that question. I want to follow up, before I get to my quick question, on Senator Shelby's comments along the notion of the institutions that have posed this systemic risk, the ``too big to fail'' excuse, and Damon's comments about perhaps not publishing those that are systemic risks, but this problem we are in the middle of the crisis now of too big to fail. And I would be curious perhaps in a written question to the Members--I know Senator Shelby has, I think, provocatively raised a number of times the issue of, well, how much more on Citi and should we go ahead and let it go through some kind of process? And the quick response normally being, well, no, that is too big to fail. Well, I would love to hear from the panel, perhaps in written testimony, if you were to see the transition, dramatic transition--and I know we are sometimes afraid of the terminology, whether it is ``receivership'' or ``nationalization,'' some other way to get it out of the current ditch that it is in--you know, how you would take one of these institutions that fall into this ``too big to fail'' category that appears to have real solvency issues and get it through a transition? And I perhaps would work with the Senator on submitting that type of written question. So we have seen, you know, the big take-aways on how we regulate and where we put this prudential or systemic risk oversight. We have seen the question of how we deal with the current challenging institution. I want to come with my question, and I know our time is about up, but I will start with Mr. Pickel, but would love to hear others' comments on this, and that is, maybe come at this from the other end. Even if we get the risk right, with the great people that Mr. Turner has advocated, where and how should we look at the products? I would argue that intellectually I understand the value of derivatives and the better pricing of risk. I candidly would love somebody to say, How much societal value have we gained from this additional pricing of this risk when we have seen all of the downside that the whole system is now absorbing because, to use your terms, you know, actions by AIG and others of misunderstanding of the products and not taking appropriate hedging? I guess I have got a series of questions. How do we prevent the current products or future products from being abused? Should we have standards whereby if an AIG, a future AIG, either misunderstood or went beyond protocols, that that would set off more than an alarm bell and would require some kind of warning? Is it simply enough to say we are going to move toward some level of a clearinghouse? Is clearing alone enough security? As some of the European regulators have talked about for those products and contracts that do not go through a clearinghouse, should there be needs of additional capital requirements? You know, I am all for innovation, but in some cases I think under the guise of financial innovation and financial engineering, we have ended up with a lot of customers, including customers that Mr. Doe represents in terms of some of the muni market, getting in way over their head. And I just fear on a going-forward basis that regulation and transparency alone may not solve the problem. So rather than coming at it at the macro level on regulation or on the specific issues that I think Senator Shelby has wonderfully raised about how do we unwind one of the ``too big to fail'' institutions, I would like to look at it from the bottom up on the products line, starting with Mr. Pickel and then anybody else can comment. " CHRG-109hhrg22160--44 Mr. Greenspan," Well, one of the things which has been quite impressive is how the financial system has adjusted to the major increase in information technology and computer technology. And the payment system has gotten extraordinarily complex in all the various different areas. To be sure, we have had privacy questions emerge, and there has been a significant battle, I may say, between those who create new encryption programs and those who are trying to break them. I think at the end of the day that the mathematics of encryption are such and the technology is such that we ought to be able to create systems which will be exceptionally difficult to break. If we are going to get the benefits of the payment system or, as I commented yesterday, the extraordinary potential benefits of information technology in the health care area, we have to create security for privacy. And the only way to do that and still have the availability and use of these technologies is to find adequate encryption. I think that is something which continues to improve. In my judgment, at the end of the day, it is going to become very difficult as the technology gets more and more complex, actually to break some of these newer, very clever encryption systems. Ms. Pryce. Would you like to comment at all on---- " CHRG-111hhrg53021Oth--152 Mr. Meeks," Let me just ask this question: There is some concern that pushing all derivatives to clearinghouses or exchanges will create the natural monopolies. I just want to talk, have a concern about that. But simply reducing the innovation factor and proper risk management system, should we consider creating some type of utility type clearinghouse? " CHRG-111hhrg53021--152 Mr. Meeks," Let me just ask this question: There is some concern that pushing all derivatives to clearinghouses or exchanges will create the natural monopolies. I just want to talk, have a concern about that. But simply reducing the innovation factor and proper risk management system, should we consider creating some type of utility type clearinghouse? " CHRG-110hhrg46591--29 Mr. Price," Thank you, Mr. Chairman. I want to join with some on both sides of the aisle who have said that the same old politics, frankly, from both sides will not get us to a solution to our current challenges. There has been lots of excellent work done on attempting to identify the cause of our current financial challenge. I will be inserting a number of items into the record. One of them is an article entitled, ``Another Deregulation Myth: A Cautionary Tale about Financial Rules that Failed.'' While the genesis of our current challenge is certainly multifactorial, what began on a microlevel with imprudent borrowers and irresponsible lenders became a full-scale financial crisis, fueled by the GSEs that were rapidly expanding their purchasing and securitization of subprime mortgages. Today, the resulting credit crunch is extended to every area of our economic system. What is taking place, though, is truly unprecedented: The direct Federal intervention in individual mortgages; a broad overreach by the Federal Reserve; an unlimited use of taxpayer dollars; and steps to nationalize banks. These actions are in their totality, I fear, an assault on American principles and on capitalism itself. It is a marked turn toward a nefarious ideal that problems can be solved by centralized decisionmaking here in Washington. To have a full understanding of the financial services' regulatory state, there must be an investigation of all facets of the sector. I look forward to working with the chairman for a more broad appreciation of that in our hearing process. Moving ahead, Congress must be sensible. The goals should be to eliminate previous destructive regulatory actions, not to eliminate all regulation but to have appropriate regulation, close the gaps in the regulatory framework, increase transparency, and enhance market integrity and innovation. The end result must promote economic growth and not stifle opportunity. I look forward to working with all who are of the same mind. 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-111shrg57709--208 Mr. Volcker," Look, there is no assurance in this area, but part of what I hope is the effect of what we are proposing is to reduce the capacity of the banks through imaginative financial engineering techniques to get way ahead of the regulators, because the most fertile field for this is in the area of hedge funds, equity funds, and proprietary trading. It doesn't mean they can't do a lot of complex things in the more traditional banking area. But at least you have cut down to some extent the risks of which you speak, quite rightly. And I do think the supervisory agencies are going to have to be better staffed. I think some of them are pretty well staffed now, but they are going to have to have the funds and the interest and the capacity to attract some of the brightest and best financial engineers, too. It takes a thief to catch a thief, so to speak. So there is a lot to be done in that area, I think. Senator Menendez. Mr. Secretary, do you want to comment on that? " 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. " CHRG-111shrg53176--53 Mr. Atkins," Thank you very much, Chairman Dodd, Ranking Member Shelby, and Members of the Committee, for inviting me here today to the hearing. It is a great honor for me to be here today, and especially appearing today with two great public servants whom I know very well and admire. This Committee has had a long history of careful study and analysis of matters relating to the financial markets and the financial services industry, and as you have already heard in your hearings, there are multiple, complex, and interrelated causes to the current situation in global financial markets. I believe that these causes are more than the competence or incompetence of individuals in particular roles, but have more to do with fundamental principles of organizational behavior and incentives. Your topic for today is rather broad, so I would like to touch on a few specific items that go to the heart of an agency that I know very well, the Securities and Exchange Commission. With respect to the subject of regulatory reform---- " FOMC20070628meeting--224 222,VICE CHAIRMAN GEITHNER.," Those choices I think I understand, but I was really thinking about the pictures. You circulated a whole different set of new things, innovative pictures that showed dispersion, uncertainty, balance of risk, histograms, and so forth. I guess you don’t need to answer this question, but do you want people to react, in the first round at least, with a view on which pictures we think should be part of the narrative?" FinancialCrisisInquiry--182 Can you turn your mic on, Mr. Rosen? ROSEN: I’m Ken Rosen. I want to thank Chairman Angelides and Vice Chairman Thomas, and the commission for having me here. I want to not read my testimony since you have it. But I’m going to talk a little bit about what I think is the epicenter of the crisis—where this started, how it got there, and where we are today, which is the housing market—the housing and residential mortgage market. Excessively easy credit, extremely low interest rates created a house price bubble. And the house price bubble when it burst has really caused a significant part of the problems that we had—at least the—initially. And of course it caused—helped cause the great recession where we have lost over eight million jobs. I think the most important thing to say is how did we get here. And I would say that low interest rates is part of the blame, but really it’s the poorly structured products that came about in this environment. Innovative products are important, and a good thing. And I’ve written papers on—on this in the 1970s and 80s while we needed innovative mortgage products. And they’re good for some people—some households. Subprime— there is a need for having that. But not to the market share it got. Low down payment loans – Alt-A loans, option arms. All those made some sense for a portion of the population. What happened is we layered all these risks. We went from a conservatively written subprime loan to a subprime loan that had no down payment, and didn’t document someone’s income or employment. So we made a mistake from what was a good idea by financial institutions became a bad idea for the entire overall market. And then we combine that with a second component which was I thought bad underwriting. We lowered underwriting standards dramatically. We started this in California, and it spread everywhere. We—we do this sometimes. Liars loans which are stated income loans, and there was rampant fraud at the consumer level. We’ve heard discussion of this at the institutional level, but I think the consumer basically really did this so they could qualify for the loan. There was some complicity on the part of brokers and originators. I think—I do not think this was at the high level institutions, but it’s at the individual originator level. CHRG-111hhrg46820--30 Chairwoman Velazquez," Okay, thank you, Mr. Ehmann. Mr. Therrien, Congress is facing a number of competing proposals, and we want to select, of course, the ones that promote energy conservation most effectively. How would shortening the depreciation schedule for green roof systems accelerate innovation and demand for energy efficient commercial roofs? " CHRG-111hhrg74090--143 Mr. Barr," I think we are much more likely to see a high standard at the national level. I think it is very rare if you set a good, high standard at the national level you are going to find it very rare for States to go off in their own way, but sometimes States are right. Sometimes States protect consumers in innovative ways, and our view is, we shouldn't block the States' ability to do what the States think in their judgment is right. " CHRG-110hhrg44900--159 Mr. Bernanke," Well, to some extent that is happening, in the following sense that first, as Secretary Paulson mentioned, the Federal Reserve is releasing on Monday a new set of rules which will limit the parameters, essentially, of how the mortgage can be constructed, and will eliminate certain kinds of confusing and other practices from the possible contracts. Second, we are continuing--as we have recently done in credit cards--a very sensitive set of disclosure reviews so that the lender will be required to explain and provide essential information to the borrower. I think we are going to go a long way towards reducing both the predatory aspects of the lending that you were referring to and also what I would just call the bad lending which ended up being losses for the lenders themselves because they had insufficient oversight and care when they made the loans. In terms of creating a standardized project in advance, I think it is an interesting idea. It would simplify things in some ways, but on the other hand, there are some benefits to having flexibility and innovation in the mortgage market to have different types of mortgages available like shared appreciation mortgages or variable maturity mortgages and so on, so I wouldn't want to take government action to eliminate the possibility of innovation in that market. " CHRG-111hhrg55811--241 Mr. Foster," It is my understanding that the major players in OTC derivatives reduced even their complex derivatives to algorithmic form for jamming into their risk evaluation computer programs. So my question is whether there is a potential benefit for having industry-wide standards for descriptions of even complex OTC derivatives, which would seem to address two concerns. One is that if this is the format in which the repositories received the description of the OTC derivatives, as well as the systemic risk regulator, that there might be a chance for the systemic risk regulator to have an analogous system where their computers would also net out the industry-wide exposure. It also might address Representative Murphy's questions about what it means to be an exchange for very complex derivatives; that what you do is, you have not a listing you can read in the newspaper, but you would have a listing of here are all the algorithmic definitions of all of these complex derivatives and what they have been selling for. So I was wondering if you think that is something that is happening already in the industry, or is there a useful role for government in enforcing that standardization? " CHRG-111shrg382--7 Mr. Tarullo," Well, I think it is going to be a challenge for most countries because we are talking about significant increases in capital over time. I think you probably noted that the G-20 leaders want to move forward with the agreement on tighter, stricter, more robust capital standards now, but the implementation of those standards is presumably going to take place as the financial institutions themselves strengthen. I think that with respect to some of these newer ideas, one I would draw your attention to is that of contingent capital requirements for large institutions. I think that is an example of where we in the United States have an opportunity to exercise some leadership to produce some good, innovative ideas that will bring market discipline and some protection for taxpayers to each of these very large financial institutions. And so I think that is one of the reasons why we and our colleagues have been promoting those ideas internationally and hope we see some progress on it. Senator Bayh. Mr. Sobel, or any of the three of you, the topic of derivatives came up several years ago and you mentioned that there have been some general statements in the Pittsburgh gathering about the importance of moving forward on this. The response that we always got previously to this was, well, if you regulate these instruments more closely in the United States, we will just take the business offshore and the risks will be run. It is just that there won't be the employment in the United States. So it is kind of a lose-lose situation. Do you think we will come up with something more specific and enforceable this time to prevent that kind of forum shopping? " CHRG-111shrg54589--104 Mr. Whalen," Oh, I think most over-the-counter contracts do not have a problem in that regard. If you are talking about energy, currency, whatever it is, if there is a rigorous traded cash market, it is easy to come up with a derivative, even if it is a very complex derivative. But when you are talking about illiquid corporate bonds or even loans to corporations, if you are talking about a complex structured asset that is, let us say, two or three levels of packaging away from the reference asset that it is supposed to be ``derived'' from, that creates complexity in terms of pricing that I think is rather daunting. And I will tell you now, there are very few firms on the street that have the people, the resources, and the money to do that work. Let me give you an example---- Senator Johanns. Mr. Whalen, doesn't that get us to the point that I was raising in previous questioning? You know, you have now got a whole regulatory scheme. You have got somebody that is going to regulate it. They are hired and paid---- " CHRG-111hhrg48868--812 Mr. Liddy," Oops, let me see if I can explain my point of view. The State regulatory system has worked well, but the insurance products have gotten so complicated and the rapid rate with which capital moves around the globe now may just be surpassing the State regulators' ability to stay current on everything. Ms. Speier. Wait a minute. Time out. Time out. With all due respect, the OTS was in a position to regulate you and didn't know what a credit default swap was and, in fact, said they are so complex that the risk was not properly addressed because of the complexity. So complexity is not something that is going to ring well for any of us moving forward because if you can't understand it, how can you really assess what the risk is? " 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-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-110hhrg46591--100 Mr. Seligman," Well, I think the issue as to whether they will ultimately be separate or consolidated should be carefully explored. We have five depository institution regulators today. I think a case can be made that we don't need that many. You then have a separate issue which you haven't touched upon, which is we also have State regulation of insurance and we have State regulation of banking. How are you going to coordinate what you do at the Federal level with the States? Then you have yet another issue, which is terribly complex, and that is increasingly financial products are sold internationally. How do you coordinate what we are doing in this country with what is being done abroad? So I think you have the right questions, but I think more evidence has to come in to flush out the answers. " CHRG-110hhrg44900--9 Mrs. Biggert," Thank you, Mr. Chairman, and thank you for holding today's hearing on systemic risk. Your responsiveness to the letter submitted in April by Mr. Garrett, Ranking Member Bachus, and more than a dozen of us on this side of the aisle is very much appreciated, and I would also like to thank Congressman Garrett for his leadership on this issue. I welcome our distinguished witnesses today: Federal Reserve Chairman Bernanke; and Treasury Secretary Paulson. Your steady leadership is helping us weather the storm that our markets and our economy are experiencing. As a side, Secretary Paulson, I would like to specifically thank you and your staff, as well as the public and private sector partners for organizing the HOPE NOW Alliance, which has helped to keep hundreds of thousands of families in their homes. And Chairman Bernanke, the Federal Reserve's actions continue to help preserve confidence and bring stability to our financial markets and institutions. Infusing liquidity into the marketplace has prevented the credit crunch from seizing the system, and facilitating the sale of Bear Stearns to J.P. Morgan is viewed by many as having been the lynchpin that prevented a run-on-the-bank type crises which could have spread throughout our financial system and caused irreparable harm. What brought us here today are these specifically and the latter actions on the part of the Fed, actions that begged the question, what can the Federal Government do to prevent future, similar bailouts that can put taxpayer dollars at risk? Is the Federal Government prepared for another Bear Stearns? Can a Federal regulator or regulators monitor specific indicators that will flag weaknesses within individual, financial institutions and prevent another Bear Stearns? And can they do so without unnecessarily increasing regulatory burdens that would diminish the competitiveness of the U.S. financial institutions in the global marketplace? It is vital that we closely examine the capacity of the Federal Government to monitor the large financial institutions like Bear Stearns, which represent not only American innovation and financial strength, but also our great vulnerability with respect to systematic risk in the financial system. I think without delay, we need to strike the right balance and create a simpler, stronger, regulatory system that preserves the resilience of our economy, protects taxpayers, and maintains the position of our financial system as the envy of the world. I look forward to the testimony and I yield back. " CHRG-111hhrg53238--92 Mr. Bartlett," Congressman, you have hit the nail on the head. These agencies should regulate for safety and soundness and for consumer protection, but not to determine products. The products themselves, leave them in the competitive marketplace, but then protect the consumers by disclosure by anti-fraud protection, by unfair and deceptive acts, by coordinating the decentralized complaint systems and, otherwise, by sales practices, but don't set the products. As for the products, consumers are far better off with choice and with innovation. " 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. ------ FOMC20080109confcall--58 56,MR. LACKER.," Yes. At the outset, in your discussion you said you were doing this in part to seek our views before you made a speech and testified and wanted our views before you engaged in overt signaling to the market. Someone else mentioned this, but I wanted to support this as a practice. I don't expect you to consult us before every public utterance you make but I would just compliment you on this innovation in Federal Open Market Committee practice. So thank you very much. " CHRG-111hhrg46820--50 Mr. Therrien," I believe those figures were from the Center for Environmental Innovation in Roofing. They are the ones that provided the figures in the background. Some of the other figures that I have also cited were from a Ducker study done by the National Roofing Contractors through their Alliance for Progress Group. It is part of our foundation and they did a Ducker study back in 2003, which also cited many of the job creations, as well as the areas of savings that would be--that were used. And that is included in the Ducker study that we have. " fcic_final_report_full--22 On the surface, it looked like prosperity. After all, the basic mechanisms making the real estate machine hum—the mortgage-lending instruments and the financing techniques that turned mortgages into investments called securities, which kept cash flowing from Wall Street into the U.S. housing market—were tools that had worked well for many years. But underneath, something was going wrong. Like a science fiction movie in which ordinary household objects turn hostile, familiar market mechanisms were be- ing transformed. The time-tested -year fixed-rate mortgage, with a  down pay- ment, went out of style. There was a burgeoning global demand for residential mortgage–backed securities that offered seemingly solid and secure returns. In- vestors around the world clamored to purchase securities built on American real es- tate, seemingly one of the safest bets in the world. Wall Street labored mightily to meet that demand. Bond salesmen earned multi- million-dollar bonuses packaging and selling new kinds of loans, offered by new kinds of lenders, into new kinds of investment products that were deemed safe but possessed complex and hidden risks. Federal officials praised the changes—these financial innovations, they said, had lowered borrowing costs for consumers and moved risks away from the biggest and most systemically important financial insti- tutions. But the nation’s financial system had become vulnerable and intercon- nected in ways that were not understood by either the captains of finance or the system’s public stewards. In fact, some of the largest institutions had taken on what would prove to be debilitating risks. Trillions of dollars had been wagered on the belief that housing prices would always rise and that borrowers would seldom de- fault on mortgages, even as their debt grew. Shaky loans had been bundled into in- vestment products in ways that seemed to give investors the best of both worlds—high-yield, risk-free—but instead, in many cases, would prove to be high- risk and yield-free. All this financial creativity was a lot “like cheap sangria,” said Michael Mayo, a managing director and financial services analyst at Calyon Securities (USA) Inc. “A lot of cheap ingredients repackaged to sell at a premium,” he told the Commission. “It might taste good for a while, but then you get headaches later and you have no idea what’s really inside.”  The securitization machine began to guzzle these once-rare mortgage products with their strange-sounding names: Alt-A, subprime, I-O (interest-only), low-doc, no-doc, or ninja (no income, no job, no assets) loans; –s and –s; liar loans; piggyback second mortgages; payment-option or pick-a-pay adjustable rate mort- gages. New variants on adjustable-rate mortgages, called “exploding” ARMs, featured low monthly costs at first, but payments could suddenly double or triple, if borrowers were unable to refinance. Loans with negative amortization would eat away the bor- rower’s equity. Soon there were a multitude of different kinds of mortgages available on the market, confounding consumers who didn’t examine the fine print, baffling conscientious borrowers who tried to puzzle out their implications, and opening the door for those who wanted in on the action. CHRG-111hhrg52261--134 Mr. Moloney," Good question. ""Yes"" is the short answer, but I probably would like to also state that I think that it is very possible that with the creation of these innovative products, we may have gotten ahead of ourselves and had things that people really did not fully think out and sold to clients who didn't have a clue. So maybe the answer is ""yes."" I want to have that ability, but I also want to make sure that the people who are involved on the buying and the selling side of it know the products that they are dealing with. " 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---- " CHRG-110shrg50420--281 Mr. Zandi," Yes. It is not even in the same universe. Senator Reed. Thank you very much. There is another aspect that I think that is important which has been alluded to: the interconnection between the financing companies and the manufacturing companies. There is a possibility that we could create a board that governs the manufacturers, but then the Federal Reserve would govern the finance companies or the new financial holding companies, which would introduce an additional level of complexity. There is also the possibility that requirements that would be imposed on the financing companies by Federal regulators could be directly in opposition to the best interests of the manufacturers. Is there an argument that whatever we do should be done on a unified basis rather than having the Federal Reserve operate on one end and an oversight board or oversight management person on the other? " CHRG-111hhrg74090--77 Mr. Leibowitz," Look, you know, if you read through our written testimony, you can sort of see it is a complex matrix within the Commission about what we support and what we don't. I do think from our perspective if you create this--from my perspective, if you create this new agency and you also give us more resources and authority, from the perspective of consumers they will be getting a better deal because we will be able--we will continue to have a backstop authority with respect to financial matters and we are going to be able to concentrate and just do more for consumers. As you know, because we have talked about this, we spent a lot of time leveraging---- " 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-111hhrg52406--88 Mrs. Biggert," Thank you, Mr. Chairman. You know, one of the things that I really care about is financial literacy and education, and we have worked with the Federal agencies and with the private sector through our caucus with Mr. Hinojosa. Ms. Warren, shouldn't we concentrate on improving financial education and regularly reviewing consumer testing and improving product disclosures which would result in an efficient and innovative market instead of so much government control? Mr. Pollock mentioned personal responsibility, and I think that he is right and that nobody has really mentioned that. There is a role for the consumer to really take responsibility when they are getting into a product and to really do the research. Are we just saying, well, the government can do it for us? Should we mandate financial literacy in the schools? You know, we have tried to stay away from that while really going forward with it. Is this something that should actually be a course in the schools? Ms. Warren. Well, Congresswoman, I actually would like to say I also talked about personal responsibility in my direct testimony. I will make the point that this is not about people who go to the mall and charge up thousands of dollars that they cannot afford or who buy five-bedroom houses that they never had a hope of paying for. This is about people who get trapped by the products themselves. I am completely in favor of making these products transparent enough that people can read them, understand them, and make smart financial decisions. Literacy is not going to solve the problem of reading a 30-page credit card contract. Congresswoman, I have assigned these contracts in the past to my own classes at Harvard Law School. Everyone in the room has a college diploma, at least 2 years of law school, and has me as a reason that they had better read carefully, and they cannot figure out the terms. " 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-111hhrg48674--24 Mr. Bernanke," Well, Congressman, you have two different questions there. The first is what are the criteria for systemically critical. And in each of the cases we have confronted, we have looked very carefully not only at the size and complexity of the firm in question, but also at the types of markets, counterparties and other transactions it was involved in, and tried to extrapolate if this firm failed, if it defaulted in the morning, how big would the implications be for the entire financial system and for the economy. And those cases where the risks for the broad system are just too great to take, we have to take whatever measures possible to try to prevent the failure. Your second point that it is not fair, I agree 100 percent. If I was a small banker, I would be very upset. Small bankers don't have this protection. The ``too big to fail'' problem is a serious, serious problem, and it should be a top priority to greatly reduce this problem as we go forward with restructuring the financial system. " CHRG-111hhrg55809--61 Mr. Bernanke," So, again, we may be talking about a coordinated effort of the systemic risk council, the Fed and so on, so it is not clear exactly how that process would work. But there are a number of considerations, not just size. For example, what is called interconnectedness, the number of counterparties the firm has around the world, the complexity of its operations, whether it provides critical services like providing market making or other utilities to the financial system. So there are a lot of considerations you would take into account. Ms. Velazquez. Is it conceivable that private equity funds, firms or venture capital funds could fall under a systemic risk regulator? " CHRG-111shrg54789--36 Mr. Barr," Senator Corker, thank you for the opportunity to clarify again that that is not at all what we have in mind. So under this Consumer Financial Protection Agency, financial institutions can continue to offer any product or service that they want. The point of having a simple product offering is to say if you are going to offer a complex product like a pay option ARM, you also have to offer a straightforward product that exists in the marketplace--a 30-year fixed-rate mortgage with straightforward pricing and terms; a 5-1 or 7-1 ARM with straightforward pricing and terms. So I think that if you look at the language that we have proposed, the factors that the agency is supposed to take into account, this is not designed to dictate all the products and services. It is not designed to---- Senator Corker. But it does dictate some, right? Because you are dictating by virtue of what you just said. " CHRG-111hhrg48873--235 Mr. Ackerman," Thank you, Mr. Chairman. The furor last week on the part of the public, the media, and the Congress over the outrageous bonuses was very, very understandable, but the truth of the matter is the bonuses did not create the problem. And even if all those people gave back double the amount that they got in bonuses and spent the week in the public pillory, which I presume they did, it wouldn't fix the problem. The real problem is greed, and I think that with all of the roaring and chest beating that we did, and are continuing to do, we are not really fixing the problem here. I am sorry to say that some of us are learning that we have hurt a lot of otherwise innocent and decent people who just fulfilled their contractual obligations in different parts of some of this massive company, having nothing to do with the real problem that took place in the financial products division. And we probably owe them an apology. And maybe, even more than that, we owe them some kind of a remedy to the damage that it looks like we have been engaging in. And we have to start looking at that, too. The problem is greed, assisted by innovation. And I think part of the solution has to be that we have to exert a little bit of common sense into the process, and I don't know that we can legislate that or you can enforce it. But certainly there are regulations and changes that we should be looking at, and one of them should be expressed in a legal regulatory way that says gimmicks are not financial products, and credit default swaps, although they might have some value somewhere, are really not insurance. Looking forward, we should know that AIG is not the only company that used credit default swaps. How big is that market? How many other companies are out there, and are we looking at them, and are we going to stop pretending that they are issuing insurance and get those products back into the range of reality, rather than letting people think they are insured and then having to bail out all those other companies? " CHRG-111hhrg53248--29 Secretary Geithner," Just 30 seconds. We welcome your committee and your counterparts in the Senate to pass reform this year. Despite this crisis, the United States remains in many ways the most productive, the most innovative, and the most resilient economy in the world. To preserve this, though, we need a more stable, more resilient system and this requires fundamental reform. Thank you. We look forward to working with you. [The prepared statement of Secretary Geithner can be found on page 140 of the appendix.] " CHRG-110hhrg46591--34 The Chairman," I thank the gentleman. I would just take a second to note that both of them quite correctly pointed out that credit unions bear absolutely no responsibility for the bad lending practices, and I think they are entitled to that recognition. We will now begin with our witnesses. We will begin with Alice Rivlin, who is a senior fellow at the Metropolitan Policy Program, economic studies, and director at the Brookings Institution. Dr. Rivlin. STATEMENT OF THE HONORABLE ALICE M. RIVLIN, SENIOR FELLOW, METROPOLITAN POLICY PROGRAM, ECONOMIC STUDIES, AND DIRECTOR, GREATER WASHINGTON RESEARCH PROJECT, BROOKINGS INSTITUTION Ms. Rivlin. Thank you, Mr. Chairman, and members of the committee. Past weeks have witnessed historic convulsions in financial markets around the world. The freezing of credit markets and the failure of major financial institutions triggered massive interventions by governments and by central banks as they attempted to contain the fallout and to prevent total collapse. We are still in damage control mode. We do not yet know whether these enormous efforts will be successful in averting a meltdown, but this committee is right to begin thinking through how to prevent future financial collapses and how to make markets work more effectively. Now pundits and journalists have been asking apocalyptic questions: Is this the end of market capitalism? Are we headed down the road to socialism? Of course not. Market capitalism is far too powerful a tool for increasing human economic wellbeing to be given away because we used it carelessly. Besides, there is no viable alternative. Hardly anyone thinks we would be permanently better off if the government owned and operated financial institutions and decided how to allocate capital. But market capitalism is a dangerous tool. Like a machine gun or a chain saw or a nuclear reactor, it has to be inspected frequently to see if it is working properly and used with caution according to carefully thought-out rules. The task of this committee is to reexamine the rules. Getting financial market regulation right is a difficult and painstaking job. It is not a job for the lazy, the faint-hearted, or the ideologically rigid. Applicants for this job should check their slogans at the door. Too many attempts to rethink the regulation of financial markets in recent years have been derailed by ideologues shouting that regulation is always bad or, alternatively, that we just need more of it. This less versus more argument is not helpful. We do not need more or less regulation; we need smarter regulation. Moreover, writing the rules for financial markets must be a continuous process of fine-tuning. In recent years, we have failed to modernize the rules as markets globalized, as trading speed accelerated, as volume escalated, and as increasingly complex financial products exploded on the scene. The authors of the financial market rule books have a lot of catching up to do, but they also have to recognize that they will never get it right or will be able to call it quits. Markets evolve rapidly, and smart market participants will always invent new ways to get around the rules. It is tempting in mid-catastrophe to point fingers at a few malefactors or to identify a couple of weak links in a larger system and say those are the culprits and that if we punish them the rest of us will be off the hook, but the breakdown of financial markets had many causes of which malfeasance and even regulatory failure played a relatively small role. Americans have been living beyond their means individually and collectively for a long time. We have been spending too much, have been saving too little, and have been borrowing without concern for the future from whomever would support our overconsumption habit--the mortgage company, the new credit card, the Chinese Government, whatever. We indulged ourselves in the collective delusion that housing prices would continue to rise. The collective delusion affected the judgment of buyers and sellers, of lenders and borrowers and of builders and developers. For a while, the collective delusion was a self-fulfilling prophesy. House prices kept rising, and all of the building and borrowing looked justifiable and profitable. Then, like all bubbles, it collapsed as housing prices leveled off and started down. Now bubbles are an ancient phenomenon and will recur no matter what regulatory rules are put in place. A housing bubble has particularly disastrous consequences because housing is such a fundamental part of our everyday life with more pervasive consequences than a bubble in, say, dot com stocks. More importantly, the explosion of securitization and increasingly complex derivatives had erected a huge new superstructure on top of the values of the underlying housing assets. Interrelations among those products, institutions, and markets were not well-understood even by the participants. But it is too easy to blame complexity, as in risk models failed in the face of new complexity. Actually, people failed to ask commonsense questions: What will happen to the value of these mortgage-backed securities when housing prices stop rising? They did not ask because they were profiting hugely from the collective delusion and did not want to hear the answers. Nevertheless, the bubbles and the crash were exacerbated by clear regulatory lapses. Perverse incentives had crept into the system, and there were instances where regulated entities, even the Federal Reserve, were being asked to pursue conflicting objectives at the same time. These failures present a formidable list of questions that the committee needs to think through before it rewrites the rule book. Here are my offers for that list: We did have regulatory gaps. The most obvious regulatory gap is the easiest to fill. We failed to regulate new types of mortgages--not just subprime but Alt-A and no doc and all the rest of it--and the lax, sometimes predatory lending standards that went with them. Giving people with less than sterling credit access to homeownership at higher interest rates is actually, basically, a good idea, but it got out of control. Most of the excesses were not perpetrated by federally regulated banks, but the Federal authorities should have gotten on the case, as the chairman has pointed out, and should have imposed a set of minimum standards that applied to all mortgage lending. We could argue what those standards should be. They certainly should include minimum downpayments, the proof of ability to pay, and evidence that the borrower understands the terms of the loan. Personally, I would get rid of teaser rates, of penalties for prepayment and interest-only mortgages. We may not need a national mortgage lender regulator, but we need to be sure that all mortgage lenders have the same minimum standards and that these are enforced. Another obvious gap is how to regulate derivatives. We can come back to that. But much of the crisis stemmed from complex derivatives, and we have a choice going forward. Do we regulate the leverage with which those products are traded or the products themselves? " CHRG-111hhrg53241--56 Mr. Mierzwinski," Well, Congresswoman, I would say you have exactly identified the problem, and the new agency would have the opportunity to hold hearings on and to regulate some of the most unfair aspects of these mortgages. As you pointed out, people were qualified based on their ability to make the payments only in the first year, not after the option kicked in, the so-called 2/28s or the 3/27s, and the regulators looked the other way. We want a regulator that will look at the product, and we want a regulator who will then say certain aspects of this product, not the product itself necessarily, should be made illegal. We regulate toasters to make sure they don't catch fire. We are not banning toasters with the Consumer Product Safety Commission, and we are not banning adjustable rate mortgages with the Consumer Financial Protection Agency. We are simply saying they have to be safe and we want the innovations to be within the circle of safe products. Ms. Waters. And, again, when many of these adjustable rate mortgages reset, this margin that they put on top of, what I understand, the existing interest rates could be flexible in terms of how much they charge. They could be 2 percent, 3 percent, 4 percent. Are you familiar with that? " CHRG-111shrg54589--134 PREPARED STATEMENT OF CHRISTOPHER WHALEN Managing Director, Institutional Risk Analytics June 22, 2009 Chairman Reed, Senator Bunning, Members of the Committee: Thank you for requesting my testimony today regarding the operation and regulation of over-the-counter or ``OTC'' derivatives markets. My name is Christopher Whalen and I live in the State of New York. \1\ I work in the financial community as an analyst and a principal of a firm that rates the performance of commercial banks. I previously appeared before the full Committee in March of this year to discuss regulatory reform.--------------------------------------------------------------------------- \1\ Mr. Whalen is a cofounder of Institutional Risk Analytics, a Los Angeles unit of Lord, Whalen LLC that publishes risk ratings and provides customized financial analysis and valuation tools.--------------------------------------------------------------------------- First let me make a couple of points for the Committee on how to think about OTC derivatives. Then I will answer your questions in summary form. Finally, I provide some additional sources and references to help you in your deliberations.Defining OTC Asset Classes When you think about OTC derivatives, you must include both conventional interest rate and currency swap contracts, single name credit default swap or ``CDS'' contracts, and the panoply of specialized, customized gaming contracts for everything and anything else that can be described, from the weather to sports events to shifting specific types of risk exposure from one unit of AIG to another. You must also include the family of complex structured financial instruments such as mortgage securitizations and collateralized debt obligations or ``CDOs,'' for these too are OTC ``derivatives'' that purport to derive their ``value'' from another asset or instrument.Bank Business Models and OTC Perhaps the most important issue for the Committee to understand is that the structure of the OTC derivatives market today is a function of the flaws in the business models of the largest dealer banks, including JPMorgan Chase (NYSE:JPM), Bank of America (NYSE:BAC) and Goldman Sachs (NYSE:GS). These flaws are structural, have been many decades in the making, and have been concealed from the Congress by the Fed and other financial regulators. The fact that today OTC derivatives trading is the leading source of profits and also risk for many large dealer banks should tell the Congress all that it needs to know about the areas of the markets requiring immediate reform. Many cash and other capital markets operations in these banks are marginal in terms of return on invested capital, suggesting that banks beyond a certain size are not only too risky to manage--but are net destroyers of value for shareholders and society even while pretending to be profitable. \2\--------------------------------------------------------------------------- \2\ See ``Talking About RAROC: Is `Financial Innovation' Good for Bank Profitability?'', The Institutional Risk Analyst, June 10, 2008 (http://us1.institutionalriskanalytics.com/pub/IRAstory.asp?tag=286).--------------------------------------------------------------------------- Simply stated, the supranormal returns paid to the dealers in the closed OTC derivatives market are effectively a tax on other market participants, especially investors who trade on open, public exchanges and markets. The deliberate inefficiency of the OTC derivatives market results in a dedicated tax or subsidy meant to benefit one class of financial institutions, namely the largest OTC dealer banks, at the expense of other market participants. Every investor in the global markets pay the OTC tax via wider bid-offer spreads for OTC derivatives contracts than would apply on an organized exchange. \3\--------------------------------------------------------------------------- \3\ See ``Credit Default Swaps and Too Big to Fail or Unwind: Interview With Ed Kane'', The Institutional Risk Analyst, June 3, 2009 (http://us1.institutionalriskanalytics.com/pub/IRAstory.asp?tag=364)--------------------------------------------------------------------------- The taxpayers in the industrial nations also pay a tax through periodic losses to the system caused by the failure of the victims of OTC derivatives and complex structured assets such as AIGs and Citigroup (NYSE:C). And most important, the regulators who are supposed to protect the taxpayer from the costs of cleaning up these periodic loss events are so captive by the very industry they are charged by law to regulate as to be entirely ineffective. As the Committee proceeds in its deliberations about reforming OTC derivatives, the views of the existing financial regulatory agencies and particularly the Federal Reserve Board and Treasury, should get no consideration from the Committee since the views of these agencies are largely duplicative of the views of JPM and the large OTC dealers.Basis Risk and Derivatives The entire family of OTC derivatives must be divided into types of contracts for which there is a clear, visible cash market and those contracts for which the basis is obscure or nonexistent. A currency or interest rate or natural gas swap OTC contract are clearly linked to the underlying cash markets or the ``basis'' of these derivative contracts, thus both buyers are sellers have reasonable access to price information and the transaction meets the basic test of fairness that has traditionally governed American financial regulation and consumer protection. With CDS and more obscure types of CDOs and other complex mortgage and loan securitizations, however, the basis of the derivative is nonexistent or difficult/expensive to observe and calculate, thus the creators of these instruments in the dealer community employ ``models'' that purport to price these derivatives. The buyer of CDS or CDOs has no access to such models and thus really has no idea whatsoever how the dealer valued the OTC derivative. More, the models employed by the dealers are almost always and uniformly wrong, and are thus completely useless to value the CDS or CDO. The results of this unfair, deceptive market are visible for all to see--and yet the large dealers, including JPM, BAC, and GS continue to lobby the Congress to preserve the CDS and CDO markets in their current speculative form. \4\--------------------------------------------------------------------------- \4\ For an excellent discussion of why OTC derivatives and complex structured assets are essentially a fraud, see the presentation by Ann Rutledge, ``What's Great about the ETP Model?'', PRMIA, June 10, 2009. (http://www.prmia.org/Chapter_Pages/Data/Files/3227_3508_PRMIA%20CDS_presentation.pdf)--------------------------------------------------------------------------- In my view, CDS contracts and complex structured assets are deceptive by design and beg the question as to whether a certain level of complexity is so speculative and reckless as to violate U.S. securities and antifraud laws. That is, if an OTC derivative contract lacks a clear cash basis and cannot be valued by both parties to the transaction with the same degree of facility and transparency as cash market instruments, then the OTC contact should be treated as fraudulent and banned as a matter of law and regulation. Most CDS contracts and complex structured financial instruments fall into this category of deliberately fraudulent instruments for which no cash basis exists. What should offend the Congress about the CDS market is not just that it is deceptive by design, which it is; not just that it is a deliberate evasion of established norms of transparency and safety and soundness, norms proven in practice by the great bilateral cash and futures exchanges over decades; not that CDS is a retrograde development in terms of the public supervision and regulation of financial markets, something that gets too little notice; and not that CDS is a manifestation of the sickly business models inside the largest zombie money center banks, business values which consume investor value in multibillion dollar chunks. No, what should bother the Congress and all Americans about the CDS market is that is violates the basic American principle of fairness and fair dealing. Jefferson said that, ``commerce between master and slave is barbarism.'' All of the founders were Greek scholars. They knew what made nations great and what pulled them down into ruins. And they knew that, above all else, how we treat ourselves, as individuals, customers, neighbors, traders and fellow citizens, matters more than just making a living. If we as a Nation tolerate unfairness in our financial markets in the form of the current market for CDS and other complex derivatives, then how can we expect our financial institutions and markets to be safe and sound? For our Nation's founders, equal representation under the law went hand in hand with proportional requital, meaning that a good deal was a fair deal, not merely in terms of price but in making sure that both parties extracted value from the bargain. A situation in which one person extracts value and another, through trickery, does not, traditionally has been rejected by Americans as a fraud. Whether through laws requiring disclosure of material facts to investors, antitrust laws or the laws and regulations that once required virtually all securities transactions to be conducted across open, public markets, not within the private confines of a dealer-controlled monopoly, Americans have historically stood against efforts to reduce transparency and make markets less efficient--but that is precisely how this Committee should view proposals from the Obama Administration and the Treasury to ``reform'' the OTC derivatives markets. To that point, consider the judgment of Benjamin M. Friedman, writing in The New York Review of Books on May 28, 2009, ``The Failure of the Economy & the Economists.'' He describes the CDS market in a very concise way and in layman's terms. I reprint his comments with the permission of NYRB: The most telling example, and the most important in accounting for today's financial crisis, is the market for credit default swaps. A CDS is, in effect, a bet on whether a specific company will default on its debt. This may sound like a form of insurance that also helps spread actual losses of wealth. If a business goes bankrupt, the loss of what used to be its value as a going concern is borne not just by its stockholders but by its creditors too. If some of those creditors have bought a CDS to protect themselves, the covered portion of their loss is borne by whoever issued the swap. But what makes credit default swaps like betting on the temperature is that, in the case of many if not most of these contracts, the volume of swaps outstanding far exceeds the amount of debt the specified company owes. Most of these swaps therefore have nothing to do with allocating genuine losses of wealth. Instead, they are creating additional losses for whoever bet incorrectly, exactly matched by gains for the corresponding winners. And, ironically, if those firms that bet incorrectly fail to pay what they owe-as would have happened if the government had not bailed out the insurance company AIG-the consequences might impose billions of dollars' worth of economic costs that would not have occurred otherwise. This fundamental distinction, between sharing in losses to the economy and simply being on the losing side of a bet, should surely matter for today's immediate question of which insolvent institutions to rescue and which to let fail. The same distinction also has implications for how to reform the regulation of our financial markets once the current crisis is past. For example, there is a clear case for barring institutions that might be eligible for government bailouts-- including not just banks but insurance companies like AIG--from making such bets in the future. It is hard to see why they should be able to count on taxpayers' money if they have bet the wrong way. But here as well, no one seems to be paying attention.CDS and Systemic Risk While an argument can be made that currency, interest rate and energy swaps are functionally interchangeable with existing forward instruments, the credit derivative market raises a troubling question about whether the activity creates value or helps manage risk on a systemic basis. It is my view and that of many other observers that the CDS market is a type of tax or lottery that actually creates net risk and is thus a drain on the resources of the economic system. Simply stated, CDS and CDO markets currently are parasitic. These market subtract value from the global markets and society by increasing risk and then shifting that bigger risk to the least savvy market participants. Seen in this context, AIG was the most visible ``sucker'' identified by Wall Street, an easy mark that was systematically targeted and drained of capital by JPM, GS and other CDS dealers, in a striking example of predatory behavior. Treasury Secretary Geithner, acting in his previous role of President of the FRBNY, concealed the rape of AIG by the major OTC dealers with a bailout totaling into the hundreds of billions in public funds. Indeed, it is my view that every day the OTC CDS market is allowed to continue in its current form, systemic risk increases because the activity, on net, consumes value from the overall market--like any zero sum, gaming activity. And for every large, overt failure in the CDS markets such as AIG, there are dozens of lesser losses from OTC derivatives buried by the professional managers of funds and financial institutions in the same way that gamblers hide their bad bets. The only beneficiaries of the current OTC market for derivatives are JPM, GS, and the other large OTC dealers.CDS and Securities Fraud One of the additional concerns that the Congress must address and which strongly argue in favor of outlawing the use of OTC CDS contracts entirely, is the question of fairness to investors, specifically the use of these instruments for changing the appearance but not the financial substance, of other banks and companies. The AIG collapse illustrates how CDS and similar insurance products may be used to misrepresent the financial statements of public companies and financial institutions. In the case of AIG, the insurer was effectively renting its credit rating to other firms, and even its own affiliates, in return for making these counterparties look more sound financially than their true financial situation justified. The use of CDS and finite insurance to window dress the financial statements of public companies is an urgent issue that deserves considerable time from the Congress to build an adequate understanding of this practice and create a public record sufficient to support legislation to ban this practice forever. For further background on the use of CDS and insurance products at AIG to commit securities fraud, see ``AIG: Before Credit Default Swaps, There Was Reinsurance,'' The Institutional Risk Analyst, April 2, 2009 (Copy attached). \5\--------------------------------------------------------------------------- \5\ See also Harris v. American International Group, et al., Los Angeles Superior Court, Central District (Case #BC414205) CHRG-111hhrg53238--42 Mr. Zeisel," Good morning, Mr. Chairman, members of the committee. My name is Steve Zeisel, and I am senior counsel at the Consumers Bankers Association. I am very pleased to be given this opportunity to present the views of CBA to the committee. CBA is a trade association focusing on retail banking issues, and we are therefore limiting our testimony today to the proposed Consumer Financial Protection Agency. CBA supports strengthening consumer protections as part of the regulatory reform initiative, and we support several of the goals outlined in the CFPA proposal, including improving transparency, simplicity, fairness, accountability, and access for consumers. Our concern is with the approach being proposed. We believe these objectives can best be achieved within the existing regulatory framework rather than dismantling the current system and creating a separate new regulatory agency. Safety and soundness and consumer protection are intimately related, and cannot be separated without doing harm to both. Furthermore, putting consumer protection in a separate agency will create a host of problems, including how the agencies will coordinate their activities--as the chairman mentioned--who will resolve inevitable disputes, and many more, none of which are necessary to achieve improved consumer protection. We also believe there needs to be stronger supervision of nonbank lenders so they receive a consistent and comparable level of oversight and enforcement as experienced by banks. Although we have many other issues, many other concerns, there are two issues I particularly want to highlight today. First, we are concerned that the proposal would subject retail banks to the consumer laws of 50 States. I ask you to consider the practical impact of such a policy. It could result in dozens, perhaps scores of differing requirements pertaining to minimum payments, fee limits, underwriting prescriptions and the like, making nationwide lending into a complex and costly undertaking. Not only will this limit the range of products available, but some banks may have to make the unwelcome decision not to do business in States they otherwise would, due to the complexity and cost associated with the compliance burdens. That could mean fewer and more expensive choices for consumers as a result of the decreasing competition. Further, due to the elimination of uniform consumer laws for federally chartered institutions, even a simple uniform disclosure, which is one of the goals of this initiative, would have to be supplemented by State disclosure requirements in every State in which the bank does business. The best intentions of the bank or the CFPA to provide simple disclosures would be frustrated, as a uniform loan agreement would become a voluminous document cluttered with State-specific information. We believe the better approach is to maintain a uniform national standard as it relates to retail banking. Second, under the proposal, the CFPA will require retail banks and other financial service providers to offer products that are designed entirely by the Federal Government. This so-called plain vanilla requirement will remove product development from banks and transfer it to the new agency. Banks will offer vanilla products, but it is less clear whether they will be able to offer the variety of products they offer today or may develop tomorrow. This is because the proposal strongly discourages the offering of other products consumers may find useful by creating regulatory uncertainty regarding how these nonvanilla products must be described, how they can be advertised, and the disclosures that must accompany them. It is also unclear whether an institution would be required to make available the same plain vanilla products and features to everyone, regardless of whether they quality. It is unclear what hurdles a consumer would have to jump to obtain any other products, and it is unclear what risks the institution would be taking when it allows a consumer to have any other products. The list of questions is long. In the final analysis, we believe retail banks are in a better position than the government to know which products serve their clients' needs. In conclusion, we believe the proposed changes, though well intentioned, may stifle innovation, raise costs to consumers, reduce access to credit, and result in more confusion rather than less. Thank you for the opportunity. I will be happy to answer any questions you may have. [The prepared statement of Mr. Zeisel can be found on page 206 of the appendix.] " CHRG-111hhrg53240--109 Mr. Carr," Good afternoon, Chairman Watt, Ranking Member Paul, and other distinguished members of the subcommittee. My name is James H. Carr, National Community Reinvestment Coalition. On behalf of the Coalition, I am honored to speak with you today. NCRC is an organization of more than 600 community-based associations that promote access to basic financial services across the country for working families. NCRC is also pleased to be a member of the new coalition, Americans for Financial Reform, that is working to cultivate integrity and accountability within the financial system. Members of the committee, the collapse of the U.S. financial system represents a massive failure of financial regulation that suffered from a host of problems, including regulatory system design flaws, gaps in oversight, conflicts of interest, weaknesses in enforcement, failed philosophical perspectives on the self-regulatory functioning of the markets, and inadequate resolution authority to deal with problems after they have occurred. At the request of the committee, I will devote my time today to one issue, and that is consumer protection. Safety and soundness and consumer protection are often discussed as separate issues, yet the safety and soundness of the financial system begins with and relies on the safety and soundness of the products that are extended to the public. If the extension of credit by a financial firm promotes the economic wellbeing and financial security of the consumer, the system is at reduced risk of failure. If the financial products exploit consumers, even if they are highly profitable to financial institutions, the system is in jeopardy of failure. Unfortunately, for more than a decade, financial institutions have increasingly engaged in practices intended to mislead, confuse, or otherwise limit a consumer's ability to judge the appropriateness of financial products offered in the market and make informed decisions. In fact, the proliferation of unfair and deceptive mortgage products led directly to the current foreclosue crisis and massive destruction of U.S. household wealth, which currently stands at about $13 trillion. The tricks and traps, as it has been described by Elizabeth Warren, used to trap consumers into high-cost abusive financial products, greatly complicated if not impaired the ability of a consumer to make an informed financial decision about the most appropriate product for their financial circumstances. Nowhere was this irresponsible and reckless behavior by financial institutions more prevalent than in communities of color. For more than a decade, Federal agencies, independent research institutes, and nonprofit organizations have described and discussed the multiple ways in which people of color have been exploited financially within the mortgage market. The result today, the foreclosure crisis is having its most damaging impact on communities of color in two ways: first, people of color are experiencing a disproportionate level of foreclosures; and second, they are most negatively harmed by rising unemployment. The Obama Administration recently proposed a sweeping reform of the financial system. A core element of the President's plan is the establishment of the Consumer Financial Protection Agency. House Financial Services Chairman Frank has proposed a similar agency in his legislation, H.R. 3126. A consumer protection agency is long overdue. Currently, the financial regulatory agencies compete with one another for fees paid by institutions that they are entrusted to regulate. The winning bid is the regulator that promises the least amount of consumer protection. Although competition is an essential element in a free market, oversight and enforcement of the law is not, nor should it be, available for purchase in a free market. In fact, regulation is one of the few instances in which a monopoly market will result in the most efficient and desired result. A consumer financial agency, as outlined by both the President and the Chairman, would achieve a commonsense goal, and that is to provide standard products to eliminate unnecessary confusion for consumers on routine transactions. The concept of a standard product seems to be an anathema to some observers, but it is worth remembering that a 30-year fixed rate mortgage has been for more than half a century, and remains today, the gold standard loan product. It was created to help the Nation recover from the collapse of the previous major fall of the housing and credit markets during the Great Depression. In short, sometimes a good standard is the best innovation. In order to be most effective, the new consumer financial protection agency must examine lending at a community level as well. Highly segregated communities of color are the primary targets for unfair, deceptive, and predatory lending. As a result, the agency must have the knowledge, experience, and resources to address this critical reality. Moreover, prohibiting reckless and irresponsible products is only half the challenge in making sure there is equal access to reliable financial services. Many financial firms simply deny access to financial services completely. America has a long, unfortunate history of redlining. The Act that most significantly can address that issue at a community level is the Community Reinvestment Act. That law was included in the consumer protection agency proposed by the President, and we recommend that it be included in the bill that is being considered by this House. In conclusion, there has and will continue to be considerable pushback against the idea of a consumer financial protection agency, primarily from financial institutions. Their argument is that such an agency will stifle innovation, limit access to credit, and discourage lending to families most in need. These arguments should be considered as having the same merit as the declaration that the markets are self-regulating. We have seen the folly of self-regulated markets, and the American people are paying an extraordinary price for failed consumer protection. Thank you very much. I look forward to your questions. [The prepared statement of Mr. Carr can be found on page 48 of the appendix.] " 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. " CHRG-111hhrg52261--6 Mr. Harris," Chairwoman Velazquez, Ranking Member Graves, members of the committee. My name is Robert R. Harris and I am Vice Chairman with the American Institute of Certified Public Accountants. I am a CPA and a partner in the CPA firm of Harris, Cotherman, Jones, Price & Associates. We are located in Vero Beach, Florida, and are a small firm with 11 CPAs. My firm's clients are primarily small businesses and individuals. We do financial planning and tax service for most of these clients. I am here today representing the American Institute of CPAs. AICPA is the national professional association of CPAs with more than 360,000 CPA members in business, industry, public practice, government, education, student affiliates, and international associates. As a result of the economic crisis precipitated by the subprime lending, the administration and Congress felt that financial regulatory restructuring was necessary. The administration called for a new regulatory scheme that encompasses strong vibrant financial markets operating under transparent fairly administered rules that protect America's consumers and our economy from the devastating breakdown that we have witnessed in recent years. The administration also said that to accomplish this goal it would be necessary to seek a careful balance that will allow our markets to promote innovation while discouraging abuse. To this end, Congress is looking at a number of financial activities with an eye towards how to appropriately and adequately regulate those activities. The AICPA supports the goal of enhanced consumer protection, but we believe that it is critical to consider the plan's effect on small business to ensure that it does not stifle the innovation, creativity and inventiveness of the American entrepreneur that has driven our economic engine. In this context, I would like to discuss The Consumer Financial Protection Act of 2009, H.R. 3126, which would create the Consumer Financial Protection Agency, or CFPA, and its effect on small business from the point of view of a CPA. The stated aim of the consumer protection bill is to protect consumers by consolidating financial consumer protection in one agency. This would be a safeguard against consumers getting inappropriate loans that they could not afford repay. But the bill is much broader than protecting consumers when they borrow money. The CFPA, as introduced, would cover most CPAs because its scope of authority includes tax return preparation, tax advice, financial planning, and pro bono financial literacy activities. The accounting profession's pro bono financial literacy programs, ""360 Degrees of Financial Literacy"" and FeedthePig.org, which are designed to teach consumers and young people how to make smart decisions would be covered by the bill. Our own Lisa Baskfield, a CPA from Minnesota, was recently awarded the civilian service medal for providing pro bono financial access to more than 2,000 armed services members. Her advice would have been covered under this bill. Many of the members are affiliated with CPA firms that are small businesses and will be adversely affected by the bill, and many of their clients are small businesses, sole proprietorships and partnerships. It is impossible to separate the advice and tax service given to these small businesses from the advice and tax services given to the owners. They both are covered by the bill--thus, both would be covered by this bill. Additionally, any person who provides a material service to a covered person such as a financial institution is included in the definition of a covered person. My practice of forensic accounting would subject me to the CFPA when I do a financial audit of a lender making consumer loans even though I do not have direct dealings with the consumers and provide no services to consumers. As a CPA, I can tell you that CPAs are heavily and effectively regulated by three sources. State boards of accountancy, the Internal Revenue Service, and the AICPA. This regulatory structure protects consumers first with the first rule being, service the public interest. The bill consolidates the enforcement of a number of Federal consumer protection laws into one Federal agency; however, it adds another layer of regulation to the accounting profession without consolidating any of our regulation. This regulation would be costly because the assessment that would be levied by CFPA, and it will take significant time from our ability to serve our clients because we would be subject to periodic examinations by the agency. These are all costs that will ultimately be borne by our clients, the very consumers that this bill is supposed to protect. And it will do so without any commensurate benefit. CPAs are asking for an exemption only for the customary and usual CPA services and volunteer or pro bono financial education activities. We are not asking for an exemption when CPAs are offering consumer financial products, such as a loan or investment products. In fact, areas of potential abuse, such as refund anticipation loans, are covered by other provisions of the bill. We are encouraged by recent press reports that Chairman Frank is considering exempting professional services from the reach of the bill. We appreciate the opportunity to testify today on the impact of the bill that will have effect on thousands of CPA firms that are small businesses and their clients, many of whom are also small business. " 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-111hhrg58044--214 Mr. Snyder," There are general legal standards, but to encourage competition in the market, the models and the variables are all subject to insurance commissioner review on a State by State basis. That is the system that has been followed, general legal standards, and then allowing the companies to innovate and experiment, and subject to both legal standards and actuarial standards. Ms. Waters. Have members of your Association done their own studies? There is not one, two, three, four or five studies every year done by the Association or do they all do different studies? " CHRG-110hhrg44900--44 Mr. Bernanke," Like Secretary Paulson, I have no objection whatsoever to early action and will continue to work with you closely in all directions. It's just our sense, and of course you're in a better place than we are to make the judgment, that the more complex issues like resolution or even financial regulatory restructuring are simply not likely to happen in a short term, and we need to take the time to make sure it's done right and thoroughly worked through. So we will continue to think about what steps might be taken on a shorter-term basis and be in close touch with Congress. But, again, we are--I just want to be clear that, you know, it's not that we don't have any tools. We have plenty of tools, and we are working together very well I think to address a difficult situation. " 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. CHRG-111shrg56376--35 Mr. Tarullo," Thank you, Senator. If you are asking, what should the public be focused on, my suggestion would be too big to fail. That is not the only problem by a long shot, but to me, it continues to be the central problem--the ability to avoid the moral hazard that comes with ``too-big-to-fail'' institutions. As I said a moment ago, I think we need a variety of supervisory and regulatory tools to contain that problem, whether it is resolution, bringing systemically important institutions into the perimeter of regulation, making sure that the kinds of capital and liquidity requirements that systemically important institutions have will truly contain untoward risk taking. I think we are going to need a broad set of activities. ``Too big to fail'' was not the only cause, but it was at the center of this crisis and that is, I think, what we all need to focus on. The only other thing I would say harks back to a colloquy you and I had a couple of weeks ago when I was testifying. You and I were talking about attitudes and orientation and how people in the Congress and the regulatory agencies and the Administration think about issues and problems. It is not easy to ensure against people losing interest in issues. But I think that is a role that, in a system of Government that has a lot of checks and balances, we have to think about. How do we try to institutionalize skepticism and critical thinking, to look at developments in the financial world so that we don't just say, well, that is just another market development; it must be benign. But instead, we must begin to distinguish intelligently between benign, useful innovations on the one hand and building problems on the other. Senator Brown. Thank you. " Mr. Bowman," " FOMC20071206confcall--83 81,MS. YELLEN.," Thank you, Mr. Chairman. I support the swap arrangement, and I can also support the TAF. In thinking about the TAF, I tried to weight the potential costs and benefits of the program. It hasn’t been an easy task given the uncertainty about what’s responsible for the run-up in term funding spreads. So I thought about potential costs. I certainly don’t see them as particularly large. It is true that it may not have the desired effects, and one could argue that the Fed’s reputation would be tarnished by a failure to succeed, but I didn’t find this compelling. On the contrary, it seems to me that taking an innovative and proactive approach does a much better job of enhancing our reputation. The greater threat is not being willing to cope with what clearly is a very difficult and disturbed situation in money markets. I congratulate the staff. I think this does represent innovative thinking. On the cost side also, the TAF would subsidize probably low-quality borrowers, but I think that’s a side effect that any intervention that’s aimed at improving liquidity will have, and that’s an acceptable price to pay. On the benefit side, though, I guess I’m concerned that the benefits won’t be particularly large. I agree with the comments that have been made. I don’t quite see how the TAF solves the stigma problem. I think there will be stigma as long as the equilibrium rate ends up being a penalty rate, and I think that’s likely to deter bidding. So I guess I don’t really see that this is very advantageous—the TAF relative to changing the spread of the discount rate and the funds rate—but I do see the merit in the arguments that you’ve made about the predictability of the quantity of discount window lending and the desirability of international cooperation. I would say that to my mind the principal risk in introducing the TAF is that it may be seen by the Committee as a substitute for standard monetary policy action since I see it as essentially a kind of sterilized intervention that may have some but not a huge effect. I’m also concerned that it won’t change the cost of funding at the margin, as President Poole argued. I don’t expect the TAF to have large effects on financial conditions, and so it’s not going to affect my own views very much on what the appropriate policy measures are to take when we meet next week." CHRG-111hhrg55814--383 Mr. Wallison," Thank you very much, Mr. Chairman, and thank you, Ranking Member Bachus, for holding this hearing. The discussion draft of October 27th contains an extremely troubling set of proposals, which if adopted will turn over control of the financial system to the government, sap the strength and vitality of our economy, and stifle risk-taking and innovation. Rather than ending ``too-big-to-fail,'' the draft makes it national policy. By designating certain companies for special prudential regulation, the draft would signal to the markets that these firms are ``too-big-to-fail,'' creating Fannies and Freddies in every sector of the economy where they are designated. These large companies will have funding and other advantages over small ones, changing competitive conditions in every sector of the financial system. The draft suggests that the names of these companies can be kept secret. That can't happen. The securities laws alone will require them to disclose their special status. For designated companies, new activities, innovations, and competitive initiatives will be subject to government approval. Companies engaged in activities that the regulators don't like will be forced to divest. That power will ensure that nothing will be done in New York that wasn't approved in Washington. Commercial companies would be separated from financial activities even though these activities are never separated in the real world. All companies--retailers, manufacturers and suppliers--finance their sales. It's a puzzle how U.S. companies will compete with other foreign companies when they can't finance their own sales. Another flawed idea in this draft is that there is some kind of discernable line between finance and commerce. That line is political, it's imaginary. For example, to protect the Realtors against competition from banks, Congress has stopped the Fed from declaring that real estate brokerage is a financial activity. Can anyone describe why securities brokerage is financial but real estate brokerage is not? Of course not. Every industry will be asking for special treatment or exemption if this draft is adopted. The resolution authority is based on the faulty assumption that anyone can know in advance whether a company will--if it fails--cause a systemic breakdown. This is unknowable, but government officials are supposed to make this determination anyway. With unfettered discretion, officials will follow a better-safe-than-sorry policy, taking over companies that would only create economic disruptions, not full-scale systemic breakdowns. General Motors and Chrysler are an example. They were not systemically important but they were politically important. Their failure would not have caused a systemic breakdown, but would have caused a loss of jobs and other economic disruption. Companies like these will be rescued, while smaller ones with less political clout will be sent to bankruptcy. The markets will have to guess which will be saved and which will not, creating moral hazard and arbitrary gains and losses. Worse than giving government officials this enormous discretionary authority is what the draft authorizes them to do with it. They can rescue some companies and liquidate others, pay off some creditors and not others, and using government funds keep failing companies operating for years and competing with healthy companies. This will not only create uncertainty and moral hazard, but will again give large and powerful firms advantages over small ones. Those that seem likely to be taken over by the government will have an easier access to credit at lower rates than those likely to be sent to bankruptcy. In other words, the draft proposes a permanent TARP. It will use government money to bail out large or politically favored companies and then will tax the remaining healthy companies to reimburse the government for its cost of competing with them. That concludes my testimony, Mr. Chairman. [The prepared statement of Mr. Wallison can be found on page 312 of the appendix. ] " CHRG-111hhrg48868--291 Mr. Polakoff," Congressman, I think your question goes well beyond AIG to whether we need a systemic regulator, because what you described is not limited to an AIG structure. When you get to be a trillion dollar company, when you operate internationally, it is a very complex unit. And I think your point, as I understand it, sir, is if it is going to be complex and arrogated like an AIG is or other companies are, there really needs to be someone from the top down who has all the powers necessary as a systemic regulator. " CHRG-111shrg55739--96 Mr. White," All right. Thank you, Senator. First, you know, your larger issue, the larger question you asked about should we strip out the regulatory reliance on ratings, and my short answer is, as my grandmother would have said, from your lips to God's ear, or perhaps President Obama's ear. But let me now address the issue you just raised. When I advocate eliminating regulatory reliance, first, it can't be done overnight. That is right. Of course, you need notice and comment, et cetera. But also, it would be replaced by placing the direct burden on the bond manager at a bank, at a pension fund, at a money market mutual fund, to justify the safety of his or her bond portfolio. That is terrifically important. And the bond manager justifies the safety of the bond portfolio to the regulator either by doing the research him or herself, but not everybody is going to be able to do that, especially the smaller institution, or relying on an advisor. The advisor could be one of the incumbent rating firms. It might be a paid consultant. It might be a special advisory firm that comes into the market. Of course, that reliance ought to be approved by the regulator, but you open up the process. Now, those money market mutual fund responses to the SEC's proposals, ah, they were bleating and saying, oh, not us. Not us. We couldn't do the research ourselves. OK, fine. You can't do the research yourself, but if you don't even have the expertise to be able to figure out who is a reliable advisor and who is not, you shouldn't be running a bond fund in the first place and the SEC ought to use its regulatory powers to remove somebody who does not have the expertise even to figure out who is a reliable advisor or who is not. Again, this is an institutional market. It is not a retail market. Senator Reed. Thank you, Mr. Froeba. I have a question, but it will be in the second round. Thank you. Senator Shelby. Senator Shelby. Thank you, Mr. Chairman. Mr. Joynt, one of the issues that was identified by the SEC staff in last year's report on credit rating agencies was that the growth and complexity of complex structured products overwhelmed the rating agencies. What steps have you taken to ensure that the next complex product--and there will be some--that is sold in the financial markets does not outpace perhaps your firm's analytic capabilities in the way that the CDOs and the CLOs did? " FOMC20080310confcall--77 75,MR. EVANS.," Thank you, Mr. Chairman. I support the extension of the swap and the term securities lending facility of up to the $200 billion amount that you're talking about. This can improve market functioning, as I understand the discussion; and it targets action to markets with major liquidity shortfalls, so I think that it is effectively targeting policy to the right place. It has some risks definitely, but it is important to do something innovative like this. I hope that, after these actions, market conditions might improve somewhat so that ultimately fewer adjustments in the funds rate might be called for. If so, then it's possible that the inflation risks that come with those adjustments might be more limited. That's not obviously true because the stance of policy depends on overall accommodation, including in financial markets, but that could be the case. If this works, as you were alluding to, we will get a lot of information from the auctions and the market conditions themselves. Removing this might be a lot easier than actually removing the funds rate accommodation that we talked about as being so important. So targeting this could have another beneficial effect on policy. I would guess that we would review or at least have some assessment of how the policy is working at each of the upcoming FOMC meetings, and that would be a natural time for the Committee to talk about that further. Thank you. " CHRG-111hhrg53238--15 The Chairman," The gentleman from California, Mr. Miller, for 2 minutes. Mr. Miller of California. Thank you, Mr. Chairman. I want to thank you for holding this hearing today. And I believe that everyone in this room would agree that our current regulatory system failed to adequately protect not only the markets, but investors, and it does need to be restructured. However, I believe we need to proceed with caution to ensure that legislation does not overregulate our markets, stifle innovation or take choices away from consumers. I want to thank the chairman for bringing up the issue of mark-to-market. I believe it was in February of last year that I introduced an amendment on a bill, the housing bill, that required the Federal Reserve and the SEC to look at mark-to-market, perhaps take part of it and revisit it and restructure it, and perhaps even avoid implementing portions of it at that point in time. It is sad to say, I think I did that 3 or 4 times, and the Senate removed it from every bill we sent over there. I think, had we moved more aggressively in that direction, perhaps some of the problems we face today might have been avoided. There has been much debate about Freddie and Fannie. I know in 2002-2003, we also passed legislation providing a strong regulator and providing oversight for Freddie and Fannie that perhaps might have avoided some of the circumstances they are facing today. But the concept of not having a Freddie or Fannie there today, when they are providing about 73 percent of all the loans out there and the guarantees in the marketplace, is bothersome to me. And if you include FHA in that, between Freddie, Fannie, and FHA, over 90 percent of the loans made today are taken by those or guaranteed by those companies. The fact is that with liquidity as it is, the banks just don't have the liquidity on hand to make fixed-rate 30-year loans and hold those loans in many cases. I think one thing we didn't do was open Freddie and Fannie up to the high-cost areas. We did that much later, in fact in this last year, but I think had we done that early on there would have been more liquidity in the overall marketplace, and I believe that certain portions of this country wouldn't have been discriminated against because they weren't having the option to participate in the program. I really hope that the comments by this group of distinguished individuals today will be honest, above board, and really tell us your concerns. I am concerned that we overregulate you. We need to allow the market to take its course. We need to allow innovation within the marketplace, and especially within your industry, we need to allow for innovation. I think sometimes we are not timely in implementing programs like mark-to-market. And I think sometimes we react overaggressively after the fact when things have occurred, and I am hoping we don't do that in many cases. I hope we are thoughtful in what we are doing here, we discuss the pros and cons as it applies to your industry, and we come up with something that is reasonable. Mr. Chairman, I thank you and I yield back the balance of my time. " CHRG-111hhrg53244--163 Mr. Bernanke," There are probably some products that, to be useful, need to be customized. But we should make sure that dealers or banks hold sufficient capital against them to make it attractive to move them onto exchanges and to standardize them whenever possible. Ms. Moore of Wisconsin. Okay. Thank you. With respect to what we can't unscramble, many of my colleagues have already talked about Gramm-Leach-Bliley and the CFTC reform. And here we are talking about too-big-to-fail, all these institutions that are allowed to perform several functions. What, in your opinion, can we not unscramble in order to continue to be innovative and profitable? What cannot be unscrambled? " CHRG-111shrg51395--51 Mr. Stevens," We, as you know, endorse with some cautions the idea of a systemic risk regulator, but if you push me to say what one thing, Mr. Chairman, I would say that we need a capital markets regulator that is really at the top of its game. This problem would not have grown unless the securities markets made available, through packaging and reselling and all the rest of it, a vast opportunity to take these mortgages and distribute them to financial institutions globally. I in 30 years have been a close observer of the SEC, and I think it is a remarkable agency. But it has seen challenges in keeping up with the growth and the complexity and the linkages, the internationalization of our capital markets. What we need to do is give it the right tools, give it the right range of authority, and make sure there is a very strong management focus there that keeps it on its mission. And I agree with you, investor protection is mission one, but it also has a very important regulatory role, and so it needs to understand and be able to keep pace with these market changes in the way that has, I think, proven to be very, very difficult. So that would be my recommendation. " Chairman Dodd," OK. Professor Bullard. " 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. " CHRG-111shrg55739--147 PREPARED STATEMENT OF JAMES H. GELLERT President and Chief Executive Officer, Rapid Ratings International, Inc. August 5, 2009Overview Rapid Ratings International, Inc. (Rapid Ratings) would like to thank the U.S. Senate Committee on Banking, Housing, and Urban Affairs for inviting us to provide testimony to the critical subject of Rating Agency regulation. This is an essential topic for the global financial markets, U.S. citizens and residents who have been directly and indirectly affected by the actions of the large, incumbent rating agencies, and those newer ratings firms, like ours, that have built a viable alternative to the status quo. Rapid Ratings is a subscriber-paid firm. We utilize a proprietary, software-based system to rate the financial health of thousands of public and private companies and financial institutions quarterly. We use only financial statements, no market inputs, no analysts, and have no contact in the rating process with issuers, bankers or advisors. Our ratings far outperformed the traditional issuer-paid rating agencies in innumerable cases such as Enron, GM, Delphi, Parmalat, LyondellBasell, Pilgrim's Pride, Linens 'N Things, and almost the entire U.S. Homebuilding industry. Currently, we are not a Nationally Recognized Statistical Rating Organization (NRSRO). We have not applied for the NRSRO status and do not have immediate plans to do so. At present, there are too many mixed messages coming from the SEC, Treasury and Congress for me to recommend to our shareholder that the designation is in their best interests. The Treasury proposal's requirement that all ratings firms would be required to register is another curve ball in an already changing playing field. That said, we believe that reform in our industry is necessary and must happen with a sense of urgency. However, we caution that speed for speed's sake may have significant, and counterproductive, unintended consequences. U.S. legislation and regulations have both global and national effects, hard lessons reinforced over the last 2 years. Despite years of legislative action on corporate governance, Sarbanes Oxley (2002), and the Credit Rating Agency Reform Act (2006), through a combination of conflict of interest, self-interest and, unfortunately, entrenched regulatory protection, issuer-paid rating agencies (principally S&P, Moody's, and Fitch (the ``Big Three'')) facilitated a toxic asset flood that deluged the global markets, contributing to the worst economic crisis in 80 years. The SEC has been wrestling with new rules and rule amendments and has made some headway in areas of curbing conflicts of interest. Though not attacking and seeking to end the clearly conflicted issuer-pay revenue model, the Commission is taking some positive initiatives to curb the more egregious behavior evidenced by these conflicts. The new Department of Treasury proposal, however, takes multiple steps in the wrong direction and threatens to further solidify the entrenched position held by the Big Three, erecting further hurdles to competition in this industry. The Treasury proposals are misdirected in 5 areas: 1. One-size does not fit all: Proposals designed to fix major deficiencies in the issuer-paid business model should not be loaded indiscriminately on to subscriber-paid agencies, thus increasing their costs, increasing barriers to entry, and reducing competition. 2. Disclosure rules affecting intellectual property: The new rules must avoid requiring the forced disclosure of proprietary intellectual property. Appropriate safeguards must be introduced to protect intellectual property. 3. Accuracy: It is unreasonable to believe the SEC can effectively be the arbiter on accuracy in the ratings industry. The market will decide very effectively which ratings are more accurate through usage of competing credit rating agencies (CRAs), as long as there are not barriers to entry protecting S&P, Moody's, and Fitch, and disadvantaging new entrants or small rating agencies. 4. Forcing NRSRO registration on all companies issuing ratings will force compliance costs on new CRAs thus erecting further barriers, potentially force small CRAs out of business and deter potential new capital sources entering this industry, all thereby undermining the growth of innovative and more accurate ratings technology. The vast number of firms captured by this sweeping net would not only confuse users of ratings, potentially hundreds of new agencies would be designated that would not have qualified as NRSROs under the Credit Rating Agency Reform Act of 2006. All of these would fuel the use of the largest brand names, and solidify regulatory protection of S&P, Moody's, and Fitch. 5. Rating Disclosure: Requiring subscriber-based rating agencies to disclose their history of ratings can undermine the subscriber- based business model which is predicated on selling current and past ratings to investors. The Treasury proposal covers all types of rating agencies and for 100 percent of their ratings. This erects a major barrier to competition by subscriber-based CRAs against the issuer-paid CRAs by stripping them of their revenues. This proposal may violate antitrust laws because the proposal undermines competition. \1\--------------------------------------------------------------------------- \1\ Spectrum Sports, Inc. v. McQuillan: ``The purpose of the [Sherman] Act is not to protect businesses from the working of the market; it is to protect the public from the failure of the market. The law directs itself not against conduct which is competitive, even severely so, but against conduct which unfairly tends to destroy competition itself.'' The Big Three have lobbied heavily to promote the notion that all business models carry conflicts of interest and therefore that theirs is no worse than any other. Can conflicts occur in other business models? Sure. Have conflicts in other business models contributed to a catastrophic financial disaster that taxpayers will be paying for dearly for years to come? No. This red herring cannot drive new legislation. The problem is not the potential behavior of the subscriber-paid rating agencies; rather it is the misbehaviors of the issuer-paid rating agencies that have already occurred. Effective legislation and regulatory framework must focus on reforming the issuer-paid model's most negative features, providing oversight of the NRSROs that prevent the self-interested behavior that contributed to the current financial crises and creating an even playing field for competition. The latter has two major components: fostering (or at least not inhibiting) new players, methodologies, and innovation; and, equivalent disclosure of data used by other NRSROs for rating the highly complex instruments The Big Three have demonstrated are in dire need of alternative sources of opinion. Innovation and responsible alternatives to a status quo are both highly American traits. For true reform to have a fighting chance, these themes must be protected by the legislative framework for the ratings industry and we must be critically aware of how the unintended consequences of poorly implemented regulations can leave us with a broken system that has proven it is not deserving of protection. Much of the current legislative effort, including the SEC's newest Rule Amendments, reproposed rule amendments, Treasury's proposal and initiatives which we understand are underway on the Hill, are all concentrating on largely the same group of issues: Ratings shopping The consultative relationships between the issuer-paid rating agencies and issuers and their bankers Access to the information used in due diligence of structured products Disclosure of ratings history and actions Ratings symbology for structured product ratings New payment structures for ratings What entities should register as NRSROs The existence of ratings in regulationsLargely neglected in the proposals, rules and acts are the following: Should the issuer-paid revenue model be abolished? The consequences of rules targeting essentially three issuer-paid firms on the subscriber-paid businesses that are growing to provide competition and alternatives to investors Accuracy of ratings ______ CHRG-111shrg50564--151 Mr. Dodaro," Thank you very much, Mr. Chairman. I appreciate the opportunity to appear before you and the members of the Committee this afternoon to assist your deliberations on the financial regulatory system. As you mentioned, we in this report embarked on an effort to assist this Committee and the Congress in tracing the evolution of the financial regulatory system over the last 150 years, how it has evolved; to talk, second, about some of the developments in the market that has really challenged that regulatory system; and to put forth a framework to help guide decisions on how to craft and evaluate proposals to change the system going forward. Our bottom line conclusion is that the current system is outdated, it is fragmented, and it is ill suited to meet the 21st century needs of our nation. There are many reasons for this. Three I would point out, trends that we identified in the report. First is that the regulators have struggled and often failed to mitigate the systemic risks of large interconnected financial conglomerates or to adequately ensure that they have managed their own risks. There is no one single regulator charged with looking at risk across the financial system. This, as mentioned in the earlier discussions today, is a problem that needs to be addressed. Second, regulators have been confronted with some large market participants that are less regulated. Non-bank mortgage lenders, credit rating agencies have been mentioned here. They are two that we point out in our report, as well. Third, both the regulators, consumers, investors have all been challenged by the emergence and growth of complex financial instruments, whether it is collateralized debt obligations, credit default swaps, over-the-counter derivatives. All these products have really evolved and introduced new dimensions into the system that really outpace the regulators' ability to be able to handle that. Now, going forward, we think that action needs to be taken. It needs to be deliberative, as pointed out here in the discussion so far. And in order to assist this, we outline nine characteristics in our report which we think are good touchstones. First is that the regulatory goals need to be clear and articulated in statute, and the goals really ought to drive the substance of the organization, as Dr. Volcker mentioned earlier, and they ought to be in statute so that they can be used to hold the regulators accountable going forward and can provide consistency over a period of time and ensure that there is consistency in the regulation going forward. Next, it has to be--reform has to be comprehensive. The current institutions and products that, where there are gaps, the gaps need to be closed and it needs to be looked at in an interrelated set of, as has been mentioned, in a unified basis going forward. System-wide risk needs to be addressed. Somebody needs to be in charge of making sure that the system-wide risks are monitored going forward. It needs to be flexible and adaptable, and by that we mean it has to allow for innovation, but somebody has to be staying abreast of risks that are emerging going forward. We know where the risks are now. What shape they will take in the future is really anybody's guess at this point, but we need to have a monitoring system in place that can triage those risks, make determination, not be totally reactive to the situations going forward. It needs to be efficient and effective. By this we mean there is overlapping jurisdictions right now that can be consolidated or looked to to consolidate so we have an efficient system going forward. Consumer protection has to be also a paramount consideration here. Every time we have evaluated an activity for this Committee or another committee in Congress in terms of whether it is credit card fees or whether it is mutual fund fees, the disclosures invariably aren't adequate enough going forward, and I believe there also needs to be more attention to financial literacy concerns. The Federal Government has a commission on this, but it hasn't been--had a strategic plan, been resourced properly. That needs to be part of the package, as well. The regulators have to have the right authorities. They have to have proper independence, and that involves the funding sources that they draw upon to ensure that independence going forward. And last, taxpayer exposure has to be minimized. We believe that whatever structure is put in place, that future failures are borne by the cost of the market participants and not by taxpayers going forward. An example here is what is set up currently in the Bank Insurance Fund, where fees are paid and then institutions, if they fail or are taken over, then the fund is recapitalized by the participants in the fund and not by taxpayers going forward. Now, to your point about seizing the moment, one of the things that we did in order to highlight attention to dealing with this issue was add the need to modernize the financial regulatory system to our most recent update for the High-Risk List that we keep for the Congress and unveil at the beginning of each new Congress, and this is important because we have added areas in need of broad-based transformation as one of the criteria to be put on the High-Risk List. We think it was important to do that, to feature this as the attention of need of change both by the executive branch and importantly by the Congress, in this case, through legislative initiatives. So that sort of concludes my opening statement. My colleagues and I would be happy to answer any questions that you have. " CHRG-111hhrg53238--39 Mr. Stinebert," Thank you, Mr. Chairman, and thank you for your assurances about no contradictory orders out there. That is very helpful. And, also, I heard from everyone in their opening statements about the desire of everyone to move cautiously and carefully as we move forward, and that is appreciated as well. Today I am going to focus most of my remarks on the new formation of the Consumer Financial Protection Agency. Let me say from the outset that AFSA fully supports strong consumer protection. What is troubling, however, is the notion that improved consumer protection depends entirely on the creation of a new Federal agency empowered to make product choices for consumers. We believe the country does not need a vast new bureaucracy, and that the goals of the Administration and Congress can be achieved through other means that are quicker, more efficient, and certainly less costly. If signed into law today, the CFPA's earliest action could be taken perhaps 2 to 3 years from now. Why then would Congress rush to launch a new agency before taking the time to carefully evaluate the potential consequences on the availability of credit and certainly the overall economy? We believe that a thorough assessment is needed to determine if the benefits will outweigh the risk and certainly the costs. In essence, the proposal would impose a new tax on consumers at a time when they are least able to afford it. Congress should think carefully about setting up a new government agency that would cost taxpayers more money at a time when they are already struggling to stay afloat financially. Given the vast scope of the new agency, it is certainly acceptable that these costs could be staggering. Any assessment or fees charged to lenders undoubtedly will be passed on to consumers. The result will be an increase in costs and hurt the availability of credit. AFSA believes consumers will be better served by a regulatory structure where the prudential and consumer production oversight is housed within a single regulator. Congress tried to separate these two functions with the GSEs. Director James Lockhart recently cited this separation of functions was one of the primary reasons for failure at Fannie Mae and Freddie Mac. We urge Congress to support a regulatory structure that continues to have that balance, that necessary balance between safety and soundness and the viability of the companies that offer them. We also believe that the proposed agency has the potential to roll back the clock 30 years, back to when consumers only had a choice of standard and plain vanilla products. In the last 30 years, in adjusted inflation dollars, consumer credit has increased from $882 billion to $2.6 trillion; household mortgages, from $2 trillion to $10.4 trillion. For the last 30 years, financial innovation has been the fuel of this economy. We are not here today to claim that financial innovation did not play some role in the subprime mortgage crisis, but regressing to a bygone era is not progress. Financial services reform should take us forward, not back to plain vanilla. Most AFSA members are regulated primarily at the State level subject to a patchwork of inconsistent requirements. Under this new proposal, you could wind up with 50 different State requirements as far as trying to meet those regulations in different forms and different disclosures, and certainly that is not a formula for simplification. We have six different suggestions: Allow time to evaluate the effects of other government initiatives, such as the Cardholders' Bill of Rights recently signed into law and the new changes to HOEPA. Make current and future consumer protection rules apply to all financial service providers. Pursue a regulatory structure that does not separate financial services and products from the viability of the companies that offer them. Leave enforcement of rules of existing regulators, but give backup authority to the Fed for these areas, and step up enforcement. Step up enforcement, make stronger enforcement of existing consumer protection laws, and make sure that the necessary resources are provided. Last but not least, I would like to mention, preserve the industrial bank charter. The Administration's proposal calls for eliminating the industrial bank charter. Industrial banks provide a safe, sound, and appropriate means for delivering financial services to many in the public. These institutions have not been part of the problem. As a matter of fact, there have been no instances of any problem within the ILC structure, and we think they should be part of the solution moving forward. I am happy to answer any questions that you might have. [The prepared statement of Mr. Stinebert can be found on page 176 of the appendix.] " CHRG-111shrg56376--231 PREPARED STATEMENT OF MARTIN N. BAILY Senior Fellow, Economic Studies, The Brookings Institution September 29, 2009 Thank you Chairman Dodd, Ranking Member Shelby, and Members of the Committee for asking me to discuss with you the reform of Federal regulation of financial institutions. \1\--------------------------------------------------------------------------- \1\ Martin Neil Baily is the Bernard L. Schwartz Senior Fellow in the Economic Studies Program at the Brookings Institutions, the cochair of the Pew Working Group on Financial Sector Reform and a member of the Squam Lake group of academics studying financial reform. He was Chairman of the Council of Economic Advisers under President Clinton. The opinions expressed are his own but he would like to thank Charles Taylor, Alice Rivlin, Doug Elliott, and many other colleagues for helpful comments.--------------------------------------------------------------------------- I would like to share with the Committee my thoughts on consolidation of the Federal financial regulatory agencies and what it would take to make them successful in the future. However, this is part of a larger puzzle--the reorganization of Federal financial regulation generally and, in some respects, it is difficult to discuss the narrower topic without examining the broader context. I will therefore also say something about possible complementary changes in the roles of the Federal Reserve, the SEC and the proposed CFPA. A summary of my testimony today is as follows: The best framework to guide current reform efforts is an objectives approach that divides regulation up into microprudential, macroprudential, and conduct of business regulation. The quality of regulation must be improved regardless of where it is done. Regulatory and supervisory agencies must have better qualified, better trained and better paid staff with clear objectives to improve safety and soundness and encourage innovation. Regulatory personnel must be accountable for their actions. A single Federal microprudential regulator should be created combining the regulatory and supervisory functions currently carried out at the Fed, the OCC, the OTS, the SEC, and the FDIC. This regulator should partner closely with State regulators to ensure the safety and soundness of State chartered financial institutions, sharing supervisory authority. The U.S. needs effective conduct of business regulation. The SEC is currently charged with protecting shareholders and the integrity of markets and must improve its performance in this area. In my judgment, the SEC should also create a new division within the agency to protect consumers, that is to say, it would add a CFPA division and become the consolidated conduct of business regulator. Although my first choice is for a single conduct of business regulator, a well-designed standalone CFPA could also be effective. The Fed should be the systemic risk monitor with some additional regulatory power to adjust lending standards. In this it should work with a Financial Services Oversight Council, as has been proposed by the Treasury.The Objectives Approach to Regulation I support an objectives-based approach to regulation. The Blueprint for financial reform prepared by the Paulson Treasury proposed a system of objectives-based regulation, an approach that is the basis for successful regulation in Australia and other countries overseas. The White Paper prepared by the Geithner Treasury did not use the same terminology, but it is clear from the structure of the paper that their framework is an objectives-based one, as they lay out the different elements of regulatory reform that should be covered. However, they do not follow through the logic of this approach to suggest a major reorganization of regulatory responsibilities. There are three major objectives of regulation: First is the microprudential objective of making sure that individual institutions are safe and sound. That requires the traditional kind of regulation and supervision--albeit of improved quality. Second is the macroprudential objective of making sure that whole financial sector retains its balance and does not become unstable. That means someone has to warn about the build up of risk across several institutions and take regulatory actions to restrain lending used to purchase assets whose prices are creating a speculative bubble. Third is the conduct of business objective. That means watching out for the interests of consumers and investors, whether they are small shareholders in public companies or households deciding whether to take out a mortgage or use a credit card. An objectives-based approach to regulation assigns responsibilities for these three objectives to different agencies. The result is clear accountability, concentration of expertise, and no gaps in coverage of the financial services industry--even as its structure changes and new products, processes and institutional types emerge. No other way of organizing regulation meets these important criteria while avoiding an undue concentration of power that a single overarching financial services regulator would involve. \2\ The main focus of this testimony will be to make the case for a single microprudential regulator, something I believe would enhance the stability of the financial sector. Having a single microprudential regulator is not a new idea. In 1993, the Clinton Administration and the Paulson Blueprint in 2008 proposed the same thing.--------------------------------------------------------------------------- \2\ See, ``Pew Financial Reform Project Note #2: Choosing Agency Mandates'', by Charles Taylor.--------------------------------------------------------------------------- It is important to remember that how we organize regulation is not an end in itself. Our plan must meet the three objectives efficiently and effectively, while avoiding over-regulation. In addition for objectives-based regulation to work, it is essential to use the power of the market to enhance stability. Many of the problems behind the recent crisis--executive and trader compensation, excessive risk taking, obscure transaction terms, poor methodologies, and conflicts of interest--could have been caught by the market with clearer, more timely and more complete disclosures. It will never be possible to have enough smart regulators in place that can outwit private sector participants who really want to get around regulations. An essential part of improving regulation is to improve transparency, so the market can exert its discipline effectively.The Independence of the Federal Reserve In applying this approach, it is vital for both the economy and the financial sector is that the Federal Reserve has independence as it makes monetary policy. Experience in the U.S. and around the world supports the view that an independent central bank results in better macroeconomic performance and restrains inflationary expectations. An independent Fed setting monetary policy is essential.The Main Regulators and Lessons From the Crisis The main Federal microprudential regulators had mixed performance at best during the recent crisis. OTS did worst, losing its most important institutions--WaMu, IndyMac, and AIG--to sale and outright failure. Without any economies of scale in regulation, OTS suffered from a small staff in relation to their supervisory responsibilities. Its revenue was dominated by fees on a very small number of institutions, leading to regulatory capture. And, as many have observed, OTS lax standards attracted institutions to a thrift charter and it because the weakest link in the Federal financial depository regulatory chain. The lessons were: regulatory competition can create a de facto race to the bottom; and large institutions cannot be supervised and regulated effectively by small regulators--not only because of the complexity of the task but also because of capture. The Office of the Comptroller of the Currency (OCC) fared only somewhat better. Their responsibilities were far wider and their resources were far greater. Nevertheless, several of their larger institutions failed and had to be rescued or absorbed. While an element of the problem was that there were parts of these institutions where their writ did not reach--OCC-regulated banks bought billions of dollars of CDOs, putting many of them into off-balance-sheet entities--it was not the only problem. Somehow, even this relative powerhouse failed to see the crisis coming. The lessons were: even the best of the Federal regulators may not have been up to the demanding task of overseeing highly complex financial institutions; and balkanized and incomplete coverage by microprudential regulators can be fatal. The FDIC is rightly given credit for having championed the leverage ratio as an important tool of policy. While the Fed and the OCC became increasingly enamored of Basel II over the past 10 years, the FDIC suffered repeated criticism for their stick-in-the-mud insistence on the leverage ratio. On that issue, they have been vindicated not only here in the U.S., but internationally. But they did not do so well in prompt corrective actions during this crisis. Their insurance fund dropped from $45bn to $10bn in 12 months. Several of the firms that failed were well capitalized just days beforehand. The lesson is that liquidity and maturity transformation can matter as much as leverage in a crisis. Prompt corrective action focused on capital ratios alone is not enough. While some State regulators have a fine record, nonbank financial institutions, largely overseen at the State level, were a major source of trouble in the recent financial crisis. Often working with brokers, these institutions originated many of the subprime, prime, and jumbo mortgages that have subsequently defaulted. They provided the initial funding for mortgages, but then quickly sold them to other entities to be packaged and securitized into the CDOs that were sliced and diced and resold with high credit ratings of dubious quality. They made money by pushing mortgages through the system and did not carry risk when these mortgages defaulted. Many State regulators failed to control bad lending practices. The main lessons: skin in the game is needed to keep the ``handlers'' of securitizations honest; and any reform of financial regulation has to somehow strengthen State regulation as well as Federal. Perhaps the most difficult regulator to assess in the current crisis is the Federal Reserve. More than any other institution, it has prevented the financial system from falling off a cliff through often brilliant and unprecedented interventions during the worst days of the crisis. I have expressed publicly my admiration for the job that Ben Bernanke has done in managing this crisis with Secretary Geithner and others. Taxpayers are understandably angry because of the funds that have been spent or put at risk in order to preserve the financial sector, but the alternative of a more serious collapse would have been much worse. The historical experience of financial crises here in the United States and around the world is that a banking collapse causes terrible hardship to the economy, even worse than the current recession. Bernanke and Geithner have helped avoid that disaster scenario. However, the Fed did nothing at all for 14 years to prevent the deterioration in mortgage lending practices, even though Congress had given it the authority to do so in 1994 under HOEPA. Several of the bank holding companies under Fed supervision faced severe problems in the crisis--its microprudential regulation was ineffective. And, while the Fed has repeatedly claimed that systemic risk management was their responsibility, they failed to anticipate, or even prepare for, the crisis in any meaningful way. In short, in its role as a regulator of bank holding companies, the record of the Fed is not good. Bank regulation has been something of a poor relation at the Fed compared to the making of monetary policy. The Fed as an institution has more stature and standing than any other Federal financial institution, but this stature comes from its control over monetary policy, not on its role in bank supervision and regulation. In addition, the Fed's powers were limited. It could not gain access to key information from many large financial institutions and had no power to regulate them. Lehman and Bear Stearns are two examples. While, the Fed has increased its knowledge and understanding of the large banks as a result of managing the crisis and conducting the stress tests, the lessons are: having an institution with a secondary mandate for consumer protection (under HOEPA) does not work well; and the Fed's focus on monetary policy also makes it difficult to direct enough institutional focus on supervision. Finally, there is the Securities and Exchange Commission which did an abysmal job in this crisis. It told the public that Bear Stearns was in fine shape shortly before the company failed; in fact it failed to supervise effectively any of the bulge bracket firms, Merrill Lynch, Bear Stearns, Goldman Sachs, Morgan Stanley, and Lehman). It did nothing to restrain the credit agencies from hyping the ratings of CDOs. And it did not stop Madoff and others from defrauding investors. However, the leadership has changed at the SEC and I believe it has learned important lessons from the crisis: its strong suit is not microprudential regulation of institutions; it must focus on investor protection and the integrity of the markets--not only the traditional ones like the stock and bond markets, but also the securitization market--including the development and implementation of policies to revamp securitization credit ratings. One vital issue to recognize in regulating the large financial institutions is that they are run as single businesses. They decide what their business strategies will be and how to execute them most effectively. The specific legal forms they choose for their different divisions is determined by what they think will work best to achieve their strategic goals, given the tax, regulatory and legal environment that policymakers have set up. Under the current regulatory system, the Fed supervises and regulates the bank holding company while, for example, the OCC supervises the U.S. banks that are the subsidiaries of the holding company. Most of the large financial institutions are in several lines of business and, at present, are regulated by more than one agency. Inevitably, this encourages them to shift activities to the subsidiary and hence the regulator that is most tolerant of the activity they want to pursue. Balkanized regulation is unlikely to stop the next crisis. This short review is not inclusive. There are credit unions that have a separate regulator and there are important issues around the GSE's and their regulation and around derivatives and their regulation that I will not tackle in this testimony. This review has been critical of the regulatory agencies but I want to note that there are many people to blame for the financial crisis, including bankers who took excessive risks and failed to do due diligence on the assets they purchased. Economists generally did not predict that such a severe crisis was possible. Very few people saw the possibility of a 20 percent or more decline in the price of housing and almost nobody saw the depth of problems that have resulted from the sharp declines in house prices.What Structure Best Meets the Objectives of Financial Regulation?Regulatory Performance Must Be Improved Regardless of Where It Is Done There must be improved performance in the supervision and regulation of financial institutions regardless of who is doing it. There were rooms full of regulators sitting in all of the large regulated financial institutions prior to the crisis and they failed to stop the crisis. This means there should be more accountability for regulators, so that they are censured or removed if they do not perform the role they were hired to do. It means they should be better paid. It seems paradoxical to reward a group that did not do so well historically, but if we want better regulators then they must receive salaries that make their jobs attractive to high quality people, those who can understand complex institutions and products and who may have the option of earning high incomes in the private sector. Adequate training must be available. Better quality regulation is a ``must-have'' of financial reform and must be part of the legislation now being considered. A lot of improvement can be made even under existing legislation if regulators have the incentives and abilities to do their jobs. Some people argue that regulation has been the cause of the problem and that if the Government were removed from the equation then the financial sector would regulate itself, with weak companies failing and the strong companies surviving. Overall, I am a strong supporter of letting markets work and letting companies fail if they cannot be efficient or innovative. This includes financial institutions that should be allowed to fail if they do make bad decisions and fail to meet the market test. The financial sector has unique features that make it different from most other industries, however. Failure in one institution can spill over to others and problems in the financial sector can rock the whole economy, as we have seen in this crisis. Regardless of one's perspective on this issue, however, it is clearly a mistake to create worst of both worlds. If the Government provides a safety net for consumer deposits and props up financial institutions in a crisis, then there must be effective high quality regulation that will protect the interests of taxpayers.The Case for a Consolidated Microprudential Regulator for the Financial Sector A single prudential regulator would become a powerful institution with stature in the policy community that could hire talented staff and attract strong and able leadership. It would be formed by drawing together the best people from the existing supervisors and regulators in the OCC, the OTS, the SEC, the FDIC, and the Federal Reserve, it would hire financial experts in areas where more expertise was needed, and it would be the primary supervisor of the institutions that make up the financial sector of the United States. The head of the organization would be chosen by the President with the consent of the Senate and would serve for a term of several years. It would be worth considering a structure like that of the Federal Reserve, with a board that served staggered 16 year terms. Thus constituted, the financial regulator would have the standing and capability to stand up to the heads of leading financial institutions and to be an independent arbiter. It would be a partner with and advisor to the Administration, Congress and the Federal Reserve. The financial sector does not stand still. It evolves and innovates and new institutions and products are born. A single prudential regulator with the necessary staff and skills would be best positioned to evolve along with the industry and adapt regulation to a changing world. Having a single prudential regulator would make it much easier to avoid gaps in regulation and discourage the kind of regulatory evasion that contributed to the crisis. It would also reduce the regulatory burden on financial institutions because it would avoid much of the duplication that now exists. A single prudential regulator would supervise and regulate large institutions and small and be able to maintain a level playing field for competition. It would be able to examine all of the activities of the large global banks and make sure they were not accumulating excessive risks through a combination of activities in different parts of their business. There is a great deal to be said for competition in our economy. Ultimately, competition in the private sector drives innovation and growth and provides choices to consumers. It is the lifeblood of our economy. It is not clear, however, that competition among regulators a good thing. The serious danger in regulatory competition is that it allows a race to the bottom as financial institutions seek out the most lenient regulator that will let them do the risky things they want to try, betting with other people's money. One possible advantage of regulatory competition is that it could make it easier for companies to innovate whereas a single regulator might become excessively conservative and discourage new products even if these would bring substantial benefits. However, given the experience of the recent crisis, the dangers created by multiple regulators, including a race to the bottom, are greater and outweigh the possible advantages of competition among regulators. An effective single prudential regulator acting as a cop on the beat could actually increase the level of effective competition among private companies in the financial sector, thus making the private market work better. In addition, it would be very important that the mandate of the single prudential regulator include the promotion of innovation and economic growth. The U.S. financial sector has been one of the strongest in the world and has been one of our major exporters. Prior to the crisis there was great concern that the New York financial markets were losing their global competitive position--See, for example the Bloomberg-Schumer report. The goal of sustaining a dynamic and competitive sector remains vital. Another advantage of creating a single Federal prudential regulator is that it would enhance the independence of the Federal Reserve in making monetary policy. It gets the Fed out of the regulatory business and lets it concentrate on its main tasks.The Role of the FDIC With a single microprudential regulator, the FDIC would lose the supervisory and regulatory authority it has now. Staff from the FDIC that have performed well in this crisis would move to the new prudential regulator, so there would not be a loss of knowledge or expertise. The role of the FDIC as manager and supervisor of the deposit insurance fund would continue. In this position, it would also be able to sound warnings about depository institutions in difficulties, acting as a backup for the new unified prudential regulator. Another possibility is that the FDIC would become the principle agency dealing with the resolution of failing institutions. \3\--------------------------------------------------------------------------- \3\ I have testified to this Committee before on the dangers of ``too big to fail'' or ``too interconnected to fail.'' An important aspect of regulatory reform is to make sure badly run financial companies are allowed to fail in a way that does not imperil the whole system, either through a resolution mechanism or through a special bankruptcy court. The FDIC would play an important role with either system.---------------------------------------------------------------------------The SEC as the Conduct of Business Regulator Under the single prudential regulator described above, the SEC would lose its authority to supervise nonbank financial institutions, which would reside instead with the prudential regulator. The SEC would continue to have a very important role as a protector of the interests of shareholders, a bulwark against insider trading, market manipulation, misselling and other practices that can undermine our capital markets. There is a case for giving the SEC additional authority to provide consumers protection against financial products that are deceptive or fraudulent. The Treasury White Paper proposed establishing a new standalone agency, the CFPA, to provide consumer protection and it is understandable that such a proposal is made given what has happened. There were a lot of bad lending practices that contributed to the financial crisis. As noted earlier, many brokers and banks originated mortgages that had little chance of being repaid and that pushed families onto the street, having lost their savings. There was also misbehavior by borrowers, some of whom did not accurately report their income or debts or manipulated their credit scores. I agree with the Administration and many in Congress--notably Chairman Dodd--on the importance of protecting families against a repetition of the bad behavior that proliferated in recent years. My first choice would be to place the responsibility for consumer protection in a new division within the SEC rather than creating a separate agency. The proliferation of regulators was a contributory factor in the crisis, so that adding a new agency is something that should be done reluctantly. While the SEC did badly in the crisis, there has been an important change in leadership and the new head of the agency is clearly someone of strength and talent who has pledged reform in the operations of the agency. Congress should ask the SEC to form a new CFPA division within its ranks charged specifically with consumer protection. \4\--------------------------------------------------------------------------- \4\ The Federal Reserve did not do a good job in protecting consumers in the period leading up to this crisis, nor did it stop the erosion of mortgage lending standards that contributed to build up of toxic assets in the financial system. Since the crisis, however, the consumer protection division within the FED has been strengthened and is now an effective force with strong leadership. The personnel from the consumer protection division of the FED, together with the best personnel in this function in other agencies, could be moved into the new CFPA division.--------------------------------------------------------------------------- Placing the tasks of the CFPA into the SEC would create a single strong conduct of business regulator with divisions specifically tasked to protect both consumers and small and minority shareholders. It would also make it easier to gain acceptance for greater consumer protection from the financial industry. The CFPA has become a lightning rod for opposition to regulatory reform. Given that the financial sector is largely responsible for the crisis, it is surprising that this sector is now lobbying so hard against greater consumer protection. Greater protection for consumers is needed and that would also provide greater protection for taxpayers. However, having the CFPA functions as a division within the SEC would accomplish that goal while calming industry fears. Having the CFPA functions within the SEC is my first choice, but if Congress decides against this approach, I could support a standalone agency. The Treasury White Paper does a good deal to allay the fears that the new agency would stifle innovation, including: the overall focus on unfair, deceptive, and dangerous practices, rather than risk, per se; the instruction to weigh economic costs and benefits; the instruction to place a significant value on access to financial products by traditionally underserved consumers; the prohibition against establishing usury limits and; the option to consider previous practice in regard to financial products. The Treasury recognizes the dangers of having an agency that would overreach and its proposed structure would avoid that possibility. \5\--------------------------------------------------------------------------- \5\ See, additional discussion of these issues by Douglas Elliott of Brookings and also by the current author posted on the Brookings Web site. The financial reform project of the Pew Charitable trusts has also posted material on the topic.--------------------------------------------------------------------------- One final issue with the CFPA is preemption. The Treasury proposal indicates that State regulators would have the power to enact consumer protection legislation that was stronger than that in the Federal statute. I understand the case for States' rights in this arena, but the prospect of a myriad of different State rules is daunting and has the potential to reduce the efficiency of the massive U.S. marketplace. There has been enormous progress towards a single market in financial products, leveling the playing field for businesses and consumers, so that the terms of loans or other financial activities are the same in all States. Whether or not Federal consumer protection rules preempt State rules is not a major issue for safety and soundness, but having single set of consumer rule uniform in all States would improve economic efficiency. As a result, I support the view that Federal rules should preempt State rules in this area.Regulating State Chartered Financial Institutions Starting with a clean sheet of paper, I would prefer to see all banks and relevant nonbank financial institutions have Federal charters and be supervised by the unified prudential regulator. However, that is not the situation we are in and I recognize the importance of States' rights and the desire to have local institutions that can help local businesses by using the power of personal knowledge and relationships. It is a fact of life that there will continue to be State chartered banks subject to State supervision. In the short run, it is unlikely that we will see again State chartered nondepository institutions that are originating and selling bad mortgages. The markets have been burned and will remember for a while that such institutions may not be selling quality products. Over the years, however, memories will fade and regulatory reform enacted today should avoid problems in the future as far as possible. I urge Congress to require State regulators to partner with the Federal prudential regulator in order to harmonize safety and soundness standards and to exchange information for State chartered banks and nonbanks. The Federal prudential regulator should set out minimum standards that it would like to see in State run financial institutions. And State regulators should be required to exchange data with the Federal regulator and work in cooperation with them. This is already how things work for most banks and it is important that we do not see in the future a situation where State charters are exploited by nonbank financial institutions to undercut the safety of the financial system.The Federal Reserve as Systemic Risk Monitor or Regulator The Treasury White Paper has proposed that there be a council, an extension of the President's Working Group on financial stability to coordinate information and assess systemic risk. The Working Group has played a valuable role in the past and I support its extension to include the leaders of all institutions with power to regulate the financial sector. As others have said, however, committee meetings do not solve crises. The proposal outlined earlier in this testimony is for a single microprudential regulator, which would deprive the Fed of all its microprudential functions. However, I propose that monitoring and managing systemic stability and responding to increased exposure to systemic risks formally be added to the Fed's responsibilities. The strong performance of the Fed in managing this crisis strongly suggests that this institution should be the primary systemic risk monitor/regulator. Moreover, this role is a natural extension of monetary policy, which can be thought of as the monitoring of, and response to, macroeconomic developments. It fits with the dominant culture of economists and the Fed's strong tradition of independence, which are both needed for systemic risk management to be effective. It would slightly cut into the role you have proposed for the Financial Services Oversight Council, but not much. For monitoring the economy and for making monetary policy the Fed needs, among other things, quick access to a broad base of financial information. Currently, the regulatory reporting is primitive. More complete, relevant and real time data should be available to all Federal financial regulators. A coordinated information strategy for the Federal financial regulatory agencies ought to be one of the first tasks of the FSOC. The Fed as systemic regulator would need to work closely with the prudential regulator so that it knows what is going on inside the big institutions, and the small ones. It would also need to work closely with the Treasury and the FSOC, exchanging information with all members that could help it see dangerous trends as they emerge. To respond to specific systemic risks, the Fed needs another instrument in addition to its control over short term interest rates and I suggest that Congress should grant the Fed the power to adjust minimum capital, leverage, collateral and margin requirements generally in response to changing systemic risks, in addition to the specific power it has had to adjust margin requirements in stock trading since the Great Depression. The microprudential regulator would set basic minimum standards. The Fed would adjust a ``multiplier'' up or down as systemic circumstances required. This additional power should be used rarely and in small increments; recall how the Volcker-Carter credit restrictions stopped the U.S. economy on a dime in 1980. No one can guarantee that a systemic regulator will be able to foresee the next bubble or crisis, but it is definitely worth the effort to spot trouble forming. In particular, the Fed may be able to spot a concentration of purchases of risky assets made with borrowed funds. A systemic regulator could have seen that many banks had lent large sums to LTCM to speculate in Russian bonds or other risky assets. It should have been able to spot the build up of risky CDOs in SIVs that were affiliated with the banks. It could potentially see if large hedge funds or private equity companies were using borrowed funds and concentrating on a particularly risk class of assets. Analysts who were studying the real estate market prior saw signs of trouble well before the crisis started.Conclusions A single strong agency would meet the objective of microprudential regulation of all financial institutions that were subject to regulation and supervision. It would work with State regulators, especially to make sure the abuses that contributed to the crisis could not be repeated. It would work closely with the conduct of business regulator(s) (the SEC and the CFPA) and the Federal Reserve to ensure that consumer protection is adequate, that monetary policymakers are well informed and that all these institutions and the Treasury would work together effectively to deal with a new crisis should it occur in the future. The Federal Reserve has shown its mettle in managing the crisis and should be given the role of principle systemic regulator or monitor. It would work closely with the members of the risk council in performing this task. It should have the power to adjust borrowing rules prudently if it sees a bubble developing driven by excessive leverage. The SEC is the natural institution to become the conduct of business regulator with a mandate to protect small and minority shareholders and, with a CFPA division, also to protect consumers in financial markets. A single prudential regulator plus a single conduct of business regulator would constitute the so-called ``twin peaks'' approach to regulation that many experts around the world see as the best regulatory structure. However, a well-designed standalone CFPA could also be an effective protector of consumers and taxpayers.Appendix: Lessons From the U.K. and Australia Opponents of regulatory consolidation in the United States frequently cite the experience of the United Kingdom, which has a consolidated regulator, the Financial Services Authority (FSA) but did not escape the crisis, indeed it has suffered perhaps even worse than the United States. Given London's status as a global financial center it was to be expected that the U.K. would face problems in the global crisis, but it is surprising that the extensive regulatory reforms undertaken in the late 1990s did not better insulate the country from the effects of the financial crisis. In 1997 the U.K. overhauled its financial regulatory system, combining a myriad of independent regulatory authorities (including the regulatory functions of the Bank of England, the Securities Investment Board, and the Securities Futures Board, among nine total) into a single entity. Then Chancellor of the Exchequer Gordon Brown argued that the distinctions between banks, securities firms and insurance companies had broken down, and that in this new era of more fluid and interchangeable institutional definitions, the old regulatory divisions no longer made sense. The FSA's statutory objectives are to maintain market confidence, to promote public awareness on financial matters, to protect consumers, and to reduce financial crime. To achieve those ends, the FSA employs broad investigatory, enforcement, and prosecutorial powers. Although the external structure of regulation in the U.K. may appear simple enough, there is a great deal of internal complexity. There are two main branches within the FSA; one branch which deals with retail markets and another branch, which focuses on wholesale and institutional markets. Within each branch, there are further divisions based on specific financial activities and institutional design, including insurance, banking and mortgages, asset management, and credit unions. There also exist some internal groups which look at specific financial activities in each of the retail and wholesale sectors. Therefore, in practice the FSA did not create an effective single prudential regulator. Instead it preserved some of its older agency divisions, albeit under a single umbrella. Critics of the FSA have pointed to the haste with which the FSA was formed and the failure of the new integrated regulator to fully overcome the old institutional divisions of its former approach to regulation. The FSA has admitted on its own to significant failings over Northern Rock. An internal FSA report cited inadequate resources devoted to overseeing the institution, including high personnel turnover and limited direct contact with the institution (no one had visited the bank for 3 years), and a failure to push management at the bank to modify an eventually disastrous business model. \6\ The U.K. Government was determined to develop London as the key financial center in Europe and that London could compete effectively with New York. As part of this strategy, they instituted ``light touch'' regulation, in which financial institutions were given the goals or principles that they should follow but were given considerable leeway to determine how the goals should be met. While there is some merit in this approach, it created significant danger and it meant in practice that U.K. financial institutions took on excessive risks. Some U.K. banks developed a reputation around the world for lending money to companies that local banks would not touch and the regulators were not stopping them from taking these bad risks.--------------------------------------------------------------------------- \6\ Hughes, 2008.--------------------------------------------------------------------------- Another problem is that there was totally inadequate communication between the FSA and the Bank of England. The Bank of England was intent on maintaining its independence and focused on its mission of fighting inflation. When the crisis struck, the Bank was unwilling to step in quickly to support troubled institutions and markets because it had not been kept up to date about the condition of the banks and had not been tasked with the job of maintaining system stability. In summary, the U.K. experience does not provide an appropriate counter example for the regulatory model proposed in this testimony. They did not create an effective, strong single prudential regulator. They did not make the Bank of England responsible for systemic stability, nor did they ensure that the Bank of England was informed about the condition of the U.K. banks. Australia does not have a major financial center serving the global market and so it cannot provide an ideal example for the United States to copy. Nevertheless, the Australian regulatory reforms seem to have been well designed and well-executed and there are some lessons to be learned. Australia determined that the ``twin peaks'' model was the right one and they created the Australian Prudential Regulatory Authority (APRA), which is responsible for prudential regulation while the Australian Securities and Investment Commission (ASIC) oversees conduct-of-business regulation. A cross-agency commission seeks to resolve conflicts of overlap and facilitate communication between the two agencies. The Australian economy weathered the financial crisis better than many other developed countries, and its experience owes much of its better-than-average performance during the financial crisis to sound policy choices and the effectiveness of its financial regulation. There was not a housing bubble and there was not the same erosion in lending standards as had occurred in the U.S. This was in part due to stricter regulation of mortgage lending. Australia's prudential regulator had raised capital requirements for banks investing in riskier mortgage products. \7\ Consumer protection laws and foreclosure laws also discouraged borrowers from taking out mortgages that they could not afford.--------------------------------------------------------------------------- \7\ Ellis, 2009.--------------------------------------------------------------------------- Until 1998 Australian financial regulation resided with the country's Central Bank and took an institutional approach. Following a review of the country's overall financial system, the twin peaks approach was put into place. As in the U.K., APRA's regulation is a largely a principles-based approach, relying heavily on dialogue between the regulators and the regulated institutions, but with a considerably heavier touch by the regulators to guard against excessive risk taking. The ASIC oversees securities market and financial services providers. ASIC has the power to impose criminal or civil sanctions against financial firms or individuals. As a corporate regulator, ASIC oversees company directors and officers, capital raising, takeovers, financial reporting, etc. It also provides licensing and monitoring for financial services firms. In addition, ASIC has been tasked to protect consumers against misleading or deceptive conduct related to financial products and services. The Australian approach is cited as a model for other countries, for example in the Paulson Treasury's blueprint, in part because it allows flexibility and innovation, while maintaining protections. The regulatory structure is not the only reason for the fact that their economy avoided the worst of the financial crisis, but it seems to have helped. One aspect of the Australian regulatory approach that could serve as a model is the process by which it arrived at reform. Where the road to reform in the U.K. was hasty and lacked adequate consideration, the Australian reform process began with the Wallis Inquiry in 1996 to review how financial system reform could be structured in Australia. The inquiry looked specifically at how prior attempts at deregulation had affected the Australian financial system, what forces were at work changing the system further, and what would provide the most efficient, effective and competitive regulatory structure for the country going forward. In summary, Australia provides a good positive example where a single prudential regulator has worked well. ______ FinancialCrisisInquiry--401 MAYO: I think about your question a lot. And, you know, accountants try to recreate reality in numbers, and we, January 13, 2010 as financial analysts, take those numbers and try to recreate reality. So if the numbers that accountants give us aren’t good, then the conclusions of the analysts won’t be good either. So, definitely, more disclosure is good and would be helpful. I’d say innovation always outpaces regulation, but in this case, it was just much further ahead. And, you know, you certainly need more capital for newer activities or more risky activities or other activities without a long enough track record. And you saw that. And, as Mr. Solomon said, we’ve had a lot of once-in-a-lifetime events. And you—you know, whether it’s Enron and WorldCom or Russia and Asia and Mexico or, you know, the tech bubble and then the real estate bubble. It seems as though these once-in-a- lifetime events happen every couple of years. So the idea of more capital overall makes a lot of sense for these once-in-a-lifetime events for these new activities. And as far as additional disclosure, no question. It would have been very helpful during the crisis and would still be helpful now especially with regard to problem loans at U.S. banks. I would make one point, though. We can’t be too pro-cyclical. If you try to correct all at once, then you’re going to kill the economy. So you have to do this in a balanced way. 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-111hhrg55811--243 Mr. Foster," Okay. My second question is whether anyone has written down a draft, even a draft definition, of what is too complex to clear, or maybe a list of things: These are clearly too complex to clear, these are clearly clearable, and these are the gray area. Is there anyone who has just had the courage to write down an operational definition? " 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. FinancialServicesCommittee--8 I also want to note that one of the issues we need to be address- ing—and I will be talking about this later—is there are some inno- cent victims here. There are individuals who had invested in Amer- ican stocks, as they have been urged to do, who suffered losses through no fault of their own, and I think we should continue to look at what could be done by way of compensation. Finally, it is clear that we have the interaction here of some technical issues plus the crisis in Europe. I welcome—and here, again, there was a difference amongst some of us; the House Re- publican Conference had written to Vice President Biden telling him to stay out of any efforts by the IMF to try to deal with the crisis in Europe. I am glad that advice was disregarded. I think the action in which the American officials participated was very helpful in averting further damage, and we will obviously be looking into that further. Chairman K ANJORSKI . Thank you, Chairman Frank. The gentleman from Alabama, Mr. Bachus, is recognized for 4 minutes. Mr. B ACHUS . Thank you, Mr. Chairman. The American financial markets are the most modern in the world. They execute trades more efficiently and economically than ever before. They are the envy of the world, the fastest and most liquid in the world. However, some of the innovations, high-frequency computer-driv- en trading across multiple platforms and forums, does create the possibility of the events that we witnessed last week. All innovations bring problems but also progress. Our challenge is to find a solution that addresses the problems, but does not de- stroy the benefits. In my opinion since, really, January, the SEC has done this. They have acted in a measured way, and I think the meeting yesterday was most appropriate. As the full Financial Services Committee ranking member, I did say that we probably should wait until at least the trades were completed to meet and let you have an opportunity to respond, and I think you have done so appropriately. But we are here, and whether they we are here today or 2 days from now is, I think, probably irrelevant. Rational concern, rising risk, and a technically over-bought mar- ket that had raced ahead 70 percent in the past year resulted in a skittish market, increased volatility, and an environment subject or vulnerable to panic. Any number of events could have contributed to the market plunge last Thursday. We have all read the laundry list of what could have happened, what may have happened, or it could have been a combination of things. But I think what is safe to assume is without some preventive measures, they can happen again, be- cause any number of things, as were mentioned, could precipitate such an event. In fact, prior to last Thursday, on April 27th, you had a smaller event occur, not of the velocity or steepness or quickness, but you have had similar events happen in individual stocks, but none as widespread as last Thursday. However, I think because of the dra- matic and suddenness of last week’s event, there is something con- structive in that, and although it undermined investor confidence, I think it clearly pointed out the need for action. CHRG-111hhrg53241--9 Mr. Hensarling," Thank you, Mr. Chairman. Over the course of these last couple of hearings and listening to some of the opening statements, it is clear that we are witnessing a clash of principles, and there is much at stake. I think the question is, in a free society, how does the State best protect consumers rights? Clearly, the right and the left do not agree. As I listen to my friends on the other side of the aisle, I am almost left with the impression that many of them believe that every consumer is a hapless fool incapable of discerning what is best for she and her family, that creditors are a powerful, monolithic evil in our society that only exist to victimize consumers. The left seems to believe that if only we will empower some type of ruling enlightened elite, that only then can consumers hope for fairness and justice. But in order to receive all of this, somehow consumers are expected to yield their rights to the State in order to be protected. Most of us on this side of the aisle believe something else. We believe that the best form of consumer protection comes from competitive markets, competitive markets that are vigorously policed for force and fraud. It is not business we believe in. It is competitive markets we believe in. And we believe in empowering consumers with effective and factual disclosure. And we believe fundamentally in the freedom to choose, the fundamental economic liberty of every American citizen to decide for himself what consumer financial products are best for he and his family. And that is the difference. I simply cannot understand how you protect a consumer by assaulting consumer rights. I simply don't get it. I don't understand how passing legislation that ultimately will result in less competition empowers the consumer. I don't understand how passing legislation that will stifle innovation, perhaps the next ATM machine, the next frequent flyer mile offering on a credit card--how by stifling innovation are you somehow protecting the consumer? I don't get it. And if we look at the turmoil, the economic turmoil that we find ourselves in today, it is the result of one and only one product, and that is subprime mortgages, more specifically, a subprime ARM. You know, Congress has acted. And, besides that, some of the people who took out these loans took out loans that they knew any couldn't repay in the first place. And so I hope that we are not taking advantage of the situation. It is more important that we get it done right than that we get it done quickly. I yield back the balance of my time. " CHRG-111hhrg54867--266 Mr. Paulsen," Thank you, Mr. Chairman. Thank you, Mr. Secretary. An area of fertile discussion has been the area of risk management. And most firms understand the risks that they run, but they don't often have the strength or the will or the foresight to say no. The competitive dynamic among firms creates the situation. And this is where a regulator with an eye towards aggregate risk in the system would be most beneficial, I think we could agree. How do you intend to have the regulator calibrate that aggregate risk so that the benefits of competition that accrue to society will be able to go forward, as opposed to creating another disaster or go too much in the opposite direction where it is going to really burden innovation? " 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. ------ fcic_final_report_full--218 In the intervening years, from  to , the banking agencies and SEC issued two draft statements for public comment. The  draft, issued the year after the OCC, Fed, and SEC had brought enforcement actions against Citigroup and JP Mor- gan for helping Enron to manipulate its financial statements, focused on the policies and procedures that financial institutions should have for managing the structured fi- nance business.  The aim was to avoid another Enron—and for that reason, the statement encouraged financial institutions to look out for customers that, like En- ron, were trying to use structured transactions to circumvent regulatory or financial reporting requirements, evade tax liabilities, or engage in other illegal or improper behavior. Industry groups criticized the draft guidance as too broad, prescriptive, and bur- densome. Several said it would cover many structured finance products that did not pose significant legal or reputational risks. Another said that it “would disrupt the market for legitimate structured finance products and place U.S. financial institutions at a competitive disadvantage in the market for [complex structured finance transac- tions] in the United States and abroad.”  Two years later, in May , the agencies issued an abbreviated draft that re- flected a more “principles-based” approach, and again requested comments. Most of the requirements were very similar to those that the OCC and Fed had imposed on Citigroup and JP Morgan in the  enforcement actions.  When the regulators issued the final guidance in January , the industry was more supportive. One reason was that mortgage-backed securities and CDOs were specifically excluded: “Most structured finance transactions, such as standard public mortgage-backed securities and hedging-type transactions involving ‘plain vanilla’ derivatives or collateralized debt obligations, are familiar to participants in the finan- cial markets, have well-established track records, and typically would not be consid- ered [complex structured finance transactions] for purposes of the Final Statement.”  Those exclusions had been added after the regulators received com- ments on the  draft. Regulators did take note of the potential risks of CDOs and credit default swaps. In , the Basel Committee on Banking Supervision’s Joint Forum, which includes banking, securities, and insurance regulators from around the world, issued a com- prehensive report on these products. The report focused on whether banks and other firms involved in the CDO and credit default swap business understood the credit risk they were taking. It advised them to make sure that they understood the nature of the rating agencies’ models, especially for CDOs. And it further advised them to make sure that counterparties from whom they bought credit protection—such as AIG and the financial guarantors—would be good for that protection if it was needed.  CHRG-111shrg56376--187 Mr. Ludwig," First, I would say, Senator, that I do think that it makes sense to enact protections so that community banks--one, it is a comfort that they are protected in terms of having a simplified, specialized regulatory approach that best suits their needs. Having said that, my own experience at the OCC, where there are--in my day, I think over 2,000 community banks. It may be actually true today. I used the word a thousand--is that you do have the quality people at the agency devoting their attention to the community banking sector. Indeed, one of the advantages of having a consolidated regulator is, as people come up, you have similar talent available for both sides of the aisle, and you find--today, for example, the gentleman in charge of small bank supervision at the OCC was a large bank supervisor during his time, and he is one of the most talented people there. I think you will find that interplay. The danger, I think, works the other way, that if you separate the two, you will only have second-class supervisors at the smaller institutions as opposed to having the cross-fertilization you do with the larger institutions. The other thing I think worth pointing out is just because you are smaller or larger does not necessarily mean you are more complex or less complex. Some of the smaller institutions by choice get involved in fairly complex issues, and there is going to be a tendency as we go into the future, because of the Internet, because of technology, because of the structured products available, that smaller institutions will indeed get involved with these more complex activities, and the supervisor not only needs to supervise that adequately, A, but it also needs to have the sophistication to help the small bank with these products. I think it is perfect doable, and I think you will just have a higher-quality supervision generally. One cannot also overstate in this whole discussion the pernicious nature of regulatory arbitrage. I know that is not your question. But both having---- Senator Warner. That was my next question. " CHRG-110hhrg44900--18 Secretary Paulson," When we released the Blueprint, I said that we were laying out a long-term vision that would not be implemented soon. Since then, the Bear Stearns episode and market turmoil more generally have placed in stark relief the outdated nature of our regulatory system and has convinced me that we must move much more quickly to update our regulatory structure and improve both market oversight and market discipline. Over the last several weeks, I have recommended important steps that the United States should take in the near term, all of which move us toward the optimal regulatory structure outlined in the Blueprint. I will summarize these briefly. First, Americans have come to expect the Federal Reserve to step in to avert events that pose unacceptable systemic risk. But the Fed does not have the clear statutory authority, nor the mandate to do this. Therefore, we should consider how to most appropriately give the Federal Reserve the authority to access necessary information from complex financial institutions, whether it is a commercial bank, an investment bank, a hedge fund, or another type of financial institution, and the tools to intervene to mitigate systemic risk in advance of a crisis. The MOU recently finalized between the SEC and the Federal Reserve is consistent with this long-term vision of the Blueprint, and should help inform future decisions, as our Congress considers how to modernize and improve our regulatory structure. Market discipline is also critical to the health of our financial system, and must be reinforced, because regulation alone cannot eliminate all future bouts of market instability. For market discipline to be effective, market participants must not expect that lending from the Fed or any other government support is readily available. I know from firsthand experience that normal or even presumed access to a government backstop has the potential to change behavior within financial institutions with their creditors. It compromises market discipline and lowers risk premiums, ultimately putting the system at greater risk. For market discipline to effectively constrain risk, financial institutions must be allowed to fail. Today, two concerns underpin expectations of regulatory intervention to prevent a failure. They are that an institution may be too interconnected to fail or too big to fail. Steps are being taken to improve market infrastructure, especially where our financial firms are highly intertwined. The OTC Derivatives market and the triparty repurchase agreement market, which is the marketplace through which our financial institutions obtain large amounts of secured financing, must be improved. It is clear that some institutions, if they fail, can have a systemic impact. Looking beyond immediate market challenges, last week I laid out my proposals for creating a resolution process that ensures the financial system can withstand the failure of a large, complex financial firm. To do this, we will need to give our regulators additional emergency authority to limit temporary disruptions. These authorities should be flexible, and to reinforce market discipline, the trigger for invoking such authority should be very high, such as a bankruptcy filing. Any potential commitment of government support should be an extraordinary event that requires the engagement of the Treasury Department and contains sufficient criteria to prevent cost to the taxpayer to the greatest extent possible. This work will not be done easily. It must begin now and begin in earnest. Again, thank you for your leadership. [The prepared statement of Secretary Paulson can be found on page 67 of the appendix.]STATEMENT OF THE HONORABLE BEN S. BERNANKE, CHAIRMAN, BOARD OF 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-111shrg55278--123 RESPONSES TO WRITTEN QUESTIONS OF SENATOR CRAPO FROM MARY L. SCHAPIROQ.1. Thank you for responding back to my letter that was signed by Senators Bunning, Martinez, Vitter, and Enzi about the need to make sure that any decision on short selling will be made based on empirical data. Has the SEC Office of Economic Analysis undertaken any independent analysis to determine if there would be a net benefit from imposing an additional short-selling restriction so that any final decision will be able to withstand scrutiny and cost-benefit analysis?A.1. The Commission's Office of Economic Analysis (OEA), now part of the newly created Division of Risk, Strategy, and Financial Innovation, has performed independent analysis of the uptick rule and various other types of short sale restrictions. For example, OEA analysis includes (1) a major empirical study based on a pilot rule change prior to the elimination of Rule 10a-1 in 2007; (2) subsequent analyses to determine how various forms of uptick rules would have operated during the financial crisis; and (3) numerous studies of how Regulation SHO and its subsequent amendments have impacted delivery failures. OEA also has reviewed and analyzed many other publicly available empirical studies of short sale restrictions, including studies conducted both before and after the recent financial crisis. Collectively, these studies provide a wealth of empirical evidence relevant to understanding the costs and benefits of short sale regulation. In addition, the public has had many opportunities to present additional commentary, analysis, and empirical evidence bearing on short sale restrictions as a part of the rule-making process. OEA has assisted the Commission in reviewing studies and evidence raised through the public comment process. ------ CHRG-111shrg50564--43 Chairman Dodd," Thank you very much. Senator Warner. Senator Warner. Thank you, Mr. Chairman. Dr. Volcker, I have got three questions, and I think they follow up on both the Chairman's and Senator Shelby's approach. It seems from the report a clear understanding that there needs to be some level of regulation of some of these institutions that fell between the cracks. Yet it seems that even though major money center banks that clearly were regulated followed the market to start putting out these same kind of complex new instruments, your term of ``over the top financial engineering.'' I guess on a going-forward basis, as we move forward to some new structure, even with regulation and transparency, is that going to be enough or should there be some point of an evaluation, almost a societal value evaluation, of some of these instruments, whether the extra ability to price that risk down to the last decimal point is worth all of the side risks that we have seen taking place by some of these instruments? " 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-111hhrg56778--2 Chairman Kanjorski," Good morning. The subcommittee will come to order. Without objection, all members' opening statements will be made a part of the record. First, we will have our opening statements, beginning with mine, and then we will hear from our distinguished panel. We meet today to further examine the issue of insurance supervision, especially as it relates to holding companies. The time is right for us to delve into this complicated and important subject. The Federal Government's intervention in American International Group has raised many questions about the existing oversight of holding companies with insurance operations. While AIG's insurance companies may not have directly caused the conglomerate's downfall, the actions of the holding company and other subsidiaries within AIG certainly could have led to serious consequences for insurance policyholders if the government had not stepped in. During our recent debates in the House on the Wall Street Reform bill, we also tackled many questions about holding company oversight. While we already know much about the supervision of financial, bank and thrift holding companies, we now need to take the time to learn more about the regulation of insurance holding companies. I believe that today's hearing will help us to identify ways that we can further improve the financial services regulatory reform bill before it becomes law. The vast majority of holding companies--some of which are shells and some of which are complex--are currently regulated at the State level. Additionally, the Federal Reserve System and the Office of Thrift Supervision together oversee no less than 100 entities with insurance operations. Our witnesses will help us to better understand the current lay of the land when it comes to consolidated supervision of insurance holding companies and bank or thrift holding companies with insurance operations. The two State commissioners with us today will specifically explain their dual roles as insurance regulators and insurance holding company supervisors. Because the failure of an insurer could affect the health of the insurance holding company, and because problems within the holding company or its subsidiaries could affect the insurers within a firm's tangled network, we need to ensure that State supervisors have strong powers to protect policyholders and ensure the solvency of any of the entities that they regulate. In those instances where a State regulator must oversee an insurer or insurance holding company with operations outside of the State, we must also ensure that we have meaningful cooperation and communication between State regulators. Moreover, to protect our economy from systemic risk, we must ensure that there is appropriate consolidated supervision of complex insurance firms. When depository institutions and insurers operate under the umbrella of the same holding company, both State and Federal regulators have important supervisory roles. In such instances, State commissioners maintain their role as functional regulators of any insurers within these complex entities. Federal regulators have the responsibility for oversight of any depository institutions and the holding company. The Federal regulatory representatives with us today will help us to better appreciate the formal rules of the road as laid out in statute and regulations about where a Federal regulator's authority begins and a State regulator's power ends in these corporate amalgamations. Their testimony may also help us to discern whether or not we have regulatory overlaps or gaps, and what steps regulators have taken to address such situations. Each of our witnesses will undoubtedly emphasize the differences between insurers and depository institutions. These distinctions are important, but they fail to address the purpose of today's hearing. The recent financial crisis has taught us that any complex financial company must have an effective umbrella supervisor who looks comprehensively at the activities and health of the whole enterprise. This includes any holding company with insurance activities. We must further explore whether the Federal banking regulators are overseeing too few or too many holding companies with insurance operations, and whether they are appropriately focused on consolidated oversight issues. We should also ask whether consolidated supervision is diversified among too many regulators, such that it has become ineffective or an afterthought. In sum, these are difficult policy issues, and the answers we receive will undoubtedly lead to new questions. Fortunately, we have already identified a way to examine these matters after we finish this hearing. One important provision of the House-passed Wall Street Reform bill, the Administration's plan, and Senator Dodd's proposals is the creation of a Federal office to review insurance matters on a national scope. The Federal Insurance Office, for which I have advocated for a number of years, should look at these very questions to advise Congress on these important policy matters in the future. Now, the gentleman from New Jersey is recognized for 5 minutes. " CHRG-111hhrg52407--39 Mr. Diaz," Well, like I said, the devil is always in the details. But what we would be focused on is access to credit, did that change. We at NCLR believe low-income families have to have access to credit. We don't believe that families should be taken advantage of, so just because they can sell a family a product doesn't mean it is right for that family. So what I would tell you is that the key for us is, whatever that new commission sets up to do, we would be focused on: What is the civil rights implication, one? And, two, is it still going to allow product innovation even within the rules that it establishes? " 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) " CHRG-111hhrg55811--9 Mrs. Biggert," Thank you, Mr. Chairman. I think that the new draft has some troubling things in it. In its current form, I am afraid there is still a one-size-fits-all approach to regulating derivatives and a ``Big Brother'' regulatory model that may stifle innovation, unnecessarily tie up capital, and see owners standards on businesses, exchanges, and clearinghouses. The bill doesn't seem like the right answer to reforming the OTC marketplace at a time when our feeble economy is trying to regain steam and at a time when we need businesses to use capital to invest in their businesses to grow and create jobs for Americans. We all know that there were abuses in the OTC markets. They must be addressed. But to my knowledge, when the entire financial system was on the verge of collapse last fall, the futures markets pulled through. This bill doesn't seem to, in a targeted approach, address those abuses, but rather considers all parties, anti-users as well as end-users as well as exchanges risky and treat them as such. Non-risky market participants may now unnecessarily have increased capital requirements, mandatory central clearing margin requirements, and product approval by bureaucrats in Washington. This doesn't seem like the right answer to managing risk and addressing abuses in the marketplace. We need robust competition, restored investor confidence, and healthier markets. I yield back. " CHRG-111hhrg51591--2 Chairman Kanjorski," We meet today to continue the review by the Capital Markets Subcommittee of insurance regulation. Our panel has taken the lead in Congress during the last few years in debating insurance matters and finding consensus reforms to modernize our national insurance laws. Unlike other financial sectors that have evolved over time to include some degree of Federal and State regulation, States alone continue to have the primary authority to regulate insurance today. For that reason, Congress has historically only passed insurance legislation to respond to a crisis, address a market failure, or adopt narrowly focused insurance reforms. For example, after September 11th, Congress ultimately passed the Terrorism Risk Insurance Act so that construction could continue after the terrorist attack and businesses could obtain coverage to protect the viability. After a series of hearings debating the insurance reform last Congress, this subcommittee considered and approved four narrow insurance bills. One of those bills, the Insurance Information Act, could help the Federal Government build a knowledge base on insurance matters so that the Federal Government could see the complete picture of the insurance industry rather than intermittently seeing the brush strokes of a particular problem in the industry or at a particular company. We are very fortunate that this committee has a long history of working in a bipartisan fashion. I hope we continue in that vein and find common ground on these matters. Thoughtful, broadly supported legislative forms are usually the most successful. We must, however, also move swiftly yet deliberately in developing a new game plan to involve the Federal Government in more direct oversight of the insurance industry. Today, we are both responding to a crisis of sizeable proportions and seeing the big picture of an interconnected modern financial services system for the first time. After the turmoil in the bond insurance marketplace, the decisions to provide substantial taxpayer support to American International Group and the requests of numerous insurers to get capital investments from the Treasury Department, we can no longer continue to ask the question about whether the Federal Government should oversee insurance. The answer here is clearly yes. The events of the last year have demonstrated that insurance is an important part of our financial markets. The Federal Government therefore should have a role in regulating the industry. As such, we now must ask how the Federal Government should oversee insurance going forward. This question is the topic of today's hearing. The answer to this question is difficult. The bond insurance crisis showed that even small segments of the industry can have a large economic impact. AIG taught us that the business of insurance has become complex and no longer always fits nicely into the State regulatory box. Moreover, some companies operate unlike traditional insurers in today's markets. Instead of insuring assets, these companies insure financial transactions and use substantial leverage. My assessments should not be taken as criticism of the present State regulatory system. By and large, State regulators have performed well despite the growing complexity of the financial services system. That said, I am also not suggesting that we expand the mission of State insurance departments beyond insurance. At the very least, this Congress must address the insurance activities as it creates a new legislative regime to monitor systemic risks and unwind failing nondepository institutions. The Administration's proposal to create a resolution authority properly includes insurance holding companies. Oversight of any financial activity, insurance or otherwise, as it relates to the safety and soundness of our economic system must also be mandatory. Insurance is complex, and it is time for the Federal Government to appreciate its importance. Equally important to me is that Congress not limit itself to simply responding to this latest crisis. Many insurance products are either of national importance or uniform in nature. We must therefore consider whether to regulate these elements of the industry nationally. In sum, we have asked our witnesses to help us to examine these issues. Their fresh perspectives can point us in the right direction as we think about these matters in a new light. Now I would like to recognize Ranking Member Garrett for 5 minutes for his opening statement. " CHRG-111shrg51395--36 Mr. Doe," Chairman Dodd, Senator Shelby, and Committee Members, is a distinct pleasure that I come before you today to share my perspective on the municipal bond market. My firm, Municipal Market Advisors, has served for the past 15 years as the leading independent research and data provider to the industry. In addition, from 2003 to 2005, I served as a public member of the Municipal Securities Rulemaking Board, the self-regulatory organization of the industry established by Congress in 1975. There are nearly 65,000 borrowers in the municipal market that are predominantly States and local governments. Recent figures identify an estimated $2.7 trillion in outstanding municipal debt. This is debt that aids our communities in meeting budgets and financing society's essential needs, whether it is building a hospital, constructing a school, ensuring clean drinking water, or sustaining the safety of America's infrastructure. A distinctive characteristic of the municipal market is that many of those who borrow funds--rural counties and small towns--are only infrequently engaged in the capital markets. As a result, there are many issuers of debt who are inexperienced when entering a transaction and are unable to monitor deals that may involve movement of interest rates of the value of derivative products. According to The Bond Buyer, the industry's trade newspaper, annual municipal bond issuance was $29 billion in 1975; whereas, in 2007, issuance peaked at $430 billion. In the past 10 years, derivatives have proliferated as a standard liability management tool for many local governments. However, because derivatives are not regulated, it is exceptionally difficult, if not impossible, to identify the degree of systemic as well as specific risk to small towns and counties who have engaged in complex swaps and derivative transactions. Municipal issuers themselves sought to reduce borrowing costs in recent years by selling bonds with a floating rate of interest, such as auction rate securities. Because States and local governments do not themselves have revenues that vary greatly with interest rates, these issuers employed interest rate swaps to hedge their risk. Issuers use the instruments to transform their floating risk for a fixed-rate obligation. A key factor in the growth of the leverage and derivative structures was the prolific use of bond insurance. Municipal issuers are rated along a conservative rating scale, resulting in much lower ratings for school districts and States than for private sector financial and insurance companies. So although most States and local governments represent very little default risk to the investor, the penal ratings scale encouraged the use of insurance for both cash and derivatives in order to distribute products to investors and facilitate issuer borrowing. So instead of requiring more accurate ratings, the municipal industry chose to use bond insurance to enhance the issuer's lower credit rating to that of the higher insurance company's rating. The last 18 months have exposed the risks of this choice when insurance company downgrades, and auction rate security failures, forced numerous leveraged investors to unwind massive amounts of debt into an illiquid secondary market. The consequence was that issuers of new debt were forced to pay extremely high interest rates and investors were confused by volatile evaluations of their investments. The 34-year era of the municipal industry's self-regulation must come to an end. Today, the market would be in a much better place if: First, the regulator were independent of the financial institutions that create the products and facilitate issuers' borrowing. Municipal departments represent a relatively small contribution to a firm's revenue, and this inhibits MSRB board members from seeking regulatory innovation. Second, if the regulator were integrated into the national regime of regulation. Since the crisis began, we have discovered a limited market knowledge here in D.C., in the Federal Reserve, Treasury, Congress, and the SEC. I might add that when the crisis began to emerge in August 2007, we were immediately contacted by the New York Federal Reserve and the Federal Reserve itself, and are quite impressed in the last 18 months with their vigilance and interest in this sector. So integration, we believe, would speed market recovery by the shared information. Third, the regulator's reach and authority needs to be extended to all financial tools and participants of the municipal transaction. This meant ratings agencies, insurers, evaluators, and investment and legal advisors for both the cash and swaps transactions. This need has become more apparent as we uncover the damaged issuers, and States such as Alabama, Tennessee, and Pennsylvania are suffering relative to interest rate swaps. Fourth, if the regulator were charged with more aggressively monitoring market data with consumers' interests in mind. When I think of consumers, I think of both investors and the issuers. In 2008, there were specific instances of meaningful transactions and price irregularities that should have prompted regulatory investigation to protect consumers. The good news is that this new era of regulatory oversight can be funded by the MSRB's annual revenue in 2008 of $20-plus million, collected from the bond transactions themselves, and can be staffed by the current MSRB policy and administrative infrastructure. I should be clear. The innovations of derivatives and swaps have a useful application and have been beneficial for those for which they are appropriate. However, it is also important that these instruments become transparent and regulated with the same care as the corresponding municipal cash market. It is critical to get this right. There is simply too much at stake. Thank you for having me here today, and I look forward to participating in the questions of the session. " CHRG-111shrg50564--65 Mr. Volcker," First of all, we are going to have--I am not sure this is what you meant in asking the question--it is going to cost more money to deal with this financial crisis. There shouldn't be any mistake in your mind about that, that this has deteriorated to the point where it is going to take Government support in the interest of overall economic stability and recovery, and it is going to be lots more billions of dollars. I don't know how many. But that is necessarily a priority, which I hope and believe the administration will face you with shortly. Now, looking ahead, I think we rather put the priority in what I put in my statement as our first point, that you have got to take these big protected institutions, particularly the large ones, but all the banks are going to be protected to some extent, and you have got to develop apparatus for protecting, but you have also got to limit what they can do, and you want to do that as intelligently as you can, because you want them to compete. You want them to be innovative in providing services. But you don't want them taking a kind of risk that is inconsistent with the fact that at the end of the day, Government support is in the background. Now it is in the foreground. But ordinarily, it is in the background. And I think that is the, I think, the most fundamental thing. But there are so many things that need attention that it is hard for me to rank them in priority. The accounting problem is a real one. And apart from the fact of the desirability of uniformity, and there has been a lot of progress in that area. That is one area I think we are going to get uniformity, and we should get uniformity. But then uniformity is one thing, but uniformity according to what standard? And there, there is a problem with all this mark to market business and fair value accounting. When should that be applied? When should it not be applied? If it is not mark to market, what else do you do? My own feeling is that is something that has to be thought about by the regulators themselves and they ought to have a voice in the accounting for the basics, banking anyway, banking, insurance companies. But intellectually, that is a very tough problem. Senator Reed. Let me ask this related question. We are debating a significant recovery package at the moment. That, I would think, would complement any efforts we make to further aid the financial institutions, because without this recovery package, then the potential hole has got to be much bigger. Is that your view, also? " CHRG-110shrg50369--60 Mr. Bernanke," Well, it is a complex question. We---- Senator Menendez. Can you give me a simple answer? " CHRG-111shrg61513--45 Mr. Bernanke," Well, Senator, I congratulate you on those contributions. As you know, the Federal Reserve developed extensive disclosures for credit cards as well as some rules which were very extensively incorporated in the Congressional bill that passed and was signed by the President. Obviously, as you point out, the more information you can provide consumers, the better decisions they can make and the kinds of information about minimum balances, time to pay off, the cost of the card, the penalties they might face, those are the kinds of things people need to shop. If they can shop, the market becomes more competitive and you get a market that better serves consumers. We have been very focused on good disclosures, good information. We have in our disclosure reform that we did earlier, we--I don't see Senator Schumer here yet today, but there is the so-called Schumer Box, which has---- Senator Bunning. He is at the White House. " Mr. Bernanke,"----has a list of key features of the account. We have done a lot of work on that to make it easier to read and more understandable to consumers. One of the innovations pioneered by the Federal Reserve has been to use consumer testing. We have gone out and instead of having some lawyers just sort of figure out what should be in the disclosure, we have actually gone out to shopping malls and had people look at the disclosures and then we have tested them to see how much they understand and retain. And by doing that, we think we are improving considerably the ability of folks to understand what they are buying and encouraging them to shop around to get a better deal. So again, I congratulate you on your contributions to this and on your longstanding support for financial literacy and for clear disclosures. Senator Akaka. Mr. Chairman, unfortunately, investment banks, credit card issuers, and predatory lenders through their excessive bonuses and unfair treatment of consumers are giving the term ``bank'' an even greater negative connotation. I am afraid that abused or angry consumers may continue to underutilize mainstream financial institutions. After having grown up in an unbanked home, I personally know the challenges that confront the unbanked. Many community banks and credit unions provide vital financial services to working families by providing opportunities for savings, borrowing, and low-cost remittances. The question is, why is it essential that we attempt to encourage the unbanked and the underbanked to utilize mainstream financial institutions more? " CHRG-110hhrg46595--299 Mr. Nardelli," Let me try to go first. It is not our intent to use the $7 billion, if we are fortunate enough to get a favorable decision, to sue those States. I would also say that it adds a level of complexity and cost at a time when we are trying to get simplification. To be able to produce cars unique to a State or unique to a city in some cases would add tremendous complexity in manufacturing and in our technology. " 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-111hhrg55814--517 The Chairman," The gentleman from North Carolina. Mr. Miller of North Carolina. Thank you, Mr. Chairman. Ms. D'Arista, before you raised the question of proprietary trading and the chairman followed up with it, I had asked the previous panel about that. Ms. D'Arista. I heard you, sir. Mr. Miller of North Carolina. In part, because while Chairman Volcker had testified last month that proprietary trading by systemically significant firms should be prohibited, that perhaps customer trading should be allowed, but not proprietary trading. And Ms. Bair seemed to agree, with respect to the depository institutions, but thought it would be okay in an affiliate within a holding company. And then Mr. Dugan, not surprisingly, found a reason not to do it at all, and that was that if you required it to be by a separate entity, the entity would still grow to be so large that it would be systemically significant. It certainly occurred to me that there are still reasons to do it, even if all the different entities end up being really big. One is the market discipline--to use the term that others have used today--that if you're dealing with a company that just does one thing, you focus on that, and do not assume that because they're so big they're going to be good for their debts. Who could imagine Citigroup not being good for their debts? Obviously, it could never ever happen--or Bank of America. It's impossible to manage a company. Obviously, the CEOs, and certainly the boards of directors, had no idea what the different parts of their companies were doing, the ones that got into trouble. And finally, it's impossible to regulate. Again, not surprisingly, we have had other discussions of Freddie and Fannie. Everybody seems to have agreed right along that the regulator for Freddie and Fannie was not up to the task, because Freddie and Fannie was so complex. And they had derivatives in case interest rates went up, they had derivatives in case interest rates went down. And there were only a handful of people on the planet who could figure out what it all meant. And the more lines of business there are that are all complex and opaque, the harder it is to regulate. Do you agree that even if the separate entities end up being really big, and probably systemically important, that proprietary trading should not be done at the same entity that's doing--that is a depository institution that's doing lending? Ms. D'Arista. I would agree, and I would think that you need to limit proprietary trading across the entire financial system, not only within the conglomerate, but with other institutions. Typically, this was the province of investment banks in the past, who have changed muchly, as we know. Mr. Miller of North Carolina. Right. Ms. D'Arista. I think as I began to say--and I will submit some information about my thinking on this--we could go at this in a number of ways: limiting leverage; limiting counterparty exposure; etc. This will reduce the amount of counterparty trading, or proprietary trading, that is going on. But you have to understand that the proprietary trading is what blew up, inflated into a balloon, our financial system. We are not Iceland, but we're getting there, if we don't do something about it. In other words, size is important Because of what it means in terms of gross domestic product, in the size of the financial institution itself, of the financial sector, etc. Where does it get to the point where we don't produce enough in the economy to cover the exposure of our financial sector? Mr. Miller of North Carolina. All right. Mr. Yingling, should depository institutions do proprietary trading? " 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-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-111shrg54533--58 Secretary Geithner," No, Senator. I know you have said that many times, but it is not true and we wouldn't do that. TARP is temporary. It will be temporary. It will, fortunately, go out of existence when the statute expires, and maybe before that. What we are proposing is to take this model that the FDIC has presided over, its existing checks and balances, its existing authorities, designed for a different financial system than we have today, and adapt it to bank holding companies and those complex institutions that present similar risks to banks. So we are doing the essentially pragmatic, conservative thing in taking a model that exists, has a lot of experience, has good checks and balances, and adapting to the financial system we face today. We are not proposing to sustain some indefinite capacity to do what Congress authorized on a temporary basis--appropriately so--under the TARP. And I would share your concerns, any concerns people express with that kind of authority. Senator Corker. So you would work with us to make sure that you didn't have the ability just to conserve into the future and make ad hoc decisions at Treasury regarding entities that were deemed to fail? " CHRG-111shrg56415--49 Mr. Tarullo," So, I would say, Senator, that I think most people at the Federal Reserve would be happy if they were not in the position where people came to us when there was a need for resolving or dealing with a specific financial institution, but I do think one needs to have a mechanism, a mechanism in law by which some part of the government can deal with the large financial institution that may be in distress. And that is why I think all three of us, certainly, have supported moving forward with a resolution mechanism that would cover the large financial institutions. I do think within the context of that, you have to address the question of potential funding streams for short-term liabilities or the sort. So, I think it needs to be addressed somewhere. It doesn't need to be in 13(3). Senator Corker. If I am hearing you properly, if we had a resolution mechanism in place, which we did not have for complex bank holding companies and others, like AIG, which is not one of those--if we had a resolution mechanism that was defined and we had the ability to fund the short term, while you are resolving that, hopefully not in conservatorship but in receivership, where you are putting them out of business, in essence, we could narrow the abilities of the Fed and also not support the Administration's proposal for Treasury to hold unto itself the ability to put taxpayer money into various entities they feel might pose systemic risk. We could do away with that if we had an appropriate resolution mechanism. " CHRG-110hhrg46596--83 Mr. Kashkari," Not yet. We have professionals at Treasury working on it and consulting with outside experts. It is a very complex legal issue. Our program intention is that every bank in America that is healthy gets to participate on equal terms. There are some real legal complexities on how to make equity investments in Subchapter S and mutuals. And if you can make the investments, how do you get it out in the end so that the taxpayers can get their money back in the future? We are looking hard at that. " CHRG-111shrg54533--95 RESPONSES TO WRITTEN QUESTIONS OF SENATOR AKAKA FROM TIMOTHY GEITHNERQ.1. Mandatory Arbitration Clause Limitations--Mr. Secretary, please provide the written response that you mentioned during the hearing on why the Consumer Financial Protection Agency should have the authority to restrict or ban mandatory arbitration clauses.A.1. Treasury's proposed legislation authorizes the CFPA by rule to prohibit or impose conditions or limitations on pre-dispute mandatory arbitration clauses if the Agency finds that such prohibition, conditions, or limitations are in the public interest and for the protection of consumers. Many financial products and services providers require their customers to agree to contracts containing provisions to arbitrate all disputes. Although arbitration may be a reasonable option for many consumers to accept after a dispute arises, mandating a particular venue and up-front method of adjudicating disputes--and eliminating access to courts--may unjustifiably undermine consumer interests. There are several aspects of mandatory pre-dispute arbitration that have raised concern. Many consumers do not know that they often waive their rights to trial when signing contracts for financial products. Arbitrators are private parties dependent on large firms for repeat business, which may give rise to conflicts of interest. Rather than banning pre-dispute mandatory arbitration in the legislation, our proposal gives the Agency the power to study it and, if warranted, impose limitations or ban it to ensure fairness for consumers. In addition, under our proposal, even if mandatory arbitration were banned, parties would still be free to agree to arbitration once a dispute has arisen. Post-dispute arbitration is much more likely to be a fair process because consumers can evaluate the arbitration process in light of the potential or actual dispute before agreeing to such an arbitration process.Q.2. Financial Literacy--Mr. Secretary, what specific financial literacy responsibilities will the Consumer Financial Protection Agency have?A.2. We believe that financial education is an important component of consumer protection and financial stability. Thus, the CFPA will play an important role in efforts to educate consumers about financial matters, to improve their ability to manage their own financial affairs. and to make their own judgments about the appropriateness of certain financial products. Once established, Treasury anticipates that the CFPA will include an Office of Financial Literacy that will work to promote consumer financial education. We also anticipate that the Director of the CFPA will be a member of the Financial Literacy and Education Commission established by the Financial Literacy and Education Improvement Act (20 U.S.C. 9701 et seq.), and that the CFPA will coordinate and work closely with the FLEC.Q.3. Promoting Access to Mainstream Financial Services--Mr. Secretary, I remain concerned that consumer access to mainstream financial services remains limited in underserved communities. The proposal indicates that a critical part of the Consumer Financial Protection Agency's mission will be promoting access to financial services. Other than rigorous enforcement of the Community Reinvestment Act, what will the CFPA do to promote access to mainstream financial services and ensure that the financial service needs of communities are being met?A.3. As part of a legislative requirement to consider the costs and benefits of any new regulation, the CFPA will analyze how regulations affect consumers' access to financial services. Under the Administration's proposal, ensuring access to traditionally underserved consumers and communities and ensuring ample room for innovation would be a core part of the CFPA's mission. As you mention, our proposed legislation gives the Agency authority to rigorously enforce the Community Reinvestment Act (CRA) in order to ensure that depository institutions meet the credit needs of the communities in which they operate. In addition, it requires the CFPA to establish a community affairs unit with the mission of providing information, guidance, and technical assistance regarding the provision of consumer financial products or services to traditionally underserved consumers and communities. The proposed legislation would also require the CFPA to create a research unit that will research, analyze, and report on market developments, disclosures and communications, consumer understanding of financial products, and consumer behavior. This unit's work will inform regulatory and market innovation that will expand access to financial services to the communities that need it most.Q.4. Financial Budget and Staffing for the CFPA--How large of a budget and how many staff members will be needed to ensure that the Consumer Financial Protection Agency will be able to effectively educate, protect, and empower consumers?A.4. The CFPA will require a budget and staff that are commensurate with its responsibilities, which include both existing functions performed by the current financial services regulators, as well as expanded authority to strengthen protections where they have been weak, particularly regarding the nonbank sector. Strong, stable funding will ensure that the agency can establish, monitor, and enforce high standards for consumers across the financial services marketplace. The CFPA's budget will include the resources used by the existing regulators to carry out their financial consumer protection functions, which will all be transferred to the new agency. The agencies that will transfer functions to the CFPA include the Federal Reserve Board and Federal Reserve Banks, the Office of the Comptroller of the Currency (OCC), the Office of Thrift Supervision (OTS), the Federal Deposit Insurance Corporation (FDIC), the National Credit Union Administration (NCUA), the Federal Trade Commission (FTC), and the Department of Housing and Urban Development (HUD). In addition to these resources, the CFPA will need to hire staff to provide a level playing field by extending the reach of Federal oversight to the nonbank providers of consumer financial products and services. We do not yet have an estimate of what amount will be necessary to fund the CFPA. We are in the process of gathering information on the resources expended from each of the agencies where funds will be transferred, and estimating the additional resources that will be required for the functions that are not being performed now, including supervision of nonbank financial companies that provide consumer financial products or services. ------ CHRG-111hhrg48873--201 Mr. Bernanke," Those restrictions, as have been the case in most of the TARP activities, for example, apply to the top management of the firm. These were not bonuses at the top management of the firm. They were bonuses to individuals working in the AIG FP division. They were highly compensated because they were using very complex financial derivatives and applying their knowledge. But, and, again, as we have discussed, the contracts were signed prior to the takeover. But I certainly agree. I mean, to be very clear, I think that the bonuses were disproportionate. And we are doing all we can to claw them back and to reduce any further bonuses to that division. Ms. Velazquez. So, did you have any--did you or any senior Fed official have discussions or e-mail communications regarding AIG's intention to make these bonuses not to the top level, but to the other employees that were given? " 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-111shrg51303--111 Mr. Polakoff," Correct. It is a very complex organization, so---- Senator Martinez. Right, but they were parallel entities, but you felt you had the regulatory authority to look beyond the S&L business to the FMP business because it impacted the S&L? " CHRG-111shrg55739--86 Mr. White," Thank you, Mr. Chairman, Members of the Committee. My name is Lawrence J. White. I am a Professor of Economics at the NYU Stern School of Business. During 1986 to 1989, I was a board member on the Federal Home Loan Bank Board. Thank you for the opportunity to testify today on this important topic. I have appended to the statement for the Committee a longer statement that I delivered at the Securities and Exchange Commission's roundtable on the credit rating agencies on April 15, 2009, which I would like to have incorporated for the record into the statement that I am presenting today. The three large U.S.-based credit rating agencies--Moody's, Standard and Poor's, and Fitch--and their excessively optimistic ratings of subprime residential mortgage-backed securities in the middle years of this decade clearly played a central role in the financial debacle of the past 2 years. Given this context, it is understandable that there would be strong political sentiment, as expressed in the proposals by the Obama administration as well as by others, for more extensive regulation of the credit rating agencies in hopes of forestalling future such debacles. The advocates of such regulation want figuratively to grab the rating agencies by the lapels, to shake them and shout, ``Do a better job.'' This urge for greater regulation is understandable, but it is misguided and potentially quite harmful. The heightened regulation of the rating agencies is likely to discourage entry, rigidify a specified set of structures and procedures, and discourage innovation in new ways of gathering and assessing information, new technologies, new methodologies, new models, including new business models, some of which have been talked about earlier this morning, and it may not even achieve the goal of inducing better rating from the agencies. It may well be a fool's errand. Ironically, it will also likely create a new protective barrier around the incumbent rating agencies. There is a better route. That route starts with a recognition that the centrality of the three major rating agencies for the bond information process was mandated by more than 70 years--it goes back to the 1930s--of prudential financial regulation of banks and other financial institutions, in essence, regulatory reliance on ratings, in essence, an outsourcing or delegating of safety judgments to these third-party credit rating agencies. For example, the prohibition on banks holding speculative bonds, as determined by the rating agencies' ratings, imbued these third-party judgments about the creditworthiness of bonds with the force of law. This problem was compounded when the SEC created the category of Nationally Recognized Statistical Rating Organization, NRSRO, in 1975, and then the SEC subsequently became a barrier to entry into the rating business. As of year-end 2000, there were only three NRSROs: Moody's, Standard and Poor's, and Fitch. It should thus come as no surprise that when this literal handful of rating firms stumbled, and stumbled badly, in their excessively optimistic ratings of the subprime residential mortgage-backed securities, the consequences were quite serious. The recognition of the role of financial regulation enforcing the centrality of the major rating agencies then leads to an alternative prescription. Eliminate the regulatory reliance on ratings, as Senator Bunning suggested earlier this morning. Eliminate their force of law, and bring market forces to bear. Since the bond markets are primarily institutional markets, as Assistant Secretary Barr mentioned earlier today, and not a retail securities market, where retail customers do need more help, market forces can be expected to work, and the detailed regulation that has been proposed would be unnecessary. Indeed, if regulatory reliance on ratings were eliminated, the entire NRSRO superstructure could be dismantled, and the NRSRO category could be eliminated. Now, let us be clear. The regulatory requirements that prudentially regulated financial institutions must maintain safe bond portfolios should remain in force. That is terrifically important. But the burden should be placed directly on the regulated institutions to demonstrate and justify to their regulators that their bond portfolios are safe and appropriate, either by doing the research themselves or by relying on third-party advisors who might be the incumbent rating agencies, or might be new firms that none of us have discovered yet, but could come forth in this more open environment. Since financial institutions could then call upon a wider array of sources of advice on the safety of their bond portfolios, the bond information market would be opened to innovation and entry and new ideas in ways that have not been possible since the 1930s. Now, my longer statement goes into greater detail, but since it was done on April 15, before the Obama administration's proposals were proposed, I just want to mention a few things about those proposals. I will be very brief, Mr. Chairman. Senator Reed. Thank you, Professor. " CHRG-111shrg54789--170 PREPARED STATEMENT OF MICHAEL S. BARR Assistant Secretary for Financial Institutions, Department of the Treasury July 14, 2009 Thank you, Chairman Dodd and Ranking Member Shelby, for providing me with this opportunity to testify about the Administration's proposal to establish a new, 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 regime just experienced massive failure. It could not stem a plague of abusive and unaffordable mortgages and exploitative credit cards despite clear warning signs. It cost millions of responsible consumers their homes, their savings, and their dignity. And it contributed to the near collapse of our financial system. We did not have just a financial crisis; we had a consumer crisis. Americans are still paying the price, and those forced into foreclosure or bankruptcy or put through other wrenching dislocations will pay for years. There are voices saying that the status quo is fine or good enough. That we should keep the bank regulators in charge of protecting consumers. That we just need some patches. They even claim consumers are better off with the current approach. It is not surprising 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 regulator, to shape the content of future regulation, and to continue financial practices that were lucrative for a time, but that ultimately proved so damaging. Entrenched interests always resist change. 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 mission focus, marketwide coverage, and consolidated authority. Today's system has none of these qualities. It fragments jurisdiction and authority for consumer protection over many Federal 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. Fragmentation of rule writing, supervision, and enforcement leads to finger-pointing in place of action and makes actions taken less effective. The President's proposal for one agency for one marketplace with one mission--protecting consumers--will resolve these problems. 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 market. It will end profits based on misleading sales pitches and hidden traps, but there will be profits made on a level playing field where banks and nonbanks can compete 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; preserves, not stifles, innovation; strengthens, not weakens, depository institutions; reduces, not increases, regulatory costs; and increases, not reduces, national regulatory uniformity.Successful consumer protection regulation requires mission focus, marketwide coverage, and consolidated authority Consumer protection regulation should be effective and balanced, independent and accountable. It can be none of these without three essential qualities: mission focus, marketwide coverage, and consolidated authority. First, consumer protection regulation requires mission focus. A clear mission is the handmaiden of accountability. It is also the basis for the expertise and effectiveness that are essential to maintaining independence. Second, the regulator must have marketwide jurisdiction. This ensures consistent and high standards for everyone. And it prevents providers from choosing a less restrictive regulator. Carving up markets in artificial, noneconomic ways is a recipe for weak and inconsistent consumer protection standards and captured regulators. Third, authorities for regulation, supervision, and enforcement must be consolidated. A regulator without the full kit of tools is frequently forced to choose between acting without the right tool and not acting at all. Moreover, if different regulators have different authorities, each can point the finger at the other instead of acting, and the sum of their actions will be less than the parts. 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 unaccountability.The present system of consumer protection regulation is designed for failure The present system of consumer protection regulation 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 responsible consumers and providers. Today's system does not meet a single one of the requirements I just laid out: mission focus, marketwide coverage, or consolidated authority. It does not even come close. The system fragments jurisdiction and authority for consumer protection over many Federal regulators, most of which have higher priorities than protecting consumers. Nonbanks avoid Federal supervision and banks can choose the least restrictive supervisor among several different banking agencies. Fragmentation of rule writing, supervision, and enforcement among several agencies lead to finger-pointing in place of action and make actions taken less effective. This structure is a welcome mat for bad actors and irresponsible practices. Responsible providers 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. Let me spell out these failures in more detail. Lack of mission focus: Protecting consumers is not the banking agencies' priority. The primary mission of Federal banking agencies, in law and in practice, is to ensure that banks act prudently so they remain safe and sound. Ensuring that banks act transparently and fairly with consumers is not their highest priority. Consumer protection regulation and supervision was added to the agencies' responsibilities relatively late in their histories, and it has never fit snugly in their missions, structures, or agency cultures. In fact, consumer protection supervision is generally conducted through the prism of bank safety and soundness. The goal of such supervision has too often been to protect banks or thrifts from excessive litigation or reputation risk, rather than to protect consumers. It was thought that supervising the banks for their effective management of ``reputation risk'' and ``litigation risk''--aspects of a safe and sound institution--would ensure the banks treated their customers fairly. It didn't. It did not prevent our major banks and thrifts from retroactively raising rates on credit cards as a matter of policy, or from selling exploding mortgages to unwitting consumers as a business expansion plan. It should not have come as a surprise that the agencies' ``check-the-box'' approach to consumer compliance supervision missed the forest for the trees. Examiners are well trained to ascertain whether the annual percentage rate on a loan is calculated as prescribed and displayed with a large enough type size. Equally or more important questions--Could this consumer reasonably have understood this complicated loan? Is this risky loan remotely suitable for this consumer?--are not a priority for an agency whose main job is to limit risks to banks, not consumers. Managing risks to the bank does not and cannot protect consumers effectively. This approach judges a bank's conduct toward consumers by its effect on the bank, not its effect on consumers. Consumer protection regulation must be based first and foremost on a keen awareness of the perspectives and interests of consumers, and a strong motivation to understand how products and practices affect them--for good and for bad. Agencies charged primarily with safeguarding banks will lack this awareness or motivation. Fragmented jurisdiction: There are two regulatory regimes for one market, and nonbanks escape Federal supervision. There is one market for residential mortgages, one market for consumer credit, and one market for payment services--but two different and uncoordinated regimes for these and other consumer financial products and services. Banks are subject to an extensive supervisory regime, with lengthy and intensive consumer compliance examinations on-site and off-site as well as a legal obligation to respond to requests for internal information. This regime, when it works, identifies and resolves weaknesses in banks' consumer protection systems before they harm consumers. The major failures of this regime were not for lack of examination hours or paperwork burdens. Failures occurred for lack of asking the right questions and taking the right perspective. These failures were rooted in the absence of mission focus. A Federal regime of consumer compliance supervision can be very effective in the right hands. Nonbank providers, however, are not subject to any Federal supervision. No Federal regulator sends consumer compliance examiners to nonbank providers to review their files or interview their salespeople. Nor does any Federal regulator regularly collects information from them, except limited mortgage data. Nonbank providers are subject only to after-the-fact, targeted investigations and enforcement actions by the Federal Trade Commission or State attorneys general. Supervision by the States of these providers is limited, uneven, and not necessarily coordinated. In general the same Federal consumer protection laws apply to this sector as apply to banks, but lack of Federal supervision and inherent limitations of the after-the-fact approach of investigations and enforcement resources leave the sector much less closely regulated. Lack of Federal supervision of nonbanks brings down standards across the board. Capital and financing flow to the unsupervised sector in part because it enjoys the advantages of weak consumer oversight. Less responsible actors face good odds that the FTC and State agencies lack the resources to detect and investigate them. This puts enormous pressure on banks, thrifts, and credit unions to lower their standards to compete--and on their regulators to let them. This is precisely what happened in the mortgage market. Independent mortgage companies and brokers grew apace with little oversight; capital and financing flowed their way. The independents peddled subprime and exotic mortgages--such as ``option ARMs'' with exploding payments and rising loan balances--in misleading ways, to consumers demonstrably unable to understand or handle their complex terms and hidden, costly features. The FTC and the States took enforcement actions, but their resources were no match for rapid market growth. And they could not set rules of the road for the whole industry, or examine institutions to uncover bad practices and prevent their spread. To compete over time, banks and thrifts and their affiliates came to offer the same risky products as their less regulated competitors and relaxed their standards for underwriting and sales. About one half of the subprime originations in 2005 and 2006--the shoddy originations that set off the wave of foreclosures--were by banks and thrifts and their affiliates. Lenders of all types paid their mortgage brokers and loan officers more to bring in riskier and higher-priced loans, with predictable results. Bank regulators were slow to recognize these problems, and even slower to act. The consequences for homeowners were devastating, and our economy is still paying the price. Mortgages are the most dramatic example of the harm that regulatory fragmentation causes consumers, but not the only one. Take the case of short-term, small-dollar credit. Payday lenders have grown rapidly outside the banking sector. They are not typically subject to State examinations or information collections. On the other side of the bank-nonbank divide, banks compete in the short-term, small-dollar credit market with cash advances on credit cards and ``overdraft protection'' programs. Each one of these three competing products is disclosed to the consumer differently, and each has been associated with abusive or unfair practices. There is a clear need for a consistent approach to regulating short-term, small-dollar credit that protects consumers while ensuring their access to responsible credit--but our fragmented system cannot deliver. The list goes on. A wide range of credit products are offered--from payday loans to pawn shops, to auto loans and car title loans, many from large national chains--with little supervision or enforcement. Credit unions and community banks with straightforward credit products struggle to compete with less scrupulous providers who appear to offer a good deal and then pull a switch on the consumer. Banks and thrifts can--and do--choose the most permissive supervisor, further depressing standards. Just as capital flows from the bank sector to the nonbank sector in search of less regulation, banks and thrifts can freely choose their Federal supervisor on the basis of which one has less restrictive oversight of consumer compliance. We saw this choice in action during the mortgage boom. But institutions do not actually have to switch supervisors to bring down standards. The mere fact that institutions have a choice exerts a subtle but pernicious drag on standards. It has little to do with who runs the agency. It is simply that Government agencies, like all other organizations, respond to incentives. The banking agencies, naturally, seek to retain or even compete to gain ``market share.'' Incomplete and fragmented supervision delays and impedes responses to emerging problems. When a consumer protection problem emerges, a new regulation is not necessarily the first and best response. It takes many months, even years, to adopt a new rule. And rules are often fairly rigid, detailed, and technical, especially if the underlying statute allows private suits. Supervisory guidance can be a much faster and more flexible, principles-based method to prevent problems. But guidance is a much weaker tool than it should be because of incomplete and fragmented Federal supervisory authority. There is no Federal supervision over nonbanks, and supervision of banks is divided among several agencies. This means that any effort to use supervisory guidance requires a massive and prolonged effort to bring many different Federal bank regulators, and State regulators of bank and nonbank institutions, to agreement on the precise wording of the document. It took the Federal banking agencies until June 2007 to reach final consensus on supervisory guidance imposing even general standards on the sale and underwriting of subprime mortgages--two years after evidence of declining underwriting standards emerged publicly in a regulator's survey of loan officers. By that time the subprime explosion was nearly over. It took additional time for States to adopt parallel guidance for independent mortgage companies. And it took a third year for the Federal agencies to settle on a model disclosure of subprime mortgages, by which point the subprime market had long ago imploded. Fragmented authorities: Rule writing is divided across agencies and largely divorced from enforcement and supervision. Fragmented rule-writing authority produces delays and inefficiencies. Separation of rule writing from supervision and enforcement invites finger-pointing in place of action and reduces the effectiveness of actions taken. Rule-writing authority is fragmented, producing delays and inefficiencies. While authority to write most Federal consumer protection regulations is exclusively in the Federal Reserve, other agencies have joint or concurrent authority to implement several statutes. It is a recipe for delay and inefficiency. For example, HUD and the Federal Reserve each implement a different statute governing mortgage disclosure, the Real Estate Settlement Procedure Act and Truth in Lending Act, respectively. The result is two forms emphasizing different aspects of the same transaction and using different language to describe some of the same aspects. It has been 11 years since the agencies recommended an integrated form. Even if they succeed in adopting an integrated form, their ability to act jointly to keep it up-to-date as the market changes will be limited at best. As another example, Congress mandated joint or coordinated rulemaking by six Federal agencies under the Fair and Accurate Credit Transactions Act of 2003 to improve the accuracy of information reported to credit bureaus and, to establish procedures for consumers to file disputes with information furnishers. Those agencies published final rules less than two weeks ago, on July 1, 2009. Clearly consumers deserve faster action on issues as important in their financial lives as accuracy of credit reports. Rule writing is divorced from enforcement and supervision, causing inertia and undermining effectiveness. The authority to write regulations implementing the Federal consumer protection statutes is largely divorced from the authority for supervision and enforcement. This deprives the rule writer of critical information about the marketplace that is essential to effective and balanced regulation. That is one reason we did not have Federal regulations for the subprime market. The Federal Reserve has authority to write regulations under the Truth in Lending Act and Homeownership and Equity Protection Act to ensure proper disclosure and prevent abusive lending. But it cannot examine, obtain information from, or investigate independent mortgage companies or mortgage brokers. So it is not surprising that the agency was slow to recognize the need for new subprime regulations. By the time it proposed rules, the subprime market had evaporated. The separation of rule writing from supervision and enforcement also leads to finger-pointing and inertia. Take the case of credit cards. Some banks found they could boost fee and interest income with complex and opaque terms and features that most consumers would not notice or understand. These tricks enabled banks to advertise seductively low annual percentage rates and grab market share. Other banks found they could not compete if they offered fair credit cards with more transparent pricing. So consumers got retroactive rate hikes, rate hikes without notice, and low-rate balance transfer offers that trapped them in high-rate purchase balances. A major culprit, once again, was fragmented regulation: One agency held the pen on regulations, another supervised most of the major card issuers. Each looked to the other to act, and neither acted until public outrage reached a crescendo. By then it was too late for millions of debt-entrapped consumers.There is only one solution to these deep structural flaws: One regulator for one market with one mission--protecting consumers--and the authority and resources to achieve it These deep structural flaws cannot be solved by tinkering with the consumer protection mandates or authorities of our existing agencies. The structure itself is the problem. There are too many agencies with consumer protection responsibilities, their authorities are too divided, and their primary missions are too distant from consumer protection. These problems have only one effective solution: a single Federal financial consumer protection agency. We need one agency for one marketplace with one mission--to protect consumers of financial products and services--and the authority to achieve that mission. A new agency with a focused mission, comprehensive jurisdiction, and broad authorities is the only way to ensure consumers and providers high and consistent standards and a level playing field across the whole marketplace without regard to the form of a product--or the type of its provider. It is the only way to ensure independence, accountability, effectiveness, and balance in consumer protection regulation. The CFPA will have one mission: To protect consumers. Mission focus will not be a problem for this agency. It will have no other mission that competes for attention or resources. And it will have the resources it needs to fulfill this mission and maintain its independence. The agency will have a stable funding stream in the form of appropriations and fee assessments akin to those regulators impose today. A mission of protecting consumers requires weighing competing considerations. Our proposal explicitly recognizes this complexity. It charges the CFPA with requiring effective disclosures and preventing abusive or unfair practices; and it also charges the CFPA with ensuring markets are efficient and innovative and preserving consumers' access to financial services. A statutory mandate to weigh these potentially competing considerations will help ensure the CFPA's regulations are balanced. The banking agencies will be able to concentrate their attention on bank safety and soundness. The Federal Reserve will be able to focus on monetary policy, financial stability, and holding company supervision without the major distractions it has experienced because it holds the pen on most major consumer protection regulations. The CFPA will have jurisdiction over the entire market. Our proposal for comprehensive jurisdiction will ensure accountability. The CFPA will not have the luxury of pointing the finger at someone else. If a problem arises in the nonbank sector, the agency will be as accountable as it will be for problems in the banking sector. Comprehensive jurisdiction will also make regulatory arbitrage a thing of the past. Providers will not have a choice of regulators. So, by definition, they will not be able to choose a less restrictive regulator. The CFPA will not have to fear losing ``market share'' because our legislation gives it authority over the whole market. Ending arbitrage will prevent the vicious cycles that weaken standards across the market. Comprehensive jurisdiction will protect consumers no matter with whom they do business, and level the playing field for all institutions and providers. For the first time, a Federal agency would apply to nonbank providers the tools of supervision that regulators now apply to banks--including setting compliance standards, conducting compliance examinations, reviewing files, obtaining data, issuing supervisory guidance and entering into consent decrees or formal orders. With these tools, the Agency would be able to identify problems before they spread, stop them before they cause serious injury, and relieve pressures on responsible providers to lower their standards. The CFPA's marketwide perspective and authority will help it work with the States to target Federal and State examination resources to nonbank providers based on risks to consumers. The CFPA can set and enforce national standards and supplement State efforts with its own examiners and analytics. The agency will be able to use efficient supervisory techniques in the nonbank sector such as risk-based examinations. The CFPA will provide leadership to the States, improve information sharing, and leverage State resources. The FTC will continue to have full authority to investigate and stop financial frauds. The CFPA will have the full range of authorities: Rule writing, supervision, and enforcement. CFPA's regulations will be based on a deep understanding of markets, providers, and products gained from the power to examine and collect information from the full range of bank and nonbank financial service providers. Combining rule-writing authorities with supervision and enforcement authorities in one agency will ensure faster and more effective rules. Where speed and flexibility are at a high premium, the CFPA will be able to exploit the full potential of supervisory guidance to address emerging concerns. Years-long delays to issue guidance because of interagency wrangling will be a thing of the past. For example, the CFPA will both implement the new Credit CARD Act of 2009--to ban retroactive rate hikes and rate hikes without notice--and supervise the credit card banks for compliance. So the agency will have a feedback loop from the examiners of the banks to the staff who write the regulations, allowing staff to determine quickly how well the regulations are working in practice and whether they need to be tightened or adjusted. It will also be able to improve credit card practices with supervisory guidance. The CFPA's rule-writing authority will be comprehensive and robust. The CFPA will be able to write rules for all consumer financial services and products and anyone who provides these products. (Its authority will not extend to entities registered with the Securities and Exchange Commission when these entities are acting within their registered capacities.) The CFPA will assume existing statutory authorities--such as the Truth in Lending Act and Equal Credit Opportunity Act. New authorities we propose--to require transparent disclosure, make it easier for consumers to choose simple products, and ensure fair terms and conditions and fair dealing--will enable the agency to fill gaps as markets change and to provide strong and consistent regulation across all types of consumer financial service providers. For example, our proposal gives the CFPA the power to strengthen mortgage regulation by requiring lenders and brokers to clearly disclose major product risks, and offer simple, transparent products if they decide to offer exotic, complex products. The CFPA will also be able to impose duties on salespeople and mortgage brokers to offer appropriate loans, take care with the financial advice they offer, and meet a duty of best execution. And it will be able to prevent lenders from paying higher commissions to brokers or salespeople (``yield spread premiums'') for delivering loans with higher rates than consumers qualify for. Lenders and consumers would finally have an integrated mortgage disclosure. Comprehensive standard-setting authority would improve other markets, too. For example, the CFPA could adopt consistent regulations for short-term loans--establishing disclosure requirements--whether these loans come in the form of bank overdraft protection plans or payday loans or car title loans from nonbank providers. The agency also could adopt standards for licensing and monitoring check cashers and pawn brokers. The new CFPA will bring higher and more consistent standards; stronger, faster responses to problems; the end of regulatory arbitrage; a more level playing field for all providers; and more efficient regulation. A dedicated consumer protection agency will help restore the trust and confidence on which our financial system so critically depends.The CFPA will ensure, not limit, consumer choice; preserve, not stifle, innovation; strengthen, not weaken, depository institutions; and reduce, not increase, regulatory burden; and increase, not reduce, uniformity The CFPA will ensure, not limit, consumer choice. The agency will have a mandate to promote simplicity. It will also be charged with preserving efficient and innovative markets and consumer access to financial services and products. The point is to make it easier for consumers to choose simpler products while preserving their ability to choose more complex products if they better suit consumers' needs. For example, the CFPA will have the authority to require providers that offer exotic, complex, and riskier products to offer at least one standard, simple, less risky product. In the mortgage market, a lender or broker that peddles mortgages with potentially exploding monthly payments, hidden fees and prepayment penalties, and growing loan balances--such as the ``pay option ARMs'' of recent years--might also be required to offer consumers 30-year, fixed-rate mortgages or conventional ARMs with straightforward terms. The idea is not new. A division between ``traditional'' and ``nontraditional'' products is deeply embedded in our mortgage markets. A similar consensus about standard and alternative products may emerge in other product markets. The CFPA's rigorous study of consumer understanding and product performance may help produce a consensus in a given market about the appropriate dividing line. This approach, to be sure, may not work in all contexts. Our draft legislation requires the agency to consider its effect on consumer access to financial services or products. In some cases the costs may outweigh the benefits--that will be for the agency to determine. In other cases, using this approach will obviate the need for costlier restrictions on terms and practices that would limit consumer choices. The CFPA will preserve, not stifle, innovation. The present regulatory system clearly failed to strike the right balance between financial innovation and efficiency, on the one hand, and stability and protection, on the other. This imbalance was a major cause of the financial crisis. Ensuring that consumers who want simple products can get them, and that consumers who take complex products understand their risks, will re-right the scales. The benefits of innovation will continue to flow. By helping ensure that significant risks are assumed only by knowing and willing consumers, the CFPA will improve confidence in innovation and make it sustainable rather than tied to quarterly results. The CFPA will strengthen, not weaken, depository institutions. Protecting consumer is not unsafe or unsound for banks. Protecting consumers is good for banks. If we had protected consumers from banks that sold risky mortgages like option ARMs in misleading ways, then we would have made the banks more sound, not less. We reject the notion that profits based on unfair practices are sound. The opposite appears true. Massive credit card revenue, for example, was not sustainable. It depended on unfair practices that bore the seeds of their own demise. These practices led this Congress to pass, and President Obama to sign, tough new restrictions on credit cards. Examiners in the field will resolve the rare conflict that arises just as they do today. For larger banks, CFPA examiners could reside in the bank just as consumer compliance examiners often do today, right next door to safety and soundness examiners. They would regularly share information--our draft legislation mandates the exchange of examination reports--and coordinate approaches. Moreover, the CFPA could work with the banking agencies to ensure bank consumer compliance examiners are trained to understand safety and soundness, as they are today. For the even rarer conflict that arises and cannot be resolved on the ground, our proposal provides mechanisms for its resolution. A safety and soundness regulator will have one of five board seats, ensuring a strong voice within the agency for prudential concerns. In addition, the agency must consult with safety and soundness regulators before adopting rules. The Financial Services Oversight Council will bring these agencies together on a regular basis. The CFPA will reduce, not increase, regulatory costs. The CFPA is not a new layer of regulation; it will consolidate existing regulators and authorities. I have already discussed the tremendous benefits this will bring to responsible providers by ensuring consistent standards and a level playing field. And consolidating authority does not just increase accountability for protecting consumers, it also increases accountability for removing unnecessary regulatory burdens. Consolidation will also bring direct efficiencies. The agency would help to simplify and reduce regulatory burdens in areas where current authorities overlap or conflict. For instance, the agency would ensure we have a single Federal mortgage disclosure--eliminating confusing and unnecessary paperwork. Other efficiencies will flow from the CFPA's ability to choose the best tool for the problem. The agency's authority to restrict terms and conditions of contracts by regulation--as the Congress did in the Credit CARD Act of 2009--will be just one of many authorities. With comprehensive supervisory authority over the whole market, the agency will also be able to use more flexible, potentially less costly tools such as supervisory guidance. The breadth and diversity of the authorities we propose will ensure the agency can tailor its solution to the underlying problem with the least cost to consumers and institutions. The agency will have ample authority to harness the benefits of market discipline by improving the quality of, and access to, information in the marketplace. The CFPA will have authority to ensure that consumers receive relevant and concrete information in a timely manner. These measures, and measures that make it easier for consumers to choose simpler products, should reduce the need for more burdensome regulations. Imposing Federal supervisory authority on nonbank institutions for the first time will increase compliance requirements on that sector. But this is well worth the benefit of higher and more consistent standards. The CFPA will increase, not reduce, national regulatory uniformity. The CFPA's rules and regulations will set a floor for the States, not a ceiling. The contention that this will somehow increase variations in State laws is a red herring. Our proposal does not alter the law of the status quo: major Federal consumer protection statutes such as the Truth in Lending Act and Homeownership and Equity Protection Act explicitly make Federal regulations a floor, not a ceiling. In fact, a strong Federal consumer protection regulator should be able to increase regulatory uniformity. States sometimes adopt new financial services laws because they perceive a lack of Federal will and leadership. That is exactly what happened in the mortgage context, where States filled a vacuum of predatory mortgage law with State statutes and regulations. If the States believe an expert, independent Federal agency is on the job and working with the States to protect their consumers, the States will feel less need to adopt new laws.Conclusion We need consumer protection regulation that is independent and accountable, effective and balanced. These goals are achievable, but only if we address fundamental flaws in the structure of consumer protection. The only real solution to these flaws is creating an agency with a focused consumer protection mission; comprehensive jurisdiction over all financial services providers, both banks and nonbanks; and the full range of regulatory, enforcement, and supervisory authorities. It is time for a level playing field for financial services competition based on strong rules, not based on exploiting consumer confusion. And 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 will be happy to answer any questions. ______ CHRG-111shrg55278--44 Mr. Tarullo," Yes. Senator Brown. OK. Chairman Schapiro. Ms. Schapiro. Thank you. Well, I would agree with you. It is always a challenge for regulators to keep up with the latest financial innovation and the latest trading practices, product designs from Wall Street. I would say, I think to some extent, Wall Street outsmarted itself over the last couple of years and not just the regulators, which is why, through a lack of good risk management procedures, perhaps a lack of understanding entirely the nature of the businesses they were engaged in or the degree to which they were dependent upon counterparties is significant contributors to the situation. I think there are a few things we can do and we really must do. We have got to bring unregulated products under the regulatory umbrella. I talked already about OTC derivatives and I won't go back through that, but I think it is a very significant gap. I think we have to be much more robust about capital requirements and risk management procedures within the firms. We have to have regulators who are willing to be skeptical every single day and every hour of every day about the quality of risk management procedures within the firms that we are all responsible for regulating. I think we have to have an across-the-board commitment to much more robust stress testing so that we are thinking more about the huge impact but low probability events and factoring that into how we go forward with our regulatory programs. And to refer back to something we talked about with Senator Corker, I think we need to find ways to encourage more engaged and knowledgeable boards in these financial institutions. Senator Brown. OK. Chairman Bair. Ms. Bair. Specifically focusing on the resolution mechanism, under the regime we would suggest going forward, a Wall Street firm couldn't come and ask for assistance from the Government without submitting to a resolution procedure, meaning that they would be closed. So I think that they will stop asking, number one, if that is the tradeoff. I do agree that there has been some Balkanization of regulatory responsibility . That is why we think a council with ownership and a clear statutory mandate to be responsible for the system, addressing systemic risk, and getting ahead of systemic risk, will help change that attitude. It would get us all working together as opposed to saying that it is not really my agency's responsibility. I do think the ability of the council to set minimum standards, as well, will be an important check against regulatory capture or perhaps a lax attitude. That is another feature that could create a more robust regulatory environment. Senator Brown. Thank you. Thank you, Mr. Chairman. " 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-111hhrg53244--238 Mr. Bernanke," We are looking at some alternative assets, but they are very complex, many of them, once you get beyond the categories we have already included. " 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-111shrg54589--2 Chairman Reed," Let me call the hearing to order. I want to thank all of our witnesses for joining us this afternoon. I am particularly happy to welcome back Chairman Schapiro. Thank you. And also I want to thank Chairman Gensler for asking to testify before us on the derivatives issue, which gives us a chance to talk directly to you about this issue which transcends several different agencies, and also Pat White from the Federal Reserve. Thank you. I also, obviously, want to recognize Chairman Harkin and his colleagues on the Agriculture Committee for their longstanding work on derivatives issues, and I look forward to having both Committees coordinate closely as we work to provide transparency and reduce risk in the financial sector. This week, we find ourselves more focused than ever on the important work of modernizing an outdated financial regulatory system. I have called this hearing to explore one of the key aspects of such reforms: to modernize the regulation of the over-the-counter derivatives markets and the institutions that participate in these markets. Both exchange-traded and over-the-counter markets have grown extremely rapidly over the past decade. Until the recent downturn of the economic markets, every category of derivatives saw almost a decade of extreme growth, in many cases more than tripling or quadrupling trading volumes. According to data compiled by the Congressional Research Service, between 2000 and 2008, the number of financial futures contracts traded on exchanges rose by 425 percent, and the total notional amount of over-the-counter contracts outstanding rose by 522 percent over that period, representing trillions of dollars of trading. This afternoon's hearing will focus in particular on over-the-counter derivative markets which today are subject to no direct regulation. One of the key questions we will examine is the extent to which existing and emerging derivatives markets should be subject to regulatory oversight. Until recently, the prevailing presumption was that market discipline alone largely protected us from any potential risks we faced from OTC derivatives. But we received a wake-up call, having had to seize AIG to keep its credit default swaps, worth trillions of dollars, from greatly exacerbating the financial crisis. It is now clearer than ever that we need to find ways to make these markets much more transparent and to ensure that the dealers and other users of these markets do a better job than AIG of ensuring that their derivative activities do not threaten the stability of the overall financial system. But we face difficult questions as we move forward in accomplishing this goal. These products are often extremely complex, and there is an equally complex history of regulation, or lack thereof, of such products. As a result, we need to take a careful and thoughtful approach to these issues. There is no doubt that improving the regulation and oversight of derivatives markets, and those who trade in them, is a key part of modernizing our financial regulatory system. I hope my colleagues and our witnesses will help us identify the key steps that we can and should take right now to address the serious problems that we are confronting. For example, what key decisions need to be considered as Congress weighs proposals to move more over-the-counter derivatives to central counterparties or exchanges? How do various proposals to enhance oversight of OTC derivatives affect different market participants? How does the issue of improved OTC derivatives regulation relate to broader regulatory reform issues, such as the creation of a new systemic risk regulator? And to what extent do U.S. efforts require international coordination? And these are just a few of the challenging questions that we will face together, and we will rely on your expertise and your insights as we go forward. At this time, I would like to call on the Ranking Member, Senator Bunning, for his comments. Senator Bunning. CHRG-111shrg50815--96 Mr. Ausubel," I am talking about fees in aggregate. What was the next thing? Senator Merkley. Well, the first was the complexity of purchases---- " CHRG-111hhrg55809--102 Mr. Bernanke," Well, first, the difference between the FHA and the GSEs is the GSEs had private debt and private shareholders, and that made it more complex in terms of the overall financial system. I think it is undeniable that the FHA loans, because of the low downpayments and so on, are riskier than other mortgages being made and therefore have greater chance of loss, which would be made up by the taxpayer. And that tradeoff is your tradeoff in terms of what you think is worth--you know, what risk you think the government should be willing to take in order to support the housing market and homeownership. You made the same decision on things like in first-time home buyers tax credit. You know, it is a cost to the government, but it supports the housing market. I don't know how to tell you that. " 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-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-111shrg54789--187 RESPONSES TO WRITTEN QUESTIONS OF SENATOR VITTER FROM MICHAEL S. BARRQ.1. Mr. Barr, do you agree with Sheila Bair, Chair of the Federal Deposit Insurance Corporation, that safety and soundness cannot be separated from consumer protection?A.1. I agree with Ms. Bair and other regulators who have testified that safety and soundness and consumer protection need not conflict. Following all applicable laws, including consumer protection laws, is a requirement of a safe and sound institution. And as we've seen in the mortgage and credit card markets, poor treatment of consumers actually undermines the safety and soundness of financial institutions. I think, however, that these complementarities can be preserved with separate agencies. Two banking agencies today, including the FDIC, typically conduct their consumer compliance and safety and soundness examinations with separate teams of examiners. It is a further step to separate the examiners into different agencies, but we would propose to require the CFPA and the prudential agencies to communicate and coordinate closely, and to share examination reports. Ultimately, we believe the complementarities will be strengthened if the CFPA is given the mandate and authority, as we propose, to identify questionable practices and provide the market and institutions clear rules of the road. The CFPA can help the prudential regulator identify practices that exploit consumer confusion for short-term profits but undermine bank earnings and reputations in the long run.Q.2. Appearing before the House Energy and Commerce Committee, you said that this new agency would not set prices, dictate what products could be offered, or regulate a firm's advertising practices. Section 1039 of the President's proposals states that, ``It shall be unlawful for any person to advertise, market, offer, sell, enforce, or attempt to enforce, any term, agreement, change in terms, fee or charge in connection with a consumer financial product or service that is not in conformity with this title or applicable rule or order issued by the Agency.'' How do you explain this discrepancy?A.2. In my testimony before the House Energy and Commerce Committee on July 8, I did state that the CFPA would not set prices. Section 1022(g) of the legislation specifically forbids the CFPA from establishing usury limits. I also stated correctly that the CFPA could not dictate what products firms could offer. With respect, however, I did not testify that the CFPA would not regulate the advertising practices of those offering financial products and services to consumers. Advertising regulations have long been a core element of Federal consumer protection statutes such as the Truth in Lending Act. Regrettably these regulations were not kept up-to-date. Indeed, before the mortgage market collapsed, the marketplace was awash with misleading advertising about low-rate mortgage loans, credit cards, or financial products. Accordingly, the CFPA would have authority, as you note, to regulate advertising practices of persons that provide consumer financial products and services to prevent incomplete or misleading information from undermining competition.Q.3. In the past, Mr. Barr, you've argued that derivation from a standard, plain-vanilla product ``would require heightened disclosures and additional legal exposure for lenders.'' Please explain why this would, or would not, discourage lenders from offering any products that are deemed unstandard or outside of the agency's safe harbor?A.3. A standard product would serve to provide a standard of comparison for borrowers, so they can make more informed choices about what loan product would be best for them. It's another tool besides disclosure, but less intrusive than outright banning complex contract terms (as Congress just did on credit cards). Since borrowers would be entirely free to select alternative, more complex products and many would do so, lenders would have substantial incentives to offer them.Q.4. How much latitude would this new agency have over determining what is a ``consumer financial product or service?'' The President's proposal says ``any financial product or service to be used by a consumer primarily for personal, family, or household purposes.'' Could agency have authority over small business loans or commercial real estate?A.4. As you note, the definition of ``consumer financial product or service'' in the CFPA Act is limited to any ``financial product or service to be used by a consumer primarily for personal, family or household purposes.'' In applying that language, the CFPA would need to determine whether the product or service is used ``primarily'' for personal, family or household purposes as a factual matter. Similar language appears in the definitions of several other consumer protection statutes, including the Truth in Lending Act (15 U.S.C. 1602(h)), the Electronic Funds Transfer Act (15 U.S.C. 1693a(2)), the Fair Debt Collection Practices Act (15 U.S.C. 1692a(5)), the Fair Credit Reporting Act (15 U.S.C. 1681a(d)(1)(A)), and the Equal Credit Opportunity Act (12 CFR 202.2(h)), which implements 15 U.S.C. 1691, et seq.). The use of such language is generally understood as meaning to exclude business credit. As a general matter, under the new authority granted to the CFPA under the CFPA Act, the CFPA would not have authority over small business loans or commercial real estate loans. However, the Equal Credit Opportunity Act (ECOA) prohibits discrimination against certain protected classes in lending for business as well as personal and household purposes, and the proposal would grant the CFPA rulemaking and enforcement authority under the ECOA. To that extent, the CFPA would have authority over business loans under the ECOA.Q.5. How did the Treasury determine that the Securities and Exchange Commission has done an adequate job protecting consumers? For example, many of Allan Stanford's victims were everyday people, not large, sophisticated institutional investors.A.5. In establishing a regulatory framework for the protection of consumers and investors, the Administration's goal was for there to be a Federal agency with the mission of consumer protection. In the consumer financial products and services area, this agency is lacking; in the nonbank sector, no Federal agency has supervision and examination authority, regardless of the mission, and in the banking sector, five different agencies share this responsibility but each has safety and soundness as its primary mission. The Securities and Exchange Commission (SEC), on the other hand, does have as its mission the protection of retail investors, so there was no need to duplicate this responsibility within the CFPA. As the SEC has acknowledged with respect to the Stanford and Madoff cases, existing authority should have been sufficient to address these frauds much earlier. The SEC needs additional authorities, however, to provide the broader and more effective oversight that is needed, and that is why the Administration proposes strengthening the agency's authority in several important ways.Q.6. Should one of the goals of the CFPA be to ``optimize household behavior''? What do you think optimal savings means?A.6. The CFPA will not optimize household behavior. It is for every family to make its own financial decisions. In order to help families make responsible decisions, the CFPA will work to ensure that markets are transparent, people have the information they need about their financial decisions, and bank and nonbank firms alike follow clear rules of the road. For many years, until the current recession, the personal saving rate in the United States has been exceedingly low. In addition, tens of millions of U.S. households have not placed themselves on a path to become financially prepared for retirement. In order to address this problem, the President has proposed two innovative initiatives in his 2010 Budget: (1) introducing an ``Automatic IRA'' (with opt-out) for employees whose employers do not offer a plan; and (2) increasing tax incentives for retirement savings for families that earn less than $65,000 by modifying the ``saver's credit'' and making it refundable. The proposals would offer a meaningful saving incentive to tens of millions of additional households while simplifying the current complex structure of the credit and raising the eligibility income threshold to cover millions of additional moderate-income taxpayers.Q.7. Mr. Barr, do you believe that the Government should steer people's choices in directions that will ``improve their lives'' or should the Government allow consumers to make their own choices free of interference or direction?A.7. We believe that it is the responsibility of consumers to make their own decisions on financial matters. There must be clear rules of the road so that firms do not deceive consumers by hiding the true costs of products. The CFPA will create a level playing field with high standards for all firms, bank and nonbank alike, which means that the marketplace will provide a broader array of high quality products from which consumers can freely choose.Q.8. Do you believe that it is more profitable for a bank to issue a mortgage or credit card loan to a customer who defaults or to one who makes their payments?A.8. If incentives are properly aligned, banks should make as much or more money when a mortgage or credit card borrower pays their loan as when they default. Problems arise, however, when markets are structured so that the bank is indifferent to future loan performance, as when the lender immediately sells the loan into an investment conduit without retaining any of the risk of default. This ``originate to distribute'' model caused incentives to deviate. The lenders--the parties in the best position to determine the creditworthiness of the borrowers--had no incentive to carefully underwrite; they were paid up front when the loan was made regardless of future performance. That is why the Administration proposes that originators of loans or the securitizer must retain 5 percent of the credit risk associated with loans sold into a conduit.Q.9. Will you please define what an ``objective reasonableness standard'' means?A.9. Disclosure mandates for consumer credit and other financial products are typically very technical and detailed, and it takes time for regulators to update them because of the need for consumer testing and public input. The growth in the types of risks stemming from new and complex credit card plans and mortgages that preceded the credit crisis far outpaced the ability of disclosure regulations to keep up. We propose a regime strict enough to keep disclosures standard throughout the marketplace, yet flexible enough to adapt to new products. Our proposed legislation authorizes the CFPA to prescribe rules that require disclosures and communications to be reasonable, not merely technically compliant. The proposal is based in part on the banking agencies' supervisory guidance on subprime and nontraditional mortgages. This guidance requires originators to make balanced disclosures.Q.10. If a financial institution developed a new product today, under the CFPA would that product be able to be brought to the marketplace tomorrow? What will financial institutions be required to do before introducing a new product?A.10. If a financial institution developed a new product today, under the CFPA Act that product could be offered in the market tomorrow--the CFPA will not be approving financial products. Of course, all products must comply with existing laws. For example, credit cards may not contain terms, such as retroactive rate increases, that would violate the Credit CARD Act of 2009. It is the institution's responsibility to determine that a new product complies with applicable laws before the institution brings the product to the market. It is CFPA's role to help ensure that products offered in the market comply with applicable laws, and to take appropriate steps if a product does not. ------ CHRG-111shrg62643--165 Mr. Bernanke," On the specifics of capital there are some rules, the Collins amendment and so on. But it was very important that we have at least some flexibility in order to negotiate and collaborate with our international colleagues on developing an international set of capital standards. So that was very important. Inevitably in a bill this complex that is addressing so many complex issues, if you want it to be responsive to changes in the environment, to deal with a lot of technical details, I think inevitably the regulators have to play a role. But Congress certainly has an oversight role. You are certainly going to be seeing what we do, and if you are dissatisfied, I am sure you will let us know. " CHRG-110hhrg44900--4 The Chairman," Okay, so there is an overflow room for people who can't find seats. We have gotten the agreement of the Chairman and the Secretary, preliminary to any opening statements, to stay until 1 p.m. We will probably have some votes, so we will maximize our time. Let me remind the members that Chairman Bernanke will be before this committee next week for the Humphrey-Hawkins hearing on the economy. Members are obviously free to raise anything they want today, but it is my hope that we would focus on these very important questions of financial regulation. I know there are members who want to review what happened with Bear Stearns and then what we do going forward, but I personally believe the best use of the committee's time today would be to focus on those structural questions and regulatory questions. We will have the Chairman before us for 3 more hours next week to talk about the economy and Humphrey-Hawkins; and, again, I would urge members to do that. All members are free, as we know, to bring up whatever they want, but that would be our hope, because I did note that some of the members of the committee had asked previously for a hearing to look into what happened with Bear Stearns. And I said at the time that I thought that was very important. I believed it was best to do that in this broader context. Members want to get a new context because the experience regarding Bear Stearns is clearly the context in which much of this hearing is and much of what we will be talking about is what happens if that should occur. So those are the parameters. Given the importance of this, and given the interest of members in speaking, we are going to hold pretty firmly to the 5-minute rule. And, obviously, we are not going to completely finish in 5 minutes, but no question can be asked after the 5 minutes have expired. We will allow the answers to conclude. But I am going to have to restrain myself and others from asking any questions after the 5 minutes. Under the rules that apply when we have cabinet and cabinet-level officials, there are two opening statements on each side, the chairs and ranking members of the appropriate subcommittees. In this case, it seems clear to me that it is the Financial Institutions Subcommittee that is the developing subcommittee so that is how we will proceed. The official part of the hearing will now begin and I will recognize myself for a fairly strict 5 minutes. When I was about to become chairman of this committee in 2006, I was told by a wide range of people that our agenda should be that of further deregulating. I was told that the excess regulation in America from Sarbanes-Oxley and other acts was putting American investment companies and financial institutions at a competitive disadvantage and that people much prefer the softer touch of the financial services authority to the harshness of the American regulatory structure. Things have changed. Where there was a strong argument as recently as November of 2006 that we had been over-regulating the financial system, I believe the evidence is now clear that we are in one of the most serious economic troubles that we have seen recently, in part because of an inadequacy of regulation. Clearly, that has been the case with regard to subprime mortgages, but what has been striking is not simply that we had the problems with subprime mortgages, but that those problems infected so much of the financial system, including, I must say, many in Europe. One of the things though that I do take away from that set of conversations, and then it's a fairly clear one is that what we do, and I believe there is a consensus now among people in the Administration, among many of us in Congress, and among people in the financial industry, that an increase in regulation is required. It must be done sensibly. It must be market sensitive. But I believe we have seen a significant shift from the notion that the most important issue was to deregulate further to one recognizing the need for more sensible regulation, but more regulation. It is clear that this needs to be done in the context of international cooperation, and I am encouraged to believe, and the first trip this committee took when I became chairman was to Belgium and London to meet with people from the European Union and Great Britain in terms of their financial regulation. This needs to be done with international cooperation and I think the prospects of that are very good. I think there was a broad international recognition that some form of increased regulation was necessary. And the form we are talking about is regulation of risk-taking outside the very narrowly defined commercial banking. Innovation is very important, and an innovation that has brought a great deal of benefit during the last few decades is securitization. Securitization replaces the lender-borrower relationship and the discipline that you have in the lender-borrower relationship. A very large part of our problem is that we have not yet found sufficient replacement for the discipline of a lender not lending to a borrower unless the lender is sure that the borrower will be able to repay. Something that simple causes problems in subprime, and it has caused problems elsewhere. We have had too many loans made without sufficient attention to whether or not the loans could be repaid. And, what we now have is a contagion, because people who bought loans in various forms that they shouldn't have bought are now resistant to buying things that they should buy. That is why I believe regulation properly done, regulation of risk that is too unconstrained today, because the various risk management techniques that were supposed to replace the lender-borrower relationship have not been successful. Diversification and quantitative models and the rating agencies, we have not yet replaced them. Some form of regulatory authority is necessary. If properly done, a market sensitive regulatory authority not only prevents some of the problems, but is pro-market, because we have investors now who are unwilling to invest even in things they should. Many of our nonprofit institutions and our State and local governments have been the victims of this. So our job, I believe--and I congratulate the officials of this Administration for having done a good job in the current legal context of dealing with these problems--is to look at what happened, to look at what is now going on, and to decide what should be done to provide a better statutory framework for the increase in regulation that I believe people agree should happen. The gentleman from Alabama. " CHRG-111shrg55739--23 Mr. Barr," I would agree with that, sir. Senator Shelby. Secretary Barr, S&P, Moody's, and Fitch have not, in most people's eyes, performed well in recent years. I think that is probably an understatement. Nevertheless, the SEC has ebbed a persistent confidence in these three firms--three firms--a sentiment that manifests itself in regulatory requirements that blessed the organizational structure, approach to ratings, and payment scheme of those firms. There seems to be similar bias in your draft legislation. I hope not. What steps, if any, did you take, you and your team, to ensure that no particular organizational structure, approached to ratings, or payment model was favored over another and that the regulatory structure will accommodate innovative entrance into the rating? I have always advocated, gosh, three firms nominate--they do not have it all, thank God, have all the business, but there has not been enough competition there. You know, why should you just bless three firms? " CHRG-111shrg61651--132 PREPARED STATEMENT OF E. GERALD CORRIGAN Managing Director, Goldman, Sachs and Co. February 4, 2010Introduction Chairman Dodd, Ranking Minority Member Shelby, and Members of the Committee, I am thankful for this opportunity to share with you my views on the urgently needed financial reform process in the wake of the financial crisis. As the Committee knows, in my earlier career at the Fed and in my current second career in the private sector, public policy issues relating to the quest for greater financial stability have been a subject of continuing interest to me. The views I will express today on financial reform are very much driven by what I consider to be in the best interest of long-term financial stability. Having said that, I cannot deny that there are instances in which my thinking about specific issues has been influenced by my tenure as an employee of Goldman Sachs and by what I have seen transpire during that period. To cite one clear example, in a sharp departure with my earlier thinking, I now recognize the value and importance of the so-called ``fair value'' or mark-to-market accounting. At the center of the great debate about financial reform is the universal agreement that the ``Too Big to Fail'' problem must be forcefully resolved in order to provide comfort that future problems with failures of large and complex financial institutions will not be ``bailed out'' with tax payer money. Achieving that goal will not be easy but it is not impossible. My formal statement contains four sections as follows: Section I: The Financial Reform Agenda Section II: Alternative Financial Structures in Perspective Section III: The Merits of Alternative Financial Structures Section IV: The Challenges Associated With Enhanced Resolution AuthoritySection I: The Financial Reform Agenda In looking to the future, almost everyone who has seriously studied the causes of the crisis agrees that certain basic reforms are a must. In summary form, those basic reforms include the following: 1. The creation of a so-called ``systemic regulator.'' Among other things, the mission of the systemic regulator would include oversight of all systemically important institutions and, importantly, looking beyond individual institutions in order to better anticipate potential sources of economic and financial contagion risk including emerging asset price bubbles. Anticipating future sources of contagion is difficult but not impossible. 2. Higher and more rigorous capital and liquidity standards that recognize the compelling reality that managing and supervising capital adequacy and liquidity adequacy must be viewed as a single discipline. 3. Substantial enhancement in risk monitoring and risk management and more systematic prudential oversight of these activities. 4. The increased reliance by institutions and their supervisors on (1) stress tests; (2) so-called ``reverse'' stress tests; and (3) rigorous scenario analysis of truly extreme contingencies. 5. Efforts to intensify the never ending task of strengthening the infrastructure of the global financial system. 6. The creation of a flexible and effective framework for the timely and orderly wind-down of failing large and complex financial institutions (the Enhanced Resolution Authority discussed in Section IV). 7. Substantially enhanced cross-border cooperation and coordination on a wide range of issues from accounting policy and practice to more uniform prudential standards to better coordinated macroeconomic policies. I believe that these measures--coupled with others that are in the House Bill such as tightening up the administration of Section 13 (3) of the Federal Reserve Act--will, over time, reduce the probability of future financial crises and materially help to limit or contain the damage caused by crises. Having said that, I want to underscore three key points: First; the execution challenges associated with this reform agenda are enormous. Second; the reforms are a ``package deal'' such that if we fail to achieve any one of these measures the prospects for success in the others will be compromised. Third; if we are successful in implementing the agenda over a reasonable period of time the case for wholesale restructuring of the financial system would hardly be compelling.Section II: Alternative Financial Structures in Perspective At the risk of considerable oversimplification, there are three somewhat overlapping suggestions on the table that are calling for a major restructuring of the core of the financial system both domestically and internationally. The more extreme of the three is the so-called ``Narrow Bank Model'' which, in effect, suggests that ``banks'' should essentially take deposits and make loans. The second approach would limit the scope of activities in banks and in companies that own banks but would allow nonbank affiliates of bank holding companies to conduct certain other financial activities including the underwriting of debt and equity securities while sharply curtailing or prohibiting banks and bank holding companies from engaging in ``proprietary'' trading and operating or sponsoring hedge funds and private equity funds. The third approach is the view that subject to a comprehensive and rigorous family of reforms as outlined in Section I, most large integrated financial institutions would be allowed to maintain much of their current configuration while being subject to much more demanding consolidated supervision. To many, the frame of reference surrounding the debate on these alternatives seems to be very much a matter of black and white. If we were starting with a clean slate, that might be the case. Unfortunately, we are not starting with a clean slate--far from it. Therefore, allow me to briefly focus on a few observations that--in my judgment--frame the perspective to be considered in shaping the debate on alternative financial structures. First; I have always believed that banks (whether stand alone or part of a Bank Holding Company) are special. Among other things, that is one of the reasons I agreed to take on the role of nonexecutive chairman of the Goldman Sachs Bank when Goldman became a Bank Holding Company in the fall of 2008. Second; under existing law and regulation there are now in place rigorous restrictions as to the activities that may be conducted in a bank that is part of a Bank Holding Company and even more rigorous standards limiting transactions that can occur between the bank, its holding company and its nonbank affiliates. Also, under precrisis rules regarding the administration of the discount window, access to the discount window applied only to the bank and such access did not extend, either directly or indirectly, to the Holding Company or the Bank's nonbank affiliates. As the Fed winds down its crisis driven extraordinary interventions, I believe we should return to the precrisis rules regarding access to the discount window so long as Section 13 (3) lending remains a possibility in extreme circumstances. Third; under existing law and regulation, the Federal Reserve, as the consolidated prudential supervisor of all U.S. Bank and Financial Services Holding Companies, already has broad discretionary authority to remove officers and directors, cut or eliminate dividends, shrink the balance sheet, etc. The Bill passed by the House in December would further strengthen this authority and extend it to systemically important financial institutions even if they do not own or control a bank. While on the subject of consolidated supervision, allow me to say a few words about the experience of Goldman Sachs since the Fed (working with other regulators) became its consolidated supervisor 16 months ago. First, and most importantly, I would describe that relationship as open, highly constructive, and very demanding. The Fed has now completed comprehensive full scale examinations of the Bank and the Group and reported the results of such examinations to both the Boards of the Group and the Bank. In addition, a large number of targeted exams and so-called ``discovery reviews'' have been completed or are in progress. In the case of major forward-looking supervisory initiatives on the part of the Fed in collaboration with other supervisory bodies--both domestic and international--I personally have actively participated in all such discussions. Finally, and to put a little color on this subject, on more than a few occasions my high-level associates at Goldman Sachs have said to me something along the following lines: ``these guys (referring to the supervisors) ask damn good questions.'' Fourth; given all that we have been through over the past 2 years, many observers are raising the perfectly natural question of whether society really needs large and complex financial institutions. Whatever else can be said about such large and complex financial institutions, financial services is one of the few sectors of the economy that make a consistent positive contribution to the U.S. balance of payments. Balance of payment issues aside, I strongly believe that well managed and supervised large integrated financial institutions play a constructive and necessary role in the financial intermediation process which is central to the public policy goals of economic growth, rising standards of living and job creation. While the business models of the relatively small number of large and complex financial institutions in the U.S. and abroad differ somewhat from one to another, as a broad generalization most are engaged to varying degrees in (1) traditional commercial banking; (2) securities underwriting; (3) a range of trading activities including at least some elements of ``proprietary'' trading; (4) financial advisory services; (5) asset management services including the management of so-called ``alternative'' investments; (6) private banking; and (7) elements of principal investing. All of these large integrated financial groups are indeed large with balance sheets ranging from the high hundreds of billions to $2.0 trillion or so. Among other things, it is their size that allows these institutions to meet the financing needs of large corporations--to say nothing of the financing needs of sovereign governments. The fact that so many of these large corporations operate on a global scale is one of the reasons why almost all large financial intermediaries also have a global footprint. As an entirely practical matter, it is very difficult to imagine how the vast financing needs of corporations and governments could be met on anything like today's terms and conditions absent the ability and willingness of these large intermediaries to place at risk very substantial amounts of their own capital in serving these companies and governments. One of the best examples of this phenomenon is the role large intermediaries have played in the recent past in raising badly needed capital for the financial sector itself. For example, over the past 2 years banking institutions in the U.S. and abroad have raised more than one-half trillion dollars in fresh private capital and the capital raising meter is still running. While there were some private placements, the overwhelming majority of such capital was raised in the capital markets and the associated underwriting, operational and reputational risks associated with such capital raising, were absorbed by various combinations of the small number of large integrated financial groups. Moreover, many of these transactions took the form of rights offerings which involve extended intervals of time between pricing and final settlement thus elevating underwriting risks. The ability and willingness of these large integrated financial groups to assume these risks depends crucially on large numbers of experienced investment bankers and highly skilled equity market specialists who are able to judge the tone and depth of the markets in helping clients shape the size, structure, and pricing for such transactions. More broadly, to a greater or lesser degree, most of these large integrated financial groups also act as day-to-day market makers across a broad range of financial instruments ranging from Treasury securities to OTC derivatives. The daily volume of such market activities is staggering and can be measured in hundreds of thousands--if not millions--of transactions. As market makers, these institutions stand ready to purchase or sell financial instruments in response to their institutional (and sometimes governmental) clients and counterparties. As such, market-making transactions--by their very nature--entail substantial capital commitments and risk-taking by the market maker. However, the capital that is provided in the market-making process is the primary source of the liquidity that is essential to the efficiency and price discovery traits of financial markets. Moreover, in today's financial environment, market makers are often approached by clients to enter into transactions that have notional amounts that are measured in hundreds of millions, if not billions, of dollars. Since transactions of these sizes cannot be quickly laid off or hedged, the market makers providing these services to institutional clients must have world-class risk management systems and robust amounts of capital and liquidity. Thus, only large and well capitalized institutions have the resources, the expertise and the very expensive technological and operating systems to manage these market-making activities. Having said that, it is also true that some of these activities are, indeed, high risk in nature. Thus, the case for greater managerial focus, heightened supervisory oversight and still larger capital and liquidity cushions for certain activities are all part of the postcrisis reform agenda. Fifth; in terms of both competition and regulatory arbitrage there is a critical international component to the outcome of the debate on alternative financial market structure in the U.S. That is, if the United States adopted a materially different and more restrictive statutory framework for banking and finance than, for example, Europe, the outcome could easily work to the competitive disadvantage of U.S. institutions. Similarly, such an outcome would, inevitably, introduce new pressures in the area of financial protectionism which, given the existing threats on the trade protection front, is one of the last things our country and the world need. Finally, if there are material international differences in financial structure and the ``rules of the road'' governing banking and finance, it is inevitable that one way or another, clever people, aided by highly sophisticated technology, will find ways to game the system. To summarize, even before approaching the very complex issue surrounding the pros and cons of alternative financial structures and effectively resolving the ``Too Big to Fail'' problem, we must recognize that even modest financial restructurings that would directly affect only a small number of institutions worldwide raise many questions about the laws of unintended consequences especially in the context of the larger agenda for reform discussed in Section I.Section III: The Merits of Alternative Financial Structures There is no question that the drive to shrink the size and activities of large and complex financial institutions is understandably driven by the political and public outrage about the use of tax payer money to ``bail out'' institutions that were deemed to be ``Too Big to Fail.'' Given that reality, it follows that many observers believe that the easiest way to solve the problem is via some combination of shrinking the size of these institutions, and/or restricting their activities in ways that will curtail risk and mitigate the conflicts of interest. Having said that, it is also true that while financial excesses were unquestionably one of the causes of the crisis, shortcomings in public policy were important contributing factors. Similarly, not all ``banks'' that received direct tax payer support were large and complex institutions. Moreover, the largest single source of write-downs and losses in financial institutions--complex or not--occurred in traditional lending activities not trading activities. Regrettably, these lending driven losses and write-downs were magnified by certain classes of securitization especially very complex and highly leveraged instruments. Finally, it is also undeniable that all classes of financial institutions--big banks, small banks, investment banks (including Goldman Sachs) and so-called ``near banks''--to say nothing of businesses small and large--benefited substantially from the large scale extraordinary measures taken by governments and central banks to cushion the economic and financial fallout of the crisis. The most radical of the restructuring suggestions is the so-called ``narrow bank'' which would essentially take deposits and make loans. As I see it, and with the exception of community banks, this approach is a nonstarter given the long history of credit problems over the business and credit cycle. In other words restricting diversification of risk and revenues is hardly a recipe for stability. A less extreme, but still transformational structural change has been suggested by Chairman Volcker and endorsed by President Obama. While the broad intent of the Volcker approach is quite clear there are a number of open definitional and important technical details that are yet to be clarified. One area of particular importance relates to the definition of proprietary trading and, in particular, the distinction between ``prop'' trading and market making. As I see it, client-driven market making and the hedging and risk management activities growing out of such market making are natural activities of banks and Bank Holding Companies. As such, these activities are subject to official supervision, including on site inspections, capital and liquidity standards and various forms of risk related stress tests. The Volcker plan would also prohibit ``banks'' and Bank and Financial Services Holding Companies from owning or sponsoring hedge funds and private equity funds. I believe that the financial risks associated with such ownership or sponsorship can be effectively managed and limited by means short of outright prohibition although bank owners or sponsors of such funds should not be permitted to inject fresh capital into an existing fund without regulatory approval. More generally, it should be noted that hedge funds and private equity funds are providing both equity and debt financing to small and medium sized businesses in such vital areas as alternative energy and technology ventures. Given the long term benefits of these activities, I also believe there is something to be said for the proposition that, subject to appropriate safeguards, regulated Bank Holding Company presence in the hedge fund and private equity fund space can help to better promote best industry practice. I am also mindful of the conflict of interest issue raised by Chairman Volcker. There is nothing new about potential conflicts in banking and finance. However, it cannot be denied that in the world of contemporary finance--with all of its complexities and applied technology--managing potential conflicts has become much more challenging. Reflecting that fact of life, so-called ``Chinese Walls'' segregating some business units from others is a necessary, but not sufficient, condition for managing potential conflicts. That is why at Goldman Sachs (and other large integrated intermediaries) conflict management policies and procedures are constantly evolving and improving. Goldman Sachs has established numerous committees and processes to help mitigate potential conflicts. We have a high level Firmwide Business Practices Committee which focuses on operational and reputational risk, including conflict management. We have a dedicated and independent high level worldwide Conflict Management team. We have a Firmwide Risk Committee which focuses on financial risk. The Firm's independent Legal and Compliance divisions, both of which have centralized teams of experts and high level officials who are embedded, but still independent, within all of the revenue producing business units, contribute to conflicts management. All of these committees and business areas are headed by senior officers who sit on the Management Committee. Side by side we have a Suitability Committee and a New Products Committee. In addition, our Capital Committee and Commitments Committee as well as all Division Heads share in the responsibility of helping to manage conflicts and reputational risk.Section IV: The Challenges Associated With Enhanced Resolution Authority There is little doubt that a well designed and well executed framework of Enhanced Resolution Authority can address the Too Big to Fail problem and the related Moral Hazard problem. However, it is also true that a poorly designed and poorly executed approach to Enhanced Resolution Authority could produce renewed uncertainty and instability. Indeed, under the very best of circumstances, the timely and orderly wind-down of any systemically important financial institution--especially one with an international footprint--is an extraordinarily complex task. That is why, at least to the best of my recollection, we have never experienced such an orderly wind-down anywhere in the world. In other words, even if we successfully implement all of the reforms outlined in Section I of this statement, that success by itself, will not ensure that Enhanced Resolution Authority can achieve its desired effects. Thus, great care must be used in the design of the approach to law and regulation for a system of Enhanced Resolution Authority. I, of course, have no monopoly on thoughts on how to best approach this task. On the other hand, as someone who has devoted much of my career to improving what I like to call the plumbing of the financial system I do have some suggestions as to (1) certain principles that I believe should guide the effort and (2) certain prerequisites that should be in place to guide the execution of a timely and orderly wind-down or merger of a failing systemically important financial institution.Guiding Principles First; the authorizing legislation and regulations must not be so rigid as to tie the hands of the governmental bodies that will administer those laws and regulations because it is literally impossible to anticipate the future circumstances in which the authorities will be required to act. Second; in my judgment, the authority and responsibility to carry out Enhanced Resolution Authority in a given situation should be vested in governmental bodies that have sufficient experience with the type of institution being resolved. Third; Enhanced Resolution Authority should be administered using the ongoing approach which probably means the troubled institution would be placed into temporary conservatorship or a similar vehicle allowing that institution to continue to perform and meet its contractual obligations for a limited period of time. As a precondition for conservatorship, one or more of the Executive Officers and the Board of the institution would be removed. The ongoing approach has many benefits including (1) preserving the value of assets that might be sold at a later date; (2) minimizing the dangerous and panic prone process of simultaneous close out by all counterparties and the need of such counterparties to then replace their side of many of the closed-out positions; and (3) reducing, but by no means eliminating, the very difficult and destabilizing cross-border events that could otherwise occur as witnessed in the Lehman episode. However, the ongoing approach is not without its problems, one of which is the sensitive question of how well an institution in conservatorship for a limited period of time can fund itself. Fourth: to the maximum extent possible, the rights of creditors and the sanctity of existing contractual rights and obligations need to be respected. Indeed, if the exercise of Enhanced Resolution Authority is seen to arbitrarily violate creditor rights or override existing contractual agreements between the troubled institution and its clients, its creditors, and its counterparties, the goal of orderly wind-down could easily be compromised and the resultant precedent could become a destabilizing source of ongoing uncertainty. Finally; the orderly wind-down of any large institution--particularly such an institution having a global footprint--is a highly complex endeavor that will take patience, skill and effective communication and collaboration with creditors, counterparties and other interested parties. Shrinking a balance sheet or selling distinct businesses or classes of assets or liabilities may prove relatively simple but the winding down of trading positions, hedges, positions in financial ``utilities'' such as payments, clearance and settlement systems is quite another matter.Prerequisites for Success: First; as a part of the reform of supervisory policy and practice, supervisory authorities responsible for systemically important institutions must work to insure that ``prompt corrective action'' becomes a reality not merely a slogan. Second; the official community must work with individual systemically important institutions to ensure that all such institutions have--or are developing--the systems and procedures to provide the following information in a timely fashion. Comprehensive data on all exposures to all major counterparties and estimates of all such exposures of counterparties to the failing institution Valuations consistent with prevailing market conditions that are available across a substantially complete range of the firm's asset classes (including derivative and securities positions) Accurate and comprehensive information on a firm's liquidity and the profiles of its assets and liabilities Fully integrated, comprehensive risk management frameworks capable of assessing the market, credit, and liquidity risks associated with the troubled institution Legal agreements and transaction documents that are available in an organized, accessible form Comprehensive information on the firm's positions with exchanges, clearing houses, custodians and other institutions that make up the financial system's infrastructure I am under no illusion that these guiding principles and prerequisites are anything close to the last word in seeking assurances that Enhanced Resolution Authority can deliver on the promise of a stability driven solution to the ``Too Big to Fail'' problem. On the other hand, I very much hope these suggestions will help to stimulate discussion and debate on this critically important subject. ______ CHRG-111shrg52619--198 RESPONSE TO WRITTEN QUESTIONS OF SENATOR CRAPO FROM DANIEL K. TARULLOQ.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 approaches of establishing systemic risk regulation and reassessing current statutory patterns of functional regulation need not be mutually exclusive, and Congress may want to consider both. Empowering a governmental authority to monitor, assess and, if necessary, curtail systemic risks across the entire U.S. financial system is one way to help protect the financial system from risks that may arise within or across financial industries or markets that may be supervised or regulated by different financial supervisors or that may be outside the jurisdiction of any financial supervisor. AIG is certainly an example of a firm whose connections with other financial entities constituted a distinct source of systemic risk. At the same time, strong and effective consolidated supervision provides the institution-specific focus necessary to help ensure that large, diversified organizations operate in a safe and sound manner, regardless of where in the organization its various activities are conducted. Indeed as I indicated in my testimony, systemic risk regulatory authority should complement, not displace, consolidated supervision. While all holding companies that own a bank are subject to group-wide consolidated supervision under the Bank Holding Company Act (12 U.S.C. 184141 et seq.) other systemically significant companies may currently escape such supervision. In addition, as suggested by your question, Congress may wish to consider whether a broader and more robust application of the principle of consolidated supervision would help reduce the potential for the build up of risk-taking in different parts of a financial organization or the financial sector more broadly. This could entail, among other things, revising the provisions of Gramm-Leach-Bliley Act that currently limit the ability of consolidated supervisors to monitor and address risks at functionally regulated subsidiaries within a financial organization and specifying that consolidated supervisors of financial firms have clear authority to monitor and address safety and soundness concerns in all parts of an organization.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. There are two separate, but related, questions to answer in thinking about regulation of large, complex financial institutions. The first pertains to the substantive regulatory approaches to be adopted, the second to how those regulatory tasks will be allocated to specific regulatory agencies. As to the former question, in considering possible changes to current arrangements, Congress should be guided by a few basic principles that should help shape a legislative program. First, recent experience has shown that it is critical that all systemically important firms be subject to effective consolidated supervision. The lack of consolidated supervision can leave gaps in coverage that allow large financial firms to take actions that put themselves, other firms, and the entire financial sector at risk. 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. Second, it is important to have a resolution regime that facilitates managing the failure of a systemically important financial firm in an orderly manner, including a mechanism to cover the costs of the resolution. 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 interest in ensuring the orderly resolution of nonbank financial institutions when a failure would pose substantial systemic risks. With respect to the allocation of regulatory missions among agencies, one can imagine a range of institutional arrangements that could provide for the effective supervision of financial services firms. While models adopted in other countries can be useful in suggesting options, the breadth and complexity of the financial services industry in the United States suggests that the most workable arrangements will take account of the specific characteristics of our industry. As previously indicated, we suggest that Congress consider charging an agency with an explicit financial stability mission, including such tasks as assessing and, if necessary, curtailing systemic risks across the U.S. financial system. While establishment of such an authority would not be a panacea, this mission could usefully complement the focus of safety and soundness supervisors of individual firms.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. Identifying whether a given institution's failure is likely to impose systemic risks on the U.S. financial system and our overall economy depends on specific economic and market conditions, and requires substantial judgment by policymakers. That 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 whole or in part. In addition, from the point of view of maintaining financial stability, it is critical that such a wind down occur in an orderly manner, the reason for our recommendation for improved resolution procedures for systemically financial firms. Still, even without improved procedures, it is important to try to resolve the firm in an orderly manner without guaranteeing the longer-term existence of any individual firm. The core concern of policymakers should be whether the failure of the firm would likely have contagion, or knock-on, effects on other key financial institutions and markets, and ultimately on the real economy. Such interdependencies can be direct, such as through deposit and loan relationships, or indirect, such as through concentrations in similar types of assets. Interdependencies can extend to broader financial markets and can also be transmitted through payment and settlement systems. The failure of the firm and other interconnected firms might affect the real economy through a sharp reduction in the supply of credit, or rapid declines in the prices of key financial and nonfinancial assets. 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.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. 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, particularly in a crisis, because of the risks that 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. It reduces market discipline and encourages excessive risk-taking by the firm. It also provides an 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, government rescues of such firms can involve the commitment of substantial public resources, as we have seen recently, with the potential for taxpayer losses. In the midst of this crisis, given the highly fragile state of financial markets and the global economy, government assistance to avoid the failures of major financial institutions was deemed necessary to avoid a further serious destabilization of the financial system, with adverse consequences for the broader economy. Looking to the future, however, it is imperative that policymakers address this issue by better supervising systemically critical firms to prevent excessive risk-taking and by strengthening the resilience of the financial system to minimize the consequences when a large firm must be unwound. Achieving more effective supervision of large and complex financial firms will require, at a minimum, the following actions. First, supervisors need to move vigorously to address the capital, liquidity, and risk management weaknesses at major financial institutions that have been revealed by the crisis. Second, the government must ensure a robust framework--both in law and practice--for consolidated supervision of all systemically important financial firms. Third, the Congress should put in place improved tools to allow the authorities to resolve systemically important nonbank financial firms in an orderly manner, including a mechanism to cover the costs of the resolution. Improved resolution procedures for these 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.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. As a general matter, a company is considered to have ``failed'' if it no longer has the capacity to fund itself and meet its obligations, is insolvent (that is its obligations to others exceed its assets), or other conditions exist that permit a governmental authority, a court or stakeholders of the company to put the firm into liquidation or place the company into a conservatorship, receivership, or similar custodial arrangement. Under the Federal Deposit Insurance Act (FDIA), for example, a conservator or receiver may be appointed for an insured depository institution if any of a number of grounds exist. See 12 U.S.C. 1821(c)(5). Such grounds include that the institution is in an unsafe or unsound condition to transact business, or the institution has incurred or is likely to incur losses that deplete all or substantially all of its capital and there is no reasonable prospect for the institution to become adequately capitalized without federal assistance. In the fall of 2008, American International Group, Inc. (AIG) faced severe liquidity pressures that threatened to force it imminently into bankruptcy. As Chairman Bernanke has testified, the Federal Reserve and the Treasury determined that AIG's bankruptcy under the conditions then prevailing would have posed unacceptable risks to the global financial system and to the economy. Such an event could have resulted in the seizure of its insurance subsidiaries by their regulators--leaving policyholders facing considerable uncertainty about the status of their claims--and resulted in substantial losses by the many banks, investment banks, state and local government entities, and workers that had exposures to AIG. The Federal Reserve and Treasury also believed that the risks posed to the financial system as a whole far outstripped the direct effects of a default by AIG on its obligations. For example, the resulting losses on AIG commercial paper would have exacerbated the problems then facing money market mutual funds. The failure of the firm in the middle of a financial crisis also likely would have substantially increased the pressures on large commercial and investment banks and could have caused policyholders and creditors to pull back from the insurance industry more broadly. The AIG case provides strong support for a broad policy agenda that would address both systemic risk and the problems caused by firms that may be viewed as being too big, or too interconnected, to fail, particularly in times of more generalized financial stress. A key aspect of such an agenda includes development of appropriate resolution procedures for potentially systemic financial firms that would allow the government to resolve such a firm in an orderly manner and in a way that mitigates the potential for systemic shocks. As discussed in my testimony, other important measures that would help address the current too-big-to-fail problem include ensuring that all systemically important financial firms are subject to an effective regime for consolidated prudential supervision and vesting a government authority with more direct responsibility for monitoring and regulation of potential systemic risks in the financial system. ------ CHRG-111hhrg48868--292 Mr. Foster," No, my point was more should we allow this level of complexity? Ms. Williams, did you have any comments on this? [no response] " FinancialCrisisInquiry--123 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. CHAIRMAN ANGELIDES: Thank you very much, Mr. Solomon. We’ll now begin our questioning. In this round, members, I’m going to actually not start off. I’m going to— Mr. Vice Chairman, do you want to ask some questions to start? 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-111shrg50814--47 Mr. Bernanke," For example, mortgage companies a couple years ago. Or, on the other hand, I think for a given institution, a much larger, more complex institution is more likely to---- Senator Schumer. But you do not rule out some regulation of the smaller---- " CHRG-111hhrg52406--157 Mr. Pollock," Congressman, I just would like to underline the point you made that a lot of extremely complex and confusing disclosure that we have, as you pointed out, is the result of regulation. " CHRG-111hhrg53242--6 Mr. Neugebauer," Thank you, Mr. Chairman. I appreciate the witnesses providing us today with their views on the Administration's financial regulatory restructuring proposal. While we have draft legislation covering a few of these areas now, I hope that we will have an opportunity to get further feedback when we actually have additional legislative language, particularly with regard to over-the-counter derivative proposals. There seems to be an agreement with broad principles of the Administration's proposal on improving transparency and information about the activities in this market. But with complex products in a complex marketplace, the devil will certainly most be in the details. At the end of the day, we must ensure businesses large and small, hedge risks, particularly risks that are customized to their particular business, and having the ability to do so. We shouldn't take actions that make users of derivatives less competitive, and we shouldn't take actions that put U.S. markets at a disadvantage with our competitors. As we consider options to correct regulatory failures, we have to acknowledge that the government cannot micromanage our capital markets to prevent future failures or losses. Government regulation can't substitute for due diligence for investors and other market participants. They need to know, in no uncertain terms, the responsibility rests on them and that future government bailouts for poor behavior are not an option. Basically, what we have seen so far is product regulation, not a new way of doing business in the regulatory structure. And one of the concerns I have is that in product regulation, we are trying to protect investors from themselves. What we do need, though, is a robust look at the way we have been doing business, looking at where the failures were in the system and making sure that we address those, but not radically changing the way that businesses have been able to take precautions to hedge their risks, which in fact protect investors, and also make sure that the marketplace is a more streamlined place to do business in a way that we can make sure that American markets continue to be very competitive. With that I yield back. " CHRG-111shrg54533--79 Secretary Geithner," In everything we do, we have to be careful that we are making the system stronger and not making it more vulnerable. And we try to be very careful and try to anticipate the potential adverse consequences of these changes. And, again, we want a system that can adapt in the future, because we will not have the foresight today to anticipate and deal with preemptively any potential source of a risk. We want a system that can adapt more flexibly in the future as our system evolves, as innovation proceeds. Senator Kohl. Thank you. Thank you so much, Mr. Chairman. Senator Johnson. Thank you. Mr. Secretary, I applaud your recommendation to create an Office of National Insurance in your reform proposal. Can you expand on other ways the Treasury envisions modernizing and improving our system of insurance regulation? " 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. FOMC20080430meeting--290 288,MR. ROSENGREN.," Okay. Just a quick question, which doesn't have to be answered now--given all of the financial turmoil, it would be interesting to see whether in other countries that have these different arrangements there was a decrease in either overnight or term lending with counterparties. Given the extent to which you can just work with a central bank rather than counterparties, is there any evidence in these other regimes that interbank lending transaction volume disappeared in some of these countries? I would be interested in seeing that. Regarding Governor Kroszner's comment on the H.4.1 release, it does seem that we could probably have a materiality requirement in our balance sheet. Under most circumstances, what we are doing at the discount window would seem not to hit that materiality criterion. I think we could be a little more innovative--I agree with President Lacker's point--but I think that the H.4.1 does seem to have an effect; and if we will be doing all these other things, taking another look at the H.4.1 and making sure that we don't have more untapped flexibilities probably makes a lot of sense. I would like a little more discussion of ""promote efficient and resilient money markets and government securities markets"" as a criterion. I'm not sure I would weight those criteria equally. It seems that all these criteria, for the most part, take care of most of the dead weight loss; and given that the banks still have to administrate for daylight credit, I am not sure that the burden is all that different across these various regimes. But I can imagine that that one might be different, and given we just had financial turmoil--I know this is a bit different from what President Lacker said--I would put a little more attention to that. Overall, I like option 2 and option 5. I'm comfortable with those two. I'm attracted to the voluntary balance program. On net, I would probably prefer a longer maintenance period to a one-day maintenance period, but I don't have a strong preference and could easily be convinced otherwise. " 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-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-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-111shrg55739--97 Mr. Joynt," A complex question, but in today's market environment, there is very little in the way of new complex instruments being issued. So in some way we have sort of a time to reassess. Some of the most complex instruments in the markets, CDO-squared and CPDOs, I think we took almost 6 months to analyze CPDOs before deciding that we could not rate them with our highest rating, and that was a very difficult process of analysts, modelers, and experienced people with judgment trying to think about the subjective aspects of the risk. It was mentioned earlier ratings have reflected the probability of loss, but some of these products where it was more important to think about the severity of the loss, how much you might lose when they go bad, and ratings were not and had not and have not been structured to address that, and maybe they need to be. We are working on that now as well. So I would say we have a healthy degree of skepticism about the complexity of the instruments. Today we have been asked to rate some resecuritizations that were mentioned earlier as well. We have only been willing to rate one class of security rather than tranche securities because in the tranching process they are creating strips that, if the probability of loss is wrong, you will have great severity. So we are uncomfortable assigning ratings of that type today. So today I would say we are pausing and reassessing how we do the analysis and what the ratings mean. Senator Shelby. OK. Professor White, you pointed out that credit rating agencies include disclaimers with their ratings, telling users not to rely on credit rating agencies in making investment decisions. Likewise, the SEC has directed money market funds not to rely solely on ratings by Nationally Recognized Statistical Rating Organizations in making their investment decisions. Does the fact that regulations require ratings send a signal that contradicts these disclaimers? " 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-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-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-111shrg61513--60 Mr. Bernanke," Well, I think for no other reason than just trying to reduce uncertainty in the markets, the sooner that you can come to some clarity on the future of Fannie and Freddie, the better. Of course, I understand that you are dealing with a lot of complex issues in financial reform and health care and in other areas right now. But it would be, obviously, helpful to try to get some clarity on that. That does not mean necessarily that you can get to that new situation quickly. It is going to take some time to move from the current situation to a more stable long-run situation. But certainly I hope Congress is looking at this issue now and thinking about where you want to go. Senator Vitter. OK. We are really not looking at the issue now, at least in a meaningful way. And the schedule, as I understand it, particularly from Treasury, is not until 2011. Is there any good reason, in your opinion, to essentially put that off to 2011? " CHRG-111hhrg53238--93 Mr. Courson," I certainly agree. And I think the key is--and there been those also who say that this might not even be prescriptive. You have a plain vanilla, and you can still then, once you have your plain vanilla, offer other products. But I think if you have a regulator out there that has the ability to call a product down the line out of bounds, that you clearly are going to move--lenders are going to move very reluctantly and with great trepidation of innovating products that may later be deemed to be ``out of bounds.'' And the other piece of that is, if the secondary market authority exists, consumers are going to pay more because the market is going to demand a premium for a product that they may buy, put on their balance sheet or secure, as it may not exist going down in the future. " CHRG-109hhrg23738--87 Mr. Greenspan," I think that is describing the situation quite correctly. It is called a learning process. It has taken us a considerable period to understand the internal mechanisms of how those GSEs function, what their structure is with respect to securitization and portfolio accumulation, how they make their profits, how they are a profit-making organization, primarily, and how they try to meld that with their housing GSE goals. It is a very complex system. I have been in the financial system for many, many decades, and when I first took a look at them, I did not understand how they worked, I mean what it is they were doing, and it took a while; and I must say that, with the help of Federal Reserve staff, we learned how they worked, and as we learned, we recognized the extent of the type of risks which they impose on the structure. And so our changing view is merely a learning curve, and we did not understand the significance 2 years ago, for example, of what was going on. " CHRG-110shrg46629--37 Chairman Bernanke," These are all on our agenda. The top page of the mortgage documents that you are alluding to is part of our Regulation Z review which will cover all home mortgage advertising solicitation and disclosures. One concern we have about that is just that in the past these disclosures have been written by lawyers sitting in an agency. And when we put them out, the public does not understand what it really means. And so if you are going to have effective disclosures, they have to be done in a way that ordinary people can understand what the implications are. And for that reason we have, for the Government at least, been very innovative in making sure that all of our disclosures are being consumer tested and focus group tested. And we are making sure that people really do understand what the disclosure is telling them. I think that is critical if this is really going to be effective and not just a cosmetic step. Senator Brown. And you can write that prescriptively in your rule? " 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-111shrg55278--2 Chairman Dodd," I will make some opening comments, turn to Senator Shelby for his, and then we will invite our very distinguished witnesses to join us at the witness table, and I will in advance apologize to them if we interrupt your testimony once the 12th Member arrives here, to go back into executive calendar to deal with this legislation. So let us shift gears, if we can now, to the hearing, and that is, as I mentioned earlier, a hearing to establish a framework for systemic risk regulation. Let me just share some thoughts, if I can. And, again, we have had a lot of discussion about this subject matter over the last number of months. We have had some 40 hearings in this Committee since January, not all of it on this subject matter, but the bulk of the hearings have been on this whole issue of how do we modernize our financial regulatory structure not only to address the problems that have brought us to this point, but also how do we create that architecture for the 21st century that will allow us to move forward with innovation and creativity that has been the hallmark of our financial services sector, and yet once again restore that credibility of safety and soundness that has been the hallmark, I think, of our financial services sector for so many years, and yet collapsed, in the views of many, over the last number of years, resulting in the economic problems that so many of our fellow citizens are facing, with joblessness, with house foreclosures, retirement accounts being wiped out, and all of the ancillary problems that our economy is suffering through. Systemic risk is going to be an important factor in all of this, and I cannot begin to express my gratitude to my fellow Members here because, unlike other matters that the Congress is dealing with, my sense is on this subject matter this is not one that has any ideology, that I can sense, to it at all. What all of us want is to figure out what works best, what makes sense for us here--not that we are going to solve every future problem. I think we make a mistake if we are sort of promising what we cannot deliver on. There will be future problems, and we are not going to solve every one of them. But if we look back a bit and see where the gaps have been, either, one, where there was no authority or, two, where there was authority but it was not being exercised, then how we fill those gaps in a way that makes sense I think will be a major contribution. And I want to particularly thank Senator Shelby, the former Chairman of this Committee, the Ranking Member now. We have had a lot of conversations together. We do not have a bill ready at all. There has been a lot of talk at this point. But I get a sense among my colleagues, as I have discussed the subject matter with them, that we share a lot of common views about this, and that is a good place to begin. It does not mean we are going to agree on every answer we have, but I sense that the overwhelming majority of us here are committed to that goal of establishing what makes sound and solid regulatory process. The economic crisis introduced a new term in our national vocabulary: ``systemic risk.'' Not words we use much. I do not recall using those words at all back over the years. It is the idea that in an interconnected global economy, it is easy for some people's problems to become everybody's problems, and that is what systemic risk is. The failures that destroyed some of our Nation's most prestigious financial institutions also devastated the economic security of millions of working Americans who did nothing wrong and never heard of these institutions that collapsed and put them at great risk. Jobs, homes, and retirement security were gone in a flash because Wall Street greed in some cases, regulatory neglect in others, resulted in these problems. After years of focusing on short-term profits while ignoring long-term risk, a number of companies, giants of the financial industry, found themselves in very serious trouble. Some, as we know, tragically, failed. Some were sold under duress. And an untold number only survived because of Government intervention--loans, guarantees, direct injections of capital. Taxpayers had no choice but to step in--and that is my strong view--assuming billions of risk and saved companies because our system was not set up to withstand their failure. Their efforts saved our economy from catastrophe, but real damage remains, as we all are painfully aware. Investors who lost billions were scared to invest. Credit markets dried up, with no one willing to make loans. Businesses could not make payrolls. Employees were laid off and families could not get mortgages or loans to buy an automobile, even. Wall Street's failures have hit Main Street, as we all know, across our Nation, and it will take years, perhaps decades, to undo the damage that a stronger regulatory system I think could have prevented. And while many Americans understand why we had to take extraordinary measures this time, it does not mean that they are not angry, because they are. It does not mean they are not worried, and they certainly are that. And it does not mean they do not expect us to fix the problems that allowed this to happen. First and foremost, we need someone looking at the whole economy for the next big problem with the authority to do something about it. The Administration has a bold proposal to modernize our financial regulatory system. It would give the Federal Reserve new authority to identify, regulate, and supervise all financial companies considered to be systemically important. It would establish a council of regulators to serve in a sole advisory role. And it would provide a framework for companies to fail, if they must fail, in a way that does not jeopardize the entire financial system. It is a thoughtful proposal, but the devil, obviously, we all know, is in the details, and I expect changes to be made in this proposal. I share my colleagues' concerns about giving the Fed additional authority to regulate systemic risk. The Fed has not done a perfect job, to put it mildly, with the responsibilities it already has. This new authority could compromise the independence the Fed needs to carry out effective monetary policy. Additionally, systemic risk regulation involves too broad of a range of issues, in my view, for any one regulator to be able to oversee. And so I am especially interested to hear from our witnesses this morning on your ideas and how we might get this right. Many of you have suggested a council with real authority that would effectively use the combined knowledge of all of the regulatory agencies. As President Obama has said, when we rebuild our economy, we must ensure that its foundation rests on a rock, not on sand. And today we continue our work to lay the cornerstones of that foundation--strong, smart, effective regulation that protects working families without hindering growth, innovation, and creativity that has been, again, the hallmark, as I said earlier, of our financial services sector. With that, let me turn to Senator Shelby, and then I will introduce our first panel. FinancialCrisisInquiry--400 VICE CHAIRMAN THOMAS: Thank you. And I’m going it ask Mr. Mayo a question as well. But that’s why I do want to, once again, extend to you a willingness, if you are willing, to have the record run until we’re done in terms of our work so that we could get back to you as we, again, get more sophisticated and understand the questions we should have asked and work with them. And appreciate your willingness to do that. Mr. Mayo, I like your sheets on the ten points. My question to you: Given the complexity of a bank’s financial statements, the derivative off-balance-sheet position that we talked about, how are you able to—I mean, they all claim that they have adequate capital. How difficult is it for you to get a clear picture of what is actually there? Are current SEC disclosures sufficient if you’re good enough and have a bright enough light? Or is that an area that we could talk about looking at as well as, perhaps, was one of the problems; no one could get a clear picture of what the situation actually was until, of course, after the fact? CHRG-110hhrg44903--11 Mr. Hensarling," Thank you, Mr. Chairman. I find it somewhat ironic that we would be holding this hearing 24 hours after we gave the Secretary of Treasury a blank check to help bail out Fannie and Freddie. It seems that we took a huge step in the wrong direction with respect to systemic risk. Moral hazard leads to more systemic risk. And I fear yesterday a very strong message was sent to every investment bank in America that if you are large enough, if you get interconnected, if you get well-connected in the halls of Congress, you can indeed figure out a way to privatize your profits and socialize your losses. And just in case somebody missed the message, we are having a serious discussion now about giving the Federal Reserve increased responsibility and ultimate authority for financial stability in our markets. This may be a good thing. It may be a bad thing. But it is also a very risky thing. And I fear that the markets will interpret this as meaning, again, that potential Fed backing is around the corner if investment banks get in trouble. I fear that, as we continue to lose market discipline, we substantially increase the chances of having yet another Fannie and Freddie debacle, perhaps another S & L debacle. I am very concerned also about where we find the role of the Federal Reserve today in all the different directions they are pulled, starting with price stability and monetary policy, minimizing unemployment. On top of that, we add a healthy dose of consumer protection. Now we are about to add potential financial stability, and oh, I at least heard the chairman say once that he cared about taxpayer protection as well. That is pulling the Fed in a lot of different directions. I do know that some believe that the ultimate answer is more regulation. I certainly believe we could have better regulation. We may need smarter regulation. I don't know if we necessarily need more regulation. And I do know that an overly restrictive regulatory regime will kill innovation and chase our capital overseas, something I do not want to see. With that, Mr. Chairman, I thank you, and I yield back the balance of my time. " CHRG-111hhrg53242--7 Mr. Kanjorski," Thank you very much, Mr. Neugebauer. Now we will hear from Ms. Waters for 3 minutes. Ms. Waters. Thank you very much, Mr. Chairman. As some of our witnesses may already know, I am very concerned with protecting our financial system from similar crises in the future. To accomplish this, we will need stronger and more innovative investor protections. We must also make sure that institutional financial instruments, such as over-the-counter derivatives, never have the chance to halt consumer or small business lending again. While products such as credit default swaps may have been sold to institutions, many of them were used to insure consumer debt in the form of CDOs. As these CDO structures failed and credit events occurred, these credit default swap contracts came due. A lack of transparency, combined with an overwhelming number of improperly collateralized swap contracts, served to freeze our lending markets and transfer billions of dollars from taxpayers to all kind of Wall Street firms such as Goldman Sachs and banks such as Bank of America. Some say we should only be concerned about naked credit default swaps, which is swaps where people have no interests insuring anything they actually own. Those who enter into naked CDS contracts are simply trying to profit from some company's bankruptcy, yet as Gillian Tett pointed out in a recent Financial Times column, even nonnaked CDSs have motivated investors to send a company into bankruptcy. No matter what shape our financial reforms take, rooting for companies, especially American companies, to fail should no longer be allowed. That is why I introduced H.R. 3145, the Credit Default Swap Prohibition Act of 2009. Banning credit default swaps is vital to preserving companies, jobs, and taxpayer funds. Our constituents and their 401(k)s will not be safe until we eliminate this product. I know that is highly controversial, and I am sure we will hear a lot of disagreement. But I thank you for arranging this hearing, Mr. Chairman, and I yield back the balance of my time. " CHRG-111shrg57321--97 Mr. Kolchinsky," Yes, sir. The synthetics, the key element of synthetics is their complexity as well as their flexibility. Senator Levin. And were they being used to short the market a lot? " CHRG-111hhrg53246--19 Mr. Lynch," Thank you, Mr. Chairman. I want to thank our panelists. I appreciate the frequency of these hearings to try to get a sense of the Administration's White Paper on regulatory reform. I would like to hear from the panelists during their testimony about the issue of these complex derivatives being traded over-the-counter. I still believe, in spite of the Administration's position, we have a big payday problem with the major banks, so I think a lot of money is going to gravitate to the OTC version of these things. There is no exchange, so we don't have a consistent valuing mechanism in place. And I just think that the complexity here is incentivized under the President's proposal. I raised these issues with Secretary Geithner in the meetings that the chairman has arranged, but I still don't think the protections are there. So I would like to hear the answer to that in your testimony. And I yield back the balance of my time. Thank you. " CHRG-111shrg61651--66 Chairman Dodd," Thank you, and let me just say again, I said at the outset in my remarks, having now just chaired this Committee in my third year, since January of 2007, the tremendous talent on this Committee. This is a hard subject matter and all of you have spent your lives involved in this. None of us claim to have lifetime experiences in all of these matters, but we have had tremendous contributions from Bob Corker and Mark Warner, Jack Reed, so many people on this Committee, delving into the various aspects of this, and it is hard work. It is difficult work. It is arcane work, in many ways, and we are all very sensitive to the notion that every good idea has an unintended consequence and trying to think through all the ripple effects of what you are suggesting. At one level, it can seem like the best idea in the world. And as you delve into it--I said the other day on these matters, I kind of regret we are not back 5 or 6 years ago when we knew a lot less about all of this than we have learned. It was easier when you knew less in terms of the answers for things. So I thank the Senator from Tennessee. He has been tremendously valuable on this Committee, along with others. Senator Reed. Senator Reed. Thank you, Mr. Chairman. Mr. Reed, I have been struck by what you have learned. I think we have learned something, too, and I think we have to carry it into the formulation of new regulations. First, we can't assume regulatory capacity adequate to the complexity of the financial markets. That is a function of funding and appropriations. It is a function of ideology. It is a function of personalities. But many of the discussions that we have heard, I think assume that, and I think that is an assumption that we have to question. The other aspect of this is managerial capacity, as you point out in your comments on culture. This would have been a different world if there had been different individuals at different institutions, but they were there. And I think also, too, in terms of who rises to the top of these complex institutions is a function not sometimes of who they are but what they do and how much money they make for the company. So I sense all of that. I think in that regard Chairman Volcker has raised the right sort of issue, but I think perhaps we have sort of taken the wrong path and we are now talking about proprietary trading and how to define it, et cetera. I think your approach is much more, I think, on target, which is what do we want? We want financial institutions, commercial banks, who focus on serving customers, who are businesses, consumers, basically, and we want them to be their core competency, et cetera. So one way to look at this is to say rather than you can't do proprietary trading, is that if your core business is just a fraction of what you do, then why should we allow you to get to the discount window? Why should we include you in Section 13(3)? That is not our policy. Our policy is to support a vigorous commercial banking system. What about that approach, Mr. Reed? " CHRG-111hhrg52397--193 Mr. Johnson," So, Congressman, I think that at the time that what AIG was doing was selling default swaps on very complex CDOs. If those credit default swaps were then subject to some type of margining certainly earlier on, the dealers that were buying those credit default swaps, to hedge their own portfolios, would have looked at it and said, ``This does not make sense. We would not be able to post a margin that the exchange would require in order for us to do this transaction.'' And margin requirements, particularly in single name default swaps, is a complex issue because the default probability that the exchange would have to calculate to get the margin is something that needs work. " CHRG-111hhrg54869--87 Mr. Volcker," I have a lot of sympathy with what the Representative from New York is saying about the loss of a sense of fiduciary responsibility. And I would like to restore that to the banks as much as possible, because they should have it. I think it is kind of hopeless in terms of--just in personal capital market operators. A tremendous amount of money, as you well know, was made in the financial system. So the incentive to get back to the situation as normal, or what was considered normal before, is pretty strong by the people who were participating. But, of course, it is that system that led us over the cliff, and with all the adverse consequences that were mentioned. And that is what we want to avoid in the future. And you talk about the capacity to make up more and more new products, get around more and more regulation. It occurs to me, as I heard you speaking, that maybe the best reform we could make is have a big tax on financial engineers so that they can't make up all these new things quite so rapidly; because it is this highly complex, opaque financial engineering which gave a false sense of confidence, which broke down. But you have outlined the challenge, and Treasury has tried to address it. The Administration has tried to address it. Many other people have made suggestions. I am making a few suggestions this morning. And you are going to have to decide. But you can't let it go without some important action. Mrs. McCarthy of New York. No, I agree with you. And I think important action is certainly where we are trying to go. And we are trying to find the right balance. Again, you know, we have a younger generation that we have been trying to convince that they should start saving. Saving in this Nation was at a zero rate before all this started. " FinancialCrisisInquiry--130 They got to raise that money, and yet it didn’t impact their total indebtedness. So it was this—it wasn’t equity, it wasn’t debt security. I think what you’re asking is should we draw lines. And I think we should absolutely draw lines between equity, preferred stock, subordinated debt, and senior debt. There should be bright lines in the cap structure of U.S. companies and not all these crazy hybrid securities where no one knows where to put into the cap structure. And I guess since I’m being brief, I wanted to add one more point that I didn’t get to make in my testimony with regard to the cap structure and the debt and the equity of these companies. When the taxpayer money comes in—and this is a separate debate. But when taxpayer money comes in to a company—I realize that Treasury was dealing with pitches as they were thrown and that this was very much ala carte model of dealing with the financial crisis because we didn’t prepare for it. But going forward, I think what has to be done from the commission’s perspective is to determine a methodology for which taxpayer money is to possibly be infused in companies. It needs to be last in and first out. It needs to be senior to the bank debt. The fact that we’re buying equity with taxpayer money is an abomination to the taxpayer. So that’s a little bit different spin on debt and equity, but that’s where those loans need to go. VICE CHAIRMAN THOMAS: Thank you very much. Thank you, Mr. Chairman. Reserve the balance of the time. CHAIRMAN ANGELIDES: Thank you, Mr. Vice Chairman. I was going to hold all my questions until the end, but I want to ask one now so I don’t forget. And that is, one thing you seem to be saying is, in a world of rapid innovation, rapid change, expansion of new industries, there’s an argument, at least for the core financial sector, to have perhaps even greater stability as opposed to, for example, all the entities out there who can take greater risk without consequence to the taxpayers. CHRG-111shrg51290--32 STATEMENT OF SENATOR SCHUMER Senator Schumer. Thank you, Mr. Chairman. Thank you for holding this hearing, and unfortunately I got here a little late, so I am going to take a little bit of my time and read my opening statement, if you don't mind. And I want to thank you and Senator Shelby for holding this hearing. I think this hearing is really important. We have a great economic crisis in our country and it extends from one end to the other. We have had an explosion of consumer debt. Now we have 12 million households that owe more on their mortgages than their house is worth. The average American family has over $8,000 in credit card debt. Mortgages and credit cards are ordinary features of middle-class life and now they are at the heart of our financial crisis. Something went awry, seriously awry. During the 1980s, I worked to pass legislation that would require disclosure on credit card terms, the ``Schumer box,'' and it had a real effect. But it doesn't do enough now, because disclosure isn't enough, and when you hear of banking institutions just raising the rates, boom, for some small almost induced mistake, you say, well, we need more, and I know that Senator Dodd, Senator Menendez, and I have been working on credit card legislation. But the deceptive practices, the predatory practices, we have seen them in the mortgage industry. The Federal Reserve was in charge of all this and did nothing. Home buyers were enticed and misled, sometimes by banks, sometimes by independent mortgage brokers, more often by the latter, but there is a serious problem. And so I would say complexity ultimately stacks the deck in favor of the financial experts who peddle the products at the expense of the consumer. So again, I am not trying to point fingers of blame here. I am trying to correct the situation. In the early 1900s, Congress created the Food and Drug Administration to protect consumers from peddlers of medicinal concoctions whose miracle elixirs did more harm than good. In today's world, we need a comparable response to peddlers of unfair and deceptive financial practices and services. And I would just say to Mr. Bartlett that all too often, they don't come only from major banking institutions or financial institutions. They come from everywhere. So this week Senator Durbin and I plan to introduce legislation to create a new regulator to provide consumers with stronger protection from excessively costly and predatory financial products and practices. The idea for a Financial Product Safety Commission was first proposed by Elizabeth Warren, professor at Harvard, in 2007. She recognized that substantial changes in the credit markets have made debt far riskier for consumers today than a generation ago and that ordinary credit transactions have become complex undertakings. Consumers are at the mercy of those who write the contracts, and simple disclosure--it is never simple anymore because the terms are so complicated--it doesn't do the job. So consumers deserve to have someone on their side, a regulator that will watch out for the average American, who will review financial products and services to ensure they work without any hidden dangers or unreasonable tricks. So the time is right for a financial services regulator with consumer focus. Professor Warren and consumer groups--CFA, Consumers Union, Public Citizen, Center for Responsible Lending--have been instrumental in helping develop the objectives and responsibilities of such a regulator and I appreciate their efforts. I also think we have got to think beyond regulatory reform of the financial system. We need to think about a new way to live, because what has happened basically over the last decade and a half is we became a country that consumed more than we produced, borrowed more than we saved, and imported more than we exported. Something has to give. And I would say the greatest challenge President Obama has after he gets us out of this financial mess is to figure out how we get back to those traditional values. We have seen it up and down the line. There are the CEOs and their salaries. We all know about that, excessive, huge, based on the short-term. We have seen it here in government with all the deficits. And we have seen it with individuals who get into debt far beyond their means. So it has been a whole societal problem that we have to do something about. The proposal that Senator Durbin and I are making is one part of that, but there are lots of other parts, and I thank you all for listening. I particularly want to thank both Ellen Seidman and Professor McCoy for arguing for this kind of thing. Do I have time for one question, Mr. Chairman? Is that OK? " CHRG-111hhrg52406--168 Mr. Ellison," Just one. And I really mean that. Thank you all for being here. My one question is, could you, perhaps Professor Warren, describe the limits of disclosure? In your testimony, you did a phenomenal job at talking about effective disclosure. But I am curious to know if in your view there are limits to that and if the consumer products board could help address some of those limitations? A quick illustration of what I mean. When I was a trial lawyer, I went and cross-examined witnesses every single day. I don't care if you were a police officer or a professor, you weren't there in that courtroom more than me, and I was going to make you look like you were lying even if you were telling the truth. People who do financial regulation, they do this every single day, even if you have a 1-pager. I mean, are there limits to disclosure, and could the board help address some of those limits in terms of just basic fairness? That is my only question. Ms. Warren. Thank you, Congressman. I want to say two things because I think you are exactly right. We have been talking about layers of complexity and how this would take out some of the complexity, but there is another point. If we make the real point about disclosure, can the consumer accurately understand what you have just done? Then the whole game shifts. So this is not about how many things can I write that make you look over here while I am really socking it to you over there. This is about someone who says, now, did you get it straight across the middle what it is that you are trying to accomplish? And you put your finger on a key point that no one has talked about, and that is expertise. You know, the largest financial institutions in this country hire literally thousands of people to play with the design of their products. I sat next to someone from Bank of America who described the number of people and the number of experts they hire. They ran 500 experiments internally on their own customers in order to determine what maximizes profits for the bank. There is no expert on the side of the consumers. And so this agency is about is leveling the playing field just a little by saying there is someone who is going to be an expert, who is going to get smart, who is going to learn to read this and be able to say, when you make a disclosure, it has to be a disclosure that is effective so that the consumer can make a real choice at the end of the day. " CHRG-111shrg57321--255 Mr. McDaniel," The actions that the SEC asked us to take, we said we would take, so we are complying. Senator Levin. This is going to complete this panel, but I just have one very brief statement. The Subcommittee now has completed three of its four hearings examining some of the causes and consequences of the 2008 financial crisis. Last week, on Tuesday, we looked at the role of high-risk mortgages. Last Friday's hearing looked at the failures of the bank regulators. Today, we looked at the role of credit rating agencies. It hasn't been a pretty picture so far and I don't think it is going to improve, although, frankly, the beginning of the Senate debate on strong financial reform next week does give us some hope. The final hearing of this quartet will be next Tuesday, when we are going to look at the role of investment banks, with Goldman Sachs being the case history. Our investigation has found that investment banks, such as Goldman Sachs, were not market makers helping clients. They were self-interested promoters of risky and complicated financial schemes that were a major part of the 2008 crisis. They bundled toxic and dubious mortgages into complex financial instruments, got the credit rating agencies to label them as AAA safe securities, sold them to investors, magnifying and spreading risk throughout the financial system, and all too often betting against the financial instruments that they sold and profiting at the expense of their clients. I am introducing into the record now four exhibits that we will be using at the Tuesday hearing to explore the role of investment banks during the financial crisis. We will be putting those exhibits up on the Subcommittee's Website either tonight or tomorrow. We thank this panel. We appreciate your being here. You have given us a great deal of documents. You have cooperated with this Subcommittee and we appreciate it. We will stand adjourned. Ms. Corbet. Thank you. " FinancialCrisisInquiry--833 ROSEN: It’s very puzzling because they wrote the right paper. A key Federal Reserve Board member was pushing it very hard. It was—and I don’t know why it didn’t happen. The chairman was a pretty strong guy, and I suspect that was it. But maybe read Ned Gramlich’s book because he’s written a whole book on this topic before he passed away. I think it would be worth it to find out why they didn’t do it. A lot of them did believe, though, there was—it wasn’t really happening; it was demographics. It wasn’t predatory; it was just market innovation at work. January 13, 2010 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. CHRG-111shrg53085--113 Mr. Whalen," Just to answer Senator Warner's question, it comes down to suitability when you are talking about complex institutional products that could hurt a bank or hurt a pension fund or a public agency that has to invest on behalf--these are nonprofessionals, oftentimes, as I describe them. These people cannot model the risks in these securities, so they should not be shown them in the first place. And I say this as a reformed investment banker. Ninety-nine percent of the people in this world cannot possibly understand complex structured assets or over-the-counter derivatives. They are not suitable. They should not be sold to these people in any case. Senator Warner. But haven't we proven the case that even in some cases the uppermost levels---- " fcic_final_report_full--435 TURNING BAD MORTGAGES INTO TOXIC FINANCIAL ASSETS The mortgage securitization process turned mortgages into mortgage-backed securi- ties through the government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac, as well as Countrywide and other “private label” competitors. The securitiza- tion process allows capital to flow from investors to homebuyers. Without it, mort- gage lending would be limited to banks and other portfolio lenders, supported by traditional funding sources such as deposits. Securitization allows homeowners ac- cess to enormous amounts of additional funding and thereby makes homeownership more affordable. It also can diversify housing risk among different types of lenders. If everything else is working properly, these are good things. Everything else was not working properly. Some focus their criticism on the form of these financial instruments. For exam- ple, financial instruments called collateralized debt obligations (CDOs) were engi- neered from different bundled payment streams from mortgage-backed securities. Some argue that the conversion of a bundle of simple mortgages to a mortgage- backed security, and then to a collateralized debt obligation, was a problem. They ar- gue that complex financial derivatives caused the crisis. We conclude that the details of this engineering are incidental to understanding the essential causes of the crisis. If the system works properly, reconfiguring streams of mortgage payments has little ef- fect. The total amount of risk in a mortgage is unchanged if the pieces are put to- gether in a different way. Unfortunately, the system did not work as it should have. There were several flaws in the securitization and collateralization process that made things worse. • Fannie Mae and Freddie Mac, as well as Countrywide and other private label competitors, all lowered the credit quality standards of the mortgages they se- curitized.  A mortgage-backed security was therefore “worse” during the crisis than in preceding years because the underlying mortgages were generally of poorer quality. This turned a bad mortgage into a worse security. • Mortgage originators took advantage of these lower credit quality securitization standards and the easy flow of credit to relax the underwriting discipline in the loans they issued. As long as they could resell a mortgage to the secondary mar- ket, they didn’t care about its quality. • The increasing complexity of housing-related assets and the many steps be- tween the borrower and final investor increased the importance of credit rating agencies and made independent risk assessment by investors more difficult. In this respect, complexity did contribute to the problem, but the other problems listed here are more important. • Credit rating agencies assigned overly optimistic ratings to the CDOs built from mortgage-backed securities.  By erroneously rating these bundles of mortgage-backed security payments too highly, the credit rating agencies sub- stantially contributed to the creation of toxic financial assets. • Borrowers, originators, securitizers, rating agencies, and the ultimate buyers of the securities into which the risky mortgages were packaged all failed to exer- cise prudence and perform due diligence in their respective transactions. In particular, CDO buyers who were, in theory, sophisticated investors relied too heavily on credit ratings. • Many financial institutions chose to make highly concentrated bets on housing prices. While in some cases they did that with whole loans, they were able to more easily and efficiently do so with CDOs and derivative securities. • Regulatory capital standards, both domestically and internationally, gave pref- erential treatment to highly rated debt, further empowering the rating agencies and increasing the desirability of mortgage-backed structured products. • There is a way that housing bets can be magnified using a form of derivative. A synthetic CDO is a security whose payments mimic that of a CDO that contains real mortgages. This is a “side bet” that allows you to assume the same risk as if you held pieces of actual mortgages. To the extent that investors and financial institutions wanted to increase their bets on housing, they were able to use syn- thetic CDOs. The risks in these synthetic CDOs, however, are zero-sum, since for every investor making a bet that housing performance will fall there must be other investors with equal-sized bets in the opposite direction. CHRG-110shrg46629--107 Chairman Bernanke," We, of course, had many areas of rapid innovation in the past and it is just one of the long-standing economic irregularities that the share of capital and labor tends to stabilize over time. We saw in the 1990s, for example, that capital went ahead of labor for a while during the productivity boom and then labor began to catch up again. So, I do think that we will see a more normal---- Senator Bayh. I do not want to use all my time on this question and I apologize for interrupting. We are not for redistributing wealth overtly. But to judge at least by the first part of your answer, if the economy is rewarding more highly skilled parts of the labor force better, then perhaps a focus on education, access to college, and those kind of things might empower the middle class to enjoy a larger share of the wealth. " CHRG-109shrg30354--112 Chairman Bernanke," We are prepared to consider anything, but I think that my judgment is that the standardized approach is essentially the same as the existing approach and would not be adequate for complex internationally active banks. Senator Sarbanes. Thank you, Mr. Chairman. " CHRG-111hhrg52400--270 Mr. Posey," So does anyone think that--the people who are putting these together are highly valued, making tremendous sums of money--does anyone have the slightest notion that we would be able to afford to hire those people, and that they would want to work for the government at evaluating the profitability of these derivatives throughout the world? I don't believe in the Tooth Fairy or the Easter Bunny, and I don't believe we're going to create somebody like that, either. I mean, if I'm wrong, somebody tell me why you think that's really a practical idea, that we're going to get somebody who is going to be able to evaluate the derivatives, the complex derivatives that are throughout the financial markets, and they're going to work for the government, and they're going to be able to tell us which are smart and which are dumb and which are going to make money and which aren't, and which are risky and which aren't risky. I mean, I just think that's an absolute absurdity, just to think that could happen. " CHRG-111shrg51290--2 Chairman Dodd," Good morning. The Committee will come to order. Let me welcome those of you here in the room, my colleagues and our witnesses, who will spend a few moments with us as we discuss ``Consumer Protections in Financial Services: Past Problems and Future Solutions.'' Let me begin by commending all three of our witnesses. I went over your testimony yesterday and I found it very, very interesting, with different perspectives on this issue, not so much on how we got where we are, but where we need to go from here. I found it very, very worthwhile, very enlightening and interesting. And really, what I liked about it is, given we have spent a lot of time over the last year talking about it in general terms, it talks specifically about where we go, and all three of you really have offered some very specific ideas on how to move forward. That is what we need to be doing in the coming days. And, of course, I am delighted to be with my friend and colleague here from Alabama, who was the former Chairman of the Committee. We have had some great times working together over the last 2 years, some difficult times, but he has been a great partner and a good Senator. We have our differences from time to time, but we try to minimize those and do whatever we can to work together. And this is a subject matter where I am determined, and I believe he is determined, as I hope our colleagues are, too, to come together and do something historic in light of all the problems that we face in our country. You need only to pick up our morning newspapers to appreciate what people are going through. We read the numbers, but, obviously, out there behind all of those numbers are people watching their jobs disappear, their retirements evaporate, and they are losing their homes, and their children's future and education are in question. And that is what has to motivate us and drive us. We keep them in mind through all of this. So this morning, we continue the conversation we have been having about how we can make our economy stronger, our institutions more stable and reliable, and of course, in the final analysis, to make sure that the consumers of all of these products are going to receive the protection that they deserve. So today, the Banking Committee meets for another time in a series of hearings to discuss ways to modernize our financial architecture to help our nation grow, to prosper, and to lead our nation into the 21st century. This hearing will focus on critical consumer, investor, and shareholder protections in financial services. For the past year, as I have traveled in my home State of Connecticut, along, I am sure, with my colleagues in their own respective States, and our constituents have underscored the importance of rebuilding our financial system by injecting tough new consumer investor protections that have been missing or overlooked for far too long. They are literally banking on change in this area, and I believe we must give it to them this year, and our common hope is to do just that, because efficient and effective markets only work when all actors have good information. It also means increased accountability, disclosure and transparency to ensure that consumers and investors understand the rules of the road regarding their transactions. And it means doing these things in a way which doesn't unduly cramp the vitality, innovation, and creativity, which is the source of genius in our financial system. Striking that balance is a tall order, but that must be our charge. The President has now made clear that regulatory modernization, which will protect consumers and investors in this way, is a top priority for him. Senator Shelby and I, joined by Chairman Barney Frank and Ranking Member Spencer Baucus, met last week met at the White House, and we agreed to work toward that goal, informed by key principles outlined by the President in that meeting. It is an historic undertaking, one of the most important debates in which we have engaged here in a long time, maybe the most important debate that members of this Committee may ever engage in, considering the significance of what we are about to undertake. It will be challenging, and no doubt it will take twists and turns in the coming months. But I hope and expect that the process will culminate in a comprehensive regulatory modernization bill at its end. Senator Shelby and his colleagues have been partners in many such legislative efforts over the past couple of years that I have chaired this Committee, and I am very grateful to him specifically and to my colleagues as well, for the fine work they have done with us on this Committee. In the last Congress, this Committee and its subcommittees held 30 hearings to identify the causes and consequences of the financial crisis, which is at the root of our economic troubles. We looked at everything from predatory lending and foreclosures to the risks of derivatives in the banking system, and security and insurance industries. What we found at the heart of the problem in these areas was a single fundamental breakdown, an almost total failure to protect consumers, investors, and shareholders. By no means is this problem exclusive to financial services. Whether it is poisoned toys imported from China or meat with deadly pathogens knowingly sold to supermarkets, some for too long have been willing to cross the bright lines of basic business operations, and fair treatment of the consumer to bolster their bottom lines. Nowhere was that failure starker or more catastrophic for our economy than the housing market, where lenders, brokers, and banks offered or financed an array of unsuitable mortgage products without regard to the borrower's ability to repay. For too long, many in the industry focused solely on large profits and ignored the major risks that accompanied them. They were willing to gamble with not only their own futures, but those of their customers, who were encouraged to take on more and more risk. And the result is clear. With unemployment now at its highest in 16 years, 8 million homes in danger of foreclosure, and some of our largest financial institutions either in ruins or at the risk of being such, this house of cards has collapsed, and today the Committee meets to continue our discussion on how to rebuild a stronger and more stable structure. I pledge personally over the coming months that we will rebuild the nation's financial architecture from the bottom up and put the needs of consumers, investors, and shareholders who own these firms not at the margins of our financial service system, but at its very center. Just as failure to protect the American people was the cause of our financial collapse, so too must our efforts to rebuild be premised on a strong foundation of consumer and investor protections. Certainly, we have a ways to go, as we all know, when mortgage brokers can charge yield spread premiums for directing customers into riskier, costlier mortgages, and when credit card companies can raise rates on customers who have always paid their bills on time. Recently, I learned of a woman named Samantha Moore from Guilford, Connecticut, a paralegal whose husband owns a small business. Not long ago, she was 3 days late on a credit card payment, the first late payment in 18 years. For that seemingly minor transgression, she had her interest rate raised from 12 percent to 27 percent and her credit line slashed from $31,400 a year to $4,500. What is a middle-class family like the Moores supposed to do if they were counting on that credit line to help them through a medical crisis? That single decision could mean the difference between scraping by during a recession and a lifetime of financial catastrophe, all because a single payment after 18 years was 3 days late. With the average household carrying more than $10,000 in revolving debt on their credit cards and millions trapped in home loans with exploding interest rates, sweeping reform of abusive credit card and mortgage lending practices will be an essential component of this Committee's financial modernization efforts. Today, we will discuss broader regulatory reform questions that focus on how we treat customers of financial institutions. For instance, should bank regulators continue to have that authority? In 1994, Congress gave the Fed authority to ban abusive home mortgages and it failed miserably. Is it time to create a new regulator whose sole function is the fair treatment of individual customers? Certainly, we need strong cops on the beat in every neighborhood. Fifty-two percent of subprime mortgages originated with companies like stand-alone mortgage brokers and others that have no Federal supervision whatsoever. Who should be charged with consumer protection for these financial institutions? Some have suggested that we set up an entity modeled on the Consumer Product Safety Commission, which protects the public from products used in the home, the school, and for recreation. In this day and age, financial products are just as commonplace and some can be equally as dangerous. No one suggests that the buyer is to blame for a dangerous toaster that catches fire or a toy for a child that is contaminated with lead. Should it be any different for a borrower who takes out a mortgage or signs up for a credit card? I think it is a fair thing to ask, and one thing is clear: These complex financial transactions, including mortgages, can be much more dangerous than a family toaster. We are talking about huge financial decisions, often the most significant in a family's life, on which they stake their life's savings. We must do everything we can to make sure that they understand precisely the terms of those transactions and their implications and that they are protected from the kinds of abuses we have seen in recent years. These protections must be comprehensive and consistent over our regulatory architecture. For too long, we have allowed a misguided belief to persist, that when you protect a consumer, you stifle innovation and growth. That is truly a false choice. Efficient, dynamic marketplaces don't function in spite of people like Samantha Moore, they function because of people like her and millions of others who work, invest, and save to send their children to school, to buy homes, and to live the often-spoken-of American dream. If we are going to grow a more sensible economy, a sustainable economy, with a safe and sound financial architecture that supports it, we need to protect and nurture and invest in our most precious resource, the American people. That starts with the work of this Committee. With that, let me turn to my colleague, Senator Shelby, and then I will ask my colleagues who are here if they would like to make any opening comments, and then we will turn to our witnesses. Richard? 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-111shrg55278--108 PREPARED STATEMENT OF VINCENT R. REINHART Resident Scholar, American Enterprise Institute July 23, 2009For Best Results: Simplify Chairman Dodd, Ranking Member Shelby, and Members of the Committee thank you for the opportunity to testify today. No doubt, the American people expect significant remedial action in the aftermath of the extraordinary Government support to financial institutions over the past year. Indeed, this is probably a generational moment in which this Congress will shape the financial landscape for decades to come. At the outset, however, we must remember that greater discipline does not always follow from more intricate oversight.The Problem In fact, complexity has been the bane of our financial system for decades and cannot be the solution going forward. We have created an intricate, multifaceted terrain of opportunities through our financial regulations, tax codes, and accounting rules. There are multiple Federal regulators and State alternatives. Different jurisdictions offer varied enticements in terms of favorable legal structure and tax treatment. And the tax code ranges across region and over time. Financial firms have burrowed into every nook and cranny. This has required the effort of legal specialists, accounting experts, and financial engineers. As a result, the balance sheets of large firms have been splintered into a collection of special purpose vehicles, and securities have been issued with no other purpose than extracting as much value as possible from the Basel II Supervisory Accord. This complexity introduces three fundamental problems in monitoring behavior. First, supervisors are at a decided disadvantage in understanding risk taking and compliance for a firm that might involve dozens of jurisdictions, hundreds of legal entities, and thousands of contractual relationships. Firms know this and tailor individual instruments to a small slice of its clientele to take advantage of tax and accounting rules. Its balance sheet might respond quickly to advances in finance and legal interpretations. And the same risks might be booked in different ways across affiliates, let alone across different institutions, with evident consequences for capital requirements. Indeed, the reliance of self-regulation inherent in the Basel II supervisory agreement can be seen as an official admission of defeat: A large complex financial institution cannot be understood from outside. But if an institution is so difficult to understand from the outside, how can we expect market discipline to be effective? The second cost of complexity is that the outside discipline of credit counterparties and equity owners is blunted. Creditors are more likely to look to the firm's reputation or a stamp from a rating agency rather than the underlying collateral provided by the financial contract. Equity owners are more likely to defer to senior management, opening the way to compensation abuses and twisting incentives to emphasize short-term gains. In this regard, it is probably not an accident that financial firms tend not to be targets for hostile takeovers--their balance sheets are impenetrable from the outside. Third, the problems in understanding the workings of a complicated firm are not limited to those on the outside. A complicated firm is also difficult to manage. Employers will find it more difficult to monitor employees, especially when staff on the ground have highly specialized expertise in finance, law, and accounting. Simply put, employees who are difficult to monitor cannot be expected to promote the long-term interests of their workplace. What follows are abuses in matching loans and investments to the appropriate customer and, in some cases, outright fraud. Note the irony. A firm's effort to take advantage of Government induced distortions by becoming more complicated and by making its instruments more complex lessens the owner's ability to monitor management and management's ability to monitor workers. Market discipline breaks down.The Simple Solution Sometimes the answer to a complicated problem is simple, as Alexander found with the Gordian Knot. Cut through the existing tangle of financial regulation. Consolidate Federal financial regulators and assume State responsibilities. Simplify accounting rules and the tax code. Make the components of financial firms modular so that the whole can be split up into basic parts at a time of stress, advice that may have eased resolution of AIG's financial products division. With simple rules that define lines more sharply, our Federal regulators will find enforcement much easier. If firms are more transparent, official supervision will be reinforced by the newfound discipline exercised by shareholders and creditors. And with fewer places for self-interest to hide, employees will be more accountable in their efforts to preserve the longer-term value of their firms. I recognize that a Congress pressed for results might be reluctant to enact radical simplification. The consolidation of multiple agencies and the shift of power away from States to a single Federal entity seem daunting. Even harder might be the necessary reduction in the variety of corporate charters and the pruning of the tax code and accounting rules. Indeed, this is an invitation to jurisdictional warfare, as each regulator jockeys for viability. But a more established set of rules for the resolution of large firms, simplification of regulations generally, and consolidation of supervision specifically should be the aspiration of this Congress. I shall argue that a well-designed financial stability supervisor can be a means to that end.A Distinct Choice The Treasury recently laid out a new foundation for financial regulation. It envisions granting the Federal Reserve new authority to supervise all firms that could pose a threat to financial stability, even those that do not own banks. I disagree. Such powers should not be given to an existing agency, especially not the Nation's central bank. Rather, the Congress should form a committee of existing supervisors, headed by an independent director, appointed by the President, and confirmed by the Senate. The director should have a budget for staff and real powers to compel cooperation among the constituent agencies and reporting from unregulated entities, if necessary. Why shouldn't an existing agency head the committee? From the Congress's perspective, an agency is a black box that is difficult to monitor, filled with technicians given multiple tools directed toward multiple goals. The more complicated is its mission, the more opportunities those technicians will have to trade off among those goals. For example, consider the plight, admittedly abstract, of an agency told to enforce a capital standard and to foster lending. At a downturn in the business cycle, it might be tempted to allow overly optimistic asset valuations so as to prevent balance-sheet constraints from slackening lending. Perhaps, this compromise might be consistent with the implied wishes of the Congress. But perhaps not. Because an agency, especially focused on technical matters, tends to be opaque, it will be difficult for its legislative creators to hold it accountable. There are adverse implications of burdening an agency, any agency, with multiple goals. First, the public will be confused about what goes on behind the curtain. This makes it less likely that the agency will find widespread support for its core responsibilities or anyone who identifies with its mission. Second, and a bit more inside the Beltway, it will be hard to fill the slots at agencies where the job description calls for multiple technical talents and competing demands on time. Third, key relationships of an agency with the Congress and other regulators can become hostage to peripheral turf fights. From my own experience, the atmosphere at Fed hearings was especially charged in 2004 and 2005 in both chambers. Some members and staff thought that Chairman Greenspan was dragging his feet on consumer disclosure regulation. My point is not that they were wrong in criticizing the Chairman. Rather, my point is that time set aside in legislation to discuss the plans and objectives of the Fed for monetary policy was chewed up on other topics. As a result, Fed credibility was impaired for reasons other than the performance of the economy.The Fed Exception I have thus far offered general objections to giving financial stability responsibilities to an existing agency. I believe that there are even more compelling reasons that those responsibilities should not be given to the Fed. Please recognize that I worked in the Federal Reserve System for a quarter-century and that I hold its staff in high esteem. They are knowledgeable, competent, and committed to their mission. But any group of people in an independent agency assigned too many goals will be pulled in too many directions. And there is one goal given to the Fed that should not be jeopardized: the pursuit of maximum employment and stable prices. Indeed, that goal is so pivotal to the Nation's interest that the Congress should be thinking of narrowing, not broadening, the Fed's focus. Three other concerns should give you pause before signing on to the Treasury's blueprint of a new role for the Fed. First, as compared to other agencies, the Fed has significant macroeconomic policy and lending tools. If it failed in its role as systemic supervisor to identify the originator of the next financial crisis, might it be more likely to use those tools beyond what is necessary for the achievement of its core monetary policy responsibility? Second, you might hear that the expertise gained in assessing financial stability will help to inform the Fed's pursuit of macropolicy goals. That would work in principal. In practice, I believe that there are precious few instances of that favorable feedback, despite the Fed's involvement in bank supervision since its inception. But I stand willing to be proved wrong. The Fed's monetary policy deliberations over the years are extremely well-documented in thousands of pages of minutes and transcripts. Anyone making the case for beneficial spillovers should be asked to produce numerous relevant excerpts from that treasure trove. I do not think they will be able to do so because I do not think those examples exist. Third, the gift of extraordinary powers to an agency merits forthright accountability from that agency. It is up to you to determine whether the Fed has been sufficiently accountable during this recent episode. In that regard, however, I would note an inconsistency in the Treasury blueprint. It wants to give the Fed new powers regarding financial stability. At the same time, it seeks to circumscribe the one unusual power that the Fed has exercised over the past year by requiring the Treasury Secretary to sign off in advance of lending in unusual and exigent circumstances. Which best describes the true Fed--empowerment or limitation?An Alternative My strong preference, absent radical simplification, is that the supervision of financial stability be delegated to a committee of existing financial supervisors. Those constituent agencies have the specific expertise to understand our complicated financial world. At the head should be someone appointed by the President and confirmed by the Senate. He or she should have a budget to staff a secretariat deemed suitable. And that agency should have independent powers. It should be able to compel the information sharing among the constituent supervisors and the reporting of information, if necessary, from unregulated entities. The constituent agencies should regularly be directed to draft reports in their areas of expertise for consideration by the full Committee and transmittal to the Congress. This would include twice-a-year reports on macroeconomic stability from the Fed, appraisals of the health of the banking system from the FDIC, and assessments on the resilience of financial market infrastructure from the SEC and the CFTC. Why does the committee head need to be appointed in that capacity and have unique powers? The committee head needs the heft associated with an independent selection. Without power, the committee would devolve to a debating society that spends the first 5 years of its existence negotiating memoranda of understanding on the sharing of information. Think about this analogy. In the run-up to the financial crisis, every single large complex financial institution had a senior risk management committee. In most cases, all those committees managed to do was to allow the build-up of large risks. Now the U.S. Government has a significant ownership stake in many of them. The few exceptional, successful firms were the ones that gave the risk managers real powers to control positioning. Why should the Federal Government settle for a toothless authority?A Longer-Term Vision The real benefits of a financial stability committee would come if the Congress were forward-looking in writing its mandate. The committee could be a vehicle to foster the achievement over time of robust rules for the resolution of private firms, simplification of the financial system, and consolidation of financial agencies. Let me take each in turn. Resolution. At a time of crisis, we resort to the injection of public funds into private firms because we are afraid of letting market forces play out. Each major firm should negotiate a ``living will'' with its regulator each year. That living will should detail how the firm should be disassembled in the event of bankruptcy. It should list the segments of the firm that are systemically important and provide contractual mechanisms to ring-fence them. The secretariat of the financial stability committee should assess those plans to make sure what looked good on paper could be applied in extremis. Also, the secretariat can recommend industry initiatives to narrow over time the ambit of firm-specific systemically important activities. Periodically, the head of the committee should report to the Congress--in closed session if necessary--about the status of resolution plans. This would be the opportunity to identify areas for legislation, if necessary, to give the Government more effective resolution powers. Simplification. It will not take long for anyone tasked with working through the innermost machinations of major financial firms to conclude that our system is hopelessly complicated. The head of the financial stability committee should report annually on opportunities to hack away at that underbrush, be it agency regulations, accounting rules, or the tax code. The ambition of the new agency to simplify financial rules, across industries and products, should be as wide as the net cast for threats to financial stability. Those opportunities are both in Federal and State legislation and agency regulation. On a flow basis, new legislation should be scored, much as is already done for budgetary impact, for the effects on the complexity of the financial system. Consolidation. The low hanging fruit of simplification will most likely come in consolidating Federal agencies and State responsibilities. An independent agency head should have the perspective and stature to identify such opportunities that can be the basis of future legislation. That is, part of the job of the committee's chair should be explaining how the committee should get smaller over time.Conclusion Facilitating resolution, simplifying rules, and consolidating regulators will go a long way in making financial firms more transparent. This will aid in enforcing remaining regulation, disciplining credit decisions, and monitoring employees. It is also patently fairer. Being bigger or more complicated or having better lobbyists will not covey an advantage in a world of clear lines, strict enforcement, and no exceptions. We have lived in a world of fine print and sharp lawyers and look where that got us. We are ready for change. I would prefer that this change come quickly, but others might see this as too abrupt. If significant simplification does not come now, a strong independent financial stability committee could provide immediate protection and the promise of identifying areas for future progress along the lines I have laid out. ______ CHRG-111hhrg53238--19 Mr. Hensarling," Thank you, Mr. Chairman. Under the national energy tax, House Democrats want to help decide what cars we can drive. Yesterday, House Democrats announced a plan to help decide what doctors we can see and when we can see them. And now under CFPA, House Democrats want to decide whether or not we qualify for credit cards, mortgages, or practically any other consumer financial product. Yes, there is a troubling trend. The CFPA represents one of the greatest assaults on economic liberty in my lifetime. It says to the American people, you are simply too ignorant or too dumb to be trusted with economic freedom. Therefore, five unelected bureaucrats, none of whom know anything about you or your family, will make these decisions for you. But never fear, surely several of them will have Ph.D. by their names, and they will engage in vigorous discussions about consumer credit issues at very exclusive cocktail parties in Georgetown. This is the commission that will now have sweeping powers to decide under the subjective phrase ``unfair,'' what mortgages, credit cards, and checking accounts you may qualify for. Sleep soundly at night. To take from consumers their freedom of choice, to restrict their credit opportunities in the midst of a financial recession, all in the name of consumer protection is positively Orwellian. Let's protect consumers from force and fraud. Let's empower them with effective and factual disclosure. Let's give them opportunities to enjoy the benefits of product innovations like ATM machines and online banking. And let's not constrict their credit opportunities. A consumer product Politburo does not equate into consumer protection. I yield back the balance of my time. " 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. ------ 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-111hhrg52406--18 The Chairman," The gentlewoman from California, Ms. Speier, for 3 minutes. There will be one more 3-minute on the other side and then we will get to our witness. Ms. Speier. Thank you, Mr. Chairman. When the Consumer Product Safety Commission was proposed in 1972, toaster manufacturers, toy companies, and car makers all screamed foul, much like the financial services industry is screaming about the Consumer Financial Protection Agency that we are discussing today. But thank God for the CPSC. It has resulted in safer and more consumer-friendly products and boosted American confidence that the products that they bring into their homes will not kill them. The proposal for a Consumer Financial Protection Agency that we are talking about today is, I believe, one of the most important reforms to come out of this economic meltdown. A landscaper in my district who works for the City of San Francisco and earns $60,000 a year got a $600,000 mortgage. He now has an $800,000 balance because his ``pick a payment'' loan allowed him to short his monthly payment and feed the balance back onto the principal. At this point, his yearly mortgage is $51,000 a year, more than his take-home pay. How did he get a loan like this, a bank gave it to him. It is far too generous to say that financial institutions were simply opportunistic for selling exotic mortgages to working people and pushing credit cards on students who were unlikely to be able to repay. Amazingly, many in the financial services industry argue that a consumer protection agency is unnecessary. Not only should consumers just trust their bankers, they also argue that the financial services industry is too complex for a consumer protection agency to understand. Really? Does anyone really want to make the argument that the status quo works. Let's be clear, existing regulators could have stopped the liar loans, the subprime steering, the option ARMs that nearly brought our economy down. The status quo could have jumped in at any time but it didn't. If a product is marketed with total disregard for a consumer's ability to repay, if it is purposefully written so you need to hire a lawyer to understand the terms, if it is manipulated so its customer is more apt to be in a costly product than in one they are entitled to, you can't blame that on the complexity of the system. Regulators stood by while credit card companies used clever tricks to draw customers into even deeper debt with cheaper rates and balance transfers and ``convenience checks'' all the while burying the real credit terms on page 30 in fine type. Now, more than 50 million American families can't pay off their credit cards every month. It is essential that this new agency have real power, that they have flexible rulemaking authority, that it be adequately funded, not subject to the starvation by Congress, and that it have real enforcement authority. Financial institutions will say that they cannot possibly function in the kinds of restrictions proposed here, to which I ask them why are you afraid of letting consumers understand the terms of their mortgages and credit cards. We have spent hundreds of billions of dollars taking care of the largest banks in our country. It is time to do something for the 117 million American families as well. I yield back. " 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-111shrg54789--156 Mr. Yingling," Well, first we are not arguing for status quo. The status quo has been a failure, and so we are arguing for change. One thing I would point out is there has been a significant change in terms of the power of the agencies using UDAP. And if you look at the credit card regulation--which you all trumped with a stronger bill, but a lot of it was in that regulation--this is a new era. The use of UDAP by the regulatory agencies is much stronger, and we would recommend that a bill that was passed by the House last year which grants that authority in a coordinated fashion to all the regulatory agencies should be adopted. You are going to deal with a systemic oversight regulatory that is controversial, but that systemic oversight regulator should have the authority to look at these consumer issues in a coordinated fashion. One of the great obvious failures is why our Government did not see--did see, to a large extent, but was not really charged with saying look at the graphs in the growth of these kinds of loans, let us investigate it, let us stop it. The systemic regulator should be given that charge. There should be a coordinated place in the Federal Government where consumers can call in. You raised that point. It is a very legitimate point. They do not know where to call. There should be a coordinated place where they can call, and then the statistics are kept, and that is referred for action to the correct regulator. There should be greater coordination at the Federal level with the States. I think we have gotten into the habit of having these court fights, and in reality we should be sitting down at the table between the States and the Federal regulators and figuring out how to do it. There are a number of things that could be done. In terms of products that would be innovative, every single day in this country in some bank they are thinking of how to adjust a mortgage product, adjust an automobile loan, adjust a basic banking account. They are sitting around a table saying, ``Oh, if we could add this Internet feature, if we could add a feature for senior citizens.'' They are constantly adjusting. And some of those fail; some of those helped in their market; some of them become great products that others start to offer. And I can only deal with the language that they have offered. All those are not plain-vanilla products. Any time you deviated, you would not be a plain-vanilla product. And so if that is not going to chill innovation, I do not know what is, because you are subject to all kinds of extra rules if you cannot make those deviations. Senator Corker. Mr. Chairman, thank you, and, gentlemen, I want to say that the comments you have made indicate to me that while you want to see strong consumer protection, because that is what you do, and you see abuses, that you, too, even see this bill in its present form as an overreach and that we have a lot of work to do to get it right. " FinancialCrisisReport--250 RMBS and CDO Ratings. Over the last ten years, Wall Street firms have devised ever more complex financial instruments for sale to investors, including the RMBS and CDO securities that played a key role in the financial crisis . Because of the complexity of the instruments , investors often relied heavily on credit ratings to determine whether they could or should buy the products. For a fee, Wall Street firms helped design the RMBS and CDO securities, worked with the credit rating agencies to obtain ratings, and sold the securities to investors like pension funds, insurance companies, university endowments, municipalities, and hedge funds. 971 Without investment grade ratings, Wall Street firms would have had a much more difficult time selling these products to investors, because each investor would have had to perform its own due diligence review of the financial instrument. Credit ratings simplified the review and enhanced sales. Here’s how one federal bank regulatory handbook put it: “The rating agencies perform a critical role in structured finance – evaluating the credit quality of the transactions. Such agencies are considered credible because they possess the expertise to evaluate various underlying asset types, and because they do not have a financial interest in a security’s cost or yield. Ratings are important because investors generally accept ratings by the major public rating agencies in lieu of conducting a due diligence investigation of the underlying assets and the servicer.” 972 In addition to making structured finance products easier to sell to investors, Wall Street firms used financial engineering to create high risk assets that were given AAA ratings – ratings which are normally reserved for ultra-safe investments with low rates of return. Firms combined high risk assets, such as the BBB tranches from subprime mortgage backed securities paying a relatively high rate of return, in a new financial instrument, such as a CDO, that issued securities with AAA ratings and were purportedly safe investments. Higher rates of return, combined with AAA ratings, made subprime RMBS and related CDO securities especially attractive investments . (2) The Rating Process Prior to the massive ratings downgrade in mid-2007, the RMBS and CDO rating process followed a generally well-defined pattern. It began with the firm designing the securitization – the arranger – sending a detailed proposal to the credit rating agency. The proposal contained information on the mortgage pools involved and how the security would be structured. The rating agency examined the proposal and provided comments and suggestions, before ultimately agreeing to run the securitization through one of its models. The results from the model were used by a rating committee within the agency to determine a final rating, which was then published. 971 See 9/2009 “The Financial Crisis of 2007-2009: Causes and Circumstances,” report prepared by the Task Force on the Cause of the Financial Crisis, Banking Law Committee, Section of Business Law, American Bar Association. 972 11/1997 Comptroller of the Currency Administrator of National Banks Comptroller’s Handbook, “Asset Securitization,” at 11. CHRG-111hhrg74090--60 Mr. Barr," Thank you, Mr. Chairman, and thank you, Ranking Member Radanovich for providing me with this opportunity to testify about President Obama's proposal to establish a new strong financial regulatory agency charged with just one job: looking out for consumers across the financial services landscape. As Secretary Geithner has said, protecting consumers is important in its own right, and also central to safeguarding our financial system as a whole. We must restore honesty and integrity to our financial system. That is why President Obama personally feels so strongly about creating this new Consumer Financial Protection Agency. I understand the committee's concerns that have been expressed today with respect to boundary issues, jurisdictional issues and the role of the FTC. I think as we work together on those issues, it is important to keep in mind the central goal we all share: having one agency for one marketplace with one mission, protecting consumers. The new agency will have the authority and the resources it needs to set consistently high standards for banks and non-bank financial providers alike, to put an end to regulatory arbitrage, to put an end to unregulated corners of our financial system that inevitably weaken standards across the board. This agency will be accountable for its mission yet independent. It will have a wide range of tools to promote transparency, simplicity and fairness. It will act in a balanced manner, considering costs as well as benefits, in a way that products consumers from abuse while ensuring their access to innovative, responsible financial services. It will be able to reduce regulatory burden while helping consumers, for example, by creating one simple mortgage disclosure form for all consumers to use. It will not set prices for any service. The federal government has failed to date in its most basic regulatory responsibility, utterly failed to protect consumers. The deep financial crisis that we are still in, let me emphasize, that we are still in today, revealed the alarming failure of our existing regime to protect responsible consumers and to keep the playing field level for responsible providers. Instead of leadership and accountability, we have had a fragmented system of regulation designed for failure. Bank and non-bank financial service providers compete vigorously in the same consumer markets but are subject to two different and uncoordinated federal regimes, one based on examination and supervision, the other on after-the-fact investigation and enforcement. Less-responsible actors are willing to gamble that the FTC and the States lack the resources to detect and investigate them. This puts enormous pressure too on banks, thrifts and credit unions to lower their standards to compete and on their regulators to let them, and no financial provider should be forced to choose between keeping market share and treating consumers fairly. This is precisely what happened in the mortgage market. Independent mortgage companies peddled risky mortgages in misleading ways to borrowers who could not handle them. To compete, banks and thrifts and their affiliates relaxed their standards on underwriting and sales and their regulators were slow to act. The consequences for homeowners were devastating and our economy is still paying the price. Fragmented regulation facilitated abusive credit cards. Tricks and traps enabled banks to advertise selectively low annual percentage rates to grab market share and boost income. Other banks could not compete if they offered fair credit cards through transparent pricing and consumers ended up with retroactive rate hikes and unfair terms. The list goes on and on. Credit unions and community banks with straightforward credit products struggled to compete with less-scrupulous providers who appeared to offer a good deal and then pulled a switch on the consumer. Our federal agencies do not currently have the mission, structures and authority suited to effective consumer protection in consumer financial markets. The FTC has no jurisdiction over banks and it does not have supervisory and examination authority to detect and prevent problems before they spread throughout the market. Mr. Chairman, I see that I will be significantly over my time. Could I take several additional minutes? " CHRG-110hhrg44900--24 Mr. Bernanke," I would associate myself with Secretary Paulson's remarks. We are working together extremely cooperatively, the Secretary and I, and the other agencies. Obviously, we'd like to have additional tools, but these are very complex matters, as the Secretary has indicated. So my hope would be that the Congress would begin soon to think hard about these issues, and we are happy of course to provide whatever support we can. But I think for the time being that the most likely outcome and the expectation is that we will continue to work in a creative way together to try to manage these ongoing situations. " The Chairman," I'm going to break my own rule just to make one statement, because I gather what you're saying is, it is better in this very complex and very important set of issues that we do it right and that we do it very quickly. " CHRG-111shrg56376--146 Mr. Hillman," Thank you very much. Mr. Chairman and Members of the Committee, I am pleased to be here today to discuss issues relating to efforts to reform the regulatory structure of our Nation's financial system. In January 2009, we reported on gaps and limitations in our current structure, and we presented a framework for evaluating proposals to modernize the U.S. financial regulatory system. Given the importance of the U.S. financial sector to the domestic and international economies, we also added modernization of the outdated regulatory structure as a new area to our high-risk list because the fragmented and outdated regulatory structure was ill-suited to meeting the challenges of the 21st century. My statement today, which is based on prior reports that we have completed, focuses on how regulation has evolved and recent work that further illustrates the significant limitations and gaps in the existing regulatory structure, the experiences of countries with other types of varying regulatory structures and how they fared during the financial crisis, and our reviews on certain aspects and proposals to reform the regulatory system. I would like to make the following points: First, the current U.S. financial regulatory system is a fragmented and complex arrangement of Federal and State regulation that has been put into place over the past 150 years but has not kept pace with major developments in financial markets and products in recent decades. My prepared statement details numerous examples from our prior work identifying major limitations of the Nation's fragmented banking regulatory structure. For example, in July, we reported that less comprehensive oversight by various regulators responsible for overseeing fair lending laws intended to prevent lending discrimination may allow many violations by independent mortgage lenders to go undetected. That same month, we also reported that regulatory capital measures did not always fully capture certain risks and that none of the multiple regulators responsible for individual markets or institutions had clear responsibility to assess the potential effects or the build-up of systemwide leverage. Recent proposals to reform the U.S. financial regulatory system include some elements that would likely improve oversight of the financial markets and make the system more sound, stable, and safer for consumers and investors. For example, under proposals under the Administration and others, new regulatory bodies would be created that would be responsible for assessing threats that could pose systemic risks. Our past work has clearly identified the need for a greater focus on systemwide risks in the regulatory system. In addition, the Administration and others are proposing to create a new entity that would be responsible for ensuring that consumers of financial services are adequately protected. Our past work has found that consumers often struggled to understand complex financial products, and the various regulators responsible for protecting them have not always performed effectively. As a result, the creation of a separate consumer protection regulator is one sound way for ensuring that consumers are better protected from unscrupulous sales practices and inappropriate financial products. However, our analysis indicates that additional opportunities for further consolidating the number of Federal regulators exist that would decrease fragmentation, reduce the potential for differing regulatory treatment, and improve regulatory independence. For example, the Administration's proposal would only combine the current regulators for national banks and thrifts into one agency while leaving the three other depository institution regulators--the Federal Reserve, FDIC, and the regulator for credit unions, NCUA--intact. Our work has revealed that multiple regulators who perform similar functions can be problematic. When multiple regulators exist, variations in their resources and expertise can limit their effectiveness. The need to coordinate their actions can hamper their ability to quickly respond to market events, and institutions engaging in regulatory arbitrage by changing regulators through reduced scrutiny or their activities or to threaten to change regulators in order to weaken regulatory actions against them. Having various regulators that are funded by assessments from the institutions they regulate can also in such regulators become overly dependent on individual large institutions for funding, which could compromise their independence in overseeing such firms. As a result, we would urge the Congress to consider additional opportunities to consolidate regulators as it deliberates reform of our regulatory system. Finally, regardless of any regulatory reforms that are adopted, we urge the Congress to continue to actively monitor the progress of such implementation and be prepared to make legislative adjustments to ensure that any changes in the U.S. financial regulatory system are as effective as possible. In addition, we believe that it is important that Congress provide for appropriate GAO oversight of any regulatory reforms to ensure accountability and transparency in any new regulatory system, and GAO stands ready to assist the Congress in its oversight capacity and evaluate the progress agencies are making implementing any changes. Mr. Chairman and Members of the Committee, I appreciate the opportunity to discuss these critical issues and would be happy to respond to any questions at the appropriate time. " 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-111hhrg48875--228 Secretary Geithner," There are different models for each of those because of the complex issues involved. But the proposal you are referring to, which is to have five asset managers raise equity income is on the securities-- " 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. CHRG-111hhrg52400--2 Chairman Kanjorski," This hearing of the Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprises will come to order. Pursuant to an agreement with the ranking member, opening statements today will be limited to 10 minutes for each side. Without objection, all members' opening statements will be made a part of the record. We meet to continue our discussion of insurance regulation, which the Capital Markets Subcommittee has debated in great depth for several years. On the eve of the Administration's unveiling of its plan to strengthen the oversight of our financial markets, it also appears likely that we will soon consider reforms aimed at mitigating systemic risk. As such, it makes sense for us to drive a bit deeper today into the issue of systemic risk and the insurance industry. While we have yet to learn much about the specifics of the Administration's plan for insurance reform, we have spent enough time debating these issues to come to some conclusions. For example, I believe that only ostriches can now deny the need for establishing a Federal insurance resource center and a basic Federal insurance regulatory structure. Insurance is a complex and important part of the U.S. financial industry, with more than $6.3 trillion in assets under management and $1.23 trillion in annual premiums. We need to recognize this reality by modernizing the overall regulatory treatment of insurance. We also need to protect against the risks certain sectors of the industry may pose and address the greater sensitivity that some industry segments have to external events. During this crisis, we saw a company that started out as an insurer spread far and wide in its activities and its international presence. American International Group, however, lacked a Federal regulator with real expertise about its vast insurance operations. Rather, the holding company purchased a small thrift and chose the Office of Thrift Supervision as its supervisor. Currently, several other insurance holding companies have a Federal banking regulator as their primary supervisor, and more than 6 dozen similar entities avoid any form of Federal oversight, with selected States instead monitoring them on a consolidated basis. Because a number of these businesses could pose systemic risk, I believe that the Federal Government should directly examine all complex financial holding companies, including those whose primary activities involve underwriting insurance and those who play with credit default swaps. In addition, our financial services markets are global and complex. Insurance is no exception. In order for effective communication and dialogue to take place on the international stage, we must have a single point of contact for the United States on these matters. Moreover, insurers must have a Federal regulatory voice on par with the banking and securities sectors in our financial markets so that the industry can communicate with its peer regulators at home. In short, we can no longer sweep insurance regulation under the rug and cross our fingers that nothing will go wrong. We tried it before and learned that such an action may hide the mess for the short term, but pose greater problems in the long term. As such, when the Administration reveals its white paper tomorrow, I very strongly hope that it will recognize today's market realities and call for the establishment of better oversight for insurance holding companies and certain insurance activities, especially those most likely to pose systemic risk. Moreover, I am confident that this Administration will recognize the wisdom of creating a Federal insurance office to advise a systemic risk overseer of the risks in the insurance sector, provide expertise to the Administration and Congress on insurance policy matters, and communicate with foreign governments. I have long advocated for such an office by introducing and advancing the Insurance Information Act. As part of the congressional restructuring of financial services regulation, I ask my colleagues to join me in the effort to enact this legislation. With any luck, the Administration with its white paper will also hopefully advance the debate about Federal insurance regulation in other ways. Personally, I now believe that the Federal Government should actively regulate some specific insurance lines, especially those that pose systemic risk or which have a national significance. Using these tests, federally regulated lines would include bond insurers, mortgage insurers, and re-insurers. I also believe that we should examine how we can promote greater uniformity in the industry, with or without the establishment of a Federal charter. The Administration might reach similar conclusions. In sum, before the Administration proposes its white paper tomorrow, we have many important issues to discuss related to regulatory restructuring as it affects the insurance sector today. I therefore look forward to the testimony of our witnesses and to a vibrant debate in the weeks and months ahead. I would like to recognize our ranking member, Mr. Garrett, for 4 minutes, for his opening statement. " CHRG-111shrg54533--89 PREPARED STATEMENT OF SENATOR MIKE CRAPO I intend to push for reforms that modernize and rationalize our Federal financial regulatory system to handle the challenges of 21st century markets while ensuring American financial companies can compete in a global economy. Although the Administration's plan takes some important steps, it does not link the regulatory structure to the reasons why we regulate. Seven Federal regulators with overlapping missions and fragmented supervision oversee our markets and financial institutions. With the abolishment of the Office of Thrift Supervision and the creation of a Consumer Financial Protection Agency we will still have seven Federal regulators with overlapping missions. Increasing the complexity and fragmented approach to our regulatory structure is counter to reports that have identified several regulatory problems that hinder the ability of the U.S. to maintain its leadership role in financial services globally. The goal should be to promote stable, orderly, and liquid financial markets so that our financial institutions can support the economy by making credit available to consumers and businesses. The recent taxpayer funded bailouts and investment scandals demonstrate our regulatory system is outdated and largely irrelevant. From banks and securities firms to insurance companies and money market funds, nearly all sectors of our financial system have experienced failures and received significant amounts of government assistance. The implications of modernizing our financial regulatory structure are significant and we need to fully understand what the intended and unintended consequences of these changes are. For example, certain companies have not been allowed to fail and taxpayers have paid unprecedented amounts to cover the costs of bank failures and to bail out financial institutions. Does this white paper institutionalize government bailouts in a new resolution authority and does designating large and interconnected companies as Tier 1 Financial Holding Companies send a signal to the markets that these companies will not be allowed to fail? Bifurcating safety-soundness oversight from consumer protection raises many questions. Good supervision should incorporate elements of both safety and soundness and consumer protection. For example, the absence of adequate underwriting, which played a role in some of the financial market problems that we have recently experienced, was as much a safety and soundness issue as a consumer protection issue. By putting the two areas into entirely different operations, each agency will lack the expertise to understand the issues that matter to the other, and the result could be less comprehensive oversight. We should proceed carefully and deliberately in creating a new systemic risk regulator. Having the Federal Reserve become the systemic risk regulator for all large financial institutions concentrates enormous power in one agency. How does this plan encourage investment and responsible lending to spur economic growth and help get our economy moving again? ______ CHRG-110hhrg34673--70 Mr. Royce," I hope the committee leadership can accommodate you on that. I also wanted to say that it is not just New York that has grown quite concerned about the disadvantage competitively that our capital markets face and the flight of capital. I think all over the United States, people are getting worried. We saw the Bloomberg-Schumer report, and then the Committee on Capital Markets Regulation report that came out, and they have really stressed this issue. And I also noticed last November, the late Dr. Milton Friedman said this, and I would just like to read it quickly. He said, ``Sarbanes-Oxley is very unfortunate. It tells every entrepreneur in America, don't take risks, that is not what we want. The function of the entrepreneur is to take risks, and if he is forced not to take risks and spend on accountants rather than products, the economy is not going to expand or grow.'' And then also the same month, Alan Greenspan said that most of Sarbanes-Oxley is, ``a cost creator with no benefit I am aware.'' And he went on to say that regulatory and statutory, statutory changes need to be made as well if we are going to move forward. And he concluded with something that I thought was rather forceful. He said, ``I hope it happens before the whole financial system walks off to London.'' It seems to me that Dr. Greenspan and others were concerned that the regulatory climate will not only deter investment in the country, but that it is also going to suppress future entrepreneurship and suppress innovation. And I was going to ask you because, you know, if they are correct, that could have a very harmful effect not only on future U.S. productivity, but as a result of that will reduce the potential standard of living gains in this country. And so, Chairman Bernanke, do you share the concerns of Dr. Greenspan and Dr. Friedman on this issue? " CHRG-111shrg54589--62 Chairman Reed," Welcome, gentlemen. Let me introduce our second panel. Our first witness is Dr. Henry Hu, the Allan Shivers Chair in the Law of Banking and Finance at the University of Texas School of Law. His research centers on corporate governance and financial innovation. A 1993 Yale Law Journal article showed how sophisticated financial institutions may make big mistakes as to derivatives. His work on the decoupling of debt and equity rights from economic interests has attracted wide attention, including, coincidentally, a story in the current issue of The Economist. So welcome, Dr. Hu. Thank you. Our next witness is Mr. Kenneth C. Griffin. He is the founder, President, and Chief Executive Officer of Citadel Investment Group, L.L.C., a global hedge fund and asset management firm. Citadel operates in the world's major financial centers, including Chicago, London, New York, Hong Kong, and San Francisco. Mr. Griffin is also a member of several philanthropic boards, including service as Vice Chairman of the Chicago Public Education Fund. Thank you, Mr. Griffin. Our next witness is Mr. Robert G. Pickel. He is the Executive Director and Chief Executive Officer of the International Swaps and Derivatives Association, or ISDA, which is the global trade association for over-the-counter derivatives. Previously, Mr. Pickel was the General Counsel of ISDA, serving in that capacity since November 1997. Prior to joining ISDA, Mr. Pickel was Assistant General Counsel in the Legal Department of Amerada Hess Corporation, an international oil and gas company, from 1991 to 1997. Welcome, Mr. Pickel. Our fourth witness is Mr. Christopher Whalen, the Managing Director of Institutional Risk Analytics, a Los Angeles-based provider of risk management tools, but Mr. Whalen is a proud resident of Croton-on-the-Hudson, New York. They provide consulting services to auditors, regulators, and financial professionals. Mr. Whalen leads the company's risk advisory practice and consults for global companies on a variety of financial and regulatory issues. He is also the regional director of the Professional Risk Managers International Association and is a board adviser Eye on Asia, a global business security and risk consultancy based in Hong Kong. Thank you, Mr. Whalen. Dr. Hu, would you please begin?STATEMENT OF HENRY T. C. HU, ALLAN SHIVERS CHAIR IN THE LAW OF FinancialCrisisReport--14 C. Recommendations The four causative factors examined in this Report are interconnected. Lenders introduced new levels of risk into the U.S. financial system by selling and securitizing complex home loans with high risk features and poor underwriting. The credit rating agencies labeled the resulting securities as safe investments, facilitating their purchase by institutional investors around the world. Federal banking regulators failed to ensure safe and sound lending practices and risk management, and stood on the sidelines as large financial institutions active in U.S. financial markets purchased billions of dollars in mortgage related securities containing high risk, poor quality mortgages. Investment banks magnified the risk to the system by engineering and promoting risky mortgage related structured finance products, and enabling investors to use naked credit default swaps and synthetic instruments to bet on the failure rather than the success of U.S. financial instruments. Some investment banks also ignored the conflicts of interest created by their products, placed their financial interests before those of their clients, and even bet against the very securities they were recommending and marketing to their clients. Together these factors produced a mortgage market saturated with high risk, poor quality mortgages and securities that, when they began incurring losses, caused financial institutions around the world to lose billions of dollars, produced rampant unemployment and foreclosures, and ruptured faith in U.S. capital markets. Nearly three years later, the U.S. economy has yet to recover from the damage caused by the 2008 financial crisis. This Report is intended to help analysts, market participants, policymakers, and the public gain a deeper understanding of the origins of the crisis and take the steps needed to prevent excessive risk taking and conflicts of interest from causing similar damage in the future. Each of the four chapters in this Report examining a key aspect of the financial crisis begins with specific findings of fact, details the evidence gathered by the Subcommittee, and ends with recommendations. For ease of reference, all of the recommendations are reprinted here. For more information about each recommendation, please see the relevant chapter. Recommendations on High Risk Lending 1. Ensure “Qualified Mortgages” Are Low Risk. Federal regulators should use their regulatory authority to ensure that all mortgages deemed to be “qualified residential mortgages” have a low risk of delinquency or default. 2. Require Meaningful Risk Retention. Federal regulators should issue a strong risk retention requirement under Section 941 by requiring the retention of not less than a 5% credit risk in each, or a representative sample of, an asset backed securitization’s tranches, and by barring a hedging offset for a reasonable but limited period of time. 3. Safeguard Against High Risk Products. Federal banking regulators should safeguard taxpayer dollars by requiring banks with high risk structured finance products, including complex products with little or no reliable performance data, to meet conservative loss reserve, liquidity, and capital requirements. 4. Require Greater Reserves for Negative Amortization Loans. Federal banking regulators should use their regulatory authority to require banks issuing negatively amortizing loans that allow borrowers to defer payments of interest and principal, to maintain more conservative loss, liquidity, and capital reserves. 5. Safeguard Bank Investment Portfolios. Federal banking regulators should use the Section 620 banking activities study to identify high risk structured finance products and impose a reasonable limit on the amount of such high risk products that can be included in a bank’s investment portfolio. CHRG-110shrg50414--176 Secretary Paulson," In terms of--when I am talking about trans, I am talking about how we report to the American people, how we report to the oversight board. If you are looking for transparency and being able to explain to you here today or anyone how some of these securities are valued and the issues surrounding them, I wish I could tell you, because we do not have--part of the problem that has gotten us here is excess complexity. And so we have very complex, illiquid securities, some tranches are more illiquid than others. And all I can say to you is we are going to need to use a variety of mechanisms, market-driven mechanisms as much as possible, bring together bright people from different backgrounds to work through this and do it with the main objective of protecting the taxpayer. Senator Brown. Thank you for that. Let me offer an idea, and you said part of the reason we got into this was the complexity. Part of the reason we got into this, too, is that the various actors had so little or no stake in the ultimate success of the mortgages. It was like a game of musical chairs. The appraiser got a fee, the broker got a fee, the investment bank got a fee, until the music stopped and somebody did not have a chair in some sense. Have you given any thought--both Chairman Bernanke and Secretary Paulson, have you given any thought to creating a system where the seller determines the price but must retain a good fraction of the asset, live with the consequences, and indemnify the Government if it was wrong on the high side? " CHRG-111hhrg54868--13 DEPOSIT INSURANCE CORPORATION Ms. Bair. Thank you, Chairman Frank, Ranking Member Bachus, and members of the committee. I appreciate the opportunity to return this afternoon to continue testifying on reforming the Nation's financial regulatory system. Differences in the regulation of capital, leverage, and consumer protection and the almost complete lack of regulation of over-the-counter derivatives created an environment in which regulatory arbitrage became rampant. Reforms are urgently needed to close those gaps. At the same time, we must recognize that much of the risk in the system involved firms that are already subject to extensive financial regulation. One of the lessons of the past few years is that regulation alone is not enough to control imprudent risk taking with our dynamic and complex financial system. So at the top of the must-do list is a need to stop future bailouts and reinstill market discipline. The government needs a way to say no. We need a statutory mechanism to resolve large financial institutions in an orderly fashion that is similar to what we have for depository institutions. While this process can be painful for shareholders and creditors, it is necessary, and it works. Unfortunately, measures taken during the year, while necessary to stabilize credit markets, have only reinforced the doctrine that some financial firms are simply ``too-big-to-fail.'' In fact, the markets are more concentrated than before. We also need disincentives for excessive growth in risk-taking. We need a better way of supervising systemically important institutions and a framework that proactively identifies risks before they threaten the financial system. We have called for a strong oversight council with rulemaking authority. It would closely monitor the system for problems such as excessive leverage, inadequate capital and overreliance on short-term funding, and have a clear statutory mandate to act to prevent systemwide risks. Finally, the FDIC strongly supports creation of a Consumer Financial Protection Agency as a stand-alone Federal regulator. As embodied in H.R. 3126, the agency would eliminate regulatory gaps between bank and nonbank financial products and services by setting robust national standards for consumer protection. However, it is essential to focus examination and enforcement on the nonbank sector to protect consumers from some of the most abusive products and practices. We believe this bill would be even stronger if amended to include a well-defined mechanism that provides oversight of nonbanks in partnership with State regulators. To be sure, there is much to be done if we are to prevent another financial crisis, but at a minimum we need to scrap the ``too-big-to-fail'' doctrine, set up a strong oversight council to prevent systemic risk, and create a strong consumer watchdog that offers real protection from abusive financial products and services. Thank you. [The prepared statement of Chairman Bair can be found on page 49 of the appendix.] " 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--168 PREPARED STATEMENT OF SENATOR TIM JOHNSON Thank you Mr. Chairman for holding today's hearing. This hearing could be one of the most important held this month as the Committee takes up legislation to modernize our financial regulatory system. The current economic crisis has exposed regulatory gaps that allowed institutions to offer products with minimal regulation and oversight. Many of these products were not just ill-suited for consumers, but were disastrous for American homeowners. There is a clear need to address the failures of our current system when it comes to protecting consumers. We need to find the correct balance between consumer protection, innovation, and sustainable economic growth. There is no doubt that the status quo is not acceptable. However, as Congress considers proposals to improve the protection of consumers from unfair, deceptive, and predatory practices, we must ask many important questions. We need to know if it is the right thing to do to separate consumer protection from functional regulation. We need to know if a separate, independent consumer protection agency is better than a consumer protection division within an existing regulatory agency. We need to know who should be writing rules for consumer products and who should be enforcing those rules. We need to know if national standards or 51 set of rules made by each State are better for consumers. Last, while the goal of any consumer protection agency is clearly better protection of consumers, we need to know if it will also preserve appropriate access to credit for the consumers it is designed to protect. The creation of a new agency is a daunting task under any circumstances; even more so in this case, considering the role a consumer protection agency would play in our Nation's economic recovery. It is important we get this right. I look forward to hearing from today's witnesses. ______ 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-110hhrg46591--234 Mr. Ryan," I am speaking on behalf of the Securities and Financial Markets today, but from 1990 to 1993, I was the Director of OTS. I also was one of the principal managers of the savings and loan cleanup. And from 1993 until April of this year, I was a senior executive at J.P. Morgan. So I would like to have my comments here reflect that background. As you all know, the debt and equity markets across the globe have experienced serious dislocations in the last few months. Congress has aggressively responded to this by passing the Emergency Economic Stabilization Act, and granted the Treasury Department extraordinary responsibility to promote the confidence in the financial system. We fervently hope that the steps being taken will unfreeze the credit markets and restore calm to the equity markets. Serious weaknesses, however, exist in our current regulatory model for financial services. And without reform, we risk repeating today's serious dislocation. I commend this committee for beginning the process of reexamining our regulatory structure, with a view toward effective and meaningful improvements. We in the securities industry and financial markets stand ready to be a constructive voice in this critical, important public policy dialogue. I have just a few specific comments on recommendations. One, which has been really a part of the comments all morning here, the need for a financial market stability regulator. As you know, our Nation's financial regulatory structure dates back to the Depression. That regulatory structure assumed, and even mandated to some extent, a financial system where commercial banks, broker dealers, and insurance companies engaged in separate businesses, offered separate products, largely within local and domestic borders. Financial institutions no longer operate in single product or business silo or in purely domestic or local markets. Instead, they compete across many lines of business and in many markets that are largely global. The financial regulatory structure remains siloed at both the State and Federal levels. No single regulator currently has access to sufficient information or the practical and legal tools and authority necessary to protect the financial system as a whole against systemic risk. Thus, we believe Congress should consider the need for a financial markets stability regulator that has access to information about financial institutions of all kinds that may be systemically important, including banks, broker dealers, insurance companies, hedge funds, private equity funds, and others. This regulator should have the authority to use the information it gathers to determine which financial institutions actually are systemically important, meaning that would likely have serious adverse effects on economic conditions or the financial stability or other entities that were allowed to fail. We believe this is a relatively small number of financial institutions. We think it is important that a stability regulator have information gathered through coordination with other regulators to avoid duplication of oversight and unnecessary regulatory burdens and provide confidentiality. If Congress takes the approach of creating a markets stability regulator, it would be important to ensure that it not become an additional layer of regulation. Rather, Congress should consider the stability regulator in the context of the overall streamlining of financial regulatory system. Second, additional steps are necessary to improve the efficiency and effectiveness of regulation. In general, financial services regulation has not kept up withinnovation or risk. Modernizing financial regulation should be a priority for regulatory reform by Congress. In general, financial regulation should encourage institutions to behave prudently, and incentivize them to implement robust risk management programs. We also believe Congress should consider how financial regulation can be streamlined to be more effective. Duplicative Federal and State regulation is one area of review. Another is the separate regulation of securities and futures. We believe that the United States should merge the SEC and the CFTC in the interests of regulatory efficiency. Combining their jurisdiction would be consistent with the approach taken in other financial markets around the world. Congress should also consider merging the Office of Thrift Supervision into the Office of the Comptroller of the Currency in order to achieve greater efficiency in the operation of Federal bank regulatory agencies. One comment on structured products and derivatives: Innovation has generated many new financial products in recent decades that have the basic purpose of managing risk. For example, over the last 2 years alone, the credit default swap market has grown exponentially. CDSs are an important tool for managing credit risk, but they also increase systemic risk if key counterparties fail to manage their own risk exposures properly. SIFMA recognizes the risk inherent in this market and will continue to work closely with ISDA, with the Futures Industry Association and with other stakeholders in an effort to create a clearing facility for CDS that will reduce operational and counterparty risk. " CHRG-111hhrg55811--281 Mr. Johnson," Thank you, Congresswoman Bean, Chairman Frank, Ranking Member Bachus, and other members of the committee for including me here in your proceedings regarding derivatives reform. First off, when I worked in the Senate Banking Committee years ago, the derivatives regulation was solely the province of the Agriculture Committee. But I believe in the current circumstance where derivatives regulation is really the centerpiece of financial reform, and that is because of the current market structure, I want to applaud you for undertaking this endeavor, because I believe in the challenge that you face following the crisis, this is the essential ingredient to restoring confidence in our financial system. The upshot is that we have roughly five large financial intermediaries: Goldman Sachs; Morgan Stanley; Citibank; JPMorgan Chase; and Bank of America. About 95 percent of the derivatives activity undertaken by the largest 25 bank holding companies, according to the Comptroller of the Currency, takes place within the walls of those five firms, who are very likely to be categorized as Category 1 or ``too-big-to-fail'' firms. Ninety percent of their activities, according to the OCC, are OTC derivatives. Bloomberg and others have estimated that this year, those 5 firms will make roughly $35 billion in the OTC derivatives market. The reason I feel this is the centerpiece of reform is the ``too-big-to-fail'' policy is eminently intertwined with derivatives reform. The American public is quite demoralized by what we might call the induced forbearance of the bailouts that we experienced last fall. And I know one other dimension that the financial committees are working on has to do with resolution powers so that financial services holding companies, insurance companies, and others can, in fact, undergo prompt corrective action, as the FDIC could do with a bank now. But in a world where the opaque and deeply intertwined and entangled derivative exposures are present, it is very, very difficult for me to imagine someone like Secretary Geithner or Lawrence Summers considering anything other than forbearance when these entanglements are present, because it is unknown; it is like sailing in the fog. You could really hit the rocks if you decide to resolve these institutions, yet the discipline of market capitalism requires that insolvent institutions be restructured and resolved not just in the financial sector, but across the entire spectrum. The concern that I have is also that markets understand when things are too difficult to fail and unwind, and creditors of those firms, the people who hold the bonds, will actually diminish the amount they charge when they know that the firm can't go bankrupt; the so-called default risk will be diminished. What that does is it creates a very nasty feedback, because these large firms get a funding cost advantage, and they can drive competitors out of the market and increase their market share by virtue of being too complex and entangled to be able to bankrupt. And I think that is very distorting for our capital markets. One goal, therefore, of policy, and as we come back to your particular work on derivatives, is to figure out ways to contribute to ending this ``too-difficult-to-fail-or-unwind'' regime. When we look back at the market crisis, two things really occurred that I thought were quite prominent. One was what you might call discontinuous pricing. When you had opaque or complex instruments that were not readily traded, and margin or capital and pricing were not readily measured, it set up the system for violent discontinuities in price. People talk about many things that were carried on the books, particularly collateralized debt obligations, being in the neighborhood of 100 cents on the dollar and then instantly 20 cents on the dollar. What this tends to do when it is opaque and when many large institutions are intertwined is it makes them afraid of each other, it makes them very, very anxious, and that compounds the fear and the breakdown of the capital markets. Ms. Bean. I am going to have to ask you to wrap up, because we are running out of time. " CHRG-110hhrg46595--428 Mr. Altman," This is a very complex company with many international as well as domestic aspects. It would not be a short period, and that is why they need sustainable funding for a long period of time. " FOMC20050630meeting--179 177,MR. LEHNERT.," Okay, let me try to answer that question. I can’t really comment on the hype mentality or the mortgage broker who uses a high pressure sales tactic. But in 2004, for example, I believe that, of the ARMs that were originated, less than 10 percent were traditional ARMs with a one-year reset period. The remaining 90 percent were hybrids that had a rate lock June 29-30, 2005 60 of 234 data on this are a little difficult to get, but it looks as if the median rate lock period was five years. If we think about people’s typical tenure in houses, five years isn’t a bad guess for how long people are going to stay in a particular house. A 30-year fixed-rate mortgage is, in effect, a hybrid mortgage that resets the day you move. So, I think of this to some degree as a financial innovation, and one that people are learning about through advertising or the press or whatever. And I believe this type of hybrid ARM probably makes sense for a lot of people who are making a decision on a mortgage loan. The other point that I’d make is that the fraction of originations that are ARMs often can overstate the role of ARMs in the total mortgage market, because people refinance out of ARMs into fixed-rate mortgages frequently. In fact, I’ve read in the Wall Street newsletters that some people seem to believe that the current rate of refinancing is elevated by this flow out of ARMs into fixed-rate loans." CHRG-111shrg57322--300 Mr. Sparks," Well, most of the time--not all the time--on synthetics, Goldman would provide the synthetic short into the deal for a number of reasons, some of which included the fact that we were involved in the deal. But then what we did with our risk on the other side could vary. Senator Ensign. I think that one of the points that needs to be made, first of all, is--and I think it is evidenced by the hearings that this Subcommittee has been having--is that this is an incredibly complex area of not only our markets but of our law. And, Mr. Chairman, I think that the hearings that you are holding are very valuable. But I think that we are just scratching the surface, and I think it is one of the reasons that I believe very strongly we need to fix the markets, we need to have a lot more transparency, and we need to make sure that people are not being market manipulators, that, some of the lines of questioning today that have come out, actually probably some good suggestions in there, but a lot more needs to be done and a lot more research needs to be done. And I hope that the Senate actually takes its time, so one is that we do not end up hurting the little guys out there in Main Street and we actually go after the people that--whether it was AIG, Goldman Sachs, any of the other big traders, whether it was Fannie Mae and Freddie Mac. I hope that is what the financial regulatory reform focuses on. I do want to get--and just I hate to keep harping on this, but I think this is going to be an important part of what comes out, and that is, do you believe that--and since the two of you are the only ones who responded to this earlier, getting back to the rating agencies, do you believe that Goldman Sachs improperly influenced the rating agencies? " 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. CHRG-111shrg57322--160 OPENING STATEMENT OF SENATOR COBURN Senator Coburn. Thank you, Mr. Chairman. I am going to take my privilege as Ranking Member to make my opening statement now, and I apologize to the panel that I was not here. I am working on another financial problem that is a little bit bigger than this one with the White House and the Debt Commission. Senator Levin, I want to thank you for this fourth and final hearing. I want to thank the staffs. I think they have worked well together, and I think we have done a good role of putting forward what the questions are. I also want to thank the witnesses for making themselves available to answer our questions. The hearing to me is particularly important because this week the Senate is trying to consider major financial reform legislation that could have profound effects on our economy. And we are hurrying these hearings. The Commission that the Congress commissioned to study this that is going to have a report due in December is not going to have a report, and yet we are going to pass a bill before we find everything, and that is somewhat concerning to me. But, nevertheless, there is a lot of evidence in front of us that needs to be clarified. In recent months, Congress and the American people have been debating the causes of our financial crisis and looking for solutions. Mr. Chairman, I commend you for advancing the discussion with our investigations of institutions like Washington Mutual, the Federal regulators, and particularly the Office of Thrift Supervision. We would have been fine without them ever being there because they actually did not do anything. What we have learned is that there are no easy answers. This is important to keep in mind when Congress debates major legislation. I certainly have my own views about what caused the financial crisis, but most honest observers would acknowledge that the roads of responsibilities lead to places like Washington and Congress as well as Wall Street. We also cannot forget that there are numerous causes to the financial crisis, not just one. In truth, we all took turns inflating the housing bubble. Today we are looking at the role of one investment bank, Goldman Sachs. My goal is simply to uncover the truth of what happened in several of these transactions. If we can understand this piece of the puzzle, we will be in a much better position to craft responsible legislation that addresses the real problem, not the symptoms of the problem. And more importantly, the American people will be better informed and more equipped to hold us accountable. The investigation into Goldman Sachs has given the Subcommittee an opportunity to dive into the firm's decisions regarding mortgage investments. Even though Goldman Sachs is the focus, I would suggest that the questions we are going to ask the witnesses today should also be asked of other leading investment banks. Congress has a responsibility to understand how widespread some of these complex financial transactions may be and the ethics and motivations behind them. The key question before us, I believe, is whether Goldman Sachs was making proprietary trades that were contrary to the financial interests of their customers. Sorting out these potential conflicts is central to understanding how we move forward with financial reform and also understanding that there is a role for a market maker who plays both sides of the market. And we cannot lose sight of that. Several instances, however, seem to show bankers and traders were focused on doing what was right for the firm rather than what was in the best interest of their clients. In an exchange over the Abacus deal, one employee remarked, ``The way I look at it, the easiest managers to work with should be used for our own priorities. Managers that are a bit more difficult should be used for trades like Paulson.'' Goldman employees knew that such tactics could hurt their reputation if they were uncovered. Markets can be complex, but they are built on three simple concepts: Truth, trust, and transparency. Without them, the cost of doing business is too high, and markets cannot function properly. I have several questions about these deliberations within Goldman Sachs. I am committed to withholding final judgment until all our hearings are complete. Some of what we uncovered paints a fairly dark picture of what was going on inside investment banks. To the witnesses, I would say this is your opportunity to explain to us and the American people what happened. And, again, I thank you for being here. Now I would like to move to my questions, Mr. Chairman. Mr. Swenson, if you would, would you turn to Exhibit 55b?\1\ This is a copy of your own performance evaluation for 2007, and I want to spend some time with you on that, with your own self-assessment, and I have some questions. You wrote this document, I believe. What was the purpose of this document?--------------------------------------------------------------------------- \1\ See Exhibit No. 55b, which appears in the Appendix on page 441.--------------------------------------------------------------------------- " FOMC20070918meeting--195 193,VICE CHAIRMAN GEITHNER.," I feel generally comfortable with the trajectory you’re on and with the evolving shape of this thing. There is one issue still where it seems to me we don’t quite have it right, which is that the narrative description does not, because it really cannot, describe the story that is reflected in the central tendency of the forecast. So the narrative is really more a repetition of the numbers and of what is in the tables around dispersion, and that is probably because we haven’t given the staff a way to talk about or let us talk about the story that underpins it in some sense. Since a central value in this innovation to the communication regime is to give a bit more texture to the story that underpins the central tendency, it would be worth exploring whether we could figure out a way to design our discussion so that the staff could write a narrative in a way that does a better job of allowing that. With that exception, that qualification, it seems as though what you laid out, Don, makes sense." CHRG-111hhrg54869--92 Mr. Lynch," Mr. Volcker, thank you for your attendance and for helping the committee with its work. I was listening to your testimony outside and I was wondering, this whole framework that we are considering here--given the complexity of some of this, some of the instruments that are being traded now, the derivatives that we are now going to put on exchanges, and some that are not but necessarily require oversight, where we are entering new territory here which we hope will bring more effective regulation to the entire financial services industry. The question for us in part will be how to pay for that, how to pay for that structure. And I know that the last time we had a great disruption here, the Great Depression, Congress and the financial services industry sat down and they derived a system that--I think it was one three-hundreth of 1 percent of every share traded on the exchanges would go in to pay for the SEC, for example. That number has been reduced over time because of the volume of trades. But would you favor some type of--when we have to grapple with how to pay for all this, would you favor some type of system, some transaction fee, for example, that would help fund all of this? We have many, many of our constituents who don't have any--they don't have an IRA, they don't have money in the stock market. And yet if we use the general taxation authority, they too will be paying for this system that they don't necessarily benefit directly from. And I was wondering if we could have your thoughts on how we might as a Congress pay for some of the regulation that we are about to implement. " CHRG-111shrg55278--97 PREPARED STATEMENT OF SENATOR TIM JOHNSON Thank you Mr. Chairman for holding today's hearing. Hearings like this will be important as the Committee prepares to consider legislation to modernize our financial regulatory system and establish a mechanism to identify systemic risks to our economy. There is widespread agreement that institutions exploiting gaps in our regulatory system greatly contributed to the current economic crisis. These institutions, while oftentimes large and complex, were able to offer products with minimal regulation and operate with little oversight. The scope of the economic crisis is indicative of the breadth of the gaps in our regulatory system. Many have suggested that the best way to close these gaps is through the creation of an entity to oversee systemically risky firms, what some have termed ``too-big-to-fail.'' This entity could watch, evaluate, and when necessary, intervene to prevent failures of large firms from leading to an economy-wide meltdown. That said, we must be able to identify systemic risks without creating unnecessary regulation and without giving large firms the idea that the Federal Government is there to bail them out if they make poor decisions. A systemic risk regulator would have to put taxpayer protection at the top of its priority list. It is my hope that Members of this Committee from both sides of the aisle can find a proposal to better monitor systemic risk, whether within an existing agency or with the creation of a new entity. Regardless of who does it, we need to identify systemic risk in our financial markets to prevent another crisis like the one we are experiencing from happening again and to aid in our economic recovery and reform. We must get this right. I look forward to hearing from today's witnesses. ______ CHRG-111shrg50815--22 Chairman Dodd," Well, I thank you very, very much. The complexity of it all for consumers is not accidental, in my view. Mr. Zywicki, thank you.STATEMENT OF TODD J. ZYWICKI, PROFESSOR OF LAW, MERCATUS CENTER CHRG-111shrg51395--268 RESPONSE TO WRITTEN QUESTIONS OF SENATOR CRAPO FROM PAUL SCHOTT STEVENSQ.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. In his March 10 speech to the Council on Foreign Relations, Chairman Bernanke suggested that policymakers should begin to think about ``reforms to the financial architecture, broadly conceived, that could help prevent a similar [financial] crisis from developing in the future.'' He further highlighted the need for ``a strategy that regulates the financial system as a whole, in a holistic way.'' ICI concurs with Chairman Bernanke that the four areas outlined in the question, and discussed in turn below, are key elements of such a strategy. It bears emphasizing that this list is not exclusive (and that Chairman Bernanke himself did not suggest otherwise). In ICI's view, other key elements of a reform strategy include consolidating and strengthening the primary regulators for each financial sector, and ensuring more effective coordination and information sharing among those regulators. These issues are addressed in detail in ICI's March 3, 2009, white paper, Financial Services Regulatory Reform: Discussion and Recommendations. \1\--------------------------------------------------------------------------- \1\ See Financial Services Regulatory Reform: Discussion and Recommendations, which is available at http://www.ici.org/pdf/ppr_09_reg_reform.pdf. We note that the white paper was included as an attachment to ICI's written testimony.--------------------------------------------------------------------------- ``Too big to fail'': ICI agrees that the notion of financial institutions that are too big or too interconnected to fail deserves careful attention. The financial crisis has highlighted how the activities of large financial institutions can have wide-ranging effects on the economy. It is incumbent upon policymakers and other interested parties to consider how best to mitigate the risks that the activities of large financial institutions can pose to the financial system as a whole. As part of this analysis, one issue is how to define what is meant by ``too big to fail.'' If it means that certain large financial institutions will receive either explicit or implicit Federal guarantees of their debt, such institutions will gain an unfair competitive advantage. Allowing these institutions to borrow at risk-free (or near risk-free) interest rates could encourage them to take excessive risks, and may cause them to grow faster than their competitors, both of which potentially would magnify systemic risks. Ultimately, U.S. taxpayers would bear the costs of such actions. Chairman Bernanke echoed these concerns in his March 10 remarks. He described the undesirable effects if market participants believe that a firm is considered too big to fail, indicating that this belief: 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. Legislative or regulatory reforms aimed at addressing risks to the financial system posed by the activities of large and complex financial firms must be designed to avoid these results. Strengthening the Financial Infrastructure: ICI strongly concurs with Chairman Bernanke's comments about the need to strengthen the financial infrastructure, in order to improve the ability of the financial system to withstand future shocks and ``reduc[e] the range of circumstances in which systemic stability concerns might prompt government intervention.'' For example, we support current initiatives toward centralized clearing for credit default swaps (CDS). Central clearing should help reduce counterparty risk and bring transparency to trading in the types of CDS that can be standardized. Not all CDS are sufficiently standardized to be centrally cleared, however, and institutional investors will continue to need to conduct over-the-counter transactions in CDS. For those transactions, we support reasonable reporting requirements, in order to ensure that regulators have enough data on the CDS market to provide effective oversight. In addition, we would be generally supportive of efforts to improve the market for repurchase agreements. Steps such as those we have outlined may serve to deepen the relevant markets, encourage buyers and sellers to continue to transact during times of market turmoil and, in particular, help foster greater price transparency. We further concur with Chairman Bernanke's assessment of the importance of money market funds--particularly their ``crucial role'' in the commercial paper market and as a funding source for businesses--and his call for policymakers to consider ``how to increase the resiliency of those funds that are susceptible to runs.'' Similarly, Treasury Secretary Geithner has outlined the Administration's position on systemic risk and called for action in six areas, including the adoption of new requirements for money market funds to reduce the risk of rapid withdrawals. In this regard, ICI and its members, working through our Money Market Working Group, recently issued a comprehensive report outlining a range of measures to strengthen money market funds and help them withstand difficult market conditions in the future. \2\ More specifically, the Working Group's recommendations are designed to strengthen and preserve the unique attributes of a money market fund as a low-cost, efficient cash management tool that provides a high degree of liquidity, stability in principal value, and a market-based yield. The proposed standards and regulations would ensure that money market funds are better positioned to sustain prolonged and extreme redemption pressures and that mechanisms are in place to ensure that all shareholders are treated fairly if a fund sees its net asset value fall below $1.00.--------------------------------------------------------------------------- \2\ See Report of the Money Market Working Group, Investment Company Institute (March 17, 2009), available at http://www.ici.org/pdf/ppr_09_mmwg.pdf--------------------------------------------------------------------------- Secretary Geithner specifically identified the SEC as the agency to implement any new requirements for money market funds. ICI wholeheartedly concurs that the SEC, as the primary regulator for money market funds, is uniquely qualified to evaluate and implement potential changes to the existing scheme of money market fund regulation. SEC Chairman Shapiro and members of her staff have indicated on several occasions that her agency is currently conducting such a review on an expedited basis, and we are pleased that the review will include consideration of the Working Group's recommendations. Preventing Excessive Procyclicality: Some financial institutions have criticized the use of mark-to-market accounting in the current environment as overstating losses, diminishing bank capital, and exacerbating the crisis. Others have applauded its use as essential in promptly revealing the extent of problem assets and the deteriorating financial condition of institutions. Investment companies, as investors in securities, rely upon financial reporting that accurately portrays the results and financial position of companies competing for investment capital. ICI supports the work of the Financial Accounting Standards Board and its mission to develop financial reporting standards that provide investors with relevant, reliable and transparent information about corporate financial performance. Certainly, regulatory policies and accounting rules should not induce excessive procyclicality. At the same time, accounting standards should not be modified to achieve any objective other than fair and accurate reporting to investors and the capital markets. Any concerns regarding the procyclical effects of mark-to-market accounting on lending institutions' capital may be better addressed through changes to capital standards themselves. Consideration should be given to, for example, developing countercyclical capital standards and requiring depositaries and other institutions to build up capital more amply in favorable market conditions and thus position themselves to weather unfavorable conditions more easily. Monitoring and Addressing Systemic Risk: Over the past year, various policymakers and other commentators have called for the establishment of a formal mechanism for identifying, monitoring, and managing risks to the financial system as a whole. ICI concurs with those commentators that creation of such a mechanism is necessary. The ongoing financial crisis has highlighted the vulnerability of our financial system to risks that have the potential to spread rapidly throughout the system and cause significant damage. A mechanism that will allow Federal regulators to look across the system should equip them to better anticipate and address such risks. In its recent white paper on regulatory reform, ICI endorsed the designation of a new or existing agency or inter-agency body as a ``Systemic Risk Regulator.'' Broadly stated, the goal in establishing a Systemic Risk Regulator should be to provide greater overall stability to the financial system as a whole. The Systemic Risk Regulator should have responsibility for: (1) monitoring the financial markets broadly; (2) analyzing changing conditions in domestic and overseas markets; (3) evaluating the risks of practices as they evolve and identifying those that are of such nature and extent that they implicate the health of the financial system at large; and (4) acting to mitigate such risks in coordination with other responsible regulators. In ICI's view, Congress should determine the composition and authority of the Systemic Risk Regulator with two important cautions in mind. First, the legislation establishing the Systemic Risk Regulator should be crafted to avoid imposing undue constraints or inapposite forms of regulation on normally functioning elements of the financial system, or stifling innovations, competition or efficiencies. Second, the 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. Rather, the Systemic Risk Regulator should focus principally on protecting the financial system--as discussed in detail in our white paper, we believe that a strong and independent Capital Markets Regulator (or, until such agency is established by Congress, the SEC) should focus principally on the equally important mandates of protecting investors and maintaining market integrity. Legislation establishing the Systemic Risk Regulator should define the nature of the relationship between this new regulator and the primary regulator(s) for each industry sector. This should involve carefully defining the extent of the authority granted to the Systemic Risk Regulator, as well as identifying 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 have a critical role to play by acting as the first line of defense with regard to detecting potential risks within their spheres of expertise. We recognize that it may be appropriate, for example, to lodge responsibility for ensuring effective consolidated global supervision of the largest bank holding companies with a designated regulator such as the Federal Reserve Board. Beyond this context, however, and in view of the two cautions outlined above, ICI believes that responsibility for systemic risk management more broadly should be assigned to a Systemic Risk Regulator structured as a statutory council comprised of senior Federal regulators. Membership should include, at a minimum, the Secretary of the Treasury, Chairman of the Federal Reserve Board of Governors, and the heads of the Federal bank and capital markets regulators (and insurance regulator, if one emerges at the Federal level).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. Establishment of a New Capital Markets Regulator: ICI strongly believes that a merger or rationalization of the roles of the Securities and Exchange Commission (SEC) and Commodity Futures Trading Commission (CFTC) would be a valuable reform. Currently, securities and futures are subject to separate regulatory regimes under different Federal regulators. This system reflects historical circumstances that have changed significantly. As recently as the mid-1970s, for example, agricultural products accounted for most of the total U.S. futures exchange trading volume. By the late 1980s, a shift from the predominance of agricultural products to financial instruments and currencies was readily apparent in the volume of trading on U.S. futures exchanges. In addition, as new, innovative financial instruments were developed, the lines between securities and futures often became blurred. The existing, divided regulatory approach has resulted in jurisdictional disputes, regulatory inefficiency, and gaps in investor protection and market oversight. With the increasing convergence of securities and futures products, markets, and market participants, the current system simply makes no sense. To bring a consistent policy focus to U.S. capital markets, ICI strongly recommends the creation of a Capital Markets Regulator as a new agency that would encompass the combined functions of the SEC and those of the CFTC that are not agriculture-related. As the Federal regulator responsible for overseeing all financial investment products, it is imperative that the Capital Markets Regulator--like the SEC and the CFTC--be established by Congress as an independent agency, with an express statutory mission and the rulemaking and enforcement powers necessary to carry out that mission. A critical part of that mission should be for the new agency to maintain a sharp focus on investor protection and law enforcement. And Congress should ensure that the agency is given the resources it needs to fulfill its mission. Most notably, the Capital Markets Regulator must have the ability to attract personnel with the necessary market experience to fully grasp the complexities of today's global marketplace. To preserve regulatory efficiencies achieved under the National Securities Markets Improvement Act of 1996, Congress should affirm the role of the Capital Markets Regulator as the regulatory standard setter for all registered investment companies. ICI further envisions the Capital Markets Regulator as the first line of defense with respect to identifying and addressing risks across the capital markets. The new agency should be granted explicit authority to regulate in certain areas where there are currently gaps in regulation--in particular, with regard to hedge funds, derivatives, and municipal securities--and explicit authority to harmonize the legal standards applicable to investment advisers and brokerdealers. These areas are discussed in greater detail in ICI's March 3, 2009, white paper, Financial Services Regulatory Reform: Discussion and Recommendations. \3\--------------------------------------------------------------------------- \3\ See Financial Services Regulatory Reform: Discussion and Recommendations, which is available at http://www.ici.org/pdf/ppr_09_reg_reform.pdf. We note that the white paper was included as an attachment to ICI's written testimony.--------------------------------------------------------------------------- Organization and Management of the Capital Markets Regulator: In the private sector, a company's success is directly related to the soundness of its management. The same principle holds true for public sector entities. Establishing a new agency presents a very valuable opportunity to ``get it right'' as part of that process. There is also an opportunity to make sound decisions up-front about how to organize the new agency. In so doing, it is important not to simply use the current structure of the SEC and/or the CFTC as a starting point. The SEC's current organizational structure, for example, largely took shape in the early 1970s and reflects the operation of the securities markets of that day. Rather, the objective should be to build an organization that not only is more reflective of today's markets, market participants and investment products, but also will be flexible enough to regulate the markets and products of tomorrow. ICI offers the following thoughts with regard to organization and management of the Capital Markets Regulator: LEnsure high-level focus on agency management. One approach would be to designate a Chief Operating Officer for this purpose. LImplement a comprehensive process for setting regulatory priorities and assessing progress. It may be helpful to draw upon the experience of the United Kingdom's Financial Services Authority, which seeks to follow a methodical approach that includes developing a detailed annual business plan establishing agency priorities and then reporting annually the agency's progress in meeting prescribed benchmarks. LPromote open and effective lines of communication among the regulator's Commissioners and between its Commissioners and staff. Such communication is critical to fostering awareness of issues and problems as they arise, thus increasing the likelihood that the regulator will be able to act promptly and effectively. A range of approaches may be appropriate to consider in meeting this goal, including whether sufficient flexibility is provided under the Government in the Sunshine Act, and whether the number of Commissioners should be greater than the current number at the SEC and at the CFTC (currently, each agency has five). LAlign the inspections and examinations functions and the policymaking divisions. This approach would have the benefit of keeping staff in the policymaking divisions updated on current market and industry developments, as well as precluding any de facto rulemaking by the regulator's inspections staff. LDevelop mechanisms to facilitate coordination and information sharing among the policymaking divisions. These mechanisms would help to ensure that the regulator speaks with one voice. Process of Merging the SEC and CFTC: Legislation to merge the SEC and CFTC should outline a process by which to harmonize the very different regulatory philosophies of the two agencies, as well as to rationalize their governing statutes and current regulations. There is potential peril in leaving open-ended the process of merging the two agencies. ICI accordingly recommends that the legislation creating the Capital Markets Regulator set forth a specific timetable, with periodic benchmarks and accountability requirements, to ensure that the merger of the SEC and CFTC is completed as expeditiously as possible. The process of merging the two agencies will be lengthy, complex, and have the potential to disrupt the functioning of the SEC, CFTC, and their regulated industries. ICI suggests that, in anticipation of the merger, the SEC and CFTC undertake detailed consultation on all relevant issues and take all steps possible toward greater harmonization of the agencies. This work should be facilitated by the Memorandum of Understanding the two agencies signed last year regarding coordination in areas of common regulatory interest. \4\ ICI believes that its recommendations with respect to the Capital Markets Regulator, outlined in detail in its white paper, may provide a helpful framework for these efforts.--------------------------------------------------------------------------- \4\ See SEC, CFTC Sign Agreement to Enhance Coordination, Facilitate Review of New Derivative Products (SEC press release dated March 11, 2008), available at http://www.sec.gov/news/press/2008/2008-40.htmQ.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. ICI does not have particular insight to offer with regard to AIG, the size of its positions in credit default swaps (CDS), and the effect that those positions ultimately had on the broader financial markets. Nevertheless, our sense is that the answers lie in a combination of all the factors outlined above. We note that Congress seems poised to establish a bipartisan commission to investigate the causes of the current financial crisis. A thorough examination of what happened with AIG would no doubt be a very useful part of the commission's inquiry. With regard to CDS generally, ICI believes that a single independent Federal regulator for capital markets should have clear authority to adopt measures to increase transparency and reduce counterparty risk, while not unduly stifling innovation. \5\ We support current initiatives toward centralized clearing for CDS, which should help to reduce counterparty risk and bring transparency to trading in the types of CDS that can be standardized. Not all CDS are sufficiently standardized to be centrally cleared, however, and institutional investors will continue to need to conduct over-the counter transactions in CDS. For those transactions, we support reasonable reporting requirements, in order to ensure that regulators have enough data on the CDS market to provide effective oversight. Finally, we believe that all institutional market participants should be required to periodically disclose their CDS positions publicly, as funds are currently required to do.--------------------------------------------------------------------------- \5\ In our March 3, 2009 white paper, Financial Services Regulatory Reform: Discussion and Recommendations (which is available at http://www.ici.org/pdf/ppr_09_reg_reform.pdf), ICI recommended the creation of a Capital Markets Regulator as a new agency that would encompass the combined functions of the SEC and those of the CFTC that are not agriculture-related. To the extent that no Capital Markets Regulator is formed, we believe that the SEC is the regulator best suited to provide effective oversight of financial derivatives, including CDS.Q.4. How should we update our rules and guidelines to address ---------------------------------------------------------------------------the potential failure of a systematically critical firm?A.4. Experience during the financial crisis has prompted calls to establish a better process for dealing with large, diversified financial institutions whose solvency problems could have significant adverse effects on the financial system or the broader economy. Depository institutions already have in place a resolution framework administered by the Federal Deposit Insurance Corporation. In contrast, other ``systemically important'' financial institutions facing insolvency either have to rely on financial assistance from the government (as was the case with AIG) or file for bankruptcy (as was the case with Lehman Brothers). The Treasury Department has expressed concern that these ``options do not provide the government with the necessary tools to manage the resolution of [a financial institution] efficiently and effectively in a manner that limits systemic risk with the least cost to the taxpayer.'' \6\ Treasury has sent draft legislation to Congress that is designed to address this concern. The legislation would authorize the FDIC to take a variety of actions (including appointing itself as conservator or receiver) with respect to a ``financial company'' if the Treasury Secretary, in consultation with the President and based on the written recommendation of the Federal Reserve Board and the ``appropriate Federal regulatory agency,'' makes a systemic risk determination concerning that company.--------------------------------------------------------------------------- \6\ See Treasury Proposes Legislation for Resolution Authority (March 25, 2009), available at http://www.treas.gov/press/releases/tg70.htm--------------------------------------------------------------------------- ICI agrees that it would be helpful to establish rules governing the resolution of certain large, diversified financial institutions in order to minimize the impact of the potential failure of such an institution on the financial system and consumers as a whole. Such a resolution process could benefit investors, including investment companies (and their shareholders). The rules for a federally-facilitated wind down should be clearly established so that creditors and other market participants understand the process that will be followed and the likely ramifications. Uncertainty associated with ad hoc approaches that differ from one resolution to the next will be very destabilizing to the financial markets. Clear rules and a transparent process are critical to bolster confidence and avoid potentially creating reluctance on the part of market participants to transact with an institution that is perceived to be ``systemically important.'' In determining which institutions might be subject to this resolution process, we recommend taking into consideration not simply ``size'' or the specific type of institution but critical factors such as the nature and extent of an institution's leverage and trading positions, the nature of its borrowing relationships, the amount of difficult-to-value assets on its books, its off-balance sheet liabilities, and the degree to which it engages in activities that are opaque or unregulated. More broadly, the reforms recommended in ICI's recent white paper, \7\ if enacted, would lead to better supervision of systemically critical financial institutions and would help avoid in the future the types of situations that have arisen in the financial crisis, such as the failure or near failure of systemically important firms. Our recommendations include:--------------------------------------------------------------------------- \7\ See Financial Services Regulatory Reform: Discussion and Recommendations, which is available at http://www.ici.org/pdf/ppr_09_reg_reform.pdf. We note that the white paper was included as an attachment to ICI's written testimony. LEstablishing a ``Systemic Risk Regulator'' that would identify, monitor and manage risks to the --------------------------------------------------------------------------- financial system as a whole; LCreating a consolidated Capital Markets Regulator that would encompass the combined functions of the Securities and Exchange Commission and those of the Commodity Futures Trading Commission that are not agriculture-related; LConsidering consolidation of the regulatory structure for the banking sector; LAuthorizing an optional Federal charter for insurance companies; and LPromoting effective coordination and information sharing among the various financial regulators. ------ 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. " CHRG-111shrg53822--78 Mr. Rajan," I agree that they could have some effect. But my point is when you set capital requirements at 20 percent of bank assets, they are going to do a lot of things, which you will be surprised about in bad times because those SIVs, they have created the conduits. It will all come back on balance sheets at that point, and you will find that even the 20 percent is not enough. That is one. The second is we also have to worry about costs. When you ask banks, which are naturally funded with debt, to take on a lot of capital, intermediation is also going to suffer. I mean, I agree with you. You could have some benefits, but maybe not that much. Senator Akaka. Thank you. Speaking about capital and ensuring adequate capital, Mr. Rajan raises the idea of having large, complex financial companies buy capital insurance plans or issue bonds that will convert to equity if capital deteriorates as a way to guard against the failure of these institutions. Mr. Rajan, can you elaborate on this idea? " CHRG-111shrg51303--105 Mr. Polakoff," I am the one, sir. This complex company is a savings and loan holding company, so at the very top---- Senator Martinez. Define that a little more for me. What is a savings and loan holding company? Is it a company that--well, go ahead, if you would. " 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-111shrg51290--8 Chairman Dodd," Thank you very much, as well, Senator. I appreciate your opening comments. Let me just introduce our witnesses so we can get to them. As I said at the outset, I was very impressed with your testimony. It is very thorough and, in fact, my constituent is extremely thorough. His testimony was 28 pages. We are going to try and limit you this morning. I am going to challenge my colleagues to read all of it, but we will try and keep it down to about somewhere between five and 8 minutes or so, so that we can get to some questions with you. Our first witness is truth in advertising. He is a good friend of mine, Steve Bartlett. Steve is CEO of the Financial Services Roundtable, previously served as the Mayor of Dallas, a former Member of the Congress. In fact, he served on the Financial Services Committee when he served in the House, and so he has a familiarity with these issues as a chief executive of a city, as a Member of the Congress serving on the counterpart Committee to this Committee, and, of course, as the CEO of the Financial Services Roundtable. Steve, we thank you immensely for joining us today and being with us. Ellen Seidman is the former Director of the Office of Thrift Supervision and currently Senior Fellow of the New America Foundation and Executive Vice President on National Policy and Partnership Development at ShoreBank Corporation. We thank you very much once again for being before the Committee. And I am proud to introduce Professor Patricia McCoy, a nationally recognized authority on consumer finance law and subprime lending. She is the George J. and Helen M. England Professor of Law at the University of Connecticut. She was a partner of Mayer, Brown, Rowe and Maw in Washington, D.C., where she specialized in complex securities banking and commercial constitutional litigation. It is a pleasure to have you. I hope you are enjoying your tenure in Connecticut. Ms. McCoy. Very much so, Senator. " 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.] " 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-111shrg57923--41 Mr. Horne," Thank you, Senator. Senator Reed. The hearing is adjourned. [Whereupon, at 4:33 p.m., the hearing was adjourned.] PREPARED STATEMENT OF CHAIRMAN EVAN BAYHPre-Opening Remarks Good morning. I am pleased to call to order this Subcommittee for a hearing entitled ``Equipping Financial Regulators with the Tools Necessary to Monitor Systemic Risk.'' I want to thank the Ranking Member, Senator Corker, and his staff, for requesting this hearing on an issue that may seem technical to some, but will prove critical as we work to reform and modernize our regulatory structure for the future. I would also like to welcome and thank Senator Jack Reed. He has been instrumental on the technical and analytic aspects of systemic risk regulation, specifically on the proposal of a National Institute of Finance. I am happy to continue the dialog he has already begun on how we equip our regulators to move beyond examining individual institutions and toward monitoring and managing systemic risk across our financial system. To our witnesses that will appear on two separate panels, welcome and thank you for appearing before the subcommittee to give an outline on regulators' current capabilities to collect and analyze financial market data; and most importantly, what additional resources and capabilities are necessary to provide effective systemic risk regulation. I understand that the weather in Washington the last few days has not been ideal, so I appreciate the dedication you have all show in making it here today. Before we turn to Governor Tarullo, I would like to make a few remarks on why this issue is essential to the safety and soundness of our financial system moving forward.Opening Statement Over a year ago, our country experienced a financial crisis that exposed the complexity and interconnectedness of our financial system and markets. The globalization of financial services and the increasing size and intricacy of major market players enabled the buildup and transferring of risk that was not fully recognized or understood by our regulators, or, in some cases, by the institutions themselves. These vulnerabilities made it clear to policymakers here in Washington that our financial system, as whole, needs its own overseer. As a result, systemic risk regulation has become a central part of our efforts to modernize our financial regulatory system. Creating a new regulatory structure to monitor systemic risk is no easy task. My colleagues here in the Banking Committee, including Chairman Dodd, Senators Corker, Reed and Warner have been working diligently to determine what tools and technical capabilities may be necessary for the regulation of systemic financial risk. To that end, the National Research Council held a workshop in November at the request of Senator Reed to identify the major technical challenges to building that capacity. While it is clear that our regulatory system currently lacks the technical resources to monitor and manage risk with sufficient sophistication and comprehensiveness, we should figure out what capabilities our regulators currently have. That involves assessing what data and analytical tools are currently available to regulators to collect real-time, consistent market data. We have Governor Tarullo here to discuss what data and analytical methodologies prudential regulators currently have in place to see real-time financial market data and how our current financial regulators collaborate in aggregating and analyzing data. Next, we can focus on the biggest challenge of this exercise--determining what further capabilities are necessary, as well as identifying the barriers and challenges to meeting the goals of systemic risk regulation. This involves much more than aggregating information, but making sure we are filling the information gaps, asking the right questions, and putting that information into the broader context of the risk dynamics in the system. Currently, risk analysis has developed solely to manage firm-specific risks. That approach needs to evolve beyond the individual institution, and work to include the complex interaction and linkages amongst the system to assemble a holistic perspective. In debating the capabilities needed, the next obvious question centers on developing the right infrastructure for the enhanced data aggregation, mathematical modeling and all the other issues that go into systemic risk regulation. An idea that has the support of six Nobel Laureates, including Professor Engle who is on our second panel this afternoon, is the creation of a National Institute of Finance. Supported by the Committee to Establish the National Institute of Finance, this proposal urges the creation of an independent institute to collect and standardize the reporting of financial market data, as well as develop tools for measuring and monitoring systemic risk. On February 4th, my colleague Senator Reed introduced legislation to create such an institute. We have some of the founders of that Committee with us today to outline what they envision in the creation of an independent NIF. I am also open to other ideas, including whether or not a separate additional agency is necessary or if these new technical capabilities can be housed in an existing independent Federal agency, such as the Federal Reserve. I look forward to hearing our witnesses' perspective on this issue, as well. Lastly, in a discussion on systemic risk and data aggregation, we would be remiss to ignore the international implications to our domestic systemic risk regulation. As I've said before, we live in an interconnected global economy, and as we've seen, that means interconnected global problems. Vulnerabilities and gaps in financial markets abroad, can impact us here at home. A key element of this discussion should focus on how we encourage global financial market reporting, aggregating and analytic capabilities, as well as identifying any legal or legislative barriers to international data sharing. Ultimately, all of us here know our country cannot afford another financial crisis that will have a devastating impact on household wealth, unemployment and our economy, at large. While seemingly technical in nature, these issues are critical to our national interest and necessary to strengthen and provide credibility to our financial system. I look forward to working with my colleagues to ensure these issues are addressed in our comprehensive regulatory reform bill. ______ CHRG-111hhrg53248--11 Mr. Kanjorski," For more than 70 years, Mr. Chairman, the regulatory reforms of the 1930's brought about, and then enacted because of the unbridled excess of dangerous speculation of an earlierera, safely steered our financial markets through the always rocky seas of capitalism. But all good things must come to an end. Created for the economy of the last century, those antiquated rules failed to respond to today's realities in which financial engineering and innovation surpassed effective oversight. For our economy to flourish once again, we must fix this problem. The Administration's diligent efforts to reform our outmoded and flawed regulatory system have resulted in a White Paper and subsequently specific legislative proposals. In particular, I am pleased that the Administration calls for establishing the Office of National Insurance, an idea I first originated and for which I have strongly advocated for some time. Also I commend efforts to regulate the advisors of hedge funds and other private pools of capital. Similarly derivatives and swaps markets will finally face a suitable level of scrutiny under the Administration's plan. These reforms are long overdue. While the Administration's proposals for credit rating agencies represent a good start, we must do more, much more, in this field. By sprinkling their magic dust on toxic assets, rating agencies turned horse manure into fool's gold. We therefore should no longer pursue only modest modifications in regulating this problematic industry. Instead, we must consider radical reforms aimed at improving accountability, reliability, transparency, and independence. We could, for example, promote better ratings quality by establishing a fee on securities transactions to pay for ratings, forcing a government quality assessment of rating agency methodologies, changing liability standards for rating agencies and altering business structures. Additionally, I must reiterate my deep and profound concerns about the selections of the Federal Reserve as the primary entity in charge of systemic risk. I believe that we need someone with real political accountability in this role like the Treasury Secretary. On the whole, however, the Administration has produced a very thoughtful approach to financial services regulatory reform. I applaud the Administration for its hard work. Congress has now begun its hard work using the Administration's promising foundation as our guide for enacting new laws that put in place a regulatory system that will last a very long time and help to ensure American prosperity for many years to come. I yield back my time. " CHRG-110shrg50417--119 Mr. Palm," I will go next. We have not established a new committee. However, what I would say, as I indicated earlier, is our whole business is committing capital and using it, and we have got now additional capital, and we have to earn a return on it for all of our shareholders, including the Government. And in that connection, our whole investment banking division is, in essence, there to service corporate relationships all around America. And part of the business model is to help them achieve whatever they are trying to do, and part of that may well be that they have something they need to do which will create, you know, productivity, jobs, innovation, or however you want to describe it, which will require additional capital. If you have more capital now, we will be able to commit some of it. That is a natural activity which, you know, just is a recurring phenomenon. There is nothing new there. But we are certainly active. " CHRG-111shrg57709--248 DESKS ARE NOT THE PROBLEM January 25, 2010 By Christopher Whalen There are certain basic things that the investor must realize today. In the first place, he must recognize the weakness of his individual position . . . [T]he growth of investors from the comparative few of a generation ago to the millions of the present day has made it a practical impossibility for the individual investor to know what is occurring in the affairs of the corporation in which he has an interest. He has been forced to relegate his rights to a controlling class whose interests are often not identical to his own. Even the bondholder who has superior rights finds in many cases that these rights have been taken away from him by some clause buried in a complicated indenture . . . The second fact that the investor must face is that the banker whom tradition has considered the guardian of the investors' interests is first and foremost a dealer in securities; and no matter how prominent the name, the investor must not forget that the banker, like every other merchant, is primarily interested in his own greatest profit. --False Security: The Betrayal of the American Investor, Bernard J. Reis and John T. Flynn, Equinox Cooperative Press, NY (1937). This is an expanded version of a comment we posted last week on ZeroHedge. Watching the President announcing the proposal championed by former Fed Chairman Paul Volcker to forbid commercial banks from engaging in proprietary trading or growing market share beyond a certain size, we are reminded of the reaction by Washington a decade ago in response to the Enron and WorldCom accounting scandals, namely the Sarbanes-Oxley law. The final solution had nothing to do with the actual problem and everything to do with the strange political relationship between the national Congress, the central bank and the Wall Street dealer community. We call it the ``Alliance of Convenience.'' The basic problems illustrated by the Enron/WorldCom scandals were old fashioned financial fraud and the equally old use of off-balance sheet vehicles to commit same. By responding with more stringent corporate governance requirements, the Congress was seen to be responsive--but without harming Wall Street's basic business model, which was described beautifully by Bernard J. Reis and John T. Flynn some eighty years ago in the book False Security. A decade since the Enron-WorldCom scandals, we still have the same basic problems, namely the use of OBS vehicles and OTC structured securities and derivatives to commit securities fraud via deceptive instruments and poor or no disclosure. Author Martin Mayer teaches us that another name for OTC markets is ``bucket shop,'' thus the focus on prop trading today in the Volcker Rule seems entirely off target--and deliberately so. The Volcker Rule, at least as articulated so far, does not solve the problem nor is it intended to. And what is the problem? Not a single major securities firm or bank failed due to prop trading during the past several years. Instead, it was the securities origination and sales process, that is, the customer side of the business of originating and selling securities that was the real source of systemic risk. The Volcker Rule conveniently ignores the securities sales and underwriting side of the business and instead talks about hedge funds and proprietary trading desks operated inside large dealer banks. But this is no surprise. Note that former SEC chairman Bill Donaldson was standing next to President Obama on the dais last week when the President unveiled his reform, along with Paul Volcker and Treasury Secretary Tim Geithner. Donaldson is the latest, greatest guardian of Wall Street and was at the White House to reassure the major Sell Side firms that the Obama reforms would do no harm. But frankly Chairman Volcker poses little more threat to Wall Street's largest banks than does Donaldson. After all, Chairman Volcker made his reputation as an inflation fighter and not in bank supervision. Chairman Volcker was never known as a hawk on bank regulatory matters and, quite the contrary, was always attentive to the needs of the largest banks. Volcker's protege, never forget, was E. Gerald Corrigan, former President of the Federal Reserve Bank of New York and the intellectual author of the ``Too Big To Fail'' (TBTF) doctrine for large banks and the related economist nonsense of ``systemic risk.'' But Corrigan, who now hangs his hat at Goldman Sachs (GS), did not originate these ideas. Corrigan was never anything more than the wizard's apprentice. As members of the Herbert Gold Society wrote in the 1993 paper ``Gone Fishing: E. Gerald Corrigan and the Era of Managed Markets'': 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. The lesson to take from the Volcker-Corrigan relationship is don't look for any reform proposals out of Chairman Volcker that will truly inconvenience the large, TBTF dealer banks. The Fed, after all, has for several decades been the chief proponent of unregulated OTC markets and the notion that banks and investors could ever manage the risks from these opaque and unpredictable instruments. Again to quote from the ``Gone Fishing'' 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. As Wall Street's normally selfish behavior spun completely out of control, Volcker has become an advocate of reform, but only focused on those areas that do not threaten Wall Street's core business, namely creating toxic waste in the form of OTC derivatives such as credit default swaps and unregistered, complex assets such as collateralized debt obligations, and stuffing same down the throats of institutional investors, smaller banks and insurance companies. Securities underwriting and sales is the one area that you will most certainly not hear President Obama or Bill Donaldson or Chairman Volcker or HFS Committee Chairman Barney Frank mention. You can torment prop traders and hedge funds, but please leave the syndicate and sales desks alone. Readers of The IRA will recall a comment we published half a decade ago (``Complex Structured Assets: Feds Propose New House Rules,'' May 24, 2004), wherein we described how the SEC and other regulators knew that a problem existed regarding the underwriting and sale of complex structured assets, but did almost nothing. The major Sell Side firms pushed back and forced regulators to retreat from their original intention of imposing retail standards such as suitability and know your customer on institutional underwriting and sales. Before Enron, don't forget, there had been dozens of instances of OTC derivatives and structured assets causing losses to institutional investors, public pensions and corporations, but Washington's political class and the various regulators did nothing. Ultimately, the ``Interagency Statement on Sound Practices Concerning Complex Structured Finance Activities'' was adopted, but as guidance only; and even then, the guidance was focused mostly on protecting the large dealers from reputational risk as and when they cause losses to one of their less than savvy clients. The proposal read in part: The events associated with Enron Corp. demonstrate the potential for the abusive use of complex structured finance transactions, as well as the substantial legal and reputational risks that financial institutions face when they participate in complex structured finance transactions that are designed or used for improper purposes. The need for focus on the securities underwriting and sales process is illustrated by American International Group (AIG), the latest poster child/victim for this round of rape and pillage by the large Sell Side dealer banks. Do you remember Procter & Gamble (PG)? How about Gibson Greetings? AIG, along with many, many other public and private Buy Side investors, was defrauded by the dealers who executed trades with the giant insurer. The FDIC and the Deposit Insurance Fund is another large, perhaps the largest, victim of the structured finance shell game, but Chairman Volcker and President Obama also are silent on this issue. Proprietary trading was not the problem with AIG nor the cause of the financial crisis, but instead the sales, origination and securities underwriting side of the Sell Side banking business. The major OTC dealers, starting with Merrill Lynch, Citigroup (C), GS and Deutsche Bank (DB) were sucking AIG's blood for years, one reason why the latest ``reform'' proposal by Washington has nothing to do with either OTC derivatives, complex structured assets or OBS financial vehicles. And this is why, IOHO, the continuing inquiry into the AIG mess presents a terrible risk to Merrill, now owned by Bank of America (BCA), GS, C, DB and the other dealers--especially when you recall that the AIG insurance underwriting units were lending collateral to support some of the derivatives trades and were also writing naked credit default swaps with these same dealers. Deliberately causing a loss to a regulated insurance underwriter is a felony in New York and most other states in the United States. Thus the necessity of the bailout--but that was only the obvious reason. Indeed, the dirty little secret that nobody dares to explore in the AIG mess is that the Federal bailout represents the complete failure of state-law regulation of the U.S. insurance industry. One of the great things about the Reis and Flynn book excerpted above is the description of the assorted types of complex structured assets that Wall Street was creating in the 1920s. Many of these fraudulent securities were created and sold by insurance and mortgage title companies. That is why after the Great Depression, insurers were strictly limited to operations in a given state and were prohibited from operating on a national basis and from any involvement in securities underwriting. The arrival of AIG into the high-beta world of Wall Street finance in the 1990s represented a completion of the historical circle and also the evolution of AIG and other U.S. insurers far beyond the reach of state law regulation. Let us say that again. The bailout of AIG was not merely about the counterparty financial exposure of the large dealer banks, but was also about the political exposure of the insurance industry and the state insurance regulators, who literally missed the biggest act of financial fraud in U.S. history. But you won't hear Chairman Volcker or President Obama talking about Federal regulation of the insurance industry. And AIG is hardly the only global insurer that is part of the problem in the insurance industry. In case you missed it, last week the Securities and Exchange Commission charged General Re for its involvement in separate schemes by AIG and Prudential Financial (PRU) to manipulate and falsify their reported financial results. General Re, a subsidiary of Berkshire Hathaway (BRK), is a holding company for global reinsurance and related operations. As we wrote last year (``AIG: Before Credit Default Swaps, There Was Reinsurance,'' April 2, 2009), Warren Buffett's GenRe was actively involved in helping AIG to falsify its financial statements and thereby mislead investors using reinsurance, the functional equivalent of credit default swaps. Yet somehow the insurance industry has been almost untouched by official inquiries into the crisis. Notice that in settling the SEC action, General Re agreed to pay $92.2 million and dissolve a Dublin subsidiary to resolve Federal charges relating to sham finite reinsurance contracts with AIG and PRU's former property/casualty division. Now why do you suppose a U.S. insurance entity would run a finite insurance scheme through an affiliate located in Dublin? Perhaps for the same reason that AIG located a thrift subsidiary in the EU, namely to escape disclosure and regulation. If you accept that situations such as AIG and other cases where Buy Side investors (and, indirectly, the U.S. taxpayer) were defrauded through the use of OTC derivatives and/or structured assets as the archetype ``problems'' that require a public policy response, then the Volcker Rule does not address the problem. The basic issue that still has not been addressed by Congress and most Federal regulators (other than the FDIC with its proposed rule on bank securitizations) is how to fix the markets for OTC derivatives and structured finance vehicles that caused losses to AIG and other investors. Neither prop trading nor the size of the largest banks are the causes of the financial crisis. Instead, opaque OTC markets, deliberately deceptive structured financial instruments and a general lack of disclosure are the real problems. Bring the closed, bilateral world of OTC markets into the sunlight of multilateral, public price discovery and require SEC registration for all securitizations, and you start down the path to a practical solution. But don't hold your breath waiting for President Obama or the Congress or former Fed chairmen to start that conversation. ______ CHRG-110hhrg46595--399 Mr. Friedman," I do worry there are risks of robbing Peter to pay Paul. If that money is shifted over without the same conditions that are currently under it, which is that those investments must provide at least a 25 percent increase in fuel economy, if the car companies and Congress do not accept the fact that the auto industry's future has to be founded on increasing fuel economy and innovation, these plans will all be doomed to fail. We need to invest in them in a smart way and make sure consumers get something back. I think it is powerful if we can tell consumers we will save you $30 billion by 2025 by requiring automakers to do more than they already have to in terms of fuel economy. I think that will build significant confidence in a world that right now, because of the previous bailout, are not very comfortable with where this money may or may not go. " CHRG-111shrg50564--186 Mr. Dodaro," Well, I clearly think--and I will ask Ms. Williams to comment on this because she has been doing a lot of our work on these instruments. But, first, clearly the goal has to be set for them to do that. And I think if the Congress sets a statutory--as part of the regulatory goal, an expectation that occur, that is there, I think they need to be given then the authorities to be able to hire the necessary people and compensate them appropriately for doing that. And I do think they would have the capability to be able to do it. There is no doubt in my mind that you have some very talented people in the regulatory system right now that, given the proper goals and expectations, can, you know, develop in that area. It will not be easy because of the ingenuity of many of the market participants, but I think it is achievable. Orice, do you have anything? Ms. Williams. The only thing that I would add is that this is an area that the regulators are always going to be at a disadvantage in dealing with because the markets are always looking to come up with new and innovative products. But I think one of the things that would really help--and we tried to speak to this with our principal, focused on having, you know, a flexible, nimble process for regulators to be able to adjust, is to get beyond the type of product and the label that is attached to a particular product and really be able to focus on the risk that that product may pose to the system and making that the focus and the driver for whether or not products need to be brought under a regulatory umbrella. Senator Warner. So actually making a risk assessment of the product, and then if the assessment was the product was too risky, then perhaps saying some universes of consumers might not be eligible to---- Ms. Williams. Or that it needs to be, you know, regulated or looked at from a regulatory perspective and not just focus specifically on it meets this statutory definition so, therefore, it falls out of a regulatory jurisdiction versus it poses this particular risk to the system, therefore, it needs to be subject to some level of regulation and oversight. Senator Warner. We had that situation last week in the Madoff hearing where we had both SEC and FINRA here, and, you know, asked very much suddenly, you know, on broker-dealers, if somebody says they were an investment adviser and FINRA is looking, they are going to suddenly stop and not turn over that information. These regulatory lines clearly in that case might have precluded exposing a real financial scam. Ms. Williams. Exactly. And one example, we have worked looking at credit default swaps, and that is another example of a product that meets a definition and, therefore, there is---- Senator Warner. No examination beyond meeting the definition. Ms. Williams. Exactly. Senator Warner. Amen. Thank you very much. Ms. Williams. You are welcome. Senator Akaka. [Presiding.] Thank you very much, Senator Warner. Mr. Dodaro, it is good to see you again, and our panel. I am so glad that we have a new team that is addressing the problems that we are facing immediately. And I think you know the history of the so-called Financial Literacy and Education Commission. That is chaired by the Secretary of Treasury, and it has a mission that has really not been carried out. And I think that is an answer to some of the problems that have been mentioned here. Previously, I heard about protecting the consumers. Well before the current economic crisis that we are facing at this time, financial regulatory systems were failing--failing to adequately protect working families from predatory practices and exploitation. And this Commission was really put in place to try to prepare strategies that would deal with the problems that people in the country would have. I would tell you that one of the huge problems that this country has is that this country is financially illiterate. And so these financial literacy programs fill that void, and we need to really, I feel, try to bring that back to life and to help the causes here. Families have been pushed into mortgage products with associated risks and costs that they could not afford. And instead of utilizing affordable, low-cost financial services found at regulated banks and credit unions, too many working families have been exploited by the high cost of fringe financial service providers such as payday lenders and check cashers. I would tell you--and I am sure it is not only in Hawaii--that you find offices like these outside of our bases, and so our military personnel really suffer on this. So my question to you, Mr. Dodaro, is: How do we create a regulatory structure that better protects working families against predatory practices? " CHRG-111hhrg53238--95 Mr. Stinebert," I think the flexibility moving forward is very important. As long as you look at specific products, I think it was mentioned on the panel earlier about adjustable rate mortgages, or ARM products--for many, many years and in other parts of the world are considered very good products. We talked about some types of balloon payments. Everything should be customized to fitting what the consumer needs in that specific circumstance, that best meets what they need. If you try a plain vanilla, if everything is just standard, you eliminate all innovation and you are really making choices of those people who don't necessarily need money, can get options, can have products that are available to them. Others that might have a more blemished credit record, might be lower income, would have less options, less choice. And I think that it is best left to the industry and the lenders to make those decisions of what products are available to them--to their customers. " FinancialCrisisInquiry--77 THOMPSON: Well, there’s the old adage that if it sounds like too good of idea, maybe it is. And perhaps some of this oversight is management’s responsibility, not necessarily that of the regulator. So, Mr. Dimon, to what extent would you put the onus on you and your management team, not defer that necessarily to the regulator? DIMON: Well, I think I started my opening statements by saying that I blame the management teams 100 percent, and no—no one else. So it does not mean we shouldn’t look at what— what gaps are in the regulatory system. So if I was—if I was the regulator, I would say there should be no gaps in the system. There should be more authority to deal with certain types of more complex situations. New products should always be reviewed and aged. But I don’t think it’s unique to financial services. New products have problems. And, you know, give it a little bit of time before people leverage up on it. And so I think that the— it’s really the responsibility of committees. And I think most of these things can actually be fixed pretty quickly in a thoughtful way, you know, as you go through your work and receive where, you know, all the flaws were. One of the surprising things about all these things—a lot of the things we all talked about—mortgages, SIVs, derivatives—they were all known. They were not a secret out there. No one put it all together. There was no systemic regulator trying to look around the corner and say, “Well, if a money market fund has a problem, that’s going to cause a problem for X.” It’s not a mystery. It’s not a surprise. And we know we have crises every five or 10 years. My daughter called me from school one day and said, “Dad, what’s a financial crisis?” And without trying to be funny, I said, “It’s something that happens every five to seven years.” And she said, “Why is everyone so surprised?” So we weren’t—we shouldn’t be surprised, but we—we have to do a better job looking forward, no regulatory gaps, better disciplines in some of the companies, eliminate some of the off balance sheet stuff that helped facilitate some of the problems. CHRG-111shrg54589--87 Mr. Whalen," I think it is an effective practical question. The chief purpose of regulation should be to focus on things like suitability and the customer-focused issues. Obviously, systems and controls, risk management, all that are very important within a dealer, there is no question. But as I was saying before, there are certain classes of instruments that you really cannot risk manage. You were talking before about an airline that wants to put together a complex, customized swap for fuel. There is no problem with that. Everybody knows what the price of fuel is today. And you do the work, you calculate the optionality in the complex structure, and you can figure out what it is worth. The trouble comes if you look at the subprime complex structured asset market of a couple years ago, that we had everybody in agreement, much like playing Liar's Poker. The model became the definition of value for this class of instruments. But one day a number of people on the buy side started to question that assumption of ``mark-to-model.'' They started backing away from these securities. So did the dealers. So at some point--it is hard to say when--the consensus about value for that class of asset broke down. And that is where we are today. The buy-side customer still does not want to know about securities that have no visible cash market basis and effectively rely upon ``mark-to-model'' for price discovery. So I question really how effective risk management can be in those cases where we do not have a completely separate, independent reference point for value such as a liquid, cash market. " FinancialCrisisReport--424 Report To Board. On March 26, 2007, Mr. Sparks and Goldman senior executives gave a presentation to Goldman’s Board of Directors regarding the firm’s subprime mortgage business . 1732 The presentation recapped for the Board the various steps the Mortgage Department had taken since December 2006, in response to the deterioration of the subprime mortgage market. 1733 The presentation noted, among other measures, the following steps: “– GS reduces CDO activity – Residual assets marked down to reflect market deterioration – GS reverses long market position through purchases of single name CDS and reductions of ABX – GS effectively halts new purchases of sub-prime loan pools through conservative bids – Warehouse lending business reduced – EPD [early payment default] claims continue to increase as market environment continues to soften.” 1734 By the time this presentation was given to the Board of Directors, Goldman’s Mortgage Department had swung from a $6 billion net long position in December 2006, to a $10 billion net short position in February 2007, and then acted to cover much of that net short. Despite having to sell billions of dollars in RMBS and CDO securities and whole loans at low prices, and enter into billions of dollars of offsetting long CDS contracts, Goldman’s mortgage business managed to book net revenues for the first quarter totaling $368 million. 1735 In a section entitled, “Lessons Learned,” the presentation stated: “Capital markets and financial innovation spread and increase risk,” 1736 an acknowledgment by Goldman that “financial innovation,” which in this context included ABX, CDO, and CDS instruments, had magnified the risk in the U.S. mortgage market. 1732 3/26/2007 Goldman presentation to Board of Directors, “Subprime Mortgage Business,” GS MBS-E- 005565527, Hearing Exhibit 4/27-22. While the final version of the presentation indicated Goldman had an overall net long position in subprime assets by about $900 million, a near-final draft of the presentation indicated that Goldman had an overall net short position of $2.8 billion. 3/16/2007 draft presentation to Board of Directors by Daniel Sparks, “Subprime Mortgage Business,” GS MBS-E-002207710. The primary difference between the two figures appears to be the inclusion in the final version of Goldman ’s net long holdings of Alt A mortgages, even though Alt A assets are not usually considered to be subprime mortgages. Subcommittee interview of David Viniar (4/13/2010). 1733 1734 1735 Id. at 4. Id. at 8 [footnotes defining CDO and CDS omitted]. 9/17/2007 Presentation to Goldman Sachs Board of Directors, Residential Mortgage Business, at 5, GS MBS-E- 001793840, Hearing Exhibit 4/27-41. 1736 3/26/2007 Goldman Sachs presentation to Board of Directors, “Subprime Mortgage Business,” GS MBS-E- 005565527, Hearing Exhibit 4/27-22. (c) Attempted Short Squeeze 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-111shrg54789--182 PREPARED STATEMENT OF PETER WALLISON Arthur F. Burns Fellow, American Enterprise Institute July 14, 2009 The Consumer Financial Protection Agency (CFPA), as proposed by the Obama Administration, is intended to be an independent agency with sole rule-making and enforcement authority for all Federal consumer financial protection laws (with the exception of those covered by the SEC and the CFTC). The draft legislation \1\ submitted by the Administration gives the agency jurisdiction over all companies, regardless of size, that are engaged generally in providing credit, savings, collection, or payment services. This is accomplished by transferring to the CFPA most or all of the authorities in 16 Federal statutes--ranging from the CRA to the Truth in Savings Act--that cover lending, mortgage financing, fair housing, credit repair, debt collection practices, fair credit reporting, and a multitude of other consumer financial products and services. The agency will be funded by fees imposed on the thousands of companies--from banks and credit card companies to local finance companies and department stores--that are subject to the legislation. In many cases, the agency's jurisdiction will be concurrent with the jurisdiction of State agencies, but the CFPA will not preempt State law.--------------------------------------------------------------------------- \1\ Consumer Financial Protection Agency Act of 2009, 1018, as proposed by the U.S. Department of the Treasury, June 30, 2009, available at www.financialstability.gov/docs/CFPA-Act.pdf (accessed July 6, 2009).--------------------------------------------------------------------------- Prior to submitting the legislation, the Administration circulated a white paper \2\ that contains clear Statements of the policies and intentions underlying the legislation. In this testimony, I will refer to the white paper as well as the legislation itself.--------------------------------------------------------------------------- \2\ U.S. Department of the Treasury, ``Financial Regulatory Reform: A New Foundation'' (June 30, 2009), 55-56, available at www.financialstability.gov/docs/regs/FinalReport_web.pdf (accessed July 6, 2009).--------------------------------------------------------------------------- As might be expected, the new agency will have jurisdiction over disclosure to consumers. This is the customary way that consumer protection has proceeded at the Federal level. In the past, consumers were generally expected to have the ability to make decisions for themselves if they were given the necessary information. The securities laws, for example, are largely consumer protection laws, developed during the New Deal period. In selling a security, an issuing company and any underwriter or dealer must supply investors with all material facts, including any additional facts needed to ensure that the information disclosed is not misleading. This approach has worked well for 75 years. The material facts standard of the SEC is of course subject to interpretation, but it is possible to give it some content by imagining what an investor would want to know about the risks a company faces and its financial and business prospects. The white paper States that the CFPA will use a ``reasonableness'' standard, which it defines as ``balance in the presentation of risks and benefits, as well as clarity and conspicuousness in the description of significant product costs and risks.'' The draft legislation follows this pattern, so that disclosure to consumers must--perhaps like a drug label or a securities prospectus--include both the benefits and the risks of a product or service. These will be difficult guidelines for the regulated industry to follow, especially because enforcement actions and lawsuits may result from violations. Despite substantial disclosure on drug labels and in securities prospectuses--in some cases ordered by the regulatory agency--successful law-suits in both areas have claimed that the disclosure was not sufficient.The Suitability Problem The real trouble begins, however, when the Administration's plan gets beyond the relatively simple issue of disclosure and proposes that the CFPA define standards for what the white paper calls ``plain-vanilla'' products and services. The draft legislation describes them as ``standard consumer financial products or services'' that will be both ``transparent'' and ``lower risk.'' According to the white paper, the CFPA will have authority ``to require all providers and intermediaries to offer these products prominently, alongside whatever other lawful products they choose to offer.'' \3\ This idea, seemingly quite simple, raises a host of significant questions. If there is a plain-vanilla product, who is going to be eligible for the product that has strawberry sauce? In other words, once the baseline is established for a product that can or must be offered to everyone, who is going to be eligible for the product that, because of its additional but more complex features, offers financial advantages? This is the suitability problem--requiring providers to decide whether a particular product or service is suitable for a particular customer--and the Administration's plan is caught in its web.--------------------------------------------------------------------------- \3\ Ibid., 15.--------------------------------------------------------------------------- As an example, consider a mortgage with a prepayment penalty. The white paper notes that the ``CFPA could determine that prepayment penalties should be banned for certain types of products, because penalties make loans too complex for the least sophisticated consumers or those least able to shop effectively.'' \4\ This seems logical if one assumes--as the Administration seems prepared to do--that some consumers can be denied access to products they want. As the white paper notes, ``[t]he CFPA should be authorized to use a variety of measures to help ensure alternative mortgages were obtained only by consumers who understood the risks and could manage them.'' \5\--------------------------------------------------------------------------- \4\ Ibid., 68. \5\ Ibid., 66.--------------------------------------------------------------------------- So, what about the husband and wife who intend to keep their home until their children are grown and are willing, for this reason, to accept a prepayment penalty in order to get a lower rate on their fixed-rate mortgage? The Administration is suggesting that this option might not be available to them if the mortgage provider (and ultimately the CFPA) does not consider them ``sophisticated'' consumers. This kind of discrimination between and among Americans is something new and troubling. The Administration's plan clearly intends for some consumers to be denied access to certain products and services. ``As mortgages and credit cards illustrate,'' the white paper declares, ``even seemingly `simple' financial products remain complicated to large numbers of Americans. As a result, in addition to meaningful disclosure, there must also be standards of appropriate business conduct and regulations that help ensure providers do not have undue incentives to undermine those standards.'' \6\ In other words, by requiring that all providers offer plain-vanilla products and services in addition to other products, the Administration is creating a regime in which providers must keep ``complicated'' products out of the hands of Americans who may not be able to understand them.--------------------------------------------------------------------------- \6\ Ibid., 67.--------------------------------------------------------------------------- This approach bears a strong resemblance to a paper published in October 2008 by the New America Foundation. \7\ One of the authors of the piece, Michael Barr, is now an assistant secretary of the Treasury. The underlying theory of the Barr paper is that consumers should be offered a baseline, simple and low risk version of every product offered by credit and other financial providers. This simple product is called a ``plain-vanilla'' product in the New America Foundation paper, just as it is in the Administration's white paper. Referring to mortgages, the Barr paper describes this sequence of events: ``Borrowers . . . would get the standard mortgage offered, unless they chose to opt out in favor of a nonstandard [i.e., more complex and risky] option offered by the lender, after honest and comprehensible disclosures from brokers and lenders about the terms and risks of the alternative mortgages. An opt-out mortgage system would mean borrowers would be more likely to get straightforward loans they could understand.'' \8\--------------------------------------------------------------------------- \7\ Michael Barr, et al., ``Behaviorally Informed Financial Services Regulation'', New America Foundation, October 2008. \8\ Ibid., 9.--------------------------------------------------------------------------- What the Barr paper fails to understand is the risks that are faced by the provider in offering to customers anything more complex than the plain-vanilla product. Although providers will be free to do so, the possibility of enforcement actions by the CFPA or the Federal Trade Commission, suits by State attorneys general (specifically authorized to enforce the CFPA's regulations), and the inevitable class action lawsuits will make the offering of the more complex product very risky. Although the Barr paper suggests that the provider can protect itself by making a full and fair disclosure, even the white paper recognizes that this is unlikely to be effective. The white paper notes: ``Even if disclosures are fully tested and all communications are properly balanced, product complexity itself can lead consumers to make costly errors.'' \9\ When these costly errors are made, they will be prima facie evidence that the product was too complex for the consumer, and the provider will be faced with a fine, an expensive enforcement action, or worse. Thus, we are not talking about a question of disclosure--making the risks and costs plain. Instead, what the Administration is setting up is a mechanism that will ultimately deny some people access to some products because of their deficiencies in experience, sophistication, and perhaps even intelligence.--------------------------------------------------------------------------- \9\ White paper, 66.--------------------------------------------------------------------------- This approach seems to be an unprecedented departure by the U.S. Government from some of the fundamental ideas of individual equality that have underpinned U.S. society since its inception. Conservatives have long argued that liberalism reflects a paternalistic desire on the part of elites to control and limit others' choices while leaving themselves unaffected. The white paper seems to validate exactly that critique. Providers will be at risk if they offer some products to ordinary consumers but could feel safe in offering the same products to those who are well educated and sophisticated. In important ways, the Administration's approach raises the issues in the famous Louis Brandeis Statement, quoted by Milton and Rose Friedman at the beginning of their book, Free to Choose: ``Experience should teach us to be most on our guard to protect liberty when the Government's purposes are beneficial. Men born to freedom are naturally alert to repel invasion of their liberty by evil-minded rulers. The greater dangers to liberty lurk in insidious encroachment by men of zeal, well-meaning but without understanding.'' \10\--------------------------------------------------------------------------- \10\ Olmstead v. United States, 277 U.S. 479 (1928).--------------------------------------------------------------------------- In addition, there are troubling questions about how determinations of sophistication or even mental capacity are going to be made, who is going to make them, and what standards will be followed. It appears that the provider must make this decision, but what kinds of guidelines will the CFPA provide to protect the provider against the inevitable legal attacks? Vague language in the legislation suggests the consumer can opt out of the plain-vanilla alternative, but as noted above this simply changes the nature of the provider's risk from the qualities of the product to the qualities of the disclosures that were made to the consumer about what such an opt out would mean. Finally, the elements of a plain-vanilla mortgage can be quite arbitrary, forcing people into structures that are financially disadvantageous. How can anyone know, for example, whether a 30-year fixed-rate mortgage is better than a 30-year adjustable-rate loan with a reasonable cap on interest costs? If interest rates rise in the future, the fixed-rate mortgage is best, but if they fall, a variable rate should be preferred. Should a Government agency have the power to determine whether a homebuyer is allowed to make this choice? In contrast, the disclosure system has always seemed appropriate in our society because it does not require invidious or arbitrary discrimination between one person and another. As long as the disclosure is fair and honest, why should anyone be prohibited from buying a product or service? While it is apparent that everyone is not equal in understanding or sophistication, our national sensibility has been that these differences should be ignored in favor of the higher ideal of equality. Where consumers of limited understanding are protected by this system is through consumer protection actions that charge providers with fraud and deception while taking into account the limited capacities of the consumer. Under this approach, fraud and deception are punished, but the Government is not involved ex ante in deciding whether one person or another is eligible to receive what our economy has to offer. Yet the white paper says: ``The CFPA should be authorized to use a variety of measures to help ensure that alternative mortgages were obtained only by consumers who understood the risks and could manage them. For example, the CFPA could . . . require providers to have applicants fill out financial experience questionnaires.'' \11\ If this sounds a bit like a literacy or property test for voting--ideas long ago discredited--it is not surprising. Both impulses spring from the same source: a sense that some people are not as capable as others to make important choices.--------------------------------------------------------------------------- \11\ White paper, 66.--------------------------------------------------------------------------- To be sure, the securities laws contemplate that some distinctions will be made among customers on the basis of suitability. A broker-dealer may not sell a securities product to a customer if the customer does not have the resources to bear the risk or the ability to understand its nature. This is the closest analogy to what the Administration is contemplating for all consumers, but as a precedent it is inapposite. Owning a security is not a necessity for living in our economically developed society, but obtaining credit certainly is. Whether through a credit card, an account at a food or department store, a car loan, or a lay-away savings plan at a local furniture dealer, credit is a benefit that enables every person and every family to live better in our economy. Denying a credit product suitable to one's needs but deemed to be beyond one's capacity to understand has a far greater immediate adverse effect on a family's standard of living than telling an investor that a collateralized debt obligation is not a suitable product for his 401(k). Moreover, investors tend to be customers of broker-dealers over extended periods, so their financial and other capacities are well known to the brokers who handle their accounts. This is unlikely to be true for various credit products, which are likely to be established in single transactions and with little follow-up. Any attempt to determine a customer's ability to handle the risks associated with, say, a credit card could also involve investigation into matters that the customer considers private. Neither the draft legislation nor the white paper suggests how the provider of a financial service is to determine suitability while still protecting the customer's privacy. As discussed below, simply determining what other credit products and obligations particular applicants might have--and thus whether they are able to meet their obligations--will be difficult and costly. These problems do not normally arise in the suitability inquiry that broker-dealers must undertake.Other Effects Several other serious problems arise out of the structure that the Administration seems to have in mind. The decision on a particular consumer's eligibility for a product will not be made by the CFPA but by the provider of the product or service. Apart from consumers themselves, providers are the first victims of this legislation. They will have to decide--at the risk of a CFPA enforcement action or a likely lawsuit--whether a particular customer is suitable for a particular product. This will place them in a difficult, if not impossible, position. If they accede to a customer's demand, and the customer later complains, the provider may face a costly enforcement proceeding or worse, but if the provider denies the customer the desired product, the provider will be blamed, not the Government agency. In not a few cases, the provider may be sued for denial of credit to someone later deemed suitable, rather than for granting credit to a person later deemed unsuitable. The white paper points out that the Administration does not intend to disturb private rights of action and in some cases ``may seek legislation to increase statutory damages.'' As noted above, State attorneys general are specifically authorized to enforce the CFPA's regulations. Although the white paper offers the possibility that a provider might get a ``no action letter'' or approval of its product and its disclosure, the personal financial condition and other capacities of the customer are what will count, not the simplicity of the product. The second victim will be innovation. Why should anyone take the risk to create a new product? Even if the CFPA will review it to determine whether it is accurately and fairly described--a process that may require the services of a lawyer and the usual expenses of completing applications and answering questions from a Government agency--the developer will still have to decide whether the people who want it are suitable to have it. The suitability decision can be expensive; a provider's better choice might be to stay with plain-vanilla products and give up the idea of developing new products to attract new customers. The third victim will be low-cost credit. The tasks of getting approval for a product and investigating the suitability of every person who wants something more than a plain-vanilla product--whatever that may be--will substantially increase the cost of credit and reduce its availability. Leaving aside the effect on economic growth generally, higher credit costs and the denial of credit facilities that are deemed to be unsuitable for particular consumers will seriously impair the quality of life for many people of modest means or limited education. Credit provided by stores to regular customers may become too costly to administer. As a result, small neighborhood establishments may simply abandon the idea of providing credit and small finance companies and other small enterprises engaged in consumer financial services may well go out of business or merge with larger competitors. Even large credit providers may find that the additional business they attract with this service does not compensate for the risk and expense. Withdrawal of these competitors from the market will not only mean that many customers will be deprived of any credit sources and other services, but also that the reduced competition will allow credit fees to rise. Litigation will also be a factor in the decision of credit sources about whether to develop new products or offer the complex products and services that might lead to disputes with customers or the CFPA. Investor complaints about suitability in the securities field are handled through an arbitration process, so that an investor who claims that he was sold a product for which he was unsuitable must make his case to an arbitrator rather than a court. The current costs of a mistake in the suitability judgment are thus much smaller for the broker-dealer. The legislation would give the CFPA the authority to ban mandatory arbitration clauses in credit arrangements, and the white paper recommends that the SEC consider ending the arbitration process for securities. If the SEC decides to do this, litigation in the securities field will substantially increase the costs of broker-dealers and investment advisers. Finally, inherent conflicts between consumer protection and prudential regulation will arise when consumer protection responsibility is moved from the bank supervisors to the CFPA. How these might be resolved has not been described in the legislation and, perhaps was not considered. For example, as noted above, the white paper suggests that prepayment penalties should be banned for certain types of products because they make loans too complex for the least sophisticated consumers. A prudential supervisor, however, might want prepayment penalties to be included in a prudently underwritten mortgage, since the ability of the borrower to prepay at any time without penalty raises the lender's interest rate risk. It is likely that the bank supervisors and the CFPA will have different policies on this and many other issues, and the banks will be caught in the middle.Conclusion The Consumer Financial Protection Agency Act of 2009 is one of the most far-reaching and intrusive Federal laws ever proposed by an Administration. Not only does it reach down to regulate the most local levels of commercial activity, but the act would also set up procedures and incentives that will inevitably deny some consumers an opportunity to obtain products and services that are readily available to others. This legislation should be rejected. ______ CHRG-111hhrg53021--215 Secretary Geithner," No, I am not prepared to answer that question that way as it was framed. But I will happy to talk to you about this at any length you would like and try to make sure we come to a better understanding about the legal complexities. " CHRG-111hhrg53021Oth--215 Secretary Geithner," No, I am not prepared to answer that question that way as it was framed. But I will happy to talk to you about this at any length you would like and try to make sure we come to a better understanding about the legal complexities. " CHRG-111hhrg48875--95 Mr. Bachus," Well, I'm talking about, is there really no alternative than saddling future generations of Americans with perhaps hundreds of billions of dollars worth of losses for the mistakes of a few institutions that grow too large or too complex? " FOMC20060328meeting--289 287,MS. YELLEN.," I would just endorse President Minehan’s summary of reactions and the comments that have been made around the table. I think the innovations in this meeting have been excellent. I think the meeting has run very well. Having more time has certainly enriched the discussion of both the economy and the policy situation. I agree, too, with President Minehan’s suggestion that there will be times when we probably do not need two days. I have also been around through some calm times, when there was just not that much to discuss on the policy front, and I think we need some flexibility. Special topics, I completely agree, are very, very worthwhile, and I would not want to see them go. On the practical front, I would endorse President Poole’s concern about conflicts with board meetings. You know, for me there would be no way of getting back for Wednesday afternoon. We begin our board meetings on Wednesday afternoon as well. So that’s a practical concern." 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 CHRG-110hhrg44901--91 Mr. Castle," Well, not to argue with you or to beg the question, I would agree with you except it is very hard and complex for many investors to do that. And I am thinking of the pension funds and others who are making relatively big decisions as well as individuals. So it concerns me a little bit. There is a dependency on the credit rating agencies' reports, I believe. " CHRG-111shrg61651--81 Chairman Dodd," Senator Menendez. Senator Menendez. Thank you, Mr. Chairman. Let me thank all of our witnesses. As I approach this issue, I look at it as how do we strike the right balance, the appropriate regulations at the end of the day to make sure we don't have another taxpayer bailout, and at the same time the opportunity to make sure that growth can take place in our country. But I have to be honest with you. I was reading through the written testimonies and I get a sense that while we take--it is like a Texas two-step. We claim the veneer of saying that we understand and need reform. And then we have so many caveats to it that we, in essence, undermine the very essence of reform. And that just--that dog simply is not going to hunt because if, in fact, we have what we had in the past, we are destined to relive it again. And I hope the financial institutions, those that are here and others, understand that because they would be far better served in helping us strike the right balance on the pendulum than going ahead and just fighting us tooth and nail. I have got to be honest with you, when I walk the streets of New Jersey, the average person comes up to me and says you know what? When I make a mistake, I have to pay for my mistake. And when they--meaning some of our financial institutions--make a mistake, I also have to pay for their mistake. Something is wrong with that, Senator. And so I think sometimes my friends on the street have a disconnect with average Americans in this country, and it is a dangerous disconnect. It is a dangerous disconnect. I think everybody would be better served in honestly moving forward on this. Let me ask you, Mr. Corrigan, I read your written statement and, you know, on page 10 you say that there is no question that the drive to shrink the size and activities of large and complex financial institutions is understandably driven by the political and public outrage about the use of taxpayer money to bail out institutions that were deemed too big to fail. And then you go on to say that because of that, observers believe that the easiest way to solve the problem is some combination of shrinking the size of these institutions and restricting their activities. But it is really more than the public and political outrage. You are not dismissing the fact that there is a need to actually do something here? " 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. FinancialCrisisReport--137 The following slide, created by Washington Mutual in March 2004, provides an overview of the GSEs’ impact on the mortgage market at the time as well as the status of WaMu’s relationship with Fannie Mae in early 2004. 496 495 Id. at JPM_WM02405461, Subcommittee Hearing Exhibit 4/16-86. The Community Reinvestment Act (CRA) was passed by Congress to encourage banks to make loans in low- and moderate-income neighborhoods. See website of the Federal Financial Institutions Examination Council, “Community Reinvestment Act,” http://www.ffiec.gov/cra/history.htm. Regulators, including the Office of Thrift Supervision, periodically reviewed banks’ CRA activities and took them into account if a bank applied for deposit facilities or a merger or acquisition. Id. A 2005 presentation prepared by WaMu stated that its relationship with Freddie Mac helped the bank meet its CRA goals by purchasing more than $10 billion in qualifying loans. See 9/29/2005 “GSE Forum,” presentation prepared by WaMu Capital Markets, at JPM_WM02575611, Hearing Exhibit 4/16-91. Between 1991 and 2006, WaMu was evaluated 20 times by OTS and the FDIC, achieving the highest possible CRA rating of “Outstanding” in each evaluation. See website of the Federal Financial Institutions Examination Council, ratings search for “Washington Mutual,” http://www.ffiec.gov/craratings/default.aspx. Regulations state that an “outstanding” institution is one that not only meets the needs of its surrounding community, but utilizes “innovative or flexible lending practices.” See 12 C.F.R. 345, Appendix A, http://www.fdic.gov/regulations/laws/rules/2000- 6600.html#fdic2000appendixatopart345. 496 Id. at JPM_WM02405459, Subcommittee Hearing Exhibit 4/16-86. 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.] " CHRG-111shrg54789--180 PROTECTION AGENCY If the CFPA is to be effective in its mission, it must be structured so that it is strong and independent with full authority to protect consumers. Our organizations have strongly endorsed President Obama's proposal regarding what should be the agency's jurisdiction, responsibilities, rule-writing authority, enforcement powers and methods of funding. \73\ His proposal would create a Consumer Financial Protection Agency (CFPA) with a broad jurisdiction over credit, savings and payment products, as well as fair lending and community reinvestment laws. \74\ (Recommendations for improvement to the Administration bill are flagged below.) The legislation has been introduced (without providing the agency jurisdiction over the Community Reinvestment Act) by House Financial Services Chairman Barney Frank as H.R. 3126.--------------------------------------------------------------------------- \73\ Senators Durbin, Schumer, Kennedy and Dodd offered the first legislative proposal to create a consumer financial agency (S. 566), known as the Financial Product Safety Commission. The bill was originally introduced in the last Congress. \74\ ``Financial Regulatory Reform, A New Foundation: Rebuilding Financial Supervision and Regulation,'' Department of the Treasury, June 17, 2009, pp. 55-70. The White House has since proposed legislation to effectuate the proposal in this ``White Paper.''--------------------------------------------------------------------------- In its work to protect consumers and the marketplace from abuses, the CFPA as envisioned by the Administration would have a full set of enforcement and analytical tools. The first tool would be that the CFPA could gather information about the marketplace so that the agency itself could understand the impact of emerging practices in the marketplace. The agency could use this information to improve the information that financial services companies must offer to customers about products, features or practices or to offer advice to consumers directly about the risk of a variety of products on the market. For some of these products, features or practices, the agency might determine that no regulatory intervention is warranted. For others, this information about the market will inform what tools are used. A second tool would be to address and rein in deceptive marketing practices or require improved disclosure of terms. The third tool would be the identification and regulatory facilitation of ``plain-vanilla,'' low risk products that should be widely offered. The fourth tool would be to restrict or ban specific product features or terms that are harmful or not suitable in some circumstances, or that don't meet ordinary consumer expectations. Finally, the CFPA would also have the ability to prohibit dangerous financial products. We can only wonder how much less pain would have been caused for our economy if a regulatory agency had been actively exercising the latter two powers during the run up to the mortgage crisis.A. Agency structure and jurisdiction. Under the Administration's proposal, the agency would be governed by a five-member board. Four of these members would be appointed by the President and confirmed by the Senate. The final member would be the director of the consolidated bank supervisory agency proposed by the President. We strongly recommend that the stipulated qualifications for board membership be improved to require that board members have actual experience and expertise with consumer protection in the financial services arena. An agency focused solely on protecting consumers must be governed by leaders who have expertise not just in the financial services marketplace, but with protecting consumers in that marketplace. The Administration proposes to have the agency oversee the sale and marketing of credit, deposit and payment products and services and related products and services, and will ensure that they are being offered in a fair, sustainable and transparent manner. This should include debit, prepaid debit, and stored value cards; loan servicing, collection, credit reporting and debt-related services (such as credit counseling, mortgage rescue plans and debt settlement) offered to consumers and small businesses. Our organizations support this jurisdiction because credit products can have different names and be offered by different types of entities, yet still compete for the same customers in the same marketplace. Putting the oversight of competing products under one set of minimum Federal rules regardless of who is offering that product will protect consumers, promote innovation, provide consumers with valuable options, and spur vigorous competition. As with the Administration, we recommend against granting this agency jurisdiction over investment products that are marketed to retail investors, such as mutual funds. While there is a surface logic to this idea, we believe it is impractical and could inadvertently undermine investor protections. Giving the agency responsibility for investment products that is comparable to the proposed authority it would have over credit products would require the agency to add extensive additional staff with expertise that differs greatly from that required for oversight of credit products. Apparently simple matters, such as determining whether a mutual fund risk disclosure is appropriate or a fee is fair, are actually potentially quite complex and would require the new agency to duplicate expertise that already exists within the SEC. Moreover, it would not be possible simply to transfer the staff with that expertise to the new agency, since the SEC would continue to need that expertise on its own staff in order to fulfill its responsibilities for oversight of investment advisers and mutual fund operations. In addition, unless the new agency was given responsibility for all investment products and services a broker might recommend, brokers would be able to work around the new protections with potentially adverse consequences for investors. A broker who wanted to avoid the enhanced disclosures and restrictions required when selling a mutual fund, for example, could get around them by recommending a separately managed account. The investor would likely pay higher fees and receive fewer protections as a result. For these reasons, we believe the costs and risks of this proposal outweigh the potential benefits. The Administration's plan wisely provides the agency with jurisdiction over a number of insurance products that are central or ancillary to credit transactions, including credit, title, and mortgage insurance. \75\ This principal behind this approach is to provide the agency with holistic jurisdiction over the entire credit transaction, including ancillary services often sold with or in connection with the credit. Additionally, there is ample evidence of significant consumer abuses in many of these lines of insurance, including low loss ratios, high mark ups, and ``reverse competition'' where the insurer competes for the business of the lender, rather than of the insurance consumer. \76\ This Federal jurisdiction could apply without interfering with the licensing and rate oversight role of the States.--------------------------------------------------------------------------- \75\ The agency should also be given explicit authority over ``forced-place'' homeowner's insurance, which banks can require borrowers to purchase if they cannot procure their own coverage. \76\ Testimony of J. Robert Hunter, Director of Insurance, Consumer Federation of America, before the Subcommittee on Capital Markets, Insurance and Government Sponsored Enterprises of the U.S. House Financial Services Committee, October 30, 2007, pp. 8-9.--------------------------------------------------------------------------- The United States has never sufficiently addressed the problems and challenges of lending discrimination and red lining practices, the vestiges of which include the present day unequal, two-tiered financial system that forces minority and low-income borrowers to pay more for financial services, get less value for their money, and exposes them to greater risk. It is therefore, imperative that the Consumer Financial Protection Agency also focus in a concentrated way on fair lending issues. To that end, the Agency must have a comprehensive Office of Civil Rights, which would ensure that no Federal agency perpetuated unfair practices and that no member of the financial industry practices business in a way that perpetuates discrimination. Compliance with civil rights statutes and regulations must be a priority at each Federal agency that has financial oversight or that enforces a civil rights statute. There must be effective civil rights enforcement of all segments of the financial industry. Moreover, each regulatory and enforcement agency must undertake sufficient reporting and monitoring activities to ensure transparency and hold the agencies accountable. A more detailed description of the civil rights functions that must be undertaken at the CFPA and at other regulatory and enforcement agencies can be found in the Civil Rights Policy Paper available at www.ourfinancialsecurity.org. \77\--------------------------------------------------------------------------- \77\ See http://ourfinancialsecurity.org/issues/leveling-the-playing-field/---------------------------------------------------------------------------B. Rule writing. Under the Administration proposal, the agency will have broad rule-making authority to effectuate its purposes, including the flexibility to set standards that are adequate to address rapid evolution and changes in the marketplace. Such authority is not a threat to innovation, but rather levels the playing field and protects honest competition, as well as consumers and the economy. The Administration's plan also provides that the rule-making authority for the existing consumer protection laws related to the provision of credit would be transferred to this agency, including the Truth in Lending Act (TILA), Truth in Savings Act (TISA), Home Ownership and Equity Protection Act (HOEPA), Real Estate Protection Act (RESPA), Fair Credit Reporting Act (FCRA), Electronic Fund Transfer Act (EFTA), and Fair Debt Collection Practices Act (FDCPA). Current rule-writing authority for nearly 20 existing laws is spread out among at least seven agencies. Some authority is exclusive, some joint, and some is concurrent. However, this hodgepodge of statutory authority has led to fractured and often ineffectual enforcement of these laws. It has also led to a situation where Federal rule-writing agencies may be looking at just part of a credit transaction when writing a rule, without considering how the various rules for different parts of the transaction affect the marketplace and the whole transaction. The CFPA with expertise, jurisdiction, and oversight that cuts across all segments of the financial products marketplace, will be better able to see inconsistencies, unnecessary redundancies, and ineffective regulations. As a marketwide regulator, it would also ensure that critical rules and regulations are not evaded or weakened as agencies compete for advantage for the entities they regulate. Additionally the agency would have exclusive ``organic'' Federal rule-writing authority within its general jurisdiction to deem products, features, or practices unfair, deceptive, abusive or unsustainable, and otherwise to fulfill its mission and mandate. The rules may range from placing prohibitions, restrictions, or conditions on practices, products, or features to creating standards, and requiring special monitoring, reporting, and impact review of certain products, features, or practices.C. Enforcement. A critical element of a new consumer protection framework is ensuring that consumer protection laws are consistently and effectively enforced. As mentioned above, the current crisis occurred not only because of gaps and weaknesses in the law, but primarily because the consumer protection laws that we do have were not always enforced. For regulatory reform to be successful, it must encourage compliance by ensuring that wrongdoers are held accountable. A new CFPA will achieve accountability by relying on a three-legged stool: enforcement by the agency, by States, and by consumers themselves. First, the CFPA itself will have the tools, the mission and the focus necessary to enforce its mandate. The CFPA will have a range of enforcement tools under the Administration proposal. The Administration, for example, would give the agency examination and primary compliance authority over consumer protection matters. This will allow the CFPA to look out for problems and address them in its supervisory capacity. But unlike the banking agencies, whose mission of looking out for safety and soundness led to an exclusive reliance on supervision, the CFPA will have no conflict of interest that prevents it from using its enforcement authority when appropriate. Under the Administration proposal, the agency will have the full range of enforcement powers, including subpoena authority; independent authority to enforce violations of the statues it administers; and civil penalty authority. Second, both proposals allow States to enforce Federal consumer protection laws and the CFPA's rules. As Stated in detail in Section 5, States are often closer to emerging threats to consumers and the marketplace. They routinely receive consumer complaints and monitor local practices, which will permit State financial regulators to see violations first, spot local trends, and augment the CFPA's resources. The CFPA will have the authority to intervene in actions brought by States, but it can conserve its resources when appropriate. As we have seen in this crisis, States were often the first to act. Finally, consumers themselves are an essential, in some ways the most essential, element of an enforcement regime. Recourse for individual consumers must, of course, be a key goal of a new consumer protection system. The Administration's plan appropriately States that the private enforcement provisions of existing statutes will not be disturbed. A significant oversight of the Administration's plan is that it does not allow private enforcement of new CFPA rules. It is critical that the consumers who are harmed by violations of these rules be able to take action to protect themselves. Consumers must have the ability to hold those who harm them accountable for numerous reasons: No matter how vigorous and how fully funded a new CFPA is, it will not be able to directly redress the vast majority of violations against individuals. The CFPA will likely have thousands of institutions within its jurisdiction. It cannot possibly examine, supervise or enforce compliance by all of them. Individuals have much more complete information about the affect of products and practices, and are in the best position to identify violations of laws, take action, and redress the harm they suffer. An agency on the outside looking in often will not have sufficient details to detect abusive behavior or to bring an enforcement action. Individuals are an early warning system that can alert States and the CFPA of problems when they first arise, before they become a national problem requiring the attention of a Federal agency. The CFPA can monitor individual actions and determine when it is necessary to step in. Bolstering public enforcement with private enforcement conserves public resources. A Federal agency cannot and should not go after every individual violation. Consumer enforcement is a safety net that ensures compliance and accountability after this crisis has passed, when good times return, and when it becomes more tempting for regulators to think that all is well and to take a lighter approach. The Administration's plan rightly identifies mandatory arbitration clauses as a barrier to fair adjudication and effective redress. We strongly agree--but it is also critically important regarding access to justice that consumers have the right to enforce a rule. Private enforcement is the norm and has worked well as a complement to public enforcement in the vast majority of the consumer protection statutes that will be consolidated under the CFPA, including TILA, HOEPA, FDCPA, FCRA, EFTA and others. Conversely, the statutes that lack private enforcement mechanisms are notable for the lack of compliance. The most obvious example is the prohibition against unfair and deceptive practices in Section 5 of the FTC Act. Though the banking agencies eventually identified unfair and deceptive mortgage and credit card practices that should be prohibited (after vigorous congressional prodding), individuals were subject to those practices for years with no redress because they could not enforce the FTC Act. Not only consumers, but the entire economy and even financial institutions would have been much better off if consumers had been able to take action earlier on, when the abusive practices were just beginning.D. Product evaluation, oversight, and monitoring. Under the Administration's proposal, the agency would have significant enforcement and data collection authority to evaluate and to remove, restrict, or prevent unfair, deceptive, abusive, discriminatory, or unsustainable products, features or practices. The agency could also evaluate and promote practices, products, and features that facilitate responsible and affordable credit, payment devices, asset-building, and savings. Finally, the agency could assess the risks of both specific products and practices and overall market developments for the purpose of identifying, reducing and preventing excessive risk (e.g., monitoring longitudinal performance of mortgages with certain features for excessive failure rates; and monitoring the market share of products and practices that present greater risks, such as weakening underwriting). Specifically, we would recommend that the agency take the following approach to product evaluation, approval and monitoring under the proposal: Providers of covered products and services in some cases could be required to file adequate data and information to allow the agency to make a determination regarding the fairness, sustainability, and transparency of products, features, and practices. This could include data on product testing, risk modeling, credit performance over time, customer knowledge and behavior, target demographic populations, etc. Providers of products and services that are determined in advance to represent low risk would have to provide de minimus or no information to the agency. ``Plain-vanilla'' products, features or practices that are determined to be fair, transparent and sustainable would be determined to be presumptively in compliance and face less regulatory scrutiny and fewer restrictions. Products, features or practices that are determined to be potentially unfair, unsustainable, discriminatory, deceptive or too complex for its target population might be required to meet increased regulatory requirements and face increased enforcement and remedies. In limited cases, products, features or practices that are deemed to be particularly risky could face increased filing and data disclosure requirements, limited roll-out mandates, post- market evaluation requirements and, possibly, a stipulation of preapproval before they are allowed to enter or be used in the marketplace. The long-term performance of various types of products and features would be evaluated, and results made transparent and available broadly to the public, as well as to providers, Congress, and the media to facilitate informed choice. The Agency should hold periodic public hearings to examine products, practices and market developments to facilitate the above duties, including the adequacy of existing regulation and legislation, and the identification of both promising and risky market developments. These hearings would be especially important in examination of new market developments, such as, for example, where credit applications will soon be submitted via a mobile phone, for example, and consumer dependence on the Internet for conducting financial transactions is expected to grow dramatically. In such hearings, in rule-makings, and in other appropriate circumstances, the Agency should ensure that there is both opportunity and means for meaningful public input, including consideration of existing models such as funded public interveners.E. Funding. The Administration's proposal would authorize Congressional appropriations as needed for the agency. It also allows the agency to recover the amount of funds it spends through annual fees or assessments on financial services providers it oversees. Our view is that the agency should have a stable (not volatile) funding base that is sufficient to support robust enforcement and is not subject to political manipulation by regulated entities. Funding from a variety of sources, as well as a mix of these sources, should be considered, including Congressional appropriations, user fees or industry assessments, filing fees, priced services (such as for compliance examinations) and transaction-based fees. See Appendix 4 for a comparison of current agency funding and fee structures. None of these funding sources is without serious weaknesses. Industry assessments or user fees can provide the regulated entity with considerable leverage over the budget of the agency and facilitate regulatory capture of the agency, especially if the regulated party is granted any discretion over the amount of the assessment (or is allowed to decide who regulates them and shift its assessment to another agency.) Transaction-based fees can be volatile and unpredictable, especially during economic downturns. Filing fees can also decline significantly if economic activity falls. Congressional appropriations, as we have seen with other Federal consumer protection agencies over the last half-century, can be fairly easily targeted for reduction or restriction by well' funded special interests if these interests perceive that the agency has been too effective or aggressive in pursing its mission. If an industry-based funding method is used, it should ensure that all providers of covered products and services are contributing equally based on their size and the nature of the products they offer. A primary consideration in designing any industry-based funding structure is that certain elements of these sectors should not be able to evade the full funding requirement, through charter shopping or other means. If such requirements can be met, we would recommend a blended funding structure from multiple sources that requires regulated entities to fund the baseline budget of the agency and Congressional appropriations to supplement this budget if the agency demonstrates an unexpected or unusual demand for its services.F. Consumer complaints. The Administration proposal would require the agency to collect and track federally directed complaints rewarding credit or payment products, features, or practices under the agency's jurisdiction. \78\ This is a very important function but it should be improved in two significant respects. First, the agency should also be charged with resolving consumer complaints. Existing agencies, particularly the OCC, have generally not performed this function well. \79\ Secondly, the agency should be designated as the sole repository of consumer complaints on products, features, or practices within its jurisdiction, and should ensure that this is a role that is readily visible to consumers, simple to access and responsive. The agency should also be required to conduct real-time analysis of consumer complaints regarding patterns and practices in the credit and payment systems industries and to apply these analyses when writing rules and enforcing rules and laws.--------------------------------------------------------------------------- \78\ The CFPA should have responsibility for collecting and tracking complaints about consumer financial services and facilitating complaint resolution with respect to federally supervised institutions. Other Federal supervisory agencies should refer any complaints they receive on consumer issues to the CFPA; complaint data should be shared across agencies . . . , ``A New Foundation'', pp. 59-60, The Obama Administration, June 2009. \79\ Travis Plunkett testimony, July 2007 ``Improving Federal Consumer Protections in Financial Services'', p. 10.---------------------------------------------------------------------------G. Federal preemption of State laws. As the Administration proposal States, the agency should establish minimum standards within its jurisdictions. CFPA rules would preempt weaker State laws, but States that choose to exceed the standards established by the CFPA could do so. The agency's rules would preempt statutory State law only when it is impossible to comply with both State and Federal law. We also strongly agree with the Administration's recommendation that federally chartered institutions be subject to nondiscriminatory State consumer protection and civil rights laws to the same extent as other financial institutions. A clear lesson of the financial crisis, which pervades the Administration's plan, is that protections should apply consistently across the board, based on the product or service that is being offered, not who is offering it. Restoring the viability of our background State consumer protection laws is also essential to the flexibility and accountability of the system in the long run. The specific rules issued by the CFPA and the specific statutes enacted by Congress will never be able to anticipate every innovative abuse designed to avoid those rules and statutes. The fundamental State consumer protection laws, both statutory and common law, against unfair and deceptive practices, fraud, good faith and fair dealing, and other basic, longstanding legal rules are the ones that spring up to protect consumers when a new abuse surfaces that falls within the cracks of more specific laws. We discuss preemption in greater detail in the next section.H. Other aspects of the Administration proposal. As discussed briefly above, the CFPA should also have the authority to grant intervener funding to consumer organizations to fund expert participation in its stakeholder activities. The model has been used successfully to fund consumer group participation in State utility rate making. Second, a Government chartered consumer organization should be created by Congress to represent consumers' financial services interests before regulatory, legislative, and judicial bodies, including before the CFPA. This organization could be financed through voluntary user fees such as a consumer check-off included in the monthly Statements financial firms send to their customers. It would be charged with giving consumers, depositors, small investors and taxpayers their own financial reform organization to counter the power of the financial sector, and to participate fully in rulemakings, adjudications, and lobbying and other activities now dominated by the financial lobby. \80\--------------------------------------------------------------------------- \80\ As his last legislative activity, in October 2002, Senator Paul Wellstone proposed establishment of such an organization, the Consumer and Shareholder Protection Association, S 3143.--------------------------------------------------------------------------- Moreover, we recommend that the Administration's proposal deal more explicitly with incentives that are paid to and whistleblower protections that are provided to employees working in the credit sector. An incentive system similar to one at the top is at work at the street level of the biggest banks. In the tens of thousands of bank branches and call centers of our biggest banks, employees-including bank tellers earning an average of $11.32 an hour-are forced to meet sales goals to keep their jobs and earn bonuses. Many goals for employees selling high-fee and high-interest products like credit cards and checking accounts have actually gone up as the economy has gone down. Risk-taking in the industry will quickly outpace regulatory coverage unless financial sector employees can challenge bad practices as they develop and direct regulators to problems. Whistleblowers are critical to combating fraud and other institutional misconduct. The Federal Government needs to hear from and protect finance sector employees who object to bad practices that they believe violate the law, are unfair or deceptive, or threaten the public welfare. If we previously had more protections for whistleblowers, we would have had more warning of the eventual collapse of Wall Street. Since 2000, Congress has enacted or strengthened whistleblower protections in six laws. They include consumer product manufacturing and retail commerce, railroads, the trucking industry, metropolitan transit systems, defense contractors, and all entities receiving stimulus funds. All of these laws provide more incentives and protections for disclosure of wrongdoing than does the current proposal from the Administration. For example, it does not protect disclosures made to an employer, which is often the first action taken by loyal, concerned employees, and the impetus for retaliation. Also conspicuously absent are administrative procedures and remedies that include best practices for fair and adequate consideration of claims by employees. We recommend the following improvements in any reform legislation before the Committee. Whistleblower protections. Innovation in the industry will quickly outpace regulatory coverage unless bank branch, call-center, and other financial sector employees can challenge bad practices as they develop and direct regulators to problems. The Federal Government needs to hear from and provide best practice whistleblower rights consistent with those in the stimulus and five laws passed or strengthened last Congress to protect finance sector employees who object to bad practices that they believe violate the law, are unfair or deceptive, or threaten the public welfare. Fair compensation. New rules need to restructure pay and incentives for front-line finance sector employees away from the current ``sell-anything'' culture. The hundreds of thousands of front-line workers who work under pressure of sales goals need to be able to negotiate sensible compensation policies that reward service and sound banking over short-term sales.SECTION 5. REBUTTAL TO ARGUMENTS AGAINST THE CFPA 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. Opponents of reform of the financial system have made several arguments against the establishment of a strong independent Consumer Financial Protection Agency. Indeed, the new CFPA appears to be among their main targets for criticism, compared with other elements of the reform plan. They have basically made six arguments. They have argued that regulators already have the powers it would be given, that it would be a redundant layer of bureaucracy, that consumer protection cannot be separated from supervision, that it will stifle innovation, that it would be unfair to small institutions and that its anti-preemption provision would lead to balkanization. Each of these arguments is fatally flawed:A. Opponents argue that regulators already have the powers that the CFPA would be given. This argument is effectively a defense of the status quo, which has led to disastrous results. Current regulators already have between them some of the powers that the new agency would be given, but they haven't used them. Conflicts of interest and missions and a lack of will have worked against consumer enforcement. While our section above goes into greater detail on the failures of the regulators, two examples will illustrate: No HOEPA Rules Until 2008: 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. \81\--------------------------------------------------------------------------- \81\ 73 FR 147, Page 44522, Final HOEPA Rule, 30 July 2008. No Action on Abusive Credit Card Practices Until Late 2008: 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) and only one other public enforcement order against a mortgage subsidiary of a large national bank (only after HUD initiated 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.'' \82\ 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). \83\ While that law was under consideration, other Federal regulators used their authority under the Federal Trade Commission Act to propose and finalize a similar rule. \84\ By contrast, the OCC requested the addition of two significant loopholes to a key protection of the proposed rule.--------------------------------------------------------------------------- \82\ 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 http://www.house.gov/financialservices/hearing110/htwilmarth042607.pdf. \83\ H.R. 627 was signed into law by President Obama as Pub. L. No. 111-24 on 22 May 2009. \84\ The final rule was published in the Federal Register a month later. 74 FR 18, p. 5498 Thursday, January 29, 2009. Federal bank regulators currently face at least two conflicts. First, their primary mission is prudential supervision, with enforcement of consumer laws taking a back seat. Second, charter shopping in combination with agency funding by regulated entities encourages a regulatory race to the bottom as banks choose the regulator of least resistance. In particular, the Office of the Comptroller of the Currency and the Office of Thrift Supervision have failed utterly to protect consumers, let alone the safety and soundness of regulated entities. Instead, they competed with each other to minimize consumer protection standards as a way of attracting institutions to their charters, which meant that they tied their own hands and failed to fulfill their missions. (Note: they weren't trying to fail, but that was a critical side effect of the charter competition.) Establishing a new consumer agency that has consumer protection as its only mission and that regulated firms cannot hide from by charter-shopping is the best way to guarantee that consumer laws will receive sustained, thoughtful, proactive attention from a Federal regulator.B. Opponents argue that the CFPA would be a redundant layer of bureaucracy. We do not propose a new regulatory agency because we seek more regulation, but because we seek better regulation. The very existence of an agency devoted to consumer protection in financial services will be a strong incentive for institutions to develop strong cultures of consumer protection. (The Obama Administration, Financial Regulatory Reform: A New Foundation, p. 57) The new CFPA would not be a redundant layer of bureaucracy. To the contrary, the new agency would consolidate and streamline Federal consumer protection for credit, savings and payment products that is now required in almost 20 different statutes and divided between seven different agencies. As the New Foundation document continues: The core of such an agency can be assembled reasonably quickly from discrete operations of other agencies. Most rule-writing authority is concentrated in a single division of the Federal Reserve, and three of the four Federal banking agencies have mostly or entirely separated consumer compliance supervision from prudential supervision. Combining staff from different agencies is not simple, to be sure, but it will bring significant benefits for responsible consumers and institutions, as well as for the market for consumer financial services and products. \85\--------------------------------------------------------------------------- \85\ The Obama Administration, ``Financial Regulatory Reform: A New Foundation'', p. 57. And today, a single transaction such as a mortgage loan is subject to regulations promulgated by several agencies and may be made or arranged by an entity supervised by any of several other agencies. Under the CFPA, one Federal agency will write the rules and see that they are followed.C. Opponents argue that consumer protection cannot be separated from supervision. The current regulatory consolidation of both of these functions has led to the subjugation of consumer protection in most cases, to the great harm of Americans and the economy. Nevertheless, trade associations for many of the financial institutions that have inflicted this harm claim that a new approach that puts consumer protection at the center of financial regulatory efforts will not work. The American Bankers Association, for example, States that while the length of time banks hold checks under Regulation CC may be a consumer issue, ``fraud and payments systems operational issues'' are not. \86\--------------------------------------------------------------------------- \86\ Letter of 28 May 2009 from the American Bankers Association to Treasury Secretary Tim Geithner, available at http://www.aba.com/NR/rdonlyres/4640E4F1-4BC9-4187-B9A6-E3705DD9B307/60161/GeithnerMay282009.pdf (last viewed 21 June 2009).--------------------------------------------------------------------------- Again, as the Administration points out in its carefully thought-out blueprint for the new agency: The CFPA would be required to consult with other Federal regulators to promote consistency with prudential, market, and systemic objectives. Our proposal to allocate one of the CFPA's five board seats to a prudential regulator would facilitate appropriate coordination. \87\--------------------------------------------------------------------------- \87\ The Obama Administration, Financial Regulatory Reform: A New Foundation, p. 59. We concur that the new agency should have full rulemaking authority over all consumer statutes. The checks and balances proposed by the Administration, including the consultative requirement and the placement of a prudential regulator on its board and its requirement to share confidential examination reports with the prudential regulators will address these concerns. In addition, the Administration's plan provides the CFPA with full compliance authority to examine and evaluate the impact of any proposed consumer protection measure on the bottom line of affected financial institutions. While collaboration between regulators will be very important, it should not be used as an excuse by either the CFPA or other regulators to unnecessarily delay needed action. The GAO, for example, has identified time delays in interagency processes as a contributor to the mortgage crisis. \88\ This is why it is important that the CFPA retain final rulemaking authority, as proposed under the Administration's plan. Such authority, along with the above mentioned mandates, will ensure that both the CFPA and the Federal prudential regulator collaborate on a timely basis.--------------------------------------------------------------------------- \88\ ``As we note in our report, efforts by regulators to respond to the increased risks associated with the new mortgage products were sometimes slowed in part because of the need for five Federal regulators to coordinate their response.'' ``Financial Regulation: A Framework for Crafting and Assessing Proposals to Modernize the Outdated U.S. Financial Regulatory System'', Testimony before the U.S. Senate Committee on Banking, Housing, and Urban Affairs, February 4, 2009, pp. 15-16.--------------------------------------------------------------------------- For most of the last 20 years, bank regulators have shown little understanding of consumer protection and have not used powers they have long held. OCC's traditional focus and experience has been on safety and soundness, rather than consumer protection. \89\ Its record on consumer protection enforcement is one of little experience and little evidence of expertise. In contrast, as already noted, the States have long experience in enforcement of non-preempted State consumer protection laws. OCC admits that it was not until 2000 that it invoked long-dormant consumer protection authority provided by the 1975 amendments to the Federal Trade Commission Act. \90\--------------------------------------------------------------------------- \89\ See Christopher L. Peterson, ``Federalism and Predatory Lending: Unmasking the Deregulatory Agenda'', 78 Temp. L. Rev. 1, 73 (2005). \90\ See Julie L. Williams and Michael L. Bylsma, ``On the Same Page: Federal Banking Agency Enforcement of the FTC Act To Address Unfair and Deceptive Practices by Banks'', 58 Bus. Law. 1243, 1244, 1246 and n. 25, 1253 (2003) (citing authority from the early 1970s indicating that OCC had the authority to bring such an action under Section 8 of the Federal Deposit Insurance Act, noting that OCC brought its first such case in 2000, and conceding that ``[a]n obvious question is why it took the Federal banking agencies more than 25 years to reach consensus on their authority to enforce the FTC Act'').---------------------------------------------------------------------------D. Opponents argue that a single agency focused on consumer protection will ``stifle innovation'' in the financial services marketplace. To the contrary, protecting consumers from traps and tricks when they purchase credit, savings or payment products should encourage confidence in the financial services marketplace and spur innovation. As Nobel Laureate Joseph Stiglitz has said: There will be those who argue that this regulatory regime will stifle innovation. However, a disproportionate part of the innovations in our financial system have been aimed at tax, regulatory, and accounting arbitrage. They did not produce innovations which would have helped our economy manage some critical risks better-like the risk of home ownership. In fact, their innovations made things worse. I believe that a well- designed regulatory system, along the lines I've mentioned, will be more competitive and more innovative-with more of the innovative effort directed at innovations which will enhance the productivity of our firms and the well-being, including the economic security, of our citizens. \91\--------------------------------------------------------------------------- \91\ ``Too Big to Fail or Too Big to Save? Examining the Systemic Threats of Large Financial Institutions'', Joseph E. Stiglitz, April 21, 2009, p. 10.---------------------------------------------------------------------------E. Opponents argue that the CFPA would place an unfair regulatory burden on small banks and thrifts. Small banks and thrifts that offer responsible credit and payment products should face a lower regulatory burden under regulation by a CFPA. Members of Congress, the media and consumer organizations have properly focused on the role of large, national banks and thrifts in using unsustainable, unfair and deceptive mortgage and credit card lending practices. In contrast, many smaller banks and thrifts have justifiably been praised for their more responsible lending practices in theses areas. In such situations, the CFPA would promote fewer restrictions and less oversight for ``plain-vanilla'' products that are simple, straightforward and fair. However, it is also important to note that some smaller hanks and thrifts have, unfortunately, been on the cutting edge of a number of other abusive lending practices that are harmful to consumers and that must be addressed by a CFPA. More than 75 percent of State chartered banks surveyed by the FDIC, for example, automatically enrolled customers in high-cost overdraft loan programs without consumers' consent. Some of these banks deny consumers the ability to even opt out of being charged high fees for overdraft transactions that the banks chose to permit. Smaller banks have also been leaders in facilitating high-cost refund anticipation loans, in helping payday lenders to evade State loan restrictions and in offering deceptive and extraordinarily expensive ``fee harvester'' credit cards. (See Appendix 1 for more information.)F. Opponents argue that the agency's authority to establish only a Federal floor of consumer protection would lead to regulatory inefficiency and balkanization. The loudest opposition to the new agency will likely be aimed at the Administration's sensible proposal that CFPA's rules be a Federal floor and that the States be allowed to enact stronger consumer laws that are not inconsistent, as well as to enforce both Federal and State laws. This proposed return to common sense protections is strongly endorsed by consumer advocates and State attorneys general. We expect the banks and other opponents to claim that the result will be 51 balkanized laws that place undue costs on financial institutions that are then passed onto consumers in the form of higher priced or less available loans. In fact, this approach is likely to lead to a high degree of regulatory uniformity (if the CFPA sets high minimum standards,) greater protections for consumers without a significant impact on cost or availability, increased public confidence in the credit markets and financial institutions, and less economic volatility. For example, comprehensive research by the Center for Responsible Lending found that subprime mortgage loans in States that acted vigorously to rein in predatory mortgage lending before they were preempted by the OCC had fewer abusive terms. In States with stronger protections, interest rates on subprime mortgages did not increase, and instead, sometimes decreased, without reducing the availability of these loans. \92\ Additionally, as Nobel Laureate Joseph Stiglitz has pointed out, the cost of regulatory duplication is miniscule to the cost of the regulatory failure that has occurred. \93\--------------------------------------------------------------------------- \92\ Wei Li and Keith S. Ernst, Center for Responsible Lending, ``The Best Value in the Subprime Market: State Predatory Lending Reforms'', February, 23, 2006, p. 6. \93\ ``Some worry about the cost of duplication. But when we compare the cost of duplication to the cost of damage from inadequate regulation--not just the cost to the taxpayer of the bail-outs but also the costs to the economy from the fact that we will be performing well below our potential--it is clear that there is not comparison,'' Testimony of Dr. Joseph E. Stiglitz, Professor, Columbia University, before the House Financial Services Committee, October 21, 2008, p. 16.--------------------------------------------------------------------------- It is also clear that the long campaign of preemption by the OTS and OCC, culminating in the 2004 OCC rules, contributed greatly to the current predatory lending crisis. After a discussion of the OCC's action eliminating State authority, we will discuss more generally why Federal consumer law should always be a floor. F.1. The OCC's Preemption of State Laws Exacerbated The Crisis. 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. In a letter to banks on November 25, 2002, the OCC openly instructed banks that they ``should contact the OCC in situations where a State official seeks to assert supervisory authority or enforcement jurisdiction over the bank . . . . \94\ The banks apparently accepted this invitation, notifying the OCC of State efforts to investigate or enforce State laws. The OCC responded with letters to banks and to State banking agencies asserting that the States had no authority to enforce State laws against national banks and subsidiaries, and that the banks need not comply with the State laws. \95\--------------------------------------------------------------------------- \94\ Office of the Comptroller of the Currency, Interpretive Letter No. 957 n.2 (Jan. 27, 2003) (citing OCC Advisory Letter 2002-9 (Nov. 25, 2002)) (viewed Jun. 19, 2009, at http://www.occ.treas.gov/interp/mar03/int957.doc, and available at 2003 OCC Ltr. LEXIS 11). \95\ E.g., Office of the Comptroller of the Currency, Interpretive Letter No. 971 (Jan. 16, 2003) (letter to Pennsylvania Department of Banking, that it does not have the authority to supervise an unnamed national bank's unnamed operating subsidiary which engages in subprime mortgage lending (unnamed because the interpretive letter is unpublished) (viewed Jun. 19, 2009, at http://comptrollerofthecurrency.gov/interp/sep03/int971.doc, and available at 2003 OCC QJ LEXIS 107).--------------------------------------------------------------------------- For example, the OCC responded to National City Bank of Indiana, and its operating subsidiaries, National City Mortgage Company, First Franklin Financial Corporation, and Altegra Credit Company, regarding Ohio's authority to monitor their mortgage banking and servicing businesses. That opinion concluded that ``the OCC's exclusive visitorial powers preclude States from asserting supervisory authority or enforcement jurisdiction over the Subsidiaries.'' \96\--------------------------------------------------------------------------- \96\ Office of the Comptroller of the Currency, Interpretive Letter No. 958 (Jan. 27, 2003) (viewed Jun. 19, 2009, at http://www.occ.treas.gov/interp/mar03/int958.pdf, and available at 2003 OCC Ltr. LEXIS 10).--------------------------------------------------------------------------- The OCC responded to Bank of America, N.A., and its operating subsidiary, BA Mortgage LLC, regarding California's authority to examine the operating subsidiary's mortgage banking and servicing businesses and whether the operating subsidiary was required to maintain a license under the California Residential Mortgage Lending Act. That opinion concluded that ``the Operating Subsidiary also is not subject to State or local licensing requirements and is not required to obtain a license from the State of California in order to conduct business in that State.'' \97\--------------------------------------------------------------------------- \97\ The OCC's exclusive visitorial powers preclude States from asserting supervisory authority or enforcement jurisdiction over the Subsidiaries (Jan. 27, 2003) (viewed Jun. 19, 2009, at http://www.occ.treas.gov/interp/mar03/int957.doc), and available at 2003 OCC Ltr. LEXIS 11).--------------------------------------------------------------------------- The OCC wrote the Pennsylvania Department of Banking, stating that Pennsylvania does not have the authority to supervise an unnamed national bank's unnamed operating subsidiary which engages in subprime mortgage lending. \98\ (The national bank and operating subsidiary were not named because this interpretive letter was unpublished.)--------------------------------------------------------------------------- \98\ Office of the Comptroller of the Currency, Interpretive Letter No. 971 (unpublished) (Jan. 16, 2003) (viewed Jun. 19, 2009, at http://comptrollerofthecurrency.gov/interp/sep03/int971.doc, and available at 2003 OCC QJ LEXIS 107).--------------------------------------------------------------------------- The OCC even issued a formal preemption determination and order, stating that ``the provisions of the GFLA [Georgia Fair Lending Act] affecting national banks' real estate lending are preempted by Federal law'' and ``issuing an order providing that the GFLA does not apply to National City or to any other national bank or national bank operating subsidiary that engages in real estate lending activities in Georgia.'' \99\--------------------------------------------------------------------------- \99\ Office of the Comptroller of the Currency, Preemption Determination and Order, 68 Fed. Reg. 46,264, 46,264 (Aug. 5, 2003).--------------------------------------------------------------------------- As Business Week pointed out in 2003, not only did States attempt to pass laws to stop predatory lending, they also attempted to warn Federal regulators that the problem was getting worse. \100\--------------------------------------------------------------------------- \100\ Robert Berner and Brian Grow, ``They Warned Us About the Mortgage Crisis'', Business Week, 9 October 2008, available at http://www.businessweek.com/magazine/content/08_42/b4104036827981.htm, (last visited 21 June 2009).--------------------------------------------------------------------------- A number of factors contributed to the mortgage disaster and credit crunch. Interest rate cuts and unprecedented foreign capital infusion fueled thoughtless lending on Main Street and arrogant gambling on Wall Street. The trading of esoteric derivatives amplified risks it was supposed to mute. One cause, though, has been largely overlooked: the stifling of prescient State enforcers and legislators who tried to contain the greed and foolishness. They were thwarted in many cases by Washington officials hostile to regulation and a financial industry adept at exploiting this ideology. Under the proposal, critical authority will be returned to those attorneys general, who have demonstrated both the capacity and the will to enforce consumer laws. In addition to losing the States' experience in enforcing such matters, depriving the States of the right to enforce their non-preempted consumer protection laws raises serious concerns of capacity. According to a recent congressional report, State banking agencies and State attorneys general offices employ nearly 700 full time staff to monitor compliance with consumer laws, more than 17 times the number of OCC personnel then allocated to investigate consumer complaints. \101\--------------------------------------------------------------------------- \101\ See H. Comm. on Financial Services, 108th Cong., Views and Estimates on Matters To Be Set Forth in the Concurrent Resolution on the Budget for Fiscal Year 2005, at 16 (Comm. Print 2004). ``In the area of abusive mortgage lending practices alone, State bank supervisory agencies initiated 20,332 investigations in 2003 in response to consumer complaints, which resulted in 4,035 enforcement actions.''--------------------------------------------------------------------------- Earlier this year, Illinois Attorney General Lisa Madigan testified before this Committee and outlined the numerous major, multistate cases against predatory lending that have been brought by her office and other State offices of attorneys general. However, she included this caveat: State enforcement actions have been hamstrung by the dual forces of preemption of State authority and lack of Federal oversight. The authority of State attorneys general to enforce consumer protection laws of general applicability was challenged at precisely the time it was most needed--when the amount of sub prime lending exploded and riskier and riskier mortgage products came into the marketplace. \102\--------------------------------------------------------------------------- \102\ Testimony of Illinois Attorney General Lisa Madigan Before the Committee on Financial Services, Hearing on Federal and State Enforcement of Financial Consumer and Investor Protection Laws, 20 March 2009, available at http://www.house.gov/apps/list/hearing/financialsvcs_dem/il_-_madigan.pdf (last visited 22 June 2009). This month, General Madigan and seven colleagues sent President Obama a letter supporting a Consumer Financial Protection Agency ---------------------------------------------------------------------------preserving State enforcement authority: [W]e believe that any reform must (1) preserve State enforcement authority, (2) place Federal consumer protection powers with an agency that is focused primarily on consumer protection, and (3) place primary oversight with Government agencies and not depend on industry selfregulation. \103\--------------------------------------------------------------------------- \103\ Letter of 15 June 2009, from the chief legal enforcement officers of eight States (California, Connecticut, Illinois, Iowa, Maryland, Massachusetts, North Carolina, and Ohio) to President Obama, on file with the authors. F.2. Why Federal Law Should Always Be a Floor. Consumers need State laws to prevent and solve consumer problems. State legislators generally have smaller districts than members of Congress do. State legislators are closer to the needs of their constituents than members of Congress. States often act sooner than Congress on new consumer problems. Unlike Congress, a State legislature may act before a harmful practice becomes entrenched nationwide. In a September 22, 2003, speech to the American Bankers Association in Hawaii, Comptroller John D. Hawke admitted that consumer protection activities ``are virtually always responsive to real abuses.'' He continued by pointing out that Congress moves slowly. Comptroller Hawke said, ``It is generally quite unusual for Congress to move quickly on regulatory legislation--the Gramm-Leach-Bliley privacy provisions being a major exception. Most often they respond only when there is evidence of some persistent abuse in the marketplace over a long period of time.'' U.S. consumers should not have to wait for a persistent, nationwide abuse by banks before a remedy or a preventative law can be passed and enforced by a State to protect them. States can and do act more quickly than Congress, and States can and do respond to emerging practices that can harm consumers while those practices are still regional, before they spread nationwide. These examples extend far beyond the financial services marketplace. States and even local jurisdictions have long been the laboratories for innovative public policy, particularly in the realm of environmental and consumer protection. The Federal Clean Air Act grew out of a growing State and municipal movement to enact air pollution control measures. The national organic labeling law, enacted in October 2002, was passed only after several States, including Oregon, Washington, Texas, Idaho, California, and Colorado, passed their own laws. In 1982, Arizona enacted the first ``Motor Voter'' law to allow citizens to register to vote when applying for or renewing drivers' licenses; Colorado placed the issue on the ballot, passing its Motor Voter law in 1984. National legislation followed suit in 1993. Cities and counties have long led the smoke-free indoor air movement, prompting States to begin acting, while Congress, until this month, proved itself virtually incapable of adequately regulating the tobacco industry. A recent and highly successful FTC program--the National Do Not Call Registry to which 58 million consumers have added their names in 1 year--had already been enacted in 40 States. But in the area of financial services, where State preemption has arguably been the harshest and most sweeping, examples of innovative State activity are still numerous. In the past 5 years, since the OCC's preemption regulations have blocked most State consumer protections from application to national banks, one area illustrating the power of State innovation has been in identity theft, where the States have developed important new consumer protections that are not directed primarily at banking. In the area of identity theft, States are taking actions based on a non-preemptive section of the Fair Credit Reporting Act, where they still have the authority to act against other actors than national banks or their subsidiaries. There are 7 to 10 million victims of identity theft in the U.S. every year, yet Congress did not enact modest protections such as a security alert and a consumer block on credit report information generated by a thief until passage of the Fair and Accurate Credit Transactions Act (FACT Act or FACTA) in 2003. That law adopted just some of the identity theft protections that had already been enacted in States such as California, Connecticut, Louisiana, Texas, and Virginia. \104\--------------------------------------------------------------------------- \104\ See California Civil Code 1785.11.1, 1785.11.2, 1785,16.1; Conn. SB 688 9(d), (e), Conn. Gen. Stats. 36a-699; IL Re. Stat. Ch. 505 2MM; LA Rev. Stat. 9:3568B.1, 9:3568C, 9:3568D, 9:3571.1 (H)-(L); Tex. Bus. & Comm. Code 20.01(7), 20.031, 20.034-039, 20.04; VA Code 18.2-186.31 :E.--------------------------------------------------------------------------- Additionally FACTA's centerpiece protection against both inaccuracies and identity theft, access to a free credit report annually on request, had already been adopted by seven States: Colorado, Georgia, Maine, Maryland, Massachusetts, New Jersey, and Vermont. Further, California in 2000, following a joint campaign by consumer groups and realtors, became the first State to prohibit contractual restrictions on realtors showing consumers their credit scores, ending a decade of stalling by Congress and the FTC. \105\ The FACT act extended this provision nationwide.--------------------------------------------------------------------------- \105\ See 2000 Cal. Legis. Serv. 978 (West). This session law was authored by State Senator Liz Figueroa. ``An act to amend Sections 1785.10, 1785.15, and 1785.16 of, and to add Sections 1785.15.1, 1785.15.2, and 1785.20.2 to the Civil Code, relating to consumer credit.''--------------------------------------------------------------------------- Yet, despite these provisions, advocates knew that the 2003 Federal FACTA law would not solve all identity theft problems. Following strenuous opposition by consumer advocates to the blanket preemption routinely sought by industry as a condition of all remedial Federal financial legislation, the final 2003 FACT Act continued to allow States to take additional actions to prevent identity theft. The results have been significant. Since its passage, fully 47 States and the District of Columbia have granted consumers the right to prevent access to their credit reports by identity thieves through a security freeze. Indeed, even the credit bureaus, longtime opponents of the freeze, then adopted the freeze nationwide. \106\--------------------------------------------------------------------------- \106\ Consumers Union, U.S. PIRG and AARP cooperated on a model State security freeze proposal that helped ensure that the State laws were not balkanized, but converged toward a common standard. More information on the State security freeze laws is available at http://www.consumersunion.org/campaigns/learn_more/003484indiv.html (last visited 21 June 2009).--------------------------------------------------------------------------- A key principle of federalism is the role of the States as laboratories for the development of law. \107\ State and Federal consumer protection laws can develop in tandem. After one or a few States legislate in an area, the record and the solutions developed in those States provide important information for Congress to use in deciding whether to adopt a national law, how to craft such a law, and whether or not any new national law should displace State law.--------------------------------------------------------------------------- \107\ New State Ice Co. v. Leibman, 285 U.S. 262, 311 (1932) (Brandeis, J., dissenting).--------------------------------------------------------------------------- A few more examples from California illustrate the important role of the States as a laboratory and a catalyst for Federal consumer protections for bank customers. In 1986, California required that specific information be included in credit card solicitations with enactment of the then-titled Areias-Robbins Credit Card Full Disclosure Act of 1986. That statute required every credit card solicitation to contain a chart showing the interest rate, grace period, and annual fee. \108\ Two years later, Congress chose to adopt the same concept in the Federal Fair Credit and Charge Card Disclosure Act (FCCCDA), setting standards for credit card solicitations, applications and renewals. \109\ The 1989 Federal disclosure box \110\ (know as the ``Schumer Box'') is strikingly similar to the disclosure form required under the 1986 California law.--------------------------------------------------------------------------- \108\ 1986 Cal. Stats., Ch. 1397, codified at California Civil Code 1748.11. \109\ Pub. L. 100-583, 102 Stat. 2960 (Nov. 1, 1988), codified in part at 15 U.S.C. 1637(c) and 1610(e). \110\ 54 Fed. Reg. 13855 (April 6, 1989, Appendix G, form G-10(B)).--------------------------------------------------------------------------- States also led the way in protecting financial services consumers from long holds on deposited checks. California enacted restrictions on the length of time a bank could hold funds deposited by a consumer in 1983; Congress followed in 1986. California's 1983 funds availability statute required the California Superintendent of Banks, Savings and Loan Commissioner, and Commissioner of Corporations to issue regulations to define a reasonable time after which a consumer must be able to withdraw funds from an item deposited in the consumer's account. \111\ Similar laws were passed in Massachusetts, New York, New Jersey, and other States. Congress followed a few years later with the Federal Expedited Funds Availability Act of 1986. \112\ California led the way on security breach notice legislation. Its law and those of other States have functioned as a de facto national security breach law, while Congress has failed to act. \113\--------------------------------------------------------------------------- \111\ 1983 Cal. Stat. Ch. 1011, 2, codified at Cal. Fin. Code 866.5. \112\ Pub. L. 100-86, Aug. 10, 1987, 101 Stat. 552, 635, codified at 12 U.S.C. 4001. \113\ More information on State security breach notice laws is available at http://www.consumersunion.org/campaigns/financialprivacynow/002215indiv.html (last visited 21 June 2009).--------------------------------------------------------------------------- It is certainly not the case that States always provide effective consumer protection. The States have also been the scene of some notable regulatory breakdowns in recent years, such as the failure of some States to properly regulate mortgage brokers and nonbank lenders operating in the subprime lending market, and the inability or unwillingness of many States to rein in lenders that offer extraordinarily high-cost, short term loans and trap consumers in an unsustainable cycle of debt, such as payday lenders and auto title loan companies. Conversely, Federal lawmakers have had some notable successes in providing a high level of financial services consumer protections in the last decade, such as the Credit Repair Organizations Act and the recently enacted Military Lending Act. \114\ This is why it is necessary for this new Federal agency to ensure that a minimum level of consumer protection is established in all States.--------------------------------------------------------------------------- \114\ Military Lending Act, 10 U.S.C. 987. Credit Repair Organizations Act, 15 U.S.C. 1679h (giving State Attorneys General and FTC concurrent enforcement authority).--------------------------------------------------------------------------- Nonetheless, as these examples show, State law is an important source of ideas for future Federal consumer protections. As Justice Brandeis said in his dissent in New State Ice Co., ``Denial of the right [of States] to experiment may be fraught with serious consequences to the Nation'' (285 U.S. at 311). A State law will not serve this purpose if States cannot apply their laws to national banks, who are big players in the marketplace for credit and banking services. State lawmakers simply won't pass new consumer protection laws that do not apply to the largest players in the banking marketplace. Efficient Federal public policy is one that is balanced at the point where even though the States have the authority to act, they feel no need to do so. Since we cannot guarantee that we are ever at that optimum, setting Federal law as a floor of protection as the default--without also preempting the States--allows us to retain the safety net of State-Federal competition to guarantee the best public policy. \115\--------------------------------------------------------------------------- \115\ For further discussion, see Edmund Mierzwinski, ``Preemption of State Consumer Laws: Federal Interference Is a Market Failure,'' Government, Law, and Policy Journal of the New York State Bar Association, Spring 2004 (Vol. 6, No. 1, pp. 6-12).---------------------------------------------------------------------------Conclusion As detailed above, a strong Federal commitment to robust consumer protection is central to restoring and maintaining a sound economy. The Nation's financial crisis grew out of the proliferation of inappropriate and unsustainable lending practices that could have and should have been prevented. That failure harmed millions of American families, undermined the safety and soundness of the lending institutions themselves, and imperiled the economy as a whole. In Congress, a climate of deregulation and undue deference to industry blocked essential reforms. In the agencies, the regulators' failure to act, despite abundant evidence of the need, highlights the inadequacies of the current regulatory regime, in which none of the many financial regulators regard consumer protection as a priority. As outlined in the testimony above, establishment of a single Consumer Financial Protection Agency is a critical part of financial reform. As detailed above, its funding must be robust, independent and stable. Its board and governance must be structured to ensure strong and effective consumer input, and a Consumer Advocate should be appointed to report semi-annually to Congress on agency effectiveness. Our organizations, along with many other consumer, community, civil rights, labor and progressive financial institutions, believe that restoring consumer protection should be a cornerstone of financial reform. It will reduce risk and make the system more accountable to American families. We recognize, however, that other reforms are needed to restore confidence to the financial system. Our coalition ideas on these and other matters can be found at the Web site of Americans For Financial Reform, available at ourfinancialsecurity.org. Thank you for the opportunity to testify. Our organizations look forward to working with you to move the strongest possible Consumer Financial Protection Agency through the Senate and into law.Appendices:Appendix 1: Abusive Lending Practices by Smaller Banks and ThriftsAppendix 2: Private Student Loan Regulatory Failures and Reform RecommendationsAppendix 3: Rent-A-Bank Payday LendingAppendix 4: Information on Income (Primarily User and Transaction Fees Depending on Agency) of Major Financial Regulatory AgenciesAppendix 5: CFA Survey: Sixteen Largest Bank Overdraft Fees and Terms ______ CHRG-111hhrg48875--254 Secretary Geithner," We could, but I don't think it would help anything. And I think it would deprive people from the ability to do things that are probably going to make the system safer. What we are proposing to do is to bring them within a framework of oversight, to put them onto clearinghouses and exchanges, which will help contain the risk, help people manage their risk better, provide much more transparency and disclosure about those risks. And we think that will do a lot to make the system safer. I am not sure this is worth going into, but if you just ban them, something else will develop like that. The better approach is to try to bring them into a framework where their risks are better managed. Ms. Waters. Well, Mr. Secretary, I wish that in the thinking that goes on about all of these markets, I wish that some deeper thought would go into not allowing some products to come on the market rather than talking about regulating everything because I think even though you talk about how creative people can be and how innovative and they will come with something else, it is better that you look at that than let something get out there that causes us a lot of pain that we haven't been able to control. Thank you. " 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-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. ______ FinancialCrisisInquiry--79 Great. Thank you. Mr. Thomas? VICE CHAIRMAN THOMAS: Could I ask a quick... CHAIRMAN ANGELIDES: Yes. VICE CHAIRMAN THOMAS: ... follow-up question? In terms of the complexity, there’s more and more drive with documents that the public deals with in terms of trying to put them in plain English to a certain extent so that you can understand them. I know sometimes it’s—it’s difficult to put it in simple terms, but don’t all of them focus on who gets what when and how? And you can permeate that in any way you want to, but there are some fundamentals that don’t have to be there, that sometimes complexity is impressive. I mean if I said, “I hate you,” you get it. If I said, “I have extremely strong feelings of animosity,” some folks may not. Now, maybe the blow has been softened by that, but the fundamentals are the same. To what extent can you folks, even from a PR point of view, talk about simplification so that people can understand? Or is it kind of an agreement that you’re going to have a fraternity which gets paid highly and has the jargon—we run into that a lot in government; I used to run into it a lot in government—in which jargon was used to reduce the number of people they had to interact with? Is that the case in terms of some of the complexity that you find now? You get paid more for 100 pages than you do for one. MACK: No, that is not. It’s more of the engineering and structuring in derivatives and synthetic products. It’s not about 100 pages instead of one page. Certain products answer certain questions or problems that someone’s trying to solve for, so all of us are lucky to have very smart people. And if there is a problem that an asset manager has are pension fund, and you try to work with them to solve that problem, as a result... CHRG-111hhrg52400--261 Mr. Posey," Thank you, Mr. Chairman. I want to thank each and every one of you for your time and your testimony. And your forthrightness, especially, is appreciated. Mr. Skinner, you are right. There has been a big disparity between the requirements for domestic and non-domestic reinsurers. And I think just in the last couple of years, though, we have been so plundered and abused by the reinsurers that have done business in some of our States--all of whom happen to have the exact same rates--that you will see some of those States are dropping those requirements. More than protectionism, the purpose of that was so that if we caught them misbehaving, theoretically we could put them in jail and hold them accountable if they were domiciled in this country. If they were domiciled some other place in the world, that becomes a little bit more problematic. So that was done more as a matter of accountability than it was protectionism, hopefully. When we talk about a systemic regulator, I wonder--and you have come the farthest, Mr. Skinner, and might have the best ideas on this--how in the world could we expect a systemic regulator to regulate derivatives, complex derivatives? I mean, from a practical application, I have not heard anyone yet explain how somebody could evaluate them and then regulate them. I mean, in theory, we say, ``Yes, we need somebody to regulate this stuff and make it right,'' but I haven't heard a practical example given yet of how they would regulate complex derivatives, for example. " CHRG-111hhrg48868--813 Mr. Liddy," No. I agree with that, and therefore, where I was going was, I think there needs to be some overarching systemic risk regulator. When you have these large $100 billion companies that are so complex and interrelated, it defies the regulatory scheme that is currently in place and there has to be something that comes along that can really guide and review the interaction of those companies. I think that was missing in this case. Ms. Speier. All right. How much of the $30 billion that is now at your disposal do you expect to use? " CHRG-111shrg51303--137 Mr. Polakoff," Senator, I do not believe so. These CDOs absolutely were complex, but the credit default swap portion was written on the super-senior AAA-plus tranche of it. And these ratings were assigned to these super-senior tranches before the credit default swaps were written. " CHRG-111shrg55479--44 Mr. Verret," Well, Senator Bunning, I would offer that the best person to make--the best group to make that assessment is the shareholders themselves. And so I would leave it to shareholders to determine how proxy access should work, how it should operate. And so for that reason, I think the innovations at the level of Delaware and in the Model Business Code, which forms the basis for 20 to 30 other corporate law codes of other States, are on the right track. And I think also Commissioner Paredes has offered a proposal to the SEC to help buttress this development, to permit access for shareholder election bylaws to the corporate ballot. So in other words, instead of saying this is how the elections should work, we say shareholders can put forward a bylaw that should say how the election should work. All the shareholders should determine how that election should work. In many ways, it is similar to the Constitutional Convention. Rather than choosing--the people got to choose the mechanism by---- Senator Bunning. You are not suggesting we go back to a Constitutional Convention---- " 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-111shrg61651--120 Mr. Johnson," Absolutely, Senator. So Mr. Corrigan said a little while ago that the total balance sheet of Goldman Sachs right now is about $800 billion. But what is the balance sheet if you take into account derivative positions? That depends on risk models that they run that they report to other people. Perhaps the regulator has some independent ability to assess that. Perhaps the market has some ability to see through what they are doing. I actually don't think that they do. So derivatives are very important because that is the complexity and it is where a lot of the interconnectedness today is manifested in problems that will always be there, and it is where a great deal of problems occur whenever there is a crisis. We just don't know what is the true balance sheet, what are the true risks, what is the true capital of these financial institutions without relying on their own risk models, and those risk models failed dramatically and repeatedly in the run-up to September of 2008. And with respect to Mr. Corrigan and the idea that Goldman Sachs was not saved by becoming a bank holding company, what would have happened to Goldman Sachs if it had not become a bank holding company, particularly based on its derivative exposure and what had happened in and around AIG? Senator Reed. You should turn on your microphone, Mr. Corrigan, because we want to hear you. " CHRG-111shrg52619--46 Mr. Dugan," I think you have choices. Basically, of the four regulators of banks, you have two for Federal charters, two for State charters, and the question is: Does that make sense? You could have a single one for Federals; you could have a single one for States; you could have a single that cuts across all of them and still have two charters. There are complexities and issues with respect to each of those, and I should not leave out you have 12 Federal Reserve banks. " CHRG-111hhrg51698--136 Mr. Damgard," I certainly share your concern about the business moving offshore. The largest agricultural futures market in the world is Dalian, China, and that is because they sent a lot of people over here, and they studied the Merc, and they studied the Board of Trade, and they went back to their respective countries and they built fantastic markets. Singapore has a great market. Hong Kong has a great market. They both trade energy futures, and they would love to see the market move out of New York to their markets. So, we have to be very cautious to make sure that whatever the Committee does, we don't encourage people to use markets outside of the United States. There will always be a place for people to speculate, and if they want to speculate in energy and they can't do it here, they will do it elsewhere, notwithstanding Mr. Greenberger, who said we have to regulate credit default swaps--truthfully they have never been regulated. This is all part of the innovation, and what the Committee is doing is extremely proper and extremely appropriate. Nobody is for excess speculation, but I do think that the CFTC knows more about it than anybody else. " 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. ______ FinancialCrisisInquiry--461 SOLOMON: Well, unless you get to the place I would like to get to, which I agree it’s unlikely, which is to hive off some of these activities and make them be private and make them be partnerships. And I understand how difficult that will be. But a lot of things we thought were difficult at one point later became true, for whatever reason. I think you just have to have a regulatory environment that is coherent, not patchwork, and enforceable. The regulatory environment failed here. And the proposals, if I may say, for a council of regulators getting together seems to me a nightmare. Just look at what happened in homeland security with the bomber. We—those regulators couldn’t all—those folks all couldn’t get together to look at information they all had. And now we’re going to have regulators get together in a council. I think that’s foolhardy. I think you’ll get nowhere with that, and it’ll just fall through the cracks again. I’m for one very strong regulator. And the best regulator that we have is the Federal Reserve. And the reason it’s the best regulator is it has—seems to have the biggest cadre in most places. And you heard the folks this morning again say that they were very impressed by the regulators in their offices. January 13, 2010 John Mack certainly made that point; others did. But you’re not going to catch up with innovation, and unless you change the structure—and I’m not sure it’s advisable; I would like it, but I’m not sure it’s going to happen—I think you’ve just got to have very strong and constant and non-patchwork regulation. CHRG-111hhrg55809--147 Mr. Bernanke," In some cases, I think that we have--for a long time, the Federal Reserve believed that transparency and disclosure was all that was needed, and we have been very much proponents of that point of view. But I do think there are some circumstances where the benefits to the consumer are overwhelmed by the complexity and other aspects that just are not worth whatever benefits. " CHRG-111hhrg74090--162 Mr. Cox," Thank you, Mr. Chairman and Ranking Member Radanovich. Abuses of consumer finance products were a disaster for millions of consumers before anyone recognized them because we had a financial crisis, a disaster. We heard previous testimony about someone committing suicide. I have sat with people whose families committed suicide after I worked with them who had heart attacks from the stress. Millions of people experienced this. Our federal regulatory system did not respond to this. It was dominated completely by the thinking and needs of the lenders and sellers and not by what was happening on the ground. It is often said that no one could have seen this. The people who were working with the victims of subprime lending and were talking to people who reflected the experience of those people as well as the others who were subject to the abuses of consumer finance products absolutely knew what was going on and were screaming at the top of our lungs. No one was listening. It was predictable and it was preventable. The Consumer Financial Protection Agency as proposed offers the first hope in generations, certainly in my adult lifetime working on these issues, for an agency with sufficient power and focus on consumer protection issues to seriously address these problems. It gets it right in terms of its model. It sets up a unified rulemaking process. It is not about whether the FTC was good or bad. It is about the fragmentation of authority and the lack of perspective and a unified rulemaker. It gets it right and setting the floor and allowing innovation where innovation should occur, which is in the state regulatory system, and it couples that with an open enforcement system. It allows the enforcement of those clear, unified rules to occur in multiple places, and there are two reasons you want that. The first is that you compare the proper enforcement agency with the problem at hand. If you have got a problem that just occurs in Indiana, the Indiana attorney general is the right place to do it. It simply won't get taken care of if you allow a federal agency. Conversely, if the Indiana attorney general turns up a problem that appears to be nationwide, that can highlight the need for the agency. Secondly, agencies like the FTC and state attorneys general often will bring violations of rules ancillary--which is what Chairman Leibowitz was saying--ancillary to other investigations because these things don't come up in little neat silos. So an open public enforcement model, which is what this bill has, by allowing the Federal Trade Commission and other federal agencies to enforce the rules and state attorneys general to enforce the rules enhances enforcement. I will make two quick comments, one about the details of the enforcement mechanisms and the other about the rulemaking investigative authority. The open enforcement mechanisms in the bill are excellent; however, I agree completely with Chairman Leibowitz that the 120 days' restriction on the FTC is way too cumbersome. It needs to be streamlined and made more efficient. Secondly, and this is, I think, a very important point in the bill as currently constructed--the FTC is given the authority to enforce extant federal consumer credit laws but not the regulations passed by the CFPA. The CFPA regulations over time will become much more important than the extant consumer credit regulations. It is really critical that the FTC get the authority to enforce the regulations that are passed by the CFPA. There is also a consulting power in there, a requirement, and that is correct and I hope that on an informal basis the agency takes account of the fact that the FTC, which enforces UDAP, unfair and deceptive acts and practices laws, gains a particular type of experience and understanding that is vital to setting those rules. Secondly, state AGs have authority but mechanisms for remedies need to be clarified because right now the section 1055 powers--it is unclear whether those are bootstrapped into the AG enforcement. Finally, in its rulemaking authority, the new CFPA desperately needs detailed and express and clear investigatory powers. Otherwise the data that is brought to bear in what the rules are will be data held by the industry that the CFPA simply doesn't have access to, so it is critical that the CFPA have that investigative power so that they can get the rules right the first time. I really appreciate the opportunity to be at this historic hearing and wish the Congress great luck in making this project work. [The prepared statement of Mr. Cox follows:] " CHRG-111shrg55739--57 Mr. Barr," I think there are ways of getting at the basic problem of complexity in alternative strategies than a flat ban. So, for example, the securitization ``skin in the game'' requirement improved transparency in the securitization structure that we have proposed requirements with respect to transparency at the loan level for all investors in the underlying asset with respect to, say, a borrower FICO score, what broker originated the loan, what the compensation scheme was, all of which are designed to get at that set of concerns, and better qualitative and quantitative information underlying the rating on such a structured product would permit investors to go underneath and say, well, the reason that they have assigned this rating is because their view of the cash-flow distribution in the waterfall was this, their loss probability measurement, their loss severity measurement is that. And it is a way of unpacking the complexity into its component parts. Senator Merkley. I appreciate your response. I am picturing what that sort of report might have looked like on some of those CDO-squared. It may have in itself---- " CHRG-111hhrg56847--37 Chairman Spratt," Before going to Ms. Schwartz, we have been informed by the Chairman's staff that you have a plane to catch at 12:30. So I am going to ride the 5-minute space pretty tightly. Ms. Schwartz. Ms. Schwartz. Thank you very much. Thank you, Mr. Chairman, for your--I do want to follow up on, I think, some of the questions that have been asked and you have elaborated, and particularly Mr. Ryan's last set of questions about business growth, small business growth. We do see, many of us, as the answer, both in the short-term and the long-term, as growing jobs in the private sector. And particularly we have focused on the job growth in a small business. And we have taken a number of actions that we feel are making a difference. If you want to comment on some of them. And I wanted to ask you specifically about lending, for you to elaborate a bit more on small business lending. We have done investment tax credits, biotherapeutics, we may do them for biofuels as a way to incentivize small businesses that don't have assets to be able to take regular tax credits, can do investment tax credits. We have extended bonus depreciation for small businesses, making capital investments. We have increased the cashflow for small business by providing a 5-year operating loss carryback. We have actually cut capital gains taxes for investments for small business, stocks would be extended, small business expensing. We have actually created tax credits for small businesses to provide health benefits. And the President has a new initiative on exports, which you referenced very briefly on the importance--I will say it is the importance of expanding our export opportunities, particularly for small business. We tend not to think about the opportunities for small businesses to increase their outreach to the markets in the world and to be able to sell their products around the world. And there is an initiative the President has directly endorsed to double that export number. It is actually really quite small, unlike many other countries. We are looking in the future in two areas to expand these investment tax credits as one way to help innovative new businesses, small businesses that have a hard time accessing capital. And I wanted to know what you think of that. Because many of us do believe that the new technology businesses, some of them in the energy sector, some of them in the health sector, but more broadly are really a great growth area for the United States. We have always been on the cutting edge of innovation and technology. And so I would ask you to comment on the actions we have taken, whether you think we should be continuing those, how much they have made a difference and will make a difference in expanding growth, small business growth in particular and we hope jobs. And secondly to expand on small business lending. We all hear it. We continue to hear it. Our concern, as you pointed out, was making sure whether banks, which is where small businesses go for this lending, are acting too conservatively. They get mixed messages a bit from the regulators to say--and we agree that they have to make sure they have enough capital themselves. But they have got to get some dollars out the door. We are looking this week at small business lending legislation that would actually encourage banks through some Federal dollars to get those dollars out the door to small businesses. And again I would highlight the interests we have in growth areas. Manufacturing, but particularly innovative entrepreneurs who are out there, want to take these steps and have a hard time accessing small business lending. Do you want to comment? I know you try not to comment on legislation, but the access to capital, what the Federal Government can do to encourage banks to do this. And again, more that we might be doing or that you might be able to do to encourage small business growth as one of the ways out of this difficult economy that I believe we have stabilized but really has a long way to go to create those jobs that we all want to see happen. " CHRG-111hhrg54869--82 The Chairman," The gentlewoman from New York. Mrs. McCarthy of New York. Thank you, Mr. Chairman. And it is good to see you again. I guess my line of questioning is, being that we are seeing, you know, the banks starting to come back and starting to loan--not as much as what they should--we are seeing the market coming back up a little bit. We see on TV that the banks and the financial institutions are spending millions of dollars with very nice fluffy ads to get customers to come back. And I guess the question is: With all that we are going to be trying to do, how long is it going to be before they start taking more risk again? And that is one of the concerns I have. You know, it used to be that all these corporations, they ran their business because of trust, trust of the American people. They have ruined that trust. We can stand here and sit here and try and make it better, but millions of people have lost their IRAs, they have lost their retirement funds. Many have had to stop their thoughts of even retiring. We can't make that up. But one of the things that I am afraid of, and I am already starting to see it, is the financial system is prone to more systemic risks today than I think ever before. I think it would be a tribute to the creation of complex investments products such as credit defaults. I mean, they are already starting on coming out with new products. And yet, you know, I think everybody was sleeping at the wheel. You talk about the Federal Reserve. No one did anything to really bring the attention to the authorities on the way they were supposed to. So how do we make that better? How do we get the industry, I guess, to have a moral backbone? That is the main point, and we can't legislate for that. " CHRG-111hhrg53248--181 Mr. Bowman," Good afternoon, Mr. Kanjorski, Ranking Member Bachus, and members of the committee. Thank you for the opportunity to testify today on the Administration's proposal for financial regulatory reform and H.R. 3126, the Consumer Financial Protection Agency Act of 2009. It is my pleasure to address the committee for the first time in my role as Acting Director of the Office of Thrift Supervision. The OTS supports the fundamental objectives at the heart of the Administration's proposal, agrees that the time to act is now, and agrees that the status quo must change. As you consider legislation to meet those objectives, I encourage you to ensure that each proposed change addresses a real problem that contributed to the financial crisis or otherwise weakens this Nation's financial system. In my view, the solutions to these real problems fall into three categories: Number one, protect consumers. One Federal agency whose central mission is the regulation of financial products should establish the rules and standards for all consumer financial products. This structure would replace the current myriad of agencies with fragmented authority and a lack of singular accountability. For entities engaged in consumer lending that are not insured depository institutions, the Consumer Protection Agency should not only have rulemaking authority, but also examination and enforcement authority. Number two, establish uniform regulation by closing gaps. These gaps became enormous points of vulnerability in the system and were exploited with serious consequences. All entities that offer financial products and services to consumers must be subject to the same consumer protection rules and regulations and vigorous examination and enforcement so that under-regulated entities cannot gain a competitive advantage over their more regulated counterparts. Number three, create the ability to supervise and resolve systemically important firms. No provider of financial production 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. The U.S. economy operates on the principles 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 treated as too-big-to-fail subvert the system. When the government is forced to prop up failing systemically important companies, it is in essence supporting poor performance and creating a moral hazard. If the legislative effort accomplishes these three objectives, it will have accomplished a great deal, and in my view, the reform effort will be a ringing success. Thank you for the opportunity to be here today. We look forward to continuing to work with the members of this committee and others to create a system of financial services regulation that promotes greater economic stability for the Nation, and I would be happy to answer your questions. [The prepared statement of Mr. Bowman can be found on page 89 of the appendix.] " CHRG-111hhrg53246--58 Mr. Bachus," Thank you. I noticed that both of you, in your opening statements, said that you were working together as colleagues and in partnership and I think that is going to be critical and I was glad to hear that. I think the key in doing this, we are going to continue to have two separate agencies, that is apparent. We are the only country in the world that really has that dual set of securities and futures, and you know they are regulated quite differently. So I think there is obviously a need for harmonization. I think the key is going to be the leadership of you two. I think that will really set the tone and will determine how successful we are. So I applaud you for your opening statements. I also want to focus on something, and I agree that Chairman Schapiro said, she said I want to emphasize to the committee that the SEC and other financial regulatory agencies have been making solid progress using our existing authority to address the financial regulatory problems that face this country. You do have a lot of existing authority, and I think it is important that we as a Congress realize that. And actually, in all this regulatory reform, my concern has been that we are telling you what to do as opposed to you looking at your authority you have, looking at the problems that we now all realize, and they are very complex problems, and saying to us this is what we need, you know this is how we are going to discharge that authority or we need additional statutory authority. As opposed to, particularly with some of the banking regulators, saying we are going to totally change our approach to regulation and some good, but maybe not so good ways. I am going to ask one question and one question only. Having to do this by September 30th is to me an overwhelming and unrealistic goal. Now, I know that the problems are there, but you have already taken steps. And other regulators have already taken steps, I think, to minimize a recurrence of what we saw last year. I don't think in the current climate that businesses are going to take that kind of risk, number one, or that regulators are allowing that kind of risk. But tell me, I will ask both of you, how realistic is that? And will you not hesitate to ask for more time? " FinancialCrisisInquiry--127 BASS: However, they set the gold standard for which what pension funds and endowments can invest and what’s investment grade. The fact that they set the investment grade guidelines makes them a de facto regulator, and it’s what everybody bases their capital decisions on. So there’s so many things we can talk about here—things that go wrong— but off-balance sheet and risk weighting are very important. I don’t know, Michael, if you want to add to that. VICE CHAIRMAN THOMAS: Thank you. And I’m going it ask Mr. Mayo a question as well. But that’s why I do want to, once again, extend to you a willingness, if you are willing, to have the record run until we’re done in terms of our work so that we could get back to you as we, again, get more sophisticated and understand the questions we should have asked and work with them. And appreciate your willingness to do that. Mr. Mayo, I like your sheets on the ten points. My question to you: Given the complexity of a bank’s financial statements, the derivative off-balance-sheet position that we talked about, how are you able to—I mean, they all claim that they have adequate capital. How difficult is it for you to get a clear picture of what is actually there? Are current SEC disclosures sufficient if you’re good enough and have a bright enough light? Or is that an area that we could talk about looking at as well as, perhaps, was one of the problems; no one could get a clear picture of what the situation actually was until, of course, after the fact? MAYO: I think about your question a lot. And, you know, accountants try to recreate reality in numbers, and we, as financial analysts, take those numbers and try to recreate reality. So if the numbers that accountants give us aren’t good, then the conclusions of the analysts won’t be good either. So, definitely, more disclosure is good and would be helpful. 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-109shrg30354--87 Chairman Bernanke," I am basing it on looking at the pattern of recent years. First, we saw the productivity gains mostly in the industries producing high-tech equipment, as companies learned how to build ships faster, for example. Then we saw it moving into the users. That is firms that were not high-tech producers but were using and consuming those goods to increase their own productivity. And what we see as we talk to people in the industries and the like is we see first that there is continuing innovation and improvement at the level of high-tech producers. And moreover, what we hear from CEO's and the like is that they feel there is a lot more diffusion to take place before they have fully exhausted the benefits of new technologies in terms of increased productivity. As a historical matter, when productivity changes from a high level to a low level, it does tend to last for a while. And that is another piece of encouraging evidence. Senator Sununu. So you have what you feel to be some pretty good anecdotal evidence. " CHRG-111shrg54789--184 PREPARED STATEMENT OF SENDHIL MULLAINATHAN Professor of Economics, Harvard University July 14, 2009 Chairman Dodd, Ranking Member Shelby, and Members of the Committee, thank you for providing me with an opportunity to testify. By way of background, I am a Professor of Economics at Harvard who specializes in behavioral economics, a topic that combines two areas--economics and psychology. Any discussion of financial regulation must incorporate both areas--economists have a healthy respect for market forces while psychologists have a healthy respect for both people's immense capacities and limitations; they recognize that people are not financial engines churning out optimal choices in all environments. Understanding the current crisis--with its combination of competing lenders and sometimes-confused borrowers--requires behavioral economics. In my comments I will make four points: First, some decision environments allow consumers to choose well while others result in poor choices. Second, when customers choose well there is healthy competition: firms clamor to provide better products at lower prices. When customers choose badly, there can be a race to the bottom. Even a few unprincipled firms offering products that exploit human fallibility can put pressure on the entire market. Third, a two-part approach to financial regulation can promote consumers capacity to choose well. Safe products would be lightly regulated while less safe ones--where low road firms could potentially exploit customers--would be more heavily regulated. A fence around the safer products creates a more level playing field between safe and less safe but superficially attractive products. It provides an additional tool that is less intrusive than bans, mandates or selective bans for some customers. It allows all customers to access products but simply ensures that those who access less safe ones would be doing so with greater safeguards.Though the scope of the proposed regulation is broad, I will use the choice between mortgages--at the heart of the current financial crisis--to illustrate my points.Choosing Well and Badly First, let me describe the psychology of choice. Over the decades much research has helped us understand how people choose. I will illustrate the insights from this research using two familiar examples. Most of you have painted a room in your house. You probably remember choosing from thousands of colors; Benjamin Moore alone proudly offers 140 shades of white. How do you tackle this ocean of choice? You pick a general color--blue, yellow, whatever. You pick a few shades within that color. You try them out in small swatches on one wall, see if you like them and repeat until you have a color you like. The bottom line: despite the explosion of choice people are largely happy with the end outcome. And certainly we don't think the Government could step in and improve this market through regulation. I am also sure most of you have bought a digital camera. Going into the electronics store, you have some sense of what you want--do you need a small camera or a big one, do you prefer one brand over another? But once there the problem gets tougher. One camera has 8 megapixels and is smaller and cheaper; another has 12 megapixels and is bigger and more expensive. How do you choose? What is a megapixel? How many is enough? Are 8 megapixels 50 percent better than 12? You can ask the camera salesman but are his incentives to give you the best advice? If the bigger camera is the cheaper per megapixel it may draw you to buy that one even without knowing fully understanding what megapixels are. Though there are far fewer cameras than paint colors the choice is far more difficult. At the end of the process, you hope you have bought the best camera but you're never really sure. Part of choosing a mortgage is like choosing a paint color. Choosing a 30-year fixed rate mortgage means deciding on what is an affordable monthly payment. How much do you earn? What are your other expenses? The consumer can intuit much of this--in fact they may know it better than any outsider. But sometimes when choosing a mortgage you encounter features all too similar to megapixels. Suppose one mortgage costs $1,000 a month for the first 2 years and then the payment is 3 points above 1 month LIBOR, while another says it is $900 a month and then the payment is 4 points about the 1 year constant Treasury bills rate. How do you make this choice? What is the difference between the LIBOR and the T-Bill rate? How much do they vary? Are 3 and 4 points about the right number? If the provider says you can refinance in 2 years, should you worry about being able to get another loan? Notice that in this morass, the $900 mortgage has some appeal; whatever else, it is cheaper now and allows you afford a bigger house. Few know the answers to these questions and those who do are the kind of people you avoid at a dinner party. This is worse than megapixels. Choices such as these are at the heart of why choosing mortgages and other financial products pose so many difficulties for customers. With paint, you can try different colors; you can't really try on many mortgages. With paint, you get feedback; with mortgages feedback comes rarely and far too late--when the payments explode. With paint, a mistake is, well, easily painted over; with mortgages mistakes have lifetime consequences. And most importantly, we understand the colors we like whereas few of us understand the financial technicalities that can have large consequences. Under such conditions, errors abound. For example, as Bucks and Pence show in their recent study ``40 percent of borrowers with income less than $50,000--corresponding roughly to the bottom half of the income distribution of ARM borrowers--do not know the per-period caps on their interest rate changes.'' \1\ To cite another example, nearly 50 percent of ARM borrowers think their mortgages can be converted to fixed rate ones whereas only 9 percent actually appear to be convertible.--------------------------------------------------------------------------- \1\ Brian Bucks and Karen Pence (2006) ``Do Homeowners Know Their House Values and Mortgage Terms?'' Federal Reserve Board of Governors. FEDS Working Paper No. 2006-03. Available at SSRN: http://ssrn.com/abstract=899152.--------------------------------------------------------------------------- Put simply, confusing choices do not represent real choices. Rather than empowering consumers it can frustrate them. To promote effective free choice one must ensure the choices can be made sense of.Competition This leads to my second point: how markets operate depends on how people choose. It is useful to separate the world between high road and low road lenders. High road lenders are in the game for the long run and trying to do what is best for their customers. They recognize that a bad mortgage is bad for business in the long run. Low road lenders have shorter time horizons; their management is focusing on the bottom line now. These firms would give out a bad mortgage--one that hurts consumers--if it makes them money today, even if it costs them in the long term. The fortunes of high and low road firms depend on how people choose. When people choose well, low road firms can do no better than offer better products or lower prices. Here markets work well and innovation helps consumers. Things change when consumers are choosing badly. High road firms now suffer from the actions of low road ones. Suppose a consumer is offered a reasonable 30-year fixed rate mortgage by one firm and offered a balloon ARM with an appealing teaser rate. Unless they understand the arcane financial details of the adjustable rate jump and amortization clauses, the balloon ARM will look deceptively attractive. The better product can look like the worse product. One lender offers a reasonable debt-to-income; another a much less safe debt-to-income. One lender offers standard principal payments while another offers a payment option ARM and advertises the minimum payments that do not even cover interest and lead to negative amortization. In all these cases, customers could easily be misled as to which is the good safe product and which is the bad unsafe one. Good firms suffer again when they start losing staff to bad firms who can pay more. And so on. This can lead all firms to begrudgingly adopt low road strategies. John Bogle, founder of Vanguard, has personal insight into this process. Vanguard faced it directly in marketing a no-load minimum-fee index fund. He points out that competition from (what I refer to as) low-road funds has shifted the ``industry's focus from management to marketing.'' He further notes, ``Small wonder that in all the rush to salesmanship in the fund industry, stewardship seems to have been left in the dust.'' \2\--------------------------------------------------------------------------- \2\ See http://johncbogle.com/wordpress/wp-content/uploads/2009/03/iacompliance2.pdf.--------------------------------------------------------------------------- The experience of credit unions provides another interesting window in to the race to the bottom. Because of their structure--they are not for profit cooperatives--they may be better equipped to resist low road approaches. According to a recent Experian-Oliver Wyman study, credit unions are experiencing as little as one-fifth the delinquency rate on mortgages and half the delinquency rate on credit cards as banks, even within the same credit score band. \3\ This does not mean credit unions are necessarily a panacea to the mortgage problem; it merely illustrates the possibility of a high-road strategy.--------------------------------------------------------------------------- \3\ See http://www.marketintelligencereports.com.--------------------------------------------------------------------------- When consumers choose badly innovation--one of the greatest benefits of markets--is also perverted. What did mortgage markets innovate in the beginning of this decade? Teaser rates, negatively amortizing loans, exploding subprime interest rates, prepayment penalties and low- or no-doc lending are hardly shining examples of how financial innovation helps consumers. Instead these products, while surely useful for a few customers, have been abused because they have a superficial appeal to confused customers. They likely contributed heavily to the defaults we must now deal with. In short, when borrowers choose badly innovation can be geared towards exploiting mistakes rather than producing products that help customers.The Challenge of Regulation I believe the financial crisis we have faced illustrates the importance of how market forces combine with how people choose. When the worst of these collide--bad banks introducing mortgages that exploit confused customers--the result is a toxic combination that leaves not just consumers but the entire financial system at risk. Successful financial regulation must pay attention to both of these. The challenge of regulation is to ensure a system where customers can choose well according to their needs. In such a system, high road lenders will face a level playing field; competition and innovation will benefit customers. This is much like the need for a referee in any sport. If there are no referees, dirty players cheat and good players lose or must follow suit. It's not a foul unless a referee calls it. A good referee applying sensible rules can ensure that all players--honest and dishonest--play by the same rules. At the same time, the referee must let players play the game and not interfere too often. I believe appropriately implemented the Consumer Financial Products Agency (CFPA) can be like a good referee for the financial sector. It can ensure that firms compete on a level playing field. It can allow players to play the game as long as they are within the bounds of the rules. As Michael Barr, Eldar Shafir, and I have proposed, a two-part approach to regulation is particularly important to accomplishing this goal. \4\ Some financial products--call them first choice products--are easily understood and easy to choose between. First choice products are regulated minimally: ensure disclosure, prevent fraud; we know how to do this, do much of it already and know how to do more of it. But notice this is not enough.--------------------------------------------------------------------------- \4\ Michael Barr, Sendhil Mullainathan, and Eldar Shafir, ``Behaviorally Informed Home Mortgage Regulation'', In Borrowing To Live: Consumer and Mortgage Credit Revisited, eds. N. Retsinas and E. Belsky, 170-202. Washington, DC: Brookings Institution Press, 2008. Also see ``Behaviorally Informed Financial Services Regulation.'' New America Foundation, 2008.--------------------------------------------------------------------------- This is because other products--option ARMs, subprime ARMs with interest rates set to increase substantially--can pose significant risks for the typical consumer. They allow bad choices and for low road lenders to enter. These exotic products may make sense for some sophisticated consumers of course. But unchecked they are dangerous because their superficial appeal--with hidden risks--makes them unfair competition for the first choice products. These products would need to be regulated far more stringently. The Federal Reserve, for example, has put forward fact sheets that might serve as disclosure for more exotic mortgages. \5\ While a good start to what can be done this is not enough. New products appear all the time, and marketing can be endlessly inventive in sidestepping disclosure. As a result, an agency like the CFPA would need to constantly update as the product mix changes. Done correctly, it would assure that customers could access exotic products. But they would do so with a greater understanding that their superficial attractiveness comes laden with hidden risks.--------------------------------------------------------------------------- \5\ See http://www.federalreserve.gov/newsevents/press/bcreg/20070531b.htm.--------------------------------------------------------------------------- This is analogous to how we regulate drugs. Those with minimal risks that consumers understand--ibuprofen, cold medicine--are regulated only to prevent fraud and malfeasance. More complicated drugs--powerful antibiotics--are more stringently regulated. Testing mechanisms ensure efficacy. Independent advisors--a prescriber--ensure those who receive them understand their purposes and risks. In short, we create a fence around a set of products within which firms can compete freely. Outside of this fence, for the more exotic products, there is greater regulation. Individuals taking a door through the fence would know they are moving to a less safe suite of products. A few points are worth noting about this two-part approach. The vast majority of the market is already inside the fence. For example, Freddie Mac reports that fixed rate mortgages made up 67-75 percent of applications in 2006. \6\ First choice products of course would include more than just fixed rate mortgages and not all fixed rates (because we do not know the LTV or DTI of these mortgages) would be first choice. Still this number gives us the sense that most products offered would likely fall into the first rate category. So such regulation would in fact help most lenders; it would insulate them from competition by low road products, which would now sit outside the fence facing higher scrutiny.--------------------------------------------------------------------------- \6\ See http://www.freddiemac.com/news/finance/refi-arm_archives.htm. It is not necessary to mandate the offer of first choice or vanilla products. Done correctly, the ring-fenced area will be made attractive enough that firms will--as they do now--want to offer products there. The challenge here is to ensure sufficient safeguards for the nonfirst choice products. Otherwise high road firms wanting to offer good products will --------------------------------------------------------------------------- once again face unfair competition from bad products. There are several precedents for this type of two-part approach. Individuals wishing to trade options or other sophisticated products must initially complete more paperwork and are given greater warnings of their dangers. In July 2008, the Federal Reserve placed higher-priced mortgages (which include all loans in the subprime market but excludes nearly all prime market loans) under far greater scrutiny such as a greater requirement for income verification, an explicit affordability requirement, ad higher-than-normal penalties for violation of these requirements. I understand that the authority for this regulation would permit the Federal Reserve, or the CFPA, to place other mortgages, such as option ARMs, in this category of mortgages that receive greater scrutiny and higher penalties. \7\--------------------------------------------------------------------------- \7\ See http://www.federalreserve.gov/newsevents/press/bcreg/20080714a.htm. For credit cards, Rep. Hensarling (R-Texas) has proposed a close cousin in the form of an amendment to the bill that eventually became the Credit Card Act in 2009. For potentially harmful features, as long as all of a lender's customers are offered a card without the feature, allow customers to opt-in to one with the feature. By ensuring the opt-in includes sufficient warnings, the CFPA could allow exactly this type of door in the fence between first choice and more exotic products. In this particular case, Congress' judgment was that the ``first choice'' approach would not work to protect consumers, and that a ban of these features was necessary. I believe, however, that it is important for the CFPA to have the first choice tool as an alternative to outright bans even if in --------------------------------------------------------------------------- some cases the ban is used. Private firms already realize the value of clarifying and simplifying choice. Charles Schwab for example has created a category of ``Select Funds'' which are prescreened for loads, fees and other qualitative criteria. \8\ Of course, no firm can control the choice set offered by the entire market; however well structured one firms' choice set is, it sits and competes with other firms' offerings.--------------------------------------------------------------------------- \8\ ``Schwab's Income Select List was developed and is managed by the Schwab Center for Financial Research (SCFR) experts and includes mutual funds that have met their rigorous criteria, including both quantitative and qualitative factors. All are no-load and no-transaction fee and are selected based on their ability to generate income in their respective asset classes. The list is designed to help you achieve income and growth.'' http://www.schwab.wallst.com/retail/public/research/mutualfunds/oneSource.asp. For such an approach to be successful there must be a transparent, predictable process by which products become first choice. First choice is not a one-size fits all solution. Since it aims to facilitate choice by customers, first choice products must include a suite of products. Who decides what is in this suite? On what basis? This is especially important as we look forward to the financial innovations that are surely on the horizon. A transparent, predictable will give lenders who create a good product comfort that they can reap rewards from it. I believe such a process can be put in place. At the very least this ought to be one of the injunctions to the CFPA to develop and codify this process.Conclusion The financial crisis has lain bare the dangers of bad financial products and generated a strong and understandable impetus for consumer protection. I believe that the research on behavioral economics gives guidance on how best to express this urge. The challenge is to provide protection while promoting healthy market competition. The two-part approach in the proposed legislation accomplishes this by providing an attractive tool that is an alternative to bans and mandates. On the one hand, the proposed CFPA would regulate strongly the most exotic products. On the other hand, vanilla or first choice products--the ones consumers really can choose well between--would be given far greater freedom. This promotes competition and helps high-road firms who operate in the part of the market that the typical consumer operates in. The result I feel will be a financial sector that benefits consumers by allowing them to choose better; that benefits firms by allowing good firms to not be undercut by bad firms offering bad products and that benefits sophisticated consumers by still letting them access more exotic products on the other side of the fence. 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-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.] " 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-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-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. FinancialCrisisReport--212 On another occasion in June 2006, the same OTS Examiner-in-Charge sent a lengthy email to his Regional Director discussing plans for the annual WaMu Report on Examination (ROE). His email expressed concern about losing credibility with the bank if OTS pressed too hard on certain reforms, twice noted the bank’s size and complexity, and stressed that the bank was making progress in fixing identified problems: “[W]e still have some strong feelings on some items that I’d like to ‘push back’ … some on. Generally we feel that we are quite balanced and do not have any gloves on in our approach to our findings and conclusions at WAMU. We have some concern that if we press forward with some things … we may run the risk of losing some credibility in terms of understanding the size and complexity of their business and looking as though we do not have a balanced perspective. My own fear is that we may not have done enough to communicate to you [the Regional Director] why we feel that the few negative things we have brought up through findings memos and meetings, while important to keep in front of management, are not so serious they wipe out all the right things the institution is doing in all those areas we reviewed and did not have any issues, nor should they negate the ongoing good progress in making improvements in a manner that seems reasonable given the size, complexity, and status of the institution.” 805 The Examiner-in-Charge then listed three areas of concern, problems at Long Beach which he seemed to downplay, the need to limit the number of corrective actions listed in the ROE, and the need to review how OTS cited the bank for compliance violations. In the Long Beach discussion, he wrote that improvements “will take time because of size and complexity …. We don’t feel demanding more than providing us with an acceptable action plan with realistic timelines is appropriate or necessary at this time.” On the corrective actions, he wrote that the list had to be limited or “more important findings will get lost. … We feel strongly that we should not cite all findings and corrective actions within the body of the ROE … [which] is already not getting read I believe.” He also expressed concern that OTS was “starting to ‘over- meeting’ the institution” and suggested that “the exit meeting” with the bank to discuss the ROE findings had “become almost unnecessary.” 804 1/27/2006 email from Lawrence Carter to Darrel Dochow, OTSWMS06-008 0001082, Hearing Exhibit 4/16-32. 805 6/15/2006 email from Lawrence Carter to Darrel Dochow, Dochow_Darrel-00022908_001, Hearing Exhibit 4/16-7. CHRG-110hhrg44900--56 Secretary Paulson," I believe that is really the trick. That's what needs to be done, to have the right balance between market stability, you know, the regulatory piece, and market discipline. That is critical. And a well-balanced, healthy system over time is going to need that. And what I have said, and what I tried to say today is that right now we are going through a period of unusual turmoil. The focus on all of our parts is on market stability. That's what the focus is. But our system will never be what it should be unless we can get to the point where market discipline plays its necessary role. And in order to get there, I want to emphasize what Ben Bernanke said. We need to do some things to strengthen the infrastructure we have, the over-the-counter derivative market, the tri-party repossession market, and that which is secured financing between institutions, and we need to do that so that the appearance and the reality that institutions are too interconnected to fail no longer exists, and we are going to need broader emergency authorities for the resolution or wind-down of complex financial institutions that don't have Federal deposit insurance. But that's where we need to get. That is what we have to drive toward, but let's not forget today our institutions have been doing the things they need to do, shoring up their liquidity, their capital, and our emphasis is on stability today. " CHRG-110hhrg46595--340 Mr. McCotter," Thank you, Mr. Chairman. I appreciate your indulgence. I have a question. But I would like to go back to what I laid out as a potential proposition for a compromised bill that could be passed by both Chambers and signed into law by the President. Because it appears we are really having two conversations within Congress. The first conversation is whether or not there should be a bridge loan to the auto industry. And that is predominantly what you are encountering in front of both the Senate and in front of the House, are Members grappling with the question of whether a bridge loan to the American auto industry is a good idea. The second step, which is one that we are going to have to take, I hope relatively quickly, to facilitate that process is what should such a bridge loan look like, starting with where does the money come from. I have to point out at this juncture that one of the misconceptions in the public's mind is that we are talking about a new appropriation of new money. That is not what the discussion that I have heard has been about. We are talking about redirecting already appropriated money. So for those, especially on my side of the aisle who say we are going to save taxpayers $25 billion or $34 billion by voting against or denying this bridge loan they are mistaken, because the money is already targeted and appropriated to be spent elsewhere. The money that we are talking about for a bridge loan is going to come from one or both of the following places: It is going to come from TARP funds, which were going to go to Wall Street firms if they are not used for the bridge loan; or they are going to come from DOE energy innovation loans which are going to be expended as well if not applied to the bridge loan. Which is why I continue to go back to a request for people to seriously consider the Solomonic approach of taking half of the bridge loan from the TARP funds and half of the bridge loan from the DOE funds. The logic behind this is quite simple. The TARP funds are there to help unfreeze the credit market. Mr. Paulson in front of this committee the day before you first testified said that the underlying problem in the credit market is the foreclosure crisis and that we must do everything we can to end the foreclosure crisis. That will unfreeze the credit markets. So my first question, and I will do them one at a time, preferably in a series and let you answer. The first question is if the bridge loan is not approved, you will face a bankruptcy proceeding and will not thousands of your employees potentially face foreclosures on the homes they are currently in and that would undermine the very logic behind Mr. Paulson's TARP plan. The second question is, the DOE funds are there to spur energy innovations and green technologies. As we all know, the auto industries and the American industries have been leaders in these innovations, especially for your research and development funding. That strikes me as a reasonable use of the DOE energy funds, is to preserve what you are already doing by incorporating it into a bridge loan. Money is fungible. What would happen if the bridge loan is not approved and you have to face bankruptcy, what happens to the research and development you are currently engaged in and how far will that be set back. The final question is regarding taxpayer protections, and it is for Mr. Gettelfinger. I believe that what you said about the incoming Administration and being the stakeholders to the table to have discussions and have a process in place to bring back to Congress not a bankruptcy proceeding, but something that could be called an accelerated restructuring map where all the stakeholders come up with an idea, show the viability and come to Congress not merely for money, if at all, but what we can legislatively do to help facilitate the industry's restructuring. I think that is something that this committee, Mr. Chairman, if legislation is pursued, should try to facilitate within that legislation to show our commitment to it. Because that, in the long run, is what is going to help the restructuring process after the bridge loan is necessitated and hopefully approved. And I would like you to just talk briefly more about your ideas in that regard because I think it is a very timely idea, and it goes to the heart of taxpayer protections in the bridge loan. Those are my thoughts. " CHRG-111shrg50814--82 Mr. Bernanke," That is right. But, nevertheless, I think as, say, the Federal Reserve's programs begin to open up some of our key credit markets--and we have--to give you an example, we have seen significant improvement in the commercial paper market, money market mutual funds, and some other areas where we have intervened. And those improvements have been sustained despite the general deterioration in the stock market and some other financial markets. So I think enough concerted effort and finding our way forward, history will perhaps put this whole episode into some context. It has been a very, very difficult episode. Obviously, many people have failed to anticipate all the twists and turns of this crisis. But it is an extraordinarily complex crisis, and being able to solve it immediately is really beyond human capacity. As we move forward, as we show commitment to solving the problem, as we take credible steps in that direction and we begin to see progress, I think the confidence will come back. And I agree with you 100 percent that a lot of this is confidence. Senator Bayh. So perhaps there is a lag between material improvement, albeit modest and gradual, and the popular appreciation of that improvement. There is some lag there before people have comprehended and, therefore, confidence---- " CHRG-110hhrg44900--137 Mr. Lynch," Thank you Mr. Chairman. Mr. Chairman I appreciate you holding this hearing and I want to thank the ranking member as well. I want to thank the Secretary and the Chairman for appearing before us and helping the committee with its work. I want to go back to a point that was raised earlier, Mr. Secretary, in your response to Ms. Maloney and also I think, Mr. Chairman, you address it at page three of your remarks. And basically my question is this. A lot of the lack of confidence, I think, in some aspects of our market come from the complexity and the opaqueness of some of these derivatives that we have actually gone back and tried to drill down into the models on which some of these derivatives are actually based. And in some cases they probably stretch from myself to Mr. Hensarling down there. I am just wondering, is there anything in your proposed reforms that might get at this issue? I mean, some of these derivatives I have to admit, it is just very, very tough to value them or mark them to book as some of my friends in the industry have described it. The credit default swaps that are a huge, huge part of the market out there, these collateral debt obligations, the failure of these risk and recovery models to really predict or to ascertain the value of these things, they are so complex, I honestly believe if we adopted a simple rule that said an investor had to understand these things before they bought them, that this whole market would come to a screeching halt. I honestly believe that, and I am only half joking. But is there anything that you have proposed that would get at that opaqueness and lack of transparency and complexity? Something that would allow investors to have more confidence? I mean, in some of these cases, and synthetic CDOs, we don't even know where the actual ownership lies. So it is just very, very tough for an investor, especially in difficult times to have confidence in their investment when they can't really determine that on their own. " CHRG-110shrg38109--38 Chairman Bernanke," Mr. Chairman, I did read that report. It had a lot of interesting things to say. I think if you look at it carefully, it suggests that the issues are different in different parts of the educational system. For example, our universities remain very strong. Our research universities lead the world. So in terms of research, development, innovation, and so on, the United States retains substantial leadership in the world. But in other parts of the educational system, perhaps in elementary school, for example, we are probably not doing what we should in terms of ensuring that all children have opportunities to learn math and science and the applications of those areas. Again, my wife is a teacher, and I have been in education for a long time. I was on the school board for many years, so I am very sensitive to these issues. But I also appreciate from those particular positions that we have been worrying about educational quality for a long time, and it is a difficult thing to achieve. I encourage continued thought and continued efforts to improve these vital components of our economy without having any delusions about how difficult that really is to accomplish effectively. " CHRG-111hhrg53248--13 Mr. Hensarling," Thank you, Mr. Chairman. When you have the wrong diagnosis, you will in turn offer the wrong remedy, and that is exactly the case with the Administration's proposal before us. Our economic turmoil has not arisen from deregulation, but more so from dumb regulation. That, and regulators who did not lack adequate regulatory authority but may have lacked adequate judgment. Although I have a number of concerns about the plan, I am simply taken aback by the lack of reform of Fannie Mae and Freddie Mac, the epicenter of the financial crisis, not to mention the suggested creation of an agency to abridge consumer rights. Rather than taking on the current status quo for these GSEs, the Administration's plan institutionalizes the problem. When President Obama referenced sweeping reform, I didn't know he meant sweeping Fannie and Freddie under the rug. Worse yet, his plan actually gives the Federal Reserve power to create more systemic risk by establishing tier one financial holding companies which can simply create more Fannies and Freddies, and signals to the market that the biggest institutions among us will always have a taxpayer safety net. In other words, the proposal enshrines us as a perpetual bailout nation. One of the more troubling components of the proposed plan is the creation of a new consumer financial product approval agency ruled by five unelected bureaucrats. Based upon their subjective determination of ``fairness,'' they will be empowered to decide which credit cards we can receive, which home mortgages we are permitted to possess, and even whether we can access an ATM machine. The proposal represents one of the greatest assaults on consumer rights I have ever witnessed. The legislation will stifle innovation, perhaps the next online banking service or the next frequent flyer mile offering, and worse yet will contract credit to our small businesses at a time of historic unemployment. There is a better way. The Republican plan under Ranking Member Bachus' leadership creates a new chapter of the Bankruptcy Code to enhance the resolution of large nonbank financial institutions. It puts an end to taxpayer-funded bailouts and too-big-to-fail. A market stability and capital adequacy board will be established and tasked with monitoring the interactions of all sectors of the financial system and identifying risk that can endanger the stability and soundness of the system. The Republican plan focuses the Federal Reserve on its core mission of conducting monetary policy. And although we preserve its 13(3) exigent powers, we do not leave them unlimited. Once the housing market is stabilized, we would phase out taxpayer subsidies of Fannie Mae and Freddie Mac and end the current model of privatized profits and socialized losses. Furthermore, our proposal creates an Office of Consumer Protection to empower consumers with effective disclosure and enhance the penalties for fraud. There are choices between more bailouts and no bailouts; market discipline or government control; consumer empowerment or the laws of consumer rights. Let's hope this committee and this Congress chooses wisely. I yield back the balance of my time. " CHRG-111hhrg53242--65 Mr. Sherman," Do all of that in writing. Mr. Brodsky, I am impressed that you were warning the Agriculture Committee of these dangers clear back in 1997. That is the only time I wish I had been a member of the Ag Committee. Mr. Nichols, you say no one should be too big to fail, but it is not clear whether you are saying that, through effective regulation, no matter how big they are, they are not too big to fail, or whether you are saying that there should be a limit on the size, of the complexity of an institution and we might have to break somebody up. I need to be convinced that the regulatory system was really good before I was convinced that unlimited size was not a problem. And I believe my time has expired. " 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? " CHRG-111hhrg52397--3 Mr. Garrett," Thank you, Mr. Chairman. Good morning to all the witnesses. Today's hearing is called, ``The Effective Regulation of the Over-the-Counter Derivatives Market.'' I think it is important to keep in mind that it is not called, ``The Most Politically Correct Sounding Regulation of Derivatives,'' nor is it called, ``Let's Regulate the Heck Out of the Derivatives Market Because They Have Been Demonized and Let's Ignore All the Positive Contributions They Make to Our Capital Markets Under Proper Management.'' Unfortunately, with some of the regulatory proposals that have come forward in this area, you might think that is the approach that is going to be taken. Here are the facts: 94 percent of the 500 largest global companies use derivatives to manage risks. Congress therefore needs to tread carefully as it looks at regulatory options for these markets. Overly-regulated or improper regulations that might sound good politically could have major unintended negative consequences, not just for our financial markets but for our broader economy as well. Rather than reducing risk, poor regulatory reform could actually exacerbate it, so before we go any further, it is important to remember that derivatives did not cause our financial difficulties. In fact, they should be seen more as symptoms of the underlying crisis, rather than a reason for it. So while our overall financial service regulatory structure can be improved, it is important to preserve and protect the important benefits that they provide. Derivatives products provide firms with the ability to minimize risks. This obviously benefits individual firms but also benefits the broader market as well. For example, as Members of Congress consider reform proposals, we must not be overwhelmed by the fact that one high profile financial institution, AIG, made a bad investment decision. We must also keep in mind that this occurred while AIG was under the supervision of its regulator, the Office of Thrift Supervision, and was part of broader regulations as well. So greater expertise then in some cases is clearly required at the functional regulator level for the derivative dealers, but AIG was, as you know, a regulated entity. And the AIG case is a reminder that regulatory failure contributed to our financial crisis as much as anything else did. Furthermore, the vast majority of exposures in the CDS market, for instance, is contained within the already overly-regulated banking sector. Arguably, everything is in place already for regulators to appropriately regulate the bulk of this market and it is dominated by a small number of dealers. Regulators then already have oversight responsibilities to ensure firms are taking appropriate risks and to set proper capital levels. So the power is there; regulators just need to do their job. Now, when there have been credit events, and there have been a number of them, with the Lehman failure being the most significant, in each case, the event has been handled in a very orderly fashion by the existing infrastructure. Now, as I look at some of the particular regulatory ideas that have been put forward, I am persuaded that essential counterparties and a clearinghouse hold promise, but I am hesitant to say that as far as they go, that they should be mandatory for all standardized products. The private sector has made significant progress in a relatively short period of time toward providing multiple clearinghouses for various derivative products, and I think we should look at this further. Inappropriate mandating of central clearinghouses will limit that ability to go further and manage risks. Another area I would like to look at is the proposal of the so-called ``naked'' swaps. It is concerning to me. It is important that legislators understand that significant negative consequences will arise if such a proposal is actually enacted. So the participants and infrastructure provided in the OTC markets have accomplished much in recent years to provide stability from the ISDA master agreement, to the recent so-called ``big bang protocol,'' to ongoing efforts to provide a more robust infrastructure for these products. So, in conclusion, I look forward to continued progress being made in regards to greater coordination between the sell side and the buy side participants as private sector efforts progress to increase efficiency and transparency and reduce the risk in the OTC derivative business. And, finally, as Congress pushes forward with further regulation in these markets, we need to guard against unnecessary, overly burdensome regulations that might cause the markets to move elsewhere, overseas, or would hinder or prohibit firms from providing themselves with superior risk management techniques that are so widely employed today and that could be enhanced by future innovation. Thank you, Mr. Chairman. " 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-111shrg57321--51 Mr. Michalek," In my opinion, I think that we would really have to begin with what we are disclosing. I personally believe that there are products that deserve a commonly understood rating, that the public can say this is safe, because the rating is saying that it is safe. And I think that for a large number of the highly complex structured products, it is a different ball game. And I think that to the extent that you are able to distinguish between those products that are clearly in the different ball game, then the caveat of buyer beware is more appropriately applied. But for that portion of the products that I think the enormous public good that comes from having an independent arbiter of risk apply a commonly understood and accepted measure of that risk, I think that is something that we should seek to preserve, and so that it would eliminate that bleed, if you will, from the extreme debate or debatable conversation that goes on with respect to the highly complex products, into what really should be beyond debate with respect to what is safe and what is definitely contributing to the public good. Senator Kaufman. And do you think you could do that? I mean, realizing that there would be some securities in the middle that would be--but having the idea that for what is commonly known as AAA corporate bonds you have one thing; for credit default swap you have something different. " fcic_final_report_full--529 The most controversial element of the vast increase in NTMs between 1993 and 2008 was the role of the CRA. 149 The act, which is applicable only to federally insured depository institutions, was originally adopted in 1977. Its purpose in part was to “require each appropriate Federal financial supervisory agency to use its authority when examining financial institutions to encourage such institutions to help meet the credit needs of the local communities in which they are chartered consistent with the safe and sound operations of such institutions.” The enforcement provisions of the Act authorized the bank regulators to withhold approvals for such transactions as mergers and acquisitions and branch network expansion if the applying bank did not have a satisfactory CRA rating. CRA did not have a substantial effect on subprime lending in the years after its enactment until the regulations under the act were tightened in 1995. The 1995 regulations required insured banks to acquire or make “flexible and innovative” mortgages that they would not otherwise have made. In this sense, the CRA and Fannie and Freddie’s AH goals are cut from the same cloth. There were two very distinct applications of the CRA. The first, and the one with the broadest applicability, is a requirement that all insured banks make CRA loans in their respective assessment areas. When the Act is defended, it is almost always discussed in terms of this category—loans in bank assessment areas. Banks (usually privately) complain that they are required by the regulators to make imprudent loans to comply with CRA. One example is the following statement by a local community bank in a report to its shareholders: Under the umbrella of the Community Reinvestment Act (CRA), a tremendous amount of pressure was put on banks by the regulatory authorities to make loans, especially mortgage loans, to low income borrowers and neighborhoods.  The regulators were very heavy handed regarding this issue.  I will not dwell on it here but they required [redacted name] to change its mortgage lending practices to meet certain CRA goals, even though we argued the changes were risky and imprudent. 150 On the other hand, the regulators defend the act and their actions under it, and particularly any claim that the CRA had a role in the financial crisis. The most frequently cited defense is a speech by former Fed Governor Randall Kroszner on 147 Fannie Mae Foundation, “Making New Markets: Case Study of Countrywide Home Loans,” 2000, http://content.knowledgeplex.org/kp2/programs/pdf/rep_newmortmkts_countrywide.pdf. 148 “Questions and Answers from Countrywide about Lending,” December 11, 2007, available at http:// www.realtown.com/articles/article/print/id/768. 149 150 12 U.S.C. 2901. Original letter in author’s files. 525 CHRG-111shrg56376--42 Mr. Tarullo," Senator, I don't think there are any proposals on the table that would really make the Fed a systemic risk regulator in the sense of being able to swoop in anywhere, anytime, and say, we want to do something about this. The proposal that we have endorsed is making the Federal Reserve the consolidated supervisor of systemically important institutions. I would say in direct response to your question, there is certainly a responsibility there, and I would be the first to say that responsibilities of all the financial regulators, including the Fed, were not exercised as effectively as they ought to have been. But I would also say that when you give an entity responsibility, you do have to make sure that you give it authority to achieve that responsibility, to fulfill it, and that you have the mechanisms that will allow it to do the job. And when you have a circumstance in which large institutions that turned out to be systemically important--I think in some cases to the surprise of many--and were not within the perimeter of regulation, it was obviously not going to be an easy matter to contain the activities of those institutions, including a lot of the wholesale funding and a lot of the very tightly wound, complex securitization that was a major contributor to these problems. So I would say, first, you need to make sure that the appropriate legal authorities are present. Second, as I have often said, there needs to be a reorientation of our regulatory approach more generally toward systemic risk. And third, the Federal Reserve, I think, needs to take more advantage of the comparative abilities that it has. That is why we wanted to move forward, to make use of the economic and financial expertise to provide a monitoring of and a check upon the on-the-ground supervisors. That is where the advantages lie and that is where we ought to bring them together. Senator Corker. Let me just ask one last question. I know there are differing thoughts on ``too big to fail,'' but each of you feel that that is a big issue, how to deal with that. I know that I would like to see a resolution mechanism in place where they resolve much like Chairman Bair proposes. Mr. Dugan, I don't understand how, if you continue to give Treasury the ability to solve the problem with taxpayer money if they deem it an important thing to do, I don't understand how that creates any market discipline. It seems to me that leaving that vague line in place defeats all market discipline. I don't understand how you can cause those to measure up or how we could craft something that actually worked and caused people like the Senator from Ohio's constituents and mine, which I think are different in thinking about some things, but I think they would agree that that is wrong, and yet you propose keeping it in place and I don't understand that. " CHRG-111hhrg53248--177 Mr. Bernanke," Thank you, Mr. Chairman. Chairman Frank, Ranking Member Bachus, and other members of the committee, I appreciate the opportunity to discuss ways that the U.S. financial regulatory system can be enhanced to better protect against systemic risks. The financial crisis of the past 2 years has had diverse causes, including both private sector and regulatory failures to identify and manage risks, but also gaps and weaknesses in the regulatory structure itself. This experience clearly demonstrates that the United States needs a comprehensive and multifaceted strategy, both to help prevent financial crises and to mitigate the effects of crises that may occur. That strategy must include sustained efforts by all our financial regulatory agencies to make more effective use of 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 the systemic risk agenda, I would like to identify the key elements that I believe should be part of that agenda. First, all systemically important financial institutions should be subject to effective consolidated supervision and to tougher standards for capital liquidity and risk management consistent with the risks that the failures such a firm may pose to the broader financial system. Second, supervision and regulation of systemically critical firms and of financial institutions more generally should incorporate a more macro prudential perspective, that is, one that takes into account the safety and soundness of the financial system as a whole. Such an approach, which considers interlinkages and interdependencies among firms and markets that could threaten the financial system in a crisis, complements the traditional micro prudential orientation of supervision and regulation which is focused primarily on the safety and soundness of individual institutions. 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. The Federal Reserve Board sees substantial merit in the establishment of a council to conduct macro prudential analysis and coordinate oversight of the financial system. The expertise and information of the members of such a council, each with different primary responsibilities, could be of great value in developing a systemwide perspective. Fourth, to help address the too-big-to-fail problem and mitigate moral hazard, a new resolution process for systemically important nonbank financial firms is needed. Such a process would allow the government to wind down a troubled systemically important firm in an orderly manner that avoids major disruptions to the broader financial system and the economy. Importantly, this process should allow the government to impose haircuts on creditors and shareholders of the firm when consistent with the overarching goal of protecting the financial system and the broader economy. And fifth, ensuring that the financial infrastructure supporting key markets can withstand and not contribute to periods of financial stress also is critical to addressing both the too-big-to-fail problem and systemic risks. For this reason, reform should ensure that all systemically important payment clearing and settlement arrangements are subject to consistent and robust oversight and prudential standards. Comprehensive reform of financial regulations should address other important issues as well, including the needs for enhanced protections for consumers and investors in their financial dealings and for improved international coordination in the development of regulations and in the supervision of internationally active firms. Let me end by noting that there are many possible ways to organize or to reorganize the financial regulatory structure. None would be perfect and each will have advantages and disadvantages. However, one criterion I would suggest as you consider various institutional alternatives is the basic principle of accountability. Collective bodies of regulators can serve many useful purposes, such as identifying emerging risks, coordinating responses to new problems, recommending actions to plug regulatory gaps, and scrutinizing proposals for significant regulatory initiatives from all participating agencies. But when it comes to specific regulatory actions or supervisory judgments, collective decisionmaking can mean that nobody owns the decision and that the lines of responsibility and accountability are blurred. Achieving an effective mix of collective process and agency responsibility, with an eye toward relevant institutional incentives, is critical to a successful reform. 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 achieve meaningful regulatory reform that will strengthen our financial system and reduce both the probability and the severity of future crisis. Thank you, Mr. Chairman. [The prepared statement of Chairman Bernanke can be found on page 72 of the appendix.] " CHRG-110hhrg46596--355 Mr. Kashkari," I think these are very large, very complex institutions, and the actions that we took for Citigroup were to strengthen the institution and improve confidence in the system as a whole. These institutions are not just there in isolation. A lot of times the market looks at these institutions in combination or in the aggregate. So we had to make sure confidence was there for the system as a whole. " CHRG-110shrg50414--91 Secretary Paulson," Not exactly that way, but here is--and, again, let me come back and say to you the reason we asked for broad flexibilities--and the Chairman said it earlier--is that we are dealing with complex securities. We are dealing with many classes of securities. We are going to need to use different approaches in different situations. So the reason we have been general and talked about market mechanisms, we are going to have to involve experts, we are going to have to use different approaches. The Chairman said, you know, Treasury, we are going to need to get some really good asset managers, we are going to--we will do a certain amount of experimentation. But if this works the way it should work, that once there is a, you know, bid from Treasury and there is more learned about these securities, the thought would be that then it is easier for private capital to come into the market; and that there will be some price discovery mechanism. Now, again, the---- Senator Bennett. Let me just comment on that. The price discovery mechanism in a simple world--and you are describing a very complex, un-simple world--has to do with the cash-flow the underlying asset will produce. And I would think the problem here is determining what that cash-flow is. Is that what you are bringing all these experts to determine what---- " CHRG-111shrg53822--24 Mr. Stern," Well, I think there are several aspects to that. One is, certainly, I am not trying to curtail appropriate innovation in the financial markets. I think, to the extent that we get the incentive--improve the incentives, we will get better pricing of risk. And that will deal directly with some of the concerns you have and the development of some of these instruments that, obviously, with the benefit of hindsight anyway, contained a good deal more risk than was appreciated at the outset. So I think that is one way to go. I think something we can also probably do in the supervisory area is where we see a very complex structure of an organization, ask about the economic rationale for that structure. And it is very good economic rationale for having X-hundred subsidiaries, for example. And if not, we could ask for streamlining of that kind of structure. So I think that is something else that could be done to help clarify the situation. I should also add--and this will be my final comment right now on this--is I think it is not just a question of incentives. I think ``too big to fail'' is a big, challenging problem. We need to improve incentives where we can. We also need to improve capital where we can. We should charge institutions some kind of insurance premiums, as I commented, where they are of systemic importance and pose systemic risks. I think we really need to address this on a number of fronts. Senator Bennet. Chairwoman Bair, I do not know if you would like to add anything to that. As I have puzzled through the news accounts of this, one of the things you are really struck by is how evolutionary all of this is. You start out with credit default swaps that are based on one set of assets, and then you move over time to another set of assets, mortgages. And people lose track; the risk gets higher. I just wonder how we are going to write those rules in such a way that we are going to stay ahead of the curve rather than following behind. Ms. Bair. Well, it is a challenge. And that is why we think there is a need to have greater market discipline. Too big to fail has diluted market discipline. There is only so much regulators can do, and you really need the market. You need people who want to invest or extend credit to these institutions, looking at their balance sheet, looking at their management, looking at the sophistication of their management and the risk management systems. What are their off-balance sheet exposures--are they done with proprietary trading, structured finance? All the things that we have seen have posed heightened risks for these larger institutions. You want the private sector in there looking at that as well. If they think the institution is ``too big to fail,'' you are going to dilute market discipline. And that is why we think it is particularly important to have a resolution authority. We also think that an assessment system can complement and enhance regulation. We have risk-based insurance assessments now for depository institutions. So there are certain categories of higher risk activity where we charge them a higher insurance assessment, for instance, for excessive reliance on broker deposits. This can also influence behavior, and I think this would be another tool that should be used for the systemic institutions. Senator Bennet. I am going to ask the Chairman's indulgence because while I have got you here, I want to ask a slightly unrelated question about New Frontier Bank in Greeley, Colorado, which I know you are aware of. I wonder if you might say a word about where we are with that; and, also, more broadly, in the context of a region like that, a rural part of my state, where the local economy is heavily reliant on one institution, namely that one. That carries with it its own systemic risk for that little corner of the world. I wonder if you might talk a little about that situation; also, more broadly, the FDIC's approach in an area like that versus one where there are many other options. Ms. Bair. Well, we did. We had a nice chat with Congresswoman Markey yesterday, too, about this. For the depositors, we have arranged for another bank to take over their accounts and help them transition into a new deposit account relationship. And for the loans, we are trying very hard to find other lenders to refinance those loans or to purchase them. I think one of the things where we engaged Congresswoman Markey, and I will take the opportunity to engage you as well, is to encourage other local lenders in the area to work with us and help these borrowers find new lending relationships. We are working very hard on that, and have been providing some additional financing out of the receivership to borrowers as we seek to transition them to lenders that are stronger. But we would love to work with your office. We talked with her about maybe having a town hall meeting. So we would be happy to work with you on that. Senator Bennet. Thank you. I would appreciate that. Mr. Chairman, thank you very much. " CHRG-111hhrg52407--19 URBAN LEAGUE POLICY INSTITUTE Ms. Jones. Thank you, Chairman Hinojosa. I thank the subcommittee for this opportunity to testify today. I am Stephanie J. Jones, executive director of the National Urban League Policy Institute. Based upon our long experience providing frontline financial education and housing counseling services in Urban League affiliate programs throughout the country, the National Urban League has developed considerable experience and insight on this issue. We are glad to offer our recommendations, which I will briefly outline now but are presented in greater detail in my written testimony. In this whole process, our overarching concern is the consumer, and we feel very strongly that the new regulatory framework must include inherent checks and balances that guarantee the advancement of the five consumer protection objectives. And those objectives are: consumer financial services markets operate fairly and efficiently; consumers have the information they need to make responsible financial decisions; consumers are protected from abuse, unfairness, deception and discrimination; traditionally underserved consumers and communities have access to lending, investment, and financial services; and national community-based organizations, such as the National Urban League, the National Council of La Raza, and others that have demonstrated effectiveness in reaching underserved minority communities, be included as full partners in any consumer protection effort. We are pleased that this committee is focusing on financial literacy today. This is a critical aspect of this issue, and it is a top priority for the National Urban League. But we can't forget that while financial literacy is important, the fundamental problem at the heart of today's foreclosure crisis was not the inadequacy of the disclosures or the financial literacy of the borrowers. Rather, it was that lenders should not have made loans that they knew borrowers would be unable to sustain without refinancing. Therefore, to effectively protect consumers, it is critical that the regulatory system monitor and address market incentives that encourage loan originators to push risky or unsuitable loan products, and must also include independent, redundant back-up systems that provide layers of protection against financial excess. And as you know, financial literacy is at the core of the Urban League's mission to empower African Americans to attain economic self-sufficiency. The rationale for our emphasis on financial literacy is buttressed by some startling data, as revealed in our annual, ``State of Black America'' report. Among other things, we have found that African Americans' economic standing is 57 percent that of White Americans, and that the median net wealth of African Americans is $10,000 versus $109,000 for whites. The Urban League strategy for addressing this glaring gap is to create culturally competent programs that address both financial principles and long-term behavioral change. Overall evaluation research of our financial literacy programs consistently finds significant correlations between the level of financial knowledge and good financial management practices. Housing counseling also plays a key role in support of the goal to increase financial awareness and sophistication and to close the wealth gap between minority and non-minority households. In addition to a deeper national commitment to housing counseling, a core tenet of our Homebuyers Bill of Rights, the National Urban League advocates three primary objectives that the Federal Government and the Financial Literacy and Education Commission should pursue to promote economic opportunity for minority and low-income families and communities. First, we must expand access to capital and financial services through mainstream banks and thrifts, particularly by ensuring that the CRA remains effective. Second, bank the unbanked with innovative new private sector products and services driven by new incentives for financial services for the poor. Third, we must promote savings among the poor by catalyzing wide-scale establishment of individual development accounts and other mechanisms that help low-income families save for homeownership and other key assets. And of course, particular emphasis must be placed in all of this on reaching neighborhoods with low-income and minority populations. On behalf of the National Urban League, I thank you for the opportunity to offer our views today on this very important issue, and we look forward to continuing to work with you as you develop and implement a new regulatory system. Thank you very much. [The prepared statement of Ms. Jones can be found on page 60 of the appendix.] " CHRG-110shrg50416--48 Mr. Kashkari," Senator, at this point we do not have a firm policy on what to do with any hedges associated with the assets. I think that those are complex issues that we are working through with the regulators. Once we identify exactly which assets we are going to buy and the purchasing mechanism, those are important details that we are going to work through. Senator Shelby. But the firms that sell their assets to the Government under the plan you are talking about, TARP, they would stand to profit if those assets default under the credit default swaps, would they not? " 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-110hhrg44903--176 Mr. Cox," I think the idea of taking a look at insurance products, at derivatives products, at securities, at all financial products, which presently fall within the rubric of--and the jurisdiction of a variety of regulators has a certain appeal. It also has a certain danger, and that is, that it might be so ambitious as to fail of its own weight. Because, as you know--I was just talking with Secretary Chertoff about this because during my 4 years chairing the Homeland Security Committee and the work we have spent here in Congress trying to do something similar in the homeland security area caused me to ask the basic question, what is the line, where are you better off merging things? And where are you better off sharing with existing structures? That is an issue that Secretary Chertoff is still managing within the Department and outside of it. I think it is vitally important to recognize the connection between the sophistication of law enforcement. President Geithner was talking about the enforcement piece and how important it is. The sophistication of that enforcement is really what makes the difference. If it weren't necessary, we would just have the NYPD or the Los Angeles Police Department go after this as a matter of routine law enforcement. But the cops on the beat really have to understand these markets. The products are very sophisticated. The trading techniques are very sophisticated. They are global markets. There is a lot of complexity here. Indeed I would go so far as to say that in all the major market disruptions and frauds that we have had, complexity has been a significant ally of the fraudsters because they kick a lot of dust up in the air, and they get away with things because people don't understand at first what they are doing. So there is a trade-off that has to be made. I like the idea of knitting this together as much as we possibly can. The question of whether you actually try and merge functions all into one agency gets a little harder because, you know, mergers present management difficulties. There are other organic statutes that are administered that might not fit together. There are a lot of complexities there as well. Ms. Waters. President Geithner, I am very concerned about what we are experiencing in the subprime meltdown. What disturbs me is, there were so many products that were introduced into the market. And it appears that there was no oversight responsibility for the no doc loans. They are not sophisticated ARMs. They are just trickery ARMs. The ARMs that have the teaser rates at the beginning, that are very low and then the resets quadruple. I mean, there is nothing sophisticated about that. Rather, it is organized in such a way that it entices, it encourages, and it supports people getting into situations that they cannot control and they cannot afford. And there are those who say, well, the consumer should know better. It is their responsibility. I take a little bit different approach. The average working man or woman who goes to work every day, who may be very well-educated, who is raising their family, who is trying to make the best use of their dollar, paying their bills, they don't know about these trickery products. Most of the Members of Congress didn't know about these products. Nobody reviewed these products and said to the initiators, I don't know. This looks a little bit difficult. I think this is going to create some problems in the market. And that is what I am talking about. I am talking about a kind of consumer protection that does not assume that the consumer is just a little bit too dumb, a little bit too stupid to understand these sophisticated products. What do you think about this Consumer Product Safety Commission idea? " CHRG-110shrg50414--74 Mr. Bernanke," I do, Senator, but let me just add a couple comments. As you know, I am a student of financial crises and financial history, and we have looked at past experiences in the United States and other countries, like the Homeowners Loan Corporation, the RTC, the RFC, Japan, other situations. Those were all situations, again, as the Secretary said, where you were dealing with failed institutions and having to dispose of relatively simple assets that were taken over by the Government. That works in that context, and there are ways to do that. The situation we have now is unique and new. It involves not failing institutions--although we have had a few failures. Where we had failures, we dealt with them in a very tough way. You know, we have insisted on, you know, bringing the shareholder value down close to zero, imposing tough terms and so on. But the firms we are dealing with now are not necessarily failing, but they are contracting, they are de-leveraging, they are pulling back. And they will be unwilling to make credit available as long as these market conditions are in the condition they are. So, in order to address the illiquidity of the market and how to deal with these complex securities in the hands of going concerns, the methods used to resolve failed institutions in other contexts are not really appropriate because that would involve, I think, a great deal of concern on the part of other potential investors that if they invest in a bank that the Government is going to come in and take away their value. So I think that we are better off trying to address the root cause of the problem. Senator Shelby. What banks would be eligible to participate in this plan, assuming Congress adopted it as you proposed it, in selling their nonperforming assets to the Treasury or to an entity? And what size banks would be eligible to participate in that plan? " CHRG-111shrg55739--33 Mr. Barr," In our judgment, this presented a complicated question. On the one hand, the changing the pleading standard might increase the incentives for due diligence in the system. On the other hand, we were concerned that such a standard might increase reliance by the investor or public on the rating agencies and may provide further avenues for issuers to sue over corporate downgrades, which we thought would potentially pose a problem in the system. So in our judgment, this was a very close question and we did not include it in our legislative proposal. Senator Reed. Thank you. Mr. Joynt, on behalf of Fitch, in his testimony says a mandatory registration concept--your concept--is unnecessary and unwarranted, is not consistent with basic free speech principles. And then Rapid Ratings' testimony predicts that the proposal will force compliance costs, raise barriers to entry of new rating agencies, and essentially impede technology and innovation. How would you respond to these, first, that mandatory registration is unnecessary, and second, to---- " CHRG-111hhrg52406--33 AMERICA FOUNDATION Ms. Seidman. Thank you. Thank you Chairman Frank, Ranking Member Bachus, and members of the committee. I appreciate your inviting me here this morning. In addition to being a senior fellow of New America Foundation, I am also executive vice president at ShoreBank Corporation, the Nation's largest community development financial institution. My views are informed by my current experience, although they are mine alone, not those of New America or ShoreBank, as well as by my years at the Treasury Department, Fannie Mae, the National Economic Council, and as Director of the Office of Thrift Supervision. The Administration has proposed creation of a very broad-based and powerful Consumer Financial Protection Agency that would have regulatory, supervisory and enforcement authority over consumer protection in the financial services sector and also over the Community Reinvestment Act. The Administration's recognition of the seminal importance of consumer protection financial services is a critical reversal of the trends over the last several decades and builds on the work this committee has done. I agree with the Administration that the time has come to create a well-funded single Federal entity with the responsibility for authority over consumer protection and financial services. The Administration has also focused on the importance of CRA. Access to high-quality financial products at fair terms and reasonable prices is an important element of consumer protection that requires both leveling the playing field by having consistent regulations across all entities providing similar products and encouraging financial institutions to responsibly serve all communities and consumers. I am concerned, however, about two elements of the Administration's proposal. First, I believe that prudential supervisors, in particular, the Federal and State banking regulatory agencies, should retain primary supervisory responsibility for consumer protection as well as for safety and soundness over the entities they regulate. I suggest, however, that Congress make changes to the organic banking statutes to emphasize the importance of consumer protection, elevating it to a higher place in the supervisory system. Second, I am concerned that what has been in many ways the most consistently successful element of CRA, namely investment and community development finance, such as affordable rental housing, community facilities and lending both with and through CDFIs, may get lost in an agency devoted to consumer protection. In my written statement, I suggest some ways to increase the likelihood that if CRA is part of the CFPA, service to all communities and community development will be a robust part of its mandate. The current crisis has many causes, including an overreliance on finance to solve many of the needs of our citizens. Those needs require broader social and fiscal solutions, not financial engineering. Nevertheless, there were three basic regulatory problems. First, there was a lack of attention and sometimes unwillingness to effectively regulate products and practices even where regulatory authority existed. Second, there were and are holes in the regulatory system, both in terms of unregulated entities and products and in terms of insufficient statutory authority. Finally, there was and is confusion for both the regulated entities and consumers and those who work with them. The solutions are not easy. Financial products, even good ones, can be extremely complex. Many, especially loans and investments, involve both uncertainty and difficult math over a long period of time. The differences between a good product and a bad one can be subtle, especially if the consumer doesn't know where to look. And different consumers legitimately have different needs. The regulatory framework, of course, involves both how to regulate and who does it. With respect to how, I suggest three basic guiding principles that I believe are fully consistent with the Administration's proposal. First, products that perform similar functions should be regulated similarly no matter what they are called or what kind of entity sells them. Second, we have to stop relying on consumer disclosure as the primary method of protecting consumers. While such disclosures can be helpful they are least helpful where they are needed the most, when products and features are complex. Third, enforcement is important. While much attention has been given in the week since the President's proposal was announced to enforcement and depository institutions, the fact that the proposal would make fairly stunning changes and improvements in consumer protection for nondepositories has largely been left unsaid. With respect to who should regulate, it is time to establish a single Federal entity dedicated to consumer protection. If properly funded and staffed, this agency will be more likely to focus on problems that are developing, to take action before they get out of hand. This is not separating regulation writing more than it currently is. Most banking consumer protection regulations are written solely by the Fed. The other prudential regulators enforce someone else's regulations. That is exactly the system that there would be in this case. Centralizing the complaints function will give consumers and those who work with them a single point of contact and the regulatory body early warning of trouble. The CFPA will also have the opportunity to become expert in consumer understanding and behavior to regulate effectively without necessarily having a heavy hand, and it could also become a focus for the myriad of Federal efforts surrounding financial education. How will the new regulator be funded and at what level? It is essential that this entity be well-funded. If it is not, it will do more harm than good as those relying on it will not be able to count on it. This almost certainly requires a dedicated revenue source in addition to general fund appropriations. What will be the regulator's supervisory and enforcement authority? I believe that the prudential supervisors can do this. Regulators who engage in prudential supervision with on-site examinations should be expected to exercise that authority. Retaining primary supervisory and enforcement authority with the prudential supervisors makes use of existing structures and resources, and keeps consumer protection and safety and soundness together, but having backup authority in the CFPA would be extremely important. In my testimony, I explain that I think that there are revisions to the organic banking statutes that could make an enormous difference in making sure that this works better than it has. The current crisis is an enormous opportunity to make a big difference that will benefit consumers, financial institutions, and the economy. The President has put forth a bold proposal, and now is the time to act. Thank you. [The prepared statement of Ms. Seidman can be found on page 179 of the appendix.] " 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-111shrg54789--186 RESPONSES TO WRITTEN QUESTIONS OF SENATOR JOHNSON FROM MICHAEL S. BARRQ.1. The Treasury's ``white paper'' on financial regulation notes that one of the key goals of the consumer protection agency is to establish consistent regulation of financial products. In fact, the paper notes that ``[State insurance regulation] has led to a lack of uniformity and reduced competition across State and international boundaries, resulting in inefficiency, reduced product innovation, and higher costs for consumers.'' However, the bill forwarded to Congress permits States to add additional and different consumer protection standards for financial products. Does this undercut the goal of consistent regulation? Should not all consumers have the same protection regardless of where they reside? Why not simply direct the new agency to write strong rules in the first place? This ensures consumer protection, yet avoids potential for conflict, confusion, and cost.A.1. Since the adoption of the first major Federal financial consumer protection law in 1969, the Truth in Lending Act, Congress has with limited exceptions explicitly allowed the States to adopt laws to protect financial consumers so long as these laws do not conflict with Federal statutes or regulations. Federal law thus establishes a floor, not a ceiling. We propose to preserve that arrangement. It reflects a decades-long judgment of Congress, which we share, that States should retain authority to protect the welfare of their citizens with respect to consumer financial services. Federal law ensures all citizens a minimum standard of protection wherever they reside. Citizens of a State, however, should be able to provide themselves--through their legislators and governors--more protection. The continued ability of citizens to protect themselves through their States is crucial to ensuring a strong Federal standard. State initiatives can be an important signal to Congress and Federal regulators of a need for action at the Federal level. Even with the best of intentions and the best of staff, it is impossible to simply mandate that Federal laws or rules remain updated, since practices change so quickly. States are much closer to abuses as they develop and they are able to move more quickly when necessary. For example, a number of States were far ahead of the Federal Government in regulating subprime mortgages. If States were not permitted to take the initiative to enact laws providing greater protection for consumers, the Federal Government would lose a critical source of information and incentive to adjust standards over time to address emerging issues. If the Consumer Financial Protection Agency (CFPA) is created and endowed with the authorities we have proposed, we expect the standards adopted by the Agency will promote regulatory consistency, even while it respects the role of the States. We believe a strong and independent CFPA that is assigned a clear mission to keep protections up-to-date with changes in the marketplace will reduce the incentives for State action and increase legal uniformity. If States retain the ability to protect their citizens as new consumer protection problems appear and the CFPA has the authority it needs to follow the market and keep Federal protections up-to-date, then the CFPA will be more likely to set a high standard that will satisfy a substantial majority of States. To be sure, federally chartered institutions have recently enjoyed immunity from certain State consumer protection laws. We propose to change that to ensure a level playing field. National banks must already comply with a host of State laws, such as those dealing with foreclosures, debt collection, and discrimination. Under our proposal, federally chartered depository institutions and their State-incorporated subsidiaries would be subject to nondiscriminatory State consumer protection to the same extent as other financial institutions. We would preserve preemption where it is critical to the Federal charter. Our proposal explicitly does not permit the States to discriminate against federally chartered institutions. Discriminatory State laws would continue to be preempted. Moreover, we do not seek to overturn preemption of State laws limiting interest rates and fees (the Smiley and Marquette decisions). Nor do we seek to disturb the exclusive authority of the national bank prudential supervisor over national banks with respect to prudential regulation and supervision. Thus, we would preserve the value of the national bank charter. ------ 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. ------ FinancialCrisisReport--10 Investment banks can play an important role in the U.S. economy, helping to channel the nation’s wealth into productive activities that create jobs and increase economic growth. But in the years leading up to the financial crisis, large investment banks designed and promoted complex financial instruments, often referred to as structured finance products, that were at the heart of the crisis. They included RMBS and CDO securities, credit default swaps (CDS), and CDS contracts linked to the ABX Index. These complex, high risk financial products were engineered, sold, and traded by the major U.S. investment banks. From 2004 to 2008, U.S. financial institutions issued nearly $2.5 trillion in RMBS and over $1.4 trillion in CDO securities, backed primarily by mortgage related products. Investment banks typically charged fees of $1 to $8 million to act as the underwriter of an RMBS securitization, and $5 to $10 million to act as the placement agent for a CDO securitization. Those fees contributed substantial revenues to the investment banks, which established internal structured finance groups, as well as a variety of RMBS and CDO origination and trading desks within those groups, to handle mortgage related securitizations. Investment banks sold RMBS and CDO securities to investors around the world, and helped develop a secondary market where RMBS and CDO securities could be traded. The investment banks’ trading desks participated in those secondary markets, buying and selling RMBS and CDO securities either on behalf of their clients or in connection with their own proprietary transactions. The financial products developed by investment banks allowed investors to profit, not only from the success of an RMBS or CDO securitization, but also from its failure. CDS contracts, for example, allowed counterparties to wager on the rise or fall in the value of a specific RMBS security or on a collection of RMBS and other assets contained or referenced in a CDO. Major investment banks developed standardized CDS contracts that could also be traded on a secondary market. In addition, they established the ABX Index which allowed counterparties to wager on the rise or fall in the value of a basket of subprime RMBS securities, which could be used to reflect the status of the subprime mortgage market as a whole. The investment banks sometimes matched up parties who wanted to take opposite sides in a transaction and other times took one or the other side of the transaction to accommodate a client. At still other times, investment banks used these financial instruments to make their own proprietary wagers. In extreme cases, some investment banks set up structured finance transactions which enabled them to profit at the expense of their clients. Two case studies, involving Goldman Sachs and Deutsche Bank, illustrate a variety of troubling practices that raise conflicts of interest and other concerns involving RMBS, CDO, CDS, and ABX related financial instruments that contributed to the financial crisis. The Goldman Sachs case study focuses on how it used net short positions to benefit from the downturn in the mortgage market, and designed, marketed, and sold CDOs in ways that created conflicts of interest with the firm’s clients and at times led to the bank = s profiting from the same products that caused substantial losses for its clients. From 2004 to 2008, Goldman was a major player in the U.S. mortgage market. In 2006 and 2007 alone, it designed and underwrote 93 RMBS and 27 mortgage related CDO securitizations totaling about $100 billion, bought and sold RMBS and CDO securities on behalf of its clients, and amassed its own multi-billion-dollar proprietary mortgage related holdings. In December 2006, however, when it saw evidence that the high risk mortgages underlying many RMBS and CDO securities were incurring accelerated rates of delinquency and default, Goldman quietly and abruptly reversed course. FOMC20080318meeting--61 59,MR. EVANS.," Thank you, Mr. Chairman. Clearly, the incoming data on activity have been weaker than we expected. I think they point to a downturn in GDP in the first half of the year similar to that in the Greenbook. While the February CPI report was welcome news, on balance I think the inflation picture continues to be troubling. I noticed a marked change in the sentiment of my business contacts this round. Many more are now telling me that the problems on Wall Street are affecting their financing. Credit availability is now an issue. With regard to borrowing from banks, these reports seem consistent with the Senior Loan Officer Opinion Survey. Credit is an issue for those tapping nonbank sources as well, as in the comments that President Yellen made. As an example, back in December a major shopping center developer indicated that, even though the commercial-mortgage-backed security market had dried up, he was still able to obtain financing on reasonable terms from other sources, such as life insurance companies. Last week he told me that these sources had dried up, too. He's now trying to raise equity funding, which he considers very costly and an unappealing alternative. Many contacts also expressed increased nervousness over the economic situation and its likely impact on demand for their products. Manpower's CEO told me that their business had deteriorated in recent weeks. Some of his clients were trimming staff because of a lower current demand, and many others were being cautious and cutting back in expectation of future weakening. Still, even though restrictive financing and heightened caution are weighing on households and businesses, there is a sense from my contacts that spending is not collapsing at this point, and exports of capital equipment in the agricultural sector continue to do well, similar to President Hoenig's comments. Another common theme I heard from my contacts is that, while the Fed's innovative response has helped, they do not expect that these measures will do a lot to solve the financial sector's fundamental problems. I doubt that any of us disagree with that. As one of my directors put it, ""Monetary policy is not enough. We need a solution to the subprime mess. Once that happens, the contagion will run in reverse."" I believe our innovative policies are helpful for facilitating market functioning, but they don't address the root problem. Markets want a firmer sense of where prices for stressed assets will bottom out and of the magnitude of the portfolio losses that will be taken by major financial players. Unfortunately, it will take a good deal of time before these uncertainties will be resolved, and I'm not sure what we can do to speed the process. After all, a number of these losses are going to stem from mortgage delinquencies that have not yet occurred and perhaps from homeowners who have not even contemplated that outcome. This means that financial headwinds likely will be weighing on the real economy for some time, as President Stern said. I agree with his comments there. The substantial uncertainty over the length and breadth of this process adds uncertainty to the medium-term outlook for growth. So while I am hopeful that the economy will begin to recover in the second half of the year, I'm a lot less confident of that outcome than I'd like to be. Turning to inflation, Friday's CPI report was about the only good news I heard during the intermeeting period (I think last time the reports weren't very good either, President Yellen), although as the Greenbook Supplement points out, the less favorable translation to PCE prices takes out some of the luster. It's no surprise that many of my contacts pointed to increasing pressures from higher costs for food, energy, and other commodity inputs. I also heard numerous reports of higher costs being passed downstream. One notable case was for wallboard. Even though demand is weak and the industry had plenty of excess capacity, higher costs for energy inputs were resulting in the first increase in wallboard prices in 20 months. The director who reported this was concerned that pricing behavior is moving toward a cost-plus mentality. This is, after all, his industry. If so, this would have negative implications for inflation expectations. However, I see this as a risk and not a base case scenario because the resource gaps opening up in the economy should bring inflation down. Firms will find it difficult to pass through cost increases in an environment of weak demand. Businesses and financial market participants will be aware of this difficulty in passing through costs, which should help keep down their inflation expectations. That said, even in a weak economy, firms will have only so much room to absorb costs, and pressures from higher prices for energy and other commodities and for imported goods pose a risk to the outlook. In addition, while I expect inflation expectations to be contained, there are risks on this front, too. Some can see a low fed funds rate path, such as that assumed by the Greenbook, as an indication of a lack of resolve on inflation. I don't agree with that assessment, but it's an increasing risk that we will be running, particularly if the inflation news breaks in the wrong way. Thank you, Mr. Chairman. " FinancialCrisisReport--320 The two case studies illustrate how investment banks engaged in high intensity sales efforts to market new CDOs in 2007, even as U.S. mortgage delinquencies climbed, RMBS securities incurred losses, the U.S. mortgage market as a whole deteriorated, and investors lost confidence. They demonstrate how these investment banks benefitted from structured finance fees, and had little incentive to stop producing and selling high risk, poor quality structured finance products. They also illustrate how the development of complex structured finance products, such as synthetic CDOs and naked credit default swaps, amplified market risk by allowing investors with no ownership interest in the “reference obligations” to place unlimited side bets on their performance. Finally, the two case histories demonstrate how proprietary trading led to dramatic losses in the case of Deutsche Bank and to conflicts of interest in the case of Goldman Sachs. Investment banks were a major driving force behind the structured finance products that provided a steady stream of funding for lenders to originate high risk, poor quality loans and that magnified risk throughout the U.S. financial system. The investment banks that engineered, sold, traded, and profited from mortgage related structured finance products were a major cause of the financial crisis. FOMC20080318meeting--70 68,MR. PLOSSER.," Well, I've been supportive of those, and I want to compliment the New York Desk and the people who have worked on this because I think they are very innovative. I'm not clear how successful these instruments will be, and they are not without their own set of risks of creating some potentially dangerous expectations regarding future Fed behavior, which eventually we must deal with. But I think they are worth trying as long as they are removed in due course. I can also support a further narrowing of the spread between the funds rate and the primary credit rate, although I would eventually like to see a review of what we think that spread ought to be in more normal times and what our exit strategy might be like as we move toward that. Giving some thought down the road to that I think would be helpful. So while I believe that we have appropriately reduced the funds rate in response to the worsening economic outlook for the real economy, I am less convinced that reducing the funds rate further will do much to stem the liquidity problems in the market or to lower risk premiums. Uncertainty about valuations seems to be the root cause of liquidity problems. The price discovery process needs to continue, and it may take a while. In this case, I think the Fed needs to continue to do its job to reassure markets that it will act as an appropriate lender of last resort, but we must be careful that a lower funds rate, if that is the path we take, doesn't become just a form of forbearance that contributes to delaying the necessary writedowns and the price discovery process itself. Yes, the financial markets can have spillovers to the real economy to which the Fed needs to react with monetary policy, and I believe we have. At the same time, we need to keep focused on both parts of our mandate. We put our credibility at risk if we do not do so, and this would be a cause for severe problems later when we may need to act to regain it. We will have to face the fact at some point that we will disappoint the markets with their ever-increasing forecast of a lower funds rate. Thank you, Mr. Chairman. " 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-110hhrg44900--103 Secretary Paulson," I wish I could tell you one thing, but there isn't a silver bullet. If there was, and we knew how to address it right now, we would. And what is going on now as I said earlier, is it's just taking us a good while because there is much more leverage than was--what was once healthier--much more leverage than was perceived to be the case. And it was in the form of financial products. And then many of which were complex. There has been recorded progress made. It hasn't been in a straight line, but the progress I would site has been the risk reduction, the de-leveraging, the things that the Chairman has cited, in terms of increased liquidity and management, funding management by the investment banks, the capital that has been raised, being raised. But I believe part of this of course, is confidence. And having been through periods like this, they always are the worst until they are resolved. And before they are resolved, you wonder how they ever are going to be resolved. But confidence has a way of returning to the markets. And over time there have been many investors, wise investors, that have come in during times of great risk, adversity, and made investments and have made money on those investments. I think one of the key things is going to be when you start to see, and we are seeing some, more of these hard-to-sell assets changing hands and private money coming into the markets. But meanwhile, we have, all of us, some real work to do. " FOMC20080130meeting--354 352,MR. MISHKIN.," We could talk about Arthur Andersen, too, because I am going to talk about the more complicated issues of conflicts of interest. With plain vanilla conflicts of interest, if there is enough information, the market frequently can solve the problem because if you know that if you do what the issuer wants and you give a good rating, then you lose your reputation. Then, if it has no value, issuers won't pay for it. What is interesting here is that for the subprime market, you didn't find any evidence of conflicts of interest, and I am not surprised by that, because those securities are much more straightforward. Where I really do worry about the conflict of interest is in the structured products because one thing that happened was that it became less plain vanilla. You actually had consulting practices inside the credit rating agencies; these structures are very complicated, and you need to slice here and dice here, and consultants were providing advice on structuring them and making a lot of money, and then it was much less transparent. What I wondered about here is that you didn't say this for the first one, subprime RMBS. You said you didn't find the evidence. I buy that. But what about the CDOs and the SIVs, for which I would expect that this problem would have been more severe? In the book that I wrote with others on conflicts of interest in the financial services industry, we actually said that there was not a problem with the plain vanilla products because the markets have the information, but we worried about exactly this issue in terms of the structured products. I am just wondering whether or not it was an accident that you said for the plain vanilla that there was less problem. Could there have been an issue here? The reason this gets complicated is that the standard view of conflicts of interest in Arthur Andersen was in the firm's compensation scheme. Actually, the conflict of interest was that the Texas unit did not worry about and weakened--not their ethics, but what is it? The center has rules for its branches so that they don't screw the overall firm, and that is what got weakened during the fight between the consulting part and the auditing part. So do you have any information on these very complicated elements, particularly the nontransparent parts? Was it an accident that you said for subprime that you didn't find evidence, and for these is there more possibility that there was a problem? That really does have important implications for the nature of the regulation and accreditation agencies and also their ability to give good ratings for these very complex nontransparent products. You talked about investor practices later, Bev, when you said that we should differentiate between plain vanilla and this very complex stuff. I don't know whether or not you have views on this. " CHRG-111hhrg54872--180 Mr. Scott," Thank you, Mr. Chairman. I would just like to kind of focus my remarks on unintended consequences, one-size-fits-all dangers of this, as well as the confusion between State and Federal laws as we move forward. It is an important legislation. Let's take my first problem of unintended consequences and whether or not this would work, particularly with some unique situations. I am sure you all are familiar with the Farm Credit Administration. The Farm Credit Administration is very, very unique. They already have what they call a borrowers' bills of rights, which basically covers much of what we are attempting to do in this bill, resulting in if they were into this duplicatory obligations, burdensome regulatory concerns as well. Consumer lending is a very, very small part of what they do. Mortgage lending, for example, is only allowed in communities with less than 2,500 individuals. Their products were not anywhere near the toxic level that caused the problem in the first place. So my question is, would not we be doing a better service here if we allowed the farm credit to continue to operate under its own current regulatory process away from this legislation? I take it all of you agree that it would be the best thing to do in this situation, to allow farm credit. The reason I mention that is, also, farm credit does not come under the jurisdiction of financial services. It is an agricultural area. And I am simply saying that it makes sense--this is a complex, complicated area, covers a lot of the waterfront when we are dealing with the financial services industry. And it might be wise as we move forward with this to look inward-outward instead of outward-inward. And I think that what I am getting from the committee here is that you agree that the Farm Credit Administration should be left away from this or doing what they are doing with the bill of rights; weren't a part of the problem in the first place; and this would be a duplication. " CHRG-111shrg57322--259 Mr. Sparks," At Goldman, ethical standards were a focus. Numerous times there would be various off-site--when I say off-site, I mean you would take people out of what they were currently doing to go and discuss ethics and how important it is and how you deal with complex issues. Senator Pryor. Were those Goldman standards, or were they some sort of national standard or some industry standard? When you talk about ethics, what are you talking about? " CHRG-111shrg55739--133 Mr. Coffee," I mean, I don't really want to delay this hearing further. The change to an issuer-pays model was the early 1970s. Asset-backed securitizations don't really become significant before about 1990. What was happening was that the Big Two back then--Fitch wasn't really one of the Big Three at that point--really were break-even marginal companies, and as the cost became more expensive--let us forget the structure of finance--the cost could be as high as three-quarters of a million dollars to rate a very complicated structured finance offering, or at least that is the fee charged in a slightly competitive market. That is such a high cost that I don't think that can easily be dealt with under a user-pay system. You can't put all that front-end work in hoping you will get paid later on as a developing startup company. That is why they have primarily focused on corporate bonds rather than on this complex structured finance field. But all I was just agreeing with is why the system broke down. It broke down well before structured finance, and frankly, every other gatekeeper you can think of, accountants, investment bankers, lawyers, they are paid by their client, also. It has got certain efficient properties. Senator Corker. So it was obviously magnified and multiplied with all of these complex securities, but when you say it broke down well before, expand on that a little bit. " CHRG-110shrg50414--175 Secretary Paulson," You know, I share the outrage that people have. It is embarrassing to look at this, and I think it is embarrassing for the United States of America. There is a lot of blame to go around. A lot of blame. And a lot of blame with the big financial institutions that engaged in--that is where I started with this--irresponsible lending, the overly complicated and complex securities that no one understood as well as they should, and it turns out they did not understand them themselves; the rating agencies that rated those securities; blame to the people that made loans they should not have made to some people that took out loans they should not have taken out; to regulators. So there is no doubt about that, but what we are focused on now is--and what I think your constituents want to hear, is let's fix the problem in the way that is going to have the least negative impact on them, and then let's go out and deal with all these problems and figure out how to make sure that we minimize the likelihood that it will happen again. Senator Brown. No disrespect, Mr. Secretary, but they understand much of that. They do want a solution. But they do not want the same people that have helped to inflict this pain on the American people to get the opportunity, because of our reluctance on executive compensation and our reluctance to do accountability, to inflict more pain. And I think that is--well, let me move on from that. I apologize for interrupting. Senator Bennett raised a good question about troubled assets, and, Mr. Secretary, how would you determine the price of a troubled asset if not by a transparent method like an auction? I am not asking you to commit to a certain way, but give me an example or two how you could determine the price of a troubled asset outside of an auction and do it in a transparent way? " CHRG-109hhrg31539--254 Mr. Bernanke," Well, I think there is a risk there. And indeed the recent report from OFHEO about some of the inadequacies of the GSEs' internal controls and their accounting makes us wonder about their ability to manage these very large and complex portfolios. I am not saying there is anything immediately about to happen, but I do think that these portfolios do present a systemic risk and that it would be in our interest to try to address that issue. " CHRG-111shrg54589--139 RESPONSES TO WRITTEN QUESTIONS OF SENATOR SCHUMER FROM GARY GENSLERQ.1. Chairman Gensler, isn't the same true regarding the potential impact of derivatives on commodities markets? Shouldn't all derivative products that impact commodities prices be overseen by your agency?A.1. Answer not received by time of publication.Q.2. Chairman Gensler, do you agree that broad-based and narrow-based derivatives products can both have an impact on the underlying markets that they reference?A.2. Answer not received by time of publication.Q.3. Chairman Gensler, I am very concerned by efforts by the European Commission to implement protectionist restrictions on derivatives trading and clearing. A letter signed by many of the world's largest financial institutions earlier this year under significant pressure from European Commission, commits them to clearing any European-referenced credit default swap exclusively in a European clearinghouse. This kind of nationalistic protectionism has no place in the 21st-century financial marketplace. What steps can you and will you take to combat these efforts to limit free trade protect free access to markets? If Europe refuses to alter its position, what steps can be taken to protect the United States' position in the global derivatives markets?A.3. Answer not received by time of publication.Q.4. Chairman Gensler, one of many important lessons from the financial panic last fall following the collapse of Lehman Brothers and AIG, it is that regulators need direct and easier access to trade and risk information across the financial markets to be able to effectively monitor how much risk is being held by various market participants, and to be able to credibly reassure the markets in times of panic that the situation is being properly managed. A consolidated trade reporting facility, such as the Trade Information Warehouse run by the Depository Trust and Clearing Corporation for the credit default swaps markets, is the critical link in giving regulators access to the information this kind of information. Currently, there is no consensus on how trade reporting will be accomplished in domestic and international derivatives markets, and it is possible that reporting will be fragmented across standards established by various central counterparties and over-the-counter derivatives dealers. Do you agree that a standardized and centralized trade reporting facility would improve regulators' understanding of the markets, and do you believe that DTCC is currently best equipped to perform this function?A.4. Answer not received by time of publication.Q.5. Chairman Gensler, in response to the need for greater transparency in the derivatives market, a joint venture between DTCC and NYSE was recently announced called New York Portfolio Clearing. Market innovations such as these, which intend to provide a single view of risk across asset classes, can help close regulatory gaps that currently exist between markets. Do you agree that this one approach that would help increase market efficiency and could reduce systemic risk? Should we expect the Commission to support this initiative?A.5. Answer not received by time of publication. ------ 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. " FOMC20080430meeting--206 204,VICE CHAIRMAN GEITHNER.," Okay, but it is a surprising gap. So I think it would be worth some time to think through that. Obviously we also disagree about how inflation works in the United States, how relative price shocks take effect, and what we should respond to in that sense. That would be worth a little time, too. Again, it is a surprise to me. We sit here to make monetary policy, and we haven't talked much about this basic core question: How should we judge the stance of policy? It would be worth some attention. I just want to end by saying something about the dollar. My basic sense about the dollar-- and I'm very worried about this dynamic now--is that it has been trading more on concern about tail risk in the economy and in the financial system than anything else. As I said yesterday, if you look back to when there has been an increase in perceived tail risk, however you want to measure it--credit default swaps on financials or something like that--and the two-year has fallen sharply or we have had a big flight to quality, those have been the periods that have been most adverse to the dollar. Now, it is not a consistent pattern, but I think it's basically right; and I think it gives an important illustration that what goes into a judgment about whether people hold dollars and U.S. financial assets has to do with a lot of things. It has a lot to do with confidence that this Committee will reduce the tail risk in the financial system and the economy to tolerable levels. It also has a lot to do with confidence in our willingness to keep inflation stable over a long period, but it's not only that. Again, we have had a pretty good experiment in that proposition over the past year or so. My sense is that the biggest risk to the dollar, since I'm pretty confident that this Committee is going to make good judgments about inflation going forward, is in the monetary policy of other countries. The real problem for us now is that we have a large part of the world economy--in nonChina, non-Japan Asia and the major energy exporters--still running a monetary policy that is based on the dollar as nominal anchor. That has left them with remarkably easy monetary policy and a pretty significant rise in asset-price inflation. The transition ahead for them as they try to get more independence for monetary policy and soften the link to the dollar is going to carry a lot of risk for us because the market is going to infer from that a big shift in preferences for the currencies that both governments and private actors in those countries hold. As that evolution takes place in their exchange rate and monetary policy regimes the risk for us is that the market expects a destabilizing shift in portfolio preferences, which people might infer is also a loss of confidence in U.S. financial assets. I think that's a big problem for us. It's not clear to me that it means that we should run a tighter monetary policy against that risk than would otherwise be appropriate because I don't think it buys much protection against that risk. I just want to associate myself with all the concerns said about the dollar in this context. The judgment that goes into confidence and people's willingness to hold U.S. financial assets is deeply textured and complex, and it has a lot to do with confidence in this Committee's capacity to navigate the perilous path between getting and keeping down that tail risk and preserving the confidence that inflation expectations over time will stay stable. So I support alternative B and its language. " CHRG-111hhrg52397--26 Mr. Hensarling," Thank you, Mr. Chairman. I appreciate the title of the hearing, dealing with ``effective regulation'' because I think there is a very big difference between effective and ineffective. Effective regulation helps make markets more competitive and transparent, empowers consumers with effective disclosure to make rational decisions, effectively polices markets for fraud, and reduces systemic risk. Ineffective regulation though can hamper competition, create moral hazards, stifle innovation, and diminish the role of personal responsibility within our economy. Now, with respect to more regulation of the OTC derivatives market, I come into this hearing with an open mind but not an empty mind. I remember that regulators and legislators do not always get it right, witness Fannie Mae and Freddie Mac; witness the credit rating agency oligopoly, and let us also remember that the former director of OTS said they had the tools to prevent AIG's position in the CDS and simply did not exercise it. Now, perhaps we should look to more enlightened risk assessment for tools for regulators, appropriate capital standards and with respect to our OTC derivatives and current economic turmoil, let's be careful we do not confuse the cause with the symptoms. With that, Mr. Chairman, I yield back the balance of my time. " CHRG-111shrg55479--124 Mr. Ferlauto," I was just going to say, I think that is true. I think the moderate form is establishing the disclosure right for proxy access. But to go all the way to keep Governors happy, if you will, is to create competition amongst the States by fully empowering shareholders. Ms. Yerger. As radical as the Council is, I have to tell you, this is not an issue we have endorsed at this point, is giving owners the right to reincorporate an entity. We are studying it, but I think that it is a complex issue that I would be very surprised the corporate community would support. " CHRG-111hhrg52406--179 Mr. Gutierrez," The time of the gentleman has expired on that question. So I just wanted to say to Professor Warren, Ms. Seidman, and the others, I would like to put a floor on payday lending, a national one, so that at least we have some minimum standard. I would like for the remitters to have somebody nationally, you know a Federal regulator, I would like to see people maybe not buy an $800 TV and 3 years later pay $2,400 for it, or people to kind of, I don't know, escape to installment loans at 500 and 600 percent. Some people might be surprised that happens. It happens. So not to take any time here, if you have any ideas about how that fits into what we are doing now in terms of setting floors and doing something now versus dealing with all of those things, you know, while we have the public's attention and the Congress' attention, I would love to hear from you later. And now to close, the sponsor, Mr. Miller, is recognized for 5 minutes. Mr. Miller of North Carolina Thank you, Mr. Chairman. Several witnesses and members have referred to the need for personal responsibility. I agree with that, but I have noticed that no one seems to use the term personal responsibility or call for personal responsibility when they are actually taking personal responsibility. It always seems to be when they are pointing out that someone else is responsible and that other person is not taking personal responsibility. Mr. Yingling used or said that a variety of products was valuable and the products would compete, and that is the way I would like to see the market work, too. I am perfectly happy where there is some rough equality of bargaining power, some rough equality of information, or information symmetry, as economists would say, that we leave the parties to a transaction to their own devices. The way economic theory says that should work is that when one competitor introduces a new product or does something different and it proves profitable, others will mimic what they are doing, and they will compete with each other, and they will be forced to contain their costs, and the prices will come down, and it will benefit the consumer. And the result is that all the competitors make an honest living, and the consumers actually get the benefits of their innovation. What we have seen in the financial sector, though, is beginning around 1980, after bouncing for decades between 5 and 15 percent of all corporate profits, the profitability of the financial sector went up steadily, dramatically, consistently, up until a couple of years ago, to more than 40 percent of all corporate profits. And compensation of the industry, about which we have heard a great deal, went from about what other Americans made beginning in 1982, about 1.8 times what most Americans made. Mr. Yingling, if the market were working properly, if there were competitive forces that were containing costs and limiting profits, how do you account for that level of profitability and that compensation level by the financial sector? " CHRG-111hhrg56767--44 Mr. Alvarez," Chairman Frank, Ranking Member Bachus, and members of the committee, thank you for the opportunity to discuss incentive compensation practices in the financial services industry. Compensation arrangements serve several important and worthy objectives. For example, they help firms attract and retain skilled staff, and promote better firm and employee performance. However, compensation arrangements can also provide employees with incentives to take excessive risks that are not consistent with the long-term health of the organization. This misalignment of incentives can occur at all levels of a firm, and is not limited to senior executives. Having experienced the consequences of misaligned incentives, many financial firms are re-examining their compensation structures to better align the interests of managers and other employees with the long-term health of the firm. For firms that have received assistance from TARP, that includes ensuring their compensation structures are consistent with the Special Master's rules designed to protect the financial interests of taxpayers. The Federal Reserve has also acted as a prudential supervisor. In October, we proposed supervisory guidance on incentive compensation practices that would apply to all banking organizations that the Federal Reserve supervises. The guidance, which we expect to finalize shortly, is based on three key principles. First, compensation arrangements should not provide employees incentives to take risks that the employer cannot effectively identify and manage. Financial firms should take a more balanced approach that adjusts incentive compensation, so that employees bear some of the risks, as well as the rewards associated with their activities over time. Second, firms should integrate their approaches to incentive compensation arrangements with their risk management and internal control frameworks. Risk managers should be involved in the design of incentive compensation arrangements, and should regularly evaluate whether compensation is adjusted in fact to account for increased risk. Third, boards of directors are expected to actively oversee compensation arrangements to ensure they strike the proper balance between risk and profit on an ongoing basis. Recently, the Federal Reserve also began two supervisory initiatives to spur the prompt implementation of improved practices. The first is a special horizontal review of incentive compensation practices at large, complex banking organizations. Large firms warrant special supervisory attention, because the adverse effects of flawed approaches at these firms are more likely to have consequences for the broader financial system. Although our review is ongoing, we have seen positive steps at many of these firms. However, substantial changes at many firms will be needed to fully conform incentive compensation practices with principles of safety and soundness. It will be some time before these changes are fully addressed. Nonetheless, we expect these firms to make significant progress in improving the risk sensitivity of their incentive compensation practices for the 2010 performance year. The second initiative is tailored to regional and smaller banking organizations. Experience suggests that incentive compensation arrangements at smaller banks are not nearly as complex or prevalent as at larger institutions. Accordingly, review of incentive compensation practices at these firms will occur as part of the normal supervisory process, a process that we expect to be effective, yet to involve minimal burden for the vast majority of community banks. Incentive compensation practices are likely to evolve significantly in the coming years. This committee's efforts in developing and passing H.R. 4173 will promote the uniform application of sound incentive compensation principles across large financial firms beyond those supervised by the Federal Reserve. In this way, H.R. 4173 would encourage financial firms, supervisors, shareholders, and others to develop incentive compensation practices that are more effectively balanced and reward and better align incentives. We appreciate the committee's efforts in this area, and thank you for the opportunity to testify on this important topic. I would be happy to answer any questions. [The prepared statement of Mr. Alvarez can be found on page 37 of the appendix.] " CHRG-111hhrg55814--327 Mr. Paulsen," Mr. Chairman, I just wanted to ask unanimous consent to submit two letters for the record, one from CMSAA and one from the American Land Title Association. Mr. Moore of Kansas. Certainly, they will be received for the record. Thank you, sir. The Chair next recognizes the gentleman from North Carolina, Mr. Miller, for 5 minutes. Mr. Miller of North Carolina. Thank you, Mr. Chairman. Ms. Bair, Mr. Garrett asked earlier whether if there was a resolution under these powers, a manufacturer who is just minding their own business might be surprised to get an invoice declaring that they were a financial company, and they had assets of more than $10 billion. And what would keep that from happening. And you said that you did not think that was intended by the legislation. Page 165, 166 includes a definition of financial company, which is a bank holding company as defined in Section 2(a) of the Bank Holding Company Act. An identified financial holding company is defined in Section 2(5) of the Financial Stability Improvement Act, any company predominately engaged in activities that are financial nature, for purposes of Section 4(k) of Bank Holding Company Act or any subsidiaries of any of those. And all of those are defined statutory terms. And with respect to the ``predominately engaged in activities,'' there is a procedure for notice that the company is regarded as predominately financial and they have an opportunity to contest that. Does that support your argument that no manufacturer minding their own business is just going to get an invoice? Ms. Bair. It certainly attempts to. Again, my apologies, as I have not had a chance to read this entire bill. I think we all understand we want this confined to financial intermediaries. If there are further refinements in the language, we are happy to work with the committee. But, yes, I think that is clearly the intent. And, as it is drafted here, that is what is expressed. But, there are other provisions I know my staff had concerns over, and I need a chance to read the entire bill before I can respond. Mr. Miller of North Carolina. Okay. All right. Thank you. There has been a substantial discussion about whether banks should not do certain things. Any systemically significant firm should not engage in some inherently risky procedures. We have had that comment from economists for several months now as part of this debate. Mervyn King, the Bank of England governor, said there should be--banks should be broken up into casino functions and utility functions. And Paul Volcker, testifying here last month, said that much the same thing, and specifically gave the example of proprietary trading. Do you agree that there are some functions that systemically significant firms should not do, among other reasons, because it is almost entirely impossible for their board of directors or even their CEO to know what they are doing if they are engaged in all manner of complex activity, do you agree with that? And do you agree specifically with respect to proprietary trading? Ms. Bair. Right. Mr. Miller of North Carolina. And does this bill give sufficient authority to do that? Ms. Bair. I think he was saying that insured depository institutions should not do that. Mr. Miller of North Carolina. Right. Ms. Bair. Those that benefit from the deposit insurance. I do not think he was saying nobody should do that. I think his preference would be basically to do away with Gramm-Leach-Bliley so that you have banking operations that take deposits and make loans separate from securities and insurance activity. So, we have somewhat of a hybrid approach. We would like much more definitive walls of separation, both legally and functionally, between insured depository institutions and other affiliates in a bank holding company. We also would agree with Comptroller Dugan that regulatory standards for the holding company activity should be higher. The capital standards should be at least as high for holding companies as they are for insured depository institutions. The quality of capital should be just as high. If you are going to have an insured depository institution, you should be in a position of strength, not weakness. We would like some strict separation of proprietary trading and a lot of these complex securitizations, etc., should be outside the insured depository. We also were very grateful that the bill does propose giving us some back-up authority for holding companies so that when a holding company affiliate is doing something that puts the insured institution at risk, we would have some back-up ability to come in there and work with the Federal Reserve, presuming the Federal Reserve is the holding company supervisor, to remediate that situation. We do want greater walls of separation between the banks and other types of activities, but we would not say that they could not co-exist within a broader holding company structure. Mr. Miller of North Carolina. I am sorry. Say the last bit again? Ms. Bair. So we would like greater separation between the insured depository and the affiliates that do other types of higher risk activities, though we would not say that the insured institution has to be taken completely out of the holding company structure. They could co-exist in a holding company structure. Mr. Miller of North Carolina. Okay. Mr. Dugan? " 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. ------ CHRG-110hhrg34673--19 Mr. Bernanke," Congressman, the story was misreported, and you misunderstand my position. I did not address the affordable housing fund, either pro or con. The concern that the Federal Reserve has had for a long time about GSE's is the potential for their portfolios to create systemic risk in our financial system. I should say that we very much support the GSE's housing mission, and we believe, in particular, that the securitization function contributes to liquidity in the mortgage market. Again, our concern is about the portfolios and their enormous size and the complex derivative exercises that are needed to maintain the balance of those portfolios. My comment was one that built on suggestions that Chairman Greenspan had made in previous testimonies, which was that one way to limit the growth of the portfolios, but also to achieve the stated public purpose of the GSE's was, in some way, to anchor the portfolios in the public purpose, which is affordable housing. According to OFHEO, only about 30 percent of the portfolios are related in any way to affordable housing. So I think what I would like to see would be the portfolios to be more directly connected to a public purpose, perhaps holding affordable housing mortgages or another way, more directly promoting affordable housing rather than acquiring all different kinds of assets that are not related to affordable housing. " 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-111hhrg48875--190 Secretary Geithner," So in any of those cases, like Lehman or AIG or Bear Stearns or any large, complex institution, you would have to look at the state of the world at that point. You would have to look at whether the costs to the economy as a whole would be so severe in the event of default that it was cheaper for the taxpayer ultimately to intervene to protect creditors from the consequences of default. " FinancialServicesCommittee--58 Mr. B ACHUS . And coordinated maybe stock-by-stock circuit break- ers? Mr. N OLL . We all agree with that. Mr. B ACHUS . Mr. Duffy, do you agree with that? Mr. D UFFY . Yes. We agree with that and we see no issue with that. But, again, this is not pertaining to the CME Group. We don’t trade individual stocks. Mr. B ACHUS . Okay. I guess if you trade an option or you trade an ETF or something, you trade options, do you trade those? Mr. D UFFY . The CME Group, no. We trade futures. We trade op- tions on futures. We don’t trade the SPDR. Mr. B ACHUS . All right. Let me ask all of you, we have kind of gone from a highly structured duopoly, at least with stock trading, to a much more fragmented system. How would you advise the reg- ulators to meet the challenges of addressing marked integrity and price discovery without hurting competition? Mr. D UFFY . I will be happy to start, even though I think this is more your bailiwick, but I will jump in. I do think that you need to have the same set of standards and protocols across the multiple markets, and I think it is as simple as that. You can’t have one set of rules at the NYSE and at NASDAQ, and then you have different sets of rules at BATS and other ECNs. It is not going to work. It is a recipe for disaster. No one has been able to explain how Accenture went from $41 to a penny yet, and that to me is just amazing, how you can’t explain that. I think you have to have the same protocol across these mar- ketplaces. Mr. B ACHUS . All right. Mr. Leibowitz or Mr. Noll? Mr. L EIBOWITZ . Sure. I think that it is clear that the complexity of our market represents a challenge for regulators. There is no doubt about it. And I think that the SEC is trying to respond to that challenge. I think the concept, the release that they just issued to review various aspects, whether it is ATSs, whether it is Reg NMS, wheth- er it is sponsored access, are all exactly well-timed, and they just need the resources and need to be nimble enough to get through that. I think the challenge is that it is just that we are in an environ- ment that is relatively complex, and small changes have unin- tended consequences. So for example, just saying, ‘‘Let’s ban high- frequency trading,’’ I think we would be stunned with the con- sequences. I think that even small changes have very big effects that we may not see, and they just need to be careful, while at the same time moving quickly when we see a problem where we all agree, like marketwide circuit breakers on individual stocks. That is easy one. That is a no-brainer. Mr. N OLL . I would agree with Mr. Leibowitz. And I think some of the things that we have talked about already indicate that we are moving in that direction, both on marketwide circuit breakers on individual stocks changing marketwide circuit breakers on the entire market as well as talking about things like the consolidated audit trail and other functionality that we give the SEC. I think this is a very complex market. I think Chairman Schapiro and Chairman Gensler are fully aware of how complex it is and have the tools and intellectual capital to deal with that. And we are here to assist them to do with that. CHRG-111shrg54589--44 Chairman Reed," Because you are right, this is a complex topic, and we are extraordinarily fortunate to have the Chairmen and Ms. White from the Federal Reserve. Let me just ask one question, though, and that is: We are engaged in a very complicated regulatory reform process which is going to touch many, many different areas. So I would ask you to just tell us what do you believe are the two or three most important legislative changes that we have to enact given the fear that it is going to be so big and so broad that every detail will be considered. But we need to know what you think the most important priorities are in terms of the legislative changes. Chairman Gensler, you seemed poise to answer. " CHRG-111hhrg55814--346 Mr. Perlmutter," So General Electric, major manufacturer, major company but also has a major financing arm. I would expect it would be, in some facet or another, covered by this. And not to pick on them, I am just trying to figure out who is covered and who is not? Ms. Bair. Right, I think we're talking about institutions of significant size and complexity. Yes, that would be my assumption. " CHRG-111hhrg51591--12 Chairman Kanjorski," Thank you very much, Mrs. Biggert. And now we will hear from the gentlelady from Illinois who is the co-author with Mr. Royce of a pending piece of legislation before the full committee. The gentlelady, Ms. Bean, for 3 minutes. Ms. Bean. Thank you, Mr. Chairman, and Ranking Member Garrett, for today's hearing and for yielding me time. The topic of today's hearing, how the Federal Government should oversee insurance, is a subject that Congressman Royce and I have worked on tirelessly for years to address the lack of Federal regulatory authority over the insurance industry. Our predominant focus has been on increasing consumer choice and protections, providing advantages to agents, and improving industry efficiency. Consumers tell us that they want product and pricing options, innovative new products available to them, the benefits of market pricing, consistency of products across State lines, and the peace of mind of knowing that they can preserve the trusted relationships with the agents that they have worked with even if they do move their families and their businesses, whether they be military, seniors, families, students, or small businesses. Agents are frustrated with the need to spend hours learning and training duplicative rules and regulations across State lines. Nationwide licensing, provided in our legislation, would allow them to eliminate that. They won't have to fight too hard to keep and grow their customer base, or have the unnecessary costs of those duplicative training efforts. And the $8- to $13 billion that the industry spends across those multiple bureaucracies would be saved and could be passed on to consumers in savings. Since we started working on this issue, much has changed in our system. After committing nearly $200 billion of taxpayer dollars to AIG, with more money expected to be granted to several other insurance companies, the need for Federal regulatory oversight has never been greater. In April, Congressman Royce and I introduced H.R. 1880, the National Insurance Consumer Protection Act, to create a national insurance regulator with the resources and authority to regulate insurance companies whose breadth and complexity far exceed the capabilities of the State-based system. H.R. 1880 is very different from past bills to create a national insurance regulator. This bill includes best-in-class nationwide investor and consumer protections exceeding the scope and resources of the current State system and any Federal legislation previously introduced on the subject. It establishes a national insurance commissioner to regulate national insurance companies, reinsurance, property and casualty, and life insurance, agencies, agents, and brokers, similarly as the Comptroller of the Currency regulates national banks. It will not only monitor insurance subsidiaries, but also the activities of the holding company in non-insurance affiliates, such as AIG's well-known financial products unit. Unlike national bank regulation, this bill includes strong protections against regulatory arbitrage by prohibiting nationally chartered insurers from switching to a State charter without the approval from the national insurance commissioner. Unlike past legislation, our bill deals with systemic risk. It recognizes that Congress will create a systemic risk regulator, which will subject all insurance companies, national or State-chartered, to a systemic risk review. In instances when an insurance company is deemed to be systematically significant, the systemic risk regulator and the national insurance commissioner can require an insurer to be regulated at the Federal level. The robust consumer protections of this bill provide best-in-class, uniform national consumer protections starting with the model market conduct laws of the NAIC, and localizes the office of national insurance by requiring each State to have a physical office of their division of consumer affairs. H.R. 1880 was recently introduced and intended to serve as a new starting point for the discussion of national insurance regulation. I believe the subcommittee should move a comprehensive bill that establishes Federal regulation of all lines of insurance, property and casualty, reinsurance, and life. Insurance rates should be actuarially sound not subject to arbitrary rate caps. And we should include strong, uniform consumer protections. I look forward to working with the chairman, our ranking member, and my colleagues toward that end. And I yield back. " 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. ______ CHRG-111hhrg74090--8 Mr. Waxman," Thank you very much. I want to thank you, Mr. Chairman, for holding this important hearing. Last year, as chairman of the House Oversight Committee, I held several hearings examining the causes of the financial crisis. Those hearings revealed a government regulatory structure that was unwilling and unable to meet the complexities of the modern economy. We found regulatory agencies that had fully abdicated their authority over banks and had done little or nothing to curb abusive practices like predatory lending. The prevailing attitude was that the market always knew best. Federal regulators became enablers rather than enforcers. The Obama Administration has developed an ambitious plan to address these failures and to strengthen accountability and oversight in the financial sector. Today's hearing will take a close look at one piece of that plan, the proposal to create a single agency responsible for protecting consumers of financial products. A new approach is clearly warranted. The banking agencies have shown themselves to be unwilling to put the interests of consumers ahead of the profit interests of the banks they regulate and the structure and division of responsibilities among these agencies has led to a regulatory race to the bottom. The Federal Trade Commission has taken steps to protect consumers but its jurisdiction is limited and it has been hampered by a slow and burdensome rulemaking process. I am pleased that this subcommittee is holding today's hearing and examining the Administration's proposal carefully. There are two areas of which attention and focus from this committee are particularly needed. First, the new agency must be structured to avoid the failures of the past. It only makes sense to create a new agency if that new agency will become a strong, authoritative voice for consumers. And second, we must ensure that the Federal Trade Commission is strengthened, not weakened, by any changes. Unlike the banking agencies, FTC has consumer protection as its core mission. In recent months, FTC has taken great strides to protect consumers of financial products, bringing enforcement actions against fraudulent debt settlement companies and writing new rules governing mortgages. The Administration's proposal would give most of the FTC's authority over financial practices and some of FTC's authority over privacy to the new agency. At the same time, the Administration proposes improving FTC's rulemaking authority and enforcement capabilities. It is not clear what impact these proposals would have on FTC or its ability to perform its consumer protection mission. As we build a new structure for protecting consumers of financial products, it is our responsibility to ensure that we do not weaken the agency currently responsible for consumer protections in this and many other areas. Once again, I thank Chairman Rush for holding this hearing. I welcome our witnesses to the committee and look forward to their testimony. " CHRG-111shrg51395--123 PREPARED STATEMENT OF PAUL SCHOTT STEVENS President and Chief Executive Officer, Investment Company Institute March 10, 2009Executive SummaryOverview: Recommendations for Financial Services Regulatory Reform The current financial crisis provides policymakers with the public mandate needed to take bold steps to strengthen and modernize our financial regulatory system. It is imperative to registered investment companies (also referred to as ``funds''), as both issuers of securities to investors and purchasers of securities in the market, that the regulatory system ensure strong investor protection and foster competition and efficiency in the capital markets. The ultimate outcome of reform efforts will have a direct and lasting effect on the fund industry and the millions of investors who choose funds to help them save for the future. As detailed in a recently released white paper (attached as Appendix A), ICI recommends: (1) establishing a Systemic Risk Regulator; (2) creating a Capital Markets Regulator representing the combined functions of the Securities and Exchange Commission and the Commodity Futures Trading Commission; (3) considering consolidation of the bank regulatory structure and authorization of an optional federal charter for insurance companies; and (4) enhancing coordination and information sharing among federal financial regulators. If enacted, these reforms would improve regulators' capability to monitor and mitigate risks across the financial system, enhance regulatory efficiency, limit duplication, close regulatory gaps, and emphasize the national character of the financial services industry.Systemic Risk Regulator The Systemic Risk Regulator should have responsibility for: (1) monitoring the financial markets broadly; (2) analyzing changing conditions in domestic and overseas markets; (3) evaluating the risks of practices as they evolve and identifying those that are of such nature and extent that they implicate the health of the financial system at large; and (4) acting in coordination with other responsible regulators to mitigate such risks. Careful consideration should be given to how the Systemic Risk Regulator will be authorized to perform its functions and its relationship with other, specialized regulators.Capital Markets Regulator The Capital Markets Regulator should have oversight responsibility for the capital markets, market participants, and all financial investment products. It should be the regulatory standard setter for funds, including money market funds. The agency's mission should focus on investor protection and law enforcement, as well as maintaining the integrity of the capital markets. Like the SEC, it should be required to consider whether proposed regulations protect investors and promote efficiency, competition, and capital formation. The Capital Markets Regulator should be an independent agency, with the resources to fulfill its mission and the ability to attract experienced personnel who can fully grasp the complexities of today's markets. ICI's white paper offers recommendations for organizing and managing the new agency and for how the agency can maximize its effectiveness.Selected Other Areas for Reform The Capital Markets Regulator should have express authority to regulate in areas where there are currently gaps that have the potential to impact the capital markets and market participants, and to modernize regulation that has not kept pace with changes in the marketplace. These areas include: (1) hedge funds; (2) derivatives; (3) municipal securities; and (4) the regulation of investment advisers and broker-dealers.Recent Market Events and Money Market Funds Money market funds, stringently regulated by the SEC, are one of the most notable product innovations in American history. These funds--which seek to offer investors stability of principal, liquidity, and a market-based rate of return, all at a reasonable cost--serve as an effective cash management tool for retail and institutional investors, and are an exceptionally important source of short-term financing in the U.S. economy. Until September 2008, money market funds, in some cases with support from their sponsors, largely weathered severe pressures in the fixed income markets that had been striking banks and other financial services firms since 2007. In mid- September, a series of extraordinary developments, including the failure of Lehman Brothers, roiled financial markets around the globe, affecting all market participants. In the midst of this market storm, one money market fund holding a substantial amount of Lehman commercial paper was unable to sustain its $1.00 price per share. The news of this fund ``breaking the buck,'' combined with broader concerns about the building stresses in the money market and possible failures of other financial institutions, led to heavy redemptions in prime money market funds as investors sought safety and liquidity in Treasury securities. Unprecedented government initiatives--designed to provide stability and liquidity to the markets and to support money market funds--successfully bolstered investor confidence. To date, the Treasury Temporary Guarantee Program for Money Market Funds has received no claims for its guarantee, and none are anticipated. Assuming continued progress in restoring the health of the money market, there will be no need to extend the Temporary Guarantee Program beyond its current one-year maximum period. To capture the lessons learned from recent experience, ICI formed a Money Market Working Group of senior fund industry leaders, led by John J. Brennan of The Vanguard Group. The Working Group has conducted a thorough examination of how the money market can function better, and how all funds operating in that market, including registered money market funds, should be regulated. The Working Group intends to report its findings, conclusions, and recommendations later this month. We believe that prompt implementation of its recommendations will help assure a smooth transition away from the Temporary Guarantee Program.Introduction My name is Paul Schott Stevens. I am President and CEO of the Investment CompanyInstitute, the national association of U.S. investment companies, including mutual funds, closed-end funds, exchange-traded funds (ETFs), and unit investment trusts (UITs). Members of ICI manage total assets of $9.88 trillion and serve over 93 million shareholders. ICI is pleased to testify today about investor protection and the regulation of securities markets. This hearing takes place at a time when the United States and a host of other nations are grappling with the most significant financial crisis in generations. In this country, the crisis has revealed significant weaknesses in our current system for oversight of financial institutions. At the same time, it offers an important opportunity for robust dialogue about the way forward. And it provides policymakers with the public mandate needed to take bold steps to strengthen and modernize regulatory oversight of the financial services industry. We strongly commend this Committee for the substantial attention it is devoting to examining the causes of the current crisis and considering how the regulatory system can best be improved, with particular focus on protecting consumers and investors. It is no exaggeration that the ultimate outcome of these reform efforts will have a direct and lasting impact on the future of our industry. By extension, the decisions you make will affect the millions of American investors who choose registered investment companies (also referred to as ``funds'') as investment vehicles to help them meet the costs of college, their retirement needs, or other financial goals. Funds themselves are among the largest investors in U.S. companies, holding about one quarter of those companies' outstanding stock. Funds also hold approximately 40 percent of U.S. commercial paper, an important source of short-term funding for corporate America, and more than one third of tax-exempt debt issued by U.S. municipalities. It is thus imperative to funds, as both issuers of securities to investors and purchasers of securities in the market, that our financial regulatory system ensure strong protections for investors and foster competition and efficiency within the capital markets. Like other stakeholders, we have been thinking very hard about how to revamp our current system so that our nation emerges from this crisis with stronger, well-regulated institutions operating within a fair, efficient, and transparent marketplace. Last week, 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 investment companies. \1\ Section II of my testimony provides a summary of these recommendations.--------------------------------------------------------------------------- \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 and attached as Appendix A.--------------------------------------------------------------------------- In addition to demonstrating the need to reform our financial regulatory system, events of the past year have highlighted the need for greater protections for both investors and the marketplace in several specific areas. Section III of my testimony outlines ICI's recommendations for legislative authority to address certain regulatory gaps that have the potential to affect the capital markets and market participants, and to modernize regulation that has not kept pace with changes in the marketplace. Finally, as discussed in Section IV of my testimony, events of the past year have brought into sharp focus the significance of money market funds and the critical role they play as a low-cost funding vehicle for the American economy. While the regulatory regime for money market funds has proven to be flexible and resilient, lessons learned from recent events suggested the need for a thorough examination of how the money market can function better and how all funds operating in that market should be regulated. To that end, ICI last November formed a working group of senior fund industry leaders with a broad mandate to develop recommendations in these areas. The Money Market Working Group is chaired by John J. Brennan, Chairman of The Vanguard Group, and expects to issue a detailed report by the end of March. We would welcome the opportunity to discuss with this Committee the recommendations of the Money Market Working Group following the release of its report.Financial Services Regulatory ReformOverview of ICI Recommendations Broadly speaking, ICI recommends changes to our regulatory structure that would create a framework to enhance regulatory efficiency, limit duplication, close regulatory gaps, and emphasize the national character of the financial services industry. To improve the government's capability to monitor and mitigate risks across the financial system, ICI supports the designation of a new or existing agency or inter-agency body as a ``Systemic Risk Regulator.'' A new ``Capital Markets Regulator'' should encompass the combined functions of the Securities and Exchange Commission and the Commodity Futures Trading Commission, thus creating a single independent federal regulator responsible for oversight of U.S. capital markets, market participants, and all financial investment products. ICI further recommends that Congress consider consolidating the regulatory structure for the banking sector and authorizing an optional federal charter for insurance companies. Such a regulatory framework--with one or more dedicated regulators to oversee each major financial services sector--would maintain specialized regulatory focus and expertise, as well as avoid the potential for one industry sector to take precedence over the others in terms of regulatory priorities or the allocation of resources. To ensure the success of this new financial regulatory structure, there must be effectivecoordination and information sharing among the financial regulators, including in particular the Systemic Risk Regulator. Stronger links among these regulators should greatly assist in developing sound policies and should facilitate U.S. cooperation with the international regulatory community. In our white paper, we discuss why the President's Working Group on Financial Markets, with certain modifications, may be the most logical mechanism through which to accomplish these purposes.Systemic Risk Regulator The current financial crisis has exposed the vulnerability of our financial system to risks that have the potential to spread rapidly throughout the system and cause significant damage. Analyses of the causes of the current crisis suggest that systemic risks may be occasioned by, for example, excessive leveraging, lack of transparency regarding risky practices, and gaps in the regulatory framework. ICI agrees with the growing consensus that our regulatory system needs to be better equipped to anticipate and address systemic risks affecting the financial markets. Some have called for the establishment of a ``Systemic Risk Regulator.'' Subject to important cautions, ICI supports designating a new or existing agency or inter-agency body to serve in this role. We recommend that the Systemic Risk Regulator have responsibility for: (1) monitoring the financial markets broadly; (2) analyzing changing conditions in domestic and overseas markets; (3) evaluating the risks of practices as they evolve and identifying those that are of such nature and extent that they implicate the health of the financial system at large; and (4) acting in coordination with other responsible regulators to mitigate such risks. The specifics of creating and empowering the Systemic Risk Regulator will require careful attention. By way of example, to perform its monitoring functions, this regulator likely will need information about a range of financial institutions and market sectors. The types of information that the regulator may require, and how the regulator will obtain that information, are just two of the discrete issues that will need to be fully considered. In ICI's view, legislation establishing the Systemic Risk Regulator should be crafted to avoid imposing undue constraints or inapposite forms of regulation on normally functioning elements of the financial system, or stifling innovations, competition, or efficiencies. For example, it has been suggested that a Systemic Risk Regulator could be given the authority to identify financial institutions that are ``systemically significant'' and to oversee those institutions directly. Despite its seeming appeal, such an approach could have very serious anticompetitive effects if the identified institutions were viewed as ``too big to fail'' and thus judged by the marketplace as safer bets than their smaller, ``less significant'' competitors. Additionally, the Systemic Risk Regulator should be carefully structured so as not to simply add another layer of bureaucracy or to displace the primary regulators responsible for capital markets, banking, or insurance. Legislation establishing the Systemic Risk Regulator thus should define the nature of the relationship between this new regulator and the primary regulators for these industry sectors. The authority granted to the Systemic Risk Regulator should be subject to explicit limitations, and the specific areas in which the Systemic Risk Regulator and the primary regulators should work together will need to be identified. We believe, for example, that the primary regulators have a critical role to play as the first line of defense for detecting potential risks within their spheres of expertise.Capital Markets Regulator Currently, securities and futures--and their respective markets and market participants--are subject to separate regulatory regimes under different federal regulators. This system reflects historical circumstances and is out of step with the increasing convergence of these two industries. It has resulted in jurisdictional disputes, regulatory inefficiency, and gaps in investor protection. To bring a consistent policy focus to U.S. capital markets, ICI recommends the creation of a Capital Markets Regulator as a new agency that would encompass the combined functions of the SEC and the CFTC. As the federal regulator responsible for overseeing the capital markets and all financial investment products, the Capital Markets Regulator--like the SEC and the CFTC--should be established as an independent agency, with an express statutory mission and the rulemaking and enforcement powers necessary to carry out that mission. It is critically important that the Capital Markets Regulator's statutory mission focus theagency sharply on investor protection and law enforcement, as distinct from the safety and soundness of regulated entities. At the same time, the Capital Markets Regulator (like the SEC today) should be required to consider, in determining whether a proposed regulation is consistent with the public interest, both the protection of investors and whether the regulation would promote efficiency, competition, and capital formation. The Capital Markets Regulator's mission also should include maintaining the integrity of the capital markets, which will benefit both market participants and consumers. Congress should ensure that the agency is given the resources it needs to fulfill its mission. Most notably, the Capital Markets Regulator must have the ability to attract personnel with the necessary market experience to fully grasp the complexities of today's global marketplace. ICI envisions the Capital Markets Regulator as the regulatory standard setter for registered investment companies, including money market funds (as is the case now with the SEC). In so authorizing this new agency, Congress would be continuing the important benefits that have flowed from the shared system of federal and state oversight established by the National Securities Markets Improvement Act of 1996. Under this system, federal law governs all substantive regulation of investment companies, and states have concurrent authority to protect against fraud. We believe that this approach is consistent with the national character of the market in which investment companies operate and would continue to achieve the regulatory efficiencies Congress intended, without compromising investor protection in any way. The Capital Markets Regulator should continue to regulate registered investment companies under the Investment Company Act of 1940. While funds are not immune to problems, the substantive protections embodied in the Investment Company Act and related rules have contributed significantly to the protection of investors and the continuing integrity of funds as an investment model. Among these protections are: (1) daily pricing and redeemability of the fund's shares, with a requirement to use mark-to-market valuation; (2) separate custody of fund assets (typically with a bank custodian); (3) restrictions on complex capital structures and leveraging; (4) prohibitions or restrictions on affiliated transactions and other forms of self-dealing; and (5) diversification requirements. In addition, funds are subject to more extensive disclosure and transparency requirements than any other financial product. This regulatory framework has proven resilient through difficult market conditions, and has shielded fund investors from some of the problems associated with other financial products and services. Indeed, recent experience suggests that consideration should be given to extending the greater discipline that has worked so well in core areas of fund regulation--such as valuation, \2\ independent custody, affiliated transaction prohibitions, leveraging restrictions, diversification, and transparency--to other marketplace participants.--------------------------------------------------------------------------- \2\ From the perspective of funds as investors in corporate and fixed income securities, ICI believes that financial reporting that requires the use of mark-to-market or fair value accounting to measure the value of financial instruments serves the interests of investors and the capital markets better than alternative cost-based measures. For a more detailed discussion of our views, see Letter from Paul Schott Stevens, President and CEO, Investment Company Institute, to The Honorable Christopher Cox, Chairman, U.S. Securities and Exchange Commission, dated November 14, 2008, available at http://www.ici.org/statements/cmltr/08_sec_mark-to-market_com.html--------------------------------------------------------------------------- With the establishment of a new Capital Markets Regulator, Congress has a very valuable opportunity to ``get it right'' in terms of how the new agency is organized and managed. Our white paper outlines several recommendations in this regard, including the need for high-level focus on management of the agency. We stress the importance, for example, of the agency's having open and effective lines of internal communication, mechanisms to facilitate internal coordination and information sharing, and a comprehensive process for setting regulatory priorities and assessing progress. ICI's white paper also suggests ways in which the Capital Markets Regulator would be able to maximize its effectiveness in performing its responsibilities. I would like to highlight two of the most significant suggestions for the Committee. First, the Capital Markets Regulator should seek to facilitate close, cooperative interaction with the entities it regulates as a means to identify and resolve problems, to determine the impact of problems or practices on investors and the market, and to cooperatively develop best practices that can be shared broadly with market participants. Incorporating a more preventative approach would likely encourage firms to step forward with self-identified problems and proposed resolutions. Second, the Capital Markets Regulator should establish mechanisms to stay abreast of market and industry developments. Ways to achieve this end include hiring more agency staff with significant prior industry experience and establishing by statute a multidisciplinary ``Capital Markets Advisory Committee'' comprised of private-sector representatives from all major sectors of the capital markets.Expected Benefits of These Reforms If implemented, the recommended reforms outlined above and discussed in detail in our white paper would help to establish a more effective and efficient regulatory structure for the U.S. financial services industry. Most significantly, these reforms would: Improve the U.S. government's capability to monitor and mitigate risks across our nation's financial system; Create a regulatory framework that enhances regulatory efficiency, limits duplication, and emphasizes the national character of the financial services industry; Close regulatory gaps to ensure appropriate oversight of all market participants and investment products; Preserve specialized regulatory focus and expertise while avoiding the potential for uneven attention to different industries or products; Foster a culture of close consultation and dialogue among U.S. financial regulators to facilitate collaboration on issues of common concern; and Facilitate coordinated interaction with regulators in other jurisdictions, including with regard to risks affecting global capital markets. We recognize that some have criticized sector-based regulation because it may not provide any one regulator with a full view of a financial institution's overall business, and does not give any single regulator authority to mandate actions designed to mitigate systemic risks across financial markets as a whole. Our proposed approach would address those concerns through the establishment of the Systemic Risk Regulator to undertake this market-wide monitoring of the financial system and through specific measures to strengthen inter-agency coordination and information sharing. We further believe that retaining some elements of the current multi-agency structure would offer advantages over a single, integrated regulator approach. Even though a single regulator could be organized with separate units or departments focusing on different financial services sectors, it is our understanding that, in practice, there can be a tendency for agency leadership or staff to gravitate to certain areas and devote insufficient attention to financial sectors perceived to be less high profile or prone to fewer problems. Such a result has the potential to stifle innovation valuable to consumers and produce regulatory disparities. Finally, we believe that a streamlining of the current regulatory structure may be more effective and workable than an approach that assigns regulatory responsibilities to separate agencies based on broad regulatory objectives, such as market stability, safety and soundness, and business conduct. These functions often are highly interrelated. Not only could separating them prove quite challenging, but it would force regulators to view institutions in a less integrated way and to operate with a narrower, less informed knowledge base. For example, a Capital Markets Regulator is likely to be more effective in protecting investors if its responsibilities require it to maintain a thorough understanding of capital market operations and market participants. And while an objective-based structure could be one way to promote consistent regulation of similar financial products and services, it is not the only way. Under our proposed approach, minimizing regulatory disparities for like products and services would be an express purpose of enhanced inter-agency coordination and information sharing efforts.Selected Other Areas for Reform Recent experiences in the markets have underscored the need for the Capital Markets Regulator (or, until Congress creates such a new agency, the SEC) to have express authority to regulate in certain areas where there are currently gaps that have the potential to impact the capital markets and market participants, and to modernize regulation that has not kept pace with changes in the marketplace. \3\ ICI supports reforms for these purposes in the areas discussed below.--------------------------------------------------------------------------- \3\ Although not necessitating legislative action, another area for reform is regulation of credit rating agencies. ICI has long supported increased regulatory oversight, disclosure, and transparency requirements for credit rating agencies. We strongly support recent regulatory initiatives that will impose additional disclosure, reporting, and recordkeeping requirements on a nationally recognized statistical ratings organization (NRSRO) for products that it rates. These requirements, which are intended to increase disclosure and transparency surrounding NRSRO policies and procedures for issuing ratings and to increase an NRSRO's accountability for its ratings, are a welcome step forward that should help to restore investor confidence in the integrity of credit ratings and, ultimately, the market as a whole. We expect to file a comment letter on the SEC's latest proposal to enhance NRSRO regulation at the end of this month. Hedge funds and other unregulated private pools of capital. The Capital Markets Regulator should have the power to oversee hedge funds and other unregulated pooled products with respect to, at a minimum, their potential impact on the capital markets. For example, the Capital Markets Regulator should require nonpublic reporting of information, such as investment positions and strategies, that could bear on systemic risk and --------------------------------------------------------------------------- adversely impact other market participants. Derivatives. The Capital Markets Regulator should have clear authority to adopt measures to increase transparency and reduce counterparty risk of certain over-the-counter derivatives, while not unduly stifling innovation. Municipal Securities. The Capital Markets Regulator should be granted expanded authority over the municipal securities market, and should use this authority to ensure that investors have timely access to relevant and reliable information about municipal securities offerings. Currently, the SEC and the Municipal Securities Rulemaking Board are prohibited from requiring issuers of municipal securities to file disclosure documents before the securities are sold. As a result, existing disclosures are limited, non-standardized, and often stale, and there are numerous disparities from the corporate issuer disclosure regime. Investment Advisers and Broker-Dealers. The Capital Markets Regulator should have explicit authority to harmonize the regulatory regimes governing investment advisers and broker- dealers. What once were real distinctions in the businesses of advisers and brokerdealers are no longer so clear, to the point that retail investors are largely unable to distinguish the services of an adviser from those of a broker-dealer. These two types of financial intermediaries, and their customers and clients, deserve a coherent regulatory structure that provides adequate investor protections without overlapping or unnecessary regulation. Of particular importance is devising a consistent standard of care in which investor protection must be paramount. The standard thus should be a high one. We recommend that both types of intermediaries be held to a fiduciary duty to their clients. \4\--------------------------------------------------------------------------- \4\ See Securities and Exchange Commission v. Capital Gains Research Bureau, Inc., 375 U.S. 180, 84 S. Ct. 275 (1963) (holding that Section 206 of the Investment Advisers Act of 1940 imposes a fiduciary duty on investment advisers by operation of law).---------------------------------------------------------------------------Recent Market Events and Money Market FundsEvolution and Current Significance of Money Market Funds Money market funds are registered investment companies that seek to maintain a stable net asset value (NAV), typically $1.00 per share. They are comprehensively regulated under the Investment Company Act and subject to the special requirements of Rule 2a-7 under that Act that limit the funds' exposure to credit risk and market risk. These strong regulatory protections, administered by the SEC for nearly three decades, have made money market funds an effective cash management tool for retail and institutional investors. Indeed, money market funds represent one of the most notable product innovations in our nation's history, with assets that have grown more than 2,000 percent (from about $180 billion to $3.9 trillion) since Rule 2a-7 was adopted in 1983. Money market fund assets thus represent about one third of an estimated $12 trillion U.S. ``money market,'' the term generally used to refer to the market for debt securities with a maturity of one year or less. \5\--------------------------------------------------------------------------- \5\ Other participants in the money market include corporations, state and local governments, unregistered cash pools, commercial banks, broker-dealers, and pension funds.--------------------------------------------------------------------------- Money market funds also are an exceptionally important source of short-term financing in the U.S. economy. They lower the cost of borrowing to the U.S. Treasury, businesses, and banks and finance companies by investing in a wide array of money market instruments. By way of example, money market funds hold roughly 40 percent of the commercial paper issued by U.S. corporations. In addition, tax-exempt money market funds are a significant source of funding for state and local governments. As of December 2008, these funds had $491 billion under management. Tax-exempt money market funds held more than 20 percent of all state and local government debt outstanding. Money market funds seek to offer investors stability of principal, liquidity, and a market-based rate of return, all at a reasonable cost. Although there is no guarantee that money market funds can always achieve these objectives (and investors are explicitly warned of this), they have been highly successful in doing so. Since Rule 2a-7 was adopted over 25 years ago, $325 trillion has flowed in and out of money market funds. Yet only twice has a money market fund failed to repay the full principal amount of its shareholders' investments. One of these instances is directly related to recent market events and is discussed below. The other occurred in 1994, when a small institutional money market fund ``broke the buck'' because it had a large percentage of its assets in adjustable-rate securities that did not return to par at the time of an interest rate readjustment. Shareholders in that fund ultimately received $0.96 per share (representing a 4 percent loss of principal). In contrast, during roughly the same time period, nearly 2,400 commercial banks and savings institutions have failed in the United States.Impact of Recent Market Events Until September 2008, money market funds largely had weathered severe pressures in the fixed income market that had been striking banks and other financial services firms since 2007. \6\ That changed as a series of extraordinary events, in rapid succession, roiled financial markets both in the United States and around the globe:--------------------------------------------------------------------------- \6\ During the period from September 2007 to September 2008, many money market fund advisers or related persons did purchase structured investment vehicles from, or enter into credit support arrangements with, their affiliated funds to avoid any fund shareholder losses. On September 7, the U.S. Government placed Fannie Mae and --------------------------------------------------------------------------- Freddie Mac intoreceivership, wiping out shareholder equity; Long-circulated rumors about the stability of Merrill Lynch, AIG, and Lehman Brothers gained traction; Over the weekend of September 13-14, Merrill Lynch hastily arranged to be sold to Bank of America; On September 15, the federal government declined to support Lehman Brothers, despite having arranged a buyout of Bear Stearns, a smaller investment bank, earlier in the year. Unable to find a buyer, Lehman declared bankruptcy; and On September 16, the Federal Reserve Board announced a bailout of AIG, in which the Federal Reserve Bank of New York agreed to lend AIG up to $85 billion and to take a nearly 80 percent stake in the company. Beginning with news of the Lehman bankruptcy on Monday, September 15, money markets in the U.S. and elsewhere began to freeze, with a severity that was unexpected. Although Lehman's viability had been questioned for several months, its failure--and that of Bear Stearns several months earlier--led to mounting concerns about the health of other financial institutions such as Wachovia, Citigroup, and many foreign banks. There was also growing uncertainty about whether and how the U.S. and foreign governments would support these institutions and their creditors. With investors running for cover, yields on Treasury securities fell, while those on commercial paper jumped. Inter-bank rates soared with the uncertainty about financial institutions' exposure to Lehman and other failing financial institutions. Governments around the globe, attempting to calm panicked markets, injected billions of dollars of liquidity into their markets. The U.S. stock market declined nearly 5 percent on September 15 alone, reflecting broad losses to financial companies. Certainly the Federal Reserve seems to have been surprised by the market's reaction to this chain of events. Appearing before this Committee on September 23, 2008, Federal Reserve Chairman Ben Bernanke noted: The failure of Lehman posed risks. But the troubles at Lehman had been well known for some time, and investors clearly recognized--as evidenced, for example, by the high cost of insuring Lehman's debt in the market for credit default swaps-- that the failure of the firm was a significant possibility. Thus, we judged that investors and counterparties had had time to take precautionary measures. While perhaps manageable in itself, Lehman's default was combined with the unexpectedly rapid collapse of AIG, which together contributed to the development last week of extraordinarily turbulent conditions in global financial markets. Intense pressure in the money market was brought to bear, affecting all market participants. In the midst of this market storm, a further pressure point occurred for money market funds. The Lehman bankruptcy meant that securities and other instruments issued by Lehman became ineligible holdings for money market funds, in accordance with the requirements of Rule 2a-7. One such fund that held a substantial amount of Lehman Brothers commercial paper, the $62 billion Reserve Primary Fund, received $25 billion in redemption requests on September 15; the following day, September 16, its NAV dropped below $1.00 per share. News of this development, combined with investors' broader concerns about the building stresses in the money market and possible failures of other financial institutions, led to heavy redemptions in prime money market funds as investors sought safety and liquidity in Treasury securities. To meet these unprecedented redemption requests, many money market funds were forced to sell commercial paper and other assets. It should be emphasized that other market participants, including unregistered cash pools seeking to maintain a stable NAV but not subject to Rule 2a-7, and money market funds in other jurisdictions, experienced difficulties as least as great as those experienced by U.S. registered money market funds.Actions by Federal Regulators To ``Unfreeze'' the Credit Markets The Federal Reserve and U.S. Treasury Department, seeking to cope with completely illiquid short-term fixed income markets, on September 19 announced a series of unprecedented initiatives designed to provide market stability and liquidity, including programs designed to support money market funds and the commercial paper market. The Federal Reserve established the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility (AMLF) and the Commercial Paper Funding Facility (CPFF). \7\ The Treasury Department announced its Temporary Guarantee Program for Money Market Funds, which guaranteed account balances as of September 19 in money market funds that signed up for, qualified for, and paid a premium to participate in the program. According to press reports, virtually all money market funds signed up for the initial term of the Treasury Temporary Guarantee Program.--------------------------------------------------------------------------- \7\ The AMLF provided non-recourse loans at the primary credit rate to U.S. depository institutions and bank holding companies to finance purchases of high-quality asset-backed commercial paper (ABCP) from money market funds. The CPFF provided a backstop to U.S. issuers of commercial paper through a special purpose vehicle that would purchase three-month unsecured commercial paper and ABCP directly from eligible issuers. On February 3, 2009, the Federal Reserve extended these and other programs for an additional six months, until October 30, 2009.--------------------------------------------------------------------------- The government's programs successfully bolstered investor confidence in the money market and in money market funds. Shortly after the programs were announced, prime money market funds stabilized and, by mid-October 2008, began to see inflows once again. By February 2009, owing to renewed confidence in money market funds at both the retail and institutional levels, assets of money market funds had achieved an all-time high of just less than $3.9 trillion. The initial three-month term of the Treasury Temporary Guarantee Program expired on December 18, 2008, but the Treasury Department extended the program until April 30, 2009. If extended again, the program will expire by its own terms no later than September 18, 2009. At the time of this hearing, an estimated $813 million has been paid in premiums. \8\ There has been--and we are hopeful that there will be--no occasion for the Treasury Guarantee Program to pay any claim. Assuming continued progress in restoring the health of the money market, we would not anticipate any need to extend the Treasury Guarantee Program beyond the one-year maximum period.--------------------------------------------------------------------------- \8\ See Shefali Anand, ``Treasury Pads Coffers in Bailout,'' The Wall Street Journal (February 17, 2009), available at http://online.wsj.com/article/SB123483112001495707.html---------------------------------------------------------------------------Industry-Led Reform Initiative The market events described above have brought into sharp focus the significance of money market funds and the critical role they play as a low-cost funding vehicle for the American economy. To us, these events and their impact also signaled a need to devote serious effort to capturing the lessons learned--by conducting a thorough examination of how the money market can function better, and how all funds operating in that market, including registered money market funds, should be regulated. To that end, in November 2008 ICI formed a Money Market Working Group, led by John J. Brennan, Chairman of The Vanguard Group. The Working Group was given a broad mandate to develop recommendations to improve the functioning of the money market as a whole, and the operation and regulation of funds investing in that market. The Working Group intends to report its findings, conclusions, and recommendations later this month, and we look forward to sharing that information with the Committee at that time. We believe that prompt implementation of the Working Group's recommendations will help assure a smooth transition away from the Treasury Guarantee Program.Conclusion ICI applauds the Committee for its diligent efforts on the very important issues discussed above, and we thank you for the opportunity to testify. We believe our recommendations for reforming financial services regulation would have significant benefits for investors and the capital markets. We look forward to continuing to work with the Committee and its staff on these matters.APPENDIX AInvestment Company Institute Financial Services Regulatory Reform: Discussion and Recommendations--March 3, 2009EXECUTIVE SUMMARY Today's financial crisis has demonstrated that the current system for oversight of U.S. financial institutions is insufficient to address modern financial markets. Yet it also affords policymakers with the public mandate necessary to take bold steps to strengthen and modernize regulatory oversight of the financial services industry. In this paper, the Investment Company Institute (ICI), the national association of U.S. investment companies, offers its recommendations on how to achieve meaningful reforms, with particular emphasis on those reforms that most directly affect the functioning of the capital markets and the regulation of investment companies (also referred to as ``funds''). To improve the U.S. government's capability to monitor and mitigate risks across our nation's financial system, ICI supports the designation of a new or existing agency or inter-agency body as a ``Systemic Risk Regulator.'' As the financial crisis has shown, our system is vulnerable to risks that have the potential to spread rapidly throughout the system and cause significant damage. The Systemic Risk Regulator should have responsibility for: (1) monitoring the financial markets broadly; (2) analyzing changing conditions in domestic and overseas markets; (3) evaluating the risks of practices as they evolve and identifying those that are of such nature and extent that they implicate the health of the financial system at large; and (4) acting to mitigate such risks in coordination with other responsible regulators. At the same time, very careful consideration should be given to the specifics of how the Systemic Risk Regulator will be authorized to perform its functions and how it will relate to other financial regulators. More broadly, ICI recommends changes to create a regulatory framework that enhances regulatory efficiency, limits duplication, closes regulatory gaps, and emphasizes the national character of the financial services industry. A new ``Capital Markets Regulator'' should encompass the combined functions of the Securities and Exchange Commission and the Commodity Futures Trading Commission, thus creating a single independent federal regulator responsible for oversight of U.S. capital markets, market participants, and all financial investment products. Also to achieve these goals, ICI recommends that Congress consider consolidation of the regulatory structure for the banking sector and authorization of an optional federal charter for insurance companies. Such a regulatory framework--with one or more dedicated regulators to oversee each major financial services sector--would maintain specialized regulatory focus and expertise, as well as avoid the potential for one industry sector to take precedence over the others in terms of regulatory priorities or the allocation of resources. To preserve regulatory efficiencies achieved under the National Securities Markets Improvement Act of 1996, Congress should affirm the role of the Capital Markets Regulator as the regulatory standard setter for all registered investment companies. The Capital Markets Regulator's jurisdiction should include money market funds. \1\ ICI further envisions the Capital Markets Regulator as the first line of defense with respect to risks across the capital markets. The new agency should be granted explicit authority to regulate in certain areas where there are currently gaps in regulation--in particular, with regard to hedge funds, derivatives, and municipal securities--and explicit authority to harmonize the legal standards applicable to investment advisers and broker-dealers. In performing its mission, the Capital Markets Regulator should maintain a sharp focus on investor protection and law enforcement. It also should be required to carefully consider the impact of its rulemaking activity on efficiency, competition and capital formation.--------------------------------------------------------------------------- \1\ ICI has formed a Money Market Working Group that is developing recommendations to improve the functioning of the money market and the operation and regulation of funds investing in that market. The group will identify needed improvements in market and industry practices; regulatory reforms, including improvements to SEC rules governing money market funds; and possibly legislative proposals. The Working Group expects to report its recommendations in the first quarter of 2009.--------------------------------------------------------------------------- Establishing the Capital Markets Regulator presents a very valuable opportunity to ``get it right'' in terms of how the agency is organized and managed. It is imperative, for example, that the Capital Markets Regulator be able to keep current with market and industry developments and understand their impact on regulatory policy. Ways to achieve this end include hiring more agency staff with significant prior industry experience and establishing a multidisciplinary ``Capital Markets Advisory Committee'' comprised of private sector representatives from all major sectors of the capital markets. There should be a high-level focus on agency management, perhaps through the designation of a Chief Operating Officer. To perform effectively, the agency must have open and effective lines of internal communication, and mechanisms to facilitate internal coordination and information sharing. We further suggest that the agency would benefit from a comprehensive process for setting regulatory priorities and assessing progress. Finally, if a new U.S. financial regulatory structure is to be successful in protecting the interests of our nation's savers and investors, there is a critical need for effective coordination and information sharing among the financial regulators, including in particular the Systemic Risk Regulator. Stronger links between regulators and an overriding sense of shared purpose would greatly assist in sound policy development, prioritization of effort, and cooperation with the international regulatory community. ICI observes that the President's Working Group on Financial Markets, with certain modifications, may be the most logical mechanism through which to accomplish this purpose. We strongly believe that the future of the fund industry depends upon the existence of strong, wellregulated financial institutions operating within a well-regulated financial marketplace that will promote investor confidence, attract global financial business, and enable our institutions to compete more effectively. ICI looks forward to working with other stakeholders and policymakers to strengthen the U.S. financial services regulatory system and to improve its ability to meet new challenges posed by the continuing evolution of the financial markets, market participants, and financial products.Introduction Well before mainstream Americans felt the widespread effects of the current financial crisis, many policymakers and commentators were calling for financial services regulatory reform. \2\ These efforts reflected general agreement that our current organization for oversight of financial institutions is insufficient to address modern financial markets. Recent market events have served to put into much sharper focus the many weaknesses of the current system and the many important linkages that exist between and among the U.S. financial markets and the markets of other developed nations.--------------------------------------------------------------------------- \2\ See, e.g., The Department of the Treasury Blueprint for a Modernized Financial Regulatory Structure (March 2008) (``Treasury Blueprint''), available at http://www.treas.gov/press/releases/reports/Blueprint.pdf; Report and Recommendations: Commission on the Regulation of U.S. Capital Markets in the 21st Century, U.S. Chamber of Commerce (March 2007), available at http://www.capitalmarketscommission.com/portal/capmarkets/default.htm; Sustaining New York's and the US' Global Financial Services Leadership (report by McKinsey & Co., Jan. 2007), at http://www.senate.gov/schumer/SchumerWebsite/pressroom/special_reports/2007/NY_REPORT%20_FINAL.pdf; Interim Report of the Committee on Capital Markets Regulation (Nov. 30, 2006), available on the Committee's Web site at http://www.capmktsreg.org/research.html--------------------------------------------------------------------------- Yet the current financial crisis also offers an important opportunity--the chance to have a frank and robust public dialogue about what works and what does not. It further affords policymakers with the public mandate necessary to take bold steps to strengthen and modernize regulatory oversight of the financial services industry. The debate over financial services regulatory reform will require careful consideration of a multitude of complicated and interconnected issues, and there are many stakeholders in the eventual outcomes of this debate--most importantly, the nation's savers and investors. In this paper, the Investment Company Institute (ICI), the national association of U.S. investment companies, \3\ offers its recommendations on how to achieve meaningful reform of financial services regulation. We give particular emphasis to reforms that most directly affect the functioning of the capital markets and the regulation of investment companies (also referred to as ``funds'').--------------------------------------------------------------------------- \3\ ICI members include mutual funds, closed-end funds, exchange-traded funds (ETFs) and unit investment trusts (UITs).--------------------------------------------------------------------------- Investment companies have a unique perspective on our regulatory system, as both issuers of securities and investors in domestic and international securities markets. It has been our experience that, in large measure, the needs of issuers and investors are aligned--that both will benefit from broad and efficient markets, transparency of information, strong investor protections, and within that context, the elimination of unnecessary regulatory impediments to innovation. We strongly believe that the future of our industry depends upon the existence of strong, well-regulated financial institutions operating within a well-regulated financial marketplace that will promote investor confidence, attract global financial business and enable our institutions to compete more effectively. The reforms suggested in this paper should help to build and foster such a financial system. Our recommendations and the benefits they are designed to achieve are summarized in Section II below. We elaborate on our recommendations in Section III (Establishment of a Systemic Risk Regulator), Section IV (Formation of a New Capital Markets Regulator), Section V (Regulatory Structure Affecting Other Financial Institutions), and Section VI (Enhanced Inter-agency Coordination and Information Sharing). In Section VII, we discuss in detail the expected benefits from these reforms. A host of different reform proposals are being advanced--by the new Administration, members of Congress, industry groups, academics, and others. ICI will closely follow these developments and participate in this debate on behalf of the fund industry. We also may refine as appropriate the views expressed in this paper.Summary of Recommendations and Expected BenefitsRecommendations for Reform ICI recommends that Congress: Designate a new or existing agency or inter-agency body to act as a Systemic Risk Regulator. Establish a new Capital Markets Regulator encompassing the combined functions of the Securities and Exchange Commission and the Commodity Futures Trading Commission. The Capital Markets Regulator should: be the regulatory standard setter for all registered investment companies, including money market funds; have explicit authority to regulate in certain areas where there are currently gaps in regulation and to harmonize the legal standards that apply to investment advisers and broker-dealers; maintain a sharp focus on investor protection and law enforcement; carefully consider as well the impact of its rulemaking activity on efficiency, competition and capital formation; serve as the first line of defense with respect to risks across the capital markets as a whole; and take proactive steps to maximize its continuing effectiveness, including: establishing the conditions necessary for ongoing dialogue with the regulated industry; establishing mechanisms to stay abreast of market/industry developments; and developing strong capability to conduct economic analysis to support sound rulemaking and oversight. Consider consolidation of the regulatory structure for the banking sector. Authorize an optional federal charter for insurance companies. Enhance inter-agency coordination and information sharing efforts, including by modernizing the Executive Order authorizing the President's Working Group on Financial Markets.Expected Benefits of These Reforms ICI believes the principal benefits of these reforms would be to: Improve the U.S. government's capability to monitor and mitigate risks across our nation's financial system. Create a regulatory framework that enhances regulatory efficiency, limits duplication, and emphasizes the national character of the financial services industry. Close regulatory gaps to ensure appropriate oversight of all market participants and investment products. Preserve specialized regulatory focus and expertise and avoid potential uneven attention to different industries or products. Foster a culture of close consultation and dialogue among U.S. financial regulators to facilitate collaboration on issues of common concern. Facilitate coordinated interaction with regulators in other jurisdictions, including with regard to risks affecting global capital markets.Establishment of a Systemic Risk Regulator Over the past year, various policymakers and other commentators have called for the establishment of a formal mechanism for identifying, monitoring, and managing risks to the financial system as a whole. For example, in a March 2008 speech, House Financial Services Committee Chairman Barney Frank (D-MA) recommended that Congress consider establishing a ``Financial Services Systemic Risk Regulator'' that has the capacity and power to assess risk across financial markets and to intervene when appropriate. \4\ Around the same time, then-Senator Barack Obama highlighted the need for a process that identifies systemic risks to the financial system. \5\--------------------------------------------------------------------------- \4\ See Frank Calls for Significant Changes in Financial Services Regulation, Press Release (March 20, 2008), available at http://financialservices.house.gov/press110/press0320082.shtml. Likewise, the Treasury Blueprint issued shortly thereafter suggested that an optimal regulatory structure would include the designation of a market stability regulator responsible for overall issues of financial market stability. \5\ See Remarks of Senator Barack Obama: Renewing the American Economy, New York, NY (March 27, 2008), available at http://www.barackobama.com/2008/03/27/remarks_of_senator_barack_obam_54.php--------------------------------------------------------------------------- The deepening financial crisis has further exposed the vulnerability of our financial system to risks that have the potential to spread rapidly throughout the system and cause significant damage. It has led to a growing consensus that bold steps are needed to equip regulators to better anticipate and address such risks. Analyses of the causes of the current crisis suggest that systemic risks may be occasioned by, for example: (1) excessive leveraging by financial institutions; (2) a lack of transparency regarding risky practices; and (3) institutions or activities that fall through gaps in the regulatory framework. Systemic risks--whether they are attributable to excessive risk taking by some market participants or to other causes--can negatively impact investment companies, thereby making it more difficult for their shareholders to achieve important financial goals. Subject to important cautions, ICI supports the designation of a new or existing agency or inter-agency body as a ``Systemic Risk Regulator.'' Broadly stated, the goal in establishing a Systemic Risk Regulator should be to provide greater overall stability to the financial system as a whole. The Systemic Risk Regulator should have responsibility for: (1) monitoring the financial markets broadly; (2) analyzing changing conditions in domestic and overseas markets; (3) evaluating the risks of practices as they evolve and identifying those that are of such nature and extent that they implicate the health of the financial system at large; and (4) acting to mitigate such risks in coordination with other responsible regulators. Very careful consideration must be given to the specifics of how the Systemic Risk Regulator will be authorized to perform its functions. In particular, the legislation establishing the Systemic Risk Regulator should be crafted to avoid imposing undue constraints or inapposite forms of regulation on normally functioning elements of the financial system, or stifling innovations, competition or efficiencies. By way of example, it has been suggested that a Systemic Risk Regulator could be given the authority to identify financial institutions that are ``systemically significant'' and to oversee those institutions directly. Despite its seeming appeal, such an approach could have very serious anticompetitive effects if the identified institutions were viewed as ``too big to fail'' and thus judged by the marketplace as safer bets than their smaller, ``less significant'' competitors. \6\--------------------------------------------------------------------------- \6\ See, e.g., Peter J. Wallison, Regulation Without Reason: The Group of Thirty Report, AEI Financial Services Outlook (Jan. 2009), available at http://www.aei.org/publications/pubID.29285/pub_detail.asp--------------------------------------------------------------------------- Additionally, the 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. Legislation establishing the Systemic Risk Regulator thus should define the nature of the relationship between this new regulator and the primary regulator(s) for each industry sector. This should involve placing explicit limitations on the extent of the authority granted to the Systemic Risk Regulator, as well as identifying specific areas in which the Systemic Risk Regulator and primary regulator(s) should work together. We believe, for example, that the primary regulators have a critical role to play by acting as the first line of defense with regard to detecting potential risks within their spheres of expertise. How these issues are resolved will have a very real impact on registered investment companies, as both issuers and investors in the capital markets. Money market funds, for example, are comprehensively regulated under the Investment Company Act of 1940 and subject to special requirements that limit the fund's exposure to credit risk and market risk. \7\ These strong regulatory protections, administered by the SEC for nearly three decades, have made money market funds an effective cash management tool for retail and institutional investors and an important source of short-term financing for American business and municipalities. Given the size of this industry segment \8\ and its important role in our nation's money markets, money market funds are likely to be on the radar screen of the Systemic Risk Regulator as it monitors the financial markets. The type of information about money market funds that the Systemic Risk Regulator may need to perform this function, and how the regulator will obtain that information, are just two of the specific issues that will need to be carefully considered. As a threshold matter, however, ICI firmly believes that regulation and oversight of money market funds must be the province of the Capital Markets Regulator.--------------------------------------------------------------------------- \7\ The term ``credit risk'' refers to the exposure of securities, through default or otherwise, to risks associated with the creditworthiness of the issuer. The term ``market risk'' refers to the exposure of securities to significant changes in value due to changes in prevailing interest rates. \8\ Money market funds had assets of approximately $3.9 trillion under management as of February 2009.--------------------------------------------------------------------------- ICI will closely follow the debate over the establishment of a Systemic Risk Regulator, and will inform policymakers as to the fund industry's views of future proposals.Formation of a New Capital Markets Regulator Currently, securities and futures are subject to separate regulatory regimes under different federal regulators. This system reflects historical circumstances that have changed significantly. As recently as the mid-1970s, for example, agricultural products accounted for most of the total U.S. futures exchange trading volume. By the late 1980s, a shift from the predominance of agricultural products to financial instruments and currencies was readily apparent in the volume of trading on U.S. futures exchanges. In addition, as new, innovative financial instruments were developed, the lines between securities and futures often became blurred. The existing, divided regulatory approach has resulted in jurisdictional disputes, regulatory inefficiency, and gaps in investor protection. With the increasing convergence of securities and futures products, markets, and market participants, the current system makes little sense. To bring a consistent policy focus to U.S. capital markets, we recommend the creation of a Capital Markets Regulator as a new agency that would encompass the combined functions of the SEC and the CFTC. As the federal regulator responsible for overseeing all financial investment products, it is imperative that the Capital Markets Regulator--like the SEC and the CFTC--be established by Congress as an independent agency, with an express statutory mission and the rulemaking and enforcement powers necessary to carry out that mission. \9\ A critical part of that mission should be for the new agency to maintain a sharp focus on investor protection and law enforcement. And Congress should ensure that the agency is given the resources it needs to fulfill its mission. Most notably, the Capital Markets Regulator must have the ability to attract personnel with the necessary market experience to fully grasp the complexities of today's global marketplace.--------------------------------------------------------------------------- \9\ Currently, regulatory oversight of both the securities and futures industries involves various self-regulatory organizations. In establishing the Capital Markets Regulator, Congress will need to determine the appropriate role for any such organization(s).---------------------------------------------------------------------------Scope of Authority ICI recommends that the Capital Markets Regulator assume on an integrated basis the responsibilities currently handled by the SEC and the CFTC. For the SEC, those functions include requiring public companies to disclose financial and other information to the public; overseeing various market participants, including securities exchanges, broker-dealers, investment advisers, and investment companies; and enforcing the securities laws. The SEC also oversees the setting of accounting standards for public companies. For its part, the CFTC regulates the commodity futures and option markets. It oversees various entities including exchanges, clearing facilities, and market participants such as futures commission merchants, commodity pool operators, and commodity trading advisors. Through its oversight and enforcement powers, it seeks to protect market users and the public from fraud, manipulation, and abusive practices. Of particular importance to the fund industry is to ensure that the Capital Markets Regulator is authorized: (1) to act as the regulatory standard setter for all registered investment companies, as is the case now with the SEC; (2) to regulate in certain areas where there are currently gaps that have the potential to impact the capital markets and market participants; and (3) to regulate broker-dealers and investment advisers in a consistent manner when they provide similar services to investors. 1. Regulation of Registered Investment Companies: In creating the new regulator, Congress should take note of the important benefits that have flowed from the shared system of federal-state oversight established by the National Securities Markets Improvement Act of 1996 (NSMIA). Under this system, federal law governs all substantive regulation of investment companies and states have concurrent authority to protect against fraud. NSMIA represented the judgment of Congress that ``the system of dual federal and state securities regulation ha[d] resulted in a degree of duplicative and unnecessary regulation . . . that, in many instances, [was] redundant, costly, and ineffective.'' \10\ In recognition of the national character of the market in which investment companies operate, and to secure the regulatory efficiencies Congress intended, Congress should affirm the role of the Capital Markets Regulator as the regulatory standard setter for registered investment companies. The Capital Markets Regulator's regulatory jurisdiction should include the authority to regulate money market funds. \11\--------------------------------------------------------------------------- \10\ Joint Explanatory Statement of the Committee of Conference, Conference Report--National Securities Markets Improvement Act of 1996, H.R. 3005, H.R. Conf. Rep. No. 104-864 (1996). \11\ ICI has formed a Money Market Working Group that is developing recommendations to improve the functioning of the money market and the operation and regulation of funds investing in that market. The group will identify needed improvements in market and industry practices; regulatory reforms, including improvements to SEC rules governing money market funds; and possibly legislative proposals. The Working Group expects to report its recommendations in the first quarter of 2009.--------------------------------------------------------------------------- 2. Regulatory Gaps: The Capital Markets Regulator should have express regulatory authority in the following areas: Hedge funds and other unregulated private pools of capital. The Capital Markets Regulator should be authorized to provide oversight over hedge funds and other unregulated pooled products with respect to, at a minimum, their potential impact on the capital markets (e.g., require nonpublic reporting of information such as investment positions and strategies that could bear on systemic risk and adversely impact other market participants). Derivatives. The Capital Markets Regulator should have clear authority to adopt measures to increase transparency and reduce counterparty risk of certain over-the-counter derivatives, while not unduly stifling innovation. Municipal Securities. The Capital Markets Regulator should be granted expanded authority over the municipal securities market, and use this authority to ensure that investors have timely access to relevant and reliable information about municipal securities offerings. Currently, the SEC and the Municipal Securities Rulemaking Board are prohibited from requiring issuers of municipal securities to file disclosure documents before the securities are sold. As a result, existing disclosures are limited, non-standardized and often stale, and there are numerous disparities from the corporate issuer disclosure regime. 3. Regulation of Investment Advisers and Broker-Dealers: The Capital Markets Regulator also should have explicit authority to harmonize the regulatory regimes governing investment advisers and broker-dealers. What once were real distinctions in the businesses of advisers and broker-dealers are no longer so clear, to the point that retail investors are largely unable to distinguish the services of an adviser from those of a broker-dealer. These two types of financial intermediaries, and their customers and clients, deserve a coherent regulatory structure that provides adequate investor protections--including, in particular, a consistent standard of care--without overlapping or unnecessary regulation.Mission The SEC describes its mission as ``to protect investors, maintain fair, orderly and efficient markets, and facilitate capital formation.'' For its part, the CFTC states that its mission is ``to protect market users and the public from fraud, manipulation and abusive practices related to the sale of commodity and financial futures and options, and to foster open, competitive, and financially sound futures and options markets.'' The differing focus expressed in these two mission statements is reflective of historical distinctions in the securities and futures industries, including with regard to the purposes of their respective markets and the participants in those markets. As growing convergence within these two industries suggests the creation of a unified regulator for the capital markets, it is important to consider how the mission statement for the new regulator can best reflect this convergence. From the perspective of the fund industry, the mission of the Capital Markets Regulator must involve maintaining a sharp focus on investor protection, supported by a comprehensive enforcement program. This core feature of the SEC's mission has consistently distinguished the agency from the banking regulators, who are principally concerned with the safety and soundness of the financial institutions they regulate, and it has generally served investors well over the years. At the same time, the SEC is required by NSMIA to consider, in determining whether a proposed regulation is consistent with the public interest, both the protection of investors and whether the regulation would promote efficiency, competition and capital formation. This NSMIA requirement suggests that Congress did not view investor protection and efficiency, competition, and capital formation as being competing considerations, but rather determined that each is relevant to the development of sound capital markets regulation. We strongly believe that the Capital Markets Regulator should be subject to the same requirements. \12\ Investors are not well served, for example, by rulemaking actions that create significant inefficiencies or have anti-competitive effects in the marketplace, which ultimately result in increased costs for investors.--------------------------------------------------------------------------- \12\ Curiously, the SEC's description of its own mission (see http://www.sec.gov/about/whatwedo.shtml) omits any reference to promoting competition--notwithstanding the specific requirement under NSMIA to consider this factor.--------------------------------------------------------------------------- Combining the market-related missions of the SEC and CFTC should be more straightforward. Generally speaking, each agency is called upon to maintain the integrity of the markets under its jurisdiction. The same must be true for the new Capital Markets Regulator. As the ongoing financial crisis demonstrates, it is imperative that the task of maintaining market integrity be viewed broadly to include monitoring and addressing risks across the markets as a whole. Formally assigning some level of responsibility to the Capital Markets Regulator in this area makes sense. Given its expertise and its position as the primary regulator of these markets, the Capital Markets Regulator can serve as the first line of defense with regard to detecting problems in the capital markets. While this approach could result in some potential overlap with the responsibilities of the Systemic Risk Regulator, we believe that any inefficiencies may be minimized through effective coordination and information sharing.Agency Management and Organization It is axiomatic in the private sector that a company's success is directly related to the soundness of its management. The same principle holds true for public sector entities. But management improvements take time and serious attention, not to mention allocation of resources. Given that they often experience frequent turnovers in leadership and strained resources, it is not surprising that government agencies can find it particularly difficult to undertake and sustain significant management reforms. Establishing a new agency presents a very valuable opportunity to ``get it right'' as part of that process. There is also an opportunity to make sound decisions up-front about how to organize the new agency. In so doing, it is important not to simply use the current structure of the SEC and/or the CFTC as a starting point. In the case of the SEC, for example, its current organizational structure largely took shape in the early 1970s and reflects the operation of the securities markets of that day. Rather, the objective should be to build an organization that not only is more reflective of today's markets, market participants and investment products, but also will be flexible enough to regulate the markets and products of tomorrow. We offer the following thoughts with regard to management and organization of the Capital Markets Regulator: Ensure high-level focus on agency management. One approach would be to designate a Chief Operating Officer for this purpose. Implement a comprehensive process for setting regulatory priorities and assessing progress. It may be helpful to draw upon the experience of the United Kingdom's Financial Services Authority, which seeks to follow a methodical approach that includes developing a detailed annual business plan establishing agency priorities and then reporting annually the agency's progress in meeting prescribed benchmarks. Promote open and effective lines of communication among the regulator's Commissioners and between its Commissioners and staff. Such communication is critical to fostering awareness of issues and problems as they arise, thus increasing the likelihood that the regulator will be able to act promptly and effectively. A range of approaches may be appropriate to consider in meeting this goal, including whether sufficient flexibility is provided under the Government in the Sunshine Act, and whether the number of Commissioners should be greater than the current number at the SEC and at the CFTC (currently, each agency has five). Align the inspections and examinations functions and the policymaking divisions. This approach would have the benefit of keeping staff in the policymaking divisions updated on current market and industry developments, as well as precluding any de facto rulemaking by the regulator's inspections staff. Develop mechanisms to facilitate coordination and information sharing among the policymaking divisions. These mechanisms would help to ensure that the regulator speaks with one voice.Additional Steps To Maximize Effectiveness ICI believes that the following proactive steps will greatly enhance the ability of the Capital Markets Regulator to fulfill its mission successfully when carrying out its regulatory responsibilities and should be priorities for the new agency. 1. Establish the conditions necessary for constructive, ongoing dialogue with the regulated industry: The Capital Markets Regulator should seek to facilitate closer, cooperative interaction with the entities it regulates to identify and resolve problems, to determine the impact of problems or practices on investors and the market, and to cooperatively develop best practices that can be shared broadly with market participants. Incorporating a more preventative approach would likely encourage firms to step forward with self-identified problems and proposed resolutions. The net result is that the Capital Markets Regulator would pursue its investor protection responsibilities through various means not always involving enforcement measures, although strong enforcement must remain an important weapon in the regulator's arsenal. 2. Establish mechanisms to stay abreast of market and industry developments: The Capital Markets Regulator would benefit from the establishment of one or more external mechanisms designed to help the agency stay abreast of market and industry issues and developments, including developments and practices in non-U.S. jurisdictions as appropriate. For example, several federal agencies--including both the SEC and CFTC--utilize a range of advisory committees. Such committees, which generally have significant private sector representation, may be established to provide recommendations on a discrete set of issues facing the agency (e.g., the SEC's Advisory Committee on Improvements to Financial Reporting) or to provide regular information and guidance to the agency (e.g., the CFTC's Agricultural Advisory Committee). ICI believes that a multidisciplinary ``Capital Markets Advisory Committee'' could be a very effective mechanism for providing the Capital Markets Regulator with ``real world'' perspectives and insights on an ongoing basis. We recommend that such a committee be comprised primarily of private sector representatives from all major sectors of the capital markets, and include one or more members representing funds and asset managers. Additionally, the Capital Markets Advisory Committee should be specifically established in, and required by, the legislation creating the Capital Markets Regulator. Such a statutory mandate would emphasize the importance of this advisory committee to the agency's successful fulfillment of its mission. The establishment of an advisory committee would complement other efforts by the Capital Markets Regulator to monitor developments affecting the capital markets and market participants. These efforts should include, first and foremost, hiring more staff members with significant prior industry experience. Their practical perspective would enhance the agency's ability to keep current with market and industry developments and better understand the impact of such developments on regulatory policy. 3. Apply reasonably comparable regulation to like products and services: Different investment products often are subject to different regulatory requirements, often with good reason. At times, however, heavier regulatory burdens have been placed on funds than on other investment products that share similar features and are sold to the same customer base. It does not serve investors well if the regulatory requirements placed on funds--however well-intentioned--end up discouraging investment advisers from entering or remaining in the fund business, dissuading portfolio managers from managing funds as opposed to other investment products, or creating disincentives for brokers and other intermediaries to sell fund shares. It is critically important for the Capital Markets Regulator to be sensitive to this dynamic in its rulemakings. Among other things, in analyzing potential new regulatory requirements for funds, the Capital Markets Regulator should consider whether other investment products raise similar policy concerns and thus should be subject to comparable requirements. 4. Develop strong capability to conduct economic analysis to support sound rulemaking and oversight: The Capital Markets Regulator will be best positioned to accomplish its mission if it conducts economic analysis in various aspects of the agency's work, including rulemaking, examinations, and enforcement. Building strong economic research and analytical capabilities is an important way to enhance the mix of disciplines that will inform the agency's activities. From helping the agency look at broad trends that shed light on how markets or individual firms are operating to enabling it to demonstrate that specific policy initiatives are well-grounded, developing the agency's capability to conduct economic analysis will be well worth the long-term effort required. The agency should consider having economists resident in each division to bring additional, important perspectives to bear on regulatory challenges. It is important that economic analysis play an integral role in the rulemaking process, because many regulatory costs ultimately are borne by investors. When new regulations are required, or existing regulations are amended, the Capital Markets Regulator should thoroughly examine all possible options and choose the alternative that reflects the best trade-off between costs to, and benefits for, investors. Effective cost-benefit analysis does not mean compromising protections for investors or the capital markets. Rather, it challenges the regulator to consider alternative proposals and think creatively to achieve appropriate protections while minimizing regulatory burdens, or to demonstrate that a proposal's costs and burdens are justified in light of the nature and extent of the benefits that will be achieved. \13\--------------------------------------------------------------------------- \13\ See, e.g., Special Report on Regulatory Reform, Congressional Oversight Panel (submitted under Section 125(b)(2) of Title I of the Emergency Economic Stabilization Act of 2008) (Jan. 2009) (``In tailoring regulatory responses . . . the goal should always be to strike a reasonable balance between the costs of regulation and its benefits. Just as speed limits are more stringent on busy city streets than on open highways, financial regulation should be strictest where the threats--especially the threats to other citizens--are greatest, and it should be more moderate elsewhere.'').--------------------------------------------------------------------------- 5. Modernize regulations that no longer reflect current market structures and practices: Financial markets and related services are constantly evolving, frequently at a pace that can make the regulations governing them (or the rationale behind those regulations) become less than optimal, if not entirely obsolete. Requiring industry participants to comply with outmoded regulations imposes unnecessary costs on both firms and investors, may impede innovation, and, most troubling of all, could result in inadequate protection of investors. It is thus important that the Capital Markets Regulator engage in periodic reviews of its existing regulations to determine whether any such regulations should be modernized or eliminated. 6. Give heightened attention to investor education: During the course of their lives, investors are called upon to make a variety of investment decisions as their personal circumstances change. These decisions may involve saving to buy a home or to finance a child's education, building an adequate nest egg for retirement, or investing an inheritance, to name a few. Whether they make their investment decisions individually or with the help of a financial adviser, investors need to be able to make informed decisions based upon their individual needs. The recent turmoil in the financial markets has underscored how important it is that investors be knowledgeable and understand their investments. Well-informed investors are more likely to develop realistic expectations, take a long-term perspective, and understand the trade-off between risk and reward. They are less likely to panic and make mistakes. To better equip investors to make good decisions about their investments, the Capital Markets Regulator should assign a high priority to pursuing regulatory initiatives that will help educate investors. The SEC's new rule allowing mutual funds and exchange-traded funds to provide a ``summary prospectus'' containing key fund information to investors--while making additional information available online or by mail or e-mail upon request--is an excellent example of a forward thinking approach to better informing investors. It should serve as a model for future disclosure improvement efforts, such as reform of fund shareholder reports. Regulatory efforts to promote investor education also should extend beyond funds. Investors who purchase other types of investment products or services, such as separately managed accounts, likewise would benefit from clear, concise, understandable disclosure. In addition, appropriately fashioned point of sale disclosure would help investors in all types of retail investment products assess and evaluate broker recommendations. The SEC has an Office of Investor Education and Advocacy and provides some investor education resources on its Web site. These types of efforts should be expanded, possibly in partnership with other governmental or private entities, and better publicized. Many industry participants, too, have developed materials and other tools to help educate investors; additional investor outreach efforts should be encouraged.Process of Merging the SEC and CFTC Legislation to merge the SEC and CFTC should outline a process by which to harmonize the very different regulatory philosophies of the two agencies, as well as to rationalize their governing statutes and current regulations. We note that there is potential peril in leaving open-ended the process of merging the two agencies. We accordingly recommend that the legislation creating the Capital Markets Regulator set forth a specific timetable, with periodic benchmarks and accountability requirements, so as to ensure that the merger of the SEC and CFTC is completed as expeditiously as possible. The process of merging the two agencies will be lengthy, complex, and have the potential to disrupt the functioning of the SEC, CFTC, and their regulated industries. We suggest that, in anticipation of the merger, the SEC and CFTC undertake detailed consultation on all relevant issues and take all steps possible toward greater harmonization of the agencies. This work should be facilitated by the Memorandum of Understanding the two agencies signed last year regarding coordination in areas of common regulatory interest. \14\ ICI believes that its recommendations with respect to the Capital Markets Regulator may provide a helpful framework for these efforts.--------------------------------------------------------------------------- \14\ See SEC, CFTC Sign Agreement to Enhance Coordination, Facilitate Review of New Derivative Products (SEC press release dated March 11, 2008), available at http://www.sec.gov/news/press/2008/2008-40.htm---------------------------------------------------------------------------Regulatory Structure Affecting Other Financial Institutions Earlier in this paper, we have recommended the establishment of a Systemic Risk Regulator, and we have discussed at length the need for a new Capital Markets Regulator to oversee markets and market participants in the securities and futures industries. In this section and the one immediately following, we comment briefly on reforms affecting the regulators overseeing other sectors of the U.S. financial system (specifically, banking and insurance) and how all regulators within the system can work together more effectively. Regulation of the banking and insurance industries is, quite obviously, not ICI's primary area of focus. That said, regulation of these industries greatly affects the performance of the U.S. financial system as a whole and the ability of investment companies to function within that system. ICI believes it is important, therefore, for policymakers to carefully consider how to achieve a more rational regulatory structure for the banking sector that consolidates duplicative regulatory agencies and clarifies regulatory missions. Any such analysis would no doubt need to address difficult issues concerning the future role of state banking regulators if we are to have a more rational regulatory system at the national level. With regard to the insurance industry, ICI supports in concept the idea of creating a regulator at the federal level, a reform that has been sought by some insurance companies as a means of providing a streamlined and efficient alternative to the current system of state regulation. Authorizing an optional federal charter for insurers appears to be a logical way to bridge the gap between what exists today and the more comprehensive approach that is required for all financial institutions operating in truly national and often international markets. We also believe that a federal insurance regulator would provide an important and practical enhancement to federal inter-agency coordination and information sharing efforts, as discussed below.Enhanced Inter-Agency Coordination and Information Sharing A recent report examined the benefits and shortcomings of the four primary approaches to regulatory supervision currently used in jurisdictions around the world. \15\ The report observed that, regardless of the type of supervisory system in place, virtually all financial supervisors emphasized the importance of inter-agency coordination and information sharing for successful oversight of the financial system as a whole and for mitigation of systemic risk.--------------------------------------------------------------------------- \15\ See Group of Thirty, The Structure of Financial Supervision: Approaches and Challenges in a Global Marketplace (Oct. 6, 2008), available at http://www.deloitte.com/dtt/cda/doc/content/us_fsi_banking_G30%20Final%20Report%2010-3-08.pdf--------------------------------------------------------------------------- Effective inter-agency coordination also plays a critical role when there is a need to engage on financial services regulatory issues at an international level. The variety of supervisory systems around the world and the increasing globalization of financial markets make coordination among U.S. regulatory agencies all the more important. In the United States at present, a variety of mechanisms are used to promote coordination and information sharing within our complex regulatory system, including arrangements at both the Federal and State levels and arrangements among federal and state agencies. These arrangements may be specifically mandated by Congress, such as the inter-agency Federal Financial Institutions Examination Council, or may be initiated by the regulators themselves, such as the July 2008 Memorandum of Understanding between the Federal Reserve and the SEC to foster greater coordination and information sharing. \16\ One particularly important mechanism for the past two decades has been the President's Working Group on Financial Markets, whose members are the heads of the Treasury Department, Federal Reserve, SEC and CFTC. As described in the Treasury Blueprint, the role of the PWG has evolved beyond the scope of the 1988 Executive Order creating it, so that the PWG has become a key communication and coordination mechanism for financial policy.--------------------------------------------------------------------------- \16\ See, e.g., SEC, FRB Sign Agreement to Enhance Collaboration, Coordination, and Information Sharing (SEC press release dated July 7, 2008), available at http://www.sec.gov/news/press/2008/2008-134.htm--------------------------------------------------------------------------- If efforts to streamline the U.S. financial regulatory structure are to be successful, some of these coordination mechanisms would almost certainly require modification or perhaps would no longer be necessary. There would, however, still be a very critical need for coordination and information sharing among the remaining regulatory bodies, presumably with involvement in particular by the Systemic Risk Regulator. The President's Working Group, with necessary modifications, would appear to be the easiest way to achieve this end. ICI concurs with the recommendation in the Treasury Blueprint that the Executive Order authorizing the PWG should be modernized ``to reinforce the group's mission and purpose . as an ongoing mechanism for coordination and communication on financial policy matters including systemic risk, market integrity, investor and consumer protection, and capital markets competitiveness.'' We suggest that any new Executive Order also discuss the following additional areas where inter-agency coordination and information sharing are critically important: (1) the regular exchange of information about the latest market and industry developments, including international trends and developments; (2) the discussion of policy initiatives that extend across jurisdictional lines; (3) the minimization of regulatory disparities for like financial products and services; and (4) the need to balance financial innovation with appropriate market and investor protection safeguards. Equally important, in ICI's view, is the role of the PWG in fostering a culture of close consultation and dialogue among senior officials within each regulatory sector that will carry over into each regulator's dealings with one another. Stronger links between regulators and an overriding sense of shared purpose would greatly assist in sound policy development, prioritization of effort, and cooperation with the international regulatory community.Expected Benefits From These Reforms If implemented, the recommended reforms outlined above would help to establish a more effective and efficient regulatory structure for the U.S. financial services industry. Most significantly, these reforms would: Improve the U.S. government's capability to monitor and mitigate risks across our nation's financial system. Create a regulatory framework that enhances regulatory efficiency, limits duplication, and emphasizes the national character of the financial services industry. Close regulatory gaps to ensure appropriate oversight of all market participants and investment products. Preserve specialized regulatory focus and expertise and avoid potential uneven attention to different industries or products. Foster a culture of close consultation and dialogue among U.S. financial regulators to facilitate collaboration on issues of common concern. Facilitate coordinated interaction with regulators in other jurisdictions, including with regard to risks affecting global capital markets. Of significant import to registered investment companies, creation of a consolidated Capital Markets Regulator would provide a single point of regulatory authority and consistent rulemaking and oversight for investment products, the capital markets, and market participants. It would create regulatory efficiencies by eliminating areas where responsibilities overlap and by ensuring against regulatory gaps and potential inconsistencies. A strong, integrated regulator for the capital markets that can see ``the whole picture'' will be better equipped to face the challenges of these rapidly evolving markets, and thus to protect the interests of investors. More generally, increased consolidation of financial services regulators, combined with the establishment of a Systemic Risk Regulator and more robust inter-agency coordination and information sharing, should facilitate monitoring and mitigation of risks across the financial system. It also should result in increased regulatory efficiency, including less duplication, and help to eliminate regulatory gaps. Consolidation of regulatory agencies also may further the competitive posture of the U.S. financial markets. It may make it easier to harmonize U.S. regulations with regulations in other jurisdictions when that is appropriate. And reducing the number of U.S. regulatory agencies, while also strengthening the culture of cooperation and dialogue among senior officials of the agencies, will likely facilitate coordinated interaction with regulators around the world. By providing for one or more dedicated regulators to oversee each major financial services sector, the proposed structure would maintain the specialized focus and expertise that is a hallmark of effective regulation. This structure also would allow appropriate tailoring of regulation to accommodate fundamental differences in regulated entities, products and activities. Additionally, it would avoid the potential for one industry sector to take precedence over the others in terms of regulatory priorities or approaches or the allocation of regulatory resources. ICI recognizes that some have criticized sector-based regulation because it may not provide any one regulator with a full view of a financial institution's overall business, and does not give any single regulator authority to mandate actions designed to mitigate systemic risks across financial markets as a whole. Our proposed approach would address those concerns through the establishment of the Systemic Risk Regulator and specific measures to strengthen inter-agency coordination and information sharing. We further believe that retaining some elements of the current multi-agency structure likely would offer advantages over a single, integrated regulator approach. Even though a single regulator could be organized with separate units or departments focusing on different financial services sectors, it is our understanding that, in practice, there can be a tendency for agency staff to ``gravitate'' to certain areas and devote insufficient attention to financial sectors perceived to be less high profile or prone to fewer problems. Such a result has the potential to stifle innovation valuable to consumers and produce regulatory disparities. Finally, we believe that a streamlining of the current regulatory structure may be more effective and workable than an approach that assigns regulatory responsibilities to separate agencies based on broad regulatory objectives (e.g., market stability, safety and soundness, and business conduct). These functions often are highly interrelated. Not only could separating them prove quite challenging, but it would force regulators to view institutions in a less integrated way and to operate with a narrower, less informed knowledge base. For example, a Capital Markets Regulator is likely to be more effective in protecting investors if its responsibilities require it to maintain a thorough understanding of capital market operations and market participants. And while an objective-based structure could be one way to promote consistent regulation of similar financial products and services, it is not the only way. Under our proposed approach, minimizing regulatory disparities for like products and services would be an express purpose of enhanced inter-agency coordination and information-sharing efforts. ______ CHRG-111hhrg51698--490 Mr. Concannon," Absolutely. Today the OTC derivatives market is a phone-based market. The only difference of NASDAQ when it was formed and the equities market at the time was that it had centralized clearing. It allowed us to form a market around this centralized clearing and bring pricing transparency to an otherwise inefficient market. OTC derivatives today, given the bilateral nature of the product, the product is actually priced based on your creditworthiness. That doesn't exist in things that are centrally cleared. We standardize creditworthiness through a clearinghouse and a system of margin, standardized margin, and collateral collection. So, just like any equity owner can buy a share of Microsoft and they are not judged on their status and their financial well-being, they don't pay a different price. And that can be delivered in the over-the-counter derivatives market. I think it is important, though, that we take steps. Clearing first is an important concept here because of the nature of the market today. It is a highly complex market. And it can continue to be a phone-based market, but we can eliminate a lot of the counterparty risk by just introducing mandated clearing. " CHRG-111hhrg52407--9 Mr. Cleaver," Thank you, Mr. Chairman. I appreciate very much the hearing. I am very much concerned about the issue of financial literacy. The purpose of this hearing is to discuss plain-language initiatives and financial literacy promotion. Both of these subjects are extremely important to me. And I have advocated in our hearings over the years for plain language. In fact, in the 2006 GAO report, ``Increased Complexity in Rates and Fees Heightens Need For More Effective Disclosure to Consumers,'' is I think a bold and accurate statement about what is needed. Some credit card disclosure statements, and I think all of you are familiar with this, are written in 27th grade language. That is 12 years of high school and 12 years of college and 3 years of graduate school. And this sort of deliberate and sometimes deceptive way of presenting credit card information is at worst appalling and despicable, and at best, just plain arrogant. Plain-language regulations could go far to help eliminate these misleading and confusing practices. When I teach Bible study, I always teach that, in the Bible, the main thing is the plain thing, and the plain thing is the main thing. And it would be, I think, appropriate if we adopted a similar policy as it relates to what we incorporate into insurance--I am sorry, into our credit card statements and frankly, even into mortgage documents. Plain language can lead to the watering down of ideas also, which can also create some problems as well. And for this reason, I have just introduced H.R. 3037, to create a pilot program for financial literacy. I will incorporate into this program a pilot project for 10 school districts across the country. These projects would receive Federal funding to help them educate and train the teachers in order to integrate financial literacy into the curricula of grades K through 12. And this pilot program is just one step toward ensuring that all students in all school districts will be able to participate in similar programs in their schools. And finally, Mr. Chairman, if you look at the crisis that we have found ourselves in today, it doesn't take a Ph.D. to realize that we have a public that, in many instances, just did not understand what they were getting into when they participated in these exotic mortgages. And so I think the thing we need to let people know is that what you don't owe won't hurt you. " FOMC20050630meeting--85 83,MS. YELLEN.," Thank you, Mr. Chairman. I just wanted to make a couple of comments June 29-30, 2005 35 of 234 seen. It seems to me that there might be a couple of factors that could explain at least some portion of the run-up, though probably not all of it, that weren’t mentioned in the presentations. First, it seems to me that financial innovations affecting housing could have improved the view of households regarding the desirability of housing as an asset to be held in portfolios and thus raised the equilibrium price-to-rent relationship for residential real estate. What I’m thinking of is the idea that equity held in residential real estate is a lot more accessible today than it has been in the past. Home equity credit at commercial banks is up fourfold since 1999, and many households obviously are now keenly aware that refinancing provides a low-cost avenue for tapping into the equity in their homes. So, in a sense, there might be less of a liquidity premium embodied in the return for housing. Also, if people feel that the liquidity constraints in holding housing as an asset are diminishing, that could explain a reduced need for precautionary saving in traditional liquid assets. It could even make people willing to put more of their wealth into down payments on houses and may have raised prices through that mechanism. The other thing that occurred to me is that there might be effects from tax changes. We’ve had changes in the rules for tax exemption and in 1997 on capital gains from the sale of primary residences that would make holding real estate assets more attractive. And the changes in capital gains taxes more generally in 1997 and then again in 2003 would have worked in the same direction. One of the things that we looked at that we thought was interesting was the behavior of price-rent ratios for residential housing and for commercial office space. Commercial office space price-rent ratios are highly cyclical—I guess they always have been—but it appears that the behavior of price-rent ratios in residential housing has closely mirrored what we’ve seen in June 29-30, 2005 36 of 234 1998, though the dynamics are totally different. Commercial office space rents have been falling— it’s not that the prices have been rising—but the price-rent ratios have moved very similarly. A second comment I wanted to make concerns the relationship of creative finance to the housing market. One view that I think is very prevalent is that the use of credit in the form of piggyback loans, interest-only mortgages, option ARMs [adjustable-rate mortgages], and so forth, involves financial innovations that are feeding a kind of unsustainable bubble. But an alternative perspective on that is that high house prices, in fact, are curtailing effective demand for housing at this point and that house appreciation probably is poised to slow. So the increasing use of creative financing could be a sign of the final gasps of house-price appreciation at the pace we’ve seen and an indication that a slowing is at hand. Previously, lenders applied very rigid constraints on loan-to­ value ratios, but essentially those constraints are now being eased at the margin through these creative financing techniques. And that’s providing some elasticity to what was a firm roof. It may slightly diminish the price elasticity of the demand for housing, but the fact that it is blossoming now basically suggests that we really are at the ceiling where it’s binding and will ultimately constrain appreciation. Finally, with those two comments, a question. It concerns the presentation by Andreas and the numbers cited on loan-to-value ratios at origination. One of the things we’re seeing in California and elsewhere in our District—and maybe this is true nationwide—is a growing use of piggyback loans. Loan-to-value ratios of 90 to 95 percent are common in California, and we’ve even seen combination loan-to-value ratios and piggyback loans going up to 125 percent. I guess that means two things, one of which is that the traditional first mortgage looks utterly conventional. Those mortgages have an 80 percent loan-to-value ratio and I suppose they are being sold off to June 29-30, 2005 37 of 234 and Freddie, there’s no need for private mortgage insurance. So Fannie’s and Freddie’s books may look better in some sense—less risky—than they really are because of all of the second mortgages going up to possibly 125 percent." CHRG-109hhrg28024--180 Mr. Bernanke," Congressman, you are correct that the incidence of these so-called non-traditional mortgage products has been increasing. There are some customers for whom these products are appropriate, but there are also some customers for whom they are probably not appropriate. The Federal Reserve and the other banking agencies have issued guidance for comment to the banks, asking them first to re-think their underwriting standards, to make sure that when they make a loan of this type, the recipient is able to finance not only their first payment but also the payments that may come later if interest rates adjust, for example. Secondly, the guidance asks banks to be sure their disclosure to consumers is adequate so the consumers fully understand these complex financial instruments and understand what they are getting into. Third, that the banks themselves are adequately managing the risks inherent in making these kinds of loans. We are addressing these issues. These loans are quite popular in terms of new credit extensions. They remain a fairly modest portion of the outstanding mortgages. This goes back to a question that was asked earlier. I think the one area where they may pose some risks if the housing market slows down might be in the sub-prime area where they have been popular and it's more likely in those cases that they are inappropriate for the borrower. " FOMC20070509meeting--157 155,CHAIRMAN BERNANKE.," I think your point about joint causality, joint endogeneity, of utilization and inflation is a good one. I have tried to make that point in testimony when I talk about aggregate demand being strong and having effects both on inflation and on resource utilization. We can think about this. It is a little hard to capture complex models in these statements, but it is certainly a point well taken. President Yellen." 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-110hhrg46591--251 Mr. Lynch," I am happy to hear you say that. I am just concerned that when this urgency goes away, that the folks over at MIT, whom I dearly love, will go back to designing these very complex models, and that we will be back into this same mess again. So I am hoping that we might fix this once and for all. I do not know if anyone else wishes to comment. " CHRG-110hhrg46591--64 Mr. Stiglitz," I think that would help. One of the things I commented on in my remarks was the need for standardization of these products. Because one of the problems is that if they are very complex, it is hard to know what is being netted. And so part of what needs to be done is moving towards more standardization which would allow greater transparency in the products themselves and greater competition in the market. When you have highly differentiated products it is more likely that they will be less transparent and that markets will be less competitive. " 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-111shrg50815--5 STATEMENT OF SENATOR AKAKA Senator Akaka. Yes. Thank you very much. I appreciate the Chairman holding this hearing. Too many in our country are burdened by significant credit card debt. Not enough has been done to protect consumers and ensure they are able to properly manage their credit burden. We must do more to educate, protect, and empower consumers. Three Congresses ago, or the 108th Congress, I advocated for enactment of my Credit Card Minimum Payment Warning Act. I developed the legislation with Senators at that time, Senators Sarbanes, Durbin, Schumer, and Leahy. We attempted to attach the bill as an amendment to improve the flawed minimum payment warning in the Bankruptcy Abuse Prevention and Consumer Protection Act. Unfortunately, our amendment was defeated. My legislation, which I will be reintroducing shortly, requires companies to inform consumers how many years and months it will take to repay their entire balance if they make only minimum payments. The total cost of interest and principal if the consumer pays only the minimum payment would also have to be disclosed. These provisions will make individuals much more aware of the true costs of credit card debt. The bill also requires that credit card companies provide useful information so that people can develop strategies to free themselves of credit card debt. Consumers would have to be provided with the amount they need to pay to eliminate their outstanding balance within 36 months. My legislation also addresses the related issue of credit counseling. We must ensure that people who seek help in dealing with complex financial issues, such as debt management, are able to locate the assistance they need. Credit card billing statements should include contact information for reputable credit counseling services. More working families are trying to survive financially and meet their financial obligations. They often seek out help from credit counselors to better manage their debt burdens. It is extremely troubling that unscrupulous credit counselors exploit for their own personal profit individuals who are trying to locate the assistance they need. My legislation establishes quality standards for credit counseling agencies and ensures that consumers would be referred to trustworthy credit counselors. As financial pressures increase for working families, credit counseling becomes even more important. As we work to reform the regulatory structure of financial services, it is essential that we establish credit counseling standards and increase regulatory oversight over this industry. Mr. Chairman, I appreciate your inclusion of this in your bill, of a provision that mirrors the minimum payment warning provisions in my bill. Thank you very much, Mr. Chairman. Senator Johnson. Thank you, Senator Akaka. Senator Menendez, do you have a very brief statement to make? 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-111shrg61651--43 Mr. Zubrow," Absolutely. And if you eliminate the shareholders' equity, if you have the ability to eliminate unsecured debt to the extent that is needed, then obviously there should be more than enough resources in those circumstances, so that the taxpayers do not have to be involved in any way in a bailout of those firms. I think it is also very important that large, complex firms be prepared with their regulators for that potential eventuality. We have already begun discussions with our lead regulator, the Fed, about how would we think about how a regulator would step in, in a resolution regime, because I think it is very important that the regulator as well as the firms themselves think about the various steps that might happen under that situation. Senator Shelby. Is it in your mind very, very important that any legislation dealing with resolution authority be unambiguous that nothing is too big to fail, and if it bellies up we are going to close it down? " 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. ______ CHRG-110hhrg46595--132 Mr. Manzullo," The other question that I have is for Ford. On page 17 of your plan, you state that you want to accomplish the goal to increase more car profitability by improving cars at competitive levels through reduced complexity of global purchasing skills. Does that mean you are going to be buying more fasteners and tool and die from China to infuse into American cars? " CHRG-111hhrg53234--220 Mr. Meyer," The OCC and the FDIC have never been responsible for consolidated supervision. They have no history of doing that. The FDIC does not have a supervisory staff that has any expertise in the complex banking situation of the institutions we are talking about. The OCC is already involved and was the bank supervisor of many of the institutions that have gotten into trouble. And in most of the large institutions, OCC is the bank supervisor and the Fed is the holding company supervisor, and they both have to work together. " 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. " FOMC20050630meeting--226 224,MR. GRAMLICH.," Well, that’s right. I understand that the link between interest rates and June 29-30, 2005 73 of 234 Affordability rates may tend to be a lot more stable than we would think just from interest rates alone, if it turns out that they do have an impact on prices. The third point: Janet raised what I thought was an interesting idea earlier that some people have picked up on, which is that maybe these credit innovations are endogenous. I recall a briefing that we had just a short time ago where the staff suggested that, in effect, what was happening—and I, frankly, was a little skeptical at the time—was that people were identified by how much they could pay for their house. And that, I think, makes the credit transaction automatically endogenous. That may be a better way to look at the whole situation, and I guess researchers at the Board have already started doing that. I don’t know how complete their research is, but given our myopic society, that may be a much better way to look at it—how much you can pay—and then nobody worries about what the implications are down the road. But that explains the initial buying decision." CHRG-111hhrg55811--136 Mr. Meeks," Thank you, Mr. Chairman. First, I want to commend you, Mr. Chairman, for trying to bring far greater clarity to many of the definitions of parties, instruments, and practices. I think the discussion draft brings back the focus to systemic risk, which I think is tremendously important. And, for example, I think the provision of a clear exemption from most of the new requirements for end-users and hedgers who use derivatives primarily for operational risk management. Though we need to be cautious about this, because we don't want to create all these loopholes, it is important, however, for us to be reasonable and responsible to require end-users who pose no systemic risk and who do the right thing by hedging business risks they don't control to be subject to the same capital or margin requirements as financial institutions and market makers who are, in fact, systemically significant institutions. Secondly, I think it was also important that we bring the focus back on proper capitalization and margining of trades by major players and by putting the responsibility of evaluating the appropriate level of capital and margin to a given market participant's functional regulator. Again, this brings the focus back to systemic risk by addressing issues of leverage and safety and soundness. And third, that other forms of collateral be held by independent third-party custodians, which is critical, I believe, in protecting the system from some critical abuses as identified in the past year. And lastly, how we deal with--and I have been talking about this a lot--international transactions, how they will be dealt with, and the criteria which--and a process by which certain international players may be excluded if they pose a systemic risk. However, there are still a few things that I think are out there that we need to--and I would like to get your opinions on this. I think we need more clarity. They include the degree of independence and competitiveness of clearinghouses which may be subject to natural monopolies, and which may have the power to skew the competitive playing field in their favor, particularly if they are predominantly owned by dealer banks. The other area of concern I think that we need to keep a close eye on, and I would like to get your opinion on that, is how our new regulations encourage continued innovation and competition in this space. Specifically, with new powers given to many regulators, particularly the SEC and the CFTC, it would be critical, I think, to hold them to a higher standard of efficiency and responsiveness. I would like to get your opinion on that. " FOMC20080724confcall--64 62,CHAIRMAN BERNANKE.," Thank you. Other questions? Well, if there are not any other questions, let me first say that I do want to thank the staff. These innovations did come from the staff members who are on the front lines. President Evans, we really have talked about these, and I know the staff has thought these through. I think that these are constructive ideas. The option idea essentially will allow for a better targeted use of our balance sheet to some short periods that have been particularly stressful, and I think it will give us overall more flexibility to use our balance sheet in the most effective way. So it seems like an innovative way to deal with a particular problem, which is this end-of-quarter issue. On the 84-day TAF, I know for sure that banks have been asking for a longer term. I have heard it directly myself and have heard a lot about this from the Desk. It is frequently pointed out by the banks that the ECB and the Bank of England have been making effective use of longer-term loans, and in their view that has made the liquidity pressures less severe in those jurisdictions. So I do think it is certainly worth considering the three-month TAF loan. Obviously, as Reserve Bank presidents, you have to administer these; and the first question that comes to your mind is, of course, the greater credit risk. In that respect, I think that taking the existing haircuts plus 33 percent should provide some comfort. Of course, you retain the right always to demand collateral to your satisfaction or to convert the loan to a primary or secondary or overnight loan or to call the loan. So you have always the same protections that you currently have. I suppose it would be, in some sense, a de facto tightening of standards, if you were looking at institutions that would be eligible on a three-month basis. At the same time, to go back to my earlier comment, we don't have to make a final decision today, but it might be worth considering not putting the overcollateralization requirement on any loan less than, say, 14 or 28 days on the grounds, as President Plosser pointed out, that we don't want to be seen as taking away something or increasing the cost of funding at a time when we still want to provide these liquidity benefits. So I guess that one option I would raise for consideration is that, if we do the three-month maturity, we use the overcollateralization for loans greater than 28 days. This means that, as a loan maturity comes down--as it comes close to payoff--some collateral could be withdrawn if desired. I do think these are reasonable extensions. They seem to me to be quite consistent with our earlier practice. I take President Hoenig's point that we are not in this business indefinitely. We need to be thinking about cutting back. But at the moment, conditions do not seem considerably better, and I don't think that at this moment we really should be reducing our support to the market. Are there others who would like to comment on any aspect of these proposals--about collateral or about any of the other issues? President Plosser. " FinancialCrisisInquiry--147 SOLOMON: Yes, I think that’s—yes, I think that’s not a bad point. It is clear that the more diversified firms did survive, and that’s why I don’t pin the blame on Gramm-Leach-Bliley. That’s why I said it was just one—that was my response. So I don’t—I think it is—I’m not sure anything is clear, incidentally, and that’s why you have the commission. HOLTZ-EAKIN: That’s not encouraging. We need to figure this out. (LAUGHTER) SOLOMON: That’s why you’re there. All right? To figure out what the clarity is, but—because all these things happened and they all happened simultaneously. The point that the chairman made, I believe it was—or the vice chairman—is they weren’t caused from outside. They were caused inside the institutions, and that’s the point you’ve got to continue to probe on. And I think we all agree on that. So I think—I think Brian is right on that point. It’s just management. It’s how you set the standards, how you set the risk and how you manage the risk, and your own hubris at managing the risk. You see, a lot of this is just pure management failure even in the best of institutions. You heard Mr. Dimon, Mr. Blankfein—all of them—Mr. Mack— say that we failed. They’re right. HOLTZ-EAKIN: Thank you. CHAIRMAN ANGELIDES: Thank you, Mr. Holtz-Eakin. Mr. Georgiou? GEORGIOU: Thank you, gentlemen. You know, Mr. Mayo, you said that innovation always outpaces regulation. fcic_final_report_full--553 Public Hearing on the Role of Derivatives in the Financial Crisis, Dirksen Senate Of- fice Building, Room , Washington, DC, Day , June ,  Session : Overview of Derivatives Michael Greenberger, Professor, University of Maryland School of Law Steve Kohlhagen, Former Professor of International Finance, University of California, Berkeley, and former Wall Street derivatives executive Albert “Pete” Kyle, Charles E. Smith Chair Professor of Finance, University of Maryland Michael Masters, Chief Executive Officer, Masters Capital Management, LLC Session : American International Group, Inc. and Derivatives Joseph J. Cassano, Former Chief Executive Officer, American International Group, Inc. Finan- cial Products Robert E. Lewis, Senior Vice President and Chief Risk Officer, American International Group, Inc. Martin J. Sullivan, Former Chief Executive Officer, American International Group, Inc. Session : Goldman Sachs Group, Inc. and Derivatives Craig Broderick, Managing Director, Head of Credit, Market, and Operational Risk, Goldman Sachs Group, Inc. Gary D. Cohn, President and Chief Operating Officer, Goldman Sachs Group, Inc. Public Hearing on the Role of Derivatives in the Financial Crisis, Dirksen Senate Of- fice Building, Room , Washington DC, Day , July ,  Session : American International Group, Inc. and Goldman Sachs Group, Inc. Steven J. Bensinger, Former Executive Vice President and Chief Financial Officer, American In- ternational Group, Inc. Andrew Forster, Former Senior Vice President and Chief Financial Officer, American Interna- tional Group, Inc. Financial Services Elias F. Habayeb, Former Senior Vice President and Chief Financial Officer, American Interna- tional Group, Inc. Financial Services David Lehman, Managing Director, Goldman Sachs Group, Inc David Viniar, Executive Vice President and Chief Financial Officer, Goldman Sachs Group, Inc. Session : Derivatives: Supervisors and Regulators Eric R. Dinallo, Former Superintendant, New York State Insurance Department Gary Gensler, Chairman, Commodity Futures Trading Commission Clarence K. Lee, Former Managing Director for Complex and International Organizations, Of- fice of Thrift Supervision Public Hearing on Too Big to Fail: Expectations and Impact of Extraordinary Gov- ernment Intervention and the Role of Systemic Risk in the Financial Crisis, Dirksen Senate Office Building, Room , Washington DC, Day , September ,  Session : Wachovia Corporation Scott G. Alvarez, General Counsel, Board of Governors of the Federal Reserve System John H. Corston, Acting Deputy Director, Division of Supervision and Consumer Protection, U.S. Federal Deposit Insurance Corporation Robert K. Steel, Former President and Chief Executive Officer, Wachovia Corporation Session : Lehman Brothers Thomas C. Baxter, Jr., General Counsel and Executive Vice President, Federal Reserve Bank of New York CHRG-111hhrg74090--167 Mr. Stinebert," Thank you, Mr. Chairman, and thank you for this opportunity to speak with you today. I am very glad to hear that this is kind of a first step and hopefully which will be a long process because as many have expressed here today, there are certainly some concerns about this issue and we hope that there will continue to be somewhat of a cautious approach as we go forward. The American Financial Services Association has been around for almost 100 years and we represent about 30 percent of all consumer credit in the United States with members in the mortgage, credit card, auto and personal installment loans. First and foremost, AFSA supports strong financial consumer protection regulation. Just because we have concerns going forward about the current agency does not mean that the industry and that the association is not committed to strong consumer protection regulation regarding financial services. We believe that consistent enforcement of existing consumer protections laws by government regulators would have greatly lessened the harmful impact that the current crisis has on consumers and certainly our economy. Many AFSA members are regulated primarily at the State level and subject to a patchwork of requirements. We firmly believe that consumer protection should be uniform in every State. Therefore, AFSA supports strong national consumer protection standards that allow the members to meet their consumer protection obligation in an efficient and cost-effective manner. In addition, strong national consumer protection standards will provide a benefit to consumers only to the extent that they are consistent with sound potential regulation. Consumer protections that threaten the safety and soundness of financial service providers offer really no protection at all. We believe consumers will be better served by a regulatory structure where prudential and consumer protection regulations are housed within a single regulator. Congress tried to separate these two intertwining functions with the GSEs. When it became apparent that this situation was unavoidable, Congress brought the two regulatory functions back under a single regulator and for good reason. We urge Congress to support regulatory structure that does not separate safety and soundness from consumer protection. The authority proposed to be vested in the new agency is breathtaking in both its scope and its effect. It would cover many entities and persons who have little or no involvement in the activities leading to the current economic crisis. Without any demonstrated need, many unsuspecting persons will be swept into a web of scrutiny and reporting requirements that yield little in the way of consumer protection but much in the way of increased cost for consumers. Attorneys, accountants, consumer reporting agencies, auto dealers, title companies among others will find themselves subject to review with no evidence that they behaved unfairly. Financial service providers will find it increasingly difficult to plan for risk as virtually any practice or product other than prescribed standard plain vanilla products could be labeled as unfair or abusive. Innovation will be discouraged. Given the vast scope of the proposed agency's authority, its funding needs are also staggering. The proposal seeks to fund the CFPA by assessing fees on persons and entities it regulates while including many that would not expect to be covered currently. There is no doubt that any assessment on financial service products will be passed on eventually to consumers. That direct unavoidable result will be an increase in the cost and availability of credit. Most AFSA members are regulated by the FTC, which has a proven record of enhancing consumer protection. It has addressed the economic crisis in two ways, first by using the enforcement authority to pursue bad actors in the financial services industry, and second, by setting federal policy through guidance and public comment. Numerous examples are listed in our written testimony. But in conclusion, AFSA believes that the FTC has done an excellent job in enforcing consumer protection law and is best suited to continue that role going forward. We believe the Administration's goal can be achieved with adjustments to the current regulatory structure and the result will be more efficient, less costly and certainly more effective. To that end, we have two specific suggestions. One, make current and future consumer protection rules apply to all financial services providers. Congress should ensure that all federal consumer protection laws and regulations apply with equal force to all providers of financial services with respect to similar cases of products and services. These laws should include strong national standards that preempt State laws and permit all Americans to enjoy a consistent level of service and access with respect to financial products and services. We have heard again and again today as you have 50 different States that can meet or exceed the current laws that this is not simplification. We are just going to wind up with 51, as you stated, Mr. Chairman, different rules that these people are going to have to follow. And number two, pursue a regulatory structure that does not separate financial products and services from the viability of the companies that offer them. All prudential agencies should work together to coordinate consumer protection regulation for financial products and services with the goal that regulations be preemptive, consistent and uniform. If we don't have that, we are not going to make any headway. Thank you for your time. [The prepared statement of Mr. Stinebert follows:] " 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-111shrg55739--103 Mr. White," Greed was there all the time. But there was concern about reputation before, and somehow that got swamped. The model failed this time around. But it worked for 30 years. That is why I am agnostic. This is something that institutional participants can figure out on their own, with oversight by the prudential regulators to make sure that at the end of the day they have safe and sound bond portfolios. Senator Shelby. Is it possible that ratings for certain instruments, such as more traditional bonds we have talked about, have a greater value as benchmarks than ratings provided for more complex and newer structured products, such as CDOs and CLOs? " CHRG-111hhrg52397--287 Mr. Scott," Thank you, Mr. Chairman. I might say that this is absolutely stunning in its scope of complexity and challenge but as we try to grasp or get our hands around this, to try to figure how we regulate it, I think it would be very helpful, Mr. Sprecher, if you might share with us the description of the day-to-day Federal regulation of your clearinghouse and whether or not you can come to the conclusion that the Federal regulation that you are currently under. And in your opening statement and your response to the chairman, you reiterated several layers of Federal regulation. It might be well for you to kind of give us kind of an overview as to how effective if, in your opinion, this regulation has been? " CHRG-111shrg50814--210 RESPONSE TO WRITTEN QUESTIONS OF SENATOR CRAPO FROM BEN S. BERNANKEQ.1. What is it going to take to encourage private investment in our banks and drawing private capital that is now on the sidelines to ensuring that our financial institutions are stable and that our capital markets can return to more normal and healthy functioning?A.1. We believe that attracting private capital to recapitalize the financial industry is very important and steps to encourage private capital should be taken. Several factors have contributed to the reluctance of private capital providers from investing in financial institutions in recent months, including uncertainty about the health of financial institutions, broader macroeconomic and financial market conditions, and how private capital claims might be treated given existing or additional government support. The Federal Reserve has taken various actions to support financial market liquidity and economic activity, which are important steps to encourage private capital flows to the financial sector. In recent weeks, indicators of market and firm risks have fallen and share prices of financial institutions have risen, suggesting some reduction in investor uncertainty. In addition, a number of institutions have issued new equity shares following the release of the results of the Supervisory Capital Assessment Program in early May.Q.2. To what extent do you believe that government and central bank policies led to the credit bubble?A.2. The fundamental causes of the ongoing financial turmoil remain in dispute. In my view, however, it is impossible to understand this crisis without reference to the global imbalances in trade and capital flows that began in the latter half of the 1990s. In the simplest terms, these imbalances reflected a chronic lack of saving relative to investment in the United States and some other industrial countries, combined with an extraordinary increase in saving relative to investment in many emerging market nations. The increase in excess saving in the emerging world resulted in turn from factors such as rapid economic growth in high-saving East Asian economies accompanied, outside of China, by reduced investment rates; large buildups in foreign exchange reserves in a number of emerging markets; and substantial increases in revenues received by exporters of oil and other commodities. Saving flowed from where it was abundant to where it was deficient, with the result that the United States and some other advanced countries experienced large capital inflows for more than a decade, even as real long-term interest rates (both here and abroad) remained low. These capital inflows and low global interest rates interacted with the U.S. housing market and overall financial system in ways that eventually proved to be dysfunctional. As outlined in a report by the President's Working Group on Financial Markets (PWG) released last year, \1\ the most evident of those was clearly a breakdown in underwriting standards for subprime mortgages. But that was symptomatic of a much broader erosion of market discipline: Competition and the desire to maintain high returns created significant demand for structured credit product by investors, and all market participants involved in the securitization process, including originators, underwriters, asset managers, credit rating agencies, and global investors, failed to obtain sufficient information or to conduct comprehensive risk assessments on instruments that were quite complex. Investors relied excessively on credit ratings, and rating agencies relied on faulty assumptions to produce those ratings. These developments revealed serious weaknesses in risk management practices at several large U.S. and European financial institutions (some of which were widely perceived to be ``too big to fail''), especially with respect to the concentration of risks, the valuation of illiquid instruments, the pricing of contingent liquidity facilities, and the management of liquidity risk.--------------------------------------------------------------------------- \1\ Policy Statement on Financial Market Developments by the President's Working Group on Financial Markets, March 13, 2008.--------------------------------------------------------------------------- In some cases, regulatory policies failed to mitigate those risk management weaknesses. For example, existing capital requirements encouraged the securitization of assets through facilities with very low capital requirements and failed to provide adequate incentives for firms to maintain capital and liquidity buffers sufficient to absorb extreme systemwide shocks. Further, supervisory authorities did not insist on appropriate disclosures of firms' potential exposure to off-balance sheet vehicles. To address these weaknesses, I believe reforms to the financial architecture are needed to help prevent a similar crisis to develop in the future. First, the problem of financial firms that are considered too big, or perhaps too interconnected, to fail must be addressed. This perception reduces market discipline, encourages excessive risk taking by the firms, and creates the incentive for any firm to grow in order to be perceived as too big to fail. Second, the financial infrastructure, including the systems, rules, and conventions that govern trading, payment, clearing, and settlement in financial markets, needs to be strengthened. In this respect, the aim should be not only to make the financial system as a whole 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 government intervention. Third, a review of regulatory policies and accounting rules is desirable 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. And finally, consideration should be given to the creation of an authority specifically charged with monitoring and addressing systemic risk, with the objective of helping to protect the system from financial crises like the one we are currently experiencing. Reforming the structure of the financial system would go a long way towards mitigating the risk that other severe episodes of financial instability would arise in the future. Reducing this risk would in turn allow the Federal Reserve to continue to direct monetary policy towards the pursuit of the goals for which it is best suited--the legislated objectives of maximum employment, stable prices, and moderate long-term interest rates. With hindsight, an argument could be made, and has been made by some, that tighter monetary policy earlier in the decade might have helped limit the rise in house prices and checked the development of the subprime mortgage market, thereby containing the damage to the economy that later occurred when the housing market collapsed. However, the rise in the Federal funds rate required to accomplish this task would likely have had to be quite large, and thus would have significantly impaired economic growth, boosted unemployment, and probably led to an undesirably low rate of core inflation. All those would have been outcomes clearly at odds with the Federal Reserve's objectives. Rather than redirecting monetary policy in this manner, a better approach going forward would be to have a stronger supervisory system in place to greatly reduce the risk that credit bubbles will merge in the first place, or at least to contain their expansion and limit the fallout from their eventual collapse. This would significantly help in the prevention of financial crises like the current one while at the same time still allowing macroeconomic performance to be as strong as earlier in the decade.Q.3. At what point does an institution or a product pose systemic risk?A.3. Identifying whether a given institution's failure is likely to impose systemic risks on the U.S. financial system and our overall economy is a very complex task that inevitably depends on the specific circumstances of a given situation and requires substantial judgment by policymakers. That being said, a number of key principles should guide policymaking in this area. First, no firm should be considered too big to fail in the sense that existing stockholders cannot be wiped out, existing senior management and boards of directors cannot be replaced, and over time the organization cannot be wound down or sold in whole or in part. In addition, from the point of view of maintaining financial stability, it is critical that such a wind down occur in an orderly manner. Unfortunately, the current resolution process for systemically important nonbank financial institutions does not facilitate such a wind down, and thus my testimony's recommendation for improved resolution procedures for potentially systemic financial firms. Still, even without improved procedures, it is important to try to resolve the firm in an orderly manner without guaranteeing the longer-term existence of any individual firm. Second, and as I indicated in my statement, the core concern of policymakers is 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. Thus, in making a systemic risk determination, we look as carefully as we can at the interconnections, or interdependencies, between the failing firm and other participants in the financial system and the implications for these other participants of the troubled firm's failure. Such interdependencies can be direct, such as through deposit and loan relationships, or indirect, such as through concentrations in similar types of assets. Interdependencies can extend to broader financial markets and can also be transmitted through payment and settlement systems. In addition, we consider the extent to which the failure of the firm and other interconnected firms would affect the real economy through, for example, a sharp reduction in the supply of credit, rapid declines in the prices of key financial and nonfinancial assets, or a large drop in the sense of confidence that financial market participants, households, and nonfinancial businesses bring to their activities. Of course, contagion effects are typically more likely in the case of a very large institution than with a smaller institution. However, I would emphasize that size is far from the only criterion for determining whether a firm is potentially systemic. Moderate-sized, or even relatively small firms, could be systemic if, in a given situation, a firm is critical to the functioning of key markets or, for example, critical payment and settlement systems. I would also reiterate that while traditionally the concern was that a run on a troubled bank could inspire contagious runs on other banks, recent financial crises have shown us that systemic risks can arise in other financial institutions and markets. For example, we now understand that highly destabilizing runs can occur on investment banks and money market funds. Third, the nature of the overall financial and economic environment is a core factor in deciding whether a given institution's failure is likely to impose systemic risks. If the overall environment is highly uncertain and troubled, as was clearly the case last fall, then the likelihood of systemic effects is typically much greater than if the economy is growing and market participants are generally optimistic and confident about the future. Indeed, and as I indicated above, the potential effects of a firm's failure on the confidence of not only financial market participants, but a wide spectrum of households and businesses is a key decision variable in policymakers' assessment of whether a given firm's failure is likely to pose systemic risks.Q.4. In a statement Monday, AIG said it is continuing to work with the government to evaluate potential new alternatives for addressing AIG's financial challenges. AIG's rescue package has already been increased twice since September, from $85 billion to nearly $123 billion in October and then to $150 billion in November. According to today's WSJ, AIG is seeking an overhaul of its $150 billion government bailout package that would substantially reduce the insurer's financial burden, while further exposing U.S. taxpayers to its fortunes. Are you and Treasury considering changing our approach to AIG from that of a creditor to one of a potential owner?A.4. As explained in the reports submitted to Congress under section 129 of the Emergency Economic Stabilization Act of 2008, the Federal Reserve, in conjunction with the Treasury Department, has taken a series of steps since September 2008, to address the liquidity and capital needs of the American International Group, Inc. (AIG) and thereby to help stabilize the company, prevent a disorderly failure, and protect financial stability, which is a prerequisite to resumption of economic activity. In particular, in September and November 2008, the Federal Reserve established several credit facilities, including a Revolving Credit Facility, to further these objectives. As part of the November restructuring, the Treasury purchased $40 billion in AIG preferred stock. In light of the significant challenges faced by AIG in the last months of 2008 and the continued risk it poses to the financial system, on March 2, 2009, the Federal Reserve and the Treasury announced a restructuring of the government's assistance to the company. The March actions announced by the Federal Reserve include partial repayment of the Revolving Credit Facility with preferred stock interests in two of AIG's life insurance subsidiaries and with the proceeds of new loans that would be secured by net cash flows from designated blocks of existing life insurance policies held by other life insurance subsidiaries of AIG. These actions were undertaken in the context of the Federal Reserve's role as a creditor of AIG. As part of the March restructuring, the Treasury established a capital facility that allows AIG to draw down up to approximately $30 billion as needed over time in exchange for additional preferred stock. For more detail, please see Federal Reserve System Monthly Report on Credit and Liquidity Programs and The Balance Sheet (June 2009) at 13-16, http://www.federalreserve.gov/monetarypolicy/files/monthlyclbsreport200906.pdf.Q.5. Recent events in the credit markets have highlighted the need for greater attention to settling credit default swaps by creating a central clearing system. While central counterparty clearing and exchange trading of relatively standardized contracts have the potential to reduce risk and increase market efficiency, market participants must be permitted to continue to negotiate customized bilateral contracts in over-the-counter markets. Do you agree that market participants should have the broadest possible range of standardized and customized options for managing their financial risk and is there a danger that a one-size-fits-all attitude will harm liquidity and innovation?A.5. The Federal Reserve supports central counterparty (CCP) clearing of credit default swaps and other over-the-counter (OTC) derivatives because, if properly designed and managed, CCPs can reduce risks to market participants and to the financial system. Counterparties to OTC derivatives trades sometimes seek to customize the terms of trades to meet very specific risk management needs. These trades may not be amenable to clearing because, for example, the CCP could have difficulty liquidating the positions in the event a clearing member defaulted. A requirement to clear all OTC derivative trades thus offers the uncomfortable alternatives of asking CCPs to accept business lines with difficult-to-manage risks or of asking customers to accept terms that do not meet their risk-management needs. A hybrid system in which standardized OTC derivative contracts are centrally cleared and in which more customized contracts are executed and managed on a bilateral, decentralized basis is a means for allowing product innovation while mitigating systemic risks. The Federal Reserve recognizes, however, that a key part of this strategy is improvements in the risk management practices for OTC derivatives by the financial institutions that are the counterparties to bilateral trades.Q.6. What is the impact of the final UDAP rule issued last December on consumers and businesses who use ``no interest'' financing? I understand the impact to be very large and I would appreciate the Federal Reserve Board working to clarify that ``no interest'' financing can be used in the future albeit perhaps with revised disclosures and marketing.A.6. In the final rule addressing unfair and deceptive credit card practices, the Board, the Office of Thrift Supervision (OTS), and the National Credit Union Administration (NCUA) (collectively, the Agencies) expressed concern regarding deferred interest programs that are marketed as ``no interest'' but charge the consumer interest if purchases made under the program are not paid in full by a specified date or if the consumer violates the account terms prior to that date (which could include a ``hair trigger'' violation such as paying one day late). In particular, the Agencies noted that, although these programs provide substantial benefits to consumers who pay the purchases in full prior to the specified date, the ``no interest'' marketing claims may cause other consumers to be unfairly surprised by the increase in the cost of those purchases. Accordingly, the Agencies concluded that prohibiting deferred interest programs as they are currently marketed and structured would improve transparency and enable consumers to make more informed decisions regarding the cost of using credit. The Agencies specifically stated, however, that the final rule permits institutions to offer promotional programs that provide similar benefits to consumers but do not raise concerns about unfair surprise, For example, the Agencies noted that an institution could offer a program where interest is assessed on purchases at a disclosed rate for a period of time but the interest charged is waived or refunded if the principal is paid in full by the end of that period. The Board understands that the distinction in the final rule between ``deferred interest'' and ``waived or refunded interest'' has caused confusion regarding how institutions should structure these types of promotional programs where the consumer will not be obligated to pay interest that accrues on purchases if those purchases are paid in full by a specified date. For this reason, the Board is consulting with the OTS and NCUA regarding the need to clarify that the focus of the final rule is not on the technical aspects of these promotional programs (such as whether interest is deferred or waived) but instead on whether the programs are disclosed and structured in a way that consumers will not be unfairly surprised by the cost of using the programs. The Agencies are also considering whether clarification is needed regarding how existing deferred interest plans should be treated as of the final rule's July 1, 2010, effective date. If the Agencies determine that clarifications to the final rule are necessary, those changes will assist institutions in understanding and complying with the new rules and should not reduce protections for consumers." 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. " CHRG-111hhrg53246--7 Mr. Kanjorski," Thank you very much, Mr. Chairman. Among other matters this morning we will address the need for effective regulatory oversight of the over-the-counter derivatives market estimated at $500 trillion in notional value. These reforms are long overdue. Fifteen years ago, I first advocated for increased regulation of our derivatives market. When I helped to introduce the Derivative Safety and Soundness Supervision Act, we sought to enhance the supervision of derivatives activities of financial institutions. Since then, I have endorsed other legislation aimed at improving transparency in and enhancing the oversight of our derivatives markets. Our witnesses today, SEC Chairman Mary Schapiro and CFTC Chairman Gary Gensler, have an important task before them. They must reposition their agencies to better respond to the crises of today and the problems of tomorrow. Fortunately, both of these leaders come equipped with extensive experience and a commitment to effective regulation. While this crisis also seems to me the ideal time to merge these two agencies, political judgments have led us down a different path. Thankfully, however, the two seem determined to work together constructively rather than battle over jurisdictional turf. These two Chairmen are working within the Obama Administration which will soon release legislative language on derivatives reform and with Congress can help to create a more transparent, safer, and less risky over-the-counter derivatives market. To increase investor protection and market confidence, we must make this reform effort a top priority. Most fair-minded observers have acknowledged that unregulated derivatives, such as the credit default swaps, played a significant role in contributing to our present financial crisis. AIG's disastrous abuse of these potentially explosive financial instruments represents the most glaring example of the dangers to our system posed by derivatives. By moving forward, we should remain sensitive to the highly varied nature of derivatives products. Derivatives that consist of highly accustomed contracts which thousands of nonfinancial businesses, both large and small, employed to managed risk simply do not easily fit within the mandatory clearing and exchange trading regime. By mandating the collection of certain data on such contracts in a repository even where they cannot be cleared, we can achieve transparency and access for regulators in the hope that we can detect warning signs of systemically risky transactions. And by requiring increased capital reserves for those who enter into unique derivatives contracts, we can also provide incentives for markets to standardize these complex financial products going forward. In closing, Chairman Schapiro and Chairman Gensler can help Congress to sensibly regulate this dark corner of our financial markets. I look forward to their testimony. " CHRG-110shrg50414--48 Mr. Bernanke," Mr. Chairman, Senator Shelby, I have submitted formal written testimony for the record. With your permission, I would like to speak just a few minutes about the Treasury proposal. The Fed supports the Treasury initiative. We believe that strong and timely action is urgently needed to stabilize our markets and our economy. But I believe some clarification is needed about why this proposal could make a positive difference, and I would like to offer a few thoughts on that subject. Let me start with a question. Why are financial markets not working? Financial institutions and others hold billions in complex securities, including many that are mortgage related. I would like to ask you for a moment to think of these securities as having two different prices. The first of these is the fire-sale price. That is the price a security would fetch today if sold quickly into an illiquid market. The second price is the hold-to-maturity price. That is what the security would be worth eventually when the income from the security was received over time. Because of the complexity of these securities and the serious uncertainties about the economy and the housing market, there is no active market for many of these securities. And, thus, today the fire-sale price may be much less than the hold-to-maturity price. This creates something of a vicious circle. Accounting rules require banks to value many assets at something close to a very low fire-sale price rather than the hold-to-maturity price, which is not unreasonable in itself given their illiquidity. However, this leads to big writedowns and reductions in capital, which in turn forces additional sales that send the fire-sale price down further, adding to pressure. Meanwhile, private capital is unwilling to come in because of uncertainty about the value of institutions and because of the prospect of more writedowns. One suggestion that has been made is to suspend mark-to-market accounting and use banks' estimates of hold-to-maturity prices. Many banks support this. But doing this would only hurt investor confidence because nobody knows what the true hold-to-maturity price is. Without a market to determine that price, investors would have to trust the internal estimates of banks. So let me come to the critical point. I believe that under the Treasury program auctions and other mechanisms could be designed that will give the market good information on what the hold-to-maturity price is for a large class of mortgage-related assets. If the Treasury bids for and then buys assets at a price close to the hold-to-maturity price, there will be substantial benefits. First, banks will have a basis for valuing those assets and will not have to use fire-sale prices. Their capital will not be unreasonably marked down. Second, liquidity should begin to come back to these markets. Third, removal of these assets from balance sheets and better information on value should reduce uncertainty and allow the banks to attract new private capital. Fourth, credit markets should start to unfreeze; new credit will become available to support our economy. And, fifth, taxpayers should own assets at prices close to hold-to-maturity values which minimizes their risk. Now, how to make this work. To make this work, we do need flexibility in design of mechanisms for buying assets and from whom to buy. We do not know exactly what the best design is. That will require consultation with experts and experience with alternative approaches. Second, understanding the concerns and the worries of the Committee, we cannot impose punitive measures on the institutions that choose to sell assets. That would eliminate or strongly reduce participation and cause the program to fail. Remember, the beneficiaries of this program are not just those who sell the asset, but all market participants and the economy as a whole. But, finally, and very importantly, this is not to say that the financial industry should not be reformed. It should be. It is critical. I agree with the Treasury Secretary. The Federal Reserve will give full support to fundamental reform of the financial industry. But whatever reforms the Congress makes should apply to the whole industry, whether they participate in this program or not. So, in summary, I believe that under the Treasury authority being requested, a program could be undertaken that will help establish reasonable hold-to-maturity prices for these assets. Doing that will restore confidence and liquidity to the financial markets and help the economy recover without an unreasonable fiscal burden on taxpayers. So I urge you to act as soon as possible. Thank you. " CHRG-111shrg54789--127 Mr. Mullainathan," Mr. Chairman, Ranking Member Shelby, and Members of the Committee, thank you for providing me with an opportunity to testify. As an academic, my comments will lay out some of the ideas and research behind consumer protection. By way of background, my area of expertise is behavioral economics. It combines economists' healthy respect for markets with psychologists' recognition that people are not financial engines churning out optimal decisions. I will focus on making three points. First, the quality of choice is a result of the context in which we choose. Some contexts--many contexts allow people to choose well, but others do not. Second, when people choose well, markets work very well. They provide healthy competition. But when people choose badly, they can race to the bottom. Third, one tool in the proposed legislation, ring fencing so-called ``standard products,'' provides a way to promote competition and prevent this race to the bottom. So let me start with the psychology of choice. I am going to try and use two examples that are pretty familiar to all of you to illustrate decades of psychological research on how people actually choose. I want you to think back to the last time you painted a room in your house. You have thousands of colors to choose from. Benjamin Moore alone offers 140 shades of white. Yet, you sifted through this explosion of options and were probably happy with your final choice. Contrast this with the last time you bought an electronic device, such as a digital camera. How do you choose between a smaller, cheaper 8-megapixel camera and a bigger, more expensive 12-megapixel camera? What is a megapixel? How many do you need? Are 12 megapixels 50 percent more than 8 megapixels? At the end of this process, you probably weren't really sure whether you bought the right camera. The distinction here is that choosing between things you don't understand--megapixels is very different from choosing between things you do understand--color. Part of choosing a mortgage is like picking a color. What monthly payment fits within your budget? Part of choosing a mortgage, however, is like choosing a megapixel. How do you choose between a fixed-rate mortgage at $1,000 a month and one that begins at $900 a month but after 2 years changes to three points above the 1-year LIBOR? What does LIBOR mean? How much does it vary? Is three points above it reasonable? The provider says, ``Hey, you can refinance this mortgage in 2 years.'' Should you worry about being able to get another loan in 2 years? Note, this has nothing to do with elites or intellectuals. This is true for all people. These features of the difficulty of choice are the challenges of being human in choice context that are really not your area of expertise. The problem is not disclosure alone, it is about understanding. Sometimes disclosure produces understanding, but sometimes it does not. Financial technicalities simply do not resonate with the concepts you use in everyday life. As a result, errors abound. For example, a recent study shows that 40 percent of borrowers with income less than $50,000 do not know the per period caps on their ARMs. It wouldn't surprise me if, like megapixels, they barely understood what a pro period cap is. Why should they? Now let me turn to competition. As I pointed out, when people choose well, low road firms with short time horizons cannot do much harm. The best they can do is offer a product the consumer likes. In this case, markets work well and innovation helps consumers. However, when people are choosing badly, low road firms can confound both the consumer and high road firms. Next to the $1,000 fixed-rate mortgage, the $900 balloon ARM has a superficial appeal. It is cheaper today. Nine-hundred is smaller than $1,000. Its risks down the road are harder to understand. The worse product can look like the better product. The high road firm can be pulled down by the low road option. Now to my final point. I feel one powerful tool in the proposed legislation can be particularly useful in preventing the race to the bottom. Ring fence the standard, well-understood products and the more exotic ones. Regulate the standard ones minimally, ensure disclosure, prevent fraud, but regulate the more exotic ones stringently. The goal of this regulation should be to ensure that customers understand not just that the risks of these products be mechanically disclosed. Marketing can be endlessly inventive in sidestepping disclosure. The Consumer Financial Protection Agency needs stronger tools for products beyond the fence. Ring fencing, though, is far more market friendly than a banner or mandate. It retains customers' ability to access exotic products. The CFPA would simply ensure that there is a door on the fence that requires conscious choice to go through. No one should unknowingly end up on the other side of the fence. There are several precedents for this approach. I do not think this is the first time in American history this has happened. In fact, the SEC uses it as a way to regulate the trading of options and derivatives. If any of you would like to see this, try and buy an option. The Federal Reserve in July of 2008 placed some mortgages under far greater scrutiny. It is also analogous to how we regulate drugs. If you want to buy ibuprofen, you simply go and buy it. If you like a strong antibiotic, there are more barriers in place. Ring fencing, however, requires a variety of things to work. First, there must be sufficient choice within the fence. This cannot be a one-size-fits-all solution. The goal of this is to maximize choice. It is not to create standard products designed by the Government. That would be a failure. Second, there must be a clear, transparent process for how products enter the fence. This is necessary to encourage innovation. Lenders who create a good product must have the comfort that they can reap rewards from it. For this reason, it is important that the legislation should instruct the CFPA to develop and codify a transparent process by which products will be declared within the fence. To summarize, real people choose badly when faced with technical features as financial choices sometimes require. To prevent a race to the bottom, financial regulation must prevent unfair competition from products with hard-to-understand risks. Ring financial provides one way to accomplish this goal. When effective, it provides a market-friendly alternative to bans and mandates. Thank you. Senator Reed. Thank you very much. Thank you, gentlemen, for your testimony. Let me take 5 minutes and then recognize Senator Shelby. General, thank you not only for your testimony, but for your service. " CHRG-111shrg50564--62 Mr. Volcker," There comes a time when you have to support these institutions in the interest of the greater good and the stability of the markets. But one of the difficulties in this whole business is very much commented on today, is how you price those assets when the taxpayer takes them over. It is possible you could think of a scenario where if the taxpayer has to take them over and the markets are stabilized, the taxpayer may actually make money. But you certainly don't want to go into it with the taxpayer unnecessarily losing a lot of money. But it is a very--this is all complex enough so it is very hard to unscramble all this stuff. Senator Johanns. Thank you very much. " 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-111hhrg51698--59 Mr. Gooch," I think having the instruments in a central environment where you can see everything optically is helpful for regulators so they can see where the risk lies. But, certainly, margining for credit default is very complex. I mean, I give the example of Lehman. Their senior debt was trading at 85 cents on the Friday before they went into bankruptcy, and on Monday morning it was trading at 11 cents. I don't see how you could effectively margin for that level of price move over the weekend. " CHRG-110shrg50420--270 Mr. Wagoner," I think we would do our best. Thirty days for these kinds of things might be a little tight. That is why we had said--we initially talked February 28 or March 31st, depending on the complexity of them. But I can assure you we would move as fast as we can. And, you know, I think it is to the advantage of the industry to have a short timeframe because it will force everyone, let's sit down, let's see where we can go, and get a yes or no on it. Senator Reed. But in that context, the initial draw of funds would be much less than you are requesting. Is that correct? " 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-111hhrg51698--177 Mr. Walz," Thank you, Mr. Chairman, and to our Ranking Member for holding this, as my colleagues have said, incredibly informative discussion. I do want to thank each and every one of you. You are being very candid, very open; and that is very helpful to us. Because, the bottom line is that we all want our markets to function correctly. We want to make sure that they are regulated to the point where people have trust in them, but that we are still encouraging innovation and people to move forward on some of these instruments. So all of us are trying to understand this. I think in that spirit, because this is very complicated--and I do thank Chairman Peterson personally. He has for several years talked to me and tried to educate me on these. What I would like to do, maybe Mr. Buis or Mr. Gooch, if you would help me, if each one of you would tell me--Mr. Buis, you can pick that soybean farmer out in Albert Lea, Minnesota, that is a Farmers Union member. Tell me how the future market works for them and how it affects their paycheck. Then, Mr. Gooch, tell me what your brokers do and what the futures market does and how they collect their paycheck, and what role each of them has in securing the economic well-being of this country. If you could do that, that would really help. Because I want to talk to my constituents about why this affects them. It is all too easy to demonize or take a populist position and point fingers. I want to get it right. So, Tom, if you want to start. " CHRG-111hhrg52406--94 The Chairman," The gentleman from Kansas. Mr. Moore of Kansas. Thank you, Mr. Chairman, and thank you, Professor Warren, for your leadership as Chair of the Congressional Oversight Panel for TARP. I appreciate the points you make in your testimony, including the need for personal responsibility, the need for fixing broken markets for hardworking and play-by-the-rules families, and for noting that this new agency should be putting consumers in a position to make the best decisions for themselves. I also appreciate your point that we are not looking for more disclosures. We just need to make disclosures and make sure that those are written so people can understand them. I believe many of our constituents may not have a good understanding of several parts of the financial regulatory reform package Congress considers; for example, systemic risk, derivatives or resolution authority; but this proposed consumer protection agency is an idea that everyone can easily understand the need for. Professor Warren, you point out that regulatory costs can put enormous financial pressure on a small institution. For the small banks in Kansas and in other parts of the country that did the right thing and did not make irresponsible loans and were not overleveraged, what will this Consumer Financial Protection Agency mean to them? Will it help level the playing field? Ms. Warren. Thank you very much, Congressman. I think that that is the most critical question here as we move forward. I see it helping the smaller banks--the community banks, the regional banks, who, as you rightly point out, were often not the cause of the problem but are now being forced to pay for it. I see it helping them in two principal ways. The first one is in the direct cost of compliance. Our complex structure right now, while it is ineffective for consumers, is nonetheless very expensive for financial institutions. Now, if you are a huge financial institution, you can hire a team of lawyers and spread that cost across millions of credit card products or home mortgage products, and it will come out okay for you. For small institutions, I believe the current burdens can be crippling. So the idea here is to slim these down, to make them effective for consumers but much cheaper for the financial institutions. The second way I think it is helpful for the smaller banks, for the community banks, is that it is my belief that often, not always but often, they offer cleaner products. They offer better products, but in a world in which all of the products are 20-, 30-pages long--the home mortgages are stacks and stacks--we do not create the appropriate functioning market so that the good products get rewarded and the bad products get driven out. Instead, the folks who can afford the multimillion dollar advertising campaign can drive consumers to the more expensive, high-risk products. Ultimately, that is not only to the injury of the consumer; it is to the injury of the small financial institutions. So, I see this as leveling the playing field, not just between the customer and the bank but between the really big banks and the smaller banks. Mr. Moore of Kansas. Thank you very much. Ms. Seidman or Mr. Yingling, do you have any comments? Ms. Seidman. I agree with Professor Warren. I think that this is one of those situations where the immediate reaction is, oh, no, another regulator; but in fact, when you look a whole lot deeper, you realize that what can happen here is a combination of consolidation and consistency in regulation that does not exist now, and it is providing a preference for quality products, which are the products that most of the community banks do in fact provide. Mr. Moore of Kansas. Thank you. Sir, do you have any comments? " 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. " CHRG-111shrg55278--64 Mr. Stevens," Thank you, Senator Warner, Senator Shelby, and Members of the Committee. You may recall I testified before the Committee in March and recommended at that time that the best way to approach systemic risk regulation would be to create a statutory council of senior Federal regulators. Such a body would be best equipped to look across the system and anticipate and address emerging threats to its stability. As I thought about the challenge, I told the Committee that my model was the National Security Council, which Congress established in 1947 to coordinate and integrate, quote, ``domestic foreign and military policies relating to the national security.'' From 1987 to 1989, I served on the NSC staff. I was its first legal advisor. I helped lead a reorganization of the NSC, of the system and of its staff, and I then served as Chief of the NSC staff under National Security Advisor Colin Powell. Based on that experience, I believe an interagency council with a strong authority in a focused area, in this case monitoring and directing the response to risks that threaten overall financial stability, could, like the NSC, serve the Nation well in addressing complex and multifaceted risks. The Administration has proposed creation of a Financial Services Oversight Council, but one that would have at best an advisory or consultative role. The lion's share of systemic risk authority would be vested in the Fed, and that approach strikes me as achieving the wrong balance. Most importantly, it fails to make meaningful use of the expertise and viewpoints of other regulators and it represents, as some Members of the Committee have observed, a very worrisome expansion of the Federal Reserve's authority over the Nation's entire financial system. I would note my reading of the Administration's legislative proposals would, for example, suggest that dozens of mutual fund companies could conceivably be under scrutiny as Tier 1 Financial Holding Companies, a result that was, to say the least, surprising to me. I would urge Congress instead to create a strong Systemic Risk Council, one with teeth. Effectively addressing risk to the financial system at large requires diverse inputs and perspectives. The standing membership of the council should include the core Federal regulators, within my judgment, the Treasury Secretary serving as Chair. For independence, the council should be supported by a very strong Executive Director appointed by the President and a small, highly experienced staff. For accountability, the council should be required to report regularly on its activities to the Congress. By statute, the council should be charged with identifying risks and directing regulatory actions needed to mitigate them. Responsibility for addressing the risks should lie with the functional regulators, operating for this purpose only under the council's direction. The council would thus have clear authority, but over a very limited range of issues, only major unaddressed hazards, not day-to-day regulation. This approach has several advantages. The council would enlist expertise across the spectrum of financial services. It would be well-suited to balancing competing interests. It would engage the functional regulators as full partners. At the same time, its independent staff could serve as a check on the functional regulators and avoid the regulatory capture that could result if one agency were set over all institutions deemed systemically risky or too-big-to-fail. And the council could be up and running quickly, while it might take years for any existing agency to assemble the requisite skills to oversee all areas of the financial system. Critics of the model have said that convening a committee is not the best way to put out a fire, and that may be, but the goal of systemic risk regulation should be to prevent or contain fires before they consume our financial system, and a broad-based council surely is the very best body for designing a strong fire code. Thank you for the opportunity to testify. I look forward to your questions. Senator Warner. Thank you for both getting your statements in under your time. Ms. Rivlin, the Chairman is back. Let us see if we can keep this, you know, if I can show off a little bit to show that everybody gets through their statements quickly.STATEMENT OF ALICE M. RIVLIN, SENIOR FELLOW, ECONOMIC STUDIES, CHRG-111shrg54789--172 PREPARED STATEMENT OF RICHARD BLUMENTHAL Attorney General, State of Connecticut July 14, 2009 I appreciate the opportunity to strongly support the Administration's proposal to create a Federal agency dedicated solely to protecting consumer interests in financial products and markets, and preserve and expand State consumer protection authority. The new agency--a consumer financial guardian--promises to be a powerful watchdog and protector, and a partner of State attorneys general in fighting for our citizens. The proposal marks a giant step toward restoring an historic Federal-State alliance in combating financial fraud and abuse. This Federal-State partnership was riven by excessive resort to Federal preemption--displacing State enforcement and replacing Federal-State collegiality and cooperation with relentless conflict. The new agency is a necessary and appropriate response to exploding complexity, scope, and scale of new financial instruments and markets--and exponentially increasing impact on ordinary citizens. It fills a deeply felt consumer need. Ever more slick and sophisticated marketing--often misleading and deceptive--cannot be battled successfully by States alone, or the existing Federal agencies. Creating a new agency to fight consumer cons and abuse in alliance with the States, the Federal Government can muster more potent and proactive policing and prosecution. A new consumer guardian--we need it, and now. New firepower, focus and drive, all are vital. The new agency will be more an enforcer, than a regulator. At the Federal level, the new agency would investigate law breaking and enable and assist Department of Justice prosecutions, both civil and criminal. Unfortunately, some opponents of this agency have misrepresented its purpose. The Financial Consumer Protection Agency will not ``regulate credit.'' It will not make choices for consumers or deny them access to products and services. Instead, one of its main missions will be to assure that consumers are informed in clear, layman's language of the terms and conditions of credit cards, mortgages, and loans. The point is to assure that consumers fully understand the financial realities and consequences of financial obligations, credit cards, or loans they are considering before they make commitments. As even experienced lawyers and consumer protection advocates can attest, anyone attempting to understand their credit card agreements all too frequently faces incomprehensible, consuming small print with huge consequences. This agency's purpose is to assure people have good information so they can make good financial decisions. Once they use that information and make decisions, they will have to live with the consequences.Federal Preemption Doctrine Disaster For far too long, States have been forced to the sidelines, standing helplessly, while credit card, mortgage, and financial rescue companies used Federal preemption as a shield to stop State consumer protection agencies from enforcing State laws against unfair and unscrupulous practices. Connecticut consumers have been scammed by fraudulent and unfair marketing schemes and products by companies who create or affiliate with national banks solely to avoid State consumer protection laws. Worse, Federal agencies have been complicit--aiding and abetting lawbreakers by supporting preemption claims when States sued to stop these unfair practices and recover consumer losses. Federal agencies went AWOL--not only disavowing their firepower but disarming State enforcers. They forced States from the battlefield and then abandoned it--in countless areas of consumer protection. They enabled and encouraged use of preemption as an impregnable shield to protect mortgage fraud, credit card abuses, securities scams, banking failure, and many deceptive and misleading snake oil pitches. The financial meltdown was foreseeable--and foreseen--by enforcement authorities who warned of irresponsible and reprehensible retreat and surrender in Federal law enforcement. There were warnings--including mine--about a regulatory black hole concerning hedge funds, derivatives, credit default swaps, excess leverage devices and other practices. I used this term--regulatory black hole--to characterize lack of oversight and scrutiny that enabled self dealing, excessive risk-taking, and other abuses that sabotaged the system. The national financial meltdown was directly due to massive Federal law enforcement failure--lax or dysfunctional Federal oversight and scrutiny of increasingly arcane, complex, opaque, risky practices and products. Federal law placed all enforcement and regulatory authority in an array of Federal agencies that were inept, underfunded, complacent or complicit. The result was a void or vacuum unprecedented since the Great Depression. Robust State investigatory and enforcement authority no doubt would have revealed unfair and illegal activities sooner and helped fill the gap left by Federal inaction and inertia. Putting State cops on the consumer protection beat would have sent a message--educating the public, deterring wrongdoing, punishing lawbreakers. Connecticut has been at the forefront of State efforts to protect consumers from unfair and fraudulent financial transactions. And two areas illustrate the obstacles that we and other States have faced under the current system. Tax preparers use the lure of instant cash to entice taxpayers--mostly low income--to borrow money at extremely high interest rates, using their tax refund to pay these loans. Recognizing that Connecticut could not regulate such usurious lending by national banks, our State sought to cap at 60 percent the interest charged on loans made through a tax preparer' or other facilitator of the loan. The statute was challenged by lenders who charge more than 300 percent annual interest rate. As a former United States Attorney, I can tell you that organized crime would offer a better deal. The Federal Second Circuit Court of Appeals held that Connecticut law could not be applied to national banks or their agents. Pacific Capital v. Connecticut, 542 F.3d 341 (2d Cir. 2008). As a result, consumers continue to pay astronomical interest rates for such refund anticipation loans. Second, even as gift cards have become increasingly popular in Connecticut and the country, consumers often see their cash value erode over time because of hidden inactivity fees or short expiration dates. In response, Connecticut prohibited both inactivity fees and expiration dates. Mall operators and retail chain stores avoided such consumer protection laws by merely contracting with national banks to issue gift cards. The Second Circuit Court of Appeals held that State consumer protection laws are preempted because the State measures affect a national bank rule. It ruled that Visa gift cards had expiration dates so the State could not prohibit them. SPGGC v. Blumenthal, 505 F.3d 183 (2d Cir. 2007). The result is pervasive consumer confusion because some gift cards issued by national banks may expire, but others have no such expiration dates. Other States have faced similar preemption obstacles to protecting consumers. My colleague in Minnesota began investigating Capital One's credit card marketing practices under the State's consumer protection laws. Capital One transferred all its credit card operations into a national bank, successfully halting the investigation, because Minnesota's consumer protection laws were preempted. Similarly, an Illinois investigation into Wells Fargo Financial's steering of minorities into high cost loans was stymied by Wells Fargo's transfer of those assets into a national bank.A Historic New Alliance I speak for other States in my enthusiastic and energetic support for section 1041 provisions of the Consumer Financial Protection Agency Act of 2009 that establish Federal law as a minimum standard for consumer protection, allowing States to enact laws and regulations ``if the protection such statute, regulation, order, or interpretation affords consumers is greater than the protection provided under this title, as determined by the [Consumer Financial Protection] agency.'' In addition, the proposal amends various Federal preemption statutes to unshackle the States, allowing enactment of consumer protections at the State level that may become a model for Federal, nationwide standards. This law exemplifies federalism at its best--State and Federal authorities working in common rather than conflict, and making the States laboratories for new, creative measures. Many of our most prominent Federal consumer protection laws were first adopted by States.A Federal Consumer Financial Super Cop I also support the establishment of the Consumer Financial Protection Agency, a Federal office dedicated solely to protection of ordinary citizens using the Federal savings and payment market. Currently, consumer credit products are regulated by at least seven different agencies whose primary focus is the proper operation of markets and the safety and soundness of institutions. While consumer protection is within their jurisdiction, it is far from their major focus. Nor does any existing agency dedicate significant or sufficient resources to this responsibility. They pay scant attention to consumer complaints, often reviewing such problems from an industry perspective rather than the consumer's. Indeed, these agencies face divided loyalties or even conflicts of interest--when high interest rates and astronomical credit card fees, for example, may be good for the bottom line, but bad for consumers. Given the understandable emphasis on safety and soundness, consumer protection not surprisingly receives Short shrift. The Consumer Financial Protection Agency would have broad authority to promulgate and enforce rules to protect consumers from unfair and deceptive practices and to ensure they understand terms and conditions. These regulations will encourage, not stifle, the development of financial products that well serve consumers. A vibrant, competitive market that is fair and honest is essential to consumers' and the Financial Industry's financial interests. Clear rules and consistent enforcement are vital prerequisites for innovation and wealth creation. To mix metaphors, what's needed is a more level playing field--essentially rational rules of the roads. When intersections become busy, they need to upgrade from stop signs to traffic lights to avoid car crashes, collisions and pile ups. As the proposal recognizes, joint proactive consumer protection enforcement by both Federal and State agencies--without preemption or exclusive jurisdiction--best serves consumer interests, especially as financial products and markets grow in complexity and number. State agencies--including State attorneys general and other consumer protection agencies--are often the first line of defense for consumers. Consumers are usually far more comfortable contacting their State officials rather than nameless faraway Federal agencies. I have seen firsthand the frustration of consumers when we have had to tell them that my office is legally powerless to help because of Federal preemption of State enforcement authority. Under the proposal, States may enact and enforce consumer protection laws that are consistent with Federal law. In addition, State attorneys general may enforce Federal rules and regulations in this area provided that the Federal Consumer Financial Protection Agency is notified of such enforcement action and has the opportunity to join or assume responsibility. This notification process seeks Federal-State coordination without necessarily allocating primacy to the Federal agency. State Attorneys General welcome the Federal Government as an ally rather than an adversary. Joint efforts can involve far more effective and more efficient use of our resources. Joint State and Federal enforcement efforts are neither new nor novel. States regularly work with each other and the Federal Government in recovering hundreds of millions of dollars in Medicaid and health care fraud, enforcing our respective antitrust laws against anticompetitive mergers and acquisitions or abuse of market power, and applying consumer protections laws against deceptive or misleading advertisements. I served for several years as chair of the National Association of Attorneys General Antitrust Executive Committee which included regular meetings with the heads of the Department of Justice Antitrust Division and the Federal Trade Commission. Successful collaborations once were common--against Microsoft for example--especially when the Federal Government was an active antitrust enforcer. There are plenty of successful models of joint action involving, for example, the Federal Trade Commission and the United States Department of Justice's Antitrust Division. Separating regulatory authority from consumer protection authority also has models at the State level. In Connecticut, for example, the Department of Banking regulates the banking industry while the Department of Consumer Protection through the Office of the Attorney General has broad consumer fraud enforcement authority. That authority extends to the banking industry. The Connecticut Supreme Court specifically applied our unfair and deceptive trade practices act to the banking industry. Mead v. Burns, 199 Conn. 651 (1986). I appreciate the industry's concern about two sets of agencies with enforcement authority. The industry justifiably wants predictability of regulation to properly plan product development and promotion. This bill will do so by creating a regulatory floor that applies nationwide. Most valuable would be predictability of vigilant and vigorous enforcement. The message must be that a revived and reinvigorated Federal-State alliance will punish any company that profits from illegal anticonsumer devices or unfair and deceptive practices. The predictable outcome is that anyone who cons or scams consumers in financial products will be prosecuted. Part of the genius of our Federal system is that it creates separate distinct sets of authority in Federal and State governments. Individual State experiments in solving problems and lawmaking can be models for Federal statutes as well as other States. Our United States Constitution assures that States cannot adopt rules inconsistent or conflicting with Federal authority. Finally, I urge the Committee to consider authorizing private rights of action against consumer fraud. Most State consumer protection statutes permit such private legal actions enabling victims to bring legal actions and recover damages, sometimes when State authorities may not do so. These initiatives supplement and strengthen State consumer protection enforcement efforts. They could similarly enhance and enlarge Federal enforcement efforts. I appreciate and applaud your and the Administration's dedication to protecting consumers in financial transactions. I commend this Committee's support of these efforts and offer my continuing assistance--along with other State attorneys general. Thank you. ______ 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-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-111shrg54789--157 Mr. Blumenthal," I would agree with everything you have just said except perhaps with the term ``overreach.'' And I do not mean to quibble or criticize. I agree with you wholeheartedly that this bill is a first draft; it needs refinement, it needs work. And I think with your help, with Senator Shelby's, and with all the Senators who are here, particularly Senator Dodd, we are going to reach the goal line. But I do think that a point of accountability somewhere that your constituents can call when they have a question or a problem and they need an enforcer to protect them against a usurious interest rate or any of the abuses we have been talking about here I think is tremendously important. Thank you. Senator Reed. Thank you. Senator Menendez. Senator Menendez. Thank you, Mr. Chairman. Thank you all for your testimony. Mr. Yingling, I appreciate many of the comments you made. I know you spent a lot of time in your testimony talking about community banks, and I am concerned about the pressures we are putting on them. But it was not just community banks. If it was just community banks, we would not be in trouble. You know, we have Bank of America, we have given it a lot of money; Citi, we have given it a lot of money. So while I understand your focus on community banks, the reality is that we have a range of banks here, some which clearly acted in ways that were not, I guess, in their interest and certainly not in our collective interest because they created systemic risk, and that is why we are giving them enormous amounts of money. And while I think you have some legitimate concerns in your testimony, I am concerned, as I have said in the past to the association on other matters, is that, you know, I read the elements of what you have listed here as improvements that can be made. And, you know, my concern is that if the industry does not get out there and be for significant changes, then it will face a legislative action that it probably will not like at the end of the day. And so I hope that when you say that we are not for the status quo and we are for change--but I read the changes and, you know, centralized call centers and, you know, basically saying that we should enable basic products, you know, when even in your testimony you recognize some of those problems become overly complex and difficult, as well as that they often have consumers buying products or enhancements that are not right for them, for which they pay too much, you know, is not in my mind the type of reform we are going to need. I appreciate what you talked about on OTS. That is, I think, a good offer, but after that it seems very little to me. So I would urge, you know, the association to be more aggressive in what they are offering here in terms of a legislative response. And I am concerned, you know, that--I look at where we are at, and it seems to me that a lot of, prior to the crisis, financial institutions changed their charters to shop for lenient regulators. And it seems to me that by imposing uniform regulations on consumers financial products across all types of financial institutions, one of your concerns, but listening to the Secretary pretty much sound to me like we are talking about all types of financial institutions no matter who regulates them, wouldn't the Consumer Financial Protection Agency reduce the incentives to shop for more lenient regulators, at least with respect to consumer product legislation? So I think that while we can tailor this a little better, the reality is that we need this. So, you know, I am--I hope the industry will be a little bit more forthcoming in terms of real change so that we can strike the right balance at the end of the day between having the financial products we all want to see open to consumers but having the protections that are critical at the end of the day. And it is in that spirit that, you know, I certainly come to this with, and I hope others do as well. I just get, you know, a sense--you know, Mr. Plunkett, when most Americans go apply for one of the hundreds of different kinds of mortgages, they do not typically bring a financial adviser along with them, do they? " 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-110hhrg45625--151 Mr. Bernanke," There have been a number of reviews and studies of all the issues that contributed to the crisis, and that is one of the issues that was identified. You are right; it was a problem. They are working to fix it now. But it was one of the contributors to this crisis. But this goes to your previous point, why not have reform all in this bill? There are many, many components to it, and it is a complex process to achieve. We need to do it. We will do it. Certainly, the Federal Reserve will do everything it can to support it. But it can't be done in a few days. " CHRG-110hhrg34673--77 Mr. Bernanke," I can respond quickly to a few. Multiple standards for Sarbanes Oxley is an interesting idea, but I would note that the audit standard that allows size and complexity to be a consideration does to some extent do that. On income inequality, this is a very long-term trend. At least since the 1970's, and according to some measures from the 1950's, we have been seeing this trend, and I don't think there is any really good way to reverse it overnight. I think it is going to be a slow progress. " CHRG-109hhrg28024--29 Mr. Bernanke," Congresswoman, thank you. I believe that research and development are essential to our growth in a technological era. I think there are considerable grounds for optimism. The United States remains a technological leader. We retain a very substantial share of the world's patents and publications and innovations. That's a position we want to keep. How to promote that? First on the public side, I think most economists would agree that support by the Government of basic research in a variety of areas is productive. Private companies can't necessarily capture the benefits of basic research and, therefore, Government support in that area is beneficial. We also have in this country substantial private sector research and research within universities. I don't want to get into any details, really, on tax policy, but I simply note that this Congress will consider extension of the research and development tax credit, which will be one mechanism to support R&D at the private sector level. So I agree. This is a very high priority for the U.S. economy, and it's needed to keep us technologically at the frontier. Ms. Biggert. Thank you. We have had a relatively warm winter, a little bit of snow lately in various parts of this country. But there hasn't been any--I don't think any noticeable slowing in the steady rise in the price of energy over the last year or more. But however, the economy is going strong. Why has the economy been able to shrug off such a significant rise in the cost of energy? " CHRG-110shrg50418--9 STATEMENT OF SENATOR CHARLES E. SCHUMER Senator Schumer. Thank you, Mr. Chairman. I thank you and Senator Shelby for holding this obviously very timely and important hearing. Survival of the auto companies is imperative for America's ability to remain the global economic leader in innovation. At a time when there are tremendous horizons of opportunity in the auto sector, helping the industry meet its challenges is very important. We should not drop out of the race before we have had a chance to compete. And given the fragility of our economy today, ignoring the plight of the auto industry would only accelerate an economic downturn and make it more difficult for our Nation to return to prosperity. Bankruptcy of one or more major companies at this point in time in our economy would have far more severe effects than during a time of relative prosperity or stability. The auto industry is a bedrock of our economy. Almost 4 percent of the Nation's GDP comes from autos. That is 10 percent of our industrial production by value. What is more, the industry supports 3 million ancillary jobs--jobs we must preserve when employment is decreasing by over 200,000 jobs a month, and more massive layoffs are expected as a result of the credit crisis. And thousands of these jobs, Mr. Chairman, are in my State of New York, where the auto industry has been an important part of the local economy for decades. Large portions of the economies in western New York, the Rochester area, Syracuse, and other places depend on the auto industry. So, while I believe that the auto industry is too vital to let fail, I do share many of my colleagues' concerns that what we are being asked to do is not the end but the beginning, and that you will be back before us in a matter of months. We must be assured that whatever aid we give you is accompanied by a real plan that shows you recognize the direction that this industry must take in order to not to survive but to thrive. I believe we must take action in the short term to save the industry, but we also need to hear a plan from the auto executives sitting here today. We need them to reassure us they will not come back again in 6 months in the same sinking boat asking for another $50 billion to plug more holes. A business model based on a gas-guzzling past is unacceptable. We need a business model based on cars of the future, and we already know what that future is: the plug-in hybrid electric car. We need to know that you will be committed to building the cars that will make America a leader in automotive innovation and are committing the appropriate resources to get this done, even if it means sacrificing some short-term income for your long-term investment in the future. I am hopeful that our Republican colleagues will recognize the urgency of this situation and join us in this critical investment in our future. Thank you, Mr. Chairman. " CHRG-111hhrg54867--3 Mr. Bachus," I thank the chairman for holding this hearing. And, Secretary Geithner, I thank you for returning to our committee to discuss the President's proposals for regulatory reform. The Administration has presented to Congress a far-reaching regulatory reform proposal which, as of today, has failed to achieve anything approaching consensus, either on Capitol Hill or even among the Federal regulators who would be responsible for implementing it. The lesson that we learned from the events that led to the financial crisis and subsequent government actions is that our 1930 regulatory system is not up to the task of monitoring the safety and soundness of complex financial institutions in the 21st Century. We do need smarter regulation, but not necessarily more regulation. We need enforcement of existing regulation, not another layer of regulation or more government bureaucracy. And, finally, what we do not need and what we have had too often is government policies which encourage harmful business practices or incentivize those practices or, when they went terribly wrong, blessed them with bailouts. The chairman used the term ``liquidate and resolve.'' And I think that most of my colleagues welcome that, as opposed to what the Administration started by saying, and the chairman, using words like ``rescue,'' because ``rescue'' implies that the taxpayers will be presented with the ultimate bill. Unfortunately, the Administration's regulatory reform plan continues the pattern that we have seen with health care and energy of a big-government solution that replaces individual choices with bureaucratic mandates. Their plan establishes the Federal Reserve as the systemic risk regulator, despite the fact that the Fed has historically done a poor job of identifying and addressing systemic risk before they become crises. It tasks the Fed with identifying a class of systemically significant firms that the market will view as ``too-big-to-fail,'' as the chairman said, and then compounds this mistake by creating a so-called resolution authority that will promote continued taxpayer-funded bailouts of these institutions rather than actually unwinding and shutting down their operations. And, finally, the Administration plan would establish a massive new government bureaucracy known as the Consumer Financial Protection Agency, which consumers will ultimately pay for on top of the numerous regulatory agencies and the regulatory legislation and patchwork that currently exists. Mr. Chairman, my deep-seated reservations about the Administration's financial reform proposals, which, again, I point out are shared by Members on both sides of the aisle and many of the regulators themselves, should not be interpreted as a rejection of commonsense reform. Although Republicans have taken a different path than the Administration's, we are not saying ``no'' to reform. Republicans are saying ``no'' to more bailouts and ``no'' to more of the same approach of misguided government regulations and interventions which helped bring about the crisis in the first place. Republicans have offered a clear alternative to the Administration's approach to reform and will continue to do so. The Republican plan promotes effective consumer protection by streamlining and consolidating the functions of the bank regulators, including consumer protection, into a unified agency. End the bailouts. Our plan directs all failed nonbanks to an enhanced bankruptcy process that will force creditors and counterparties of those firms to bear the cost of failure rather than sticking the taxpayer with the tab. To promote sound monetary policy, our plan relieves the Fed of its current supervisory duties and prohibits the Fed from bailing out any specific financial institution. Mr. Chairman and Mr. Secretary, I thank both of you. I look forward to working with you and my colleagues in the months ahead as we address regulatory reform. Thank you. " CHRG-110hhrg45625--95 Mr. Bernanke," Well, we really had two stages in this credit cycle. The first stage was the write-downs of subprime and CDOs and those kind of complex instruments. We are now in the stage, with the economy slowing down, where we are seeing increased losses in a variety of things, ranging from car loans and credit cards, to business loans and so on. And that is going to put additional pressure on banks. It is another reason why they are pulling back, building up their reserves, building up their capital, de-leveraging their balance sheets, and that is going to prevent them from providing as much credit as our economy needs. Ms. Velazquez. Thank you. Secretary Paulson, we are hearing about small business loans being called in, and up to a third may have a callable provision and not be delinquent. Lenders are also reducing credit to entrepreneurs, and we are aware that the Federal Reserve reported that 65 percent of lending institutions tightened their lending standards on commercial and industrial loans to small firms. Given these challenging conditions, how will the current proposal specifically address the challenges facing small business? Before, you said in your intervention how this is going to help small businesses. Well, they too are victims now of the financial market mess that we are in. " 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. CHRG-111hhrg54867--197 Secretary Geithner," Even on the systemic risk, the stability's function, which is so important, what we are proposing to give the Fed is the authority to make sure they can actually supervise and apply conservative capital requirements on these large complex institutions; they can make sure that the payment system, which is what spreads crisis, runs with tighter capital margin requirements. Those are important authorities that are not as clearly established in the law as we think is necessary. That would be a good thing for the country. " FOMC20080130meeting--363 361,MR. GIBSON.," Really, the question is, What sort of market forces would produce that outcome? It certainly seems as though things should move in that direction, and we feel that some of the recommendations we are making on the differentiation between structured-finance securities and corporate securities would encourage the rating agencies to put more scrutiny on the structured-finance side of it. Yes, those ratings should be lower, especially when you factor in things like the complexity and the uncertainty. " CHRG-111hhrg48875--170 Secretary Geithner," Well, that is the great question. I mean, under the laws of the land, AIG was allowed to build up, through a variety of complex structures, huge amounts of risk relative to the capital they put up. And there was really no accountable competent authority overseeing that broad process. And that is what put us to the point where, again, the government had no choice but to come in and try to unwind this in a sort of carefully measured way. " CHRG-111shrg54789--116 Mr. Blumenthal," Thank you, Senator. I am very, very honored by those kind words, especially from someone who has led consumer protection efforts in the country, most recently in the credit reform bill, and I want to thank you very sincerely for all that you have done in other areas of consumer protection and the leadership that you will no doubt provide the Committee in this area, which as you have said marks what seems to be a radical departure from past practices in a time that demands radical solutions. It is a fundamental break with the past that is very well justified by recent history. This proposal would create a new agency, a very strong financial products watchdog and guardian, similar to the one that now exists at the Federal level in the Federal Trade Commission for other kinds of products, the Consumer Product Safety Commission for certain kinds of other goods and services, and essentially would restore the historic State-Federal alliance that existed for so many years so productively in combating financial fraud and abuse. This financial State partnership was riven and destroyed by excessive resort to Federal preemption, which displaced State enforcement and replaced that collegiality between Federal and State officials with conflict and tension that need not have existed. In fact, that conflict was one of the reasons why we saw the kinds of abuses that led to the financial meltdown. That meltdown was foreseeable. Indeed, it was foreseen. I used the word ``regulatory black hole'' to characterize hedge funds and many of the other inventive and innovative financial instruments that very few people understood even as they used them, and the excessive risk taking, often with other people's money, that was enabled by that regulatory black hole. And so I think that the genius of this proposal, or its great advantage, is to restore the alliance between consumer protectors at the Federal and State level. The doctrine of Federal preemption has essentially led to the Federal Government abandoning the battlefield and then foreclosing the States from fighting on that battlefield. It has in so many areas prevented States, in fact, in many of those same areas that Secretary Barr answered to Senator Warner's question--payday loans, tax preparer anticipation refund loans, credit card issues, mortgage abuses--and I describe in my testimony--I am not going to read the testimony but just briefly say that in many of those areas where these abuses developed, our opponent was most frequently the Office of the Comptroller of the Currency. I litigated more against the OCC than I did against any other single institution. And the most recent Supreme Court decision, Cuomo v. Clearinghouse Association, which restores some of our authority under the National Bank Act, was really against the OCC. And so it isn't only that Federal authority has been fragmented, that the culture has been wanting, that the FTC has lacked the tools and resources, it is the hostility, the overt antagonism and adversarial posture of the Federal Government as against the States in consumer protection. And if it does nothing else--and it does a lot else--this proposal will help restore that alliance between State Attorneys General and the Federal Government. I believe very strongly that this proposal is a good idea. There are details, as many Senators have already remarked, that need to be refined and perhaps changed. But in concept, the idea of having one central point accountable, fully accountable to those consumers out there who don't know where to call--and right now call my office--is a very, very important concept. The accountability to this body of the Consumer Financial Products Commission or Agency will be a tremendous advantage. And let me just close by saying I couldn't agree more, based on 18 years as Attorney General, that consumers ultimately have to be their own protectors. But anybody who right now reads most of these documents, and I am trained to read them, will find them extraordinarily perplexing and confusing, not just in the fine print but in their concepts. And so this agency, as job number one, ought to not only fill that regulatory black hole, but provide for clear, truthful, accurate disclosure, and that is one of the essential missions that has been completely absent. I agree completely that the prudential responsibilities of the Fed and other existing agencies probably conflict, or at least create divided loyalties so far as consumer protection is concerned, another reason why we can't use either the FTC or the Federal Reserve to carry these important responsibilities, because consumer protection, especially in disclosure, is a mission that really requires, in financial products, a separate and distinct agency that has that accountability and will replace the current culture, the current mindset of conflict with the States and resistance to aggressive and vigorous consumer protection. Thank you very much. " CHRG-110hhrg44900--46 Secretary Paulson," Well, yes. I think maybe I should have even been clearer on this. In terms of--when we started thinking about regulatory structure, we began the thinking before this period of market turmoil, well before this. And we started off saying, if we were beginning from scratch, which we obviously aren't, how would you design a system? And that was more of a vision to start a discussion. And to me, to get to there, as the Chairman said, would take a good while. We are talking about multiple years. But if you don't know which way you would like to head, you know, you have no chance of getting there. So we started with that vision, and then we came up with some immediate priorities and some other things that could be done in the intermediate term. And as I look at what can be done in terms of the timing the one thing we are not talking about a lot here, but I do believe we don't want to forget, is the fact that a lot of this problem came about as a result of sloppy and lax mortgage origination procedures. These mortgages were originated, most--many cases at the State level with State regulation and supervision. We weren't proposing doing away with this, but a mortgage origination commission to set standards at the Federal level and evaluate what's going on, you know, at the States, I think is something you shouldn't lose sight of. And then the things we have talked about here that can be done quickly are the resolution authorities for complex financial institutions that aren't federally insured, giving the Federal Reserve authority and responsibility over the payment systems, which can be done very quickly; moving to have the Fed while retaining their responsibilities as a consolidated regulator, to give them the authorities they need to do the macro stability job, can be done. And then, looking out a little bit further, there is no doubt that we should have a merger, in my mind, with the SEC and the CFTC. And so that again is something that can be done in the intermediate term, as could an optional Federal charter for insurance. " CHRG-111shrg54789--123 Mr. Plunkett," Mr. Chairman, Ranking Member Shelby, Members of the Committee, it is good to be back with you. I am testifying today on behalf of the Consumer Federation of America and 23 consumer, community, civil rights, and labor organizations. We strongly support the Administration's proposal to create a Federal Consumer Protection Agency focused on credit, banking, and payment products because it targets the most significant underlying causes of the massive regulatory failures that have led to harm for millions of Americans. First, agencies did not make protecting consumers from lending abuses a priority. In fact, they appeared to compete against each other to keep standards low and reduce oversight of financial institutions, ignoring many festering problems that grew worse over time. If they did act, and they often didn't, the process was cumbersome and time consuming. As a result, they did not stop abusive lending practices in many cases until it was too late. Finally, regulators were not truly independent of the influence of the financial institutions they regulated. The extent and impact of these regulatory failures is breathtaking. I offer 10 pages of detail on 12 separate regulatory collapses in my testimony over the last decade that have harmed consumers and increased their financial vulnerability in the middle of a deep recession. This involves not just the well-known blunders that we have heard about on mortgage lending and credit card lending. I also offer lesser-known but quite damaging cases of regulatory inaction, such as the failure of regulators to stop banks from offering extremely high-cost overdraft loans without consumer consent, the permission that Internet payday lenders have gotten from regulators to exploit gaps in Federal law, and the fact that regulators have not stopped banks that impose unlawful freezes on accounts containing Social Security and other protected funds. Meanwhile, the situation for consumers keeps getting worse as a result of these regulatory failures and the economic problems in our country. One in two consumers who get payday loans default within the first year. Mortgage defaults and credit card charge-offs are at record levels. Personal bankruptcies have increased sharply, up by one-third in the last year. Combining safety and soundness supervision with its focus on bank profitability in the same institutions, regulatory institutions, as consumer protection magnified an ideological predisposition or antiregulatory bias by Federal officials that led to unwillingness to rein in abusive lending before it triggered the housing and economic crisis. But we now know that effective consumer protection leads to effective safety and soundness. Structural flaws in the Federal regulatory system compromised the independence of banking regulators and encouraged them to overlook, ignore, and minimize their mission to protect consumers. The Administration's proposal would correct these structural flaws. Key facets of this proposal include streamlining the Federal bureaucracy by consolidating consumer protection rulemaking for seven different agencies in almost 20 statutes; providing the agency with authority to address unfair, abusive, and deceptive practices; ensuring that agency rules would be a floor and not a ceiling and that States could exceed and enforce these standards. In response to this far-sighted proposal, the financial services industry has launched an elaborate defense of the status quo by minimizing the harm that the current disclosure-only regime has caused Americans, making the usual threats that improving consumer protection will increase costs and impede access to credit, and offering recommendations for reform that barely tinker with the existing failed regulatory regime. These critics are hoping that this Committee will overlook the fact that the deregulatory regime that they championed and largely controlled has allowed deceptive, unsustainable, and abusive loan products to flourish, which has helped cause an economic crisis and a credit crunch. In other words, the regulatory system that creditors helped create has not only led to direct financial harm for millions of vulnerable Americans, but it has reduced their access to and increased their costs on the credit they are offered. Only a substantial restructuring of the regulatory apparatus through the creation of this kind of agency offers the possibility of meaningful improvement for consumers in the credit markets. The agency will be charged with spurring fair practices, transparency, and positive innovation in the credit markets, which should lead to a vibrant, competitive credit marketplace for many years to come. We strongly urge the Committee to support this proposal. Thank you. Senator Reed. Thank you, Mr. Plunkett. Mr. Wallison, please. STATEMENT OF PETER WALLISON, ARTHUR F. BURNS FELLOW, AMERICAN CHRG-111shrg51395--98 Mr. Stevens," Thank you, Senator. I think it is a really excellent question, and I have asked myself this, and it is not intended as a competitive observation. If Franklin Roosevelt were to come back today and he would find we had these enormous pooled funds that were outside, virtually outside of any form of regulation, I think he would say, ``I thought we solved that problem in 1940.'' We need to make sure that the evident developments--and these are not secrets--the evident developments, major developments in our capital markets are addressed as they arise. Hedge fund investing is no doubt a tremendous innovation that can be of great value. But there were trillions of dollars in hedge funds that had no form of regulation. I think that is something that Congress was aware of, certainly the SEC was aware of. You could say the same about the major pooled funds in the money markets that will be part of the subject of our report when it is issued. Money market mutual funds are about a $4 trillion intermediary, but we're only about a third of the money market, which has many other pooled funds. So I think it is a problem--and this is how I envision it--of making sure that the capital markets regulator is staying even with market developments, and that is going to require not only nimbleness at a regulatory level, but, frankly, Mr. Chairman, it requires--it puts a burden on Committees like yours, because in many instances it is going to require the tough work of closing regulatory gaps, providing new authority, and even providing new resources. I do not think, however, that the answer, Senator is creating a new agency that only looks at products, because those products arise and exist in the context of a larger marketplace, and they need to be understood in that context. Senator Warner. Mr. Ryan. " CHRG-111shrg52966--55 Mr. Sirri," I think there is an element of accuracy to that, but I think there are tools available to us as regulators. Let me give you a specific instance. You are right, a particular complex financial firm will develop a model for risk, but they will have a process around that model for risk. And we care about the processes and the robustness of the processes and controls. So, for example, a model for risk is developed. Who validates it? Who verifies it? Who runs that model? If they report to the trading desk whose assets they are pricing, that is not helpful and that is problematic. If they report to an independent third-party that perhaps reports directly to the CFO or a risk officer, much stronger structure, gives you some comfort. Again, let me take a second one, a price verification group. You may have a firm that trades assets, but they have problems valuing assets, as you do when liquidity dries up. When valuations are struck, how are those valuations struck? There may be a model. Who validates the model? And how do you resolve disputes? If the trader says it is worth more than the risk person says it is worth, how do you resolve that? Is there a process where it could go up to the audit committee? And if it goes to the audit committee, does the After Action Report--the phrase you used--for that instance, does that go to the board of directors? Such processes, if they are in place, tell you that that firm is taking their job seriously. Senator Reed. I would presume, and correct me, that those procedures, those appropriate procedures you described, were not being deployed very successfully at Bear Stearns or Lehman Brothers. Were you aware of kind of those deficiencies contemporaneously with their---- " 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-111hhrg55814--263 DEPOSIT INSURANCE CORPORATION Ms. Bair. Chairman Frank, Ranking Member Bachus, Congressman Moore, and members of the committee, I appreciate the opportunity to testify today regarding proposed improvements to our financial regulatory system. The proposals being considered by the committee cover an array of critical issues affecting the banking industry and financial markets. There is an urgent need for Congress to address the root causes of the financial crisis, particularly with regard to resolution authority. In the past week, this committee passed a bill to create a Consumer Financial Protection Agency, a standard-setting consumer watchdog that offers real protection from abusive financial products offered by both banks and non-banks. The committee is also considering other important legislation affecting derivatives and securitization markets. However, today, I will focus on two issues that are of particular importance to the FDIC. First, a critical need exists to create a comprehensive resolution mechanism to impose discipline on large interconnected firms and end ``too-big-to-fail.'' I truly appreciate the efforts of the committee in moving forward with legislation to address this crucial matter. Second, changes need to be made to the existing supervisory system to plug regulatory gaps and effectively identify and address issues that pose risks to the financial system. 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. So at the top of the must-do list is a need to ban bailouts and impose market discipline. The discussion draft proposes a statutory mechanism to resolve large interconnected institutions in an orderly fashion that is similar to what we have for depository institutions. While our process can be painful for shareholders and creditors, it is necessary and it works. Unfortunately, measures taken by the government during the past year, while necessary to stabilize credit markets, have only reinforced the doctrine that some financial firms are simply ``too-big-to-fail.'' The discussion draft includes important powers to provide system-wide liquidity support in extraordinary circumstances, but we must move decisively to end any prospect for a bailout of failing firms. For this reason, we would suggest changes that take away the power to appoint a conservator for a troubled firm and eliminate provisions that could be interpreted to allow firm-specific support for open institutions. Ending ``too-big-to-fail'' and the moral hazard it brings requires meaningful restraints on all types of government assistance, whatever its source. Any support should be subject at a minimum to the safeguards existing today in the systemic risk procedures. To protect taxpayers, working capital for this new resolution process should be pre-funded through industry assessments. We believe that a pre-funded reserve has significant advantages over an ex-post fund. All large firms, not just the survivors, would pay risk-based assessments into the fund. This approach would also avoid assessing firms in a crisis. The assessment base should encompass only activities outside insured depository institutions to avoid double counting. The crisis has clearly revealed regulatory gaps that can encourage regulatory arbitrage. Therefore, we need a better regulatory framework that proactively identifies and addresses gaps or weaknesses before they threaten the financial system. I believe a strong oversight council should closely monitor the entire system for such problems as excessive leverage, inadequate capital, and overreliance on short-term funding. A strong oversight council should have authority to set minimum standards and require their implementation. That would provide an important check to assure that primary supervisors are fulfilling their responsibilities. To be sure, there is much to be done if we are to prevent another financial crisis. But at a minimum, we need to establish a comprehensive resolution mechanism that will do away with ``too-big-to-fail'' and set up a strong oversight council and supervisory structure to keep close tabs on the entire system. The discussion draft is an important step forward in this process, and I look forward to working with you on these proposals. Thank you. [The prepared statement of Chairman Bair can be found on page 99 of the appendix.] Mr. Moore of Kansas. [presiding] Mr. Comptroller? STATEMENT OF THE HONORABLE JOHN C. DUGAN, COMPTROLLER, OFFICE OF THE COMPTROLLER OF THE CURRENCY (OCC) " CHRG-111shrg382--26 Mr. Tarullo," Senator, a little bit of history here may be useful. In the spring, the Financial Stability Board came out with its set of principles on incentive compensation, and we, meaning the United States, but specifically the staff from the Federal Reserve, have been very closely involved in the articulation of those principles. At that time, we began internally our process of thinking about how we would want to give guidance to the institutions we supervise to implement those principles. And the press reports which people saw a couple of weeks ago reflected, more or less accurately, the direction in which we are headed. The Board has not actually voted on the guidance yet, but it reflected accurately the direction in which we are headed. And that direction is one which, as you say, emphasizes that there is not a single formula that is sensible for all kinds of employees who have the capacity to assume a lot of risk for their enterprises in a variety of different companies. So our approach, I think, has been to want a rigorous internal process in firms in which the onus is on them to develop the right kinds of compensation contracts and provisions, taking into account their particular business and the kinds of responsibilities their employees have, but that those specific policies and practices need to be consistent with the overall goals of risk-appropriate incentive-based compensation. We worked on that and continue to work on it, but we worked on it through the spring and the summer, knowing what kinds of discussions were going on internationally as well. I think that our view has been that the direction in which we are going is completely consistent with the FSB principles of last spring, and I think if you look at the final FSB report which was referenced by the leaders this fall, that there was not a mandating of particular formulas applicable to all employees. It is, once again, an emphasis on the goals to be served, and I think you will see that our guidance, when it does come out, will be consistent with those principles. Senator Corker. The resolution mechanism--I know that our distinguished Ranking Member brought it up a minute ago--many of us--and, thankfully, Paul Volcker has been vocal lately and talked about the ``too big to fail'' category just should not exist. And I know that, you know, there have been discussions about whether there was or was not a mechanism in place when we started all of the things with did with TARP because maybe there was not an orderly way to resolve a highly complex bank holding company. So I know the administration has put forth a proposal that I think is exactly the wrong direction to go, but the fact is there is gaining momentum, I think, around actually having a resolution mechanism that says when an institution fails, it actually fails, and there is a process through which they go. They are not conserved and new life breathed into them with taxpayer money. If that type of solution prevails--and I hope that it does--what does that do as it relates to the international systems and the fact that there are different laws in different countries? You know, we may have a large entity here that obviously has subsidiaries all around the world. Talk to us about some of the complexities that might exist if that type of mechanism were put in place. " FinancialCrisisInquiry--402 VICE CHAIRMAN THOMAS: A question to all of you, and it’s just from my previous job on Ways and Means and the tax code. Would it make a big difference, not much difference, if we had in the time of all of these once-in-a-lifetime events, a better understanding between equity and debt and the way in which major American corporations and even international corporations can utilize debt versus equity? And had we recognized it in the tax code, that, to a certain extent, the old cash-on-the-barrel head is, perhaps, a good way to see what’s going on, notwithstanding the complexity of the world today? January 13, 2010 CHRG-111shrg51290--15 STATEMENT OF ELLEN SEIDMAN, SENIOR FELLOW, NEW AMERICA FOUNDATION, AND EXECUTIVE VICE PRESIDENT, SHOREBANK CORPORATION Ms. Seidman. Thank you very much, Chairman Dodd, Ranking Member Shelby, and members of the Committee. I appreciate your inviting me here this morning. As the Chairman mentioned, my name is Ellen Seidman. I am a Senior Fellow at the New America Foundation as well as Executive Vice President at ShoreBank. My views are informed by my current experience, although they are mine alone, not those of New America or ShoreBank, as well as by my years at the Treasury Department, Fannie Mae, the National Economic Council, and as Director of the Office of Thrift Supervision. In quick summary, I believe the time has come to create a single well-funded Federal entity with the responsibility and authority to receive and act on consumer complaints about financial services and to adopt consumer protection regulations that with respect to specific products would be applicable to all and would be preemptive. However, I believe that prudential supervisors, and particularly the Federal and State banking regulatory agencies, should retain primary enforcement jurisdiction over the entities they regulate. Based on my OTS experience, I believe the bank regulators, given proper guidance from Congress and the will to act, are fully capable of effectively enforcing consumer protection laws. Moreover, because of the system of prudential supervision with its onsite examinations, they are ultimately in an extremely good position to do so and to do it in a manner that benefits both consumers and the safety and soundness of the regulated institutions. In three particular cases during my OTS tenure, concern about consumer issues led directly to safety and soundness improvements. However, I think the time has come to consider whether the consolidation of both the function of writing regulations and the receipt of complaints would make the system more effective. The current crisis has many causes, including an over reliance on finance to solve many of the problems of our citizens. Those needs require broader social and fiscal solutions, not financial engineering. Nevertheless, there were three basic regulatory problems. First, there was a lack of attention and sometimes unwillingness to effectively regulate products and practices, even where regulatory authority existed. The clearest example of this is the Federal Reserve's unwillingness to regulate predatory mortgage lending under HOEPA. Second, there were and are holes in the regulatory system, both in terms of unregulated entities and products and in terms of insufficient statutory authority. Finally, there was and is confusion for both regulated entities and consumers and those who work with them. The solutions are neither obvious nor easy. Financial products, even the good ones, can be extremely complex. Many, especially loans and investments, involve both uncertainty and difficult math over a long period of time. The differences between a good product and a bad one can be subtle, especially if the consumer doesn't know where to look. And different consumers legitimately have different needs. The regulatory framework, of course, involves both how to regulate and who does it. With respect to how, I suggest three guiding principles. First, products that perform similar functions should be regulated similarly, no matter what they are called or what kind of entity sells them. Second, we should stop relying on consumer disclosure as the primary method of protecting consumers. While such disclosures can be helpful, they are least helpful where they are needed the most, when products and features are complex. Third, enforcement is at least as important as writing the rules. Rules that are not enforced or are not enforced equally across providers generate both false comfort and confusion and tend to drive through market forces all providers to the practices of the least well regulated. As I mentioned at the start, I believe the bank regulators, given guidance from Congress to elevate consumer protection to the same level of concern of safety and soundness, can be highly effective in enforcing consumer protection laws. Nevertheless, I think it is time to give consideration to unifying the writing of regulations as to major consumer financial products, starting with credit products, and also to establish a single national repository for the receipt of consumer complaints. A single entity dedicated to the development of consumer protection regulations, if properly funded and staffed, will be more likely to focus on problems that are developing and to propose and potentially take action before the problems get out of hand. In addition, centralizing the complaint function in such an entity will give consumers and those who work with them a single point of contact and the regulatory body early warning of trouble. Such a body will also have the opportunity to become expert in consumer understanding and behavior, so as to regulate effectively without necessarily having a heavy hand. It could also become the focus for the myriad of Federal activities surrounding financial education. The single regulator concept is not, however, a panacea. Three issues are paramount. How will the regulator be funded, and at what level? It is essential that this entity be well funded. If it is not, it will do more harm than good as those relying on it will not be able to count on it. What will be the regulator's enforcement authority? My opinion is that regulators who engage in prudential supervision, whether Federal or State, with onsite examinations, should have primary regulatory authority with the new entity having the power to bring an enforcement action if it believes the regulations are not being effectively enforced, and having primary authority where there is no prudential supervision. And finally, will the regulations written by the new entity preempt both regulations and guidance of other Federal and State regulators? This is a difficult issue, both ideologically and because there will be disagreements about whether the regulator has set a high enough standard. Nevertheless, my opinion is that where the new entity acts with respect to specific products, their regulations should be preemptive. We have a single national marketplace for most consumer financial products. Where a dedicated Federal regulator has acted, both producers and consumers should be able to rely on those rules. The current state of affairs provides a golden opportunity to make significant improvements in the regulatory system to the benefit of consumers, financial institutions, and the economy. If we don't act now, what will compel us to act? Thank you, and I would be pleased to respond to questions. " CHRG-111hhrg51591--22 FINANCIAL SERVICES, TOWERS PERRIN Ms. Guinn. Thank you. Chairman Kanjorski, Ranking Member Garrett, and members of the subcommittee, it is an honor to testify today on behalf of Towers Perrin. Towers Perrin is a global professional services firm that helps organizations improve their performance through effective people, risk, and financial management. The insurance industry is a particular focus of our firm, and I appreciate this opportunity to offer our perspective on the important issue of insurance industry oversight. Without a doubt, the financial crisis has had a significant adverse impact on the balance sheets and profitability of insurance companies. However, with the obvious exception of AIG, the insurance industry as a whole has not been as severely impacted by the crisis as has the banking industry. Insurers have benefitted from strong risk management practices, particularly in the property/casualty sector. In addition, the focus of the current State regulatory framework on solvency and policyholder protection has served the industry well. That said, the financial crisis has exposed a number of issues that raise valid questions about the adequacy of the current regulatory system. And while it is a relatively small part of the overall financial services industry, insurance has a far-reaching impact on our economy as a whole. Think of your own experience. The businesses you rely on can't open their doors each day without liability insurance, workers compensation, and various other coverages. And as individuals, we can't register our automobiles or get a mortgage without appropriate insurance. Furthermore, insurance companies are major investors in the U.S. financial markets, with trillions of dollars of invested assets. Finally, the insurance industry fills a less-well-known role as the provider of financial guarantee insurance to enhance the credit quality of a wide range of municipal bonds and structured securities. The importance of this role has been highlighted in the current financial crisis. These are sufficient reasons for the insurance industry to warrant Federal attention. Yet, in our opinion, there is no need to start from scratch. Any new Federal role in insurance regulation should build on the industry's very positive risk management characteristics and the current regulatory structure. Federal oversight also should address the challenges presented by systemic risk, regulatory arbitrage, and an increasingly complex landscape that blurs the lines between insurers and other financial services players. We have made a number of suggestions in our written testimony that I will briefly summarize. First, we recommend a more holistic regulatory framework for the financial services industry that is underpinned by economic capital requirements based on enterprise-wide stress testing. This would improve transparency into an organization's ability to withstand extreme loss scenarios on a consolidated basis. To be effective, Federal oversight of the insurance industry needs to recognize the industry's unique characteristics. We recommend that the Federal Government avoid a one-size-fits-all approach derived from the larger banking industry, and one way to do that is to build an insurance industry knowledge base with contributions from State regulators along with industry and professional associations. Next, the Federal Government should avoid direct participation in insurance markets. Except in the most dire of circumstances, the private insurance and reinsurance markets have continued to function well and are able to finance a wide variety of risks. While the State insurance guarantee associations have also performed well, we believe a Federal resolution authority for multi-jurisdictional and multi-entity conglomerates should be considered. Finally, risk management professionals with appropriate training, credentials, and professional standards can play an important role in the Federal oversight of financial services. The current State regulatory framework for insurance requires actuaries to give a professional opinion on the adequacy of an insurance company's reserves to meet its future obligations to policyholders. We can easily envision expanding this role to the evaluation of other financial obligations and hard-to-value assets. Thank you for the opportunity to express our views. [The prepared statement of Ms. Guinn can be found on page 79 of the appendix.] " FinancialCrisisReport--226 In October 2008, after Washington Mutual failed, the OTS Examiner-in-Charge at the bank, Benjamin Franklin, deplored OTS’ failure to prevent its thrifts from engaging in high risk lending because “the losses were slow in coming”: “You know, I think that once we (pretty much all the regulators) acquiesced that stated income lending was a reasonable thing, and then compounded that with the sheer insanity of stated income, subprime, 100% CLTV [Combined Loan-to-Value], lending, we were on the figurative bridge to nowhere. Even those of us that were early opponents let ourselves be swayed somewhat by those that accused us of being ‘chicken little’ because the losses were slow in coming, and let[’]s not forget the mantra that ‘our shops have to make these loans in order to be competitive’. I will never be talked out of something I know to be fundamentally wrong ever again!!” 860 Failure to Consider Financial System Impacts. A related failing was that OTS took a narrow view of its regulatory responsibilities, evaluating each thrift as an individual institution without evaluating the effect of thrift practices on the financial system as a whole. The U.S. Government Accountability Office, in a 2009 evaluation of how OTS and other federal financial regulators oversaw risk management practices, concluded that none of the regulators took a systemic view of factors that could harm the financial system: “Even when regulators perform horizontal examinations across institutions in areas such as stress testing, credit risk practices, and the risks of structured mortgage products, they do not consistently use the results to identify potential system risks.” 861 Evidence of this narrow regulatory focus includes the fact that OTS examiners carefully evaluated risk factors affecting home loans that WaMu kept on its books in a portfolio of loans held for investment, but paid less attention to the bank’s portfolio of loans held for sale. OTS apparently reasoned that the loans held for sale would soon be off WaMu’s books so that little analysis was necessary. From 2000 to 2007, WaMu securitized about $77 billion in subprime 860 10/7/2008 email from OTS Examiner-in-Charge Benjamin Franklin to OTS Examiner Thomas Constantine, Franklin_Benjamin-00034415, Hearing Exhibit 4/16-14. 861 3/18/2009 Government Accountability Office, “Review of Regulators’ Oversight of Risk Management Systems at a Limited Number of Large, Complex Financial Institutions,” Testimony of Orice M. Williams, Hearing Exhibit 4/16-83 (GAO reviewed risk management practices of OTS, as well as the Federal Reserve, the Office of the Comptroller of the Currency, the SEC, and self-regulatory organizations.). loans, mostly from Long Beach, as well as about $115 billion in Option ARM loans. 862 Internal documents indicate that OTS did not consider the problems that could result from widespread defaults of poorly underwritten mortgage securities from WaMu and other thrifts. CHRG-111hhrg53244--251 Mr. Bernanke," I wouldn't want to give a single number. I think it depends also on the complexity and interconnectedness of the firm, and it also depends on what is happening in the broader markets. There may be be times of stability when a firm can fail and wouldn't cause broad problems, but during a period of intense instability letting the firm fail would be a problem. So I hesitate to give a single number. Ms. Speier. But is that around the threshold, would you say? " CHRG-111shrg51395--2 Chairman Dodd," The Committee will come to order. Let me thank our witnesses for being here this morning, and colleagues as well, and just to notify the room how we will proceed. Again, there are only a handful of us here, but we have eight witnesses, and so we have got a long morning in front of us to go through these issues. And what I would like to do is I will make some opening remarks, turn to Senator Shelby, and then as long as the room does not all of a sudden get crowded with a lot of Members here, I will ask Senator Reed and Senator Bennet if you would like to make a couple of opening comments, and we will get right to our witnesses, who have supplied very thorough testimony. And if they each read all of their testimony, we are going to be here until Friday, in a sense. But it is very, very good and very helpful to us. So we will proceed along those lines and hopefully have a good, engaging morning here on a very, very critical issue. So I welcome all of you to the hearing this morning entitled ``Enhancing Investor Protection and the Regulation of Securities Markets.'' The purpose of today's hearing is to examine what went wrong in the securities markets and to discuss how we can prevent irresponsible practices that led to our financial system seizing up from ever happening again and how to protect investors, including small investors, from getting burned by the kinds of serious abuses and irresponsible behavior that we have seen in certain quarters of the markets in recent years. We are going to hear about proposals to regulate the securities market so that it supports economic growth and protects investors rather than threatens economic stability. As important, today we will begin to chart a course forward--a course that acknowledges how complex products and risky practices can do enormous damage to the heart of our financial system, the American people as well, absent a strong foundation of consumer and investor protections. Half of all U.S. households are invested in some way in securities, meaning the path we choose for regulating this growth and growing segment of our financial system will determine the futures not only of traders on Wall Street but of families, of course, across the country. A year ago this coming Saturday, the collapse of Bear Stearns underscored the importance role that securities play in our financial system today. When I was elected to the Senate in 1980, bank deposits represented 45 percent of the financial assets of the United States and securities represented 55 percent. Today, the securities sector dominates our financial system, representing 80 percent of financial assets, with bank deposits a mere 20 percent. As the securities market has expanded, so, too, has its influence on the lives of average citizens. Much of that expansion has been driven by the process known as ``securitization,'' in which everyday household debt is pooled into sophisticated structures, from mortgages and auto loans to credit cards and student loans. In time, however, Wall Street not only traded that debt, it began to pressure others into making riskier and riskier loans to consumers. And lenders, brokers, and credit card companies were all too willing to comply, pushing the middle-class family in my State of Connecticut and elsewhere across the country who would have qualified for a traditional secure product into a riskier subprime mortgage or giving that 17-year-old college student, who never should have qualified in the first place, a credit card with teaser rates that were irresistible but terms that were suffocating. As one trader said of the notorious subprime lender, they were moving money out of the door to Wall Street so fast, with so few questions asked, these loans were not merely risky, they were, in fact, built to self-destruct. As we knew it, securitization did not reallocate risk. It spread risk throughout our financial system, passing it on to others like a high-stakes game of hot potato. With no incentive to make sure these risky loans paid off down the road, each link in the securitization chain--the loan originators, Wall Street firms and fund managers, with the help of credit rating agencies--generated more risk. They piled on layers of loans into mortgage-backed securities, which were piled into collateralized debt obligations, which were in turn piled into CDO squared and cubed, severing the relationship between the underlying consumer and their financial institutions. Like a top-heavy structure built on shoddy foundations, it all, of course, came crashing down. I firmly believe that had the Fed simply regulated the mortgage lending industry, as Congress directed with the law passed in 1994, much of this could have been averted. But despite the efforts of my predecessor on this Committee, myself, and others over many years, the Fed refused to act. But the failure of regulators was not limited to mortgage-backed securities. As many constituents in Connecticut and elsewhere have told me, auction rate securities, misleadingly marketed as cash equivalents, left countless investors and city pension funds across the country with nothing when the actions failed and the securities could not be redeemed. As this Committee uncovered at a hearing about AIG last week, the unregulated credit derivatives market contributed to the largest quarterly loss in history. In recent months, we have unearthed two massive Ponzi schemes, bilking consumers, investors, charities, and municipal pension funds out of tens of billions of dollars that two separate regulators failed to detect in their examinations. In January, I asked Dr. Henry Backe of Fairfield, Connecticut, to address this Committee about the losses suffered by the employees at his medical practice in the Bernard Madoff fraud. His testimony prompted Senator Menendez and me to urge the IRS to dedicate serious resources to helping victims like Linda Alexander, a 62-year-old telephone operator from Bridgeport, Connecticut, who makes less than $480 a week and lost every penny of her retirement savings. In an instant, the $10,000 she had saved over a lifetime evaporated because regulators has no idea a massive fraud was occurring right under their noses. This crisis is the result of what may have been the greatest regulatory failure in human history. If you need any further evidence, consider this: At the beginning of the credit crisis in 2008, the SEC regulated five investment banks under the Consolidated Supervised Entity Program: Lehman Brothers, Bear Stearns, Merrill Lynch, Goldman Sachs, and Morgan Stanley--names synonymous with America's financial strength, having survived world wars and the Great Depression. And though the seeds of their destruction have been planted nearly a decade ago, each was sold, converted to a bank holding company, or failed outright inside of 6 months--every single one of them. Our task today is to continue our examination of how to begin rebuilding a 21st century financial structure. We do so not from the top down, focusing solely on the soundness of the largest institutions, with the hope that it trickles down to the consumer but, rather, from the bottom up, ensuring a new responsibility in financial services and a tough new set of protections for regular investors who thought these protections were already in place. The bottom-up approach will create a new way of regulating Wall Street. For the securities markets, that means examining everything, from the regulated broker-dealers and their sales practices, to unregulated credit default swaps. It means ensuring that the creators of financial products have as much skin in the game when they package these products as the consumers do when they buy them, so that instead of passing on risk, everyone shares responsibility. And that means we need more transparency from public companies, credit rating agencies, municipalities, and banks. We are going to send a very clear message that these modernization efforts, the era of ``don't ask''--in these modernization efforts, the era of ``don't ask, don't tell'' on Wall Street and elsewhere is over. For decades, vitality, innovation, and creativity have been a source of genius of our system, and I want to see that come back. It is time we recognized transparency and responsibility are every bit as paramount, that whether we are homebuyers, city managers, entrepreneurs, we can only make responsible decisions if we have the accurate and proper information. We want the American people to know that this Committee will do everything in its power to get us out of this crisis by putting the needs of people first, from constituents like Linda Alexander, who I mentioned a moment ago, to millions more whose hard-earned dollars are tied up in our securities markets. Today's hearing will provide an opportunity to hear ideas and build a record upon which this Committee can legislate a way forward for the American people to rebuild confidence in these securities markets, and to put our country back on a sound economic footing. With that, I thank our witnesses again for being here, and let me turn to my colleague, former Chairman, Senator Shelby. 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.] " CHRG-111hhrg55814--379 Mr. Kandarian," Chairman Frank, Ranking Member Bachus, and members of the committee, thank you for inviting me to testify today. You have asked MetLife for its perspective on the proposals under discussion today. MetLife is the largest life insurer in the United States. We are also the only life insurer that is also a financial holding company. Because of our financial holding company status, the Federal Reserve serves as the umbrella supervisor of our holding company, in addition to the various functional regulators that serve as the primary regulators of our insurance, banking, and securities businesses, including our State insurance regulators, the OCC, and the SEC. While I'll comment on certain aspects of the Administration and congressional proposals, I can best contribute to the dialogue on systemic risk and resolution authority by providing some thoughts about the potential impact of the proposals being discussed. My written statement also includes some suggested guidelines that we believe are important to keep in mind as you consider how to improve the securitization process. Let me start by saying that we support the efforts of Congress and the Administration to address the root causes of the recent financial crisis and to better monitor systemic risk within the financial system. We applaud your thoughtful and deliberate approach to these very complex issues. The discussion draft proposes to establish a new regulatory structure to oversee systemic risk within the financial system, enhance prudential regulation, and authorize Federal regulators to assist or wind-down large financial companies whose failure could pose a threat to financial stability or economic conditions in the United States. We recognize the need to identify, monitor and control systemic risk within the financial system, but we are concerned that creating a system under which companies will be subjected to differing requirements based on their size will result in an unlevel playing field and will create new problems. As proposed, the concept of designating tier one financial holding companies and subjecting such companies to enhanced prudential standards and new resolution authority may address some of the problems we have seen in the financial markets, but it may also create new vulnerabilities, including the creation of an unleveled playing field if tier one status is assigned to only a small number of companies in industry. Systemic threats can stem from a number of sources in addition to large financial institutions. For example, in 1998, the hedge fund Long-Term Capital Management was not particularly large, but it created a significant amount of potential systemic risk when it was at the brink of failure because of its leverage and the volatility in the financial markets. Attempting to address systemic risk by focusing a higher level of regulation on a discrete group of companies under a tiered system could result in little or no oversight of those other sources of risk, leaving the financial system exposed to potentially significant problems. We suggest that Congress consider regulating systemic risks by regulating the activities that contribute to systemic risk without regard to the type or size of institution that is conducting the activity. Linking regulatory requirements to the activity will help close existing loopholes and prevent new regulatory gaps that could be exploited by companies looking to operate under a more lenient regulatory regime. The discussion draft also introduces a new resolution authority based on the premise that large institutions must be treated differently than smaller ones. While we are pleased that the drafters have excluded certain types of institutions from the enhanced resolution authority provisions, including insurance companies, we are concerned about the potential conflicts the new resolution system may create. For example, what if the new Federal resolution authority decided to wind-down a financial holding company that also has a large insurance subsidiary? Given their different missions, the Federal resolution authority might seek one treatment of the insurance subsidiary that is in direct conflict to the desires of the State insurance regulators. As a result, creditors, counterparties, and other stakeholders will likely find it difficult to assess their credit risks to these institutions. These large financial institutions will have to pay a higher-risk premium because of this uncertainty, placing them at a competitive disadvantage both domestically and globally and leading to higher costs that will ultimately be borne by consumers and shareholders. We believe the current system of functional regulation has worked well in the insurance industry. In our experience, the Fed and the functional regulators have worked cooperatively, sharing information and insights that allow each regulator to perform its function. In light of the issues outlined here and in my written statement, I will conclude by suggesting that Congress regulate activities that contribute to systemic risk rather than creating a system of regulation that uses size of the financial institution as a key criterion. We believe that such a system can be more effective, easier to administer, and result in fewer unintended consequences then the proposed tiered structure. Thank you. [The prepared statement of Mr. Kandarian can be found on page 155 of the appendix.] " FinancialCrisisReport--169 In addition, for institutions with assets of $10 billion or more, the FDIC had established a Large Insured Depository Institutions (LIDI) Program to assess and report on emerging risks that may pose a threat to the Deposit Insurance Fund. Under that program, the FDIC Dedicated Examiner and other FDIC regional case managers performed ongoing analysis of emerging risks within each covered institution and assigned it a quarterly risk rating, using a scale of A to E, with A being the best rating and E the worst. In addition, senior FDIC analysts within the Complex Financial Institutions Branch analyzed specific bank risks and developed supervisory strategies. If the FDIC viewed an institution as imposing an increasing risk to the Deposit Insurance Fund, it could perform one or more “special examinations” to take a closer look. C. Washington Mutual Examination History For the five-year period, from 2004 to 2008, OTS repeatedly identified significant problems with Washington Mutual’s lending practices, risk management, appraisal procedures, and issued securities, and requested corrective action. WaMu promised to correct the identified deficiencies, but failed to do so. OTS failed, in turn, to take enforcement action to ensure the corrections were made, until the bank began losing billions of dollars. OTS also resisted and at times impeded FDIC examination efforts at Washington Mutual. (1) Regulatory Challenges Related to Washington Mutual Washington Mutual was a larger and more complex financial institution than any other thrift overseen by OTS, and presented numerous regulatory challenges. By 2007, Washington Mutual had over $300 billion in assets, 43,000 employees, and over 2,300 branches in 15 states, including a securitization office on Wall Street, a massive loan portfolio, and several lines of business, including home loans, credit cards, and commercial real estate. Integration Issues. During the 1990s, as described in the prior chapter, WaMu embarked upon a strategy of growth through acquisition of smaller institutions, and over time became one of the largest mortgage lenders in the United States. One consequence of its acquisition strategy was that WaMu struggled with the logistical and managerial challenges of integrating a variety of lending platforms, information technology systems, staff, and policies into one system. OTS was concerned about and critical of WaMu’s integration efforts. In a 2004 Report on Examination (ROE), OTS wrote: “Our review disclosed that past rapid growth through acquisition and unprecedented mortgage refinance activity placed significant operational strain on [Washington Mutual] during the early part of the review period. Beginning in the second half of 2003, market conditions deteriorated, and the failure of [Washington Mutual] to fully integrate past mortgage banking acquisitions, address operational issues, and realize expectations from certain major IT initiatives exposed the institution’s infrastructure weaknesses and began to negatively impact operating results.” 608 CHRG-109hhrg22160--125 Mr. Greenspan," There is actually a committee in Basel, a subcommittee of the Basel Committee on Supervision and Regulation, which is trying to coordinate this very critical issue. From our point of view, for example, because of the extraordinary complexity of a lot of stuff, we are going to have to depend, in many cases, on the supervisory actions on the part of home regulators. That doesn't mean that we don't operate in it. But what we are trying to do is to make the transition as smooth as possible, so that who has authority, the host regulator or the home regulator, is clearly defined and that it is done so in a way which implements the particular Basel II regulations most effectively. " 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-111shrg382--5 Mr. Tarullo," Thank you, Mr. Chairman, Ranking Member Corker, and Ranking Member Shelby. As Chairman Bayh noted, in less than a year we have had three G-20 leaders meetings at which financial stability was either the sole subject or, as in Pittsburgh last week, one of the most important subjects. During this period, the Financial Stability Board has emerged as an important forum for identifying, analyzing, and setting in motion coordinated responses to the financial crisis and to regulatory gaps and shortcomings. There is much promise in what is now a lengthy agenda for the Financial Stability Board and the many other important groups intended to foster international regulatory cooperation. But there is also some risk that progress will get bogged down or that the negotiation of standards or recommendations in a particular area will become an end in itself. Needless to say, it is essential to ensure that well-devised standards are implemented effectively by all participating countries and that problems revealed during this implementation are cooperatively addressed and changes made. As we look ahead from Pittsburgh and all the international meetings that preceded it, I would offer a few thoughts on how we should proceed from here. First, it is important for the U.S. representatives to the FSB and other groups to focus on the topics and initiatives that we believe are most significant for promoting global financial stability and that are also susceptible to practical international cooperative action. My prepared testimony covers a number of these areas, but I would like to draw particular attention to the emphasis of the G-20 leaders on improvements to capital requirements, which is both an appropriate and critical emphasis. Second, we will need to work with our counterparts from other countries to rationalize the activities of the many international organizations and groups whose mandates involve financial stability. While overlap among these various institutions can sometimes be useful in fostering alternative ideas and approaches, uncoordinated duplication of effort can be inefficient and sometimes even counterproductive. A third and related point is that the expansion of both membership and mandate in certain of these international groups will require changes in operating procedures in order to maintain some of the advantages these groups have had. Fourth, while the financial crisis has understandably, and appropriately, concentrated international energies and attentions on the new standards that will be necessary to protect financial stability, we must guard against these fora being transformed into exclusively negotiating entities. One of the virtues of the original Financial Stability Forum was that is provided a venue for participating officials to exchange views on current developments and problems in a relatively unstructured fashion that provided at least the potential for new ideas to emerge. Similarly, a number of the international standard-setting bodies, such as the Basel Committee on Banking Supervision, traditionally provided a venue for senior supervisors to understand the perspectives of their foreign counterparts and at times to develop shared views of common supervisory challenges, quite apart from the negotiation of new international standards. These other purposes of international financial regulatory groups are, in my view, useful both as ends in themselves and as mechanisms to reinforce the implementations of the standards previously promulgated by these groups. Thank you, Mr. Chairman. I would be pleased to answer any questions you or your colleagues may have. Senator Bayh. Thank you, Mr. Tarullo, and thank you to the other panelists. Why don't I work in reverse order and start with you. On the issue of systemic risk, experts point out that the regulatory reform discussion during the summit meetings has still been fairly vague on critical and complex issues, like systemic risk, cross-border resolution authority, and what to do about derivatives. However, the political hot button issue of executive compensation seems to have been more on a fast track. My question is: What do you think we can end up doing on the issue of systemic risk, which gets to the heart of the problem that we face? And will we have more than just--and I understand there is a lot going on. It is a full plate. These things take time. But do you think we will end up with something more than unenforceable, you know, vague standards this time? Or can we look forward to something more specific with some real enforceability to it? " CHRG-111shrg55117--37 Mr. Bernanke," Well, there are multiple objectives, including access, quality, and others, and I think everyone would agree that probably a number of improvements can be made on all those fronts. And, of course, Congress is looking at that, and I encourage you to keep looking at ways to improve our health care system. But, again, I come back to the cost issue, which I think is the one that is most relevant to the broad economy and to the fiscal stability of this country, and just urge you that, as you look at other aspects of health care reform, that you keep cost on the front burner, because it is very important to achieve. Senator Reed. Mr. Chairman, we will engage shortly in a debate about systemic regulation, and I know you are interested in not only the debate but the topic. But one of the things that, looking back, we discovered is that we did not have a coordinated mechanism to evaluate risk to the system; we did not anticipate the risk, et cetera. In that complex, what would you describe as the systemic risk that we face today? " CHRG-111hhrg52397--12 Mr. Price," Thank you, Mr. Chairman, I appreciate it. In a free market, over-the-counter derivatives provide an essential function by allowing companies to customize the way that they address their risks. Many companies have successfully used OTC products to help their consumers save money and to create jobs, including 3M, which is testifying today, as an end user of derivatives. A market-based economy allows institutions to succeed and to fail. And they fail for a number of reasons: The business takes on too much risk; it may be under bad management; or it may have an ineffective business model. Despite the fact that credit default swaps have come under fire lately because of AIG's remarkable over-exposure, when they are used appropriately, they can be a very effective risk management tool. Thus, we need to be extremely cautious and careful as we decide how to appropriately regulate derivatives. In fact, the market has already begun addressing some of the concerns that credit default swaps and OTC derivatives posed. So I look forward to hearing from the witnesses about what they are doing to make OTC and CDS trades more transparent. In the end, however, regulation must not be a one-size-fits-all system. Such a system stifles innovation, raises prices for consumers, punishes entrepreneurs, and destroys jobs. Thank you, Mr. Chairman. " CHRG-111shrg57321--76 Mr. Raiter," No, sir, I do not. Senator Levin. Now, there are also some things that should not happen regardless of the complexity of how you design a better system. There are some things, it seems to me, that are clearly wrong that happened and should not happen. In the subprime loan deals, a number of loans in which borrowers paid a low initial rate, sometimes interest-only payments, and then after a specified number of months or years, switched to a higher floating rate that was often linked to an index. Did you have any data at the time as to how those subprime loans would perform? Mr. Raiter, did you have data? " CHRG-111shrg51395--82 Mr. Stevens," Senator, could I comment on that? I know that many have not had a chance to absorb it, but I am very struck by what Chairman Bernanke had said today, because everyone is talking about his agency, of course, and he says, and I am quoting now, ``Any new systemic risk authority should rely on the information assessments and supervisor and regulatory programs of existing financial supervisors and regulators whenever possible.'' What that means to me is they don't want to take all these functions aboard themselves. They want a very strong Capital Markets Regulator. They want a very strong bank regulator. They probably want a very strong Federal insurance regulator that they can work with. The notion that they can pull all of that inside the Fed and at the same time accomplish their traditional missions is something I think, as I read the speech, and this is more subtext than text, is unsettling to the Chairman of the Fed, and with good reason, I believe. I would say also in commenting on Chairman Dodd's quandary, and I don't know if this is useful or not, but I spent a considerable period of time as Chief of Staff of the National Security Council and I have reflected a lot on that innovation in our government. It came online after World War II and our experience as a nation of the inability to coordinate and integrate the efforts of our Diplomatic Service, our Armed Forces, and the like at a time when we had burgeoning global responsibilities as the superpower in the aftermath of World War II. It is a Cabinet-level Council that is chaired by the President. It has a staff whose professionalism and abilities have been built up over time. And its function is there to collect information, to monitor developments, to integrate and coordinate the efforts of government. I think it is not out of the question that you could create a similar coordinating mechanism, and I think this is part of what Damon is pointing toward, at a very high level with the regulatory agencies that would pull all their expertise together, give the chairmanship of it to someone, and maybe that is the Chairman of the Fed, give it a permanent staff, and allow it to be monitoring and collecting data and doing the analysis, but in conjunction with those who are the front-line regulators and whose expertise has got to be leveraged. At least that is, I think, a reasonable concept on which to reflect. Senator Bennet. A completely unrelated question. I didn't come here to ask it, but the Ranking Member asked about mark-to-market and your answer is very clear. This is a place where I have gone back and forth. If our markets were lubricated and were doing what they were supposed to be doing, we wouldn't be sitting here talking about investing taxpayers' money the way we are talking about investing it to create stability in the market. And I wonder whether there are others here that have a different point of view on mark-to-market in this sense. It seems to me that there is a legitimate distinction between assets that are held by these banks that have no collateral behind them or very little collateral and assets that are held by our banks that have collateral but simply have no market right now and therefore aren't trading at all. I know there is a pure view that says that should tell you that the assets don't have value, but the thing I keep stumbling over is that some have collateral and some don't have collateral and shouldn't we be taking notice of that? " CHRG-111hhrg53244--5 Mr. Bachus," Let me say this in response. I want to express my appreciation to you for postponing that markup. We have simply been overwhelmed with the health care matters, with just literally such substantial issues under consideration. I think the membership is simply overwhelmed. Because many of these are unprecedented, and there are proposals, they are complex, the ramifications are hard to gauge. And I believe that slowing this whole process down would be in the best interest of not only this committee but also our country as we consider these very weighty matters. " 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-111hhrg53246--16 Mrs. Biggert," Thank you, Mr. Chairman. Thank you for holding today's hearing. And welcome, Chairman Schapiro and Chairman Gensler. I am very interested in the Administration's evolving ideas regarding regulatory reform. I am interested in hearing from you all today about the discussions with the Administration about OTC derivatives clearing and reporting. How will the Administration define standardized and customized OTC derivatives? Will new rules include trigger mechanisms that will mandate that OTC products be electronically traded, cleared or reported to a central database for review. Which firms or trading will fall into these three buckets? I think I want to hear your views on the recently House-passed cap and trade bill, which includes a transaction tax. Taxing transactions to raise Federal revenues for more spending or creating an unnecessary burdensome regulatory environment may force U.S. businesses and jobs to move overseas. Our economy can't afford it. I also look forward to you addressing concerns about the SEC-CFTC regulatory harmonization, specifically concerns about the inefficiencies of the SEC's rule-based approach to regulation. My fear, which I think is shared by many in Chicago, is that an effort to harmonize regulations between the SEC and the CFTC may slow down market innovations and give international competitors an unfair advantage. It is crucial that we strike the right balance, not overreact and fashion sound regulation to address the deficiencies in the current regulatory environment. With that, I yield back. " CHRG-111shrg52619--36 Mr. Reynolds," Chairman Dodd, I appear today on behalf of NASCUS, the professional association of State Credit Union Regulators. My comments focus solely on the credit union regulatory structure and four distinct principles vital to the future growth and safety and soundness of State chartered credit unions. NASCUS believes regulatory reform must preserve charter choice and dual chartering, preserve the States' role in financial regulation, modernize the capital system for credit unions, and maintain strong consumer protections. First, preserving charter choice is crucial to any regulatory reform proposal. Charter choice is maintained by an active system of federalism that allows for clear communications and coordination between State and Federal regulators. Congress must continue to recognize and affirm the distinct roles played by State and Federal regulatory agencies. The Nation's regulatory structure must enable State credit union regulators to retain their regulatory authority over State-chartered credit unions. Further, it is important that new polices do not squelch the innovation and enhanced regulatory structure provided by the dual chartering system. The second principle I will highlight is preserving the State's role in financial regulation. The dual chartering system is predicated on the rights of States to authorize varying powers for their credit unions. NASCUS supports State authority to empower credit unions to engage in activities under State-specific rules. States should continue to have the authority to create and to maintain appropriate credit union powers in any new regulatory reform structure. Preemption of State laws and the push for more uniform regulatory systems will negatively impact our Nation's financial services industry and ultimately consumers. The third principle is the need to modernize the capital system of credit unions. We encourage Congress to include capital reform as part of the regulatory modernization process. State credit union regulators are committed to protecting credit union safety and soundness. Allowing credit unions to access supplemental capital would protect the credit union system and provide a tool for regulators if a credit union faces declining network or liquidity needs. Further, it will provide an additional layer of protection to the National Credit Union Share Insurance Fund, the NCUSIF, thereby maintaining credit unions' independence from the Federal Government and taxpayers. A simple fix to the definition of ``net worth'' in the Federal Credit Union Act would authorize regulators the discretion, when appropriate, to allow credit unions to use supplemental capital. The final principle I will discuss is the valuable role States play in consumer protection. Many consumer protection programs were designed by State legislators and State regulators to protect citizens in their States. The success of State programs have been recognized at the Federal level when like programs have been introduced. It is crucial that State legislatures have the primary role to enact consumer protection statutes for their residents and to promulgate and enforce State regulations. I would also mention that both State and Federal credit unions have access to the NCUSIF. federally insured credit unions capitalize this fund by depositing 1 percent of their shares into the fund. This concept is unique to credit unions and it minimizes exposure to the taxpayers. Any modernized regulatory system should recognize the NCUSIF. NASCUS and others are concerned about any proposal to consolidate regulators and eliminate State and Federal credit union charters. As Congress examines a regulatory reform system for credit unions, the following should be considered. Enhancing consumer choice provides a stronger financial regulatory system. Therefore, charter choice and dual chartering must be preserved. Preservation of the State's role in financial regulation is vital. Modernization of the capital system for credit unions is critical for safety and soundness. And strong consumer protection should be maintained, and these should be protected against Federal preemption. NASCUS appreciates the opportunity to testify and share our priorities. We urge the Committee to be watchful of Federal preemption and to remember the importance of dual chartering and charter choice in regulatory modernization. Thank you. " CHRG-111hhrg51591--9 Mr. Scott," Thank you very much, Mr. Chairman. I want to congratulate you and the ranking member for holding this very important hearing regarding insurance regulation reform. I think it is very important that as we move forward, we realize and learn from the experiences we have just gone through, especially with AIG, as we move forward to deal with this issue. Most experts would agree that the problems with AIG stem from their excessive trading and credit default swaps out of their financial products unit in both London and in Connecticut that was not regulated by the State commissioners, but was regulated at the Federal level with the Federal Office of Thrift Supervision. And also, the majority of insurance companies are indeed solvent. They are functioning well. So the fundamental question as we go forward is this: Does this not only suggest that a radical overhaul of insurance regulation at the Federal level might not only be unnecessary but it could also be potentially dangerous? I think it is very important that we take into account as we move forward the actual operations of these businesses, take into account the complexities of them, the areas in which they must be free to compete. We have to make sure we understand how to ensure that whatever actions we take, that it does not deter competition, that it does not lessen efficiency or increase costs of operating. From the development of global markets to the various and detailed policy rationales toward pursuing regulatory reform, we must take all of these into account. We must listen to both sides of the issue before taking further action. This is an extraordinarily important facet of our financial regulatory reforms. I will soon be introducing or reintroducing legislation which is called the National Association of Registered Agents and Brokers Reform Act, or NARAB, which I believe is a start to reforming one part of the insurance industry in ensuring adequate agent and broker licensing, which is extraordinarily important. The legislation is straightforward. Insurance agents and brokers who are licensed in good standing in their home States can apply for membership in NARAB, which would allow them to operate in multiple States. Last Congress, this bill garnered 52 bipartisan, Democratic, and Republican cosponsors, and I believe that with continued strong support and interest, this provision will be included in our insurance regulatory reform package as we move forward. Again, I congratulate you, Mr. Chairman, and our ranking member, and I look forward to the testimony of our distinguished visitors. " CHRG-111hhrg48873--476 Mr. Bernanke," Well, Congressman, that is a very good question. I am sure you appreciate how complex and difficult this whole situation has been. I do think there is a plan. First, I should mention the Federal Reserve has been very aggressive on a lot of fronts, both in terms of lowering interest rates, both short-term and long-term interest rates, and providing liquidity to the system. Secondly, the Treasury now has essentially a five-point plan. It includes supervisory review and putting in capital, buying assets off of balance sheets, the foreclosure mitigation plan, and then the joint program with the Federal Reserve, the TALF, which will help get the securitization markets going. That covers all the major elements needed to get the banking system going again. But then, to make this all work for the future, in order to avoid an AIG or a similar situation, we also have to very seriously undertake a financial reform program. The Federal Reserve has developed some proposals, which I talked about last week. I know Secretary Geithner will be here on Thursday to talk about the Treasury's proposals. So I think there is a plan. If you have ever read books on battles and warfare, you know that a lot of battles are very chaotic at the beginning until the situation becomes clear and the smoke starts to clear. I think we have gotten to the point now where we can see the terrain, and we are taking the steps necessary to stabilize the situation and get out of this downturn we are in. " CHRG-109shrg21981--158 Chairman Greenspan," I think the issue essentially is that savings, as you know as well as I, doesn't create investment. Implicit in all of this is that the incentives for investment are there and that when you think in terms of taxation and how one creates the savings, it is conceivable that you can create the savings, but regrettably at the same time so diffuse the incentives to invest that we will not get the capital assets we need to essentially produce the goods and services. So proper balance here, I think, is quite important, and I think that it is an extraordinarily complex and difficult issue. We have known about the demographics for quite a long time, but we have never really addressed them. And it is only now that we are beginning to see the significance of how big the size of the hole is. Senator Corzine. Mr. Chairman, I---- " FinancialCrisisReport--400 In internal documents, Goldman described itself as “the leader and principal driver in the creation of” the ABX Index. 1615 In July 2006, Joshua Birnbaum, Rajiv Kamilla, David Lehman, and Michael Swenson from the Mortgage Department nominated Goldman’s role in the creation of both the ABX and CMBX – a similar index based on Commercial Mortgage Backed Securities – for an internal Goldman award, called the “Mike Mortara Award for Innovation.” 1616 That award “recognize[d] the creative, forward-looking, and entrepreneurial contributions of an individual or team” within the equities or fixed income divisions. 1617 The Mortgage Department personnel wrote that the new indices “enable[d] market participants to trade risk without ownership of the underlying SP [structured product] security – thereby permitting market participants to efficiently go short the risk of these securities.” 1618 They also wrote that “Goldman Dominates Client Trading Volume” with “an estimated 40% market share,” and also “dominates the inter-dealer market.” 1619 In 2007, Rajiv Kamilla, the ABS trader who spearheaded Goldman’s efforts to launch the ABX Index, wrote that he “[c]ontinued to enhance our trading dominance in ... ABX indices.” 1620 While Mr. Kamilla led Goldman’s efforts to develop the ABX Index, the firm’s day-to-day ABX trading was conducted primarily by Joshua Birnbaum on the Mortgage Department’s Structured Products Group (SPG) Trading Desk. 1621 Mr. Birnbaum had a negative view of the 1615 6/20/2006 email from David Lehman, “Mortara Nomination – ABX/CM BX Indices,” GS MBS-E-014038810 (attached file, “2006 Mike Mortara Award for Innovation Nomination Template for ABX & CMBX Indices,” GS MBS-E-014038811 at 6 (hereinafter “Mortara Award Submission ”)). 1616 1617 Id. at 8. 6/20/2006 email from “Equities and FICC Communications” to “All Equities and FICC,” Mike Mortara Award for Innovation,” GS MBS-E-010879020 [original email]. 1618 1619 Mortara Award Submission at 2. Id. at 3-4. See also 8/30/2006 Fixed Income, Currency and Commodities Individual Review Book for Rajiv K. Kamilla, at 20, GS-PSI-04064 (hereinafter “Kamilla 2006 Review ”); 9/6/2007 Fixed Income, Currency and Commodities Individual Review Book for Rajiv K. Kamilla, at 19, GS-PSI-04100 (hereinafter “Kamilla 2007 Review ”). 1620 1621 Kamilla 2007 Review at 19. In 2007, Mr. Kamilla was named a Managing Partner at Goldman. Daniel Sparks, the Mortgage Department head, viewed Mr. Birnbaum as a talented trader, writing in October 2006: “Josh for EMD [Extended Managing Director] – he is an extraordinary commercial talent and a key franchise driver. ... He will make us a lot of money. ” 10/17/2006-10/18/2006 emails from Daniel Sparks, “3 things,” GS MBS-E-010917469. Other Goldman senior executives also relied on his trading skills. See, e.g., 2/21/2007 email from David Lehman, “ACA/Paulson Post, ” GS M BS-E-003813259 (before approving the Abacus CDO, Mr. Lehman asked Mr. Tourre to “[w]alk josh through the $, if that makes sense, let ’s go ”); 6/29/2007 email from David Lehman, “ABS Update, ” GS M BS-E-011187909 (during exceptionally bad trading day, Mr. Lehman asked M r. Swenson, “Is Josh in? Mr. Swenson replied “No he is in Spain – don ’t worry I am fine. ”). subprime mortgage market, and favored the firm’s building a net short position. 1622 However, during 2006, Goldman’s overall ABX position was net long, not net short. 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] " CHRG-110hhrg44903--2 The Chairman," The hearing will come to order. This is the second hearing we have had in a series that may continue in the fall and will certainly lead to action next year. What we are dealing with here is the action that we ought to be taking as a Congress and as a government to the events that manifested themselves in the reaction of the Department of the Treasury and the Federal Reserve to Bear Stearns. We are not here specifically to look at that, although that is obviously one of the subjects, given the centrality of the role of the New York Federal Reserve. It is a subject that was discussed before. But what we want to do is to look at that in the context of what do we do going forward? There is, I think, an increasing consensus that some extension of regulation is called for with regard to currently lightly-regulated aspects, lightly-regulated financial institutions. I say ``lightly regulated'' because we have represented here, our former colleague, the Chairman of the Securities and Exchange Commission. That institution has some responsibility, but I think it ought to be clear that Congress has never given the SEC the kind of full statutory mandate over systemic stability. They have a focus on investor protection and on keeping the markets functioning, and I don't think there was any basis for any criticism of the SEC's performance. Some, frankly, of what I have seen is based on a misunderstanding of their mandate. And the fact is that they have, I think, acted within their mandate. It is up to the Congress and the Executive Branch working together to decide whether that mandate should be expanded. And that is what we are talking about. We are talking about the extent to which regulatory authority over the activities of investment banks and others, particularly since they may now be asking for access to various instruments in the Federal Reserve, to what extent should we deal with this? I think we have shown an ability as an economy and as a government to deal on an ad hoc basis with crises. It is important, however, that we do two things: First of all, examine what further instruments the regulators ought to have in dealing with the crisis; and even more important to me--because I do believe we can cobble together things in the short term, but that is not a very satisfactory long-term answer--what new regulatory approaches should we be taking to make the crises less likely? To what extent should we be giving some Federal entities in the regulatory field new powers over institutions that are not now heavily regulated, particularly from the standpoint of avoiding systemic risk? Then the related question is, there are different functions here. This is investor protection. And I know that the gentleman from Pennsylvania and I were just telling the Chairman of the SEC privately, but we both will say it publicly, that we are very pleased with the action he has taken regarding short selling, and we think that has been very helpful from the standpoint of protecting the integrity of the market. But there is a question as to what extent actions that are taken to protect the integrity of the market in the individual instance and the investor do or don't conflict from time to time with questions of systemic stability? It is, in fact, we don't want to take individual enforcement actions that, in a particular context--well, we may want to take them, but it is conceivable that individual enforcement actions, particularly against a number of institutions, could have some systemic impacts. How do we evaluate that? That also leads to the question of what is the institutional arrangement? I congratulate the Federal Reserve and the Securities and Exchange Commission for the memorandum of understanding they signed. That was a very good example of how we get cooperation. And the memorandum of understanding was useful. It does open the question that is, should there be some statutorization of that memorandum of understanding? Are there areas that should be approached in defining the relationship of these two important entities that could not be reached without some further legislation? How do we structure it? This is a noncrisis hearing. It is the second in our efforts to ask the responsible regulators here what their recommendations are to us for going forward. And of course, the goal I think we all share is very simple. We want to continue to reap the benefits of financial innovation, including securitization and the other creative ways of financial institutions serving the economy, while diminishing the risks. And you never hit 100 percent optimality there. But I do believe that there is room for us to take some action that will diminish risks without unduly impinging on the benefits we get from these operations. That is the purpose of this hearing. Let me say, under the rules, having the Department heads here, particularly the head of the SEC, we will just have the four opening statements, the two Chairs and the two ranking members. So the gentleman from Alabama is recognized for 5 minutes. " CHRG-111shrg52619--192 RESPONSE TO WRITTEN QUESTIONS OF SENATOR REED FROM MICHAEL E. FRYZELQ.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?A.1. For the most part, the credit unions have not become large, complex financial institutions. By virtue of their enabling legislation along with regulations established by the NCUA, federal credit unions are more restricted in their operation than other financial institutions. For example, investment options for federal credit unions are largely limited to U.S. debt obligations, federal government agency instruments, and insured deposits. Federal credit unions cannot invest in a diverse range of higher yielding products, including commercial paper and corporate debt securities. Another example of restrictions in the credit union industry includes the affiliation limitations. Federal credit unions are much more limited than other financial institutions in the types of businesses in which they engage and in the kinds of affiliates with which they deal. Federal credit unions cannot invest in the shares of an insurance company or control another financial depository institution. Limitations such as these have helped the credit union industry weather the current economic downturn. These limitations among the other unique characteristics of credit unions make credit unions fundamentally different from other forms of financial institutions and demonstrate the need to ensure their charter is preserved in order to continue to meet their members' financial needs. Restructuring the regulatory system to include a systemic regulator would add a level of checks and balances to the system to address the issue of regulators using their authorities more effectively and aggressively. The systemic regulator should be responsible for establishing general safety and soundness guidelines for financial institutions and then monitoring the financial regulators to ensure these guidelines are implemented. This extra layer of monitoring would help ensure financial regulators effectively and aggressively address problems at hand.Q.2. 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.2. If a systemic regulator is established, one of its responsibilities should include monitoring the implementation of the established safety and soundness guidelines. This monitoring will help ensure financial regulators effectively and aggressively enforce the established guidelines. The oversight entity's main functions should be to establish broad safety and soundness principles and then monitor the individual financial regulators to ensure the established principles are implemented. This structure also allows the oversight entity to set objective-based standards in a more proactive manner, and would help alleviate competitive conflict detracting from the resolution of economic downturns. This type of structure would also promote uniformity in the supervision of financial institutions while affording the preservation of the different segments of the financial industry, including the credit union industry. Financial regulators should be encouraged to aggressively address areas of increased risk as they are discovered. Rather than financial institution management alone determining risk limits, financial regulators must take administrative action when the need arises. Early recognition of problems and implementing resolutions will help ensure necessary actions are taken earlier rather than later. In addition, financial regulators should more effectively use off-site monitoring to identify and then increase supervision in areas of greater risk within the financial institutions.Q.3. 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.3. There is a need to establish concentration limits on risky products. NCUA already has limitations in place that have helped the credit union industry avoid some of the issues currently faced by other institutions. For example: Federal credit unions' investments are largely limited to United States debt obligations, federal government agency instruments, and insured deposits. \2\ Federal credit unions cannot invest in a diverse range of higher yielding products, including commercial paper and corporate debt securities. Also, federal credit unions have limited authority for broker-dealer relationships. \3\--------------------------------------------------------------------------- \2\ NCUA Rules and Regulations Part 703. \3\ NCUA Rules and Regulations Part 703. Federal credit unions are much more limited than other financial institutions in the types of businesses in which they engage and in the kinds of affiliates with which they deal. Federal credit unions cannot invest in the shares of an insurance company or control another financial depository institution. Also, they cannot be part of a financial services holding company and become affiliates of other depository institutions --------------------------------------------------------------------------- or insurance companies. Unlike other financial institutions, federal credit unions cannot issue stock to raise additional capital. \4\ Also, federal credit unions have borrowing authority limited to 50 percent of paid-in and unimpaired capital and surplus. \5\--------------------------------------------------------------------------- \4\ 12 U.S.C. 1790d(b)(1)(B)(i). \5\ 12 U.S.C. 1757(9). Sound decision making should always take precedence over following the current trend. The addition of a systemic regulator would provide the overall monitoring for systemic risk that should be limited. The systemic regulator would then establish principles-based regulations for the financial regulators to implement. This would provide checks and balances to ensure regulators were addressing the issues identified. The systemic regulator should be charged with monitoring and implementing guidelines for the systemic risks to the industry, while the financial regulators would supervise the financial institutions and implement the guidelines established by the systemic regulator. Since the systemic regulator only has oversight over the financial regulators, they would not have direct supervision of the financial institutions. This buffer would help overcome the issue of when limits should be ---------------------------------------------------------------------------implemented.Q.4. Is this an issue that can be addressed through regulatory restructure efforts?A.4. As stated above, the addition of a systemic regulator would help address these issues by providing a buffer between the systemic regulator establishing principles-based regulations and the financial regulators implementing the regulations. The addition of the systemic regulator could change the approach of when and how regulators address areas of risk. The monitoring performed by the systemic regulator would help ensure the financial regulators were taking a more proactive approach to supervising the institutions for which they are responsible.Q.5. 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.5. While regulators are a safety net to guard against dangerous amounts of risk taking, the confluence of events that led to the current level of failures and troubled institutions may have been beyond the control of individual regulators. While many saw the risk in lower mortgage loan standards and the growth of alternative mortgage products, the combination of these and the worst recessionary conditions and job losses in decades ended with devastating results to the financial industry. Exacerbating this combination was the layering of excess leverage that built over time, not only in businesses and the financial industry, but also in individual households. In regards to the credit union industry's record in the current economic environment, 82 federally insured credit unions have failed in the past 5 years (based on the number of credit unions causing a loss to the National Credit Union Share Insurance Fund). Overall, federally insured credit unions maintained reasonable financial performance in 2008. As of December 31, 2008, federally insured credit unions maintained a strong level of capital with an aggregate net worth ratio of 10.92 percent. While earnings decreased from prior levels due to the economic downturn, federally insured credit unions were able to post a 0.30 percent return on average assets in 2008. Delinquency was reported at 1.37 percent, while net charge-offs was 0.84 percent. Shares in federally insured credit unions grew at 7.71 percent, with membership growing at 2.01 percent, and loans growing at 7.08 percent. \6\--------------------------------------------------------------------------- \6\ Based on December 31, 2008, Call Report (NCUA Form 5300) data.Q.6. While we know that certain hedge funds, for example, have ---------------------------------------------------------------------------failed, have any of them contributed to systemic risk?A.6. As the NCUA does not regulate or oversee hedge funds, it is not within our scope to be able to comment on the impact of failed hedge funds and whether or not those failures contributed to systemic risk.Q.7. 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.7. NCUA does not have on-site examiners in natural person credit unions. However, as a result of the current economy, NCUA has shortened the examination cycle to 12 months versus the prior 18 months schedule. NCUA also performs quarterly reviews of the financial data submitted to the agency by the credit union. NCUA does have on-site examiners in some corporate credit unions. Natural person credit unions serve members of the public, whereas corporate credit unions serve the natural person credit unions. On March 20,2009, NCUA placed two corporate credit unions into conservatorship, due mainly to the decline in value of mortgage backed securities held on their balance sheets. Conventional evaluation techniques did not sufficiently identify the risks of these newer structured securities or the insufficiency of the credit enhancements that supposedly protected the securities from losses. NCUA's evaluation techniques did not fully keep pace with the speed of change in the structure and risk of these securities. Additionally, much of the information obtained by on-site examiners is provided by the regulated institutions. These institutions may become less than forthcoming in providing negative information when trends are declining. NCUA is currently evaluating the structure of the corporate credit union program to determine what changes are necessary. NCUA is also reviewing the corporate credit union regulations and will be making changes to strengthen these entities. ------ 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-111hhrg53248--183 Mr. Smith," Thank you, sir. Representative Kanjorski, Representative Bachus, members of the committee, good afternoon. My name is Joseph A. Smith, Jr., and I am North Carolina Commissioner of Banks and Chairman of the Conference of State Bank Supervisors. Thank you for inviting CSBS to testify today on the Administration's plan for financial regulatory reform. CSBS applauds this committee and the Administration for the time and energy put into a challenging undertaking. We look forward to working with Congress and the Administration toward a reform plan that makes meaningful and sustainable improvements in the way our financial system serves the public and strengthens local communities and the Nation's economy. My statement today reflects the perspectives of commissioners and deputy commissioners from around the country, and I would like to thank them for their efforts in helping to put this together. Our major concern is that the legacy of this crisis could be a highly concentrated and consolidated industry that is too close to the government and too distant from consumers and the needs of its communities. That need not be the result. To avoid that outcome, Congress needs to realign the regulatory incentives around consumer protection and end too-big-to-fail. We believe that many provisions of the Administration's plan would advance these goals. These include the continuation of the current supervisory structure for State-chartered banks, a comprehensive approach to consumer protection, and the recognition of the importance of State law and State law enforcement in accomplishing consumer protection. However, we also have some concerns. In our view, the Administration's plan inadequately addresses the systemic risk posed by large, complex financial institutions. My testimony today will present our perspective on these issues. We support the creation of the Consumer Financial Protection Agency in concept and we support its goals. Restoring public confidence in our financial system is a necessary objective. Consumer protection standards for all financial service or product providers, such as those to be promulgated by the agency, are an important step in that direction. Any proposal to create a Federal Consumer Financial Protection Agency must preserve for the States the ability to set higher, stronger consumer protection standards. We are pleased to see that the Administration's proposal, as well as H.R. 3126, does just that, explicitly providing that Federal consumer protection standards constitute a floor for State action. We believe that the new agency's activities would be most effective if focused on standard setting and rulemaking. As part of this, we support the agency having broad data and information gathering authority. We believe the agency's visitorial authority should be a backup function aimed at filling in regulatory gaps. We also believe the agency's enforcement authority should be a backstop to the primary enforcement authority of State and Federal prudential regulators and law enforcement. As part of this, timely coordination and information sharing among Federal and State authorities will be absolutely critical. We do not believe that systemically significant institutions should be too-big-to-fail. There should be a clearly defined resolution regime for these institutions that actually allows them to fail. Every type of institution must have a clear path to resolution. We believe the FDIC is the best choice as receiver or conservator for any type of financial institution. It is an independent agency with demonstrated resolution competence. For systemically significant institutions, the regulatory regime should be severe, meaning tougher capital leverage and prompt corrective action standards, and it must protect taxpayers from potentially unlimited liability. We applaud the Administration for its prompt and comprehensive response to the obvious need for improvement in our system of financial regulation. We now look forward to the members of this committee bringing your specialized knowledge and legislative experience to this proposal in order to ensure that it accomplishes its stated objective, a safer, sounder financial system that provides fair and stable access to credit for all sectors of the economy. We look forward to working with you on this legislation to reduce systemic risk, assure fairness for consumers, preserve the unique diversity of our financial system, and enhance Federal-State coordination to create a seamless network of supervision for all industry participants. Thank you again for the opportunity to share our views today. I look forward to any questions you may have. Thank you. [The prepared statement of Mr. Smith can be found on page 149 of the appendix.] " CHRG-111shrg53085--100 Chairman Dodd," Thank you. Senator Warner. Senator Warner. Thank you, Mr. Chairman. I want to continue a little bit on the line of my colleague from Nebraska on the ``too big to fail'' component. Mr. Whalen, I thought some of your comments were very telling in terms of the amount of exposure we have from the top four banks. I guess I would ask Mr. Patterson, perhaps wearing more of your ABA hat than just your Bancorp hat, whether, one, you agree with Mr. Whalen's comments; and, two, some argument meant that if we were to try to look at size and complexity and draw the line, how that would position our industry with our foreign competitors that may or may not take similar actions. " CHRG-111shrg50564--562 DODARO 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. As we noted in our January 2009 report, financial regulators have been appropriately focused on limiting the damage from the current crisis to the United States economy and its financial system.\1\ Given the experiences of other countries, particularly Japan that suffered stagnation for a decade likely as a result of its ineffective attempts to address its financial crisis in the 1990s, Congress and regulators should likely continue to address in the near term efforts to further stem the crisis and restore our financial institutions to more normal operating conditions, including finding an appropriate and effective solution to the issue of troubled assets being held by so many institutions.--------------------------------------------------------------------------- \1\ GAO, Financial Regulation: A Framework for Crafting and Assessing Proposals to Modernize the Outdated U.S. Financial Regulatory System, GAO-09-216 (Washington, D.C.: Jan. 8, 2009.)--------------------------------------------------------------------------- However, directing actions more to the current crisis should not preclude Congress from exploring with regulators plans for modernizing the United States financial regulatory system. As we pointed out, taking piecemeal actions and creating new regulations and regulatory bodies in the aftermath of past financial turmoil is one reason why our current structure is so fragmented and has the gaps and inconsistencies in oversight that have contributed to the current crisis. As a result, careful consideration of how best to develop a structure and financial regulatory bodies within it that more holistically embodies aspects like the nine elements of an effective regulatory system that we described in our report is important. Taking adequate time to consider and complete this critical task is more advisable than taking quick actions that could lead to gaps or inconsistencies later. 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. Over the years, GAO has reported on the inconsistency and lack of uniformity of regulation that insurance companies receive across states. This lack of consistency can lead to uneven protections for consumers across states as well as inefficiencies for insurers that could lead to higher premiums. We currently have a study under way looking at reciprocity and uniformity of State insurance regulation in three key areas: product approval, producer licensing, and market conduct regulation. The study will touch on issues of consistent oversight across states. Having an optional Federal charter for insurance would be one way to potentially increase the consistency of oversight of insurance companies. Although the problems experienced by AIG and the subsequent action by the Government to address them demonstrates that the United States has significant gaps in its oversight of significant financial institutions, the extent to which this case demonstrates the need for Federal insurance oversight is unclear. Although some of AIG's financial difficulties arose from the securities lending activities engaged in by its life insurance companies, and some of the Federal assistance went toward unwinding those transactions, the insurance company operations were, and have remained, stable. Those companies have been negatively affected by the damage to the parent company's reputation, and may no longer benefit to the same extent from the parent company's financial strength, but they appear to be financially sound. While it's possible closer review by State insurance regulators may have more quickly identified the risk associated with the life insurance companies' securities lending operations, the primary problems appear to have originated in one of AIG's non-insurance subsidiaries. In addition, State insurance laws require State insurance regulators to approve any significant transactions between an insurance company and its parent company or other subsidiaries, and, according to State regulatory officials and AIG securities filings, some State regulators did not allow transactions that would have transferred capital from AIG's insurance companies to the parent company. Q.3. The GAO recommends consistent financial oversight--to ensure that similar institutions, products, risk and services are subject to consistent regulation oversight and transparency. In the case of insurance, the regulation and oversight is not consistent. Shouldn't insurance receive the same consistent financial oversight that is desperately needed for other financial institutions? A.3. In our January 2009 report on the need for regulatory reform, we noted that the United States needs a financial regulatory system that is appropriately comprehensive and provides consistent oversight of institutions engaging in similar activities and risks. In addition, we advocated that consumer protections be similarly consistent across institutions and products. As a result, to the extent that insurance companies conduct activities, such as over-the-counter derivatives trading or market products as investment alternatives to securities or bank saving products, we advocated that they be overseen with similar risk management, capital, and consumer disclosure requirements. In general, the operations of most insurance companies themselves do not appear to have given rise to the complexities that made regulation difficult in the case of AIG. For entities that just engage in insurance activities, having Federal oversight could be one way that more uniformity of oversight is achieved. However, our report also noted that State regulators, including those for insurance, have played important roles in identifying and taking actions to address problems for consumers. As noted above, we have a study under way looking at reciprocity and uniformity of State insurance regulation that will touch on issues of consistent oversight across States. Q.4. The GAO's report suggests that Congress should consider establishing a Federal insurance regulator; can you comment on the advantages of creating a Federal insurance regulator in the United States? A.4. As we noted above, a Federal insurance charter could have the potential to alleviate some of the challenges in harmonizing insurance regulation across States. However, we also note that such an approach could have various disadvantages. Currently, property and casualty insurance activities are heavily influenced by State laws--including those relating to insurance, torts, and business operations--and having Federal oversight of such varying requirements could be very challenging. In addition, State regulators assert that because of their greater familiarity with the particular demographics of their jurisdictions, they are in a better position to protect consumers. Another issue that would have to be addressed in implementing a Federal insurance charter would be the loss of income to states from taxes paid on insurance premiums by consumers. These taxes generally provide funds beyond what is required to fund the regulation of insurance. Q.5. 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.5. Various options exist for addressing the systemic risk posed by large interconnected financial institutions. As we advocated in our January 2009 report, such institutions should receive comprehensive and consistent regulation from both a prudential and consumer protection standpoints.\2\ Having such oversight should reduce the potential for such institutions to experience problems that threaten the stability and soundness of other institutions and the overall financial system itself. In addition, we advocated that our regulatory system needs a systemwide focus to address the potential threats to system stability that can arise from institutions, products, and markets. Such a focus could be achieved by designating an existing regulator or creating a new entity to be tasked with overseeing systemic risk in the United States. Such an entity could also be tasked with prudential oversight of the large interconnected financial institutions or their primary oversight could remain the responsibility of another regulator with the systemic risk regulator supplementing this oversight by collecting information, examining operations, and directing changes from the large institutions as needed.--------------------------------------------------------------------------- \2\ GAO-09-216.--------------------------------------------------------------------------- While one obvious way of ensuring that these large institutions are all subject to similar regulatory requirements and oversight would be to designate them as systemically important and place them under the regulation of a single regulatory body, such an approach also has disadvantages. Some market observers have expressed concerns that designating certain institutions as systemically important could distort competition in the financial market sectors in which these entities operate by providing the designated institutions with funding advantages and reducing market discipline of the firms that do business with them because of the belief that the Government will not allow such institutions to fail. In light of the experience of the housing Government-sponsored enterprises recently, such concerns should be taken seriously. However, the more extensive oversight that systemically important financial institutions would likely receive could offset some of the competitive advantage they receive from being designated as so. Given such institutions greater potential than other institutions to create systemic problems, they should appropriately be subject to higher prudential standards for capital, liquidity, and counter-party risk management, etc. So although their status as systemically important institutions could possibly create competitive distortions or moral hazard, increased prudential standards would seek to mitigate that (and any systemic risks they might pose). Other countries have not generally had to face the issue of whether their systemically important institutions should be supervised separately because of the differences in the regulatory and market structures outside the United States. In many countries, the primary financial institutions are universal banks that offer a range of services across sectors, including banking, securities, and insurance activities, and that are overseen by a single regulatory body, which reduces the potential for inconsistent oversight. In addition, the number of financial institutions in many countries is relatively small, which also reduces the potential for less consistent oversight across institutions that might provide a competitive advantage for those designated as systemically important. ------ ------ ------ ------ ------ " 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-111hhrg51698--471 Mr. Brickell," Thank you, Mr. Chairman. Thank you, Members of the Committee, for inviting Blackbird Holdings to testify at this hearing about the ``Derivatives Markets Transparency and Accountability Act of 2009.'' We are grateful that the Committee and the Congress want to address the causes of the financial crisis. Americans are concerned. Banks have been shaken. The stock market has tumbled. Pension investments and home values have shriveled. The wolf is at the door. What can Congress do to help? The first step would be to identify the true causes of the financial crisis. Our global financial crunch is a housing finance crisis. Trillions of dollars of mortgage loans have been made that are not being repaid on time. Those loans are worth less than face value, and so are the mortgage-backed securities that contain them. Stockholders, bond holders, taxpayers will absorb as much as $1 trillion of losses from loans that should not have been made. But this bill doesn't target foolish mortgage loans. It targets derivatives. If our country has a wolf problem, it probably won't help to go into the field to shoot birds. Mr. Chairman, these privately negotiated derivatives, these swap contracts, have helped the financial system and the economy. Every company faces risks when it opens its doors to do business, and swaps help those companies shed the risks they don't want and assume the risks that they do. Each company's portfolio of risks is unique. Each firm's appetite and ability to manage risk is unique. And swaps meet those individual needs because they can be custom-tailored. Banks structure them to meet a client's market risks, right down to the dollar and to the day, if necessary. And we don't just structure them to meet market risks. Swappers custom-tailor the credit risk of the contracts, too. Each counterparty in a swap contract is on the hook to the other. So each one has a good reason to assess the other's credit quality, and do it with care. If one doesn't like what he sees, he asks the other to shrink the deal, or shorten the maturity, or post collateral, or raise more capital. We use innovative technology to promote transparency, integrity, and control of credit risk, the goals of your bill. And our company has built an electronic trading platform for swaps. Not only does it allow users to find counterparties for their swaps online, our patented credit filter prevents one firm from trading with another when credit lines are full. Credit risk is managed more precisely than it is with a central clearinghouse to the individual specifications of each user of the system. Companies need custom-tailoring, and that is why swaps were invented. It is also why there are nearly $700 trillion, a notional amount, that are managing risks today for companies and governments around the globe. And Congress knows this. You all have passed the laws that make the framework in which standardized futures contracts are traded on futures exchanges, regulated by the CFTC, and cleared through CFTC-regulated clearinghouses. While swaps that have many of the same risks as bank loans are defined in Federal law as banking products, banking supervisors have access to the details of every swap on a bank's books. How good is this framework? Not only has it been good for the economy, it has also been good for the futures exchanges. The custom-tailored risks that banks collect from their clients they often manage with futures contracts. So futures trading has grown along with swap activity. No country has built a more diverse, robust risk management industry. Now, it is not perfect. No financial transaction or system of risk management can prevent all investment losses. Good judgment remains the essential element in sound financial management. But it is good. Swaps make it easier and less expensive to create the risk management profile that a company prefers. I am concerned about the proposed legislation because it will do damage to all of this. It is not just that derivatives are the wrong target. This legislation is like shooting doves with an 8-gauge: If you connect, there won't be anything left. And American firms, in the middle of a credit crunch, would face new obstacles as they try to manage credit risk. Important tools for managing not just credit risk but interest rate risk, as well, would be more costly and less available. So American firms would have to watch from the sidelines as their competitors in other countries manage their risks with greater precision, and more freely than American companies would be able to do. So if this bill passes, we will not have much of a swaps activity left in the United States, and we would not be better off. Suppose that Congress passed a law that outlawed swaps completely? Would the financial crisis be gone? No. Those trillions of dollars of troubled mortgage loans would still be there. They would just be harder to manage. Privately negotiated derivatives with bilateral infrastructure, sound documentation, netting provisions to support them, have been called no less than the creation of global law by contractual consensus. It is a system that has benefited thousands of companies, financial institutions, and sovereigns. It is a system that has an important part to play as we work to solve the problems of economic weakness and financial market uncertainty. Great care should be taken to optimize and not to weaken this innovative and important business. Thank you. [The prepared statement of Mr. Brickell follows:]Prepared Statement of Mark C. Brickell, CEO, Blackbird Holdings, Inc., New York, NY Mr. Chairman and Members of the Committee: Thank you very much for inviting Blackbird Holdings, Inc. to testify at this hearing about the ``Derivatives Markets Transparency and Accountability Act of 2009''. We are grateful to the Committee for asking for our views as it seeks a wide perspective on the benefit and drawbacks of legislation affecting privately negotiated derivatives. For more than 2 decades, swaps and related derivatives contracts have made an important contribution to improvements in risk management at banks, in the financial sector, and in the economy. The benefits of these transactions are sufficiently important that any measures adopted by the Committee or the Congress should not reduce the availability or increase the cost of these valuable tools.About Blackbird Blackbird Holdings, Inc. is a privately held corporation headquartered in Charlotte, North Carolina. It was founded by swap traders from J.P.Morgan & Co. who developed an electronic trading platform for the negotiation of interest rate and currency swaps. Our innovative technology has been patented three times by the U.S. Government. The benefits of electronic trading have already been achieved in the execution of most types of financial transactions, including foreign currency, equities, U.S. Treasury bonds and corporate bonds, and futures contracts. When swap contracts are executed electronically in greater numbers, swaps will have greater transparency, and accurate electronic records will be created at the moment the trade is executed so that error-free straight through processing, including accurate record-keeping, will be a hallmark of the business. Blackbird is still a small company, but we are global, and we help swap counterparties find each other and execute swaps either across our electronic platform, or through our people in Singapore, Tokyo, London, and New York. I have served as Chief Executive Officer of Blackbird since 2001. Before that, I served for 25 years at JP Morgan & Co., Inc., where I was a Managing Director and worked in the derivatives business for 15 years. During that time, I served for 4 years as Chairman of the International Swaps and Derivatives Association, and for 2 years as Vice Chairman, during more than a decade that I served on its board of directors. ISDA represents participants in the privately negotiated derivatives business, and is now the largest global financial trade association, by number of member firms. ISDA was chartered in 1985, and today has over 850 member institutions from 56 countries on six continents. These members include most of the world's major institutions that deal in privately negotiated derivatives, as well as many of the businesses, governmental entities and other end users that rely on swaps and related contracts to manage efficiently the financial market risks inherent in their core economic activities. As a result, I was involved in discussions about all Federal swaps legislation between 1988 and 2000.Why Swaps? The moment that companies open their doors to do business, they become exposed to financial and other risks that they must manage. Changes in foreign currency rates can affect the volume of their exports; interest rate volatility the level of investment returns, and commodity price fluctuations the cost of raw materials--or sales revenue. Managing these risks was an essential part of decision-making in business and finance before swaps were developed, and would remain so if swaps did not exist. Custom-tailored swap transactions were developed to make it easier to manage these risks. They allow a party to shed a risk that he does not want to take, in return for assuming another risk to which he would rather be exposed, or for making a cash payment. By tearing apart and isolating the strands of risk that are entwined in traditional business and financial transactions, they make it possible to manage risks with greater precision, and allow businesses to focus on the things they do best. A company that sells hamburgers around the globe can use swaps to shift its exposures to interest rates and foreign currencies to other parties, and concentrate on managing its operations, raw materials costs, and real estate holdings, if it believes that these are the source of its comparative advantage. Similarly, the counterparties to its swap trades believe that they are better able to manage the interest rate and currency risks being shed by the other enterprise.Benefits of Swap Activity As thousands of swap counterparties make individual decisions about which risks to take and which to transfer to others, several useful things happen. First, the risk profiles of the firms improve every time they make a correct decision. This strengthens them, and makes it possible for them to serve their customers better and grow more rapidly. A bank that has a strong relationship with a borrower might find that the size of its loans to that customer was becoming so great that its loan portfolio was becoming poorly diversified. By entering into credit default swaps, the banker can transfer enough of the loan risk to make room for more loans to its customer, strengthening its business relationship and helping credit to flow. That's good for business, jobs, and the economy. Second, as thousands of swap transactions have been executed in the past 3 decades, bankers and finance professionals have gained access to new information about financial risks. This allowed better measurement and management of risks, first in swap portfolios and, as time passed, in the other financial portfolios. I watched that process take place in the 1980s as the risk management techniques developed on the swap desks of ISDA member banks, including my own, were adopted by the managers of the same risks that had long been embedded in other financial portfolios at their institutions, including the portfolios of loans and deposits. This process was so constructive that swap professionals were asked in 1993 by the Group of Thirty, to write down their best principles and practices for managing financial risks. The report that we produced was disseminated through the global banking system and other parts of the financial world, and was also used by banking supervisors and financial system regulators to improve their supervisory practices. As Paul Volcker, the Chairman of the Group of Thirty wrote in the introduction to our report, ``. . . there can be no doubt that each organization's conscious and disciplined attention to understanding, measuring, and controlling risk along the lines suggested should help ensure that the risks to individual institutions and to markets as a whole are limited and manageable.'' As swap transactions are executed, the prices of these deals reveal the beliefs of thousands of individuals about the future course of interest rates, or the creditworthiness of borrowers, which are collected and distilled in the price of the deals. This information can be used even by parties who do not enter into the transactions. Central bankers now use swaps prices to understand interest rate expectations and help them make decisions about monetary policies. Rating agencies have begun to track the information about the credit quality of borrowers that is contained in the price of credit default swaps to identify changes in market opinion, and alert their analysts to changes in the condition of companies that they rate, so that they can drill down on potential problems and strengthen the quality of their ratings. If credit default swaps had existed a decade earlier, to sound a tocsin of warning, current problems in the financial system might not be so grave. Of course, no type of financial transaction or system of risk management can prevent all investment losses. The good judgment of financial professionals remains the essential element in sound financial management. Swaps simply make it easier and less expensive to create the risk management profile that a company prefers. You might expect a business that does so much good for so many people to grow quickly, and the swaps business has. While I have been a participant in the swaps business, I have seen it grow by roughly 25% per annum for more than 20 years. As a result, there are now according to the BIS almost $684 trillion of swaps outstanding, mainly on interest rates and currencies As of January 27, there were some $28 trillion of credit default swaps outstanding. It is worth noting that, even when other financial activities become illiquid, the swap business tends to be resilient. Credit default swaps dealers, for example, indicate that there has been liquidity in swaps even when traditional cash markets have become illiquid at times in the past year.Public Policy for Swaps in the United States These are important benefits. They exist in part because Congress has legislated carefully and wisely with respect to swaps on at least five earlier occasions since 1988. We all want to preserve benefits like these, and I am grateful to you for identifying in legislation now before the Committee several policy ideas that have been floated in recent months, and for your careful consideration of those ideas at this hearing. With careful action, this Committee can continue to play an essential role in building a sound framework for swap activity. The policy consensus about swaps that is embodied in the statutory and regulatory framework reflects the fact that swap activity arose not in the exchange traded, centrally cleared business of standardized futures contracts regulated by the Commodity Futures Trading Commission, but in the banking sector. Swap contracts are custom-tailored transactions that are often designed to match the exact cash flows that a corporation wants to hedge; this makes them harder to construct, to value, and to transfer, than the futures contracts regulated by the CFTC, in much the same way that a bank loan is different from a corporate bond. This is why the first policy adopted by the CFTC with respect to swaps, in its May 1989 Swaps Policy Statement, after more than 18 months of study, was that swaps are not appropriately regulated as futures. That original CFTC Policy reflects a policy consensus that has lasted 2 decades, reaffirmed and strengthened by the 1991 CFTC Statutory Interpretation, the 1992 Futures Trading Practices Act, and the Commodity Futures Modernization Act enacted in 2000 and signed into law by President Clinton, as well as other legislation. That is why swaps are defined in Federal law as banking products. A robust, innovative American financial services business has been built on the foundation of this policy consensus. I am concerned that provisions in the legislation before the Committee would undermine that foundation and weaken a business that helps the American economy, and the world.Management of Credit Risk in Swaps Transactions One area of the legislation that would have that effect is the section requiring clearing of privately negotiated derivatives. Like every commercial and financial contract, swaps contain credit risk. One party must be confident that his counterparty will perform according to the terms of the contract. Financial institutions are able to manage this credit risk in different ways. In the banking system, where swaps originated, credit risk is managed by experts who analyze the quality of each counterparty, including its financial strength, the quality and character of management, even the legal and political risk of the country where it is based. In doing this, bankers and their counterparties often rely on private information available to them in their special role as creditors. The techniques used to manage the credit risk of swaps are usually the same ones used to manage the risk of other privately negotiated credit contracts such as bank loans or bank deposits, and they can include the posting of collateral so that if a counterparty defaults on a trade, the non-defaulting party will be able to enter into a new, replacement transaction at no additional cost. Of course, if a counterparty is not satisfied with the amount or quality of the information he receives, or the credit enhancement techniques available, he is not required to enter into any swap deal. Financial institutions have developed a number of ways to manage credit risk in privately negotiated derivatives, appropriate to their capital levels and those of their clients. First, there are different ways to document transactions. The simplest method is to use an exchange of confirmations, one for each transaction. This approach makes no attempt to reduce risks by netting, it simply relies on well drafted confirmations and good credit judgment in the choice of counterparties. Risks are reduced by netting under bilateral master agreements, either for single products--interest rate swaps against interest rate swaps--or reduced further by including other derivatives under the master. Netting across products--foreign exchange options against credit default swaps, for example--reduces potential exposures even more than single product netting. The ISDA Master Agreement is used around the globe to achieve this purpose. As you can see, we are starting to build a sort of continuum of approaches, in which increasing the numbers of transactions netted against each other results in greater netting benefits. Multilateral netting of credit risks is another step along the continuum, in which a multilateral clearinghouse substitutes its own credit for that or others, and has a bilateral relationship with each of them. In each bilateral relationship, the credit exposure at any moment in time is the net value of the transactions. At first, this might sound different from the banking model, because futures exchanges operate multilateral clearinghouses. But the difference is mainly one of scale. Every bank serves as a central counterparty for its inter-bank trading partners and its clients. So, in this sense, every swap dealer bank using netting provisions under the ISDA Master Agreement is a clearinghouse. Each swap dealer assesses the likelihood that his counterparty will default, and his own ability to withstand such a default. In doing so, he is mindful of his own capital base, and the capital strength of his counterparty. Where capital is not high relative to risk, it is more likely that one or both swap counterparties will demand collateral from the other. Now we have a more complete picture of credit risk mitigation schemes for derivatives. Each scheme has characteristics appropriate to its participants. On one end of the continuum are banks and insurance companies, with traditionally strong capital cushions. At the other end are margin-reliant entities including futures exchange clearinghouses.A Clearinghouse for Swaps? It should be clear at this point that creating a new clearinghouse for swaps, or for one type of swaps like credit default swaps, or forcing swaps into some other clearinghouse, would not exactly make order out of chaos. A good deal of order already exists. It is the order that markets bring to human affairs, giving participants the opportunity to choose, and to change their choices. Today swap participants can choose among several different methods to handle credit risk. We can keep the contracts on our own books, netting them against other contracts, taking collateral to support the risk as appropriate, or we can submit them to a third party clearinghouse. A system like this allows us to make the right judgments for ourselves and our counterparties, as capital positions change and the mix of clients changes. Every bank changes its mix of business along the continuum, every day. For this reason, section 13 of the bill is troubling. This section requires that all currently exempted and excluded OTC transactions must be cleared through a CFTC regulated clearing entity, or an otherwise regulated clearinghouse which meets the requirements of a CFTC regulated derivatives clearing organization. While the provision authorizes the CFTC to provide exemptions from the clearing requirement, it can only grant the relief under limited circumstances, provided that the transaction is highly customized, infrequently traded, does not serve a significant price discovery function and is entered into by financially sound counterparties. Driving swap activity into a central clearinghouse would be undesirable for several reasons. First, it would create a central choke point for activity that is, today, distributed across multiple locations. If a single swap dealer has processing problems or other difficulties, they affect only the dealer's clients. If a central clearinghouse were to have problems, they would affect the entire system's derivatives flows. Second, the same is true of the credit risk of such a central entity. Pulling the credit risk of swaps out of the institutions where they reside today, and forcing them into a central counterparty, risks creating a new, ``too-big-to-fail'' enterprise that represents a new risk to taxpayers. Third, a centralized, collateral-reliant scheme would tend to reduce market discipline. Because parties to bilateral netting agreements retain some individual credit exposure, they must assess their counterparties' credit standing, giving them an incentive to control their positions carefully. The resulting widespread awareness of credit risk makes the financial system safer. In contrast, clearinghouse arrangements tend to socialize credit risk. Our financial system today shows the ill effects of a reduction in market discipline, and Federal policies should increase it, not reduce it. Fourth, one reason for this is that credit discipline encourages financial institutions to strengthen their capital bases. Finally, building a central clearinghouse may be an expensive proposition, requiring new capital of its own. In contrast, increased use of bilateral cross product netting under ISDA Master Agreements can be accomplished at low cost. The marginal cost of adding another transaction to an ISDA bilateral master agreement is zero. No other technique offers such substantial risk reduction at such a low cost. Since, as I indicated above, every swap dealer bank serves as a clearinghouse for its swap trading partners and clients, the provision would have the effect of limiting the ability of banks to engage in this segment of the banking business without the approval of the CFTC. I do not know of any reason to unwind the policy consensus for swaps to adopt such a policy. The netting and close out arrangements that are in use among swap counterparties are the result, in part, of careful work by Congress to establish the enforceability of netting agreements under bankruptcy law. These arrangements have been used in the marketplace and tested in the courts and have managed the credit risk of hundreds of thousands of swap transactions. In the last 12 months alone, the failure or default of a major swap dealer, Lehman Brothers, two of the world's largest debt issuers, Fannie Mae and Freddie Mac, and a sovereign country Ecuador, in addition to the more routine failures of other counterparties have been successfully resolved using these arrangements. In every case the well drafted netting and close out provisions of the ISDA Master Agreements have done what they were supposed to do. Simply put, these arrangements work well, and there is no evidence to support a statutory requirement for clearing of all swap agreements through CFTC-approved central counterparties.Conclusion The privately negotiated derivatives business--and the bilateral infrastructure, documentation, and netting that support it--have been called ``no less than the creation of global law by contractual consensus.'' It is a system that works. It is a system that has well served the economy and the financial markets in the U.S. and around the world. It is a system that has benefitted thousands of companies, financial institutions and sovereigns. And it is a system that has an important part to play as we work toward a solution to today's economic weakness and financial markets uncertainty. Great care should be taken to optimize--and not weaken--this innovative and important system. " CHRG-111shrg51395--23 Mr. Stevens," Thank you very much, Mr. Chairman. On behalf of the Institute and our member funds, I thank you, Chairman Dodd, Senator Shelby, and all the Members of the Committee for making it possible for me to appear today. We serve 93 million American investors, as you know, and we strongly commend the Committee for the attention you are devoting to improving our system of financial regulation. I believe the current financial crisis provides a very strong public mandate for Congress and for regulators to take bold steps to strengthen and modernize regulatory oversight. Like other stakeholders, and there are many, of course, we have been thinking hard about how to revamp the current system. Last week, we published a white paper detailing a variety of reforms, and in it we recommend changes to create a regulatory framework that provides strong consumer and investor protection while also enhancing regulatory efficiencies, limiting duplication, closing conspicuous regulatory gaps, and frankly, emphasizing the national character of our financial services markets. I would like briefly to summarize the proposals. First, we believe it is crucial to improve the government's capability to monitor and mitigate risks across the financial system, so ICI supports creation of a Systemic Risk Regulator. This could be a new or an existing agency or interagency body, and in our judgment should be responsible for monitoring the financial markets broadly, analyzing changing conditions here and overseas, evaluating and identifying risks that are so significant that they implicate the health of the financial system, and acting in coordination with other responsible regulators to mitigate these risks. In our paper, we stress the need to carefully define the responsibilities of a Systemic Risk Regulator as well as its relationships with other regulators, and I would say, Mr. Chairman, that is one of the points that Chairman Bernanke made in his speech today, to leverage the expertise and to work closely with other responsible regulators in accomplishing that mission. In our judgment, addressing systemic risk effectively, however, need not and should not mean stifling innovation, retarding competition, or compromising market efficiency. You can achieve all of these purposes, it seems to us, at the same time. Second, we urge the creation of a new Capital Markets Regulator that would combine the functions of the SEC and the CFTC. This Capital Markets Regulator's statutory mission should focus sharply on investor protection and law enforcement. It should also have a mandate, as the SEC does currently, to consider whether its proposed regulations promote efficiency, competition, and capital formation. We suggest several ways to maximize the effectiveness of the new Capital Markets Regulator. In particular, we would suggest a need for a very high-level focus on management of the agency, its resources, and its responsibilities, and also the establishment of mechanisms to allow it to stay much more effectively abreast of market and industry developments. Third, as we discuss more fully in our white paper, effective oversight of the financial system and mitigation of systemic risk will require effective coordination and information sharing among the Systemic Risk Regulator and regulators responsible for other financial sectors. Fourth, we have identified areas in which the Capital Markets Regulator needs more specific legislative authority to protect investors and the markets by closing regulatory gaps and responding to changes in the marketplace. In my written statement, I identify four such areas: hedge funds, derivatives, municipal securities, particularly to improve disclosure standards, and the inconsistent regulatory regimes that exist today for investment advisors and broker dealers. Now, as for mutual funds, they have not been immune from the effects of the financial crisis, nor, for that matter, have any other investors. But our regulatory structure, and this bears emphasizing, which grew out of the New Deal as a result of the last great financial crisis, has proven to be remarkably resilient, even through the current one. Under the Investment Company Act of 1940 and other securities laws, fund investors enjoy a range of vital protections: Daily pricing of fund shares with mark-to-market valuation every business day; separate custody of all fund assets; minimal or no use of leverage in our funds; restrictions on affiliated transactions and other forms of self-dealing; required diversification; and the most extensive disclosure requirements faced by any financial products. Funds have embraced this regulatory regime and they have prospered under it. Indeed, I think recent experience suggests that policymakers should consider extending some of these very same disciplines that have worked so well for us since 1940 to other marketplace participants in reaction to the crisis that we are experiencing today. Finally, let me comment, Mr. Chairman, briefly on money market funds. Last September, immediately following the bankruptcy of Lehman Brothers, a single money market fund was unable to sustain its $1 per share net asset value. Coming hard on the heels of a series of other extraordinary developments that roiled global financial markets, these events worsened an already severe credit squeeze. Investors wondered what other major financial institution might fail next and how other money market funds might be affected. Concern that the short-term fixed income market was all but frozen solid, the Federal Reserve and the Treasury Department took a variety of initiatives, including the establishment of a temporary guarantee program for money market funds. These steps have proved highly successful. Over time, investors have regained confidence. As of February, assets in money market funds were at an all-time high, almost $3.9 trillion. The Treasury Department's temporary guarantee program will end no later than September 18. Funds have paid more than $800 million in premiums, yet no claims have been made and we do not expect any claims to be made. We do not envision any future role for Federal insurance of money market fund assets and we look forward to an orderly transition out of the temporary guarantee program. The events of last fall were unprecedented, but it is only responsible that we, the fund industry, look for lessons learned. So in November 2008, ICI formed a working group of senior fund industry leaders to study ways to minimize the risk to money market funds of even the most extreme market conditions. That group will issue a strong and comprehensive set of recommendations designed, among other things, to enhance the way money funds operate. We expect that report by the end of the month. We hope to place the executive summary in the record of this hearing, and Mr. Chairman, I would be delighted to return to the Committee, if it is of interest to you, to present those recommendations at a future date. Thank you very much. " 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-111hhrg56778--3 Mr. Garrett," I thank the gentleman, and I thank the members of the panel who are here today. Insurance holding company supervision obviously is a very complex topic and I think the hearing today will help members be able to delve into it and get a better understanding of how insurance companies are structured, how they're operated, and how they're regulated. And as I have delved deeper into this issue and the way that insurers are regulated within holding companies, either through insurance holding companies, financial holding companies or thrift holding companies, my belief that the problems are really more attributed to failures by regulators as opposed to gaps in regulatory structures continues to be reinforced. So while I do agree that there are a number of areas out there within our insurance regulatory system that do need to be updated and modernized, I believe we must be really careful and deliver it in our approach. The insurance industry as a whole, I think, has performed better than most other parts of the financial sector during this crisis. And so we must ensure that we first do no harm in whatever we do. I know my friend and colleague, who is not here right now, Mr. Royce, has continually pointed out that the securities lending problems with the AIG situation highlight the problems with State-based regulation, and he says it shows the need to have a larger Federal role in the regulating of the insurance companies. And I would remind him, while the losses attributed to securities lending were significant, had it not been for the cascade of problems with AIG's Financial Products Unit, the FP, that company would have been able to handle those losses without the need of taxpayer support. Now, once the Office the Thrift Supervision had the Federal regulatory authority over AIG, and they had the power to oversee AIG's FP leverage, they unfortunately failed to identify and correct that problem. And this is really a prime example of the regulator not doing their job; and, it's not really a problem of a gap in regulation. I would even argue that if the securities lending operations of the insurers had been handled by the Federal regulators in this case, things might actually have been much worse than they were. I agree that the securities lending by insurance companies, as I said at the outset, needs additional reforms, and I do look forward to hearing from the Commissioner and Director Frohman, as well, Mr. Dilweg and Ms. Frohman on what reforms have already been made in these areas and other solutions as well. Now, on another topic, though, I would like to briefly discuss a major concern I had with Chairman Dodd's recent release of a financial regulatory reform draft. The Dodd package has a provision that would require an up-front tax on any bank holding company with assets greater than $50 billion. Also, Dodd's plan would tax any financial company, including insurers, who present an extremely low risk with greater than $50 billion in assets after any systemic event occurred. I believe that this tax would simply lead to higher costs for consumers and additional job losses in the private sector as well. I also believe that we greatly increase the moral hazard within the financial sector. I would like to read a quote from the recently released White Paper from the Property Casualty and Insurers Association of America regarding the topic of using the absolute size of a financial company as the basis for determining a systemic risk. The paper states, ``Such a process, if enacted, would create a cross subsidy of significant magnitude from firms that do not pose a systemic risk to those firms whose activities are systemically risky. So the resulting moral hazard would encourage increased risk-taking, and as such could ultimately defeat the legislation's intent of reducing the economy's exposure to systemic risk.'' So ultimately, we need a system here in place that can allow big companies to fail without being bailed out either by the taxpayer or by the consumer as his proposal would allow. So while I agree that there are numerous areas of insurance regulation that need to be addressed and updated and modernized, I believe that the main problems here really were with regulators and not the structure of the regulation. So, once again, I thank my good friend from Pennsylvania for holding this important hearing, and also for the education that we're going to get today. And I look forward to hearing from all the witnesses. " CHRG-111shrg51395--121 PREPARED STATEMENT OF T. TIMOTHY RYAN, JR. President and Chief Executive Officer, Securities Industry and Financial Markets Association March 10, 2009 Chairman Dodd, Ranking Member Shelby, Members of the Committee; My name is Tim Ryan and I am President and CEO of the Securities Industry and Financial Markets Association (SIFMA). \1\ Thank you for your invitation to testify at this important hearing. The purpose of my testimony is to share SIFMA's views on how we might improve investor protection as well as the regulation of our financial markets.--------------------------------------------------------------------------- \1\ The Securities Industry and Financial Markets Association brings together the shared interests of more than 600 securities firms, banks and asset managers locally and globally through offices in New York, Washington, D.C., and London. Its associated firm, the Asia Securities Industry and Financial Markets Association, is based in Hong Kong. SIFMA's mission is to champion policies and practices that benefit investors and issuers, expand and perfect global capital markets, and foster the development of new products and services. Fundamental to achieving this mission is earning, inspiring and upholding the public's trust in the industry and the markets. (More information about SIFMA is available at http://www.sifma.org)---------------------------------------------------------------------------Overview Our current financial crisis, which has affected nearly every American family, underscores the imperative to modernize our financial regulatory system. Our regulatory structure and the plethora of regulations applicable to financial institutions are based on historical distinctions among banks, securities firms, insurance companies, and other financial institutions--distinctions that no longer conform to the way business is conducted. Today, financial services institutions perform many similar activities without regard to their legacy charters, and often provide investors with similar products and services, yet may be subject to different rules and to the authority of different regulatory agencies because of the functions performed in a bygone era. Regulators continue to operate under authorities largely established many decades ago. They also often operate without sufficient coordination and cooperation and without a complete picture of the market as a whole. For example, the Securities and Exchange Commission (SEC) oversees brokerdealer activity. Futures firms are regulated by the Commodity Futures Trading Commission (CFTC), while the insurance industry is regulated by 50 State insurance regulators. Thrifts are regulated by the Office of Thrift Supervision, and banks may be overseen at the Federal level by the Office of the Comptroller of the Currency, the Federal Reserve Board, or the Federal Deposit Insurance Corporation. At the same time, some financial institutions, such as hedge funds, largely escape regulation altogether. As a result, our current regulatory framework is characterized by duplicative or inconsistent regulation, and in some instances insufficient or insufficiently coordinated oversight. The negative consequences to the investing public of this patchwork of regulatory oversight are real and pervasive. Investors do not have comparable protections across the same or similar financial products. Rather, the disclosures, standards of care and other key investor protections vary based on the legal status of the intermediary or the product or service being offered. For example, similar financial advisory services may be delivered to retail clients via a broker-dealer, an investment adviser, an insurance agent, or a trustee, thereby subjecting similar advisory activities to widely disparate regulatory requirements. From the perspective of financial institutions, many are subject to duplicative, costly, and unnecessary regulatory burdens, including multiple rulebooks, and multiple examinations and enforcement actions for the same activity, that provide questionable benefits to investors and the markets as a whole. This regulatory hodgepodge unnecessarily exposes investors, market participants, and regulators alike to the potential risk of under-regulation, overregulation, or inconsistent regulation, both within the U.S. and globally. A complex and overlapping regulatory structure results in higher costs on all investors, depriving them of investment opportunities. Simply enhancing regulatory cooperation among the many different regulators will not be sufficient to address these issues. In light of these concerns, SIFMA advocates simplifying and reforming the financial regulatory structure to maximize and enhance investor protection and market integrity and efficiency. More specifically, we believe that a reformed--and sound--regulatory structure should accomplish the following goals: First, it must minimize systemic risk. Second, through a combination of structural and substantive reforms, it must be as effective and efficient as possible, while at the same time promoting and enhancing fair dealing and investor protection. Finally, it should encourage consistent regulation across the same or similar businesses and products, from country to country, to minimize regulatory arbitrage.Creation of a Financial Markets Stability Regulator Systemic risk has been at the heart of the current financial crisis. While there is no single, commonly accepted definition of systemic risk, we think of ``systemic risk'' as the risk of a system wide financial crisis characterized by a significant risk of the contemporaneous failure of a substantial number of financial institutions or of financial institutions or a financial market controlling a significant amount of financial resources that could result in a severe contraction of credit in the U.S. or have other serious adverse effects on economic conditions or financial stability. SIFMA has devoted considerable time and resources to thinking about systemic risk, and what can be done to identify it, minimize it, maintain financial stability and resolve a financial crisis in the future. A regulatory reform committee of our members has met regularly in recent months to consider these issues and to develop a workable proposal to address them. We have sponsored roundtable discussions with former regulators, financial services regulatory lawyers and our members, as well as other experts, policymakers, and stakeholders to develop solutions to the issues that have been exposed by the financial crisis and the challenges facing our financial markets and, ultimately and most importantly, America's investors. Through this process, we have identified a number of questions and tradeoffs that will confront policymakers in trying to mitigate systemic risk. Although our members continue to consider this issue, there seems to be consensus that we need a financial markets stability regulator as a first step in addressing the challenges facing our overall financial regulatory structure. The G30, in its report on financial reform, supports a central body with the task of promoting and maintaining financial stability, and the Treasury, in its blueprint, also has supported a market stability regulator. We are realistic in what we believe a financial markets stability regulator can accomplish. It will not be able to identify the causes or prevent the occurrence of all financial crises in the future. But at present, no single regulator (or collection of coordinated regulators) has the authority or the resources to collect information system-wide or to use that information to take corrective action in a timely manner across all financial institutions and markets regardless of charter. We believe that a single, accountable financial markets stability regulator will improve upon the current system. While our position on the mission of the financial markets stability regulator is still evolving, we currently believe that its mission should consist of mitigating systemic risk, maintaining financial stability and addressing any financial crisis, all of which will benefit the investing public. It should have authority over all markets and market participants, regardless of charter, functional regulator or unregulated status. In carrying out its duties, the financial markets stability regulator should coordinate with the relevant functional regulators, as well as the President's Working Group, as applicable, in order to avoid duplicative or conflicting regulation and supervision. It should also coordinate with regulators responsible for systemic risk in other countries. It should have the authority to gather information from all financial institutions and markets, adopt uniform regulations related to systemic risk, and act as a lender of last resort. It should probably have a more direct role in supervising systemically important financial organizations, including the power to conduct examinations, take prompt corrective action and appoint or act as the receiver or conservator of all or part of a systemically important organization. These more direct powers would end if a financial group were no longer systemically important.Other Reforms That Would Enhance Investor Protection and Improve Market Efficiency While we believe that a financial markets stability regulator will contribute to enhancing investor protection and improving market efficiency, we also believe, as a second step, that we must work to rationalize the broader financial regulatory framework to eliminate regulatory gaps and imbalances that contribute to systemic risk. Specifically, SIFMA believes that more effective and efficient regulation of financial institutions--resulting in greater investor Protection--is likely to be achieved by regulating similar activities and firms in a similar manner and by consolidating certain financial regulators.Core Standards Governing Business Conduct Currently, the regulation of the financial industry is based predominantly on rules that were first established during the 1930s and 1940s, when the products and services offered by banks, broker-dealers, investment advisors and insurance companies were distinctly different. Today, however, the lines and distinctions among these companies and the products and services they offer have become largely blurred. Development of a single set of standards governing business conduct of financial institutions towards individual and institutional investors, regardless of the type of industry participant or the particular products or services being offered, would promote and enhance investor protection, and reduce potential regulatory arbitrage and inefficiencies that are inherent in the existing system of multiple regulators and multiple, overlapping rulebooks. The core standards should be crafted so as to be flexible enough to adapt to new products and services as well as evolving market conditions, while providing sufficient direction for firms to establish enhanced compliance systems. As Federal Reserve Board Chairman Ben Bernanke once suggested, ``a consistent, principles-based, and risk-focused approach that takes account of the benefits as well as the risks that accompany financial innovation'' is an effective way toprotect investors while maintaining the integrity of the marketplace. \2\--------------------------------------------------------------------------- \2\ See Ben S. Bernanke, Federal Reserve Board Chairman, Remarks at the Federal Reserve Bankof Atlanta's 2007 Financial Markets Conference, Sea Island, Georgia (May 15, 2007), at http://www.federalreserve.gov/boarddocs/Speeches/2007/20070515/default.htm--------------------------------------------------------------------------- This core standards approach, however, must be accompanied by outcome-oriented rules (where rules are necessary), an open dialogue between the regulator and regulated, and enforcement efforts focused on addressing misconduct and fraud and protecting the investing public.Harmonize Investment Advisor and Broker-Dealer Regulation SIFMA has long advocated the modernization and harmonization of the disparate regulatory regimes for investment advisory, brokerage and other financial services in order to promote investor protection. A 2007 RAND Corporation report commissioned by the SEC found that efforts to describe a financial service provider's duties or standard of care in legalistic terms, such as ``fiduciary duty'' or ``suitability,'' contributes to--rather than resolves--investor confusion. \3\ Further complicating matters, the laws that apply to many customer accounts, such as ERISA (for employer-sponsored retirement plans) or the Internal Revenue Code (for IRAs), have different definitions of fiduciaries, and prohibitions on conduct and the sale of products that differ from those under the Investment Advisers Act and state law fiduciary concepts. The RAND report makes clear that individual investors generally do not understand, appreciate, or care about such legal distinctions.--------------------------------------------------------------------------- \3\ Investor and Industry Perspectives on Investment Advisers and Broker-Dealers, RAND Institutefor Civil Justice, December 31, 2007, available at http://www.sec.gov/news/press/2008/2008-1_randiabdreport.pdf--------------------------------------------------------------------------- Rather than perpetuating an obsolete regulatory regime, SIFMA recommends the adoption of a ``universal standard of care'' that avoids the use of labels that tend to confuse the investing public, and expresses, in plain English, the fundamental principles of fair dealing that individual investors can expect from all of their financial services providers. Such a standard could provide a uniform code of conduct applicable to all financial professionals. It would make clear to individual investors that their financial professionals are obligated to treat them fairly by employing the same core standards whether the firm is a financial planner, an investment adviser, a securities broker-dealer, a bank, an insurance agency or another type of financial services provider. A universal standard would not limit the ability of individual investors to contract for and receive a broad range of services from their financial services providers, from pure execution of customer orders to discretionary investment advice, nor would it limit the ability of clients to define or modify relationships with their financial services providers in ways they so choose. As Congress contemplates regulatory reform, particularly in the wake of the Madoff and Stanford scandals and the recent turbulence in our financial markets, we believe that the time has come to focus on the adoption of a universal investor standard of care. In addition, we urge Congress to pursue a regulatory framework for financial services providers that is understandable, practical and provides flexibility sufficient for these intermediaries to provide investors with both existing and future products and services. Such a framework must also avoid artificial or vague distinctions (such as those based on whether any investment advice is ``solely incidental'' to brokerage or whether any compensation to the financial services provider is ``special''). Finally, the framework should support investor choice through appropriate relief from the SEC's rigid prohibitions against principal trading, particularly with respect to products traded in liquid and transparent markets, which has had the effect of foreclosing investors from obtaining more favorable pricing on transactions based on the requirement for transaction-by-transaction consent.Broaden the Authority of the MSRB The Municipal Securities Rulemaking Board (MSRB) regulates the conduct of only broker-dealers in the municipal securities market. We feel it is important to level the regulatory playing field by increasing the MSRB's authority to encompass the regulation of financial advisors, investment brokers and other intermediaries in the municipal market to create a comprehensive regulatory framework that prohibits fraudulent and manipulative practices; requires fair treatment of investors, state and local government issuers of municipal bonds and other market participants; ensures rigorous standards of professional qualifications; and promotes market efficiencies.Merge the SEC and CFTC The United States is the only jurisdiction that splits the oversight of securities and futures activities between two separate regulatory bodies. When the CFTC was formed, financial futures represented a very small percentage of futures activity. Now, an overwhelming majority of futures that trade today are financial futures. These products are nearly identical to SEC regulated securities options from an economic standpoint, yet they are regulated by the CFTC under a very different regulatory regime. This disparate regulatory treatment detracts from the goal of investor protection. An entity that combines the functions of both agencies could be better positioned to apply consistent rules to securities and futures.OTC Derivatives Although OTC derivatives transactions generally are limited to institutional participants, the use of OTC derivatives by American businesses to manage risks and reduce funding costs provides important benefits for our economy and, consequently, for individual investors as well. At the same time, problems with OTC derivatives can adversely affect the financial system and individual investors. Accordingly, we believe that steps should be taken to further develop the infrastructure that supports the OTC derivatives business and to improve the regulatory oversight of that activity. In particular, we strongly support our members' initiative to establish a clearinghouse for credit default swaps (CDS) and we are pleased to note that ICE US Trust LLC opened its doors for clearing CDS transactions yesterday. We believe that development of a clearinghouse for credit derivatives is an effective way to reduce counterparty credit risk and, thus, promote market stability. In addition to reducing risk, the clearinghouse will facilitate regulatory oversight by providing a single access point for information about the CDS transactions it processes. We also believe that all systemically significant participants in OTC derivatives markets should be subject to oversight by a single systemic regulator. (It is noteworthy that the AIG affiliate that was an active participant in the CDS market was not subject to meaningful regulatory supervision.) The systemic regulator should be given broad authority to promulgate rules and regulations to promote sound practices and reduce systemic risk. We recognize that effective regulation requires timely access to relevant information and we believe the systemic regulator should have the necessary authority to assure there is appropriate regulatory transparency.Investor Protection Through International Cooperation and Coordination Finally, the current financial crisis reminds us that markets are global in nature and so are the risks of contagion. To promote investor protection through effective regulation and the elimination of disparate regulatory treatment, we believe that common regulatory standards should be applied consistently across markets. Accordingly, we urge that steps be taken to foster greater cooperation and coordination among regulators in major markets in the U.S., Europe, Asia, and elsewhere around the world. There are several international groups in which the U.S. participates that work to further regulatory cooperation and establish international standards, including IOSCO, the Joint Forum, the Basel Committee on Banking Supervision, and the Financial Stability Forum. Congress should support and encourage the efforts of these groups.Conclusion Recent challenges have highlighted the necessity of reforms to enhance investor protection. SIFMA strongly supports these efforts and commits to be a constructive participant in the process. SIFMA stands ready to assist the Committee as it considers regulatory reform to minimize systemic risk, promote consistent and efficient regulation, eliminate regulatory arbitrage, and promote capital formation--all of which serve, directly or indirectly, the interest of investor protection. We are confident that through our collective efforts, we have the capacity to emerge from this crisis with stronger and more modern regulatory oversight that will not only prepare us for the challenges facing financial firms today and in the future, but also help the investing public meet its financial needs and support renewed economic growth and job creation. ______ CHRG-111hhrg53242--24 Mr. Stevens," Thank you, Chairman Kanjorski, Congressman Royce, and members of the committee. I am very pleased to appear today to discuss the Obama Administration's proposal for financial regulatory reform. And I must say we commend this committee for all the very hard work and attention it is devoting to these important and complex issues. As you know, mutual funds and other registered investment companies are a major factor in our financial markets. For example, our members hold roughly one-quarter of all the outstanding stock of U.S. public companies, and funds have not been immune from the effects of the financial crisis. But the regulatory structure that governs funds has proven to be remarkably resilient. As a result of New Deal reforms that grew out of the Nation's last major financial crisis, mutual fund investors enjoy significant protections under the Investment Company Act of 1940 and the other securities laws. These include daily pricing of fund shares with mark-to-market valuations, separate custody of fund assets, very tight restrictions on leverage, prohibitions on affiliated transactions and other forms of self-dealing, the most extensive disclosure requirements faced by any financial product, and strong independent governance. The SEC has administered this regulatory regime effectively, and funds have embraced it and have prospered under it. Indeed, recent experience suggests that policymakers should consider extending some of these same disciplines, which arrived in our industry in 1940, to other marketplace participants. We are pleased that the Administration's reform proposals reaffirm the SEC's comprehensive authority not just with respect to registered investment companies and their advisers, but also over capital markets, brokers, and other regulated entities. The SEC can and should do even more to protect investors and maintain the integrity of our capital markets. But for this it needs new powers and additional resources. We agree with the Administration that the SEC should have new regulatory authority over hedge fund advisers, along with expanded authority over credit rating agencies. And we welcome plans to give the SEC new powers to increase transparency and reduce counterparty risk in certain over-the-counter derivatives. We have long supported additional resources for the SEC. It is just as important, however, that the SEC bolster its internal management and deepen the abilities of its staff. We commend SEC Chairman Mary Schapiro for the steps she is taking in this regard. Lastly, I would like to address one of the central questions of reform, how to regulate systemic risk. ICI was an early proponent of the idea that a statutory council of senior Federal regulators would be best equipped to look across our financial system to anticipate and address emerging threats to its stability. Thus, we are pleased that the Administration recommends creation of a Financial Services Oversight Council. We are concerned, however, that the Administration proposes that this council would have only an advisory or consultative role. The lion's share of systemic risk authority would be invested in the Federal Reserve. In our view, that strikes the wrong balance. Addressing risks to the financial system at large requires diverse inputs and perspectives. We would urge Congress instead to create a strong systemic risk council, one with teeth. The council should coordinate the government's response to identified risks, and its power to direct the functional regulators to implement corrective measures should be clear. The council also should be supported by an independent, highly experienced staff. Now, some have said 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. And isn't that the real goal here, to prevent the fire before it consumes our financial system? This council approach offers several advantages. As I mentioned, the model would enlist expertise across the spectrum of financial services. It would be well suited to balancing the competing interests that will often arise. It would also likely make the functional regulators more attentive to emerging risks or gaps because they would be engaged as full partners. And the council could be up and running quickly, while it might take years for any existing agency to assemble the requisite skills to oversee all areas of our financial system. Mr. Chairman, thank you again for the opportunity to testify. We look forward to continuing to work with the committee as it develops legislation on these and other issues. [The prepared statement of Mr. Stevens can be found on page 121 of the appendix.] " FOMC20080805meeting--157 155,MR. BULLARD.," Thank you, Mr. Chairman. I am going to make my remarks a little shorter here. My judgment is that the current situation is a difficult one for the Committee. Because of the very appropriate focus on financial market turmoil over the past year, our attention has naturally turned away from keeping the level of interest rates consistent with longer-term inflation objectives. This was done to avert particularly extreme, but low probability, outcomes in which the economy would experience an especially severe downturn. As it turned out, the bad state did not materialize, which I think will go down in history as a successful element of the Committee's policy over the past year. The ability to take on financial market turmoil of this magnitude and prevent it from doing substantial damage to the economy-- a recession of the magnitude of 1980-82, let's say--has been a real achievement. In that sense, all has gone according to plan. At the same time, we have moved interest rates to a very low level in the context of rising inflation and rising inflation expectations. A severe downturn was unwelcome, to be sure, but it was also projected to keep inflation in check. Since that did not materialize, we are left with low rates and an environment of CPI inflation running at 5 percent headline, measured from one year earlier, and long-term inflation expectations creeping higher. We face more risk now of creating a serious inflation problem than we have in a generation. To make progress, I think we should keep rates steady today but with the plan of preparing markets for an increase in rates at the September meeting, conditional of course on incoming data. This would be consistent with alternative B today; and with intermeeting statements, it would move probability mass toward higher rates through the fall and through the first half of 2009. I have several remarks on a fall tightening campaign. First of all, moving 25 basis points is by itself not likely to have a large effect on economic activity, nor does it bring the level of the federal funds rate high enough to have a meaningful effect on inflation. The FOMC started tightening in mid-2004 but achieved a core CPI inflation rate below 2 percent in only one month during the entire three-year period of 2005, 2006, and 2007. What the move would do is get the Committee started on returning interest rates to a more normal level, a level more consistent with our inflation objectives. The Committee could pause or even reverse course should particularly adverse data suggest that economic activity was weakening substantially. Preparing for an increase in rates means that we would be signaling that financial market turmoil is no longer the paramount concern. On that, I think we can reasonably stress that we have provided accommodation over the past year in the form of lower interest rates and innovative liquidity facilities. We have bought time for financial firms to repair and adjust. While all is not as it was, we do not want to create an inflation problem in the aftermath of a shock of this magnitude, which may actually compound the situation and make it worse. Longer-term inflation expectations have been creeping higher, a fact that has been widely cited in commentary on monetary policy. I would like to stress that, in my view of a wellfunctioning inflation-targeting regime, these inflation expectations would not be moving at all. Short-term interest rates would be moving higher and lower in response to shocks to the economy, and inflation expectations would never move. This would reflect the confidence that the central bank's short-term interest rate adjustments were being accomplished in just the right way to offset disturbances buffeting the economy. Because of this, I prefer not to interpret observed movements in inflation expectations as evidence of what we should or should not do with respect to interest rates. The short-term interest rate would have to move to offset the shocks to the economy even if longer-term inflation expectations never moved. Thank you. " CHRG-111shrg51290--11 Mr. Bartlett," Thank you, Chairman Dodd and Ranking Member Shelby and members of the Committee. To start with the obvious, it is true that many consumers were harmed by the mortgage-lending practices that led to the current crisis, but what is even more true is that even more have been harmed by the crisis itself. The root causes of the crisis, to overly simplify, are twofold: One, mistaken policies and practices by many, but not all, not even most, financial services firms; and two, the failure of our fragmented financial regulatory system to identify and to prevent those practices and the systemic failures that resulted. This crisis illustrates the nexus, then, between consumer protection regulation and safety and soundness regulation. Safety and soundness, or prudential regulation, is the first line of defense for protecting consumers. It ensures that financial services firms are financially sound and further loans that borrowers can repay with their own income are healthy both for the borrower and for the lender. In turn, consumer protection regulation ensures that consumers are treated fairly. Put another way, safety and soundness and consumer protection are self-reinforcing, each strengthening the other. Given this nexus, we do not support, indeed, we oppose proposals to separate consumer protection regulation from safety and soundness regulation. Such a separation would significantly weaken both. An example, Mr. Chairman, in real time, today, a provision in the pending omnibus appropriations bill that would give State attorneys general the authority to enforce compliance with the Federal Truth in Lending Act illustrates this problem. It would create additional fragmented regulation, and attempting to separate safety and soundness and consumer protection would harm both. My testimony has been divided into two parts. First, I address what went wrong, and second, I address how to fix the problem. What went wrong? The proximate cause of the current financial crisis was the nationwide collapse of housing values. The root cause of the crisis are twofold. The first was a breakdown, as I said, in policies, practices, and processes at many, but not all financial services firms. Since 2007, admittedly long after all the horses were out of the barn and running around in the pasture, the industry identified and corrected those practices. Underwriting standards have been upgraded. Credit practices have been reviewed and recalibrated. Leverage has been reduced as firms were rebuilt. Capital incentives have been realigned. And some management teams have been replaced. The second underlying cause, though, is our overly complex and fragmented financial regulatory structure which still exists today as it existed during the ramp-up to the crisis. There are significant gaps in the financial regulatory system in which no one has regulatory jurisdiction. The system does not provide for sufficient coordination and cooperation among regulators and does not adequately monitor the potential for market failures or high-risk activities. So how to fix the problem? The Roundtable has developed over the course, literally, of 3 years a draft financial regulatory architecture that is intended to close those gaps, and our proposed architecture, which I submit for the record, has six key features. First, we propose to expand the membership of the President's Working Group on Financial Markets and rename it the Financial Markets Coordinating Council, but key, to give it statutory authority rather than merely executive branch authority. Second, to address systemic risk, we propose that the Federal Reserve Board be authorized as a market stability regulator. The Fed would be responsible for looking across the entire financial services sector to identify interconnections that could pose a risk to the entire financial system. Third, to reduce the gaps in regulation, we propose a consolidation of several existing Federal agencies, such as OCC and OTS, into a single national financial institutions regulator. The new agency would be a consolidated prudential and consumer protection agency for three broad sectors: Banking, securities, and insurance. The agency would issue national prudential and consumer protection standards for mortgage origination. Mortgage lenders, regardless of how they are organized, would be required to retain some of the risk for the loans they originate, also known as keeping some skin in the game, and likewise, mortgage borrowers, regardless of where they live or who their lender is, would be protected by the same safety and soundness and consumer standards. Fourth, we propose the creation of a national capital markets agency with the merger of the SEC and the Commodities Futures Trading Commission. And fifth, to protect depositors, policy holders, and investors, we propose that the Federal Deposit Insurance Corporation would be renamed the National Insurance Resolution Authority and that it manage insurance mechanisms for banking, depository institutions, but also federally chartered insurance companies and federally licensed broker dealers. Before I close, Mr. Chairman, I have also included in my testimony two other issues of importance to this Committee and the policymakers and the industry. One, lending by institutions that have received TARP funds is a subject of great comment around this table. And second, the impact of fair value accounting in illiquid markets. I have attached to my statement a series of tables that the Roundtable has compiled on lending by some of the nation's largest institutions. These tables are designed to set the record straight. The fact is that large financial services firms have increased their lending as a result of TARP capital. And second, fair value accounting continues to be of gargantuan concerns for the industry and should be for the public in general. We believe that the pro-cyclical effects of existing and past policies, which have not been changed, are unnecessarily exacerbating the crisis. We urge the Committee to take up this subject and deal with it. We thank you again for the opportunity to appear. I yield back. " CHRG-111hhrg53244--319 Mr. Bernanke," We have already included both new CMBS and legacy CMBS in the TALF. We are looking at some other asset classes, but as I mentioned, they are more complex than the ones we have already included. We will give the markets plenty of notice about the extent of the program. We have to make judgments about whether markets are normalizing. If things return to normal, which I don't expect in the very near term, then we would have to think about scaling it down. But, otherwise, we will try to give plenty of notice to the markets about the time frame for these programs. Ms. Kosmas. Okay. I appreciate it. Thank you very much. " CHRG-111hhrg54869--95 Mrs. Capito," Thank you, Mr. Chairman. Thank you, Mr. Chairman, for being here. I would like to go to the resolution authority that the Administration has proposed. Those of us--we put together a Republican plan to deal with re-regulation and new regulation. And one of the ideas that we put forward was an enhanced bankruptcy rather than a resolution authority by the Reserve. And I think in doing that, I think we were--we feel that it creates more transparency, accountability; it can go into the bankruptcy court, with the accompanying experts in that bankruptcy court that would understand the complexity of what is going on. And also, it would remove, I think, any kind of appearance of a bailout or another implicit or implied government backstop. Do you have an opinion on an enhanced bankruptcy as opposed to the resolution before you? " CHRG-111hhrg51592--129 Mr. Bachus," And I think part of that answer, if you expand, and you don't--you know, these nationally recognized, I think, people have relied on that as somewhat of a guarantee, and we need to expand that number. But also, I mean, I would have to say that we also--you know, there have to be some qualifications for registration. Can I ask one other question? I know you have gone over with everybody else. Mr. Joynt, is the problem--you have mentioned fraud. Obviously, that can be a problem, when they fail to disclose information. But how about expertise, I mean, or competence? I mean, that, on occasion, you know, there probably just wasn't the competence there, because of the complexity. Is that true? " CHRG-111hhrg52407--14 COALITION FOR PERSONAL FINANCIAL LITERACY Ms. Levine. Thank you, Representative McCarthy, and members of the subcommittee. Good afternoon. Thank you for this opportunity to speak with you today. My name is Laura Levine, and I am the executive director of the Jump$tart Coalition for Personal Financial Literacy, a nonprofit organization based here in Washington, D.C. Jump$tart is a coalition of about 180 companies, such as Visa and Charles Schwab, and organizations like NEFE, EBRE, and FINRA, as well as Federal agencies which share a commitment to advance financial literacy among students in kindergarten through college. Jump$tart is also a network of 48 affiliated State coalitions. The Coalition was founded in 1995 by a small group of organizations that recognized the need to educate students about personal finance, as well as the importance of meeting this need through a collaborative effort. Jump$tart does not conduct financial education itself or create financial education resources; rather, its role is to support and promote individual and collective efforts to educate young people about money management. As the committee considers the importance of financial literacy within the regulatory system, Jump$tart encourages you to keep in mind the difference between educating and informing adult consumers and providing standards-based tested personal finance education for students in kindergarten through high school. Any widespread effort to require personal finance education at that level must be coordinated by or with the Department of Education, as well as the State Departments of Education and the various appropriate educational organizations at the State, local, and national levels. Jump$tart believes that financial literacy is an important element of consumer protection, and even with better regulation designed to protect consumers and more readable disclosures that most consumers can easily understand, an adequate level of financial literacy would give most consumers comfort, confidence, and the ability to make decisions most advantageous to their specific needs. But today, many young people are not adequately prepared to handle the growing variety and complexity of financial products and services or to make wise decisions in managing their own money. In 1997, the Jump$tart Coalition launched its first survey of financial literacy among high school students. The survey was conducted again in 2000 and has been repeated biannually since. Nationally, the average score on the test portion of the survey has ranged from 48.3 percent and, unfortunately, that was the most recent survey in 2008, to a high of 57 percent, which still could be called a failing grade. In each of the surveys, participants were 12th grade students recruited from randomly selected public high schools. It is important to note that the Jump$tart survey is intended as a general measure of the level of financial literacy among high school students and is not designed to be an assessment of the effectiveness of specific financial education curricula, and therefore, we should not conclude that the low scores reflect that financial education is ineffective. Rather, the consistently disappointing results over more than a decade of research do seem to indicate the need for more and better financial education. In 2008, Jump$tart also surveyed college students for the first time. Given the same test questions, college students on average answered 62.2 percent of the questions correctly, substantially better than their high school counterparts. But, unfortunately, college graduates are still a relatively small segment of our total population. Jump$tart believes that personal finance must be included in the education of all students during the kindergarten through high school years to provide young people with the knowledge and skills they need to make smart financial decisions. Some positive strides have been made in financial education in recent years. Jump$tart has identified three States, Missouri, Tennessee and Utah, that currently require all students to take and pass a one-semester course devoted to personal finance in order to graduate from high school. And another 18 States require some personal finance content to be incorporated into the other subject matter. I think it is important to note that personal finance education is taking place in schools across the country, whether or not the State or local jurisdiction requires it. We believe that personal finance education needs to be introduced early in the elementary school years while students are forming their behaviors and beliefs, and we believe that effective financial education in the middle grades could help troubled or unmotivated students make the connection between staying in school and their lifelong income-earning potential, possibly changing the path of would-be dropouts. Thank you for the opportunity to speak with you today. And as you start to shape the future of the regulatory atmosphere for financial institutions, I urge you to keep the financial literacy of our Nation's students in mind, too. More and not less personal finance education is needed, and we need to have a long-term nationwide strategy in place to ensure that this education is available to all students. Thank you. [The prepared statement of Ms. Levine can be found on page 73 of the appendix.] " Mr. Hinojosa," [presiding] Thank you, Ms. Levine. At this time, I would like to recognize Mr. Diaz. STATEMENT OF LAUTARO ``LOT'' DIAZ, VICE PRESIDENT, COMMUNITY DEVELOPMENT, NATIONAL COUNCIL OF LA RAZA (NCLR) " 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. CHRG-111hhrg54872--36 The Chairman," Next, we will hear from Janice Bowdler, who is the senior policy analyst at the National Council of La Raza. STATEMENT OF JANIS BOWDLER, DEPUTY DIRECTOR, WEALTH-BUILDING POLICY PROJECT, NATIONAL COUNCIL OF LA RAZA (NCLR) Ms. Bowdler. Good morning. Thank you. I would like to thank Chairman Frank and Ranking Member Bachus for inviting NCLR to share perspective on this issue. Latino families have been particularly hard hit by the implosion of our credit markets. Lax oversight allowed deceptive practices to run rampant, driving Latino families into risky products and ultimately cyclical debt. In fact, Federal regulators routinely missed opportunities to correct the worst practices. Congress must plug holes in a broken financial system that allowed household wealth to evaporate and debt to skyrocket. Today, I will describe the chief ways our current regulatory system falls short, and I will follow with a few comments on the CFPA. Most Americans share a fundamental goal of achieving economic security they can share with their children. To do so, they rely on financial products--mortgages, credit cards, car loans, insurance, and retirement accounts. Unfortunately, market forces have created real barriers to accessing the most favorable products, even when families are well-qualified. Subprime creditors frequently targeted minority communities as fertile ground for expansion. Subprime lending often served as a replacement of prime credit, rather than a complement. With much of the damage coming at the hands of underregulated entities, gaming of the system became widespread. Despite the evidence, Federal regulators failed to act. This inaction hurt the Latino community in three distinct ways. Access to prime products was restricted, even when borrowers had good credit and high incomes. This most often occurred because short-term profits were prioritized over long-term gains. Lenders actually steered borrowers into costly and risky loans, because that is what earned the highest profits. Disparate impact trends were not acted upon. Numerous reports have documented this trend. In fact, a study conducted by HUD in 2000 found that high-income African Americans, living in predominantly black neighborhoods, were 3 times more likely to receive subprime home loans than low-income white borrowers. Regulators failed to act, even when Federal reports made the case. And shopping for credit is nearly impossible. Financial products have become increasingly complex, and many consumers lack reliable information. Many chose to pay a broker to help them shop. Meanwhile, those brokers have little or no legal or ethical obligation to actually work on behalf of the borrower. Regulators dragged their feet on reforms that could have improved shopping opportunities. If our goal is to truly avoid the bad outcomes in the future, the high rates of foreclosure and household debt, little or no savings and the erosion of wealth, we have to change the Federal oversight system. Lawmakers must ensure that borrowers have the opportunity to bank and borrow at fair and affordable terms. We need greater accountability and the ability to spot damaging trends before they escalate. Some have argued that it is the borrower's responsibility to look out for deception. However, it is unreasonable to expect the average family to regulate the market and in effect to do what the Federal Reserve did not. The proposed CFPA is a strong vehicle that could plug the gaps in our regulatory scheme. In particular, we commend the committee for including enforcement of fair lending laws in the mission of the agency. This, along with the creation of the Office of Fair Lending and Equal Opportunity, will ensure that the agency also investigates harmful trends in minority communities. This is a critical addition that will help Latino families. We also applaud the committee for granting the CFPA strong rule-writing authority. This capability is fundamental to achieving its mission. Also, we were pleased to see that stronger laws are not preempted. This will ensure that no one loses protection as a result of CFPA action. As the committee moves forward, these provisions should not be weakened. And I will close just by offering a few recommendations of where we think it could be strengthened. A major goal of CFPA should be to improve access to simple prime products. Obtaining the most favorable credit terms for which you qualify is important to building wealth. This includes fostering product innovation to meet the needs of underserved communities. We need to eliminate loopholes for those that broker financing, and for credit bureaus. Real estate agents, brokers, auto dealers, and credit bureaus should not escape greater accountability. And we need to reinstate a community-level assessment. Without it, good products may be developed but will remain unavailable in entire neighborhoods. Including CRA in the CFPA will give the agency the authority necessary to make such an assessment. Thank you. And I would be happy to answer any questions. [The prepared statement of Ms. Bowdler can be found on page 66 of the appendix.] Ms. Waters. [presiding] Ms. Burger is recognized for 5 minutes. STATEMENT OF ANNA BURGER, SECRETARY-TREASURER, SERVICE EMPLOYEES INTERNATIONAL UNION (SEIU) Ms. Burger. On behalf of the 2.1 million members of SEIU and as a coalition member of the Americans for Financial Reform, I want to thank Chairman Frank, Ranking Member Bachus, and the committee members for their continued work to reform our broken financial system. It has been a year since the financial world collapsed, showing us that the action of a few greedy players on Wall Street can take down the entire global economy. As we continue to dig out of this crisis, we have an historic opportunity and a responsibility to reform the causes of our continued financial instability, and protect consumers from harmful and often predatory practices employed by banks to rake in billions and drive consumers into debt. The nurses, the childcare providers, janitors, and other members of SEIU continue to experience the devastating effects of the financial crisis firsthand. Our members and their families are losing their jobs, homes, health care coverage, and retirement savings. As State and local governments face record budget crises, public employees are losing their jobs and communities are losing vital services. And we see companies forced to shut their doors as banks refuse to expand lending and call on lines of credit. At the same time, banks and credit card companies continue to raise fees and interest rates and refuse to modify mortgages and other loans. We know the cause of our current economic crisis. Wall Street, big banks, and corporate CEOs created exotic financial deals, and took on too much risk and debt in search of outrageous bonuses, fees, and unsustainable returns. The deals collapsed and taxpayers stepped in to bail them out. According to a recent report released by SEIU, once all crisis-related programs are factored in, taxpayers will be on the hook for up to $17.9 trillion. And I would like to submit the report for the record. The proliferation of inappropriate and unsustainable lending practices that has sent our economy into a tailspin could and should have been prevented. The regulators' failure to act, despite abundance of evidence of the need, highlights the inadequacies of our current regulatory system in which none of the many financial regulators regard consumer protection as a priority. We strongly support the creation of a single Consumer Financial Protection Agency to consolidate authority in one place, with the sole mission of watching out for consumers across all financial services. I want to thank Chairman Frank for his work to strengthen the Proposed Consumer Financial Protection Agency language, particularly the strong whistle-blower protections. We believe to be successful, the CFPA legislation must include a scope that includes all consumer financial products and services; sovereign rulemaking and primary enforcement authority; independent examination authority; Federal rules that function as a floor, not a ceiling; the Community and Reinvestment Act funding that is stable and does not undermine the agency's independence from the industry; and strong whistle-blower and compensation protections. We believe independence, consolidated authority, and adequate power to stop unfair, deceptive, and abusive practices are key features to enable the CFPA to serve as a building block of comprehensive financial reforms. Over the past year, we have also heard directly from frontline financial service workers about their working conditions and industry practices. We know from our conversations that existing industry practices incentivize frontline financial workers to push unneeded and often harmful financial products on consumers. We need to ban the use of commissions and quotas that incentivize rank-and-file personnel to act against the interest of consumers in order to make ends meet or simply keep their job. The CFPA is an agency that can create this industry change. Imagine if these workers were able to speak out about practices they thought were deceptive and hurting consumers, the mortgage broker forced to meet a certain quota of subprime mortgages, or the credit card call center worker forced to encourage Americans to take on debt that they cannot afford and then they threaten and harass them when they can no longer make their payments, or the personal banker forced to open up accounts of people without their knowledge. Including protection and a voice for bank workers will help rebuild our economy today and ensure our financial systems remain stable in the future. Thank you for the opportunity to speak this morning. The American people are counting on this committee to hold financial firms accountable and put in place regulations that prevent crises in the future. Thank you. Ms. Waters. Thank you very much. [The prepared statement of Ms. Burger can be found on page 74 of the appendix.] Ms. Waters. I will recognize myself for 5 minutes. And I would like to address a question to Mr. David C. John, senior research follow, Thomas A. Roe Institute for Economic Policy Studies, The Heritage Foundation. I thank you for participating and for the recommendation that you have given, an alternative to the Consumer Financial Protection Agency. You speak of the consumer protection agency as a huge bureaucracy that would be set up, that would harm consumers, rather than help consumers, and you talk about your council as a better way to approach this with lots of coordination and outside input. It sounds as if you are kind of rearranging the chairs. Basically, what you want to do is leave the same regulatory agencies in place who had responsibility for consumer protection but did not exercise that responsibility. Why should the American public trust that, given this meltdown that we have had, this crisis that has been created, that the same people who had the responsibility are now going to see the light and they are going to do a better job than starting anew with an agency whose direct responsibility is consumer protection? " CHRG-111hhrg52407--15 Mr. Diaz," Good afternoon. My name is Lot Diaz, and I am vice president for housing and community development at the National Council of La Raza. NCLR is the largest Hispanic civil rights organization in the United States dedicated to improving the opportunities for Hispanic Americans. I would like to thank Chairman Gutierrez and Ranking Member Hensarling for inviting us to share our views. I would also like to thank Congressman Hinojosa for his leadership in the area of financial literacy. In my remarks today, I will lay out a strategy for using national financial counseling programs as a glue to hold major asset-building programs together. There are a number of Federal programs, like housing counseling, individual development accounts, and the VITA initiative that aim to increase asset ownership among low- and moderate-income families. However, none of them offer a targeted strategy for improving the choices of financial consumers and advancing them to more sophisticated products and transactions. In 1997, NCLR created a counseling network that today consists of 51 community-based counseling providers that will this year provide counseling education to over 40,000 families. Also in 2005, NCLR released a report which found that most financial education programs did not have the impact of helping Hispanic families obtain assets. We have learned that one-on-one counseling to low-income families is a meaningful and effective tool for building financial knowledge and sustainable wealth. While one goal of the Administration's proposed Consumer Finance Protection Agency would be to streamline financial literacy and education efforts, we believe a bolder, more targeted approach is necessary to achieve a shared goal, the shared goal of changing consumer choices and behavior. A successful national counseling program should include elements like in-person, one-on-one service, provide advice on a wide range of financial services, and deliver services through community-based organizations currently providing asset programs. As Congress considers regulatory reform, it must also consider how to improve the efforts of Federal agencies to educate financial consumers. Several proposed reforms, like additional disclosure, will curb deceptive practices. However, these reforms will not necessarily improve the daily financial decisions of families or ensure that these decisions set them on a path to build true financial security. Many times, improving families' financial decisions requires tailored guidance from a professional who can take into consideration the totality of the family's circumstances and goals. In fact, this is a mainstream approach taken by families with the means to do so. They seek advice from a professional financial planner or investment advisor. One NHN member, the Resurrection Project in Chicago, provides a model that brings these large wealth-building programs together through financial counseling. TRP is a certified housing counseling agency which provides free tax preparation, financial counseling, and other services. A typical client meets with a counselor individually to determine their financial status. A counselor reviews the client's credit report, budget, and financial goals. On average, 80 percent of the Resurrection Project's clients are not ready to purchase a home and likely need to work through other financial barriers before pursuing homeownership. In some cases, homeownership may not be the right choice. Together, the client and the counselor establish an action plan that would address credit repair, plan savings accounts, financial dictation and available tax programs. As the family works through their action plans, they continue to meet with the counselor, who helps them tackle basic and complex financial issues. Organizations like the Resurrection Project run into several barriers implementing this model due to the structure of the current system. As stated earlier, financial counseling is not a federally funded stand-alone service. They are also limited in size and scope of the current Federal programs. A national financial counseling program would allow counselors to move families through asset-building programs to create a real opportunity for families to make fruitful financial choices. NCLR applauds the Administration's and Congress' efforts to modernize our financial regulatory system. We urge you not to lose sight of the long-time bipartisan goal of improving families' understanding and choices in financial matters. A national financial counseling program would offer meaningful tailored financial advice, link existing asset programs, and improve the relationship between underserved communities and the banking sector. In conclusion, NCLR recommends that: Congress establish a national financial counseling program; they expand programs that help families obtain assets; and finally, they create new incentives for low-income families. Thank you. [The prepared statement of Mr. Diaz can be found on page 45 of the appendix.] " 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-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-111shrg52966--9 Mr. Cole," Well, I really need to go back somewhat in time in answering that, but in 1995, we issued a supervisory letter to our examiners directing them in terms of taking a systematic approach to assessing the risk management, including the major risk categories of credit risk, market risk, operational risk, liquidity, reputational, and legal risk, and then that became part of the formal exam process and rating process. Kind of fast forwarding to the 9/11-type situation, as I mentioned in my testimony, we focused on some significant risk issues there that we thought needed to be addressed, and some of them tended to focus on, say, operational risks, such as payments and settlements, others on contingency planning, locating backup facilities at appropriate different distances, and then very importantly on BSA/AML, Bank Secrecy/Anti-Money Laundering. In that regard, with regard to one of the institutions in question, we took very strong action to require a significant change in their business risk management and that was accomplished with a very forceful hand in terms of requiring them to make those changes. So I think that is a good example of where, when we see a significant problem, we do act. Senator Reed. Let me be more specific. The issue, I think, that the GAO has revealed is a lack of the capacity of large complex financial institutions, which all of you regulate, to assess adequately all of the risks they face, not so much a particular risk---- " Mr. Cole," OK. Senator Reed.----but the fact that they did not have systems in place to adequately assess the risk, which I think is a fair conclusion of the report of the GAO. At what point did this fact or this observation become resonant with the Fed and how was it communicated to the banking community, to the regulating community, and on to the broader audience, the Congress, for one? " CHRG-110hhrg46595--423 Mr. Bachus," Thank you. Professor Sachs, I want to welcome you and express to you that I have enjoyed our friendship and working together on issues. It is good to see you. I am going to address my question to Professor Altman, because my question deals with restructuring. And I think we all agree that there has to be a fundamental restructuring of the industry. My first question is, the Comptroller General mentioned that general restructuring--I may be paraphrasing you. There are a lot of complex issues. I think you expressed your concern that these couldn't be dealt with in a matter of months or weeks for sure; is that correct? " FOMC20061025meeting--174 172,MS. MINEHAN.," I was just going to say, too, that all of this is complicated by the fact that our assessment of potential has been written down. Even an informed observer might not have caught that nuance of how much we’ve written it down. Looking at what would have been referred to in a “moderate” or “solid” context, the numbers were different two years ago from what they are now. That creates an even greater level of possible confusion here. Is 2 percent good, bad, or indifferent? It depends on where you think potential is, and that has changed. So there is a complexity here that I think speaks to the difficulty of wording this sentence." 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. ______ FOMC20050630meeting--196 194,MS. JOHNSON.," Well, for one thing, the U.K.’s 1990 cycle was amplified by regulatory changes that preceded it, which led to mortgage lending that was excessive and not well supervised. It was a kind of blind-leading-the-blind situation: The regulator changed the rules and the financial institutions moved into the market and practices and norms changed. A great deal of lending took place. The supervisors were learning as much as the lenders were and—well, let me put it this way—it didn’t go well. In the past, there has certainly been a correspondence between household consumption and housing wealth in the U.K. So when they suffered the big drop in the 1990 rundown of housing prices, they also had a big change in household consumption out of disposable income, and so forth, June 29-30, 2005 67 of 234 Now, a couple of the characteristics of the U.K. market have always led us to think that it’s not a telling example. One is the prevalence of variable-rate mortgages, which causes the process of tightening monetary policy to contain the macroeconomy to have a bit of extra leverage over the discretionary income of households—to an extent that is not the case with fixed-rate mortgages Obviously, there’s a counterpart effect on the earnings of mortgage lenders, and so forth, in the U.S. economy that you need to take account of to fully understand that. But there is that characteristic. And there is the fact that house prices actually fell in the U.K., so they had big negative equity problems, which complicated the process of how to unwind the interaction of household behavior and financial intermediary behavior. To the extent people walked away from the houses, the financial intermediaries were getting collateral that perhaps no longer equaled the value of the loan. On the other hand, some households didn’t walk away; they just remained in a negative equity position for some time. And that had a long, dampening effect on their spending patterns. So there were complex reactions involved. But this time around, at least based on my conversations with U.K. officials, they think they’ve improved a lot of those things. So in that sense, there is something to be learned. Financial institutions now know better how to maintain their balance sheets and how to do this lending. The households know better, too; they’ve learned a bit. U.K. officials think they’ve seen a lessening to some degree of this tight link between housing wealth and consumption so that they’re not both on the run-up and then, when it stops, extrapolating what the consequences would be. On the other hand, I have to admit that I occasionally read my little machine while I sit here, and in the last hour it carried three statements from a member of the Bank of England’s Monetary Policy Committee who must have been making a speech. And all three statements the media chose June 29-30, 2005 68 of 234 [Laughter] And all of the statements were slightly two-handed, along the lines of: Monetary policy should not be driven by housing prices, but we must look at them closely. [Laughter] I think there are lessons to be learned; I’m not saying there aren’t. But certainly the 1990s episode had some characteristics that were far more extreme and that would never happen here because of institutional differences. And the present episode, which has remedied some of those earlier problems, I think is not such a bad deal. They’ve slowed the increase in housing prices. They aren’t having negative equity. They don’t have financial institutions that look like they’re going to become or technically are insolvent. I think in that sense they moved to improve their infrastructure, so to speak. They talk about the issue a lot but I think they feel the situation is okay at this time." FOMC20081216meeting--217 215,CHAIRMAN BERNANKE.," Thank you. It was a good suggestion. I have looked at that example and had a chance to talk with Stefan Ingves, who is the Governor of the Central Bank of Sweden and was very much involved in that. It was a very good and prompt response, but it was different from our current situation in that the banks were already mostly insolvent and no longer functioning when the government intervened. They took the standard steps of taking off nonperforming loans--so the usual process. They still had a significant recession. I think the basic lessons are there, but we have some characteristics in this particular episode--banks still functioning, the complexity of the assets, and so on--that make it even more difficult. " 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. ______ fcic_final_report_full--550 Mark Zandi, Chief Economist and Co-founder, Moody’s Economy.com Kenneth T. Rosen, Chair, Fisher Center for Real Estate and Urban Economics, University of California, Berkeley Julia Gordon, Senior Policy Counsel, Center for Responsible Lending C. R. “Rusty” Cloutier, President and Chief Executive Officer, MidSouth Bank, N.A., Past Chairman, Independent Community Bankers Association Public Hearing, Washington, DC, Day , January ,  Session : Current Investigations into the Financial Crisis—Federal Officials Eric H. Holder Jr., Attorney General, U.S. Department of Justice Lanny A. Breuer, Assistant Attorney General, Criminal Division, U.S. Department of Justice Sheila C. Bair, Chairman, U.S. Federal Deposit Insurance Corporation Mary L. Schapiro, Chairman, U.S. Securities and Exchange Commission Session : Current Investigations into the Financial Crisis—State and Local Officials Lisa Madigan, Attorney General, State of Illinois John W. Suthers, Attorney General, State of Colorado Denise Voigt Crawford, Commissioner, Texas Securities Board, and President, North American Securities Administrators Association, Inc. Glenn Theobald, Chief Counsel, Miami-Dade County Police Department; Chairman, Mayor Carlos Alvarez Mortgage Fraud Task Force Forum to Explore the Causes of the Financial Crisis, American University Washing- ton College of Law, Washington, DC, Day , February ,  Session : Interconnectedness of Financial Institutions; “Too Big to Fail” Randall Kroszner, Norman R. Bobins Professor of Economics, University of Chicago Session : Macroeconomic Factors and U.S. Monetary Policy Pierre-Olivier Gourinchas, Associate Professor of Economics, University of California, Berkeley Session : Risk Taking and Leverage John Geanakoplos, James Tobin Professor of Economics, Yale University Session : Household Finances and Financial Literacy Annamaria Lusardi, Joel Z. and Susan Hyatt Professor of Economics, Dartmouth University; Research Associate at the National Bureau of Economic Research Forum to Explore the Causes of the Financial Crisis, American University Washing- ton College of Law, Washington, DC, Day , February ,  Session : Mortgage Lending Practices and Securitization Chris Mayer, Paul Milstein Professor of Real Estate, Columbia University; Visiting Scholar at the Federal Reserve Bank of New York and Research Associate at the National Bureau of Economic Research Session : Government-Sponsored Enterprises and Housing Policy Dwight Jaffee, Willis Booth Professor of Banking, Finance, and Real Estate; Co-chair, Fisher Center for Real Estate and Urban Economics, University of California, Berkeley Session : Derivatives and Other Complex Financial Instruments Markus Brunnermeier, Edwards S. Sanford Professor of Economics, Princeton University 547 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." FinancialCrisisReport--15 Recommendations on Regulatory Failures 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. 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. Recommendations on Inflated Credit Ratings 1. Rank Credit Rating Agencies by Accuracy. The SEC should use its regulatory authority to rank the Nationally Recognized Statistical Rating Organizations in terms of performance, in particular the accuracy of their ratings. 2. Help Investors Hold CRAs Accountable. The SEC should use its regulatory authority to facilitate the ability of investors to hold credit rating agencies accountable in civil lawsuits for inflated credit ratings, when a credit rating agency knowingly or recklessly fails to conduct a reasonable investigation of the rated security. 3. Strengthen CRA Operations. The SEC should use its inspection, examination, and regulatory authority to ensure credit rating agencies institute internal controls, credit rating methodologies, and employee conflict of interest safeguards that advance rating accuracy. 4. Ensure CRAs Recognize Risk. The SEC should use its inspection, examination, and regulatory authority to ensure credit rating agencies assign higher risk to financial instruments whose performance cannot be reliably predicted due to their novelty or complexity, or that rely on assets from parties with a record for issuing poor quality assets. 5. Strengthen Disclosure. The SEC should exercise its authority under the new Section 78o-7(s) of Title 15 to ensure that the credit rating agencies complete the required new ratings forms by the end of the year and that the new forms provide comprehensible, consistent, and useful ratings information to investors, including by testing the proposed forms with actual investors. 6. Reduce Ratings Reliance. Federal regulators should reduce the federal government’s reliance on privately issued credit ratings. 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-110hhrg38392--140 Mr. Bernanke," Well, there is some complexity to that issue because, even in a society where government provides health care, corporations still have to pay taxes to support that. So, it isn't free. That being said, the more resources are unnecessarily consumed by health care--as opposed to the part which is valuable--clearly lowers the overall productivity of our society and the lower our living standards will be in the long run. So, it is a first-order issue to make sure that our health care system is delivering good outcomes, but at a reasonable cost. " CHRG-111shrg55117--85 Mr. Bernanke," Well, one comment is that one of the main sources of small business financing is smaller banks, community banks which have closer relationships, more information, more local information. And to the extent that they remain strong, and some of them are under a lot of pressure for various reasons, but many of them remain strong and they in some cases have been able to step in where the national banks have had to pull back. That is one slightly encouraging direction and that suggests that we should continue to support community banking, which plays a very important role in supporting small business. You know, beyond that, I think we just need to get the banking system working as well as possible again. I think there are even large banks that view small business as an important profit center and will continue to lend there. But clearly, in a downturn like this, small business, which already has a pretty high mortality rate, is even a riskier proposition, and so it does pose a tremendous problem right now. Senator Warner. My time has expired, but Mr. Chairman, I know we have got a lot on the docket, but I would love to have the Committee perhaps take a hearing or some examination of what we as the Congress could do to look at the state of lending in small business and startup businesses, and not just existing small businesses but how we get that next step of innovation, because that financing market has disappeared. I have a lot of folks in that spectrum who say they don't see any signs of it returning, that it is basically totally broken. So I would love to have your thoughts on that. " 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. ------ FinancialCrisisReport--30 Structured Finance. In recent years, Wall Street firms have devised increasingly complex financial instruments for sale to investors. These instruments are often referred to as structured finance. Because structured finance products are so complicated and opaque, investors often place particular reliance on credit ratings to determine whether they should buy them. Among the oldest types of structured finance products are RMBS securities. To create these securities, issuers – often working with investment banks – bundle large numbers of home loans into a loan pool, and calculate the revenue stream coming into the loan pool from the individual mortgages. They then design a “waterfall” that delivers a stream of revenues in sequential order to specified “tranches.” The first tranche is at the top of the waterfall and is typically the first to receive revenues from the mortgage pool. Since that tranche is guaranteed to be paid first, it is the safest investment in the pool. The issuer creates a security, often called a bond, linked to that first tranche. That security typically receives a AAA credit rating since its revenue stream is the most secure. The security created from the next tranche receives the same or a lower credit rating and so on until the waterfall reaches the “equity” tranche at the bottom. The equity tranche typically receives no rating since it is the last to be paid, and therefore the first to incur losses if mortgages in the loan pool default. Since virtually every mortgage pool has at least some mortgages that default, equity tranches are intended to provide loss protection for the tranches above it. Because equity tranches are riskier, however, they are often assigned and receive a higher rate of interest and can be profitable if losses are minimal. One mortgage pool might produce five to a dozen or more tranches, each of which is used to create a residential mortgage backed security that is rated and then sold to investors. Cash CDOs. Collateralized debt obligations (CDOs) are another type of structured finance product whose securities receive credit ratings and are sold to investors. CDOs are a more complex financial product that involves the re-securitization of existing income-producing assets. From 2004 through 2007, many CDOs included RMBS securities from multiple mortgage pools. For example, a CDO might contain BBB rated securities from 100 different RMBS securitizations. CDOs can also contain other types of assets, such as commercial mortgage backed securities, corporate bonds, or other CDO securities. These CDOs are often called “cash CDOs,” because they receive cash revenues from the underlying RMBS bonds and other assets. If a CDO is designed so that it contains a specific list of assets that do not change, it is often called a “static” CDO; if the CDO’s assets are allowed to change over time, it is often referred to as a “managed” CDO. Like an RMBS securitization, the CDO arranger calculates the revenue stream coming into the pool of assets, designs a waterfall to divide those incoming revenues among a hierarchy of tranches, and uses each tranche to issue securities that can then be marketed to investors. The most senior tranches of a CDO may receive AAA ratings, even if all of its underlying assets have BBB ratings. CHRG-110shrg50415--93 Mr. Rokakis," Mr. Chairman, the destruction of the agency relationship, if you look at, I think, the three principal causes of this entire crisis, clearly deregulation at the top of the list, reliance on these complex, mathematical constructs that nobody really understands, yet Wall Street relied upon. But if you look at the destruction of the agency relationship, the fact that that broker sitting across from you is not working for you but is working against you, Mayor Morial talked about some of the other statistics. I think it is absolutely critical that we move in that area of regulation. I also know that when there was talk about eliminating the yield-spread premium, this Congress was bombarded by, I believe, hundreds of thousands of calls and letters arguing against that. But I think it is that yield-spread---- " CHRG-110shrg50420--119 Chairman Dodd," Thank you, Senator, very much. Senator Bayh. Senator Bayh. Thank you, gentlemen. One of the things that has become apparent to me and probably all of my colleagues this morning--and by the way, thank you for the substantial amount of work you have done in a very short period of time in a very intricate area--is how complex this all is. Is it fair to say, Mr. Dodaro, that even doing the best we can, and you have answered a lot of questions about what are the alternatives, how would this work, what would the results be, isn't it true that there is just an irreducible amount of uncertainty at the end of the day that we are going to have to come to grips with? You mentioned in the context of bankruptcy. I think the phrase you used, that there are significant uncertainties in all of this. There is no dead certain guarantee about how it is going to function at the end of the day. That is not possible, isn't that correct? " 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-111hhrg48868--290 Mr. Foster," I have been struck by the complexity of AIG from a corporate point of view, and I was wondering if you could give me an impression of what fraction of these difficulties could have been avoided if AIG was simply simpler or a series of independent companies accomplishing the same thing. You know, if they were a bunch of independent insurance companies, and if the thing called the holding company basically didn't exist, and that you had a credit default swap trading house that was regulated so that the regulator only had to look at that. " Mr. Ario," AIG started as an insurance company, and in my view, if they had stuck to that, they would still be the number one insurance company in the world on the property and casualty side. " CHRG-110shrg50418--5 STATEMENT OF SENATOR TIM JOHNSON Senator Johnson. Mr. Chairman, thank you for calling today's hearing to examine the condition of the domestic auto industry and the effects of interest rate turmoil on job creation and economic growth. As you know, I did not support the $700 billion bailout, in part because I did not believe that the conditions set for bailout monies for Wall Street firms were strong enough. I expect that if help is extended to the auto industry, these companies and their executives will be held to very high standards of accountability and that the taxpayer protection remains a top priority. Going forward, Congress must focus on how to secure the hundreds of thousands of jobs connected to the auto industry and also ensure that this industry makes dramatic improvements to innovate and reflect consumers' changing tastes for fuel-efficient vehicles, including flex-fuel vehicles and alternative-fuel vehicles, cars, and trucks. The U.S. has the ability to lead the world powering vehicles on renewable fuels. What is lacking has been the domestic auto industry's embrace of policies and misallocations of resources, resulting too often in an inferior product. I am keenly interested in learning from today's witnesses as to how additional investment of taxpayer dollars to this interest would not repeat these missteps. Thank you, Chairman Dodd. " CHRG-111hhrg53242--27 Mr. Lowenstein," Thank you, Mr. Chairman, and members of the committee. I appreciate the opportunity to be here this morning and to present our views on the financial regulatory reform issues. The Private Equity Council is a trade association representing 12 of the largest private equity firms in the world. I think members of this committee are well aware of the positive role private equity has played in helping hundreds of American companies grow, create jobs, innovate, and compete in global markets. In the process, over the last 20 years, private equity firms have been among the best, if not the best performing asset class for public and private pension funds, foundations, and university endowments, distributing $1.2 trillion in profits to our investors. In these remarks, I want to make four general points. First, it is important for Congress to enact a new reform regime. Obviously, action which elevates speed over quality is undesirable. But the sooner businesses understand how they will be regulated, the quicker they will be able to organize themselves to carry out their roles in reviving strong capital markets. Private equity firms today have $470 billion in committed capital to invest, and we are looking forward to the opportunity to do that. Second, the Obama Administration articulated three fundamental factors that trigger systemic risk concerns: first, the impact a firm's failure would have on the financial system and the economy; second, the firm's combination of size, leverage, including off balance sheet exposures, and the degree of its reliance on short-term funding; and third, the firm's criticality as a source of credit for households, businesses, and State and local governments, and as a source of liquidity for the financial system. Private equity contains none of these systemic risk factors. Specifically, PE firms have limited or no leverage at the fund level, and thus are not subjected to unsustainable debt or credit or margin calls. PE firms don't rely on short-term funding. Rather, PE investors are patient, and commit their capital for 10 to 12 years or more, with no redemption rights. Private equity does not invest in short-term tradeable securities like derivatives and credit default swaps, and private equity firms are not deeply interconnected with other financial market participants through derivative positions, counterparty exposures, or prime brokerage relationships. And finally, private equity investments are not cross-collateralized, which means that neither investors nor debt holders can force a fund to sell unrelated assets to repay a debt. Third, we support creation of an overall systemic risk regulator who has the ability to obtain information, is capable of acting decisively in a crisis, and possesses the appropriate powers needed to carry out its mission. As to exactly how you carry that out, we are frankly agnostic on that subject. And fourth, regarding private equity and regulation specifically, we generally support the Administration's proposal for private equity firms, venture capital firms, hedge funds, and other private pools of capital to register as investment advisers with the SEC. And we support similar legislation introduced by Representatives Capuano and Castle. To be clear, registration will result in new regulatory oversight for private equity firms. There are considerable administrative and financial burdens associated with being a registered investment adviser. And in fact, these could be especially problematic for smaller firms. So it is important to set the reporting threshold at a level which covers only those firms of sufficient scale to be of potential concern. But despite the potential burdens, we do support strong registration requirements for all private pools of capital because it is clear that such registration can help restore confidence in the financial markets. And in the long run, private equity will benefit when confidence in the system is high. While supporting registration, we believe Congress should direct regulators to be precise in how new regulatory requirements are calibrated so the burdens are tailored to the nature and size of the individual firm and the actual nature and degree of systemic risk it may pose. It is vital that any information provided to the SEC be subjected to strong confidentiality protections so as not to expose highly sensitive information beyond that required to carry out the systemic risk oversight function. We stand ready to work with you, Mr. Chairman, and members of the committee as these issues are resolved through the legislative process. Thanks again. [The prepared statement of Mr. Lowenstein can be found on page 76 of the appendix.] " CHRG-111hhrg52406--23 Mr. Delahunt," Thank you, Chairman Frank and Mr. Bachus, for allowing me to testify today. There should be no doubt that we need a new regulatory framework and as importantly sustained supervision of the financial system. The current system failed us and we must avoid a repeat. While the near collapse of the financial system began on Wall Street, it quickly spread to Main Street, taking a devastating toll on families everywhere. Consumers have lost trillions in investment income and home equity. Investors both domestically and internationally have lost confidence. But I am confident that with your leadership and the excellent work of this committee, coupled with the commitment from the White House, we can extricate ourselves from this mess and move forward. Let me speak to the proposed Consumer Financial Protection Agency in the President's plan. It creates a consumer watchdog and in many respects reflects a proposal put forth by my friend and colleague from North Carolina and a member of this committee, Brad Miller. It is charged with ensuring that financial products sold to consumers are safe, responsible, accountable, and transparent. I also want to acknowledge the presence of the intellectual author of this concept, Harvard Professor Elizabeth Warren, who will testify on the next panel. There are currently 10 different Federal regulators that have some responsible for protecting consumers from predatory or deceptive financial products, but none have consumer protection as their simple sole primary objective. As a consequence, debt instruments have become increasingly risky. American families have been steered often deceptively into overpriced credit products including credit cards, car loans, and subprime mortgages. And as a result, Americans are overwhelmed with debt. These levels of personal debt have not only played a significant role in the financial crisis, but represent a significant impediment to full economic recovery. Today, one in four families are worried about how they will pay their credit card bill each month and nearly half of all credit cardholders have missed payments in the past year. There are more than 2 million families who have missed at least one mortgage payment and one in seven families are currently dealing with a debt collector. Like other government agencies, the Consumer Financial Protection Agency would seek to shield the consumer from unreasonable risk. The Agency would review financial products for safety, modify dangerous products before they hit the market, establish guidelines for consumer disclosure, and collect and report data about different consumer loans. I am sure Professor Warren will outline the specific provisions of the proposal. Undoubtedly credit helps dreams come true. Consumers can buy homes, cars and pay for a college education. But when seeking a loan consumers should not have to understand the nuances of complex financial instruments just as they don't need to understand how a toaster works, how a drug acts in our bodies or whether the food they eat is safe. By creating an agency whose primary role is to help the consumer people can again borrow with confidence that they are protected from fraudulent unsafe credit products. This will increase overall consumer confidence, will create demand, and stimulate the markets and spur investments. It is a win-win, not just for the consumer, but I believe will accelerate the recovery that is our common goal. Let me conclude with this: The Congress has attempted to enact reforms in the past but to no avail. Sensible reforms were thwarted by special interests and some will come before this committee to say that our regulations go too far, that this is simply too much. I say to them, give me a break. Just look at what has occurred. For too long, we have frankly let the American people down by failing to create a prudent regulatory regiment to protect the consumer from dangerous financial products. And we have seen the results. We can't let it happen again. And the consequences are simply too profound. Thank you, Mr. Chairman. [The prepared statement of Representative Delahunt can be found on page 78 of the appendix.] " CHRG-110hhrg46596--340 Mr. Kashkari," Congressman, we want all of our healthy banks across the country to apply and participate in the program. We put out term sheets, as I am sure you are aware, for public banks as well as for private C Corp banks. There are other categories of banks such as the mutuals, subchapter S, which we are working to come up with term sheets so they can access the funds on the same terms as everybody else. There are some real legal complexities with doing that, and we are working to make this as broad a program as possible, because we want the healthy banks around the country to participate. " FOMC20071211meeting--181 179,MR. FISHER.," Mr. Chairman, I just want to make sure that I heard you clearly earlier. We have kept this contained, including the swap ranges, which is very impressive. Everybody should pat themselves on the back. [Laughter] We’re broadening the circle tonight or this afternoon, and I’m not quite sure what your message is. I assume that we are announcing it tomorrow morning because of the international complexities. Nobody seems to know about this yet that I am aware of. Do you want us to inform our full boards, or do you want us just to inform our chairmen, or do it late tonight, or is it up to our discretion? I just worry about leakage." 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-111shrg51395--58 Mr. Doe," As I have listened to my fellow panelists, I am reminded of a book called ``Why Most Things Fail'' by a U.K. economist named Paul Oremerod, where he draws comparisons between species extinction models and those of corporate and market failures. And in it, he cites two conditions where we have failure of a species. And one is when it gets soft and is not challenged. The second is when there is not incremental learning that is constantly being done. And I think what I have gathered in the last 18 months--and, again, in our small niche in the municipal bond industry, which is smaller than others that have been addressed here today. But it is that the idea of a regulator that has an inspired inquisitiveness and a sense of purpose so that they are eager to pursue an understanding of the markets that they regulate. If there has been one--and this is where I hope that if we have a consolidated or a sharing of information across the different asset classes or the different products, whether they be cash, whether they be swaps, whether they are equity, whether they are fixed income, that this provides an opportunity of being able to identify the first hints of failure that might occur in a system, and that way we might be faster to act. I think what is very interesting about, again, the industry that I have been involved with in the municipal bond sector is that when innovation of products finally makes its way into the public sector, it is almost the last place, again, because the revenue relatively is small compared to the other asset classes in the taxable markets. But I think it becomes magnified because you are starting to deal now with the public trust in the most intimate form. And I think so that when we start looking at regulation, it is, again, how do you inspire that trust, but how do you inspire that inquisitiveness of the regulator, and maybe it is the pride that is associated with doing the job that they feel that they are really able to accomplish something and make a difference. And I think that is what we are all trying to do here. Thank you. " CHRG-111shrg56376--205 Chairman Dodd," One of these things that is going to be important for us, this is not being punitive. I think that is one of the things we are getting into, this notion that because some have been good actors and bad actors, I think we have some history of that. So I think it is really important as we look at all of this, this is not to punish some or discipline some, but rather to try to think in 21st century architectural terms. How do we create an architecture and a structure that makes sense in all of this? And the only thing I was getting at on the assessment issue, because I think putting aside the question of who was responsible for what, just given the magnitude and size and complexity of institutions, I mean, the idea that you would level sort of the same assessments across the board because you have one regulator, to me would be offensive. I mean, you have got to clearly make some distinguishing features. But I hope we can stay away from the punitive quality here as we look at all of this. We can go back and examine, how did we get here and what we are trying to do, and I think all of us agree that, in part, it was this patchwork out there that contributed, certainly, among other things. It is not the only thing. I think somebody made that point, that there are a lot of issues we need to look at. This is one of one. And it isn't going to solve everything, either. I think Bob Corker made the point, and I agree with him on this, is the assumption that if you solve this, you would solve the problem, I think would be false. But clearly I want to get away--because I think you can see that developing, that argument that somehow we are laying--we are blaming institutions by putting them in this. That is not the argument at all. The question is whether or not this makes sense. Let me raise one other question I have for you, and then I will see if anyone has interest in a second round. I wonder if you agree with the Administration's proposal regarding the systemically important financial companies that have a parent or significant affiliate engaged in commercial activities, whether they should be regulated as a bank holding company and forced to divest commercial activities. This is a big issue that is going to be before us. It sort of follows on with Jeff's question, I think, that he raised. Does anyone want to jump into this one? Professor, you sound like you have got some strong views on this, so---- " FinancialCrisisInquiry--197 ZANDI: Well... CHAIRMAN ANGELIDES: How insane it got in different sectors, to see whether it was so deep and widespread in terms of its genesis versus a set of particular circumstances that might have fueled it in one arena? ZANDI: Well, the way I think about it is that the hubris was probably running as thick in nearly every market. I mean, just go to junk corporate bond market. The junk corporate spread over treasury at the height of the euphoria in 2007 was 250 basis points. That’s the lowest it had ever been. Average is 500 basis points. At the worst of the crisis and the panic, it was 2,000 basis points. But I think what was important is the magnitude of the—of the lending in these markets. So, to give you context, the residential mortgage market is $11 trillion deep. Right? The commercial mortgage market is $4 trillion deep. The junk corporate bond market is $1 trillion, $1.5 trillion. So what really made the mortgage market so important is the magnitude of the problem. CHAIRMAN ANGELIDES: But did we see—last question—I said one question, but this is interesting—did we see the evolution of, I hate to use the word innovation, but did—you know, in the same way we saw a whole new set of products was it matched in those other sectors? ZANDI: It was in every single market, every single market. CHAIRMAN ANGELIDES: I mean, I saw it in commercial real estate, but... CHRG-111shrg50814--3 Chairman Dodd," I am sure the Federal Reserve operates in a similar pattern as we do here on the Banking Committee. Do you get as much luck as the Chairman as I just did on that? Well, let me tell you how we will proceed here this morning, and we welcome you, Mr. Chairman, to the Committee. We have got a good turnout of our Members here for all the obvious reasons. When the Chairman of the Federal Reserve comes before our Committee, it is obviously of deep interest to the country, and we welcome you here this morning. I will take a few minutes for some opening comments, turn to Senator Shelby for any opening comments he may have, and then we will go right to you, Mr. Chairman, for your statement this morning, and we will try and follow the 5-minute rule so that everybody gets a chance to raise questions with you. And if we need a second round, we will do so. The record will stay open for a few days to submit questions, and any and all statements, documents, and other materials that my colleagues and others feel would be important to include in the record will be considered included at this moment, without objection. Well, Chairman Bernanke, we welcome you to the Committee to present the Fed's semiannual monetary policy report to the U.S. Congress. We meet obviously at a very important moment for our country, with our Nation in the midst of the worst economic crisis in generations. Since the end of World War II, America's business cycles have oscillated between periods of growth and rising inflation, with the Fed raising interest rates to slow the economy, creating a recession, which then caused inflation to slow. The Fed then typically lowered interest rates, restarting the Nation's economy again. And while the Fed manages our recessions, our economic recoveries have typically been led by the housing and automobile sectors, which are highly sensitive to interest rates. In the past, the typical American worker saved during the good times for rainy days, and when recession hit, they may have been laid off. But once the recession receded, they not only had some savings hopefully stored up, but also a reasonably good chance of getting their jobs back or finding new employment. This time, however, Mr. Chairman, our housing and auto sectors are leading us not out of recession but into it in many ways. This time our recession is being caused not by rising interest rates but, rather, a massive credit crunch, resulting from years of reckless spending and, as the Banking Committee has uncovered during the 80 hearings and meetings in the last Congress, regulatory neglect as well. Such neglect allowed for and even encouraged a problem that began in the subprime mortgage market to spread throughout our Nation and the entire global financial system like a cancer. This time, nearly half the jobs we have lost are not likely to come back, we are told, and that is why the American Recovery and Reinvestment Act is so essential. This time, the American people entered this recession with a negative personal savings rate and a false sense of confidence that we can count on the value of our homes and stocks to go up forever. In fact, Mr. Chairman, I read with great interest that your own boyhood home recently went into foreclosure. I am saddened by that, as I am sure you are. Most recently, that home was owned by a soldier in the South Carolina Army National Guard, who reportedly volunteered to go on active duty during wartime in order to try and save his home and your former home. Mr. Chairman, I do not suggest that you are to blame for any of this. Quite the contrary. I happen to commend your conduct of monetary policy during your tenure. Last year, you began to cut interest rates in the face of opposition from some regional bank presidencies at the Fed. You followed through on your commitment that you made, a meeting which I will never, ever forget in August of 2007, when you were in my office with Hank Paulson. And I will never forget the words you spoke to me that day when asked what we could about the problems, and you said at that time you would use all the tools at your disposal to attack the problems in the global financial market. And I commended you for those comments then, and your efforts, through aggressive and often innovative monetary policy. You have worked creatively to adapt the Fed to handle the greatest financial market crisis in any of our lifetimes. If, as it is said, those who do not study history are doomed to repeat its mistakes, I am relieved we have one of the foremost scholars of the Great Depression at the helm of the Fed at this moment. But for all the successes the Fed has had in carrying out its core mission--monetary policy--its regulation and consumer protection missions have been abject failures, in my view. And while many of these failures predate your arrival, they cannot be ignored. When I am approached by a constituent in New London, Connecticut, for instance, who was outraged that some of these banks were allowed to grow into behemoths and given a clean bill of health, only to turn around months later on the verge of bankruptcy, asking for billions of dollars in taxpayer funding, I am reminded of the shortcomings in the Fed's regulation of bank holding companies. When a family in Bridgeport, Connecticut, with their 5,000 foreclosures in that one city in my home State pending, who have lost everything ask me where the cops were on the beat, where were they to stop the abusive predatory mortgages from being written, I am reminded of the Fed's failure to implement the law Congress passed in 1994 to protect consumers and regulate mortgage lending practices. When I learn a direct marketing business in greater Hartford has to close its doors, not because they missed a payment to their bank but because the bank is having capital problems, I cannot help but remember your predecessor's fondness for ``regulatory competition,'' as he called it, for actually encouraging bank regulators to compete with one another to see who could provide the most effective regulation of our banks, but apparently at the least. As a result, today countless banks are left with dangerously low cash reserves and a massive buildup of leverage, which have created a veritable boomerang of debt that has now snapped back, ensnaring countless honest small businesses in the process. Finally, when I am asked how our Government could have allowed these toxic financial products to proliferate, products that served to dilute the appearance of risk rather than the risk itself, I remember the Federal Reserve's mantra of financial innovation and its leaders' repeated warnings against any additional Government regulation of any kind. I remember very, very clearly the mood in January of 2007 when I became Chairman of this Committee and the mantra--the mantra in those months was, ``Deregulate, fast, before everyone runs to London.'' Mr. Chairman, you have an extraordinarily difficult task ahead of you, not only to fulfill the Fed's primary mandate to conduct monetary policy to create maximum economic growth, full employment, and price stability, you do so in the face of an economy in deep recession, closing credit markets and unemployment rising at its fastest pace in a generation, having already cut interest rates to almost zero. You do so managing a balance sheet that has spiked to $2 trillion and now includes the remnants of an investment bank and the control of the world's largest insurance company. You do so having to conduct monetary policy in ways never tried before to unlock frozen credit markets, and you do so with an agency whose structure is virtually unchanged since its creation in 1913, when nearly a third of the Americans worked on farms, even as your mission has expanded exponentially from regulating the smallest banks in the country to the largest bank holding companies, from protecting consumers to being the lender of last resort for any company in the Nation. Mr. Chairman, I would say your plate is full, to put it mildly. As this Committee works to modernize our Nation's financial regulatory structure, the question is whether we should be giving you a bigger plate or whether we should be putting the Fed on a diet. I do not question your track record on monetary policy, as I have said--the Fed's primary goal. But when you keep asking an agency to take on more and more and more, it becomes less and less and less likely that the agency will succeed at any of it. And at the same moment, in my view, nothing will be more important for the Federal Reserve than getting monetary policy right. It is absolutely paramount, and I know you know that as well. So we welcome you to this Committee, and let me turn to Senator Shelby for any opening comments he may have. FinancialCrisisReport--18 In 2002, the Treasury Department, along with other federal bank regulatory agencies, altered the way capital reserves were calculated for banks, and encouraged the retention of securitized mortgages with investment grade credit ratings by allowing banks to hold less capital in reserve for them than if the individual mortgages were held directly on the banks’ books. 11 In 2004, the SEC relaxed the capital requirements for large broker-dealers, allowing them to grow even larger, often with borrowed funds. 12 In 2005, when the SEC attempted to assert more control over the growing hedge fund industry, by requiring certain hedge funds to register with the agency, a federal Court of Appeals issued a 2006 opinion that invalidated the SEC regulation. 13 These and other steps paved the way, over the course of little more than the last decade, for a relatively small number of U.S. banks and broker-dealers to become giant financial conglomerates involved in collecting deposits; financing loans; trading equities, swaps and commodities; and issuing, underwriting, and marketing billions of dollars in stock, debt instruments, insurance policies, and derivatives. As these financial institutions grew in size and complexity, and began playing an increasingly important role in the U.S. economy, policymakers began to ask whether the failure of one of these financial institutions could damage not only the U.S. financial system, but the U.S. economy as a whole. In a little over ten years, the creation of too-big-to-fail financial institutions had become a reality in the United States. 14 9 Gramm-Leach-Bliley Act of 1999, also known as the Financial Services Modernization Act, P.L. 106-102. See also prepared statement of SEC Chairman Christopher Cox, “Role of Federal Regulators: Lessons from the Credit Crisis for the Future of Regulation,” October 23, 2008 House Committee on Oversight and Government Reform Hearing, (“It was a fateful mistake in the Gramm-Leach-Bliley Act that neither the SEC nor any regulator was given the statutory authority to regulate investment bank holding companies other than on a voluntary basis.”). 10 The 2000 Commodity Futures Modernization Act (CFMA) was enacted as a title of the Consolidated Appropriations Act of 2001, P.L. 106-554. 11 See 66 Fed. Reg. 59614 (Nov. 29, 2011), http://www.federalregister.gov/articles/2001/11/29/01-29179/risk-based- capital-guidelines-capital-adequacy-guidelines-capital-maintenance-capital-treatment-of. 12 See “Alternative Net Capital Requirements for Broker-Dealers That Are Part of Consolidated Supervised Entities,” RIN 3235-AI96, 17 CFR Parts 200 and 240 (8/20/2004) (“amended the net capital rule under the Securities Exchange Act of 1934 to establish a voluntary alternative method of computing net capital for certain broker-dealers”). The Consolidated Supervised Entities (CSE) program, which provided SEC oversight of investment bank holding companies that joined the CSE program on a voluntarily basis, was established by the SEC in 2004, and terminated by the SEC in 2008, after the financial crisis. The alternative net capital rules for broker- dealers were terminated at the same time. 13 Goldstein v. SEC , 451 F.3d 873 (D.C. Cir. 2006). 14 The financial crisis has not reversed this trend; it has accelerated it. By the end of 2008, Bank of America had purchased Countrywide and Merrill Lynch; Wells Fargo had acquired Wachovia Bank; and JPMorgan Chase had purchased Washington Mutual and Bear Stearns, creating the largest banks in U.S. history. By early 2009, each controlled more than 10% of all U.S. deposits. See, e.g., “Banks ‘Too Big To Fail’ Have Grown Even Bigger: Behemoths Born of the Bailout Reduce Consumer Choice, Tempt Corporate Moral Hazard,” Washington Post CHRG-111shrg57322--865 Mr. Blankfein," Thank you, Chairman Levin, Ranking Member Coburn, and Members of the Subcommittee, thank you for the invitation to appear before you today as you examine some of the causes and consequences of the financial crisis.--------------------------------------------------------------------------- \1\ The prepared statement of Mr. Blankfein appears in the Appendix on page 225.--------------------------------------------------------------------------- Today, the financial system is fragile, but it is largely stable. This stability is the result of decisive and necessary government action during the fall of 2008. Like other financial institutions, Goldman Sachs received an investment from the government as a part of its various efforts to fortify our markets and the economy during a very difficult time. I want to express my gratitude and the gratitude of our entire firm. We held the government's investment for approximately 8 months and repaid it in full, along with a 23 percent annualized return for taxpayers. Until recently, most Americans had never heard of Goldman Sachs or weren't sure what it did. We don't have banking branches. We provide very few mortgages and don't issue credit cards or loans to consumers. Instead, we generally work with companies, governments, pension funds, mutual funds, and other investing institutions. These clients usually come to Goldman Sachs for one or more of the following reasons: They want financial advice; they need financing; they want to buy or sell a stock, bond, or other financial instrument; or they want help in managing and growing their financial assets. The nearly 35,000 people who work at Goldman Sachs, the majority of whom work in the United States, are hard working, diligent, and thoughtful. Through them, we help governments raise capital to fund schools and roads. We advise companies and provide them funds to invest in their growth. We work with pension funds, labor unions, and university endowments to help build and secure their assets for generations to come. And we connect buyers and sellers in the securities markets, contributing to the liquidity and vitality of our financial system. These functions are important to economic growth and job creation. I recognize, however, that many Americans are skeptical about the contribution of investment banking to our economy and understandably angry about how Wall Street contributed to the financial crisis. As a firm, we are trying to deal with the implications of the crisis for ourselves and for the system. What we and other banks, rating agencies, and regulators failed to do was sound the alarm that there was too much lending and too much leverage in the system, that credit had become too cheap. One consequence of the growth of the housing market was that instruments that pooled mortgages and their risk became overly complex. That complexity and the fact that some instruments couldn't be easily bought or sold compounded the effects of the crisis. While derivatives are an important tool to help companies and financial institutions manage their risk, we need more transparency for the public and regulators as well as safeguards in the system for their use. That is why Goldman Sachs, in supporting regulatory reform, has made it clear that it supports clearinghouses for eligible derivatives and higher capital requirements for non-standard instruments. As you know, 10 days ago, the SEC announced a civil action against Goldman Sachs in connection with a specific transaction. It was one of the worst days of my professional life, as I know it was for every person at our firm. We believe deeply in a culture that prizes teamwork, depends on honesty, and rewards saying no as much as saying yes. We have been a client-centered firm for 140 years, and if our clients believe that we don't deserve their trust, we cannot survive. While we strongly disagree with the SEC's complaint, I also recognize how such a complicated transaction may look to many people. To them, it is confirmation of how out of control they believe Wall Street has become, no matter how sophisticated the parties or what disclosures were made. We have to do a better job of striking the balance between what an informed client believes is important to his or her investing goals and what the public believes is overly complex and risky. Finally, Mr. Chairman, the Subcommittee is focused on the more specific issues revolving around the mortgage securitization market. I think it is important to consider these issues in the context of risk management. We believe that strong, conservative risk management is fundamental and helps define Goldman Sachs. Our risk management processes did not and could not provide for absolute clarity. They highlighted uncertainty about evolving conditions in the housing market. That uncertainty dictated our decision to attempt to reduce the firm's overall risk. Much has been said about the supposedly massive short Goldman Sachs had on the U.S. housing market. The fact is, we were not consistently or significantly net short the market in residential mortgage-related products in 2007 and 2008. Our performance in our residential market-related business confirms this. During the 2 years of the financial crisis, while profitable overall, Goldman Sachs lost approximately $1.2 billion from our activities in the residential housing market. We didn't have a massive short against the housing market and we certainly did not bet against our clients. Rather, we believe that we managed our risk as our shareholders and our regulators would expect. Mr. Chairman, thank you for the opportunity to address these issues. I look forward to your questions. Senator Levin. Thank you very much, Mr. Blankfein. We have heard in earlier panels today example after example where Goldman was selling securities to people and not telling them that they were taking and intended to maintain a short position against those same securities. I am deeply troubled by that, and it is made worse when your own employees believe that those securities are junk or a piece of crap or a shi**y deal, words that those emails show your employees believed about a number of those deals. Billion-dollar Timberwolf: A synthetic CDO-squared--CDOs get squared now--a senior executive called it a ``shi**y'' transaction, but the Goldman sales force was told that it was a priority item for 2 straight months. Goldman sold $600 million in Timberwolf securities to clients while at the same timeholding a short position, in other words, betting against it. The CDO went to junk status in about 7 months. Your investors lost big time, but Goldman won on that deal; you profited on that deal. In the $500 million Long Beach RMBS deal, Goldman shorted it at the same time that it was selling it to clients. The securities defaulted within a few years with a 65 percent delinquency rate. The bad news, in your own words, was that your clients lost money, but the good news is that Goldman Sachs made money on that deal. The next one, the $700 million Fremont deal. This was a RMBS of subprime loans from a notoriously bad lender. Your folks knew it. One of your clients talks to your sales force about it, and your sales force among themselves call it ``crap loans.'' They go out and sell them anyway. At the same time that your sales people are selling those items, they are shorting the deal. So you short them so that Goldman makes money when this security fails, which it did in 10 months. On the $300 million Anderson synthetic CDO, the CDO is stuffed with New Century loans. These are known to be shoddy loans. I think it was one or two on the list of bad loan producers. A client of yours asked, how did Goldman Sachs get comfortable with this deal? In other words, pointing out that it was New Century. Goldman Sachs didn't respond and did not say, we are not comfortable, we are shorting it. We are betting against this deal. Asked a direct question, how can you guys get comfortable with a deal involving those loans, and instead of responding honestly, we have got problems, too, we are not taking any chances on this deal, we may be selling it, but we are also betting against it, that is not what happened. Instead, the client was told that Goldman was an equity holder, which it was at the same time, but that was a half-truth because it was also betting against that same security. That CDO failed within 7 months. Your clients lost. Goldman profited. The $2 billion Hudson synthetic CDO: Goldman Sachs was the sole protection buyer on this CDO with a $2 billion short. In other words, they were betting against it. A Goldman sales person described it as junk, not to the buyer, of course, but inside. The CDO imploded within 2 years. Your clients lost. Goldman profited. Now, there is such a fundamental conflict, it seems to me, when Goldman is selling securities which--particularly when its own people believe they are bad items, described in the way these emails show that they were described and what your own sales people believed about them--to go out and sell these securities to people and then bet against those same securities, it seems to me, is a fundamental conflict of interest and raises a real ethical issue. I would like to ask you whether or not you believe that Goldman, in fact, treated those clients properly. As you say, if clients believe we don't deserve their trust, you are not going to survive. Those are the ringing words you give us in your opening statement. Given that kind of a history here, going heavily short in a market, which you did--you made a strategic decision to do that--but then on these specific examples to be betting against the very securities which you are selling to your clients, and internally your own people believe that these are crappy securities, how do you expect to deserve the trust of your clients, and is there not an inherent conflict here? " CHRG-111shrg52619--191 RESPONSE TO WRITTEN QUESTIONS OF SENATOR SHELBY FROM MICHAEL E. FRYZELQ.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. Credit unions occupy a very small space within the originate-to-distribute landscape. Less than 8 percent of the $250 billion in loans originated by credit unions in 2008 were sold in whole to another party. While selling loans has grown within the credit union industry, it remains a small portion of business, with most credit unions choosing to hold their loans in portfolio when possible. Additionally, the abuses of consumers seen in some areas have not manifested themselves within the credit union community. The originate-to-distribute model would seem to create an environment where the loan originator is less concerned about consumer protection and more concerned with volume and fee generation. The lender using this model may focus less on what is best for the borrower, as they will not be the entity retaining the liability should the borrower later default. Maintaining consumer protection with the same regulator who is responsible for prudential supervision adds economies of scale and improves efficiencies for completing the supervision of the institutions. This approach allows one regulator to possess all information and authority regarding the supervision of individual institutions. In the past, NCUA has performed consumer compliance examinations separate from safety and soundness examinations. However, in order to maximize economies of scales and allow examiners to possess all information regarding the institution, the separation of consumer compliance and safety and soundness examinations was discontinued. Some federal and state agencies currently perform those functions as two separate types of examination under one regulator. The oversight of consumer protection could be given to a separate regulatory agency. The agency would likely have broad authority over all financial institutions and affiliated parties. In theory, creating such an agency would allow safety and soundness examiners to focus on those particular risks. For those agencies without consumer compliance examiners, it would create an agency of subject matter experts to help ensure consumer protection laws are adhered to.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. NCUA does not directly or indirectly regulate or oversee the operation of AIG. Therefore, we defer to the other regulatory bodies. Chartering and regulatory restrictions prevent federally chartered credit unions from investing in companies such as AIG. Federally chartered credit unions are generally limited to investing in government issued or guaranteed securities and cannot invest in the diverse range of higher yielding products, including commercial paper and corporate debt securities.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. Funding long-term, fixed-rate loans with short-term funds is a significant concern. The inherent risk in such balance sheet structuring is magnified with the increased probability that the United States may soon enter a period of inflation and rising rates on short-term funding sources. The effects of a rising interest rate environment when most funding sources have no maturity or a maturity of less than one year creates the potential for substantial narrowing of net interest margins moving forward. NCUA recently analyzed how credit union balance sheets have transformed over the last 10 years, especially in the larger institutions. Letter to Credit Unions 08-CU-20, Evaluating Current Risks to Credit Unions, examines the changing balance sheet risk profile. The Letter provides the industry words of caution as well as direction on addressing current risks. NCUA has also issued several other Letters to Credit Unions over the past several years regarding this very issue and has developed additional examiner tools for evaluating liquidity and interest rate risk. While there are various tools the industry uses for measuring interest rate and liquidity risk, the tools involve making many assumptions. The assumptions become more involved as balance sheets become more complex. Each significant assumption needs to be evaluated for reasonableness, with the underlying assumption not necessarily having been tested over time or over all foreseeable scenarios. The grey area in such analysis is significant. In our proposed regulatory changes for corporate credit unions, better matching of maturities of assets and liabilities will be regulated with concentration and sector limits as well as other controls.Q.4. 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.4. While the NCUA continues to recommend maintaining multiple financial regulators and charter options to enable the continued checks and balances such a structure produces, the agency also agrees with the need for establishing a regulatory oversight entity to help mitigate risk to the nation's financial system. Extending the reach of this entity beyond the federally regulated financial institutions may help impose market discipline on systemically important institutions. Care needs to be taken in deciding how to address the too-big-to-fail issue. Overreaching could stifle financial innovation and actually cause more harm than good. At the same time, under reaching could provide inadequate resolution when it is needed most. The statutory construct of federal credit unions limits growth with membership restrictions, so no new initiatives are deemed necessary to address the ``too big to faily7is sue for credit unions. Federally insured credit unions hold $8 13.44 billion in assets, while financial institutions insured by the FDIC hold $13.85 trillion in assets. Federally insured credit unions make up only 5.56 percent of all federally insured assets. \1\ Therefore, the credit union industry as a whole does not pose a systemic risk to the financial industry. However, federally insured credit unions serve a unique role in the financial industry by providing basic and affordable financial services to their members. In order to preserve this role, federally insured credit unions must maintain their independent regulator and insurer.--------------------------------------------------------------------------- \1\ Based on December 31, 2008, financial data.Q.5. 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. It will be difficult to convince a market accustomed to seeing taxpayer bailouts of systemically important institutions that those institutions will no longer be protected by taxpayer resources. A regulatory oversight entity empowered to resolve institutions deemed systemically important would help impose greater market discipline. Given the recent and historical government intercession, consumers and the marketplace have become accustomed to and grown to expect financial assistance from the government. The greater the expectation for government to use taxpayer resources to resolve institutions the greater the moral hazard becomes. This could cause institutions to take greater levels of risk knowing they will not have to face the consequences.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?A.6. In managing the National Credit Union Share Insurance Fund (NCUSIF), the NCUA Board's Normal Operating Level policy considers the counter-cyclical impact when managing the Fund's equity level. During otherwise stable or prosperous economic periods, the Board may assess a premium, up to the statutory limits, to increase the Fund equity level, in order to avoid the need to charge premiums at the trough of the business cycle. In order to improve this system, NCUA would need the ability to charge premiums, during good times, above the current threshold (an equity level of 1.30). A more robust and flexible risk-based capital requirement for credit unions would improve counter-cyclical impact. Currently, NCUA does not have authority to allow overall capital levels to vary based on swings in the business cycle. Prompt Corrective Action (12 U.S.C. 1790d) establishes statutory minimum levels of capital which are not flexible.Q.7. Do you see any circumstances under which your agencies would take a position on the merits of counter-cyclical regulatory policy?A.7. NCUA will support efforts to improve counter-cyclical regulatory policy. Greater flexibility in the management of the NCUSIF's equity level and improvements in the measurement and retention of capital for credit unions are good starting points.Q.8. 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.8. Many news accounts characterize the recent G20 summit as a forum for international cooperation to discuss the condition of the international financial system and to promote international financial stability. NCUA supports these efforts to share information and ideas and to marshal international support for a concerted effort to stabilize the global economy. In comparison to banks, federally insured credit unions are relatively small institutions. Additionally, because of the limited nature of a credit union's field of membership (those individuals a credit union is authorized to serve), U.S. credit unions are almost exclusively domestic institutions with virtually no, or highly limited, international presence. Accordingly, NCUA believes that a supranational regulatory institution would not be an effective tool for credit union regulation. Because of credit unions' small size and unique structure, NCUA believes credit unions need the customized supervisory approach that can only be provided by an agency dedicated to the exclusive regulation of credit unions, and which understands the unique nature of credit union operations. In the broader financial regulatory context, NCUA is hesitant to endorse the creation of powerful supranational regulatory institutions without knowing more about the extent of authority and jurisdiction those regulatory entities would have over U.S. financial institutions. While NCUA supports international cooperation, NCUA believes it is vital to economic and national security to maintain complete U.S. sovereignty over U.S. financial institutions. ------ 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-111hhrg51698--546 Mr. Weisenborn," Thank you. Mr. Chairman, Ranking Member Lucas and Members of the Committee, thank you for the opportunity to share my views on the important questions of OTC commodity market regulation that you are now considering. Before addressing the substance of my testimony, let me place my views in context by saying a few words about Agora-X and my background. Agora-X is a development stage company located in Parkville, Missouri. It is dedicated to bringing efficiency, liquidity and transparency to the over-the-counter commodity markets by means of advanced, regulatory compliant electronic platforms for OTC transaction. Agora-X was founded by FCStone, a commodities firm headquartered in Kansas City. Agora-X is now also partially owned by NASDAQ OMX. I have been a member of both the Chicago Board of Trade and the Kansas City Board of Trade. I also have self-regulatory experience of the NASDR, now renamed FINRA. OTC markets play an important role in market innovation. They provide an alternative venue for contract formation, price discovery and risk mitigation. For institutional participants, these markets can provide substantial public benefit if they are required to be transparent, reportable, clearable, and to function within the bounds of an electronic platform. Well-organized OTC markets can dramatically improve efficiency of commodity markets. By doing so, OTC markets can reduce the cost that consumers ultimately pay for commodities. When the markets are transparent, liquid and open, transaction costs fall and spreads contract. In transparent markets, there is much less room for manipulation. With broad, transparent OTC markets, the likelihood of devastating speculative bubbles is significantly reduced. Thus, well-regulated OTC markets can contribute to the integrity of U.S. financial markets as a whole. Of course, we must not ignore the lessons taught by the current crisis, but we should be careful to identify the true nature of these problems. In my view, the major problems have been in the misuse of certain commodity contracts and have not been in the means by which they are traded. This brings me to the major point I wish to make. I urge the Committee to preserve the existing OTC commodity markets, but to modify the existing law to improve them. The present financial crisis has demonstrated the need to reform to the OTC commodity markets. Clearly these markets can be improved by means of mandatory reporting, clearing, and by moving these markets to transparent electronic facilities. In addition, an important issue for this Committee is the treatment of OTC contracts on agricultural commodities. Contracts on agricultural commodities deserve the same treatment as contracts on non-ag commodities. Existing law and regulation discriminate against these commodities by making it difficult or impossible to create OTC agricultural contracts electronically, or to clear them. These restrictions, which do not advance any regulatory goal, make no sense today. An example may help to illustrate my point. Last summer, grain prices in the United States reached a very high level, but many producers who wanted to lock in those prices with cash-forward contracts were unable to do so. The country elevators who ordinarily offer such contracts could not do so because they could not finance the margin required for offsetting future positions. I think clearable, structured OTC contracts could have emerged to bridge that gap if it were not for the restrictive regulations. We currently face a time when agricultural markets desperately need liquidity. Allowing cleared, structured OTC contracts can help facilitate and accelerate liquidity. With the safeguards this Committee will add to protect the OTC markets, it is time for eligible agricultural commodity producers, processors, and users to have full access to the OTC markets. I think four things are essential to the OTC commodity markets' reform agenda. First, all physical commodities, including agricultural commodities, should be treated equally. Second, OTC commodity markets should be transparent and reportable to the CFTC. Third, OTC markets should be clearable and less narrow. CFTC-crafted exemptions should apply. Fourth, all OTC contracts should be established on or reported to an electronic facility. Accordingly, I generally support the language of the draft bill, but propose that it be improved to allow a quality of treatment of agricultural commodities, establish electronic documentation and audit trail, trading and clearing requirements, and to give CFTC authority to craft exemptions. Finally, the bill should appropriately define and authorize electronic trading facilities. Thank you for giving me the opportunity to share my views on the draft bill. [The prepared statement of Mr. Weisenborn follows:] Prepared Statement of Brent M. Weisenborn, CEO, Agora-X, LLC, Parkville, MO Mr. Chairman and Members of the Committee, My name is Brent Weisenborn of Parkville, Missouri. I am CEO of Agora-X, LLC. Thank you for the opportunity to share my views on the important questions of regulation of the OTC commodities markets that you are now considering in the proposed bill (draft bill) to amend the Commodity Exchange Act (CEA).(1) Background. Agora-X, LLC is a development stage company that is dedicated to bringing efficiency, liquidity and transparency to over-the-counter (OTC) commodity markets by means of state of the art, regulatory compliant, electronic platforms for OTC contract negotiation as well as trading and transaction execution. Its initial focus is on cash-settled OTC contracts related to physical commodities, such as energy and agricultural commodities. Agora-X, LLC was founded in 2007 by FCStone Group, Inc, which is a commodities firm with deep roots in agricultural commodities markets. FCStone originated as a regional cooperative in the Midwest offering traditional hedging services to cooperative grain elevators, and has grown to offer commodity trading and price risk management services throughout the nation and beyond. In addition to FCStone, Agora-X is now also partly owned by The NASDAQ OMX Group, Inc. I am tremendously excited about the opportunity that exists to improve the functioning of the commodities markets by means of innovations such as the electronic platforms offered by my company and by adjustments to existing regulatory systems that you are now considering. I feel qualified to comment on these points, not only because of my role with Agora-X, but also because of years of experience in both the securities and commodities markets. I have been a member of both the Chicago Board of Trade (CBOT) and the Kansas City Board of Trade (KCBT). I traded futures and was an option market maker as a proprietary trader. I served on the Board of Directors of the KCBT from 1996 to 1998. I was a founder and served from 1987 until 2001 as President of Security Investment Company of Kansas City, an institutional only Broker-Dealer and NASDAQ Market Maker. Security Investment Company specialized in proprietary trading and wholesale market making. I was elected to the NASDR (renamed FINRA), District No. 4 District Committee in 1998 and was elected Chairman in 1999. I served as Chairman until January of 2001 and as co-Chairman of the District 4 & 8 (Chicago) Regional Committee. The NASDR (FINRA) District No. 4 covers seven states: Missouri, Kansas, Iowa, Nebraska, North Dakota, South Dakota and Minnesota. At that time I was responsible for the regulatory oversight of approximately 55,000 stockbrokers in 2,500 offices. I also served on the NASDR National Advisory Council for the year 2000. In June of 2000, I was elected to the NASDR National Small Firm Advisory Board. As a result of my experience I have observed at close hand the evolution of the electronic markets for securities, and I see strong parallels with electronic markets for commodities that are just now emerging.(2) Need for Regulatory Change. OTC markets play an important role of market innovation. They provide an alternative venue of contract formation, price discovery and risk mitigation outside the rigid and restrictive regulatory framework for ``designated contract markets'' that applies to commodity exchanges. OTC markets can provide substantial public benefit without creating systemic risk of the kind that precipitated last September's financial crisis if they are required to be transparent, reportable, clearable, and to function within the bounds of electronic communication networks (ECNs) or exempt commercial markets (ECMs). Well organized OTC markets also dramatically improve efficiency of commodity markets and by doing so OTC markets reduce the costs that consumers ultimately pay for commodities. When the markets are transparent, liquid and open, the spreads that swaps dealers can charge shrink and as a result, transaction costs fall. Efficient markets also inevitably attract liquidity and become broader. If these markets become clearable, they will also bring increased liquidity to clearing houses and registered commodity exchanges. In addition, in open markets there is much less room for manipulation and the possibility of committing fraud. Because of the transparency and breadth of these markets, the likelihood of devastating speculative bubbles is also significantly reduced. These markets will help bring interests of traders and sound market fundamentals into balance. Thus, well regulated and well managed OTC markets will contribute to the integrity of U.S. financial markets as a whole. Of course, we must not ignore the problems that have emerged from the current crisis, but we should be careful in identifying the sources of these problems. In my view, the major problems have been in the misuse of securities and commodities contracts, and have not been in the means by which they are traded. This brings me to the major point I wish to make. I urge the Committee to preserve the OTC commodity markets, but to modify the existing law to derive improvements in them. The present financial crisis demonstrated that there are inefficiencies in the regulation and functioning of the OTC commodities markets and that these markets can be improved by means of electronic audit trail and reporting, by clearing and by moving these markets to a transparent ECN or ECM facilities, where possible. In addition, an important issue for this Committee is the treatment of OTC contracts on agricultural commodities. We believe that agricultural derivatives, such as commodity swaps and options, deserve the same treatment as the non-agricultural commodities under the draft bill. Existing law and regulation discriminate against these commodities by making it difficult or impossible to create OTC agricultural contracts electronically or to clear them. Harmonization of regulation for OTC contracts on agricultural commodities with other contracts will provide the same public benefits to agricultural commodities as are available to all other commodities. In addition it will eliminate existing regulatory anomalies such as prohibitions of clearing and electronic trading that arose in the evolution of the OTC markets and were discarded over time for other commodities, but retained without critical analysis for agricultural commodities. An example may help illustrate the point. Last summer grain prices in the United States reached very high levels, but many producers who wanted to lock in those prices with cash forward contracts were unable to do so because the country elevators who ordinarily offer such contracts did not do so because of inability to finance the margin required for offsetting futures positions. I think clearable, structured OTC contracts could have emerged to bridge that gap if it were not for restrictive regulations. We currently face a time when agriculture desperately needs liquidity. The agricultural OTC market is a significant existing market that is developing entirely outside of registered commodity exchanges. Allowing cleared, structured agricultural OTC contracts on ECNs can help facilitate and accelerate liquidity, while adding transparency and efficiency. With the safeguards that this Committee will add to protect the OTC markets it is time for agricultural commodity producers, processors and users to have full access to such regulated markets.(3) Conclusions and Recommendations. During the last few decades the securities markets have been truly revolutionized by innovative electronic trading methods. Now, the commodities markets are following the same path of innovation. Based on my experience I think four things are essential to the OTC commodity markets reform agenda: (A) The OTC commodity markets should be retained, but improved; (B) Unless exempted by the CFTC, all OTC commodity contracts, agreements and transactions must be reportable to the CFTC; (C) Unless exempted by the CFTC, all OTC commodity contracts, agreements and transactions must be clearable; and (D) Unless exempted by the CFTC, all OTC commodity contracts, agreements and transactions must be negotiated on an electronic communication network (ECN) via the request for quote process (RFQ) or traded or executed algorithmically on an exempt commercial market (ECM) or posted by means of give-ups to such electronic trade reporting facilities. Accordingly, I generally support the language of the draft bill, but propose amending the draft bill as follows: 1. Clearing of all OTC commodity contracts, agreements and transactions. Repeal existing laws and regulations which prohibit electronic trading and clearing of OTC contracts on agricultural commodities and provide that agricultural commodities should be given equal regulatory treatment with non-agricultural commodities by amending section 2(g) of the CEA. The draft bill implies some of this, but it should be further clarified to assure that agricultural commodities fully benefit from the reforms enacted. 2. Electronic Documentation. Require that all OTC commodity contracts, agreements and transactions be electronically documented, whether or not cleared, to assure transparency and to facilitate the reporting of these transactions. 3. Negotiation, Trading and Execution on ECNs or ECMs. Require that unless certain limited CFTC-defined exemptions and exclusions apply, all OTC commodity contracts, agreements and transactions be negotiated, traded and executed on an ECN or ECM or posted by means of the give-ups to such electronic facilities. 4. Definition of ECN. The definition of ``Trading Facility'' in the CEA should be amended to explicitly not include the ECNs. A new definition of the ECN should be drafted and added to the CEA. Thank you for giving me the opportunity to share my views on the draft bill. I look forward to offering any assistance with drafting this proposed legislation as you may request.Brent M. Weisenborn,CEO, Agora-X, LLC.[Redacted]cc:Richard A. Malm, Esq.,Dickinson, Mackaman, Tyler & Hagen, P.C.,[Redacted];Peter Y. Malyshev, Esq.,McDermott, Will & Emery, LLP.,[Redacted]. " CHRG-111hhrg55814--377 Mr. Talbott," I will let him know. The Roundtable supports greater systemic risk oversight. We support creation of a resolution mechanism. We support more effective prudential supervision. And we agree with asking mortgage securitizers to retain some risk. As such, we commend the committee in addressing these necessary reforms through the creation of a financial services oversight council. We oppose the idea of ``too-big-to-fail,'' and believe that if a firm is going to fail, it should be allowed to fail. Creative destruction is part of the market system. The key here is to strengthen the regulatory framework to spot developing trends, and then if the firm does fail, to minimize the effects of its demise on the entire system. Let me turn to the discussion draft and offer our perspectives on a few of the details. First of all, the draft allows for better coordination between prudential regulators. This is a very crucial step necessary to break down the silos that allow, in part, this crisis to develop as it was. There are other ways, however, to increase the coordination and communication between the prudential regulators. One would be to have a Federal insurance regulator on the council. I know there are proposals working their way through Congress to create an FIO, and we believe that once it is created, like we heard earlier today with the CPA, they should be added to the council. Additionally, we believe that the Financial Accounting Standards Board should be underneath the council's purview. Accounting standards are integral to protecting the investor, and we believe they should be part of the council. Next, the discussion draft preserves thrift charters and grandfathers industrial loan charters and their lawful affiliations in commercial companies. However, the limits on cross-marking between the parents and ILCs would restrict activities and their abilities to meet their customers' needs. These standards would freeze the ILCs in time, and would force a company to choose between keeping its ILC and satisfying the ever-changing demands of customers and the markets. The discussion draft correctly focuses on the U.S. financial firms and does not extend beyond its borders. We should ensure that this regulation, as well as any others, are examined to ensure that they do not conflict or overlay with home country regulations. The G-20 is focusing on this area, and we think they are headed in the right direction. The draft, unfortunately, focuses, we feel, too much on size and the complexity of the identified financial holding company, and we think that there is excessive authority that is focused, as I said, based solely on size or complexity. And these two factors are not necessarily an indicator of risk to safety and soundness, and we believe that other factors should be considered. And those include liquidity, assets, the quality of assets, and the strength of management. The discussion draft also places an excessive focus on capital as the answer to safety and soundness concerns. While capital is important, it should not become the siren song, and could overpower economic growth. Any increase in capital, we believe, should be based on activities rather than the size of the institution, and should be applied across the industry regardless of size. In addition to capital, we recommend a comprehensive approach that focuses not just on capital but activity restrictions where appropriate, prudential supervision, liquidity requirements, as well as prudential standards. We oppose the idea of requiring firms to issue contingent capital as a debt they can convert to equity if the company runs into trouble. This would greatly increase the costs of raising capital. The standards used in the draft must be examined carefully as well to ensure that the power that is granted under this authority is not exercised unless there is an extreme emergency. You want to make them high enough that they aren't triggered unnecessarily. On securitization, the draft proposes a 10 percent risk retention requirement for mortgage lenders as well as securitizers. We support the concept of risk retention, but believe that the risk retention provisions contained in H.R. 1728, which called for a 5 percent requirement, are the right one; 5 percent should be the ceiling and not the floor. Furthermore, the 10 percent risk requirement is unstudied. There have been no hearings on the matter. And we believe that this is a crucial piece that should be discussed further, and should not apply to the FHFA, to Ginnie Mae, as well as the GSE standards. It could have the unintended consequence of significantly limiting securitization and subsequent the ability of a home mortgage finance company, and limit the ability of customers who are trying to seek to purchase a home. The discussion draft would subject derivative transactions between the bank and its affiliates to a quantitative limit contained in Section 23(a), and we oppose this. We believe that the arm's length standard contained in 23(b) is sufficient. Additional, the discussion draft would mandate haircuts for unsecured creditors, and we think this would raise the costs of capital going forward. On the issue of costs, we have heard a lot of testimony today. We support having a post-event assessment. We believe that the $10 billion should be studied so it is not over-inclusive as well as under-inclusive. We believe it should be fair and equitable assessment, possibly on a sector-by-sector basis, or even limited to possible stakeholders. Finally, the discussion draft should be one--going forward, we should focus on the concept of balance. We want to make sure that we regulate properly, but we don't hinder the ability of markets to serve consumers to promote and sustain economic growth. I look forward to any questions you may have. Thank you. [The prepared statement of Mr. Talbott can be found on page 236 of the appendix.] " CHRG-111shrg55117--128 PREPARED STATEMENT OF SENATOR JACK REED Today's hearing provides an important opportunity to hear from Chairman Bernanke on the overall health of the economy, labor market conditions, and the housing sector. These semiannual hearings are a critical part of ensuring appropriate oversight of the Federal Reserve's integral role to restore stability in our economy and protect families in Rhode Island and across the country. I continue to work with my colleagues on this Committee to address three key aspects of recovering from the financial crisis. First, we must stabilize and revive the housing markets. With estimates of more than a million foreclosures this year alone, we must recognize this as a national emergency no different than when banks are on the verge of failing. One in eight mortgages is in default or foreclosure. These are more than statistics. They represent individuals and families uprooted, finances destroyed, and communities in turmoil. We need to keep pushing servicers to expand their capacity and hold them accountable for their performance. And we need to make the process more transparent for homeowners. Second, we need to create jobs, which the American Recovery and Reinvestment Act is already doing throughout the U.S. Although there have been some positive signs in the economic outlook, the unemployment rate in Rhode Island and nationally has continued to climb steeply. In the 5 months since you addressed the Committee in February, the national unemployment rate has risen from 8.1 percent to 9.5 percent, and in Rhode Island it has surged from 10.5 percent to 12.4 percent--the second highest in the country. I will soon introduce legislation to encourage more States to use work share programs, similar to our program in Rhode Island, which provide businesses with the flexibility to reduce hours instead of cutting jobs. Third, we need to stabilize and revitalize the financial markets. We've made significant progress in this area, but we need to continue to monitor these institutions to ensure they remain well-capitalized and are able to withstand market conditions much better than they did in the recent past. And we need to be smart about the Federal Reserve lending programs to get our credit and capital markets once again operating efficiently and effectively. This is especially true for small businesses, our job creators, which are the key to our Nation's economic recovery. Finally, complimenting all of these is a need for comprehensive reform of the financial regulatory system. We face several major challenges in this area, including addressing systemic risk, consolidating a complex and fragmented system of regulators, and increasing transparency and accountability in traditionally unregulated markets. It is important to recognize that our economic problems have been years in the making. It will not be easy to get our economy back on the right track. But in working with President Obama we can begin to turn the tide by enacting policies that create jobs and restore confidence in our economy. ______ CHRG-111hhrg56776--86 Mr. Volcker," Let me make a general point. We have a lot of discussion about supervision and gaps and supervisory policies. Supervision is a tough job. You are dealing with a very complex situation with some known and some unknown factors in a political world where your tools are limited and you have to be able to explain what you are doing, which is very hard to take restrictive rules when things are going well. Do not put more burdens on the supervisors than are necessary. If there are some structural factors in the market that you want to promote or eliminate, do it by legislation and do not leave everything up to the supervisor, or give the supervisor a very clear framework within which to work. The more you do that, I think the better off we will be in terms of supervision. " 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.  FinancialCrisisReport--121 The following two diagrams created for a 2005 Long Beach securitization, LBMC 2005- 2, demonstrate the complex structures created to issue the RMBS securities, as well as the “waterfall” constructed to determine how the mortgage payments being made into the securitization pool would be used. 437 437 See “LBMC 2005-2 Structure” and “LBMC 2005-2 Cash Flow Waterfall,” FDIC_WAMU_000012358-59, Hearing Exhibit 47a. __ -----------------------------------------------------Page 128-----------------------------------------------------  122 CHRG-111hhrg51591--42 Mr. Grace," I kind of agree with what everyone said in many different respects. I don't think it is ever too late to fix a problem. I don't want to ever throw my hands up and say we can't do something. But there is always going to be another problem. And if we get into the situation of just setting up a problem fix and then adding on another fix for another problem, and adding on another fix for another problem, then we are at the limit where Scott suggests we might be, where we are just insuring everything. So I think it is imperative that we think about the types of things that we can fix. Using the autopsy example that one of the members mentioned this morning, I think, is an excellent example to do that, find out where the gaps are, and use, you know, a scalpel rather than a sledgehammer to fix that. That is probably not a very good example, but I think you understand what I am getting at. My metaphors are mixed. And the second thing, and I like what Ms. Guinn said, is that the whole sort of academic risk management area now is about enterprise risk management. And if we think about what the Europeans--how they are thinking about Basel II accords, they are making every insurer be extraordinarily sophisticated about the risks they are carrying. Not only that, their extraordinary sophistication is supposed to be transparent. And the NAIC's way of regulating insurers' solvency is--it is not archaic yet, but it is kind of getting a patina on it where it looks old. And we really need to change that particularly solvency system. We need to be moving towards a capital model-based system. And this is something that I think the NAIC recognizes. But that will help. I mean, understanding what our risks are and then treating them appropriately at the entire organizational level is a major innovation. Right now, every company is sort of examined separately by the regulators, and they are not put together in a big whole, in a ``w-h-o-l-e,'' whole. And that is something I think from the very beginning would go to some extent to solve some of the patches that we need to put into our system of regulation. " FOMC20070918meeting--28 26,CHAIRMAN BERNANKE.," One complexity in this whole period is that there is a surprisingly large demand for dollars in Europe, which of course is early in the day. So the fed funds rate was opening very, very high, very tight, and then there were judgments about how to bring it down during the peak trading period of the U.S. markets. That led to guesses about how many reserves to inject before the end of the day. So the dysfunction in the normal interbank market process—precautionary demand for dollars in Europe—led to some very unusual stresses early in the day, which complicated Bill’s job considerably." fcic_final_report_full--217 And Merrill continued to push its CDO business despite signals that the market was weakening. As late as the spring of , when AIG stopped insuring even the very safest, super-senior CDO tranches for Merrill and others, it did not reconsider its strategy. Cut off from AIG, which had already insured . billion of its CDO bonds  —Merrill was AIG’s third-largest counterparty, after Goldman and Société Générale—Merrill switched to the monoline insurance companies for protection. In the summer of , Merrill management noticed that Citigroup, its biggest com- petitor in underwriting CDOs, was taking more super-senior tranches of CDOs onto its own balance sheet at razor-thin margins, and thus in effect subsidizing returns for investors in the BBB-rated and equity tranches. In response, Merrill continued to ramp up its CDO warehouses and inventory; and in an effort to compete and get deals done, it increasingly took on super-senior positions without insurance from AIG or the monolines.  This would not be the end of Merrill’s all-in wager on the mortgage and CDO businesses. Even though it did grab the first-place trophy in the mortgage-related CDO business in , it had come late to the “vertical integration” mortgage model that Lehman Brothers and Bear Stearns had pioneered, which required having a stake in every step of the mortgage business—originating mortgages, bundling these loans into securities, bundling these securities into other securities, and selling all of them on Wall Street. In September , months after the housing bubble had started to deflate and delinquencies had begun to rise, Merrill announced it would acquire a subprime lender, First Franklin Financial Corp., from National City Corp. for . billion. As a finance reporter later noted, this move “puzzled analysts because the market for subprime loans was souring in a hurry.”  And Merrill already had a  million ownership position in Ownit Mortgage Solutions Inc., for which it provided a warehouse line of credit; it also provided a line of credit to Mortgage Lenders Net- work.  Both of those companies would cease operations soon after the First Franklin purchase.  Nor did Merrill cut back in September , when one of its own analysts issued a report warning that this subprime exposure could lead to a sudden cut in earnings, because demand for these mortgages assets could dry up quickly.  That assessment was not in line with the corporate strategy, and Merrill did nothing. Finally, at the end of , Kim instructed his people to reduce credit risk across the board.  As it would turn out, they were too late. The pipeline was too large. REGULATORS: “ARE UNDUE CONCENTRATIONS OF RISK DEVELOPING? ” As had happened when they faced the question of guidance on nontraditional mort- gages, in dealing with the rapidly changing structured finance market the regulators failed to take timely action. They missed a crucial opportunity. On January , , one year after the collapse of Enron, the U.S. Senate Permanent Subcommittee on In- vestigations called on the Fed, OCC, and SEC “to immediately initiate a one-time, joint review of banks and securities firms participating in complex structured finance products with U.S. public companies to identify those structured finance products, transactions, or practices which facilitate a U.S. company’s use of deceptive account- ing in its financial statements or reports.” The subcommittee recommended the agen- cies issue joint guidance on “acceptable and unacceptable structured finance products, transactions and practices” by June .  Four years later, the banking agencies and the SEC issued their “Interagency Statement on Sound Practices Con- cerning Elevated Risk Complex Structured Finance Activities,” a document that was all of nine pages long.  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-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-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-111hhrg52400--23 Mr. McCarthy," Thank you. Chairman Kanjorski, Ranking Member Garrett, and members of the subcommittee, my name is Sean McCarthy, and today I am testifying in my role as president of Financial Security Assurance Holdings, or FSA, and Assured Guaranty Corporation, which is expected to complete the acquisition of FSA on July 1st. We appreciate the opportunity to testify at this hearing to improve oversight of the insurance industry and a restructuring of the Federal Government's role with regard to insurance products. As monoline insurance companies, we provide, in the case of FSA, bond insurance for the U.S. municipal and global infrastructure markets. And in the case of Assured, bond insurance for U.S. municipal, global infrastructure, and structured financings. Insurance utilized only in the financial markets is a very different product from that of property casualty, life, and health insurance companies. Article 69 was enacted by New York State to segregate financial guaranty insurance from multiline products and the risks those entail. While it was a good step, it is not strong enough. We believe we require mandatory Federal regulation that is closer to that of the banks, and that, being centralized and encompassing all aspects of regulation, including required capital. The current decentralized regulatory regime for monolines is aimed at preserving their solvency, rather than their financial stability. There are no uniform, consistent credit, capital, and financial strength standards. Recognizing this, the New York insurance commissioner, Eric Dinallo--who has recently announced that he is leaving--had noted the potential need for Federal regulation with the bond insurers in the monoline industry. Importantly, due to the lack of a single regulator, the rating agencies have become the de facto regulators of our industry. While we continue to strive to achieve the highest possible ratings, we believe the rating agency views currently play too singular a role in the evaluation of our financial strength. Ratings are based on criteria that vary, and include many subjective characteristics. And rating agency methodologies are not readily transparent. Additionally, all three rating agencies have different sets of guidelines, which present conflicting goals, and make it possible to manage a stable company. Though investors cannot easily evaluate rating agency conclusions, due to the impact of their ratings on trading value of securities that monolines have insured, investors are forced to accept the impact that ratings have, with respect to financial guarantors. The end result of this de facto regulation by rating has been to destabilize markets and reduce municipal issuers' cost effective access to the capital markets. This has been most difficult for small municipal issuers and municipal issuers of complex bonds, where bond insurance homogenizes the credits, providing market liquidity and market access. The penetration of the bond insurance industry for the first 5 months of 2009 has been 13 credit. The letter of credit has now declined to about 6 percent. Certainly, there is no question that some financial guarantors took large, concentrated risks in mortgage-backed securities that severely underperformed, which, in turn, caused downgrades, or failures, of five of the seven primary guarantors. Notably, many of these now problematic transactions were rated AAA by the rating agencies at the time of issuance. The financial guaranty industry is now in a rebuilding phase, and a number of potential new entrants are poised to participate in the market. Assured and FSA have come through this unprecedented period of turmoil in strong capital positions. And, despite the understandable concerns that the market has expressed about the financial guarantee model, we are confident that investors will continue to see value in guarantors that combine capital strength with diligent experienced credit selection skills. In conclusion, we would like to see mandatory Federal oversight of our industry that would provide regulation by design, not by default. We believe that licensing requirements should be stringent, and require high but predictable capital levels. Guarantors should provide detailed disclosure of risks to all constituencies, and should be subject to an annual stress test that would be applied equally to all companies. This would increase investor confidence, and provide much needed transparency and stability to the capital markets. Thank you. I look forward to your questions. [The prepared statement of Mr. McCarthy can be found on page 98 of the appendix.] " 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-111hhrg52407--17 Mr. Salisbury," Mr. Chairman, members of the committee, it is a pleasure to be here. I thank you for the invitation to testify today. My employer since 1978, the Employee Benefit Research Institute, I would note, does not lobby or take positions for or against proposals. And my full submission for the record includes a significant amount of survey data and financial literacy status information as dealing with the full description. The letter you sent me, however, inviting me to testify asked four specific questions that actually call for the statement of positions, and in that sense, I would want to stress that my statements from this point forward are my own personal views and not those of my employer. First, as a consumer of financial services, my reaction is positive to the creation of an independent consumer financial protection agency if, and I would stress this, the consumer is a dominant presence on the board and in advisory council positions. For example, deep experience in financial services, in quotation marks, should be interpreted broadly enough to include lifetime consumers of financial services, not just individuals working for the financial services industry. I would personally prefer regulation and protection by an entity that is not governed by the regulated or, as stated on page 29 of the President's document, captured by the regulated, a problem found in recent years at the regional Federal Reserve banks, the Federal Reserve, and other existing regulatory agencies. As a consumer, I currently see no such independent regulator, which if properly implemented, the CFPA could become. If the consumer is not dominant at CFPA, however, I would stress that the agency would likely be a waste of time, money, and effort and would only serve to mislead the public into thinking that they will be protected. Second, the plain-language financial products proposed need to be what my grandmother termed, and the ranking member termed, plain vanilla. For example, a 20 percent down, 30-year fixed-rate mortgage with clearly specified closing costs and that can be paid off with no penalties; or a 3-year fixed-rate car loan that can be paid off any time without the complexity of the Rule of 78 that I got tripped up by in 1972 personally, in spite of thinking that I am an informed consumer; or a charge or credit card that tells you any and all fees in advance and cannot change fees without giving you notice that the opportunity to cancel is present and giving you a prorated refund for any annual card fee. Research has found that individuals make the same choices with a 1-page disclosure as with multiple pages of fine print; thus, they require one plain English summary page with all key facts in addition to more detailed disclosure. Third, the President's Advisory Council on Financial Literacy has proven to be a worthy effort. It has also provided direct input to the Treasury and to the Financial Literacy Education Commission. Long-term value, however, will depend upon some formalization of the role of the White House and some level of dedicated funding and staffing. The current approach of heavily depending upon those appointed to donate time, money, and other resources or to raise them from others, leads to potential conflicts of interest and confusion of roles. Related to FLEC, I find, regrettably, that I am in agreement with the critical review by the Government Accountability Office that, as currently structured, FLEC has not met the legislated objectives. The Administration may already contemplate integration of FLEC into CFPA, but if it is not focused on this issue, the Administration and the Congress should do so as details of CFPA are developed. Fourth, and finally, as your request letter notes, the President's document states the CFPA should review and streamline existing financial literacy and education initiatives government-wide. Based upon my work on savings and retirement issues since joining the Labor Department in 1975, giving one agency the absolute responsibility for direction of all Executive Branch activities in the area of financial literacy and education could possibly add needed coordination and consistency. But that would only occur if the leadership of the agency was committed to the issue and to the approach set out in the legislation. Over my 34 years of working on this issue, I have watched multiple agency programs and priorities and financial education shift dramatically as political leadership changes. This is not just the case when party control changes, but occurs within a party even with new staff changes. Thus, the role being set out for CFPA may or may not add value in this area, depending upon the specificity of the legislation, the attitudes and priorities of the director, and adequate staff and budget resources provided for funding. Assurance that most of those appointed to the board and advisory committee with ``deep experience in financial services'' are there as individual financial services consumers, not as financial services industry representatives, would make success more likely. Needed technical expertise can be hired. But policy direction from the appointed leadership and advisors will determine ultimate results. I look forward to working with your committee and all others on these important issues. Financial literacy on issues as simple as understanding compound interest would be essential, even if there are plain-vanilla products. Thank you. [The prepared statement of Mr. Salisbury can be found on page 82 of the appendix.] " CHRG-110shrg50416--139 Mr. Lockhart," It could be long, could be short. Senator Corker. It is my goal that--or it is my hope that you will work yourself out of a job pretty quickly. I know the biggest part of your portfolio is Fannie and Freddie; the others sort of lesser, if you will. Is there any need for--I have a strong prejudice in this regard, but is there any need for Federal involvement in Fannie and Freddie? My sense is absolutely not. I knowwe have had some conversations in our office about that, and I am just wondering what your answer to that might be. And if not, if the markets can deal--I mean, housing finance is not particularly complex. It really is not. Any sense as to how soon we might be out of the business, if you will, of having these Government-sponsored entities and you maybe being on the beach someplace? " 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-110shrg50369--119 Mr. Bernanke," Well, I think the subprime crisis sort of triggered these events. But it is true that investors have lost confidence in a lot of different assets at this point, including, it was mentioned, some student loans and other things as well. And part of the problem--not all of the problem, but part of the problem--is that in these complex structured credit products, it is very difficult for the investor to know exactly what is in there and what derivative support or credit liquidity support is involved. Senator Corker. So, in essence, the subprime issue that has occurred has caused us to look at those in a more healthy way, and hopefully the market will create some mechanisms for us to actually value those in real time and create a way for us to have some transparency there. Is that correct? " CHRG-111hhrg52397--236 Mr. Sprecher," Chairman Kanjorski, Ranking Member Garrett, and members of the subcommittee, my name is Jeff Sprecher, and I am the chairman and chief executive officer of IntercontinentalExchange, which is also known by our New York Stock Exchange ticker symbol as ICE. I very much appreciate the opportunity to appear before you today to testify on the over-the-counter derivatives regulation. And, Congressman Scott, thank you for your kind introduction earlier today. In the mid-1990's, I was a power plant developer in California, and I witnessed the State's challenge in launching a market for electricity. Problems arose from a complex market design and partial deregulation, and I was convinced that there was a more efficient and transparent way to manage risks in the wholesale markets for electric power and natural gas. Therefore, in 1997, I purchased a small energy trading platform that was located in Atlanta, and I formed ICE. The ICE over-the-counter platform was designed to bridge a void that existed between a bilateral, voice-brokered over-the-counter market, which were opaque, and open up futures exchanges, which were inaccessible or they lacked products that were needed to hedge power markets. ICE has grown substantially over the past decade, and we now own three regulated futures exchanges and five regulated clearinghouses. Yet, we still continue to offer the over-the-counter processing along with futures markets. In discussing the need for the over-the-counter regulation, it is important to understand the size of the over-the-counter derivatives market and their importance to the health of the U.S. economy. In this current credit crisis, derivatives have been commonly described as complex, financially engineered products transacted between large banks. However, in reality, an over-the-counter derivative can encompass anything from a promise of delivery in the future between a farmer and his grain elevator, to a uniquely structured instrument, like an exotic option, and much of the Nation's risk management occurs in between these two extremes. Derivatives are not confined to large corporations. Small utilities, farmers, manufacturing companies and municipalities all use derivatives to hedge their risks. Providing clearing, electronic execution and trade processing are core to ICE's business model. As such, my company would clearly stand to benefit from legislation that required all derivatives to be traded and cleared on an exchange. However, forcing all OTC derivatives onto an exchange would likely have many negative and unintended consequences for our markets as a whole. In derivative markets, clearing and exchange trading are separate concepts. At its core, exchange trading is a service that offers order matching to market participants. Listing a contract on an exchange does not necessarily mean it will have better price discovery. Exchange trading works for highly liquid products, such as the Russell 2000 or standardized commodity contracts that appeal to a whole host of a broad set of market participants. However, for many other markets, exchange trading is not the best solution as the market may be illiquid, with very wide bid offer spreads, leading to poor or misleading price signals. Nonetheless, these illiquid products can still offer value to hedgers and thus they have a place in the over-the-counter deliberative market. Turning to clearing, this technique gracefully reduces counterparty and systemic risk in markets where you have standardized contracts. However, forcing unstandardized contracts into a clearinghouse could actually increase market risk. Where the market depth is poor or the cost of contracts are not accurate for price discovery, it is essential that the clearinghouse be operated so that it can see truly discovered value. So while ICE certainly supports clearing as much standardized product as is possible, there will always be products which are either non-standard nor sufficiently liquid for clearing to be practical, economic or even necessary. Firms dealing in these derivatives should nonetheless have to report them to regulators so that regulators have a clear and a total view of the market. ICE has been a proponent of appropriate regulatory oversights of markets and as an operator of global futures and over-the-counter markets, we know the importance of ensuring the utmost confidence, which regulatory oversight contributes to. To that end, we have continuously worked with regulatory bodies in the United States and abroad to ensure that they have access to relevant information that is available from ICE regarding trading activity in our markets. We have also worked closely with Congress and regulators to address the evolving oversight challenges that are presented by complex derivatives. We continue to work cooperatively to seek solutions that promote the best marketplace possible. Mr. Chairman, thank you for the opportunity to share our views with you, and I will be happy to answer any questions that you may have. [The prepared statement of Mr. Sprecher can be found on page 182 of the appendix.] " CHRG-111hhrg48868--231 Mr. Hensarling," I read on your Web site that, ``OTS has supervisory and enforcement authority over the entire corporate structure. The scope of this authority includes the savings association, its holding company, and other affiliates and subsidiaries of the savings association.'' I continue to quote, ``These supervisory tools allow OTS to obtain a complete picture of the interrelationships and risk throughout the savings and loan holding company enterprise regardless of its size and complexity.'' Again, it appears, if this is correct, it was not a lack of supervisory authority that caused you not to take action with respect to these two lines, is that correct? " CHRG-111hhrg55811--11 Mr. McMahon," Thank you, Chairman Frank, and Ranking Member Bachus, and all the members of the committee for allowing me to join you today at this very important hearing. I would also like to especially thank Chairman Frank and his dedicated staff for putting together this balanced discussion draft as an excellent starting point for our deliberations in working with my legislative director Jeff Siegel, who has done an outstanding job as well. I know I can speak for many of my colleagues and the new Democrats when I say that we look forward to working with you constructively to improve this draft in the days ahead. Although the regulation of derivatives is complex, this issue is extremely important to the proper functioning of our capital markets and to almost every business in America, and we need to get this right. We all know the effect of derivatives and what role they played in particular with the credit default swaps in the collapse of AIG and the broader credit crisis. Derivatives amplified the effects of the subprime mortgage crisis and the overleveraging of our economy. There is no doubt that we need much greater transparency and regulation of our derivative markets to be sure that we do not have to face another AIG-type collapse or spend billions of dollars bailing out companies for taking imprudent risks. But we must be sure that any new regulation is smart and rational regulation. We need to target any new rules to directly address the potential for systemic risk without needless imposing of regulations that could have unintended effects. Because derivatives are financial instruments that help all of us, they help keep our energy costs low and stable. They help insurance companies keep premiums low. They help companies complete construction projects on time and under budget. And despite the negative press and lack of understanding of the derivatives market, for the most part, the derivatives market works. We cannot throw the baby out with the bath water. We must work to protect the end-users, good American businesses that are just trying to manage their cash flows and hedge against uncertain risks beyond their control in a cost-effective manner. We should work to require standardized trades between entities that pose systemic risk, swap dealers, and major swap participants to clear their trades. For products that are more unique, those should continue to be traded in the OTC markets but with higher margin and capital requirements for the big players. At the same time, we must increase transparency and disclosure requirements and grant regulators the authority to monitor these important markets for any sign of stress or overexposure. Our derivative markets need more regulation, but we also must be sure not to needlessly tie up capital or increase the cost of credit in ways that stifle economic growth or risk sending our financial services industry overseas, particularly important to the 80,000 people from my district in Staten Island and Brooklyn, New York, who work every day in the financial services industry. In this age of instant global capital flows, if the regulations are not carefully written, any poorly conceived rule here in Washington could have a dramatic impact on our economy. Mr. Chairman, I yield back the remainder of my time, and I again thank you for the honor of being here today. " CHRG-111hhrg53238--139 Mr. Courson," Congresswoman, being president of an association that is subject to 50-State regulation, we can tell you; and I would say that we think that is one of the things that, had we had a uniform national standard, we could have avoided. Some of this could have been avoided. It is really a disservice to consumers in the different States. I will tell you we deal in all of the States; and some States, as I have said before, have very good regulations, very solid laws on the books. And, frankly, there are others that don't. And we have a map that we put in the back of our testimony that shows this patchwork. We have to have a uniform national standard. State regulation, particularly if this is--if the national standard is a floor, just merely adds more complexity, additional disclosures, which we are trying to go the other way with our HUD and Fed initiative, and really doesn't well serve, assuming that the uniform national standard has to be strong and at the proper ceiling. " CHRG-111shrg51303--84 Mr. Polakoff," Well, I think our respective staffs certainly at the annual conferences that we held communicated the various risks within this complex company. There is a difference between, as you know, underwriting credit default swaps and actually investing in residential mortgage-backed securities. Nonetheless, Senator, as you described, the theme should have been consistent in both parties. And certainly, in listening to the testimony today, I think it is worthy for us to go back and chat with our staffs as to what was communicated. Clearly, we know in the supervisors' college in 2007 we discussed the risks of the credit default swaps in FP, and I suspect that the various State insurance commissioners had ample opportunities to discuss in the supervisory colleges the risks that they were identifying. Senator Reed. Thank you very much. Mr. Chairman, thank you. " FinancialCrisisReport--288 Mr. McDaniel: In this section, he is talking about the issue of rating shopping, and I agree that that existed then and exists now. 1116 (3) Inaccurate Models The conflict of interest problem was not the only reason that Moody’s and S&P issued inaccurate RMBS and CDO credit ratings. Another problem was that the credit rating models they used were flawed. Over time, from 2004 to 2006, S&P and Moody’s revised their rating models, but never enough to produce accurate forecasts of the coming wave of mortgage delinquencies and defaults. Key problems included inadequate performance data for the higher risk mortgages flooding the mortgage markets and inadequate correlation factors. In addition, the companies failed to provide their ratings personnel with clear, consistent, and comprehensive criteria to evaluate complex structured finance deals. The absence of effective criteria was particularly problematic, because the ratings models did not conclusively determine the ratings for particular transactions. Instead, modeling results could be altered by the subjective judgment of analysts and their supervisors. This subjective factor, while unavoidable due to the complexity and novelty of the transactions being rated, rendered the process vulnerable to improper influence and inflated ratings. (a) Inadequate Data CRA analysts relied on their firm’s quantitative rating models to calculate the probable default and loss rates for particular pools of assets. These models were handicapped, however, by a lack of relevant performance data for the high risk residential mortgages supporting most RMBS and CDO securities, by a lack of mortgage performance data in an era of stagnating or declining housing prices, by the credit rating agencies’ unwillingness to devote sufficient resources to update their models, and by the failure of the models to incorporate accurate correlation assumptions predicting how defaulting mortgages might affect other mortgages. Lack of High Risk Mortgage Performance Data. The CRA models failed, in part, because they relied on historical data to predict how RMBS securities would behave, and the models did not use adequate performance data in the development of criteria to rate subprime and other high risk mortgages that proliferated in the housing market in the years leading up to the financial crisis. From 2004 through 2007, many RMBS and CDO securities were comprised of residential mortgages that were not like those that had been modeled in the past. As one S&P email observed: 1116 April 23, 2010 Subcommittee Hearing at 100-101. “[T]he assumptions and the historical data used [in the models] … never included the performance of these types of residential mortgage loans .… The data was gathered and computed during a time when loans with over 100% LTV or no stated income were rare.” 1117 CHRG-111shrg53176--158 PREPARED STATEMENT OF JAMES CHANOS Chairman, Coalition of Private Investment Companies March 26, 2009 Chairman Dodd, Ranking Member Shelby, and Members of the Committee. My name is James Chanos, and I am President of Kynikos Associates LP, a New York private investment management company that I founded in 1985. \1\ I am appearing today on behalf of the Coalition of Private Investment Companies (CPIC), a group of about twenty private investment companies with a wide range of clients that include pension funds, asset managers, foundations, other institutional investors, and qualified wealthy individuals.--------------------------------------------------------------------------- \1\ Prior to founding Kynikos Associates LP, I was a securities analyst at Deutsche Bank Capital and Gilford Securities. My first job on Wall Street was as an analyst at the investment banking firm of Blyth Eastman Paine Webber, a position I took in 1980 upon graduating from Yale University with a B.A. in Economics and Political Science.--------------------------------------------------------------------------- I want to thank the Senators of this Committee for your efforts to develop and implement an approach to modernize financial regulation which would address the failures and inadequacies that contributed to the financial crisis confronting our country and our global economy. I am honored to have this opportunity to testify on behalf of CPIC and look forward to working with you and your staff in the months ahead.I. Executive Summary This is a difficult time for our Nation. Overhauling our regulatory structure is necessary to regain investor confidence. Honesty and fair dealing are at the foundation of the investor confidence our markets 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. In recent years, prior to the current economic downturn, many observers of the financial system believed that hedge funds and other private pools of capital would be the source of the next financial crisis. Of course, as we have all painfully learned, in fact, the greatest danger to world economies came not from those entities subject to indirect regulation, such as hedge funds, but from institutions such as banks, insurance companies, broker-dealers, and government-sponsored enterprises operating with charters and licenses granted by state and federal regulators and under direct regulatory supervision, examination, and enforcement. Indeed, Bernard Madoff used his firm, Bernard L. Madoff Investment Securities, LLC--which was registered with the SEC as a broker-dealer and investment adviser and subject to examination and regulation--to perpetrate his Ponzi scheme. Nonetheless, hedge funds and other private investment companies are important market players, and we recognize that a modernized financial regulatory system--one that addresses overall risk to the financial system and that regulates market participants performing the same functions in a consistent manner--will include regulation of hedge funds and other private pools of capital. We are ready to work with you as you seek to craft appropriate regulation for our industry. With respect to the new regime for monitoring systemic risk, CPIC would like to offer the following principles upon which to base legislative and regulatory action: First, regulation must be based upon activities, not actors, and it should be scaled to size and complexity. Second, all companies that perform systemically significant functions should be regulated. Third, regulators should have the authority to follow the activities of systemically important entities regardless of where in the entity that activity takes place. Fourth, as complexity of corporate structures and financial products intensifies, so, too should regulatory scrutiny. Fifth, there should be greater scrutiny based upon the ``Triple Play''--being an originator, underwriter/securitizer and investor in the same asset. Sixth, and above all, the systemic risk regulator must enforce transparency and practice it. With respect to increasing the functional regulation of hedge funds, CPIC offers the following for your consideration: Simply removing exemptions from the Investment Company Act and the Investment Advisers Act upon which private investment funds rely will prove unsatisfactory. Any new regulation should provide for targeted controls and safeguards to provide appropriate oversight of private investment companies, but should also preserve the flexibility of their operations. More detailed requirements for large private investment companies would address the greater potential for systemic risk posed by such funds, depending on their use of leverage and their trading strategies. Regulation should address basic common-sense protections for investors in private investment companies, particularly with respect to disclosure, custody of fund assets, and periodic audits. Areas such as counterparty risk, lender risk, and systemic risk should be addressed through disclosures to regulators and counterparties. With respect to hedge funds as significant investors in the capital markets, 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.II. The State of the Hedge Fund Sector Since I last testified before the Senate Banking Committee on May 16, 2006, \2\ the hedge fund industry has undergone profound change in the face of unprecedented challenges. In 2006, the industry was continuing its rapid growth and evolution into new strategies and products, to offer qualified investors greater flexibility and opportunities for managing risks and achieving returns that exceeded equity and bond markets' performance. In 2006, the industry had an estimated $1.47 trillion in assets under management and there were an estimated 9,462 funds. A year later, total assets under management for an estimated 10,096 funds rose to about $1.87 trillion, culminating 18 years of growth since 1990 at a cumulated average annual growth rate (CAGR) of 25 percent. In several markets, hedge funds became the main players, accounting for more than 50 percent of trading in U.S. convertible bonds, distressed debt, and credit derivatives. \3\ We experienced a host of new strategies to address investors' increasingly complex risk-management and asset growth demands, as the variety and complexity of financial instruments--and the global nature of those products--grew exponentially. The sheer variety of investment strategies that hedge funds employed strengthened capital markets, improved opportunities for price discovery, and facilitated the efficient allocation of capital. \4\--------------------------------------------------------------------------- \2\ Testimony of James Chanos, Chairman, Coalition of Private Investment Companies. U.S. Senate Committee on Banking, Housing, and Urban Affairs Subcommittee on Securities and Investment. Hearing on the Hedge Fund Industry. May 16, 2006. Available at: http://banking.senate.gov/public/_files/ACF82BA.pdf. \3\ Kambhu, John, Schuermann, Til and Stiroh, Kevin J., Hedge Funds, Financial Intermediation, and Systemic Risk. Economic Policy Review, Vol. 13, No. 3, December 2007 (available at SSRN: http://ssrn.com/abstract=1012348). \4\ Knowledge@Wharton, ``Hedge Funds Are Growing: Is This Good or Bad?'' June 29, 2005. Available at: http://knowledge.wharton.upenn.edu/article.cfm?articleid=1225&CFID=4349082&CFTOKEN=6202640. Jeremy Siegel, Professor of Finance at the Wharton School of the University of Pennsylvania, observes that short selling contributes to the market's process of finding correct prices, and it's valuable to have hedge funds doing this. Sebastian Mallaby, ``Hands Off Hedge Funds,'' Foreign Affairs, January/February 2007. Available at: http://www.foreignaffairs.org/20070101faessay86107/sebastian-mallaby/hands-off-hedge-funds.html. The importance of hedge funds has been acknowledged by the President's Working Group on Financial Markets, the Commodities Futures Trading Commission, the Securities and Exchange Commission, two chairs of the Federal Reserve Board, and members of Congress.--------------------------------------------------------------------------- The attraction of hedge funds was a function, too, of their performance. According to Hedge Fund Research, Inc., hedge funds have returned an average of 11.8 percent annually during the period 1990 through 2008, and an average 15.9 percent in the 12 months following the five largest historical declines. \5\--------------------------------------------------------------------------- \5\ Hedge Fund Research, Inc. ``Investors Withdraw Record Capital from Hedge Funds as Industry Concludes Worst Performance Year in History.'' Press Release. Available at: https://www.hedgefundresearch.com/pdf/pr_01212009.pdf.--------------------------------------------------------------------------- As Andrew W. Lo, a professor at the MIT Sloan School of Management, testified on November 13, 2008, ``[t]he increased risk-sharing capacity and liquidity provided by hedge funds over the last decade has contributed significantly to the growth and prosperity that the global economy has enjoyed.'' \6\ It is a point that Treasury Secretary Timothy F. Geithner made as Federal Reserve Bank President and CEO in speeches in 2004 and 2005. \7\--------------------------------------------------------------------------- \6\ Written Testimony of Andrew W. Lo, Hedge Funds, Systemic Risk, and the Financial Crisis of 2007-2008, Prepared for the U.S. House of Representatives Committee on Oversight and Government Reform November 13, 2008 Hearing on Hedge Funds. \7\ Mr. Geithner stated: ``Hedge funds play a valuable arbitrage role in reducing or eliminating mispricing in financial markets. They are an important source of liquidity, both in periods of calm and stress. They add depth and breadth to our capital markets. By taking risks that would otherwise have remained on the balance sheets of other financial institutions, they provide an importance source of risk transfer and diversification.'' Available at: http://www.ny.frb.org/newsevents/speeches/2004/gei041117.html. Mr. Geithner also stated ``Hedge funds, private equity funds and other kinds of investment vehicles help to disperse risk and add liquidity.'' See Keynote Address at the National Conference on the Securities Industry: Hedge Funds and Their Implications for the Financial System (November 17, 2004). Remarks at the Institute of International Bankers Luncheon in New York City (October 18,2005). Available at: http://www.ny.frb.org/newsevents/speeches/2005/gei051018.html.--------------------------------------------------------------------------- Despite the rapid growth and size of hedge funds ($1.41 trillion), their relative size with the financial sector is small, accounting for 0.7 percent of the $196 trillion invested in equities, tradable government and private debt, and bank deposits, according to McKinsey Global Institute. \8\--------------------------------------------------------------------------- \8\ McKinsey Global Institute, Mapping Global Capital Markets: Fifth Annual Report. October 2008. Available at: http://www.mckinsey.com/mgi/reports/pdfs/fifth_annual_report/fifth_annual_report.pdf.--------------------------------------------------------------------------- In the summer of 2007 and throughout 2008, financial markets began to unravel. Major regulated financial institutions collapsed or went bankrupt as the U.S. Treasury administered life support through both capital infusions and U.S.-backed guarantees to prevent the demise of banks, insurance companies, and others who were deemed ``too big to fail,'' and thereby stave off an imminent global economic collapse comparable to that of the Great Depression. A chain of interlinked securities--including derivatives and off-balance sheet vehicles--sensitive to housing prices triggered a death spiral in financial markets worldwide, demonstrating the scale and intensity of interdependence in the global economy and the vulnerability it causes. \9\ As the problems became more severe, the crisis mushroomed beyond subprime debt to threaten less risky assets. Credit markets dried up, and equity markets in 2008 posted one of their worst years since the 1930s. As a result, the value of financial assets held at banks, investment firms, and others collapsed, jeopardizing their survival as they sharply curtailed activities. Institutional investors rushed to the sidelines, seeking safe havens in cash investments. The downturn spread throughout our economy and worldwide, fueling job losses, prompting bankruptcies, and causing household wealth to erode. That is a greatly distilled and simplified recounting of the events in 2007-2009. And, as might be expected with those events, the hedge fund industry experienced a sharp reversal. \10\--------------------------------------------------------------------------- \9\ There are many research papers and studies that examine the source of the financial crisis. One example: Gary B. Gorton, ``The Panic of 2007.'' August 25, 2008. Yale ICF Working Paper No. 08-24. Available at: http://ssrn.com/abstract=1255362. \10\ I would encourage you to read the trenchant analysis by Lord Adair Turner, Chairman of the U.K. Financial Services Authority (``FSA''), in which he eloquently recounts how developments in the banking and the near-bank system caused serious harm to the real economy. Lord Adair Turner, Chairman, FSA. ``The financial crisis and the future of regulation.'' January 21, 2009. The Economist's Inaugural City Lecture (available at http://www.fsa.gov.uk/pages/Library/Communication/Speeches/2009/0121_at.shtml. A more extensive discussion is provided in: The Turner Review: A Regulatory Response to the Global Banking Crisis. March 18, 2009 (available at http://www.fsa.gov.uk/pages/Library/Communication/PR/2009/037.shtml).--------------------------------------------------------------------------- As a consequence of the financial crisis, as was the case with other sectors of the financial services industry, the amount of money managed by hedge funds plummeted, reflecting an amalgam of sharp declines in asset values, the rise in client redemptions, and regulatory closures of margin accounts. Last year was easily among the worst in the industry's history, with total assets under management falling to $1.41 trillion--a decline of $525 billion from the all-time peak of $1.93 trillion reached mid-year 2008, with more than 1,471 funds--a record in 1 year--liquidating. Investors withdrew a record $155 billion. Hedge funds on average in 2008 posted their worst performance since 1990. The HFRI Fund Weighted Composite Index dropped 18.3 percent for all of last year, which was only the second calendar year decline since 1990. \11\ That said, though, hedge fund losses on average were less than those of the S&P500, with 24 different hedge fund strategies performing better than the S&P 500 benchmark.--------------------------------------------------------------------------- \11\ According to Hedge Fund Research, Inc. ``during 2008, the industry experienced a period of six consecutive months of declines between June and November, interrupted only by December's 0.41 percent gain, including a concentrated, volatile two-month period in September and October in which the cumulative decline approached 13 percent.'' See supra n. 5.---------------------------------------------------------------------------III. Mitigation of Systemic Risk The financial crisis of the past 2 years has raised many questions about the extent to which systemic risks are effectively contained and ameliorated within the U.S. and global economies. As globalization has led to better risk sharing and increased market liquidity, shocks originating in one market are more quickly transmitted to other markets. Regulators and central banks say they need more information to understand the sources of risks and potential impact on markets and economies. Consensus is emerging among U.S. policy makers and in other countries for the need to strengthen systemic risk regulation. Towards that end, allow me to outline some basic principles to guide the thinking about establishing a regulator with responsibility for addressing systemic risks and the attendant laws and regulations to accomplish that objective. First, regulation must be based upon activities, not actors, and it should be scaled to size and complexity. Regulatory scrutiny should be triggered based upon any of the following: the overall scale of market participants, relative importance in a given market or markets, complexity of corporate structure, and complexity of financial instruments used for investment or dealer purposes. All participants undertaking a similar activity should be treated equally; for example, proprietary trading by financial institutions should not be treated in a different manner than trading by any other kind of entity. While the regulator should have broad and flexible authority to determine the basis upon which it wants to include systemically significant entities, it should be clear and transparent in disclosing the criteria upon which it seeks to include a specific market participant. Second, all companies that perform systemically significant functions should be regulated. The regulator should have the authority to examine and discipline market players such as credit rating agencies and financial guarantors, based on the importance of the integrity of their functions to the entire financial system. Third, the regulator should have the authority to follow the activities of systemically important entities regardless of where in the entity that activity takes place. No matter where the activity takes place in a corporation, regulators should be allowed to look into those activities. This point speaks against assigning regulators specific discrete parts of entities to cover and for an evolution of functional regulation. Fourth, as complexity of corporate structures and financial products intensifies, so, too should regulatory scrutiny. Greater regulatory scrutiny should be borne by complex enterprises--not just in the sense of adding additional functional regulation for each new piece of a diversified company but also in the sense of materially increasing the federal regulatory oversight exercised by any new systemic regulator. Entities should come under the ambit of a systemic regulator based upon the complexity, opacity, and system-wide interdependent nature of the instruments that they underwrite, produce, deal in or invest. Fifth, there should be greater scrutiny based upon the ``Triple Play''--being an originator, underwriter/securitizer, investor in the same asset. Greater regulatory scrutiny should be borne by those entities that endeavor to achieve the trifecta: that is, to own the ``means of production'' of an asset, to act as a dealer in financial instruments created from those assets, and to be a direct investor in those instruments or assets. In other words, if a company were a mortgage originator, a dealer in mortgage-backed securities, and an investor for its own account in mortgage-backed securities, that ``triple play'' would trigger oversight by the systemic regulator not only of the individual activities but also the management of the inherent conflicts of interest between those vertically integrated pieces. Sixth, and above all, a systemic risk regulator must enforce transparency and practice it. The regulatory structure should include reviews of how accurately entities make required disclosures of their true financial condition to their shareholders and/or counterparties and investors. The regulator, too, must be transparent; it should annually disclose the entities under its regulatory umbrella and the reason for their inclusion. The regulator should be accountable to Congress and the public. Although the markets alone are not up to the task of identifying and containing systemic risk, it is also the case that the government alone is not up to the task. The combined efforts of government regulators and market discipline brought about by transparent disclosure of risks are needed in any plan for future operation of our financial markets. Further, consideration should be given to modeling disclosure of regulatory or enforcement activity on those of the SEC or CFTC, rather than some of the other, more opaque, federal regulatory agencies.IV. Hedge Funds and Functional Regulation Private investment companies of all types play significant, diverse roles in the financial markets and in the economy as a whole. Venture capital funds, for instance, are an important source of funding for start-up companies or turnaround ventures. Other private equity funds provide growth capital to established small-sized companies, while still others pursue ``buyout'' strategies by investing in underperforming companies and providing them with capital and/or making organizational changes to improve results. These types of funds may focus on providing capital in the energy, real estate, and infrastructure sectors. Hedge funds trade stocks, bonds, futures, commodities, currencies, and a myriad of other financial instruments on a global level. These flexibly structured pools of capital provide substantial benefits to their investors and to the markets more broadly in terms of liquidity, efficiency, and price discovery. In addition, they are a potential source of private investment to participate with the government in addressing the current financial crisis. \12\ It, therefore, is in all of our interests that private investment funds continue to participate in our financial markets.--------------------------------------------------------------------------- \12\ United States Department of the Treasury, Fact Sheet: Public-Private Investment Program (Mar. 23, 2009) (available at http://www.treas.gov/press/releases/reports/ppip_fact_sheet.pdf).--------------------------------------------------------------------------- While it often is said that private investment companies are ``unregulated,'' they are, in fact, subject to a range of securities antifraud, antimanipulation, \13\ margin, \14\ and other trading laws and regulations that apply to other securities market participants. \15\ They also are subject to SEC enforcement investigations and subpoenas, as well as civil enforcement action and criminal prosecution if they violate the federal securities laws. However, private investment companies and their advisers are not required to register with the SEC if they comply with the conditions of certain exemptions from registration under the Investment Company Act of 1940 (the ``Investment Company Act'') and the Investment Advisers Act of 1940 (``Advisers Act''). \16\ Congress created exemptions under these laws because it determined that highly restrictive requirements of laws designed to regulate publicly offered mutual funds and investment advisers to retail investors were not appropriate for funds designed primarily for institutions and wealthy investors.--------------------------------------------------------------------------- \13\ See Section 10(b) of the Securities Exchange Act of 1934 (Exchange Act) (15 U.S.C. 78j) and Rule 10b-5 thereunder (17 C.F.R. 240.10b-5). \14\ 12 C.F.R. 220, 221, 224. \15\ See, e.g., Exchange Act 13(d), 13(e), 14(d), 14(e) and 14(f) (15 U.S.C. 78m(d), 78m(e), 78n(d), 78n(e) and 78n(f)) and related rules (which regulate and require public reporting on the acquisition of blocks of securities and other activities in connection with takeovers and proxy contests). \16\ Section 3(c)(1) of the Investment Company Act excludes a company from the definition of an ``investment company'' if it has 100 or fewer beneficial owners of its securities and does not offer its securities to the public. Under the Securities Act of 1933 and SEC rules, an offering is not ``public'' if it is not made through any general solicitation or advertising to retail investors, but is made only to certain high-net-worth individuals and institutions known as ``accredited investors.'' ``Accredited investors'' include banks, broker-dealers, and insurance companies. The term also includes natural persons whose individual net worth or joint net worth with a spouse exceeds $1 million, and natural persons whose individual income in each of the past 2 years exceeds $200,0000, or whose joint income with a spouse in each of the past 3 years exceeds $300,000, and who reasonably expect to reach the same income level in the current year. Section 3(c)(7) of the Investment Company Act excludes a company from the definition of an ``investment company'' if all of its securities are owned by persons who are ``qualified purchasers'' at the time of acquisition and if the Company does not offer its securities to the public. Congress added this section to the Investment Company Act in 1996 after determining that there should be no limit on the number of investors in a private investment fund, provided that all of such investors are ``qualified purchasers.'' In brief, ``qualified purchasers'' must have even greater financial assets than accredited investors. Generally, individuals that own not less than $5 million in investments and entities that own not less than $25 million in investments are qualified purchasers. Section 203(b)(3) of the Advisers Act exempts from registration any investment adviser that, during the course of the preceding twelve months has had fewer than fifteen clients and that does not hold itself out as an investment adviser nor act as an investment adviser to any investment company. Advisers to hedge funds and other private investment companies are generally excepted from registration under the Advisers Act by relying upon Section 203(b)(3), because a fund counts as one client. In some cases, where these companies and their advisers engage in trading commodity futures, they also comply with exemptions from registration under the ``commodity pool operator'' and ``commodity trading advisor'' provisions of the Commodity Exchange Act (``CEA''). These exemptions generally parallel the exemptions from registration under the securities laws.--------------------------------------------------------------------------- To date, legislative proposals to regulate private investment companies have been directed at removing the exemptions from regulation of private investment companies under the Investment Company Act and Advisers Act and thus subjecting private investment companies to the requirements of those Acts. But, for policy makers who believe private investment companies and their managers should be subject to greater federal oversight, I would argue that simply eliminating the exemptions in either or both of these statutes will prove unsatisfactory. \17\--------------------------------------------------------------------------- \17\ In my testimony before the SEC's public roundtable on hedge funds in 2003, I recommended that, as a further condition to exemption under the Advisers Act, hedge funds should be subject to specific standards relating to investor qualifications, custody of fund assets (an issue on which there now is significant focus as a result of the Madoff scandal), annual audits and quarterly unaudited reports to investors, clear disclosure of financial arrangements with interested parties (such as the investment manager, custodian, prime broker, and others--in order to address conflicts issues), clear disclosure of investment allocation policies, and objective and transparent standards for valuation of fund assets that are clearly disclosed, not stale, and subject to audit. Statement of James Chanos, President, Kynikos Associates, SEC Roundtable on Hedge Funds (May 15, 2003) (available at http://sec.gov/spotlight/hedgefunds/hedge-chanos.htm). When I testified before this Committee in 2004, I expanded upon these points and recommended that the SEC require, as a condition to a hedge fund's exemption under the Advisers Act, that hedge funds file basic information with the SEC and certify that they met the standards outlined above. Testimony before the Senate Committee on Banking, Housing and Urban Affairs, Hearing on Regulation of the Hedge Fund Industry (Jul. 15, 2004) (available at http://banking.senate.gov/public/index.cfm?FuseAction=Hearings.Hearing&Hearing_ID=79b80b77-9855-47d4-a514-840725ad912c). See also Letter from James Chanos to Jonathan Katz, SEC (Sept. 15, 2004) (available at http://www.sec.gov/rules/proposed/s73004/s73004-52.pdf). This would have provided the SEC with hedge fund ``census'' data it has long said it needs; it also would have provided a basis for SEC enforcement action against any fund failing to meet the above standards. Had the SEC adopted this recommendation, the agency would have avoided the legal challenge to the rule it adopted later that year to change its interpretation of the term ``client'' under the Advisers Act in order to require hedge fund managers to register. See Goldstein v. SEC, 451 F.3d 873 (D.C. Cir. 2006). As this Committee knows, the SEC's hedge fund adviser registration rule was struck down in 2006, (id.) and the SEC decided not to appeal. Some hedge fund managers that had registered with the SEC under the rule withdrew their registrations. I decided that my firm should remain registered as an investment adviser (which we are still today), but, as I testified in 2006 before this Committee, the Advisers Act is ``an awkward statute for providing the SEC with the information it seeks . . . and for dealing with the broader issues that are outside the Act's purposes.'' Testimony of James Chanos, CPIC, before the Senate Committee on Banking, Housing and Urban Affairs, Subcommittee on Securities and Investment; Hearing on the Hedge Fund Industry, at 7 (available at http://banking.senate.gov/public/--files/ACF82BA.pdf).--------------------------------------------------------------------------- The first lesson we all learned in shop class is you need to use the right tool for the job. Although you can use a pipe wrench to pound in a nail, or a claw hammer to loosen up a pipe, it is not a good idea to do so. Neither the Investment Company Act nor the Advisers Act is the right tool for the job of regulating hedge funds and other private investment companies. They do not contain the provisions needed to address the potential risks posed by the largest large private investment companies, the types of investments they hold, and the contracts into which they enter. At the same time, those laws each contain provisions designed for the types of businesses they are intended to regulate--laws that would either be irrelevant to oversight of private investment companies or would unduly restrict their operation. If Congress determines that legislation is needed, I believe a more tailored and targeted law should be drafted in order to address current public policy concerns about investor protection and systemic risks. Yet, Congress should avoid trying to shoehorn private investment companies into laws designed for retail investors. For example, the Investment Company Act and Advisers Act are designed purely for investor protection, and have no provisions designed to protect counterparties or to control systemic risk. Similarly, these acts are generally silent on methods for winding down an investment fund or client account, an area which the law should address in some detail for large private investment companies. Further, the Advisers Act custody provisions exclude certain types of instruments that are commonly owned by private investment funds, an exclusion that would deprive investors in those funds of the protection that a custody requirement provides. At the same time, many requirements of the Investment Company Act and the Advisers Act are irrelevant, or would be counterproductive, if applied to private investment companies. For example, current restrictions on mutual funds from engaging in certain types of transactions, such as trading on margin and short selling, would severely inhibit or foreclose a number of hedge fund trading strategies that are fundamental to their businesses and the markets. \18\ As another example, requirements for boards of directors imposed by the Investment Company Act and compensation restrictions imposed by the Advisers Act are not particularly well suited to the regulation of managers of investment pools with high net worth and institutional investors. Such investors are fully capable of understanding the implications of performance-based fees, and do not need regulatory attention to protect themselves. Likewise, client-trading restrictions under the Advisers Act that require client consent on a transaction-by-transaction basis are unduly burdensome for private fund management. In sum, the Investment Company Act and Advisers Act, which were adopted in largely their current forms in 1940, are not well suited to being adapted for a new use in regulating investment structures and strategies developed primarily over the last 20 years.--------------------------------------------------------------------------- \18\ For example, convertible bond arbitrage relies on selling short the underlying equity security while buying the bond. This strategy provides an essential support for the convertible bond market, upon which many corporations rely for capital.--------------------------------------------------------------------------- Congress should think carefully as it considers the right tool for the task of regulating private investment companies. In my view, whatever legislation is developed should contain targeted controls and safeguards needed to provide appropriate oversight for the regulation of such entities, yet retain the flexibility of their operations. Congress may wish to consider more detailed requirements on large private investment companies (or families of private investment companies) in order to address the greater potential for systemic risk posed by such funds, depending upon their use of leverage and their trading strategies. Congress also may wish to consider giving legal effect to certain measures that were identified as ``best practices'' for fund managers in a report issued earlier this year by the Asset Managers' Committee (``AMC Best Practices'')--a group on which I served at the request of the President's Working Group on Financial Markets. \19\ For example, one of the most important of these recommendations is that managers should disclose more details--going beyond Generally Accepted Accounting Standards--regarding the portion of income and losses that the fund derives from Financial Accounting Standard (FAS) 157 Level 1, 2, and 3 assets. \20\ Another recommendation is that a fund's annual financial statements should be audited by an independent public accounting firm that is subject to PCAOB oversight. Still another recommendation would assure that potential investors are provided with specified disclosures relating to the fund and its management before any investment is accepted. This type of information should include any disciplinary history and pending or concluded litigation or enforcement actions, fees and expense structure, the use of commissions to pay broker-dealers for research (``soft dollars''), the fund's methodology for valuation of assets and liabilities, any side-letters and side-arrangements, conflicts of interest and material financial arrangements with interested parties (including investment managers, custodians, portfolio brokers, and placement agents), and policies as to investment and trade allocations.--------------------------------------------------------------------------- \19\ Report of the Asset Managers' Committee: Best Practices for the Hedge Fund Industry (January 15, 2009) (available at http://www.amaicmte.org/Asset.aspx). \20\ In brief, under FAS 157, Level 1 assets are those that have independently derived and observable market prices. Level 2 assets have prices that are derived from those of Level 1 assets. Level 3 assets are the most difficult to price--theirs are derived in part by reference to other sources and rely on management estimates. Disclosure of profits and losses from these categories will allow investors to better assess the diversification and risk profile of a given investment, and to determine the extent to which fund valuations are based on the ``best guess'' of fund management.--------------------------------------------------------------------------- Congress also should require safeguards that I have advocated for many years--simple, common-sense protections relating to custody of fund assets and periodic audits. As I mentioned earlier, there are areas of importance to the financial system that the Investment Company Act and Advisers Act do not address, including counterparty risk, lender risk, and systemic risk. These types of issues can be addressed through required disclosures to regulators and to counterparties. Of course, Congress also will need to choose a regulator, and since the SEC already has regulatory responsibility over publicly-offered funds, the SEC is the logical choice. If Congress decides to establish an overall systemic risk regulator, that regulator also may have a role in overseeing the largest, systemically important funds.V. Hedge Funds as Financial Investors One of the most important roles that hedge funds play in our economy is that of investor. Perhaps no other role played by hedge funds and other private investment vehicles, like venture capital funds, is more important to a return to economic growth than this one. From the point of view of an investor that provides capital to corporations by buying equity or debt, or of a potential purchaser of asset-backed securities in the secondary market, certain principles will be essential to encouraging investment in products that do not carry an explicit government and taxpayer guarantee against loss. One key principle is a generally accepted and respected valuation of assets. Mark-to-market (``MTM'') accounting is not perfect, but it does provide a compass for investors to figure out what an asset would be worth in today's market if it were sold in an orderly fashion to a willing buyer. Before mark-to-market accounting took effect, the Financial Accounting Standards Board (FASB) produced much evidence to show that valuing financial instruments and other difficult-to-price assets by ``historical'' costs, or ``mark to management,'' was folly. The rules now under attack are neither as significant nor as inflexible as critics charge. Mark-to-market accounting is generally limited to investments held for trading purposes, and to certain derivatives. For many financial institutions, these investments represent a minority of their total investment portfolio. For example, Bloomberg columnist David Reilly reports that of the 12 largest banks in the KBW Bank Index, only 29 percent of the $8.46 trillion in assets are at MTM prices. \21\--------------------------------------------------------------------------- \21\ David Reilly, Elvis Lives and Mark to Market Rules Fuel Crisis (Mar. 11, 2009), Bloomberg (available at http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aD11FOjLK1y4). ``Of the $8.46 trillion in assets held by the 12 largest banks in the KBW Bank Index, only 29 percent is marked to market prices, according to my analysis of company data. General Electric Co., meanwhile, said last week that just 2 percent of assets were marked to market at its General Electric Capital Corp. subsidiary, which is similar in size to the sixth-biggest U.S. bank. What are all those other assets that aren't marked to market prices? Mostly loans--to homeowners, businesses and consumers. Loans are held at their original cost, minus a reserve that banks create for potential future losses. Their value doesn't fall in lockstep with drops in market prices. Yet these loans still produce losses, thanks to the housing meltdown and recession. In fact, bank losses on unmarked loans are typically bigger than mark-to-market losses on securities like bonds backed by mortgages.''--------------------------------------------------------------------------- Why is that so? Most bank assets are in loans, which are held at their original cost using amortization rules, minus a reserve that banks must set aside as a safety cushion for potential future losses. MTM rules also give banks a choice. MTM accounting is not required for securities held to maturity, but you need to demonstrate a ``positive intent and ability'' that you will do so. Further, an SEC 2008 report found that ``over 90 percent of investments mark-to-market are valued based on observable inputs.'' \22\--------------------------------------------------------------------------- \22\ SEC, Office of the Chief Accountant, Report and Recommendations Pursuant to Section 133 of the Emergency Economic Stabilization Act of 2008: Study on Mark-To-Market Accounting (available at: http://www.sec.gov/news/studies/2008/marktomarket123008.pdf). The report concludes: ``The Staff observes that fair value accounting did not appear to play a meaningful role in bank failures occurring during 2008. Rather, bank failures in the U.S. appeared to be the result of growing probable credit losses, concerns about asset quality, and, in certain cases, eroding lender and investor confidence. For the failed banks that did recognize sizable fair value losses, it does not appear that the reporting of these losses was the reason the bank failed.'' At 4.--------------------------------------------------------------------------- Obfuscating sound accounting rules by gutting MTM rules will only further reduce investors' trust in the financial statements of all companies, causing private capital--desperately needed in securities markets--to become even scarcer. Worse, decreased clarity will further erode confidence in the American economy, with dire consequences for many of the financial institutions who are calling for MTM changes. Greater transparency is also necessary in the over-the-counter derivatives markets. These markets play a critical role in the establishment of prices in almost every public or regulated market, from determining interest rates to share prices. Reducing the need for reliance on a few opaque counterparties, increasing regulatory access to price and volume and other transactional information, and fostering integrity in the price discovery function for OTC products that affect the borrowing costs of individual companies, are all objectives that should be aggressively pursued as part of this Committee's modernization of our financial regulatory structure.VI. Conclusion Honesty and fair dealing are at the foundation of the investor confidence our markets 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 policy makers to achieve that difficult but necessary goal. ______ CHRG-111shrg56376--208 Chairman Dodd," Let the word go forth from all of this. Senator Corker, any---- Senator Corker. No. I think you have just given evidence as to where the real political clout is. [Laughter.] Senator Corker. I referred earlier to sot of a super-OCC, and I realize it is sort of that, what you are proposing. As we have looked at the resolution mechanisms that need to be in place so that we don't have the same kind of problem, I think we all understand part of the reason we had the problems we had was there was no resolution mechanism for highly complex bank holding entities and one of the only solutions was to prop them up artificially. So the OCC has argued strongly to keep in place the ability to use taxpayer monies to prop up institutions that fail. The FDIC, on the other hand, has argued strongly against that. I happen to have fallen on their side of the equation and think that having any institution that is too big to fail creates tremendous problems, and I really appreciate what Paul Volcker has said about that recently. But hand-in-hand with this is the notion of how we resolve--in other words, we have the regulator--how we resolve that. You all have already made a great case for this type of arrangement that you want to have. I don't think there is any point in going down that path anymore. I understand what it is you would like to see happen. But what should we do as a it relates to a resolution mechanism and how should that be set up? " CHRG-110hhrg41184--101 Mr. Bernanke," Well, we do work with the SEC and the accounting board and FASB and others to make sure that the accounting rules are followed, and I know they're being looked at and revised to try to increase disclosure. The Basel II Capital Accord also has a Pillar 3, which is about disclosure. So more disclosure is on the way and is a good thing. And we continue to encourage banks and other institutions to provide as much information as they can to investors, and I think that's a very constructive step to take. It's not the whole answer, though, at this point. Relatively simple instruments like prime jumbo mortgages, for example, are not selling on secondary markets, less because of complexity and more just because of uncertainty about their value in an uncertain economy. " CHRG-111shrg55739--3 STATEMENT OF SENATOR RICHARD C. SHELBY Senator Shelby. Thank you, Mr. Chairman. The nature of today's credit rating industry reflects decades of regulatory missteps rather than market preferences. Over the years, the Government granted special regulatory status to a small number of rating agencies and protected those firms from potential competitors. Beginning in 1975, the Securities and Exchange Commission began embedding NRSRO ratings into certain key regulations. Once credit ratings acquired regulatory status, they crept into State regulations and private investment guidelines. The staff of the SEC controlled access to the prized National Recognized Statistical Rating Organization, or NRSRO, designation by subjecting potential entrants to a vague set of criteria and an incredibly slow timeline. The SEC did little to oversee the NRSROs once so designated. Nevertheless, because of the doors they open, ratings from an NRSRO became an excuse for some investors to stop doing their own due diligence that Senator Dodd alluded to. Widespread overreliance on ratings meant that the effects of poor quality or inadequately updated ratings could ripple through the markets. By encouraging reliance on a small number of big credit rating agencies, bureaucrats at the SEC exposed the economic system to tremendous risk. Our current financial crisis, which was caused in part by the credit rating agencies' failure to appreciate the risk associated with complex structured products, demonstrates just how big that systemic risk was. The troubles caused by the SEC's flawed regime, however, did not come as a surprise. Several years ago, when I was Chairman of this Committee, we acted to address the problem after the SEC failed to take action on its own. I felt then that the industry's heavy concentration and high profits were symptoms of an industry in serious need of reform. We then passed the Credit Rating Agency Reform Act of 2006, as Senator Dodd mentioned. The act set forth clear standards for the NRSRO application process. It also gave the SEC authority to regulate disclosures and conflicts of interest, as well as unfair and abusive practices. Unfortunately, the law we passed in 2006 did not have time to take root before the problems that they were intended to remedy took their toll. The SEC adopted rules pursuant to that legislation in June of 2007. Over the following months, the number of NRSROs doubled, just as the performance of many highly rated subprime securities revealed that such securities were not as safe as the rating agencies said they were. Today, we will consider a legislative proposal by the Administration and others to revisit the regulation of credit rating agencies. In determining whether new legislative steps are required, I believe we should keep in mind that the 2006 reforms are still working their way through the system. That does not mean, however, that we should not consider further changes. Every option should be on the table. One option is to remove rating mandates from regulations. Another is materially improving disclosure. As with any regulatory reform, however, we must also be mindful of unintended consequences. I strongly believe that the credit rating agencies played a pivotal role in the collapse of our financial markets. Any regulatory reform effort must take that into consideration, and I believe we will. Thank you, Mr. Chairman. " 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-111hhrg51698--442 Mr. Short," I would just like to add one comment. I do think Mr. Masters is right that the original focus of position limits in the Commodity Exchange Act in its original form was to protect farmers who were growing their crops and needed to hedge. But it is an interesting question depending on which side of the table you happen to be on, as far as being a net producer or a net consumer of something. I would just ask people to contemplate global oil. We produce very little global oil in this country. We are a massive consumer of it. If you really want to have the producers setting the price, aren't you giving the fox the keys to guard the henhouse? Speculators keep those prices in line. And it is a more complex question than just saying that we need to hand it back over to the physical side of the market. " CHRG-110hhrg46594--229 Mr. Gettelfinger," Well, I think what we do, if we look back at the conclusion of negotiations last year and, as Mr. Wagoner pointed out earlier, and look at the value of their stock then, which was over $42, it begs the question, why is the stock where it is at today? And you look at the subprime mortgages, you look at the stock market, you look at what has happened across the board to our economy, this major downturn. I am not one right here who is focused on reflecting where the problem originated in the past. I think that we have to focus on where we are at now, look at the improvements that have been made, look at the innovation that is under way, and look at the direction that we are trying to go in. And I am not bashful to criticize this management. Every one of them will tell you privately that our union tells them exactly what we think. And, to me, I sat here with glee at some of the comments that were made to them, because I am sure it echoes what they have already heard from us. So I am not here focused on that. I am focused on the bigger picture, which is what happens if this industry goes down and the spiral effect. And I just noticed here, on these companies, the number of parts that they buy compared to the foreign brands that are manufactured here, and what it would mean if it would just cut back. If they just cut back to the content of the manufacturers that are here today, it would create a loss of thousands of jobs. So this is an important industry to our country, and that is why we are here standing with them on behalf of our membership to appeal to Congress to give this the most serious consideration possible. " FOMC20050630meeting--145 143,MS. MINEHAN.," Thank you, Mr. Chairman. I also want to thank the authors of the papers—the international paper as well as all of the papers that were talked about today—because I found them very helpful and reassuring, along the lines that Michael Moskow was discussing. I also thought that Janet’s comments on the financial innovations were insightful. Despite the fact that it’s hard to sort out the U.S. experience vis-à-vis other countries, the whole point of this—to me anyway—is that we’re seeing a phenomenon in the housing markets. So the question is: Do the June 29-30, 2005 50 of 234 terms of changes in the fundamentals. So, to the extent that they’ve made many of the transactions in the housing market easier to do, that has to have had some impact on the underlying asset prices. So I thought that argument was a very interesting one, and it will be interesting to see if there is any way one can tease out the effects of that. My second point is that when you look at the relationship between rising prices on either the OFHEO or the constant-quality index against disposable income as opposed to median household income, you see an even more reassuring chart. And I would think there’s at least a little bit of logic to doing that, based on Dick Peach’s chart about the differences in house-price acceleration depending on income—with the value of higher-priced houses moving up faster than lower-priced houses. So I would think that there is some logic to looking at this with disposable income. I know that you have done those charts. I think we have every chart you could do! [Laughter] But it is interesting that one sees in that perspective somewhat less acceleration and a somewhat more reassuring picture. Finally, and this is more of a question, we talked about a 20 percent decline in house prices and what that would do in terms of the basic macroeconomic effects of it. But, of course, that wouldn’t happen overnight. Something would make it happen. And, as we consider our current policy stance, one of the conundrums—though I hate to use that word—is why haven’t the 10-year yield and, therefore, mortgage interest rates, taken the same upward path as rates at the short end of the curve. So a question I was asking myself—and I think it’s probably not so difficult to figure this out—was where the point is, as mortgage rates start to go up, when we look at that affordability curve and start to worry about households beginning to get into trouble. That would then have an impact on house prices. Obviously, higher interest rates would tend to level house prices off or take June 29-30, 2005 51 of 234 house that they’re in. How far do interest rates have to go up before that affordability curve starts to move in the direction that causes a problem in that regard?" 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-111shrg55739--140 PREPARED STATEMENT OF SENATOR RICHARD C. SHELBY Thank you, Mr. Chairman. The nature of today's credit rating industry reflects decades of regulatory missteps rather than market preferences. Over the years, the Government granted special regulatory status to a small number of rating agencies and protected those firms from potential competitors. Beginning in 1975, the Securities and Exchange Commission began embedding NRSRO ratings into certain key regulations. Once credit ratings acquired regulatory status, they crept into State regulations and private investment guidelines. The staff of the SEC controlled access to the prized ``nationally recognized statistical rating organization'' or NRSRO designation by subjecting potential entrants to a vague set of criteria and an incredibly slow time line. The SEC did little to oversee NRSROs once so designated. Nevertheless, because of the doors they opened, ratings from an NRSRO became an excuse for some investors to stop doing their own due diligence. Widespread overreliance on ratings meant that the effects of poor quality or inadequately updated ratings could ripple through the markets. By encouraging reliance on a small number of big credit rating agencies, bureaucrats at the SEC exposed the economic system to tremendous risk. Our current financial crisis, which was caused in part by the credit rating agencies' failure to appreciate the risks associated with complex structured products, demonstrates just how big that systemic risk was. The troubles caused by the SEC's flawed regime, however, did not come as a surprise. When I was Chairman of this Committee, we acted to address the problem after the SEC failed to take action on its own. I felt that the industry's heavy concentration and high profits were symptoms of an industry in serious need of reform. We then passed the Credit Rating Agency Reform Act of 2006. The Act set forth clear standards for the NRSRO application process. It also gave the SEC authority to regulate disclosures and conflicts of interest, as well as unfair and abusive practices. Unfortunately, the law that we passed in 2006 did not have time to take root before the problems that they were intended to remedy took their toll. The SEC adopted rules pursuant to that legislation in June of 2007. Over the following months, the number of NRSROs doubled, just as the performance of many ``highly rated'' subprime securities revealed that such securities were not as safe as the rating agencies said they were. Today, we will consider a legislative proposal by the Administration to revisit the regulation of credit rating agencies. In determining whether new legislative steps are required, we should keep in mind that the 2006 reforms are still working their way through the system. That doesn't mean, however, that we shouldn't consider further changes. Every option should be on the table. One option is to remove rating mandates from regulations. Another is materially improving disclosure. As with any regulatory reform, however, we must also be mindful of unintended consequences. I strongly believe that the credit rating agencies played a pivotal role in the collapse of our financial markets. Any regulatory reform effort must take that into consideration. Thank you, Mr. Chairman. ______ CHRG-109hhrg22160--246 Mr. Greenspan," The issue of education is so critical to this that it overwhelms, in my judgment, all alternate policies to address this issue. Now, you have to include in education, obviously, on-the-job training, even education which is not even formal. And the essential reason is that what makes our country competitive is in my judgment two things. One, it is our Constitution, which creates a rule of law which people want to invest in. And two, it is what is in the heads of our children, because they are the future of the people who will staff our increasingly complex capital stock. I am not sure what else there is to do, because the job is very large in the issue of education and I would not divert resources to anything other than that, if the purpose is to address and resolve this particular issue. " 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-111shrg54589--19 Chairman Reed," Thank you very much. This is an issue of great complexity and great importance, and so this is the beginning of a process, I think, not the conclusion of one, in trying to determine what Congress must do and will do to provide adequate regulation for a complicated part of our financial markets. Let me begin by saying that one aspect that we have to get right is to cover the whole waterfront, if you will, to make sure that there are no gaps, that there is an effective and efficient way to do this, and I wonder if all of you in turn could give your comments about how we ensure there is a comprehensive approach, that we don't create these areas where there is an opportunity to operate outside of the framework. We will start with Chairman Schapiro. Ms. Schapiro. Thank you very much, Mr. Chairman. I agree with you completely that it is really important that as we seek to solve the existing gaps, we not create any additional ones. So I think there are several mechanisms for that. The first is to encourage and use the tools like capital and margin, standardization and central clearing, to the greatest extent possible and even encourage exchange trading of currently OTC derivatives. That will give us, as Chairman Gensler said, some control over the stage and it will allow us to have a centralized view of what is happening in these markets and the benefits of capital and margin requirements with respect to those institutions. But it is also critically important that we have regulation of the dealers who participate in the marketplace, meaning, in my view, registration, capital requirements, margin requirements, record keeping, reporting to regulators, reporting at least aggregated information to the public, and very tight risk management processes within the dealers, including governance, risk controls, trading limits, all of the things we would normally think about as being important for dealers to control the risks that they are undertaking. I also think that whether we have a systemic risk regulator at the end of this process or a council or a combination as in the Administration proposals, it will be very important for the regulators to share as much information on a continuing basis as possible so that as new products are being developed, and I am sure that as we sit here, somebody is developing a new product that perhaps falls between the regulators' current authorities, that we know about those products as quickly as possible, understand their implications for the system, and bring them under the Federal regulatory umbrella, either by moving that into a central clearinghouse or exchange platform or through the regulation of the dealers who participate in those transactions on a bilateral basis. " CHRG-111shrg52966--4 Mr. Long," Chairman Reed, Ranking Member Bunning, 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 views on risk management and the role it plays in banks we supervise, the weaknesses and gaps that we have identified in risk management practices and the steps we are taking to address those issues, and how we supervise risk management at the largest national banks. Recent events have revealed a number of weaknesses in banks' risk management processes that we in the industry must address, and we are taking steps to ensure this happens. More importantly, these events have reinforced that even the best policy manuals and risk models are not a substitute for a strong corporate governance and risk management culture, a tone and approach to business that must be set at the top of the organization and instilled throughout the company. While risk management practices are legitimately the focus of much current attention, risk management is hardest when times are good and problems are scarce. It is in those times when bank management and supervisors have the difficult job of determining when accumulating risks are getting too high and that the foot needs to come off the accelerator. These are never popular calls to make, but in retrospect, we and bankers erred in not being more aggressive in addressing our concerns. However, we must also not lose sight that banks are in the business of managing financial risks. Banks must be allowed to compete and innovate, and this may at times result in a bank incurring losses. The job of risk management is not to eliminate risk, but to ensure that those risks are identified and understood so that bank management can make informed choices. Among the lessons we have learned are: Underwriting standards matter, regardless of whether the loans are held or sold. Risk concentrations can excessively accumulate across products and business lines. Asset-based liquidity is critical. Back-room operations and strong infrastructure matters. And robust capital and capital planning are essential. As described in my written testimony, we are taking steps to address all of these issues. Because the current problems are global in nature, we are working closely with my colleagues here and internationally. Critical areas of focus are on improved liquidity risk management, stronger enterprise-wide risk management, including rigorous stress testing, and further strengthening the Basel II capital framework. Risk management is a key focus of our large bank supervision program. Our program is organized with a national perspective. It is centralized and headquartered in Washington and structured to promote consistent and uniform supervision across the banking organizations. We establish core strategic objectives annually based on emerging risks. These objectives are incorporated into the supervisory strategies for each bank and carried out by our resident onsite staff with assistance from specialists in our Policy and Economics Unit. Examination activities within a bank are often supplemented with horizontal reviews across a set of banks. This allows us to look at trends not only within but across the industry. Throughout our resident staff, we maintain an ongoing program of risk assessment and communication with bank management and the board of directors. Where we find weaknesses, we direct management to take corrective action. For example, we have directed banks to make changes in personnel and organizational structures to ensure that risk managers have sufficient stature and ability to constrain business activities when warranted. Through our examinations and reviews, we have directed banks to be more realistic about recognizing credit risks, to improve their valuation techniques for certain complex transactions, to aggressively build loan loss reserves, to correct various risk management weaknesses, and to raise capital as market opportunities permit. Finally, the Subcommittee requested the OCC's views on the findings that Ms. Williams from the GAO will be discussing with you today. Because we only recently received the GAO's summary statement of findings, we have not had an opportunity to review and assess their full report. We take the findings from GAO very seriously, and we would be happy to provide the Subcommittee with a written response to this report once we receive it. My preliminary assessment based on the summary we were provided is that the GAO raised a number of legitimate issues, some of which I believe we are already addressing; and others, as they pertain to the OCC, may require further action on our part. Thank you, and I will be happy to answer questions you may have. Senator Reed. Thank you. Mr. Polakoff, please. STATEMENT OF SCOTT M. POLAKOFF, ACTING DIRECTOR, OFFICE OF FinancialServicesCommittee--13 So it is important that we listen to you: The Securities and Ex- change Commission, you have to make it work; the Commodities Trading Commission; NASDAQ; the Chicago Mercantile Exchange; and, of course, the New York Stock Exchange. But we have a very complex system. We have nearly 50 markets. We have hundreds of millions of computers that are making these sales in megaseconds, far outpacing our human capacity to deal with it. If we do get the circuit breaker concept, we have to make sure how that is going to work. Will it do the job? What is impor- tant here is to move carefully and thoughtfully to get the right cor- rection to this problem. The American investors and the world in- vestors are depending on us. Chairman K ANJORSKI . Thank you, Mr. Scott. We will now hear from Mr. Perlmutter for 2 minutes. Mr. P ERLMUTTER . Thank you, Mr. Chairman. I just would like to remind the committee and the panelists that in the financial re- form bill that we passed to the Senate, we were sort of directed to this nanotrading high-frequency trading issue by some of our prior hearings; and there is a section of the bill, section 7304, asking the SEC and other regulators to take a look at high-frequency trading and its impact upon the markets. The good news is, it is in the bill. The bad news is that Thursday hit us before there was any action on the bill. I know that the regulators have been looking at this under their own authority, and I would encourage them to continue to do this. I am surprised by my friends on the other side of the aisle who question whether it is too early to look at this. We should be look- ing at this high-frequency trading; 5,000 trades per second, how do you manage something like that? That is the real question. In the blink of an eye, by a mistake or by an intentional act, whatever it might be, boom, this country lost $1 trillion over 20 minutes. My friends on the other side of the aisle complain about the spending and all this stuff by the Obama Administration; when, be- cause of failures in the market, because of sales and failure of the uptick rule, not having those kinds of things, we lost $17.2 trillion in the last 18 months of the Bush Administration. Since the Obama Administration has come in, we have gained about $6.5 trillion back. We lost $1 trillion last Thursday, and then have gained most of that back. There has to be a real good understanding of the algorithm-driv- en nanotrading that we have. It has benefits, Mr. Hensarling is right, the liquidity that it brings. But certainly if you were on the wrong side of that sale, you lost a lot of money, and we can’t have that in this system. I yield back, Mr. Chairman. Chairman K ANJORSKI . Now, the last presenter, Mr. Foster, for 2 minutes. Mr. F OSTER . Thank you. I want to thank the chairman for hold- ing this important and timely hearing. As a high-energy particle physicist, I spent many years program- ming and debugging large systems of high-speed digital logic com- puters. So the fact that large interconnected processing systems, in- dividually programmed by very smart individuals, exhibit complex and erratic behavior when they are simply thrown together, does not surprise me at all. However, the fact that these complex sys- tems are put in control of a large and important section of our economy, without sufficiently robust testing of their interoper- ability and immunity to coherent instabilities is an outrage. The absence of systemwide circuit breakers to limit the damage when a single element or set of elements malfunctions is indefen- sible, as is the absence of uniform legal clarity when it comes time to bust trades that have been made on a clearly erroneous basis. Part of the problem that we are facing is the mismatch between the time scales of human thought and machine action. While the logic of circuit breakers and market pauses to restore liquidity has been understood for decades, we see now that it must be imple- mented on a time scale of computer trading and it must be imple- mented uniformly across a wide variety of trading platforms. The race towards lower latencies and higher-speed trading shows no sign of abating. Startup companies are already developing trad- ing and matching engines based not on clusters of computer serv- ers, which will be too slow to compete, but on dedicated pipeline logic based on field-programmable data arrays that will typically perform a dedicated calculation 100 times faster than a dedicated computer processor. CHRG-111shrg55739--56 Mr. Barr," We looked at a range of models that had been proposed, from switching back to a full investor-pay model. We looked at the utility model that had been suggested. We looked at the roulette wheel model of using rating agencies that had been suggested. In our judgment, each of those suffered from some significant infirmities. If you used the utility model, for example, you are really just enshrining the rating agencies even more in the process and putting a Government seal of approval on them. If you use the roulette wheel model, you are reducing the incentives for meaningful competition and for better ratings. If you go fully to an investor-pay model, it is not obvious that the resulting conflicts are going to be, on balance, better. And so our judgment was, better to have a diversity of payment schemes out there. Let us have a level playing field with competition, but on the basis of serious high standards. And let us provide information that is given to one agency to all the agencies so that there is a chance for them to show that their competitor isn't good at doing a rating. Senator Merkley. Thank you. That is helpful, and I will have my team follow up to try to get a better understanding of the weaknesses of those other possibilities. We have in the structured products world very complex CDOs and CDO-squared that made it virtually impossible for anyone to determine the underlying foundation for what went into a CDO-squared, and by that I mean situations where you had BBB bonds that you dedicated 60 percent of the revenue and suddenly you had AAA bonds coming out of the BBB portfolio, et cetera. And yet you are so far removed from whether they were liar loans, whether the loans had been thoroughly vetted in terms of the income of the individual, et cetera--underwritten, if you will. So is there a level of complexity that should simply be banned in the interest of reducing systemic risk? Is there a level of slicing and dicing that gets to where you really cannot create--it is too messy, the path is too messy from the buyer back to the foundation that essentially they do not make sense to allow in the marketplace? " CHRG-111hhrg52400--7 Mr. Royce," Thank you, Mr. Chairman. And I would like to briefly thank Mr. Skinner for making this trip here to testify, and also congratulate him on his recent election. He has been a leader in the European Union and in Parliament. He has been a leader and champion of the Solvency II directive, which provides an important yet relevant example of an effort underway to create a more efficient regulatory structure. And yesterday's op ed in the Washington Post by Larry Summers and Tim Geithner noted the importance of international coordination among regulators, and reiterated the Administration's commitment to leading the effort to improve supervision around the world. Unfortunately, with our fragmented regulatory regime over insurance, we are lagging at this point; we are not leading the rest of the world. As Solvency II works to unite the insurance markets in 27 member countries in the EU, we continue, on the other hand, to struggle with a patchwork system of 50-plus State regulators. With the implementation of this directive nearing, it is becoming more apparent that the framework potentially will be at odds with the U.S. regulatory structure. It is unlikely that the EU would find the current U.S. State-based regulatory structure equivalent. This means the ability of our regulatory system to detect offshore risks will be weakened, and it also means that many of our U.S.-based institutions will be forced to shift significant operations overseas if they hope to continue to do business in the EU. Certainly, an office of insurance information would be a logical first step to address this, and to address other problems we face in the international insurance market. However, an OII would rely heavily on the various State insurance commissioners to implement the regulatory policies. Without strong pre-emptive authority over the States, the ability of an OII to enact policies nationwide--and, consequently, the ability of an OII to adequately represent the entire U.S. insurance market--would be greatly weakened. I remain concerned, however, that an OII will not go far enough. Maintaining solvency regulation at the State level will limit the effectiveness of a potential systemic risk regulator, as well as coordination efforts with foreign regulators. Certainly, noting the failure of AIG, once the Nation's largest insurer, is relevant, given the focus of today's hearing. Dating back to 2006, the Paulson Treasury Department noted systemic gaps in the State-based system, which AIG exploited. The blame for the collapse of the company should start with AIG. From a regulatory standpoint, there were failures at both the State and Federal level. Using capital from their insurance subsidiaries, with the approval of various State regulators, the securities lending division, in tandem with the financial products unit, put at risk the entire company and the broader financial system. Half of this came from the securities lending division, the other half from the financial products unit, in terms of the overleveraging. With more than 250 subsidiaries operating in 14 States and more than 100 countries, AIG is the poster child for both the need to open up lines of communication among regulators worldwide, and the need to establish a domestic insurance regulator with the ability to oversee these large and complex institutions. And again, Mr. Chairman, thank you for holding this hearing. " CHRG-110hhrg45625--28 Mr. Carson," Thank you, Mr. Chairman. First, let me salute you for your bold, courageous, and visionary leadership with regards to this matter. I come to this hearing on behalf of hardworking American taxpayers, not greedy corporate CEOs. It is taxpayer funding that we are using as collateral for this rescue package, not CEO bonuses, not investment bank revenues, but taxpayer funding. So if hard working American taxpayers are going to front the bill, then we better ensure that they reap the benefits. Tax subsidized corporate welfare must end. It is unbecoming, unjust, and unpatriotic. The American people are skeptical of this rescue package and with good reason. For years, they have seen Wall Street get bailed out while they were sold out. Over the last decade, deregulation rewarded the recklessly rich and penalized the pension dependent poor. Proponents of deregulation would have us believe that it is more important to reach out to America's struggling millionaires and billionaires, because according to them, they are the ones who have been left behind, not our small businesses, not our unemployed, and not our working families. The greed of Wall Street that flourished under these deregulation policies have now brought our economy to her knees. Leading financial institutions have collapsed. Home values have plummeted and thousands of Americans' jobs are at risk. So while it is important that we act, I urge that we proceed cautiously and responsibly. A knee-jerk reaction to a complex problem will only prolong the instability in our markets, not curtail it. Again, thank you for your bold leadership in this matter, Mr. Chairman. I yield back the balance of my time. " CHRG-111hhrg54872--35 Mr. John," Thank you for having me. And it is a delight to be a part of this panel. I think we all agree on the problem. The area that I am going to disagree is the solution. I thoroughly agree that consumer regulation has been faulty and has been a cause of some, if not all, of the disruptions that we faced in the last year. I also agree that the various financial regulators have not given the consumer regulation the emphasis it needs. However, I believe that a far better approach would be to coordinate the consumer activities of existing State and Federal and financial regulators by creating a coordinating council designed to promote equal standards of consumer protection, using agencies' existing powers and perhaps additional powers passed by the States. Critics of the current regulatory system justified the need for a CFPA by citing instances where different agencies apply different regulatory standards to similar products, or fail to apply any standards at all. And they point to unregulated entities or products that took advantage of consumers. But these are problems that can just as easily be solved by a coordinating committee as they can by anything else. The council, which would be actually similar to your Consumer Financial Protection Oversight Board, in your most recent draft, would consist of one representative from each Federal agency, regulatory agency, and elected representatives from the councils of the various types of the State regulators. In addition, it would have a fully participating chairman appointed by the President, a board of outside experts who would monitor consumer regulatory activities and issue reports on that. Staffing would come from within the agencies, except for a very small support staff for the chairman and advisors. The inclusion of State regulators the council would make coverage even more universal than it would be under the proposed CFPA. Standards agreed to by the council would also apply to insurance companies, which are exempted from the CFPA approach, and as States move to license in the unregulated mortgage brokers and others who are often responsible for abuses in mortgage lending. Instead of a one-size-fits-all policy dictated by Washington, States would continue to have some flexibility in implementing regulations, subject to the oversight of the council and its expert advisors who would issue public statements and studies to make sure that consumers and legislators were aware of States with poor coverage or enforcement. Likewise, poor Federal agencies. The failure to act could make loans from State-regulated entities in those States that failed to work properly ineligible for securitization or sale to investors in other States. This approach would preserve State regulation of those entities that are currently State-regulated, rather than attempting to federalize all aspects of consumer financial relationships. The council would also include both the SEC and the CFTC, thus closing gaps in the CFPA, as proposed, including the regulation of retirement savings accounts, which are also becoming ever more complex and difficult for consumers to understand. The council would be responsible for developing broad standards for consumer regulation, while leaving the writing and enforcement of specific regulations to those agencies with responsibilities in that area. This ensures that the regulations would take into consideration the operational realities of regulated institutions as well as any special characteristics of regional markets. Another key advantage to the council is that by using existing regulators in their current authority, the regulators' individual efforts can be better monitored than the results of a proposed vast new bureaucracy with vague and almost unlimited powers. Through proper congressional oversight and reports from the new council's expert advisors, Congress and State legislators could better pinpoint successes and failures than it could by attempting to keep track of the efforts of one massive agency. I have proposed--there is a footnote on page 6 that a mechanism similar to the Uniform Commercial Code be used to recommend policies and specific regulatory and legal language to the individual States to ensure that the proper standards are kept and met. I believe that this approach would have a much better opportunity to solve some of the problems that have been raised here, and will be raised here later, than a proposed new agency. Thank you. [The prepared statement of Mr. John can be found on page 123 of the appendix.] " FOMC20080929confcall--56 54,MR. MADIGAN.," Thanks, Mr. Chairman. As the Chairman indicated, the TARP legislation includes a provision that accelerates the effective date of the authority to pay interest on reserves from October 1, 2011, to October 1, 2008. The Federal Reserve staff believes that we're ready to start paying interest on reserve balances beginning with the reserve maintenance period that starts on October 9. Assuming that the legislation is passed by the Congress and signed by the President later this week, we plan to recommend shortly thereafter to the Board that the Board direct the Reserve Banks to begin paying interest on reserves on October 9. Specifically, we plan to suggest that required reserve balances be remunerated at a rate of the target federal funds rate less 10 basis points, and more significantly in current circumstances, that excess reserve balances be remunerated initially at a rate of the target federal funds rate less 50 basis points. We anticipate that the spread between the excess reserves rate and the target federal funds rate may well need to be adjusted over time, but we're suggesting a 50 basis point spread initially. We're proposing no other significant changes to the reserve maintenance framework at this time, although we'll be recommending a few relatively technical changes that are motivated by the ability to pay interest on reserves. In more normal circumstances, we'd think of the system that we're recommending at this time as being a type of a corridor system but with required reserves. The primary credit rate should set the ceiling for the federal funds rate; the excess reserves rate should set the floor. In the current circumstances, though, it may turn out that the system will operate more like what we have been calling a floor system in which the gap between the target federal funds rate and the excess reserves rate is narrow. This is because, as was discussed earlier, our tools to absorb reserves provided by, again, various lending operations could be constrained given the limited remaining capacity to sell securities and possibly reluctance on the part of Treasury to expand further the supplementary financing program. In any case, the interest rate on excess reserves should put a floor-- possibly a soft floor, but a floor--under the funds rate and thereby allow the Federal Reserve to conduct monetary policy appropriately while providing liquidity consistent with financial stability. I would note that the overall reserve maintenance framework will remain very complex, possibly overly complex. The staff plans to continue the study that we presented to the Reserve Bank presidents and the Board members earlier this year, and at some point, we expect to bring significant further changes to the policymakers for consideration. But for now, we think that the changes that we're proposing will make effective use of the authority that we expect we'll have beginning on October 1. Thanks, Mr. Chairman. " CHRG-111shrg52619--193 RESPONSE TO WRITTEN QUESTIONS OF SENATOR CRAPO FROM MICHAEL E. FRYZELQ.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. NCUA has previously expressed its support for establishing a systemic risk regulator to monitor financial institution regulators, issue principles-based regulations and guidance, and establish general safety and soundness guidance for financial regulators under its control. This oversight entity would monitor systemic risk across institution types. \7\ This broad oversight would complement NCUA's more in-depth and customized approach to regulating federally insured credit unions.--------------------------------------------------------------------------- \7\ For purposes of this response, financial institutions include commercial banks and other insured depository institutions, insurers, companies engaged in securities and futures transactions, finance companies, and specialized companies established by the government as defined by the Treasury Blueprint. Individual financial regulators would implement and enforce the established guidelines for the institutions they regulate.--------------------------------------------------------------------------- Credit unions are unique, cooperative, not-for-profit entities with a statutory mandate to serve people of modest means. NCUA believes the combination of federal functional regulators performing front-line examinations and oversight by a systemic risk regulator would be a good method to fill weaknesses exposed by AIG. Additionally, because of the small size of most credit unions and the limitations placed on their charters, credit unions generally do not become part of a large conglomerate of business entities.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. Credit unions have not become financial service conglomerates due to limitations within the laws impacting credit unions including restricted fields of membership and limited potential activity. Therefore, the functional regulatory approach currently in place has worked in the credit union industry. While there is no perfect regulatory model to adopt and follow that addresses all of the current issues in the financial services industry, we can take portions from different plans to create a regulatory system that meets the needs of the current economy. A modernized functional regulatory system would divide the financial services industry into at least five categories: credit unions, banks, insurance, securities, and futures. This approach would allow the functional regulators to operate with expertise within their segment of the financial institutions. A functional regulator provides regulation for the specific issues facing their financial sector. This approach also allows a single regulator to possess the information and authority necessary to completely oversee the regulated entities within their segment of the industry while eliminating inefficiencies made with multiple overseers of the same entity. One drawback of this system is the possibility of regulators addressing the same issue with different approaches. One way to address this issue is the addition of a systemic oversight agency to the financial services industry. A systemic oversight agency could issue principles-based regulations and guidance, promoting uniformity in the supervision of the industry, while allowing the functional regulators to implement the regulations and guidance in a manner most appropriate for their financial segment. This type of structure would help preserve the different segments of the industry and maintain the checks and balances afforded by the different segments within the industry. With the single consolidated regulator approach, authority over all aspects of regulated institutions would be established under one regulator. This approach would allow the regulator to possess all information and authority regarding individual institutions, which would eliminate inefficiencies of multiple overseers for the same institution. This approach would also ensure the financial services industry operated under a consistent regulatory approach. However, this approach could result in the loss of specialized attention and focus on the various distinct segments of the financial institutions. An agency responsible for all institutions might focus on the larger institutions where the systemic risk predominates, potentially to the detriment of smaller institutions. For example, as federally insured credit unions are generally the smaller, less complex institutions in a consolidated financial regulator arrangement, the unique character of credit unions would quickly be lost, absorbed by the for-profit model and culture of other financial institutions. Loss of credit unions as a type of financial institution would limit access to the affordable services for persons of modest means that are offered by credit unions. An objectives-based regulatory approach as outlined in the Treasury Blueprint (market stability, prudential, and business conduct regulators) would ensure all financial institutions operated under a consistent regulatory approach. However, like the single consolidated regulator, this approach could also result in the loss of specialized attention and focus on the distinct segments of financial institutions, thus harming the credit union charter. Again, each regulator might focus on the larger financial institutions where the systemic risk predominates, while not addressing the different types of risks found in the smaller institutions. This approach also would result in multiple regulators for the same institution, where no single regulator possessed all of the information and authority necessary to monitor the overall systemic risk of the institution. In addition, disputes between the regulators regarding jurisdiction over the different objectives would arise. Inefficiencies would be created with multiple regulators supervising the same institution. Again, the focus on the objective rather than the charter could potentially harm the credit union industry where credit unions only comprise a small part of the financial institution community. In closing, the approach selected to regulate the financial services providers must protect the unique regulatory needs of the various components of the financial sectors, including the credit union industry.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. If the definition of ``too big to fail'' encompasses only those institutions that are systemically significant enough where their failure would have an adverse impact on financial markets and the economy, then credit unions would not be considered too big to fail. Within the credit union system there are regulatory safeguards in place to reduce the potential for ``too big to fail'' entities. The field of membership restrictions that govern membership of the credit union limit the potential for any systemic risk. The impact of a failure of a large natural person credit union would be limited to any cost of the failure, which would be passed on to all other federally insured credit unions via the assessment of a premium should the equity level of the NCUSIF fall below the required level.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. In large, multinational and systemically significant institutions, federal regulators should take an aggressive approach to examining and monitoring. As issues are discovered, the regulator must quickly and firmly take the appropriate action before the issue escalates. Very few federally insured credit unions have a multinational presence. Due to field of membership limitations, only credit unions where a portion of their members are located in foreign counties, such as a Department of Defense related credit union, would have multinational exposure. \8\ In those cases, there is limited multinational significance to the credit union business model.--------------------------------------------------------------------------- \8\ Credit unions are chartered to serve a field of membership that shares a common bond such as the employees of a company, members of an association, or a local community. Therefore, credit unions may not serve the general public like other financial institutions and the credit unions' activities are largely limited to domestic activities, which has minimized the impact of globalization in the credit union industry.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. NCUA regulates federally insured credit unions, which do not file Chapter 11 bankruptcies. However, federally insured credit unions can become insolvent and be liquidated. No member of a federally insured credit union has ever lost a penny of insured shares. In order to preserve confidence in the credit union industry, NCUA usually pays out members within three days from the time a federally insured credit union fails. NCUA has an Asset Management and Assistance Center that is available to quickly handle credit union liquidations and perform management and asset recovery. Based on the requirements set forth in 12 U.S.C. 1790d of the Federal Credit Union Act, NCUA considers a credit union in danger of closing (a potential failure) when the credit union: Is subject to mandatory conservatorship, liquidation or ``other corrective action'' for not maintaining required levels of capital; Is subject to discretionary conservatorship or liquidation or is required to merge for not maintaining required levels of capital; Is subject to a high probability of sustaining an identifiable loss (e.g., fraud, unexpected and sudden outflow of funds, operational failure, natural disaster, etc.) and could not maintain required levels of capital, so that it would be subject to conservatorship or liquidation. ------ FinancialCrisisInquiry--149 John Mack certainly made that point; others did. But you’re not going to catch up with innovation, and unless you change the structure—and I’m not sure it’s advisable; I would like it, but I’m not sure it’s going to happen—I think you’ve just got to have very strong and constant and non-patchwork regulation. GEORGIOU: But does that mean—are you suggesting that really that regulation means enforcing significantly higher capital requirements? SOLOMON: Well, that’s certainly one thing. I don’t think anybody doubts that. Nobody—again, the folks today testified that they thought their capital was too low. So definitely higher capital requirements. That’s a sine qua non. That’s a starting point. But that’s just a starting point. GEORGIOU: Right. But the criticism when I—when we suggested that in the course of the questioning I did, the banker suggested, well, that, you know, that limits the amount of business that they can do, which of course is... SOLOMON: Well, you asked that—if I may—in terms of underwritings, I think, and whether they should hold back—be required to hold a piece of their underwriting. And I don’t know, they didn’t give you—that wasn’t a bad answer they gave, meaning that there is a legitimacy to that, but whether the firm should have more capital is the issue I’m saying, not whether they are required to take a part of their underwriting and hold it back instead of underwriting fees or suffer the loss. Now, one of the things that does happen today is they’re much smarter. They’re, you know, when you talk to these folks, you read about Goldman Sachs, and if none of you have read the Charley Ellis book on Goldman Sachs you should all read it, particularly the updated version. I’ll give Charley a plug. You should read it, because it’s very revelatory about the thinking of Goldman Sachs about their business and how they look at markets. And, you know, let the—let their words tell you where they’re going. CHRG-111shrg54533--83 PREPARED STATEMENT OF CHAIRMAN CHRISTOPHER J. DODD Good morning. Thank you all for being here. I would like to welcome Secretary Geithner, who is here today to discuss the Administration's proposal to modernize the financial regulatory system. Mr. Secretary, we applaud your leadership on a very complex set of issues intended to restore confidence and stability in our financial system. I look forward to exploring the details of your plan and working with you and my colleagues on this truly historic endeavor. In my home State of Connecticut and around the country, working men and women who did nothing wrong have watched this economy fall through the floor--taking with it jobs, homes, life savings, and the economic security that has always been the cherished promise of the American middle class. These folks are hurting, they are angry, they are worried. And they are wondering: who's looking out for me? I've seen first-hand how hard people work in Connecticut to support their families and build financial security. I've seen how devastating this economic crisis has been for them. And I firmly believe that someone should have their backs. So as we work together to rebuild and reform the regulatory structures whose failures led to this crisis, I will continue to insist that improving consumer protection be a first principle and an urgent priority. I welcome the Administration's adoption of this principle, and I'm pleased to see it reflected in the plans we'll be discussing today. At the center of this effort will be a new, independent consumer protection agency to protect Americans from poisonous financial products. This is simple common sense. We don't allow toy companies to sell toys that could hurt our kids. We don't allow electronics companies to sell defective appliances. Why should a usurious payday loan be treated any differently than we'd treat an unsafe toy or a malfunctioning toaster? Why should an unscrupulous lender be allowed to dupe a borrower into a loan the lender knows can't be repaid? There's no excuse for allowing a financial services company to take advantage of American consumers by selling them dangerous financial products. Let's put a cop on that beat so that the spectacular failure of consumer protection at the root of this mess is never repeated. We have been engaged in an examination of just what went wrong in the lead-up to this crisis ever since February 2007, when experts and regulators testified that poorly underwritten mortgages would create a tsunami of foreclosures. Those mortgages were securitized and sold around the world. The market is supposed to distribute risk, but because for years, no one was minding the store, these toxic assets served to amplify risks in our system. Everything associated with these securities--the credit ratings applied to them, the solvency of the institutions holding them, and the creditworthiness of the underlying borrowers--became suspect. And as the financial system tried to pull back from these securities, it took down some of the country's most venerable institutions--firms that had survived world wars and the Great Depression--and wiped out over $6 trillion in household wealth since last fall. Stronger consumer protection could have stopped this crisis before it started. Consumers who were sold subprime and exotic loans they couldn't afford to repay were, frankly, cheated. They should have been the canaries in the coal mine. But instead of heeding the warnings of many experts, regulators turned a blind eye. And it was regulatory neglect that allowed the crisis to spread to the point where the basic economic security of my constituents in Connecticut--including folks who'd never even heard of mortgage-backed securities--was threatened by the greed of some bad actors on Wall Street and the failure of our regulatory system. To rebuild confidence in our financial system, both here at home and around the world, we must reconstruct our regulatory framework to ensure that our financial institutions are properly capitalized, regulated, and supervised. The institutions and products that make up our financial system must act to generate wealth, not destroy it. In November, I announced five principles that would guide the Banking Committee's efforts. First and foremost, regulators must be focused and empowered--aggressive watchdogs, rather than passive enablers of reckless practices. Second, we have to remove the gaps and overlaps in our regulatory structure that have encouraged charter-shopping and a race to the bottom in an effort to win over bank and thrift ``clients.'' Third, we must ensure that any part of our financial system that poses systemwide risk is carefully and sensibly supervised. A firm ``too-big-to-fail'' is a firm too big to leave unmonitored. Fourth, we can't have effective regulation without more transparency. Our economy has suffered from the lack of information about trillion-dollar markets and the migration of risks within them. And, fifth, our actions must help America remain prosperous and competitive in the global marketplace. These principles will guide my consideration of the plan you bring to the Committee today. Mr. Secretary, I believe that we can find common ground in a number of areas contained in your proposal. I want to thank you, Mr. Secretary, for your leadership on these issues, as well as for your willingness to consider different perspectives in forging your plan. I hope you will view this as a continuation of the dialogue you've had with Members of this Committee as we work together to shape a regulatory framework that will serve our country well through the 21st century. I want to thank all of my colleagues on the Committee who have demonstrated a strong interest in this issue. Our continued, bipartisan collaboration will be critical to ensuring that we enact sound and needed reforms to put our financial system back on solid footing. And I want to urge everyone to remember that, at the end of the day, the success of what we attempt will be measured by its effect on the borrower, the shareholder, the investor, the depositor, and consumers seeking not to attain extravagant wealth, but simply to grow a small business, pay for college, buy a home, and pass on something to their kids. That's the American Dream. That's what we've gathered here to restore. Thank you. ______ FinancialCrisisReport--316 The Act stated that these reforms were needed, “[b]ecause of the systemic importance of credit ratings and the reliance placed on credit ratings by individual and institutional investors and financial regulators,” and because “credit rating agencies are central to capital formation, investor confidence, and the efficient performance of the United States economy.” 1236 (3) Recommendations To further strengthen the accuracy of credit ratings and reduce systemic risk, this Report makes the following recommendations. 1. Rank Credit Rating Agencies by Accuracy. The SEC should use its regulatory authority to rank the Nationally Recognized Statistical Rating Organizations in terms of performance, in particular the accuracy of their ratings. 2. Help Investors Hold CRAs Accountable. The SEC should use its regulatory authority to facilitate the ability of investors to hold credit rating agencies accountable in civil lawsuits for inflated credit ratings, when a credit rating agency knowingly or recklessly fails to conduct a reasonable investigation of the rated security. 3. Strengthen CRA Operations. The SEC should use its inspection, examination, and regulatory authority to ensure credit rating agencies institute internal controls, credit rating methodologies, and employee conflict of interest safeguards that advance rating accuracy. 4. Ensure CRAs Recognize Risk. The SEC should use its inspection, examination, and regulatory authority to ensure credit rating agencies assign higher risk to financial instruments whose performance cannot be reliably predicted due to their novelty or complexity, or that rely on assets from parties with a record for issuing poor quality assets. 1235 See id. at §§ 931-939H; “Conference report to accompany H.R. 4173,” Cong. Report No. 111-517 (June 29, 2010). 1236 See Section 931 of the Dodd-Frank Act. 5. Strengthen Disclosure. The SEC should exercise its authority under the new Section 78o-7(s) of Title 15 to ensure that the credit rating agencies complete the required new ratings forms by the end of the year and that the new forms provide comprehensible, consistent, and useful ratings information to investors, including by testing the proposed forms with actual investors. 6. Reduce Ratings Reliance. Federal regulators should reduce the federal government’s reliance on privately issued credit ratings. CHRG-111hhrg56766--178 Mr. Bernanke," First of all, we all agree that we don't want banks to take excessive risks when they have a safety net from the government. So the question is, then, how do you control those risks? The Volcker Rule might be appropriate. You have to be careful that you don't inadvertently prevent good hedging, which actually reduces risks, or that you don't prevent market making, which is good for liquidity. One possibility is that--if you were to go in this direction would be to give some discretion to the supervisors to decide whether a set of activities is so risky or complex that the firm doesn't have the risk management capacity or the managerial capacity to deal with it and then give the supervisors the authority to ban that activity. So there might be ways to do it using supervisors. " CHRG-111shrg54589--71 Mr. Pickel," Chairman Reed, Ranking Member Bunning, and Members of the Subcommittee, thank you very much for inviting ISDA to testify today. We are grateful for the opportunity to discuss public policy issues regarding the privately negotiated, or OTC, derivatives business. Our business provides essential risk management and cost reduction tools for many users. Additionally, it is an important source of employment, value creation, and innovation for our financial system. In my remarks today, I would briefly like to underscore ISDA and the industry's strong commitment to identifying and reducing risks in the privately negotiated derivatives business. We believe that OTC derivatives offer significant value to the customers who use them, to the dealers who provide them, and to the financial system in general by enabling the transfer of risk between counterparties. OTC derivatives exist to serve the risk management and investment needs of end users. They include over 90 percent of the Fortune 500, 50 percent of mid-size companies, and thousands of other smaller American companies. The vast majority of these transactions are interest rate and currency swaps and equity and commodity derivatives. These are privately negotiated, bilateral contracts that address specific needs of thousands of companies. We recognize, however, that the industry today faces significant challenges and we are urgently moving forward with new solutions. We have delivered and are delivering on a series of reforms in order to promote greater standardization and resilience in the derivatives markets. These developments have been closely overseen and encouraged by regulators who recognize that optimal solutions to market issues are usually achieved through the participation of market participants. As ISDA and the industry work to reduce risk, we believe it is essential to preserve flexibility to tailor solutions to meet the needs of customers, and the recent Administration proposals and numerous end users agree. Mr. Chairman, let me assure you that ISDA and our members clearly understand the need to act quickly and decisively to implement the important measures that I will describe in the next few minutes. Last week, President Obama announced a comprehensive regulatory reform proposal for the financial industry. The proposal is an important step toward much-needed reform of financial industry regulation. The reform proposal addressed OTC derivatives in a manner consistent with the proposals announced on May 13 by Treasury Secretary Geithner. ISDA and the industry welcomed in particular the recognition of industry measures to safeguard smooth functioning of our markets and the emphasis on the continuing need for the companies to use customized derivatives tailored to their specific needs. The Administration proposes to require that all derivative dealers and other systemically important firms be subject to prudential supervision and regulation. ISDA supports the appropriate regulation of financial and other institutions that have such a large presence in the financial system that their failure could cause systemic concerns. Most of the other issues raised in the Administration's proposal have been addressed in a letter from ISDA that ISDA and various market participants delivered to the Federal Reserve Bank of New York earlier this month. As you may know, a Fed-industry dialogue was initiated under Secretary Geithner's stewardship of the New York Fed nearly 4 years ago. Much has been achieved and much more has been committed to, all with the goal of risk reduction, transparency, and liquidity. These initiatives include increased standardization of trading terms, improvements in the trade settlement process, greater clarity in the settlement of defaults, significant positive momentum central counterparty clearing, enhanced transparency, and a more open industry governance structure. In our letter to the New York Fed this month, ISDA and the industry expressed our firm commitment to strengthen the resilience and robustness of the OTC derivatives markets. As we stated, we are determined to implement changes to risk management, processing, and transparency that will significantly transform the risk profile of these important financial markets. We outlined a number of steps toward that end, specifically in the areas of information transparency and central counterparty clearing. ISDA and the OTC derivatives industry are committed to engaging with supervisors globally to expand upon the substantial improvements that have been made in our business since 2005. We know that further action is required and we pledge our support in these efforts. It is our belief that much additional progress can be made within a relatively short period of time. Our clearing and transparency initiatives, for example, are well underway with specific commitments aired publicly and provided to policy makers. As we move forward, we believe the effectiveness of future policy initiatives will be determined by how well they answer a few fundamental questions. First, will these policy initiatives recognize that OTC derivatives play an important role in the U.S. economy? Second, will these policy initiatives enable firms of all types to improve how they manage risk? Third, will these policy initiatives reflect an understanding of how the OTC derivatives markets function and their true role in the financial crisis? Finally, will these policy initiatives ensure the availability and affordability of these essential risk management tools to a wide range of end users? Mr. Chairman and Committee Members, the OTC derivatives industry is an important part of the financial services business in this country and the services we provide help companies of all shapes and sizes. We are committed to assisting this Committee and other policy makers in its considerations of these very important policy initiatives. I look forward to your questions. Thank you. " 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-111shrg55739--150 PREPARED STATEMENT OF LAWRENCE J. WHITE Leonard E. Imperatore Professor of Economics, New York University August 5, 2009 Chairman Dodd, Ranking Member Shelby, and Members of the Committee: My name is Lawrence J. White, and I am a Professor of Economics at the NYU Stern School of Business. During 1986-1989 I served as a Board Member on the Federal Home Loan Bank Board. Thank you for the opportunity to testify today on this important topic. I have appended to this statement for the Committee a longer Statement that I delivered at the Securities and Exchange Commission's (SEC) ``Roundtable'' on the credit rating agencies on April 15, 2009, which I would like to have incorporated for the record into the statement that I am presenting today. The three large U.S.-based credit rating agencies--Moody's, Standard & Poor's, and Fitch--and their excessively optimistic ratings of subprime residential mortgage-backed securities (RMBS) in the middle years of this decade played a central role in the financial debacle of the past 2 years. Given this context and history, it is understandable that there would be strong political sentiment--as expressed in the proposals by the Obama administration, as well as by others--for more extensive regulation of the credit rating agencies in hopes of forestalling future such debacles. The advocates of such regulation want (figuratively) to grab the rating agencies by the lapels, shake them, and shout ``Do a better job!'' This urge for greater regulation is understandable--but it is misguided and potentially quite harmful. The heightened regulation of the rating agencies is likely to discourage entry, rigidify a specified set of structures and procedures, and discourage innovation in new ways of gathering and assessing information, new technologies, new methodologies, and new models (including new business models)--and may well not achieve the goal of inducing better ratings from the agencies. Ironically, it will also likely create a protective barrier around the incumbent credit rating agencies. There is a better route. That route starts with the recognition that the centrality of the three major rating agencies for the bond information process was mandated by more than 70 years of prudential financial regulation of banks and other financial institutions. In essence, regulatory reliance on ratings--for example, the prohibition on banks' holding ``speculative'' bonds, as determined by the rating agencies' ratings--imbued these third-party judgments about the creditworthiness of bonds with the force of law! This problem was compounded when the SEC created the category of ``nationally recognized statistical rating organization'' (NRSRO) in 1975 and subsequently became a barrier to entry into the rating business. As of year-end 2000 there were only three NRSROs: Moody's, Standard & Poor's, and Fitch. \1\--------------------------------------------------------------------------- \1\ Because of subsequent prodding by the Congress, and then the specific barrier-reduction provisions of the Credit Rating Agency Reform Act of 2006, there are now ten NRSROs.--------------------------------------------------------------------------- It should thus come as no surprise that when this (literal) handful of rating firms stumbled badly in their excessively optimistic ratings of the subprime RMBS, the consequences were quite serious. This recognition of the role of financial regulation in forcing the centrality of the major rating agencies then leads to an alternative prescription: Eliminate regulatory reliance on ratings--eliminate the ratings' force of law--and bring market forces to bear. Since the bond markets are primarily institutional markets (and not a retail securities market, where retail customers are likely to need more help), market forces can be expected to work--and the detailed regulation that has been proposed would be unnecessary. Indeed, if regulatory reliance on ratings were eliminated, the entire NRSRO superstructure could be dismantled, and the NRSRO category could be eliminated. The regulatory requirements that prudentially regulated financial institutions must maintain safe bond portfolios should remain in force. But the burden should be placed directly on the regulated institutions to demonstrate and justify to their regulators that their bond portfolios are safe and appropriate--either by doing the research themselves, or by relying on third-party advisors. Since financial institutions could then call upon a wider array of sources of advice on the safety of their bond portfolios, the bond information market would be opened to innovation and entry in ways that have not been possible since the 1930s. My appended April 15 Statement for the SEC provides greater elaboration on many of these points. Since that Statement preceded the Obama administration's specific proposals for further regulation of the credit rating agencies, I will expand here on the drawbacks of those proposals. The proposals--as found initially in the Administration's Financial Regulatory Reform: A New Foundation (p. 46) that was released in mid June, and then in the specific legislative proposals that were released on July 21--are devoted primarily to efforts to increase the transparency of ratings and to address issues of conflicts of interest. The latter arise largely from the major rating agencies' business model of relying on payments from the bond issuers in return for rating their bonds. \2\ These proposals expand and elaborate on a set of regulations that the SEC has recently implemented.--------------------------------------------------------------------------- \2\ It is worth noting that three smaller U.S.-based NRSRO rating agencies have ``investor pays'' business models and that the ``investor pays'' model was the original model for John Moody and for the industry more generally, until the major rating agencies switched to the ``issuer pays'' model in the early 1970s.--------------------------------------------------------------------------- Again, the underlying urge to ``do something'' in the wake of the mistakes of the major credit rating agencies during the middle years of this decade is understandable. Further, the ``issuer pays'' business model of those rating agencies presents an obvious set of potential conflict-of-interest problems that appear to be crying out for correction. \3\--------------------------------------------------------------------------- \3\ It is important to remember, however, that the major credit rating agencies switched to the ``issuer pays'' model in the early 1970s, and that the serious problems only arose three decades later. Apparently, the agencies' concerns for their long-run reputations and the transparency and multiplicity of issuers prior to the current decade all served to keep the potential conflict-of-interest problems in check during those three intervening decades.--------------------------------------------------------------------------- Nevertheless, the dangers of the proposals are substantial. They ask the SEC to delve ever deeper into the processes and procedures and methodologies of credit ratings--of providing judgments about the creditworthiness of bonds and bond issuers. In so doing, the proposals (if enacted) are likely to rigidify the industry along the lines of whatever specific implementing regulations that the SEC devises, as well as raising the costs of being a credit rating agency. In so doing, the proposals will discourage entry and innovation in new ways of gathering and assessing information, in new methodologies, in new technologies, and in new models--including new business models. There is one especially worrisome provision in the specific legislation that was proposed in July (and that was absent in the earlier June proposals) that is guaranteed to discourage entry: the requirement that all credit rating agencies should register as NRSROs with the SEC. This requirement would seem to encompass the independent consultant who offers bond investment recommendations to clients (such as hedge funds or bond mutual funds), as well as any financial services company that employs fixed income analysts whose recommendations become part of the services that the company offers to clients. This provision, if enacted, will surely discourage entry into the broader bond information business, as well as encouraging the exit of existing providers of information. Ironically, it will likely become a new protective barrier around the incumbent credit rating agencies (when, again ironically, the Credit Rating Agency Reform Act of 2006 was intended to tear down the earlier barrier to entry that the SEC had erected when it create the NRSRO category in 1975). This can't be a good way of encouraging new and better information for the bond market. Further, it is far from clear that the proposals will actually achieve their goal of improving ratings. One common complaint against the large agencies is that they are slow to adjust their ratings in response to new information. \4\ But this appears to be a business culture phenomenon for the agencies (which was present, as well, in the pre-1970's era when the rating agencies had an ``investor pays'' business model). As for the kind of over-optimism about the RMBS in this decade that subsequently created such serious problems, the rating agencies were far from alone in ``drinking the Kool-Aid'' that housing prices could only increase and that even subprime mortgages consequently would not have problems. It is far from clear that the proposed regulations would have curbed such herd behavior. Also, the incumbent rating agencies are quite aware of the damage to their reputations that have occurred and have announced measures--including increased transparency and enhanced efforts to address potential conflicts--to repair that damage.--------------------------------------------------------------------------- \4\ This complaint has been present for decades. It surfaced strongly in the wake of the Enron bankruptcy in November 2001, with the revelation that the major rating agencies had maintained ``investment grade'' ratings on Enron's debt until 5 days before that company's bankruptcy filing. More recently, the major agencies had ``investment grade'' ratings on Lehman Brothers' debt on the day that it filed for bankruptcy.--------------------------------------------------------------------------- The Obama administration's proposals do--briefly--entertain the possibility of reducing regulatory reliance on ratings. But this seems to be largely lip service, embodied in promises that the Administration will examine the possibilities. The only specific provision on this point in the proposed legislation is a requirement for the U.S. Government Accountability Office (GAO) to undertake a study and deliver a report. Also, the reference in the proposals is to ``reduction'' rather than to elimination; and there seems to be no recognition that even a reduction of regulatory reliance on ratings would represent a movement in the opposite direction from increasing the regulation of the credit rating agencies. In sum, the proposals of the Obama administration with respect to the reform of the credit rating agencies are deeply flawed and wrongheaded. There is a better route: Eliminate regulatory reliance on ratings--eliminate the force of law that has been accorded to these third-party judgments. The institutional participants in the bond markets could then more readily (with appropriate oversight by financial regulators) make use of a wider set of providers of information, and the bond information market would be opened to new ideas and new entry in a way that has not been possible for over 70 years. Thank you again for the opportunity to appear before this Committee, and I would be happy to respond to any questions from the Committee.Attachment Statement by Lawrence J. White* for the Securities and Exchange Commission ``Roundtable To Examine Oversight of Credit Rating Agencies''Washington, DC----April 15, 2009Summary The three major credit rating agencies--Moody's, Standard & Poor's, and Fitch--played a central role in the subprime mortgage debacle of 2007-2008. That centrality was not accidental. Seven decades of financial regulation propelled these rating agencies into the center of the bond information market, by elevating their judgments about the creditworthiness of bonds so that those judgments attained the force of law. The Securities and Exchange Commission exacerbated this problem by erecting a barrier to entry into the credit rating business in 1975. Understanding this history is crucial for any reasoned debate about the future course of public policy with respect to the rating agencies.--------------------------------------------------------------------------- * Lawrence J. White is professor of economics at the NYU Stern School of Business. During 1986-1989 he was a board member on the Federal Home Loan Bank Board. This statement draws heavily on a forthcoming article, ``The Credit Rating Agencies and the Subprime Debacle'', in the journal Critical Review.--------------------------------------------------------------------------- The Securities and Exchange Commission has recently (in December 2008) taken modest steps to expand its regulation of the industry. Further regulatory efforts by the SEC and/or the Congress would not be surprising. There is, however, another direction in which public policy could proceed: Financial regulators could withdraw their delegation of safety judgments to the credit rating agencies. The goal of safe bond portfolios for regulated financial institutions would remain. But the financial institutions would bear the burden of justifying the safety of their bond portfolios to their regulators. The bond information market would be opened to new ideas about rating methodologies, technologies, and business models and to new entry in ways that have not been possible since the 1930s. ``an insured State savings association . . . may not acquire or retain any corporate debt securities not of investment grade.'' 12 Code of Federal Regulations 362.11 ``any user of the information contained herein should not rely on any credit rating or other opinion contained herein in making any investment decision.'' The usual disclaimer that is printed at the bottom of Standard & Poor's credit ratingsIntroduction The U.S. subprime residential mortgage debacle of 2007-2008, and the world financial crisis that has followed, will surely be seen as a defining event for the U.S. economy--and for much of the world economy as well--for many decades in the future. Among the central players in that debacle were the three large U.S.-based credit rating agencies: Moody's, Standard & Poor's (S&P), and Fitch. These three agencies' initially favorable ratings were crucial for the successful sale of the bonds that were securitized from subprime residential mortgages and other debt obligations. The sale of these bonds, in turn, were an important underpinning for the U.S. housing boom of 1998-2006--with a self-reinforcing price-rise bubble. When house prices ceased rising in mid 2006 and then began to decline, the default rates on the mortgages underlying these bonds rose sharply, and those initial ratings proved to be excessively optimistic--especially for the bonds that were based on mortgages that were originated in 2005 and 2006. The mortgage bonds collapsed, bringing down the U.S. financial system and many other countries' financial systems as well. The role of the major rating agencies has received a considerable amount of attention in Congressional hearings and in the media. Less attention has been paid to the specifics of the regulatory structure that propelled these companies to the center of the U.S. bond markets. But an understanding of that structure is essential for any reasoned debate about the future course of public policy with respect to the rating agencies. \1\--------------------------------------------------------------------------- \1\ Overviews of the credit rating industry can be found in, e.g., Cantor and Packer (1995), Partnoy (1999, 2002), Richardson and White (2009), Sylla (2002), and White (2002, 2002-2003, 2006, 2007).---------------------------------------------------------------------------Background A central concern of any lender--including investors in bonds--is whether a potential or actual borrower is likely to repay the loan. Lenders therefore usually spend considerable amounts of time and effort in gathering information about the creditworthiness of prospective borrowers and also in gathering information about the actions of borrowers after loans have been made. The credit rating agencies offer judgments--they prefer the word ``opinions'' \2\--about the credit quality of bonds that are issued by corporations, governments (including U.S. State and local governments, as well as ``sovereign'' issuers abroad), and (most recently) mortgage securitizers. These judgments come in the form of ratings, which are usually a letter grade. The best known scale is that used by S&P and some other rating agencies: AAA, AA, A, BBB, BB, etc., with pluses and minuses as well. \3\ Credit rating agencies are thus one potential source of such information for bond investors; but they are far from the only potential source.--------------------------------------------------------------------------- \2\ The rating agencies favor that term because it allows them to claim that they are ``publishers'' and thus enjoy the protections of the First Amendment of the U.S. Constitution (e.g., when the agencies are sued by investors and issuers who claim that they have been injured by the actions of the agencies). \3\ For short-term obligations, such as commercial paper, a separate set of ratings is used.--------------------------------------------------------------------------- The history of the credit rating agencies and their interactions with financial regulators is crucial for an understanding of how the agencies attained their current central position in the market for bond information.Some History John Moody published the first publicly available bond ratings (mostly concerning railroad bonds) in 1909. Moody's firm \4\ was followed by Poor's Publishing Company in 1916, the Standard Statistics Company in 1922, \5\ and the Fitch Publishing Company in 1924. \6\ These firms' bond ratings were sold to bond investors, in thick rating manuals. In the language of modern corporate strategy, their ``business model'' was one of ``investor pays.'' In an era before the Securities and Exchange Commission (SEC) was created (in 1934) and began requiring corporations to issue standardized financial statements, Moody and the firms that subsequently entered were clearly meeting a market demand for their information services.--------------------------------------------------------------------------- \4\ Dun & Bradstreet bought Moody's firm in 1962; subsequently, in 2000, Dun & Bradstreet spun off Moody's as a free-standing corporation. \5\ Poor's and Standard merged in 1941, to form S&P; S&P was absorbed by McGraw-Hill in 1966. \6\ Fitch merged with IBCA (a British firm) in 1997, and the combined firm was subsequently bought by FIMILAC, a French business services conglomerate.--------------------------------------------------------------------------- A major change in the relationship between the credit rating agencies and the U.S. bond markets occurred in the 1930s. Eager to encourage banks to invest only in safe bonds, bank regulators issued a set of regulations that culminated in a 1936 decree that prohibited banks from investing in ``speculative investment securities'' as determined by ``recognized rating manuals.'' ``Speculative'' securities were bonds that were below ``investment grade.'' Thus, banks were restricted to holding only bonds that were ``investment grade'' (e.g., bonds that were rated BBB or better on the S&P scale). \7\--------------------------------------------------------------------------- \7\ This rule still applies to banks today. This rule did not apply to savings institutions until 1989. Its application to savings institutions in 1989 forced them to sell substantial holdings of ``junk bonds'' (i.e., below investment grade) at the time, causing a major slump in the junk bond market.--------------------------------------------------------------------------- This regulatory action importantly changed the dynamic of the bond information market. Banks were no longer free to act on information about bonds from any source that they deemed reliable (albeit within constraints imposed by oversight by bank regulators). They were instead forced to use the judgments of the publishers of the ``recognized rating manuals'' (i.e., Moody's, Poor's, Standard, and Fitch). Further, since banks were important participants in the bond markets, perforce other participants would want to pay attention to the bond raters' pronouncements as well. On the regulatory side of this process, rather than the bank regulators' using their own internal resources to form judgments about the safety of the bonds held by banks (which the bank regulators continued to do with respect to the other kinds of loans made by banks), the regulators had effectively delegated--``outsourced'' (again using the language of modern corporate strategy)--to the rating agencies their safety judgments about bonds that were suitable for banks' portfolios. Equivalently, the creditworthiness judgments of these third-party raters had attained the force of law. In the following decades, the insurance regulators of the 48 (and eventually 50) States followed a similar path: The State regulators wanted their regulated insurance companies to have adequate capital (in essence, net worth) that was commensurate with the riskiness of the companies' investments. To achieve this goal, the regulators established minimum capital requirements that were geared to the ratings on the bonds in which the insurance companies invested--the ratings, of course, coming from that same small group of rating agencies. Once again, an important set of regulators had delegated their safety decisions to the credit rating agencies. And in the 1970s, Federal pension regulators pursued a similar strategy. These additional delegations of safety judgments to the rating agencies meant that the latter's centrality for bond market information was further strengthened. The SEC crystallized the rating agencies' centrality in 1975. In that year the SEC decided to set minimum capital requirements for broker-dealers (i.e., securities firms). Following the pattern of the other financial regulators, it wanted those capital requirements to be sensitive to the riskiness of the broker-dealers' asset portfolios and hence wanted to use bond ratings as the indicators of risk. But it worried that references to ``recognized rating manuals'' were too vague and that a ``bogus'' rating firm might arise that would promise ``AAA'' ratings to those companies that would suitably reward it and ``DDD'' ratings to those that would not; and if a broker-dealer chose to claim that those ratings were ``recognized,'' the SEC might have difficulties challenging this assertion. To deal with this problem, the SEC created a wholly new category--``nationally recognized statistical rating organization'' (NRSRO)--and immediately ``grandfathered'' Moody's, S&P, and Fitch into the category. The SEC declared that only the ratings of NRSROs were valid for the determination of the broker-dealers' capital requirements. The other financial regulators soon adopted the SEC's NRSRO category and the rating agencies within it as the relevant sources of the ratings that were required for evaluations of the bond portfolios of their regulated financial institutions. \8\--------------------------------------------------------------------------- \8\ Also, in the early 1990s, the SEC again made use of the NRSROs' ratings when it established safety requirements for the short-term bonds (e.g., commercial paper) that are held by money market mutual funds.--------------------------------------------------------------------------- Over the next 25 years the SEC designated only four additional firms as NRSROs; \9\ but mergers among the entrants and with Fitch caused the number of NRSROs to return to the original three by year-end 2000. In essence, the SEC had become a significant barrier to entry into the bond rating business, because the NRSRO designation was important for any potential entrant. Without the NRSRO designation, any would-be bond rater would likely be ignored by most financial institutions; and, since the financial institutions would ignore the would-be bond rater, so would bond issuers. \10\--------------------------------------------------------------------------- \9\ The SEC bestowed the NRSRO designation on Duff & Phelps in 1982, on McCarthy, Crisanti & Maffei in 1983, on IBCA in 1991, and on Thomson BankWatch in 1992. \10\ The SEC's barriers were not absolute. A few smaller rating firms--notably KMV, Egan-Jones, and Lace Financial--were able to survive, despite the absence of NRSRO designations. KMV was absorbed by Moody's in 2000.--------------------------------------------------------------------------- In addition, the SEC was remarkably opaque in its designation process. It never established criteria for a firm to be designated as a NRSRO, never established a formal application and review process, and never provided any justification or explanation for why it ``anointed'' some firms with the designation and refused to do so for others. One other piece of history is important: In the early 1970s the basic business model of the large rating agencies changed. In place of the ``investor pays'' model that had been established by John Moody in 1909, the agencies converted to an ``issuer pays'' model, whereby the entity that is issuing the bonds also pays the rating firm to rate the bonds. The reasons for this change of business model have not been established definitively. Among the candidates are: a. The rating firms feared that their sales of rating manuals would suffer from the consequences of the high-speed photocopy machine (which was just entering widespread use), which would allow too many investors to free-ride by obtaining photocopies from their friends; b. The bankruptcy of the Penn-Central Railroad in 1970 shocked the bond markets and made issuers more conscious of the need to assure bond investors that they (the issuers) really were low risk, and they were willing to pay the credit rating firms for the opportunity to have the latter vouch for them (but that same shock should have also made investors more willing to pay to find out which bonds were really safer, and which were not); c. The bond rating firms may have belatedly realized that the financial regulations described above meant that bond issuers needed the ``blessing'' of one or more NRSROs in order to get their bonds into the portfolios of financial institutions, and the issuers should be willing to pay for the privilege; and d. The bond rating business, like many information industries, involves a ``two-sided market,'' where payments can come from one or both sides of the market; in such markets, which side actually pays can be quite idiosyncratic. \11\--------------------------------------------------------------------------- \11\ Other examples of ``two-sided'' information markets include newspapers and magazines, where business models range from ``subscription revenues only'' (e.g., Consumer Reports) to ``a mix of subscription revenues plus advertising revenues'' (most newspapers and magazines) to ``advertising revenues only'' (e.g., The Village Voice, some metropolitan ``giveaway'' daily newspapers, and some suburban weekly ``shoppers''). Regardless of the reason, the change to the ``issuer pays'' business model opened the door to potential conflicts of interest: A rating agency might shade its rating upward so as to keep the issuer happy and forestall the issuer's taking its rating business to a different rating agency. \12\--------------------------------------------------------------------------- \12\ Skreta and Veldkamp (2008) develop a model in which the ability of issuers to choose among potential raters leads to overly optimistic ratings, even if the raters are all trying honestly to estimate the creditworthiness of the issuers. In their model, the raters can only make estimates of the creditworthiness of the issuers, which means that their estimates will have errors. If the estimates are (on average) correct and the errors are distributed symmetrically (i.e., the raters are honest but less than perfect), but the issuers can choose which rating to purchase, the issuers will systematically choose the most optimistic. In an important sense, it is the issuers' ability to select the rater that creates the conflict of interest.---------------------------------------------------------------------------Recent Events of the Current Decade The NRSRO system was one of the less-well-known features of Federal financial regulation, and it might have remained in that semisecretive state had the Enron bankruptcy of November 2001 not occurred. In the wake of the Enron bankruptcy, however, the media and then Congressional staffers noticed that the three major rating agencies had maintained ``investment grade'' ratings on Enron's bonds until 5 days before that company declared bankruptcy. This notoriety led to the Congress's ``discovery'' of the NRSRO system and to Congressional hearings in which the SEC and the rating agencies were repeatedly asked how the latter could have been so slow to recognize Enron's weakened financial condition. \13\--------------------------------------------------------------------------- \13\ The rating agencies were similarly slow to recognize the weakened financial condition of WorldCom, and were subsequently grilled about that as well.--------------------------------------------------------------------------- The Sarbanes-Oxley Act of 2002 included a provision that required the SEC to send a report to Congress on the credit rating industry and the NRSRO system. The SEC duly did so; but the report simply raised a series of questions rather than directly addressing the issues of the SEC as a barrier to entry and the enhanced role of the three incumbent credit rating agencies, which (as explained above) was due to the financial regulators' delegations of safety judgments (and which the SEC's NRSRO framework had strengthened). In early 2003 the SEC designated a fourth NRSRO (Dominion Bond Rating Services, a Canadian credit rating firm), and in early 2005 the SEC designated a fifth NRSRO (A.M. Best, an insurance company rating specialist). The SEC's procedures remained opaque, however, and there were still no announced criteria for the designation of a NRSRO. Tiring of the SEC's persistence as a barrier to entry (and also the SEC's opaqueness in procedure), the Congress passed the Credit Rating Agency Reform Act (CRARA), which was signed into law in September 2006. The Act specifically instructed the SEC to cease being a barrier to entry, specified the criteria that the SEC should use in designating new NRSROs, insisted on transparency and due process in the SEC's decisions with respect to NRSRO designations, and provided the SEC with limited powers to oversee the incumbent NRSROs--but specifically forbade the SEC from influencing the ratings or the business models of the NRSROs. In response to the legislation, the SEC designated three new NRSROs in 2007 (Japan Credit Rating Agency; Rating and Information, Inc. [of Japan]; and Egan-Jones) and another two NRSROs in 2008 (Lace Financial, and Realpoint). The total number of NRSROs is currently ten. Finally, in response to the growing criticism (in the media and in Congressional hearings) of the three large bond raters' errors in their initial, excessively optimistic ratings of the complex mortgage-related securities (especially for the securities that were issued and rated in 2005 and 2006) and their subsequent tardiness in downgrading those securities, the SEC in December 2008 promulgated regulations that placed mild restrictions on the conflicts of interest that can arise under the rating agencies' ``issuer pays'' business model and that required greater transparency in the construction of ratings. \14\ Political pressures to do more--possibly even to ban legislatively the ``issuer pays'' model--remain strong.--------------------------------------------------------------------------- \14\ See, Federal Register, 74 (February 9, 2009), pp. 6456-6484.---------------------------------------------------------------------------An Assessment It is clear that the three dominant credit rating firms have received a considerable boost from financial regulators. Starting in the 1930s, financial regulators insisted that the credit rating firms be the central source of information about the creditworthiness of bonds in U.S. financial markets. Reinforcing this centrality was the SEC's creation of the NRSRO category in 1975 and the SEC's subsequent protective barrier around the incumbent NRSROs, which effectively ensured the dominance of Moody's, S&P, and Fitch. Further, the industry's change to the ``issuer pays'' business model in the early 1970s meant that potential problems of conflict of interest were likely to arise, sooner or later. Finally, the major agencies' tardiness in changing their ratings--best exemplified by the Enron incident mentioned above \15\--has been an additional source of periodic concern. \16\--------------------------------------------------------------------------- \15\ Most recently, the major rating agencies still had ``investment grade'' ratings on Lehman Brothers' commercial paper on the day that Lehman declared bankruptcy in September 2008. \16\ This delay in changing ratings has been a deliberate strategy by the major rating agencies. They profess to try to provide a long-term perspective--to ``rate through the cycle''--rather than providing an up-to-the-minute assessment. But this means that these rating agencies will always be slow to identify a secular trend in a bond's creditworthiness, since there will always be a delay in perceiving that any particular movement isn't just the initial part of a reversible cycle but instead is the beginning of a sustained decline or improvement. It may be that this sluggishness is a response to the desires of their investor clients to avoid frequent (and costly) adjustments in their portfolios; See, e.g., Altman and Rijken (2004, 2006); those adjustments, however, might well be mandated by the regulatory requirements discussed above. It may also be the case that the agencies' ratings changes are sluggish (especially downward) so as not to anger issuers (which is another aspect of the potential conflict-of-interest problem). And the absence of frequent changes also allows the agencies to maintain smaller staffs. Except for the regulatory mandates, however, the agencies' sluggishness would be inconsequential, since the credit default swap (CDS) market provides real time market-based judgments about the credit quality of bonds.--------------------------------------------------------------------------- The regulatory boosts that the major rating agencies received, starting in the 1930s, were certainly not the only reason for the persistent fewness in the credit rating industry. The market for bond information is one where economies of scale, the advantages of experience, and brand name reputation are important features. The credit rating industry was never going to be a commodity business of thousands (or even just hundreds) of small-scale producers, akin to wheat farming or textiles. Nevertheless, the regulatory history recounted above surely contributed heavily to the dominance of the three major rating agencies. The SEC's belated efforts to allow wider entry during the current decade were too little and too late. The advantages of the ``Big Three's'' incumbency could not quickly be overcome by the entrants (three of which were headquartered outside the U.S., one of which was a U.S. insurance company specialist, and three of which were small U.S. firms). It is not surprising that a tight, protected oligopoly might become lazy and complacent. The ``issuer pays'' model opened the door to potential abuses. Though this potential problem had been present in the industry since the early 1970s, the relative transparency of the corporations and governments whose debt was being rated apparently kept the problem in check. Also, there were thousands of corporate and Government bond issuers, so the threat of any single issuer (if it was displeased by an agency's rating) to take its business to a different rating agency was not potent. The complexity and opaqueness of the mortgage-related securities that required ratings in the current decade, however, created new opportunities and apparently irresistible temptations. \17\ Further, the rating agencies were much more involved in the creation of these mortgage-related securities: The agencies' decisions as to what kinds of mortgages (and other kinds of debt) would earn what levels of ratings for what sizes of ``tranches'' (or slices) of these securities were crucial for determining the levels of profitability of these securitizations for their issuers. Finally, unlike the market for rating corporate and Government debt, the market for rating mortgage-related securities involved only a handful of investment banks as securitizers with high volumes. An investment bank that was displeased with an agency's rating on any specific security had a more powerful threat--to move all of its securitization business to a different rating agency--than would any individual corporate or Government issuer.--------------------------------------------------------------------------- \17\ The Skreta and Veldkamp (2008) model predicts that greater complexity of rated bonds leads to a greater range of errors among (even honest) raters and thus to the ability of the issuers to select raters that are even more optimistic.---------------------------------------------------------------------------Fueling the Subprime Debacle The U.S. housing boom that began in the late 1990s and ran through mid 2006 was fueled, to a substantial extent, by subprime mortgage lending. \18\ In turn, the securitization of the subprime mortgage loans, in collateralized debt obligations (CDOs) and other mortgage-related securities, importantly encouraged the subprime lending. \19\ And crucial for the securitization were the favorable ratings that were bestowed on these mortgage-related securities.--------------------------------------------------------------------------- \18\ The debacle is discussed extensively in Gorton (2008), Acharya and Richardson (2009), Coval, et al. (2009), and Mayer, et al. (2009). \19\ This importance extended to the development of other financing structures, such as ``structured investment vehicles'' (SIVs), whereby a financial institution might sponsor the creation of an entity that bought tranches of the CDOs and financed their purchase through the issuance of short-term ``asset-backed'' commercial paper (ABCP). If the CDO tranches in a SIV were highly rated, then the ABCP could also be highly rated. (Interest rate risk and liquidity risk were apparently ignored in the ratings.)--------------------------------------------------------------------------- Favorable ratings were important for at least two reasons: First, as has been discussed above, ratings had the force of law with respect to regulated financial institutions' abilities and incentives (via capital requirements) to invest in bonds. \20\ More favorable ratings on larger fractions of the tranches that flowed from any given package of mortgage securities thus meant that these larger fractions could more readily be bought by regulated financial institutions Second, the generally favorable reputations that the credit rating agencies had established in their corporate and Government bond ratings meant that many bond purchasers--regulated and nonregulated--were inclined to trust the agencies' ratings on the mortgage-related, even (or, perhaps, especially) if the market yields on the mortgage-related securities were higher than on comparably rated corporate bonds.--------------------------------------------------------------------------- \20\ For banks and savings institutions, in addition to the absolute prohibition on holding bonds that were below investment grade, there was a further important impact of ratings: Mortgage-backed securities (MBS)--including CDOs--that were issued by nongovernmental entities and rated AA or better qualified for the same reduced capital requirements (1.6 percent of asset value) as applied to the MBS issued by Fannie Mae and Freddie Mac the instead of the higher (4 percent) capital requirements that applied to mortgages and lower rated mortgage securities.--------------------------------------------------------------------------- Driving all of this, of course, was the profit model of the securitizers (packagers) of the mortgages: For any given package of underlying mortgages (with their contractually specified yields) to be securitized, the securitizers made higher profits if they attained higher ratings on a larger percentage of the tranches of securities that were issued against those mortgages. This was so because the higher rated tranches would carry lower interest rates that needed to be paid to the purchasers of/investors in those tranches, leaving a greater spread for the securitizers. It is not surprising, then, that the securitizers would be prepared to pressure the rating agencies, including threats to choose a different agency, to deliver those favorable ratings.A Counterfactual Musing It is worth ``musing'' about how the bond information industry's structure would look today if financial regulators hadn't succumbed (starting in the 1930s) to the temptation to outsource their safety decisions and thus allowing the credit rating agencies' judgments to attain the force of law. Suppose, instead, that regulators had persisted in their goals of having safe bonds in the portfolios of their regulated institutions (or that, as in the case of insurance companies and broker-dealers, an institution's capital requirement would be geared to the riskiness of the bonds that it held) but that those safety judgments remained the responsibility of the regulated institution, with oversight by regulators. \21\--------------------------------------------------------------------------- \21\ This oversight would be an appropriate aspect of the safety-and-soundness regulation of such institutions. For a justification of safety-and-soundness regulation for these kinds of institutions, see, White (1991).--------------------------------------------------------------------------- In this counterfactual world, banks (and insurance companies, etc.) would have a far wider choice as to where and from whom they could seek advice as to the safety of bonds that they might hold in their portfolios. Some institutions might choose to do the necessary research on bonds themselves, or rely primarily on the information yielded by the credit default swap market. Or they might turn to outside advisors that they considered to be reliable--based on the track record of the advisor, the business model of the advisor (including the possibilities of conflicts of interest), the other activities of the advisor (which might pose potential conflicts), and anything else that the institution considered relevant. Such advisors might include the credit rating agencies. But the category of advisors might also expand to include investment banks (if they could erect credible ``Chinese walls'') or industry analysts or upstart advisory firms that are currently unknown. The end-result--the safety of the institution's bond portfolio--would continue to be subject to review by the institution's regulator. \22\ That review might also include a review of the institution's choice of bond-information advisor (or the choice to do the research in-house)--although that choice is (at best) a secondary matter, since the safety of the bond portfolio itself (regardless of where the information comes from) is the primary goal of the regulator. Nevertheless, it seems highly likely that the bond information market would be opened to new ideas--about ratings business models, methodologies, and technologies--and to new entry in ways that have not actually been possible since the 1930s.--------------------------------------------------------------------------- \22\ Again, this is necessary because the regulator has the goal that the regulated institution should maintain a safe bond portfolio (or have appropriate capital for the risks).--------------------------------------------------------------------------- It is also worth asking whether, in this counterfactual world, the ``issuer pays'' business model could survive. The answer rests on whether bond buyers are able to ascertain which advisors do provide reliable advice (as does any model short of relying on Government regulation to ensure accurate ratings). If the bond buyers can so ascertain, \23\ then they would be willing to pay higher prices (and thus accept lower interest yields) on the bonds of any given underlying quality that are ``rated'' by these reliable advisors. In turn, issuers--even in an ``issuer pays'' framework--would seek to hire these recognized-to-be-reliable advisers, since the issuers would thereby be able to pay lower interest rates on the bonds that they issue.--------------------------------------------------------------------------- \23\ This seems a reasonable assumption, since the bond market is, for the most part, one where financial institutions are the major buying and selling entities. It is not a market where ``widows and orphans'' are likely to be major participants.--------------------------------------------------------------------------- That the ``issuer pays'' business model could survive in this counterfactual world is no guarantee that it would survive. That outcome would be determined by the competitive process.Conclusion Whither the credit rating industry and its regulation? The central role--forced by seven decades of financial regulation--that the three major credit rating agencies played in the subprime debacle has brought extensive public attention to the industry and its practices. The Securities and Exchange Commission has recently (in December 2008) taken modest steps to expand its regulation of the industry. Further regulatory efforts by the SEC and/or the Congress would not be surprising. There is, however, another direction in which public policy could proceed. That direction is suggested by the ``counterfactual musing'' of the previous section: Financial regulators could withdraw their delegation of safety judgments to the credit rating agencies. \24\ The policy goal of safe bond portfolios for regulated financial institutions would remain. But the financial institutions would bear the burden of justifying the safety of their bond portfolios to their regulators. The bond information market would be opened to new ideas about rating methodologies, technologies, and business models and to new entry in ways that have not been possible since the 1930s.--------------------------------------------------------------------------- \24\ The SEC proposed regulations along these lines in July 2008; See, Federal Register, 73 (July 11, 2008), pp. 40088-40106, 40106-40124, and 40124-40142. No final action has been taken on these proposals.--------------------------------------------------------------------------- Participants in this public policy debate should ask themselves the following questions: Is a regulatory system that delegates important safety judgments about bonds to third parties in the best interests of the regulated institutions and of the bond markets more generally? Will more extensive SEC regulation of the rating agencies actually succeed in forcing the rating agencies to make better judgments in the future? Would such regulation have consequences for flexibility, innovation, and entry in the bond information market? Or instead, could the financial institutions be trusted to seek their own sources of information about the creditworthiness of bonds, so long as financial regulators oversee the safety of those bond portfolios?ReferencesAcharya, Viral, and Matthew Richardson, eds., Restoring Financial Stability: How To Repair a Failed System. New York: Wiley, 2009.Altman, Edward I., and Herbert A. Rijken, ``How Rating Agencies Achieve Rating Stability'', Journal of Banking & Finance, 28 (November 2004), pp. 2679-2714.Altman, Edward I., and Herbert A. Rijken, ``A Point-in-Time Perspective on Through-the-Cycle Ratings'', Financial Analysts Journal, 62 (January-February 2006), pp. 54-70.Cantor, Richard, and Frank Packer, ``The Credit Rating Industry'', Journal of Fixed Income, 5 (December 1995), pp. 10-34.Coval, Joshua, Jakub Jurek, and Erik Stafford, ``The Economics of Structured Finance'', Journal of Economic Perspectives, 23 (Winter 2009), pp. 3-25.Gorton, Gary B., ``The Panic of 2007'', NBER Working Paper #14358, September 2008; available at http://www.nber.org/papers/w14358.Mayer, Christopher, Karen Pence, and Shane M. Sherlund, ``The Rise in Mortgage Defaults'', Journal of Economic Perspectives, 23 (Winter 2009), pp. 27-50.Partnoy, Frank, ``The Siskel and Ebert of Financial Markets: Two Thumbs Down for the Credit Rating Agencies'', Washington University Law Quarterly, 77 No. 3 (1999), pp. 619-712.Partnoy, Frank, ``The Paradox of Credit Ratings'', In Richard M. Levich, Carmen Reinhart, and Giovanni Majnoni, eds., Ratings, Rating Agencies, and the Global Financial System. Boston: Kluwer, 2002, pp. 65-84.Richardson, Matthew C., and Lawrence J. White, ``The Rating Agencies: Is Regulation the Answer?'' In Viral Acharya and Matthew C. Richardson, eds., Restoring Financial Stability: How To Repair a Failed System. New York: Wiley, 2009, pp. 101-115.Skreta, Vasiliki, and Laura Veldkamp, ``Ratings Shopping and Asset Complexity: A Theory of Ratings Inflation'', Working Paper #EC-08- 28, Stern School of Business, New York University, October 2008.Sylla, Richard, ``An Historical Primer on the Business of Credit Ratings'', In Richard M. Levich, Carmen Reinhart, and Giovanni Majnoni, eds., Ratings, Rating Agencies, and the Global Financial System. Boston: Kluwer, 2002, pp. 19-40.White, Lawrence J., The S&L Debacle: Public Policy Lessons for Bank and Thrift Regulation. New York: Oxford University Press, 1991.White, Lawrence J., ``The Credit Rating Industry: An Industrial Organization Analysis'', In Richard M. Levich, Carmen Reinhart, and Giovanni Majnoni, eds., Ratings, Rating Agencies, and the Global Financial System. Boston: Kluwer, 2002, pp. 41-63.White, Lawrence J., ``The SEC's Other Problem'', Regulation, 25 (Winter 2002-2003), pp. 38-42.White, Lawrence J., ``Good Intentions Gone Awry: A Policy Analysis of the SEC's Regulation of the Bond Rating Industry'', Policy Brief #2006-PB-05, Networks Financial Institute, Indiana State University, 2006.White, Lawrence J., ``A New Law for the Bond Rating Industry'', Regulation, 30 (Spring 2007), pp. 48-52. CHRG-110hhrg46594--181 Mr. Wagoner," We are going to continue our focus on new product launches and, particularly and in line with the prior question, commitment to technology leaders like the Chevy Volt, which can raise the image of the company. We are going to continue to work on making sure that, particularly, we keep the car products on time in our portfolio and execute them to the highest standards. And we have continued work to do to make sure we have the right size distribution channel so our dealers can be profitable. Ms. Velazquez. So, sir, what about marketing and advertising? Would you have an ad at a cost of $3 million per 30 seconds during the Super Bowl this year? Or what about rationalizing the complex web of GM's product lines and cutting bureaucracy? And what about cutting travel costs? I wasn't here, but I understand you traveled in a private jet today. " CHRG-110hhrg45625--38 Mr. Perlmutter," Thank you, Mr. Chairman, and thank you to the ranking member. I just want to applaud both of you for really jumping into the fray to try to do something in a very difficult time in America. This is going to take a bipartisan effort, whatever it is that we achieve. I found myself in agreement with a number of the remarks by Mr. Barrett as well as by Mr. Garrett. I think that ultimately there is a way for this country to stabilize itself, to become strong again, and to become that beacon of light that the rest of the world looks to for confidence. For me, there are three things that have to be proven before I will support any of this because, Mr. Davis is correct, people in Colorado don't want to bail out folks who have been making a fortune while they have been barely hanging on. And so there are three pieces. One, there has to be proof that this really will stabilize the financial markets; the financial markets not being the economy, but being the lubricant for the economy. Two, there have to be protections for the taxpayers. If we are going to come in and as a Nation subsidize this, try to resolve this, there better be plenty of protections. And I know, Mr. Chairman, and you, Mr. Ranking Member, that has been something that has been critical as you have been negotiating with the Administration, who are going to give us no protections in their initial rendition of the bill. The third piece, and I think it is the critical piece, but it is the long-term piece, is to rebuild the economy. Let's go back to how this all started. This started with us sending lots of money overseas; to China, because we buy we so much from them; to the Middle East, because we buy their oil, and then money coming back to the United States because it is a secure investment, and real estate prices only go up. So even if people can't pay their mortgages, you are going to be secure because real estate just goes up. So a lot of investment from overseas, a lot of investment locally. Well, in Colorado we went through a more or less depression back in the 1980's, and we know that real estate prices don't always go up. But what was going on here is more and more exotic products were being presented to less and less creditworthy customers. Ultimately, that house of cards came tumbling down. Now I did an op ed, and I am going to read from it just a little bit. Financial markets can be a fragile things. At their root, they are based upon the confidence of everyday people in Colorado, in Wyoming, New York, in California. And in this day and age, it is also based on the confidence of leaders in China and sheiks in Saudi Arabia and businessmen and women in Brussels and Brazil. What creates this confidence is a question philosophers and economists have asked for centuries. From the outset, the confidence in America's markets was built upon the values of sacrifice and thrift, investment and innovation, opportunity for anyone who wished to put their training, talent, and best effort to work, and a sense of community. That we are in this together. But recently, these values have been eclipsed by a philosophy that greed is good, immediate gratification is better; borrowing the norm, investment the exception; and every man for himself, and a giant payoff for a select few while most people are barely breaking even. The last time this philosophy took hold was the Roaring Twenties. A recent commercial touting the need for bling was reminiscent of the party atmosphere of the 1920's. The crash of 1929 was a stark reminder that the party cannot go on forever, and the hangover of the Great Depression resulted in misery for millions of Americans. As a consequence of that crash, steps were taken by the Roosevelt Administration to place safeguards and restraints within the financial markets to rebuild confidence in them, and at the same time, Americans of every creed and color returned to the basic values of thrift, sacrifice, investment, opportunity for all, and community, and the result was a creation of wealth on a national scale never before seen in the history of the world. We are at a place now where we can take this crisis that has been presented to us, although John McCain and others say the fundamentals of the economy are sound. Obviously, we are going to hear from Mr. Paulson and Mr. Bernanke that they are not. I believe this is an opportunity to set this country on stable footing, but proof has to be made that this is going to stabilize the markets, this is going to protect the taxpayer, and help us to rebuild this economy. With that, I yield back my time. " fcic_final_report_full--2 We have tried in this report to explain in clear, understandable terms how our complex financial system worked, how the pieces fit together, and how the crisis oc- curred. Doing so required research into broad and sometimes arcane subjects, such as mortgage lending and securitization, derivatives, corporate governance, and risk management. To bring these subjects out of the realm of the abstract, we conducted case study investigations of specific financial firms—and in many cases specific facets of these institutions—that played pivotal roles. Those institutions included American International Group (AIG), Bear Stearns, Citigroup, Countrywide Financial, Fannie Mae, Goldman Sachs, Lehman Brothers, Merrill Lynch, Moody’s, and Wachovia. We looked more generally at the roles and actions of scores of other companies. We also studied relevant policies put in place by successive Congresses and ad- ministrations. And importantly, we examined the roles of policy makers and regula- tors, including at the Federal Deposit Insurance Corporation, the Federal Reserve Board, the Federal Reserve Bank of New York, the Department of Housing and Ur- ban Development, the Office of the Comptroller of the Currency, the Office of Fed- eral Housing Enterprise Oversight (and its successor, the Federal Housing Finance Agency), the Office of Thrift Supervision, the Securities and Exchange Commission, and the Treasury Department. Of course, there is much work the Commission did not undertake. Congress did not ask the Commission to offer policy recommendations, but required it to delve into what caused the crisis. In that sense, the Commission has functioned somewhat like the National Transportation Safety Board, which investigates aviation and other transportation accidents so that knowledge of the probable causes can help avoid fu- ture accidents. Nor were we tasked with evaluating the federal law (the Troubled As- set Relief Program, known as TARP) that provided financial assistance to major financial institutions. That duty was assigned to the Congressional Oversight Panel and the Special Inspector General for TARP. This report is not the sole repository of what the panel found. A website— www.fcic.gov—will host a wealth of information beyond what could be presented here. It will contain a stockpile of materials—including documents and emails, video of the Commission’s public hearings, testimony, and supporting research—that can be stud- ied for years to come. Much of what is footnoted in this report can be found on the website. In addition, more materials that cannot be released yet for various reasons will eventually be made public through the National Archives and Records Administration. Our work reflects the extraordinary commitment and knowledge of the mem- bers of the Commission who were accorded the honor of this public service. We also benefited immensely from the perspectives shared with commissioners by thou- sands of concerned Americans through their letters and emails. And we are grateful to the hundreds of individuals and organizations that offered expertise, informa- tion, and personal accounts in extensive interviews, testimony, and discussions with the Commission. CHRG-111hhrg53246--61 Mr. Bachus," And I endorse this idea of trying to get at least an interim report, but I would caution you as well as you cautioned, I think, in your statements, how complex these matters are and that you want to get it right because these have tremendous implications for our economy if they are not done right. So I thank you and look forward to what I hope will be an interim report September 30th. But I would caution you also, you are going to be asked to speak to all sorts of forums and all sorts of public addresses. You need to limit some of that. You need to set your priorities because there is a lot of hard work back at the agencies. And I hope that the public and the Congress will realize that the agencies are going to have to do a lot of hard work, a lot of concentration, and a lot of study in a very short period of time. " CHRG-111hhrg51591--15 Chairman Kanjorski," Thank you very much, Mr. Hensarling. We will now hear from the gentlelady from California, Ms. Speier, for 2 minutes. Ms. Speier. Thank you, Mr. Chairman, and Ranking Member Garrett. The subject of today's hearing is how should the Federal Government regulate insurance? I think at first we really need to answer the question, should the Federal Government regulate insurance? Here in Washington, the common perception seems to be that Federal regulation is always preferable to State regulation. In this case, however, I believe the move towards replacing State regulatory authority with Federal, particularly if it creates a dual optional Federal structure, is seriously misplaced and misguided. AIG, the world's largest insurance company, is often cited as the poster child for the need for Federal regulation of insurance. The case of AIG proves just the opposite. AIG's insurance operations, and the fact that they were regulated by the States and required to hold risk-based reserves, is the only reason AIG was salvageable, even if it took $150 billion in taxpayer money to bail out the federally regulated holding company. If the State regulators hadn't prevented the holding company from raiding State-based reserves, even the insurance subsidiaries would have gone down, jeopardizing consumers and State-guaranteed funds all across our country. In my opinion, AIG makes the argument not for Federal regulation of insurance, but for the reintroduction of Glass-Steagall. In the words of AIG CEO Liddy before this committee, and just yesterday before the Government Oversight Committee, ``AIG needs to return to doing what it does best, insurance.'' If it had stuck to insurance and hadn't been able to buy a small savings and loan so that it could choose OTS as its regulator, we likely wouldn't be facing the crisis we are facing today. Instead, it launched into the high-risk and supposedly high-reward world of derivatives, where Federal regulators were largely asleep at the switch. OTS has admitted to this committee that they really had no idea what was going on. I think we can all agree that the regulator-shopping among financial institutions has been a disaster, and we should not now be considering giving that opportunity to insurance companies. The insurance industry chafes under State regulation not because of the onerous regulatory burden, but because States impose stringent capital reserve requirements, and because of the ability in some States like California to pass tough consumer protection laws and rate regulation. Let me be blunt. I think the discussion is all about life insurance companies being further able to leverage their positions. I served as chair of the California State Senate Banking, Finance, and Insurance Committee for 8 years. The insurance industry lobbyists were always looking to weaken consumer protections. I think one of the frequent refrains, that they needed to be free of State restrictions so they could be able to speed creative and innovative products to market so that they could compete with Wall Street, has been shown to be the fallacy that it was and is. Insurance is an essential part of our economy. It needs to be strong and robust. The protections for the consumers and taxpayers must be equally strong and robust. I yield back. " CHRG-111hhrg53021Oth--273 Secretary Geithner," I would be happy to respond. The overall estimates of magnitude of the total face value of these markets are in the $600 trillion range. The market value of those contracts, my testimony, says are more in the $20 trillion range. That still itself doesn't really capture the risk. It probably substantially overstates it. But these are enormously large markets, enormously important to how our markets function. These markets include interest rate risk, exchange risk, equity derivatives, commodity derivatives, energy, food, et cetera. And the way this happened in credit derivatives was very similar to what happened in commodity derivatives and others, which is that decades ago people figured out a way to offer a company the ability to hedge against a particular risk, the cost of energy, cost of seeds, cost of movement in exchange rates, cost of a change in interest rates, and over time products emerged to meet that economic demand. What we did not do in our country is stay abreast of that innovation and put in place the framework of protections over those markets that was commensurate with the risk they proposed. We were behind that curve. And we had a lot of institutions, including regulated institutions like the monoline insurance companies and AIG that wrote a huge amount of protections without the capital to back it, and that combination of factors helped bring us to the edge of this very severe crisis. And it is an obligation we all share to make sure that we not just address those principal causes of this crisis, but we have a stronger framework to address future vulnerabilities, and that our framework adapts more quickly in the future. And that is what we are trying to do. " CHRG-111hhrg53021--273 Secretary Geithner," I would be happy to respond. The overall estimates of magnitude of the total face value of these markets are in the $600 trillion range. The market value of those contracts, my testimony, says are more in the $20 trillion range. That still itself doesn't really capture the risk. It probably substantially overstates it. But these are enormously large markets, enormously important to how our markets function. These markets include interest rate risk, exchange risk, equity derivatives, commodity derivatives, energy, food, et cetera. And the way this happened in credit derivatives was very similar to what happened in commodity derivatives and others, which is that decades ago people figured out a way to offer a company the ability to hedge against a particular risk, the cost of energy, cost of seeds, cost of movement in exchange rates, cost of a change in interest rates, and over time products emerged to meet that economic demand. What we did not do in our country is stay abreast of that innovation and put in place the framework of protections over those markets that was commensurate with the risk they proposed. We were behind that curve. And we had a lot of institutions, including regulated institutions like the monoline insurance companies and AIG that wrote a huge amount of protections without the capital to back it, and that combination of factors helped bring us to the edge of this very severe crisis. And it is an obligation we all share to make sure that we not just address those principal causes of this crisis, but we have a stronger framework to address future vulnerabilities, and that our framework adapts more quickly in the future. And that is what we are trying to do. " CHRG-111hhrg53246--3 Mr. Garrett," Thank you, Mr. Chairman, and thank you, members of the panel. Today's hearing is on the President's financial regulatory reform proposals. You know, your agencies oversee some of the most transparent, efficient, and complex markets in the world that are also responsible for ensuring that our capital markets promote price discovery, capital formation, and investor protection. Now, the Administration's reform proposals task the SEC and the CFTC with developing a regulatory infrastructure for over-the-counter derivatives and reporting to Congress by September 30th on how the agencies will harmonize two very disparate regulatory approaches. So I look forward to hearing from you to see how well those are coming together and where some of your sticking points are going to be, if there are some, I think there will, and whether you will be able to meet that deadline. You know, with regard to the Administration's proposals, I agree with some of them. I think it is evenhanded and certainly less radical than other ideas that have been proposed so far in Congress. Still, there are some aspects of the Administration's proposals that trouble me. And I am worried that in the name of systemic risk reduction, requirements that would force more OTC transactions into central clearinghouses or onto exchanges, as well as strident new margin requirements for both centrally cleared and noncentrally cleared transactions will make hedging just too expensive for many end users of derivatives throughout the broader economy. The perverse outcome, therefore, of efforts to reduce systemic risk in these markets can actually increase risk for many companies if they are no longer able to cost effectively engage in a comprehensive risk management practice. So if you take a step back for a moment, perhaps an even more fundamental question should be asked here: Were standardized derivatives significantly related to the recent meltdown of our financial markets, and if not, why are we prescribing cures for a nonexistent ailment? You know, the failed oversight of one large dealer directly related to broader regulatory failures in the housing finance markets should not cause us to pursue radical fixes for the broader OTC derivative markets and their nondealers participants that had little or really nothing to do with the recent crisis. What we do need is comprehensive regulatory reform, but it needs to be sensible and we need to make sure that we are addressing actual problems in the way that we are doing it and not causing more harm than good. The risk of mobile capital migrating elsewhere as we overshoot the mark in regulatory reform, I think, is a real one and we should take the time to carefully evaluate the proposals presented to us before we move ahead with legislation. So once again, thank you both for coming to the panel today, thanks to the people who have been here numerous times in the past as well. Thank you. " CHRG-111hhrg48875--164 Mr. Castle," Thank you, Mr. Chairman. And thank you, Mr. Secretary, for being here and for your judgment on all this. And let me say that I by and large agree with what you have stated. But I want to talk about what you didn't talk about a little bit, and that is what you referred to as the complex and sensitive questions on who should be responsible for what. I am not trying to pin you down; I am trying to sell you something, actually. You may--I am sure you probably did see or read about Senator Collins' proposal, which I have also introduced here in the House, forming a Financial Stability Council. And I am not suggesting that is magic. Who knows. But I have looked at this issue, and I am very concerned about where this all may rest. I think there is majority agreement, if not unanimous agreement, we need to do something. And the question then becomes, who is going to do it, and I think what you have outlined substantively is about what we have to do. But I am worried about the powers we are going to give to any one entity in doing this. And I thought that this council, which would have an outside chairman but would bring in the different agencies that do the regulating now, would be a good way to go. And the word in the media is that the Federal Reserve is the natural entity to run this. And that is fine, and I have a lot of respect for Mr. Bernanke and the Federal Reserve. But they have some regulatory authority now in a certain aspect of the economy. They also have other responsibilities for the economy. And I just worry about potential conflicts there. On the other hand, having them at the table, having the other regulatory entities, including Treasury and FDIC and the others, I think is important. So I would hope that when we get down to that important question of how this is going to be organized, that careful thought is given--and for all I know, you have already given careful thought to this--but careful thought is given to being inclusive, even having an advisory council, perhaps some of the entities that are going to be regulated to help with this. I mean, after all, you know, the AIG people may have been a little more thoughtful if they had been at the table hearing some of this. So there is a variety of things perhaps we can do. And I just don't want it to be so closed that all of a sudden you have that iron-fisted hand making all these decisions, perhaps without consultation with other people or groups, and maybe unintentionally, but in conflict with itself in terms of other things that they may have to do. So I pose all that to you, and I would be interested in your comments on it. Again, I am not asking you to reveal something that you are not ready for yet. But I just want to make sure that the Administration is paying attention to the breadth of this issue as well as the substance of it in terms of how we are going to manage it. " CHRG-111shrg55278--15 Chairman Dodd," Thank you very much, Dan. We appreciate your testimony and your involvement with the Committee, as well. I will ask the Clerk to put on--why don't you put on 6 minutes and try and keep an eye on that. We have got a lot of participation here this morning and I want to make sure we get around to people. I have asked the staff to make sure you give me a very accurate account of the arrival of Members in terms of the order in which they will be asked to address the questions to our panel. Let me begin with you, Governor Tarullo, if I can. I suspect a lot of the questions I am going to raise for you, you are going to hear variations of these same kind of questions, I suspect that sort of a theme will emerge here. You testified that the Administration's proposal to give the Fed systemic risk supervision is incremental. It builds on the robust authority which you already have under the Bank Holding Company Act, and you also detail your plan for a new surveillance program, which you mentioned here, for large complex financial organizations that will look at emerging risks to the system as a whole. Now, obviously, we are not speaking about you, because obviously you are new to this, but given the Federal Reserve's history and record on this as an institution as we look back, why should we in this Congress have any confidence in the Federal Reserve, other than what is being said today, and I appreciate what is being said today, but given the history of the Federal Reserve, you can argue that this authority has already existed. We don't need new authority. It has been there. Under the Bank Holding Company Act, you have had that authority for a long, long time. Certainly all the powers are there, the personnel, the resources to do a job, and yet there was an abysmal failure when it came to these institutions. So why at this juncture, and I raise this with you, why should this Committee or the Congress have any heightened degree of confidence that the Federal Reserve, having failed in that function, given the authority for years, should now be granted expanded authority in that same area? " 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-110hhrg34673--71 Mr. Bernanke," Let me say this: I think it is very important that as we try to achieve the objectives of greater clarity and transparency in corporate governance and internal controls and so on that we do it at the lowest cost we can, and I think that it is a good development that the Public Company Accounting Oversight Board along with the SEC has recently promulgated for a comment a new audit standard which would be less ``checking of the box'' and more focused on the major concerns of the company, and also that would take into account the size and complexity of the company, so we wouldn't be putting these costs on the smaller companies. I think that is an important step in the right direction. I would be curious to see how that goes. More generally, you know, as a regulator, I think it is very important that we have to achieve the objectives that Congress gives us, and there are some very important ones, but we also need to do the best we can to minimize the cost and unnecessary burden created by those regulations. " CHRG-111shrg57709--3 STATEMENT OF SENATOR RICHARD C. SHELBY Senator Shelby. Thank you, Mr. Chairman. Chairman Volcker, welcome again to this hearing. I think one of my first few weeks on this Committee was you testifying when you were Chairman of the Federal Reserve. That was a few moons ago, as we both know, but we welcome you back. The financial crisis has had a devastating effect on our economy. Millions of people have lost their jobs, trillions of dollars of household wealth have evaporated, and the American taxpayer is on the hook for nearly all of it. We cannot allow such a calamity to occur again. For this reason, and others, I am willing to consider any proposal that will strengthen our regulatory framework and help our economy, including the President's latest recommendations. That is why I joined my Republican colleagues and asked for this hearing. Today, we hope we can gain a better understanding of the specific activities that would be banned under the President's proposal and the risks associated with those activities. We also need to understand clearly the costs and the benefits associated with the plan's proposed changes. Finally, we need to determine whether we should incorporate the President's latest ideas into the current regulatory reform debate or whether they can be considered at a later date. I believe our main goal today in regulatory reform must be to eliminate taxpayer exposure to private risk while establishing the strongest, most competitive, and economically efficient regulatory structure possible. Achieving this goal will involve ending bailouts, addressing ``too big to fail,'' reorganizing our financial regulators, strengthening consumer protection, and modernizing derivatives regulation, among others. Putting this together in a legislative package is a very difficult task, yet as difficult as our task may be, I remain committed to considering any concept that may help us achieve our overarching goal. With that said, however, I am quite disturbed by the manner in which the Administration has gone about introducing their latest proposals for consideration. We are more than a year into our deliberation on regulatory reform. The House already has completed action. Regrettably, the Administration waited until a little over a week ago to bring this very significant concept to the table. Seven months after the Administration first introduced broad recommendations that the President characterized as ``sweeping reform not seen since the Great Depression,'' this concept that we have before us today was air-dropped into the debate. I applaud Chairman Dodd for giving us the opportunity to begin a thoughtful process regarding the President's latest notions on regulatory reform. I hope, however, that this is not an indication that the Administration intends to substitute thoughtful analysis with whatever polls will on a given day. This is too important, it is too complex to be subject to the vagaries of political litmus testing. I know Chairman Volcker knows this, and I hope that he will continue to work with us. Mr. Chairman, last fall you offered a regulatory reform discussion draft, and while I supported your policy aims, I questioned the means at that time. In response, you rightly slowed the process to consider more carefully how to accomplish our mutual objectives. I believe we have made tremendous progress in that regard. Whether we ultimately reach a consensus remains to be seen, but we are working at it. And as I have said many times, we must get it right, and this is a goal that I know we both share. Thank you. " CHRG-110hhrg46593--200 Mr. Findlay," Thank you, Congressman Kanjorski. I am Cameron Findlay, the executive vice president and general counsel of Aon, and I appreciate the opportunity to testify today on behalf of the Council of Insurance Agents and Brokers. My written testimony provides the details of an innovative proposal for the Department of the Treasury to exercise the authority you have granted under Section 102 of TARP, so please permit me here just to summarize the high points. We start with the premise that the insurance industry has a lot to offer in the efforts to stabilize the economy, because insurance is a critical but sometimes overlooked part of the financial services industry. Put simply, we believe that the Department of the Treasury should use its statutory authority, the authority you have granted it, to establish a program to insure a portion of the expected payment of principal and interest from troubled and illiquid financial instruments. While Treasury's efforts to inject capital in financial institutions is important--and has succeeded in some respects--this effort doesn't address a primary cause of the liquidity problem, the hundreds of billions of dollars of illiquid assets that are on the books of America's financial institutions. Our proposed approach is an insurance program that would combine risk pooling, risk retention by the financial institutions themselves, and potential government backstop liquidity. In our view, such an approach would benefit all the stakeholders here, taxpayers, financial institutions, and homeowners. The plan involves, first, the sharing of risk by participants in an asset stabilization pool. Participants in the pool would pay risk-based premiums, and the pool would insure a portion of the principal and the interest from illiquid assets on their books. Thus, the program would insulate an asset holder from having to immediately recognize the decline in value resulting from the nonpayment or expected nonpayment of principal and interest. Second, our plan requires financial institutions to retain some risk. Just as holders of insurance policies retain risk through deductibles, asset holders would be required to retain a percentage of the shortfall of principal and interest. Asset holders would be reimbursed from the pool for a shortfall, only when the shortfall exceeds their retained amount in a single year. It is just like a deductible in your home insurance policy. Third, our plan involves the potential of government loans as a backstop. That is, in the event that in the early years, payments from the pool exceeded premium collections, the government could loan the pool funds needed to make good on the guarantees. The government would then be reimbursed by premium collections in subsequent years. Let me illustrate the proposal by using a very simple example. Suppose an institution holds $1 million in mortgage-backed assets. Assume that the current lack of confidence in the liquidity of these assets has dropped the market value to, say, $600,000. Now, this $400,000 drop is not necessarily the result of a true decrease in the asset's intrinsic value. It may simply be the result, at best, of a lack of information about the value of the asset or, at worst, in the current environment, to sheer panic. Let's assume in our example that the actual intrinsic value of the asset is $800,000. Without our proposed insurance program, the institution might have to mark the asset to market, resulting in an immediate loss of $400,000 in value or, even worse, the institution might have to sell the asset into a panicked market. But an insurance pool that guarantees the repayment of the principal and interest from these assets would, under proper accounting treatment, result in the institution holding assets worth $800,000, not $600,000. The insurance industry knows how to do this. Actuaries can set initial premiums based on the law of large numbers, and then after experience working with the proposed pool, actuaries could use the accumulated data about the performance of the assets to develop ever-more-accurate premium pricing models, reflecting the actual value of the underlying securities. In our view, this program will have significant benefits for all stakeholders: Taxpayers; financial institutions; and homeowners. For taxpayers, an insurance program would have significantly less short-term cash requirements and capital infusions. Also, because it would be funded by its direct beneficiaries, it would restore liquidity without requiring massive immediate outlays of government funds. The insurance solution would also assist financial institutions. As an insurance program, it would provide asset holders the option to hold assets until maturity or until economic conditions permit the recognition of the assets' real value. It wouldn't flood the market with distressed assets, which could have the effect of further depressing asset values. An insurance program would also prevent opportunistic purchases of depressed assets by predatory investors. Finally, our plan helps homeowners as well, homeowners facing foreclosure, by proposing that participating companies have to agree to a plan to restructure individual mortgages as a condition of participation. On behalf of Aon and the CIAB, I want to thank you again for the opportunity to testify today. We stand ready to work with you on our proposal, and we would be pleased to take any questions that you may have. [The prepared statement of Mr. Findlay can be found on page 185 of the appendix.] " 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-111shrg55479--17 Mr. Coates," Thank you, Senator Reed, thank you, Ranking Member Bunning, and the rest of the Members of the Committee who are. I very much appreciate the opportunity to talk about corporate governance. Good corporate governance is an essential foundation to economic growth, and so this could not be a more important time for the Congress to be focusing on it. There are a large number of reforms--six in Senator Schumer's bill alone, and there are many others--that we could talk about. I am going to talk about a few. I am happy to talk about others that you may have questions about or want to explore. But before I talk about specifics, let me make two general remarks that I think should be kept in mind in thinking about any particular reform. First, and maybe a little controversially, I think it is fair to say that the academic perspective on corporate governance would view financial firms differently than other kinds of corporations, and not in the straightforward way that you might think; that is to say, shareholders of financial firms want financial firms to take risk and want them to take more risk than may be appropriate from the perspective of the taxpayer. That is because many of the large financial institutions are, as we have learned, too big, too complex to fail, so that from the shareholders' perspective, if things go well with the risks that the companies take, they are on the upside; and if things go badly, then in the end it is the taxpayer who helps defray the costs to the shareholders. As a result of that, I do not think that it would be a good idea to give shareholders considerably more power in the governance of large financial institutions. I think, in fact, if anything, financial regulators should be given more authority to check the power that shareholders have, at least on particular issues--compensation being one. The compensation structures and incentives that shareholders, even if the boards are doing exactly the right thing for shareholder, that shareholders want of large banks are not the ones that are going to be the most safe and most sound from the perspective of the American public. So that is the first general remark. Second is across the board on this, I think it is fair to say that academic and scientific research more generally is quite weak. It is evolving. There is almost no nontrivial issue in corporate governance about which there is not fierce academic as well as political argument. That cautions against passing rules that are fixed, mandatory, and are hard to change over time. Instead, it cautions for giving shareholders the ability to adopt rules for their own companies, facilitating collective action by them--and that is an important role, I think, that regulation can play. Shareholders of public companies are dispersed, cannot easily act on their own, and often face entrenched boards who are unwilling to make changes when they are, in fact, the best thing for the companies. The caution about the weakness of the scientific evidence is also not a reason to do nothing because what I just said is one thing that there is general consensus on. Disperse shareholders have a hard time acting for themselves as the number of shareholders increase. And the other general consensus, I would say, across the board is that corporate governance in the United States in the last 10 to 20 years has not performed terribly well at a large number of companies. And so there is need for change, and there is need for carefully considered moderate reforms of a kind that can be revised over time as learning on these subjects grows. So on the specifics, let me say quickly, I think the evidence that we do have is that ``say-on-pay'' is a good idea, and I am happy to expound on that beyond that bottom-line conclusion. I would say for large companies, splitting CEOs from chairmen has some evidence behind it that that is a good thing. Smaller companies, I am not so sure the evidence is there. But as long as the SEC is given appropriate authority to tailor any legislation in this area, I think that would be a good thing to pursue. I would say that staggered boards, the evidence, if anything, runs against eliminating them. They are an important option between, on the one hand, a fully contestable corporate governance structure where every director is up for election every year, and a governance structure where essentially the insiders have complete control, as in the case of Google, which is a reasonably successful company. In between, staggered boards have proven to be a type of governance structure that investors and new IPOs have been willing to put their money behind, and to ban them across the board I don't think is supported by the evidence at the moment. On shareholder access, just to wrap up, frankly there is no evidence, and I think there is--that is a reason to proceed, but to proceed cautiously, to proceed through the SEC, and here I think the SEC already has adequate authority to pursue this topic. But the one thing Congress probably could clarify is exactly what their authority is in this area, and I think that would be a good thing. With that, thank you. " FOMC20080318meeting--59 57,MS. PIANALTO.," Thank you, Mr. Chairman. Through my conversations with people in the Fourth District financial community, I get the clear impression that some credit channels are closing down. Given the uncertainties in financial markets, some of the large banks in my District are finding it challenging to ascertain potential loss exposures in certain asset categories, especially to residential real estate developers. Two large banks in the District have seen their asset quality deteriorate more quickly than they had projected in January. Clearly, banks and other financial institutions are getting squeezed from both sides of their balance sheets, and the most highly leveraged institutions are getting squeezed the hardest. Many of the large banks in my District are going to considerable lengths to stay liquid and to conserve capital. The largest and most complex institutions are attempting to raise more capital. The deteriorating environment in the financial markets is clearly affecting business conditions. Most manufacturers in the District have seen a slowing in business activity. Those that are doing better are doing so because they are being helped some by stronger export demand. Pessimism over economic prospects is now prevalent among the CEOs that I talked with, and many are scaling back their business plans for 2008 by a considerable amount. The faltering business prospects are making the financial environment even more uncertain--a pattern that conforms to the adverse feedback loop that Governor Mishkin and others have been warning about. Like others, I have once more cut my growth projections for 2008 and, again, by a relatively large margin. As in the Greenbook, I have factored into my projection the weaker than previously expected estimates of spending and employment as well as the sharp run-up in energy costs. An especially important element in my current thinking is the future path of housing values. Many of my contacts have told me that they don't see how financial market conditions can stabilize without more confidence about where the bottom of the housing market lies and, as a corollary, where the bottom of the residential-mortgage-backed security prices might lie. Unfortunately, I haven't seen evidence that we are seeing a leveling out in housing prices. The Greenbook baseline projection carries with it nominal house-price declines of about 5 percent this year and next. A month ago that may have seemed like a reasonably good assumption to me, but today I fear that projection may be too optimistic. Certainly, the decline in house values that one sees in futures markets for the markets that are covered by the Case-Shiller index indicates a decline of twice that magnitude. My own baseline projection is closer to the ""greater housing correction"" alternative than the Greenbook's baseline projection. Even the ""greater housing correction with more financial fallout"" alternative seems somewhat plausible to me. Turning to the inflation outlook, at our January meeting my modal outlook was one in which the inflation trend declined to just below 2 percent in 2010. At the same time, I was one of the few participants who said that the inflation risk had shifted to the upside. I still hold to those views--that is, I still expect the trend of inflation to fall below 2 percent by 2010, but I still worry that we are going to continue to experience upside surprises to that inflation outlook. Indeed, I can't recall a single conversation that I have had with my business contacts recently that hasn't touched on the increasing cost pressures that they are facing. In most cases, they are now successfully passing along price increases to their customers. Nevertheless, as I assess the economic environment this morning relative to where I was in January, particularly given the prospects of yet larger wealth losses stemming from the real estate market and certainly the chance for even greater impairment to the functioning of our credit markets, I think the downside risks to economic growth continue to outweigh the upside risks to inflation. Thank you, Mr. Chairman. " CHRG-111shrg61513--52 Mr. Bernanke," Well, financial services obviously has a place to play in a modern economy, and it is a productive industry in the sense that it helps allocate capital more effectively and share risk and do important things like that. I think we would all agree that over the past decade or so, financial services, residential construction, and some other sectors may have become too big relative to other sectors, and we are now seeing the painful unwinding of that process. I think the right way to address the size of financial services is to make sure that it is being productive and constructive, and that means having a good regulatory regime that directs--that provides a context in which financial services will do productive, constructive things for the economy. So good financial regulatory reform should lead the financial services industry to adjust to an appropriate size that is right for the economy. On manufacturing, it is really a mixed picture in the United States. We still are probably the biggest or one of the biggest manufacturers in the world. We are the most productive. We have had extraordinary increases in productivity, in manufacturing recently. That, in fact, is part of the reason why the employment share of manufacturing keeps going down, is that we need fewer workers to produce a car or an airplane than we used to. Senator Brown. That is true, Mr. Chairman, but look at the profits of the financial services--the chasm between financial services and manufacturing is--the chasm is big in terms of the percentage of GDP. It is even larger in terms of profits in the last 5 years. Keep that in mind. " FinancialCrisisInquiry--117 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. CHRG-110hhrg46591--13 Mr. Lynch," Thank you, Mr. Chairman. I want to thank the ranking member as well and the witnesses for helping the committee with its work. I want to associate myself with the remarks of the gentleman from Ohio, who said that the time for finger pointing is long past, and we really, within this committee structure, have to figure out where we need to go in the future and how to fix this regulatory system. I would like the economists and the industry participants who are before us today to really focus on the purpose of the regulatory regime that we put in place, which is to provide information to investors, not only in external transparency but also in internal transparency. Because what we have seen is that these companies themselves do not understand truly the value of some of these complex derivatives that they hold. So, again, I thank you for your attendance here today, but I would like to see the focus on transparency, after reading your remarks, and on the value that that would have in any system that we will devise going forward. Thank you. I yield back. " CHRG-111shrg57709--71 Mr. Volcker," If you want my response, I haven't been involved in those very complex discussions, but I think you do need to do some rethinking of Basel II with some more explicit overall leverage limit, I think is a good thing. But a lot of the Basel II stuff has to be clarified and made, I believe, more binding. It rested very heavily on banks' internal risk management procedures and on credit rating agencies. Both of those have been somewhat discredited in the past couple of years, so a lot of rethinking is involved there. And that is a place where you need, speaking of common international per capita requirements, I think you do need a common standard. And getting agreement among a lot of--this is now a lot of countries. It is not just the United States and United Kingdom and Europe, it is Japan and China and emerging countries. And getting them all to agree is a challenge. " CHRG-110shrg50369--142 PREPARED STATEMENT OF SENATOR ELIZABETH DOLE Thank you, Chairman Dodd and Ranking Member Shelby for holding this very important hearing today. Chairman Bernanke, I join my colleagues in extending you a warm welcome. Since last August, our financial markets have experienced tremendous uncertainty. Credit and capital markets around the world have struggled to comprehend the ramifications of the U.S. subprime lending and housing crisis. Fortunately, the Federal Reserve has been quick to act, lowering the federal funds rate from 5.25 percent to 3 percent. Congress also is working to help boost our economy. Several recent reports have highlighted ongoing economic challenges. Such as last week, the Wall Street Journal said that the ``leading economic indicators'' fell for the fourth straight month. Since its July 2007 high, the index has fallen by 2 percent, which is the largest 6-month drop since 2001. Additionally, for the week ending on February 16, the 4-week average of initial unemployment claims rose by 10,750 to 360,500, pointing to a softening of the labor market. Furthermore, by the third quarter of 2007, household debt rose to $13.6 trillion from $7.2 trillion in 2001, a 10-percent annual increase. Over this same time period, mortgage borrowing more than doubled. As a result, one out of every seven dollars of disposable income earned by Americans goes towards paying down debt. Fears loom of higher inflation and more ``pain at the pump.'' The price of a barrel of oil has hovered around the $90 mark and recently closed above $100 per barrel. If these higher gas prices and inflationary pressures continue, coupled with the well-known weakness in across our housing sector, I--like many folks I hear from--am very concerned that future economic growth could be hindered. No question, the health of our economy is influenced by many complex issues and expected and unexpected events. That said, I would like to highlight a few areas where I am focused to help spur growth and job creation. I strongly support Trade Adjustment Assistance, which helps ensure that displaced workers have the ability to train for new careers. In recent years, my home state of North Carolina has undergone a difficult economic transition, as our state continues to evolve from a manufacturing and agriculture-based economy to a more services-oriented economy. In North Carolina and across the country, there is a need to address the growing gap between skilled and unskilled workers. Senator Cantwell and I have introduced legislation that would allow more workers to receive TAA benefits, including training, job search and relocation allowances, income support and other reemployment services. Additionally, with respect to current regulation of financial institutions, it has come to my attention that some smaller banks are overburdened by compliance with Sections 404 and 302 of the Sarbanes-Oxley corporate accountability law. Mr. Chairman, these financial institutions are already highly-regulated, and it has become increasingly apparent that these regulations, while well-intended, only increase their costs of doing business. I hope this committee will soon consider legislation that would provide true regulatory relief for all financial institutions. Chairman Bernanke, thank you again for being here today. I look forward to hearing from you--and working with you--on these and other important issues. CHRG-111shrg52619--189 RESPONSE TO WRITTEN QUESTIONS OF SENATOR KOHL FROM SHEILA C. BAIRQ.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. 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. 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 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. This leads to the third element to address systemic risk--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.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. Through the Federal Financial Institutions Examination Council (FFIEC), the federal and state bank regulatory agencies have adopted a number of information-sharing protocols and joint operational work streams to promote consistent information flow and reasonable access to supervisory activities among the agencies. The FFIEC's coordination efforts and joint examination process (when necessary) is an efficient means to conduct joint federal and state supervision efforts at banking organizations with multiple lines of business. The FFIEC initiates projects regularly to enhance our supervision processes, examination policies and procedures, examiner training, and outreach to the industry. The FFIEC collaboration process for bank supervision works well. However, for the larger and more complex institutions, the layering of insurance and securities/capital markets units on a traditional banking organization increases the complexity of the overall federal supervisory process. This complexity is most pronounced within the small universe of systemically important institutions which represent a concentration of risk to the FDIC's Deposit Insurance Fund. The banking regulators generally do not have jurisdiction over securities and insurance activities which are vested in the U.S. Securities and Exchange Commission (SEC) and the U.S. Commodity Futures Trading Commission (CFTC) for securities activities, and state insurance regulators for insurance operations. In some cases, large banking organizations have significant involvement in securities and capital markets-related activities supervised by the SEC. The FFIEC agencies do have information sharing protocols with the securities regulators and rely significantly on the SEC's examination findings when evaluating a company's overall financial condition. In fact, the FDIC has signed information-sharing agreements with the SEC as well as the state securities and insurance commissioners. Prospectively, it may be appropriate to integrate the securities regulators' activities more closely with the FFIEC's processes to enhance information sharing and joint supervisory analyses. Finally, as mentioned in the previous question, an additional way to improve information sharing would be through 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. 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 among regulators more readily.Q.3. If Congress charged the FDIC with the responsibility for the ``special resolution regime'' that you discuss in your written testimony, what additional regulatory authorities would you need and what additional resources would you need to be successful? Can you describe the difference in treatment for the shareholders of Bear Sterns under the current situation verses the situation if the ``special resolution regime'' was already in place?A.3. Additional Regulatory Authorities--Resolution authority for both (1) systemically significant financial companies and (2) nonsystemically significant depository institution holding companies, including: Powers and authorities similar to those provided in the Federal Deposit Insurance Act for resolving failed insured depository institutions; Funding mechanisms, including potential borrowing from and repayment to the Treasury; Separation from bankruptcy proceedings for all holding company affiliates, including those directly controlling the IDI, when necessary to address the interdependent enterprise carried out by the insured depository institution and the remainder of the organization; and Powers and authorities similar to those provided in the Federal Deposit Insurance Act for assistance to open entities in the case of systemically important entities, conservatorships, bridge institutions, and receiverships. Additional Resources--The FDIC seeks to rely on in-house expertise to the extent possible. Thus, for example, the FDIC's staff has experts in capital markets, including securitizations. When pertinent expertise is not readily available in-house, the FDIC contracts out to complement its resources. If the FDIC identifies a longer-term need for such expertise, it will bring the necessary expertise in-house. Difference in the Treatment for the Shareholders of Bear Stearns--With the variety of liquidation options now proposed, the FDIC would have had a number of tools at its disposal that would have enhanced its ability to effect an orderly resolution of Bear Stearns. In particular, the appointment of the FDIC as receiver would have essentially terminated the rights of the shareholders. Any recovery on their equity interests would be limited to whatever net proceeds of asset liquidations remained after the payment in full of all creditors. This prioritization of recovery can assist to establish greater market discipline.Q.4. Your testimony recommends that ``any new plan ensure that consumer protection activities are aligned with other bank supervisory information, resources, and expertise, and that enforcement of consumer protection rules be left to bank regulators.'' Can you please explain how the agency currently takes into account consumer complaints and how the agency reflects those complaints when investigating the safety and soundness of an institution? Do you feel that the FDIC has adequate information sharing between the consumer protection examiners and safety and soundness examiners? If not, what are your suggestions to increase the flow of information between the different types of examiners?A.4. Consumer complaints can indicate potential safety-and-soundness or consumer protection issues. Close cooperation among FDIC Consumer Affairs, compliance examination, and safety-and-soundness examination staff in the Field Office, Regional Office, and Washington Office is essential to addressing issues raised by consumer complaints and determining the appropriate course of action. Consumer complaints are received by the FDIC and financial institutions. Complaints against non FDIC-supervised institutions are forwarded to the appropriate primary regulator. The FDIC's Consumer Affairs staff receives the complaints directed to the FDIC and responds to and maintains files on these complaints. Consumer Affairs may request that examiners assist with a complaint investigation if an on-site review at a financial institution is deemed necessary. Consumer complaints received by the FDIC, as well as the complaints received by a financial institution (or by third party service providers), are reviewed by compliance examiners during the pre-examination planning phase of a compliance examination. In addition, information obtained from the financial institution pertaining to consumer-related litigation, investigations by other government entities, and any institution management reports on the type, frequency, and distribution of consumer complaints are also reviewed. Compliance examiners consider this information, along with other types of information about the institution's operations, when establishing the scope of a compliance examination, including issues to be investigated and regulatory areas to be assessed during the examination. During the on-site compliance examination, examiners review the institution's complaint response processes as part of a comprehensive evaluation of the institution's compliance management system. During risk management examinations, examiners will review information about consumer complaints and determine the potential for safety-and-soundness concerns. This, along with other types of information about the institution's operations, is used to determine the scope of a safety-and-soundness examination. Examples of complaints that may raise such concerns include allegations that the bank is extending poorly underwritten loans, a customer's account is being fraudulently manipulated, or insiders are receiving benefits not available to other bank customers. Where feasible, safety-and-soundness and compliance examinations may be conducted concurrently. At times, joint examination teams have been formed to evaluate and address risks at institutions offering complex products or services that prompted an elevated level of supervisory concern. Apart from examination-related activity, the Consumer Affairs staff forwards to regional management all consumer complaints that appear to raise safety-and-soundness concerns as quickly as possible. Regional management will confirm that a consumer complaint raises safety-and-soundness issues and determine the appropriate course of action to investigate the complaint under existing procedures and guidance. If the situation demonstrates safety-and-soundness issues, a Case Manager will assume responsibility for coordinating the investigation and, in certain situations, may prepare the FDIC's response to the complaint or advise the Consumer Affairs staff in their efforts to respond to the complaint. The Case Manager determines whether the complaint could be an indicator of a larger, more serious issue within the institution. Quarterly, the Consumer Affairs staff prepares a consumer complaint summary report from its Specialized Tracking and Reporting System for institutions identified on a regional office's listing of institutions that may generate a higher number of complaints. These types of institutions may include, but are not limited to, banks with composite ratings of ``4'' and ``5,'' subprime lenders, high loan-to-value lenders, consumer lenders, and credit card specialty institutions. This report provides summary data on the number and nature of consumer complaints received during the previous quarter. The Case Manager reviews the consumer complaint information for trends that may indicate a safety-and-soundness issue and documents the results of the review. We believe FDIC examination staff effectively communicates, coordinates, and collaborates. Safety-and-soundness and compliance examiners work in the same field offices, and therefore, the regular sharing of information is commonplace. To ensure that pertinent examination or other relevant information is shared between the two groups of examiners, field territories hold quarterly meetings where consumer protection/compliance and risk management issues are discussed. In addition, Relationship Managers, Case Managers, and Review Examiners in every region monitor institutions and facilitate communication about compliance and risk management issues and develop cohesive supervisory plans. Both compliance examination and risk management examination staff share the same senior management. Effective information sharing ensures the FDIC is consistent in its examination approach, and compliance and risk management staffs are working hand in hand. Although some suggest that an advantage of a separate agency for consumer protection would be its single-focus mission, this position may not acknowledge the reality of the interconnectedness of safety-and-soundness and consumer protection concerns, as well as the value of using existing expertise and examination infrastructure, noted above. Thus, even if such an agency only were tasked with rule-writing responsibilities, it would not be in a position to fully consider the safety-and-soundness dimensions of consumer protection issues. Moreover, if the agency also were charged with enforcing those rules, replicating the uniquely comprehensive examination and supervisory presence to which federally regulated financial institutions are currently subject would involve creating an extremely large new federal bureaucracy. Just providing enforcement authority, without examination or supervision, would simply duplicate the Federal Trade Commission. Placing consumer compliance examination activities in a separate organization, apart from other supervisory responsibilities, ultimately will limit the effectiveness of both programs. Over time, staff at both agencies would lose the expertise and understanding of how consumer protection and the safe and sound conduct of a financial institution's business operations interrelate.Q.5. In your written testimony you state that ``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.'' Do you believe that there should be a suitability standard placed on lending institutions?A.5. Certainly, as a variety of nontraditional mortgage products became widely available, a growing number of consumers began to receive mortgage loans that were unlikely to be affordable in the long term. This was a major precipitating factor in the current financial crisis. With regard to mortgage lending, lenders should apply an affordability standard to ensure that a borrower has the ability to repay the debt according to the terms of the contract. Loans should be affordable and sustainable over the long-term and should be underwritten to the fully indexed rate. Such a standard would also be valuable if applied across all credit products, including credit cards, and should help eliminate practices that do not provide financial benefits to consumers. However, an affordability standard will serve its intended purpose only if it is applied to all originators of home loans, including financial institutions, mortgage brokers, and other third parties.Q.6. Deposit Insurance Question--Recently, the FDIC has asked Congress to increase their borrowing authority from the Treasury up to $100 billion, citing that this would be necessary in order avoid imposing significant increases in assessments on insured financial institutions. Currently, the FDIC provides rebates to depository financial institutions when the DIF reaches 1.5 percent. Given the increase in bank closings over the past 12 months, do you believe the rebate policy should be reviewed or eliminated? What do you think is an appropriate level for the insurance fund in order to protect depositors at the increased amount of $250,000?A.6. While the Federal Deposit Insurance Reform Act of 2005 provided the FDIC with greater flexibility to base insured institutions' assessments on risk, it restricted the growth of the DIF. Under the Reform Act, when the DIF reserve ratio is above 1.35 percent, the FDIC is required to dividend half of the amount in excess of the amount required to maintain the reserve ratio at 1.35 percent. In addition, when the DIF reserve ratio is above 1.50 percent, the FDIC is required to dividend all amounts above the amount required to maintain the reserve ratio at 1.5 percent. The result of these mandatory dividends is to effectively cap the size of the DIF and to limit the ability of the fund to grow in good times. A deposit insurance system should be structured with a counter-cyclical bias-that is, funds should be allowed to accumulate during strong economic conditions when deposit insurance losses may be low, as a cushion against future needs when economic circumstances may be less favorable and losses higher. However, the current restrictions on the size of the DIF limit the ability of the FDIC to rebuild the fund to levels that can offset the pro-cyclical effect of assessment increases during times of economic stress. Limits on the size of the DIF of this nature inevitably mean that the FDIC will have to charge higher premiums when economic conditions cause significant numbers of bank failures. As part of the consideration of broader regulatory restructuring, Congress may want to consider the impact of the mandatory rebate requirement or the possibility of providing for greater flexibility to permit the DIF to grow to levels in good times that will establish a sufficient cushion against losses in the event of an economic downturn. Although the process of weighing options against the backdrop of the current crisis is only starting, taking a look at what might have occurred had the DIF reserve ratio been higher at its onset may be instructive. The reserve ratio of the DIF declined from 1.22 percent as of December 31, 2007, to 0.36 percent as of December 31, 2008, a decrease of 86 basis points. If at the start of the current economic downturn the reserve ratio of the DIF had been 2.0 percent, allowing for a similar 86 basis point decrease, the reserve ratio would have been 1.14 percent at the end of the first quarter of 2009. At that level, given the current economic climate and the desire to structure the deposit insurance system in a counter-cyclical manner, it is debatable whether the FDIC would have found either the special assessment or an immediate increase in deposit insurance premiums necessary. An increase in the deposit insurance level will increase total insured deposits. While increasing the coverage level to $250,000 will decrease the actual DIF reserve ratio (which is the ratio of the fund to estimated insured deposits), it will not necessarily change the appropriate reserve ratio. As noted in the response to the previous question, building reserve ratios to higher levels during good times may obviate the need for higher assessments during downturns. ------ 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. ______ FOMC20070321meeting--120 118,CHAIRMAN BERNANKE.," Thank you. Thank you very much for the comments. I’m going to offer, as I always do, a brief summary and invite any comments and corrections, and then I’d like to add a few comments of my own. Most participants today agree that growth looks as though it’s going to be slower, but there is some diversity of opinion about how persistent the slowdown would be. Many people have marked down growth expectations for the remainder of the year, and there was a general sense that the uncertainty about growth prospects and downside risk have increased. However, some people saw the current slowdown as only a soft patch that would be reversed soon. Housing remains weak, and some participants noted the risk that problems in mortgage and credit markets and increased foreclosure rates might contribute to further weakness. However, others felt that the housing situation has not changed materially since the last meeting. The slowdown in capital investment drew more concern, in part because it has proved difficult to explain. An inventory correction continues, but automobile inventories have been brought into line. Some factors that will support growth include a booming global economy and stronger government spending at both the federal and the state and local levels. The labor market continues to be tight, with some noting increases in wages. Developments in the labor, housing, and credit markets will be important in determining the future course of consumption. Several participants pointed to potential financial risks, including possible knock-on effects of the subprime mortgage problems and the possibility of the drying up of currently abundant liquidity and financial markets. Corporate earnings are also likely to slow. If these risks materialize, they could add to downside pressures on output. However, some thought that financial conditions will remain supportive. Some, but not all, think that inflation will continue to moderate, albeit very slowly. There is general disappointment with recent inflation readings, and some were skeptical that any meaningful progress against inflation is being made. In particular, resource utilization pressures, particularly tight labor markets, pose a longer-term inflation threat. Import prices and slower productivity growth also add to inflation risk. The views of most participants were that upside inflation risks still outweigh downside risks to output, that uncertainty has increased, and that the tails of the distribution have become fatter. Are there comments? If not, let me just add a few thoughts. It’s very difficult to speak last—all the good ideas have already been presented. So I’ll say just a few things. I think the growth outlook is slightly worse. The housing market is, of course, central to near-term developments. The central scenario that housing will stabilize sometime during the middle of the year remains intact, but there have been a few negative innovations. We’ve noted the subprime issues and the possibility of foreclosures, reduced confidence, and tightened credit terms, and I’ve also noted that reports from builders about the spring selling season have not been particularly upbeat, in general. At the same time, we continue to see rough stability in sales, starts, and permits. The effects of the decline in subprime lending may have already been mostly seen, since that has slowed from last fall. Mortgage rates, of course, remain quite low, and the labor market is a key determinant of housing demand and of mortgage delinquencies, particularly cross- sectionally. Across the country, there’s a very close correlation between foreclosure rates and state unemployment rates. So long as the labor market remains strong, I would think that the general health of the housing market would be improving. The housing market, I think, will follow the same scenario, but there are a few negative innovations. There was a lot of discussion about capital investments, and I share the puzzlement about why that’s happening. Like Governor Mishkin, I am concerned that it might signal something about productivity. Another possibility in the current environment goes back to my Ph.D. thesis on the effects of uncertainty on investment, which found that greater uncertainty can make people delay their commitments. In our last meeting, we discussed the possible upside risk to consumption. I think that risk is much diminished now. Our retail sales have been quite flat, and the strong growth of consumption in the first quarter is almost entirely due to the December blip, which will carry through to the quarterly arithmetic. But consumption is very likely to slow. Gas prices are another reason that consumption is likely to slow. The labor market, again, remains strong. I agree with the Greenbook that there is some likelihood of softening going forward. In particular, I think Governor Kohn mentioned that the slowing productivity growth we’re seeing could be consistent with some labor hoarding in this late stage of the cycle. Again, I’ve marked down my growth expectations only a bit, but if we were handicapping recessions, I’m afraid that risk has probably gone up a bit. I would cite at least three reasons. First, there seems to be a pretty good chance that potential output growth is lower than in the past; and almost by definition, if growth is lower, then the chance of negative quarters is greater. Second, the Greenbook has a 60 basis point increase in unemployment occurring stably over the next two years. If that happens, it will be the first time it has ever happened. [Laughter] Generally speaking, increases in unemployment tend either not to occur or to be bigger than 60 basis points. Finally, we’ve discussed the financial market sensitivities, which are having an effect, so that changes in the outlook could have pretty substantial feedback effects onto the economy through the stock market, other financial markets, and credit markets. So I think, as President Fisher does, that the tail in that direction is unfortunately somewhat fatter. Likewise with inflation, the news was disappointing. We knew that there would be—and we have seen—month-to-month volatility. It is difficult, as President Pianalto noted, to make a firm conclusion based on the recent data about whether or not inflation is moderating. I would just note that rents and owners’ equivalent rent are still pretty important here. They have not yet slowed much, which may have to do with the nature of the uncertainties about the housing market. That possibility will be helpful going forward. At an earlier meeting I indicated that medical costs were a risk; and they have, indeed, proved to be a risk. Speaking about inflation makes me reflect on the difficulties of measuring aggregate supply in general. As we think about the economy going forward, we face two countervailing possibilities. One, which I and several others have already mentioned, is that potential output growth may well be lower than many outsiders and maybe even the Greenbook think. Obviously that will make it difficult to get economic slack and will make this situation much more challenging. At the same time, the lack of wage acceleration at least raises the possibility that the NAIRU might be somewhat lower than 5 percent, which would be helpful in the other direction. With respect to inflation, again, as I said, I’m disappointed by the recent numbers. I don’t get a sense from business people or from surveys and so on that the general public’s worry about inflation has increased very much, except insofar as they perceive that inflation is constraining the Fed from acting. So, again, I don’t think we’ve seen an adverse breakout by any means, but obviously we’re going to have to remain very vigilant and make sure that we maintain our credibility on the inflation front. As the last item, I would like Vincent to distribute table 1. We made a couple of changes in the description of the economy. He can make a few comments, and then everyone will have an opportunity to look at it overnight, and we can discuss the communication issues tomorrow." CHRG-111shrg53176--143 PREPARED STATEMENT OF MARY L. SCHAPIRO Chairman, Securities and Exchange Commission March 26, 2009I. Introduction Chairman Dodd, Ranking Member Shelby, and Members of the Committee: Thank you very much for inviting me to testify as we face a critical juncture in the history of our Nation's financial markets. I am here today testifying on behalf of the Commission as a whole. The Commission agrees that our goal is to improve the financial regulatory system, that we will work constructively to that end, and that we all are strongly dedicated to the mission of the SEC. In light of the economic events of the past year and their impact on the American people, I believe this Committee's focus on investor protection and securities regulation as part of a reconsideration of the financial regulatory regime is timely and critically important. Thank you also for giving me an opportunity to talk about the historic mission of the Securities and Exchange Commission, what we do for the Nation's investors and capital markets, and how our critical mission is a necessary foundation for a modernized financial regulatory structure. These are matters that have been the central focus of my entire professional career. I strongly support the view that there is a need for system-wide consideration of risks to the financial system and for the creation of mechanisms to reduce and avert systemic risks. I am convinced that regulatory reform must be accomplished without compromising the quality of our capital markets or the protection of investors. I am also convinced that getting it right will require hard work, attention to detail, and an over-riding commitment--not to engage in bureaucratic turf wars--but to further the public interest. All of that is well within our grasp. In my testimony this morning, I will explain some general principles that I believe should guide this effort. These principles are: first, an integrated capital markets regulator that focuses on investor protection is indispensable; second, that regulator must be independent; and third, a strong and investor-focused capital markets regulator complements the role of a systemic risk regulator, resulting in a more effective financial oversight regime. Included as an Appendix to my testimony is an overview of the major functions of the SEC, a summary of recent activity, and the resources allocated to each function.II. A Capital Markets Regulator Devoted to Investor Protection Is Indispensable All economic activity starts with capital. Small businesses need money to start up, and all companies need capital to innovate, compete, create jobs, and thrive. This capital comes from a variety of sources. Ultimately, capital comes from investors--people who invest directly in companies; people who invest in financial institutions that lend capital; people who invest in mutual funds and other pooled vehicles that in turn invest in America's businesses; people who buy municipal securities to help fund the operations of state and local governments; and people who look to the capital markets to save, put away money for their kids' education, and prepare for retirement. Markets that attract this capital are critical to America's economic future. And a strong, focused, vibrant, and nimble market regulator is critical to getting investors back into the market and to maintaining their trust and confidence in the future. Such a regulator is fundamental to the future growth of our economy. That's where the SEC comes in. Let me review some of the core functions of the SEC. These functions are interdependent: remove one function and the agency's capacity to do the others is diminished.A. Regulation of the Integrity of Markets Investor protection starts with fair and efficient capital markets. In these tumultuous economic times, despite record volumes and enormous volatility, the markets that the SEC oversees have priced, processed, and cleared trillions of dollars in customer orders in an orderly and fair way. The dollar value of average daily trading volume was approximately $251 billion a day in February 2009 in stocks, exchange-traded options and security futures. By comparison, the average daily trading volume for such securities was approximately $87 billion a day in February 1999, and $10 billion a day in February 1989. The securities laws and our rules, and the rules of the exchanges and the national securities association we supervise, prohibit fraudulent trading practices, manipulation of securities prices, insider trading and other abuses. These laws and rules require trades to be executed at fair prices, require market participants to keep records of their activities, and require prompt dissemination of pricing information. We regulate transfer agents and clearing agencies, so that transactions are effected seamlessly and without interruption. In overseeing the markets, the Commission is guided by its professional staff, which has extensive knowledge and expertise developed over decades of overseeing our Nation's dynamic capital markets. Innovation has completely transformed our securities markets over the last decade. The shouts on the trading floors of the Nation's securities exchanges have largely given way to the whir of computers. Transactions that took minutes to execute now take well under a second. In an instant, traders can search within markets and across markets to locate counterparties willing to pay the very best price. Spreads--that is the price differences in transactions captured by intermediaries rather than investors--have narrowed dramatically over the past decade. This has been due in part to the SEC's rules requiring intermediaries acting for customers to trade at the very best prices as well as rules permitting securities prices to be quoted in pennies. In many instances, spreads in stocks have shrunk from 12 cents to less than a penny. According to a 2005 GAO study, decimalization of stock quotes alone cut trading costs by 30-50 percent. We've achieved similar results in the options markets. These pro-investor changes have been possible because of a regulatory regime that focuses on competition--one that does not pick winners and losers but instead, one that removes barriers to new entrants. It is a regime that requires a focus on the needs of investors and their welfare, allowing market participants to innovate and compete for their customers' business. While it is a regime that works well, it is one that requires a regulator to keep up with the breakneck pace of change in our ever-evolving markets. This is not to say that our markets always function perfectly. There are practices that are contrary to fair and orderly markets; abusive short selling, for example, would fall into that category. To target potentially abusive ``naked'' short selling in certain equity securities, the Commission has tightened up the close-out requirements and adopted a new antifraud rule specifically aimed at abusive short selling when it is part of a scheme to manipulate the price of a stock. And, early next month, the Commission will consider proposals to re-institute the uptick rule, or something much like it.B. Regulation of the Integrity of Market Information However well structured, markets fail without timely and reliable information. Accurate information is the lifeblood of the securities market. A big part of the SEC's mission is to safeguard the markets' blood supply. We operate from the premise that our markets work best when investors are fully informed. Our job is to make sure investors get full and complete information. It involves setting meaningful disclosure standards, monitoring compliance with them, and, when appropriate, enforcing the law against those who fail to comply. It also involves programs to equip investors with tools to understand and analyze the market information they receive. SEC rules require complete and accurate disclosure of information that investors need to make informed investment and voting decisions. Companies cannot raise capital from the public without first filing with us comprehensive disclosures about their business, their performance, and their prospects. One of our major accomplishments over the last few years has been to streamline this process so that potential issuers of securities can raise money more quickly, while providing investors with more, and more current, information. Registrants file extensive disclosures about their business performance annually and update them quarterly, and--because today's markets demand immediate information--whenever certain specified events occur. We review these filings on a selective basis, and work closely with reviewed companies to improve the quality of their disclosure. In fiscal year 2008, our staff reviewed the filings of nearly 5,000 reporting companies in addition to more than 600 new issuers. Accurate information, of course, encompasses both words and numbers, and we work to protect the integrity of both. We play a special role in the formation of accounting standards for public companies and other entities that file financial statements with the Commission. We oversee the process by which they are set to ensure that professional, independent standard-setters include those whose primary concern is the welfare of investors, that the deck is not stacked against investors, and that the outputs of the process are fair and appropriate. There is a delicate balance here. We have authority to set standards, and we use this authority prudently. Sometimes we prod the standard-setters to act more quickly, and we often give them the benefit of our views. But we are convinced that accounting standard-setting should be the product of an independent, expert body that is organized to act in the public interest and with appropriate due process. While the Commission rarely sets accounting standards, we deal with accounting matters every day. We and our staff provide guidance about how accounting standards should be applied in particular situations; our staff reviews corporate filings to determine whether companies are applying standards properly; and where the accounting is wrong, we ask companies to fix it. Our rules, given new vigor by the landmark Sarbanes-Oxley Act that emerged from this Committee in 2002, promote the independence of those who audit the financial statements of public companies. Investors need accurate and comprehensive information not only when they trade but also when they vote, whether it is to elect directors, adopt compensation plans, approve transactions, or consider shareholder proposals. And so we have a variety of means to promote fair corporate voting. Speaking for myself, I believe the SEC has not gone far enough in this latter area. And so I intend to make proxy access--meaningful opportunities for a company's owners to nominate its directors--a critical part of the Commission's agenda in the coming months.C. Regulation and Oversight of Financial Intermediaries and Market Professionals For our markets to be fair and efficient and to operate in the best interests of investors, those who control access to our capital markets must be competent, financially capable, and honest. That brings me to a third core function of the SEC: regulation and oversight of financial intermediaries and other market professionals, including approximately 5,500 broker-dealers, over 11,000 investment advisers, stock and option exchanges, clearing agencies, credit rating agencies and others. Exchanges and clearing agencies are an essential part of the plumbing of our financial system. Their smooth operation is something that many Americans take for granted, but that the Commission takes very seriously and works to ensure. Brokers, advisers and credit rating agencies are the entities that Americans turn to for guidance and technical assistance when accessing our Nation's financial markets. It is essential that these firms--and the people who work in them--be held to the high standards expected of professionals. The SEC's regulatory role, along with its oversight of the various self-regulatory organizations with respect to financial intermediaries and market professionals, focuses on helping to ensure that investors are treated fairly and that the institutions managing and processing their investments are subject to meaningful controls to protect investor assets. Our statutes and rules require that brokers and advisers tell investors the truth, that brokers recommend to their customers only those products that are suitable for them to buy, and that advisers act in accordance with their fiduciary duties. In the same way, we require that investment advisers manage any potential conflicts of interests and fully disclose them to investors. Our capital requirements go a long way to ensuring that customer funds entrusted with a broker-dealer are safe in the event the broker-dealer gets in financial trouble. Again, our focus is not to insulate broker-dealers from competition and the risks of failure, but to protect investors in the event that failures do occur. We conduct examinations of these firms to assess their compliance with laws and regulations. And when we find violations or deficiencies, we direct that corrective action be taken. Since 2006, with the authority provided by the Congress, we have adopted significant reforms related to credit rating agencies. Given the critical role of ratings in our capital markets, it is essential that we stay active in this area. We have rule proposals outstanding and are convening a public roundtable on possible further reforms to be held next month. Some of our rules regulating financial intermediaries need to be modernized, and the Commission is considering what, if any, legislation to ask for from the Committee. Among other things, we are considering asking for legislation that would require registration of investment advisers who advise hedge funds, and possibly the hedge funds themselves. We are studying whether to recommend legislation to break down the statutory barriers that require a different regulatory regime for investment advisers and broker-dealers, even though the services they provide often are virtually identical from the investor's perspective. We also are carefully considering whether legislation is needed to fill other gaps in regulatory oversight, including those related to credit default swaps and municipal securities. It is time for those who buy the municipal securities that are critical to state and local funding initiatives to have access to the same quality and quantity of information as those who buy corporate securities. I will lead the Commission to continue to focus efforts in this area in 2009. In addition, I have asked the staff to develop a series of reforms designed to better protect investors when they place their money with a broker-dealer or an investment adviser. I have asked the staff to prepare a proposal for Commission consideration that would require investment advisers with custody of client assets to undergo an annual third-party audit, on an unannounced basis, to confirm the safekeeping of those assets. I also expect the staff to recommend proposing a rule that would require certain advisers to have third-party compliance audits to review their compliance with the law. And to ensure that all broker-dealers and investment advisers with custody of investor funds carefully review controls for the safekeeping of those assets, I expect the staff to recommend that the Commission consider requiring a senior officer from each firm to attest to the sufficiency of the controls they have in place to protect client assets. The list of certifying firms would be publicly available on the SEC's Web site so that investors can check on their own financial intermediary. In addition, the name of any auditor of the firm would be listed, which would provide both investors and regulators with information to then evaluate the auditors.D. Regulation of Mutual Funds and Other Pools of Investor Money Most retail investors participate in the capital markets through pooled investment vehicles, the most common of which are mutual funds. The size of these investments is astonishing: mutual funds hold over $9 trillion in assets--representing the investments of approximately 92 million Americans. As part of its oversight functions, the SEC focuses on ensuring that funds are run to benefit investors and not insiders. SEC rules also seek to ensure that fund investors are provided accurate, timely and complete information about their funds in a form that is investor-friendly. The SEC requires that funds comply with investor-oriented prohibitions against complex capital structures, excessive leverage and preferential treatment for certain shareholders. In addition, the SEC examines the actions of independent fund directors and chief compliance officers to evaluate whether they are fulfilling their critical responsibilities on behalf of fund investors. A particular focus of the Commission in coming weeks will be proposals to enhance the standards applicable to money market mutual funds, which are widely used by both retail and institutional investors as a cash management vehicle. The SEC has been closely monitoring money market funds and their investments, since we permitted the first money market fund in the early 1970s. Over that time, we have built up significant money market fund expertise. We will bring that expertise to bear as we act quickly this spring to strengthen the regulation of money market funds by considering ways to improve the credit quality, maturity, and liquidity standards applicable to these funds. These efforts will be aimed at shoring up money market fund investments and mitigating the risk of a fund experiencing a decline in its normally constant $1.00 net asset value, a situation known colloquially as ``breaking the buck.''E. Enforcement of the Securities Laws Finally, there's enforcement. We are an integrated regulator of the country's capital markets with an important focus on law enforcement. We enforce the securities laws aggressively and intelligently, without fear or favor. Enforcement is one of our core competencies and a central part of our heritage as an agency. In the past year alone, the SEC has brought enforcement actions related to sub-prime abuses, market manipulation through the circulation of false rumors, insider trading by hedge funds and other institutional investors, Ponzi schemes, false corporate disclosures, and penny stock frauds. This past year we brought the biggest foreign bribery case ever. We also required securities violators to disgorge illegal profits of approximately $774 million and to pay penalties of approximately $256 million, and we distributed over $1 billion to injured investors. Enforcement is integrated with our regulation of the capital markets for the benefit of investors. We enforce the securities laws and the rules we promulgate. We understand markets because we regulate them. We understand disclosure because we regulate it. Our regulatory functions add nuance and sophistication to our enforcement efforts, and enforcement adds backbone to our rules. It is all one piece. We have work to do to stay one step ahead of the predators and sharp practices that prey on investors. It is a never-ending struggle, and it requires never-ending energy and ingenuity. As part of this effort, I expect to come to you in the near term with a request for authority to compensate whistleblowers who bring us well-documented evidence of fraudulent activity. Currently, we have the authority to compensate sources in insider trading cases. I would like to see this authority extended so that the SEC can further encourage individuals to come forward with helpful information.III. A Capital Markets Regulator Devoted to Investor Protection Should Be Independent As we look to the future of securities regulation, we believe that independence is an essential attribute of a capital markets regulator that protects investors. There are other agencies of government that touch on what we do, just as what we do touches on other agencies of government. But Congress created only one agency with the mandate to be the investors' advocate. Other agencies have had, as part of their responsibilities, the protection of important financial institutions and, as part of those responsibilities, customer protection. But, as Justice Douglas pointed out long ago, only the SEC has the mission, and the privilege, of serving as ``the investors' advocate.'' We are a creature of the Congress. The vision of the Congress when it created an independent SEC was to make sure that there was one agency of government focused single-mindedly and without dilution on the well-being of America's investors. That independence has allowed us to build expertise and a culture of investor protection, which benefits the public and the economy. And it has been a tremendous success as U.S. capital markets lead the world. If there were ever a time when investors need and deserve a strong voice and a forceful advocate in the federal government, that time is now. Individual investors may not be the strongest political force; they are disparate in their backgrounds and not always well-organized or funded. They are typical Americans--our families, friends, and fellow citizens. These investors expect and deserve a strong and independent regulator dedicated to providing for fair financial dealings, timely and meaningful disclosure of information, and protection from unscrupulous actors. Congress made us independent precisely so we can champion those who otherwise would not have a champion, and when necessary take on the most powerful interests in the land. Regulatory reform must guarantee that independence in the future.IV. A Strong and Independent Capital Markets Regulator Is Important to Systemic Risk Oversight An independent, investor-first capital markets regulator is vital to a revamped regulatory structure that pays due attention to overarching systemic risk. Investor protection enhances the mission of controlling systemic risk. More than that, financial services exist to serve investors and our markets, and a focus on investors is absolutely essential to any credible regulatory restructuring. The SEC, as the independent capital markets regulator with unique experience and competencies, must continue to be the primary regulator of important market functions, and would be a critical party in contributing to any systemic risk regulator's evaluation of risks. Appropriate regulation must safeguard both investor protections and important market functions. The SEC, as a strong independent regulator with market expertise, can perform its critical capital markets and investor protection functions without compromising the oversight of systemic risk. Even as attention focuses on reconsidering the management of systemic risk, investor protection and capital formation--both of which are fundamental to economic growth--cannot be compromised as a product of any reform effort. The SEC stands alone as the government agency responsible for both protecting investors and promoting capital formation for the past 75 years. To the extent the activities of the SEC touch systemically significant institutions, there is rarely a risk of inconsistency between the SEC and other regulators focused on systemic risk. No one, for example, argues that major financial institutions should be permitted to lie, cheat, or steal as a means of avoiding systemic risk. To the extent those issues do arise, and have arisen in the past, any tensions have been creative, and well-meaning regulators can and have been able to resolve them. There are questions that need to be answered in the months ahead. Among others, there is a need to identify or create the appropriate systemic regulatory regime; determine how such a regime can identify systemic risks without creating additional ones; and determine how much and how heavily any systemic risk regulator should touch the other participants in the system of financial regulation. We will need to figure out what should be consolidated, what should be split off, what should be added, and what should be subtracted. As it has since it was formed, the Commission stands ready to assist. We view regulatory reform as vital. We will give Congress, our fellow regulators, and other parts of the government the benefit of our insights. It is critical that the reform is done right, and the Commission will actively engage with all stakeholders throughout the process.V. Conclusion When I returned to the SEC as Chairman in January, I appreciated the need to act swiftly to help restore investor confidence in our capital markets. In less than 2 months, we have instituted important reforms to reinvigorate our enforcement program, better train our examination staff and improve our handling of tips and complaints. In the near term, I will ask the Commission to consider taking action related to short selling, money market fund standards, investor access to public company proxies, credit rating agencies, and controls over the safekeeping of investor assets. But, speaking personally, much more needs to be done. Everyday when I go to work, I am committed to putting the SEC on track to serve as a forceful capital markets regulator for the benefit of America's investors. Today, more than ever, the SEC's core mission of capital markets oversight and investor protection is as sound and fundamentally important as it ever was, and I am fully committed to ensuring that the SEC carries out that job in the most effective way it can. Thank you again for the opportunity to share the SEC's views. We look forward to working with the Committee on any financial reform efforts in the months ahead, and I would be pleased to answer any questions. ______ CHRG-111hhrg52397--36 Mr. Pickel," Thank you, Mr. Chairman, Ranking Member Garrett, and members of the subcommittee. Thank you very much for inviting ISDA to testify today. We are grateful for the opportunity to discuss public policy issues regarding the privately negotiated or OTC derivatives business. Our business provides essential risk management and risk reduction tools for many users. Additionally, it is an important source of employment, value creation, and innovation for our financial system. It is one that employs tens of thousands of individuals in the United States and benefits thousands of American companies across a broad range of industries. In my remarks today, I would briefly like to underscore ISDA's and the industry's strong commitment to identifying and reducing risk in the privately negotiated derivatives business. We believe that OTC derivatives offer significant value to customers who use them, to the dealers who provide them, and to the financial system in general by enabling the transfer of risk between counterparties. OTC derivatives exist to serve the risk management and investment needs of end users. These end users form the backbone of our economy. They include over 90 percent of the Fortune 500 companies, 50 percent of mid-size companies, and thousands of other smaller American companies. We recognize, however, that the industry today faces significant challenges, and we are urgently moving forward with new solutions. We have delivered and are delivering on a series of reforms in order to promote greater standardization and resilience in the derivatives markets. These developments have been closely overseen and encouraged by regulators who recognize that optimal solutions to market issues are effectively achieved through the participation of market participants. As ISDA and the industry work to reduce risk, we believe that it is essential to preserve flexibility, to tailor solutions to meet the needs of customers. Efforts to mandate that privately negotiated derivatives trade only on an exchange would effectively stop any such business from being conducted. Requiring exchange trading of all derivatives would harm the ability of American companies to manage their individual, unique financial risks and ultimately harm the economy. Mr. Chairman, let me assure you that ISDA and our members clearly understand the need to act quickly and decisively to implement the important measures that I will describe in the next few minutes. Last month, Treasury Secretary Geithner announced a comprehensive regulatory reform proposal for the OTC derivatives market. The proposal is an important step toward much needed reform of financial industry regulations. ISDA and the industry welcomed in particular the recognition of industry measures to safeguard smooth functioning of our markets and the emphasis on the continuing need for the ability to customize derivatives for the specific needs of users of derivatives. The Treasury plan proposes to require that all derivatives dealers and other systemically important firms be subject to prudential supervision and regulation. ISDA supports the appropriate regulation of financial and other institutions that have such a large presence in the financial system that their failure could cause systemic concerns. Most of the other issues raised in the Treasury proposal and the questions you have asked of the panelists today were addressed in a letter that ISDA and industry participants delivered to the Federal Reserve Bank of New York earlier this month. As you may know, a Fed-industry dialogue was initiated under Secretary Geithner's stewardship of the New York Fed nearly 4 years ago. This dialogue has led to substantial and ongoing improvements in the key areas of the OTC derivatives infrastructure, increased standardization of trading terms, improvements in the trade settlement process, greater clarity in the settlement of defaults, significant positive momentum toward central counterparty clearing, enhanced transparency, and a more open industry governance structure. In our letter to the New York Fed this month, ISDA and the industry expressed our firm commitment to strengthen the resilience and robustness of the OTC derivatives market. As we stated, we are determined to implement changes to risk management, processing, and transparency that will significantly transform the risk profile of these important financial markets. We outlined a number of steps towards that end, specifically in the areas of information transparency and central counterparty clearing. ISDA and the OTC derivatives industry are committed to engaging with supervisors globally to expand upon the substantial improvements that have been made in our business since 2005. We know that further action is required, and we pledge our support in these efforts. It is our belief that much additional progress can be made within a relatively short period of time. Our clearing and transparency initiatives, for example, are well underway with specific commitments aired publicly and provided to policymakers. As we move forward, we believe the effectiveness of future policy efforts will be driven by how well they answer a few fundamental questions. First, do they recognize that OTC derivatives play an important role in the U.S. economy? Second, do the policy efforts enable firms of all types to improve how they manage risk? Third, are the policy efforts based on a complete understanding of how the OTC derivatives markets function and their true role in the financial crisis? And, fourth, do the policy efforts ensure the availability and affordability of these essential risk management tools? Mr. Chairman and committee members, the OTC derivatives industry is an important part of the financial services business in this country and the services we provide help companies of all shapes and sizes. Let me assure you that we in the derivatives industry do recognize the challenges that we face as we seek to enact a comprehensive and prudent system of regulatory reform. As I have indicated, we are fully committed to working with legislators, this committee, and supervisors to address the key issues ahead. Thank you for your time, and I look forward to your questions. [The prepared statement of Mr. Pickel can be found on page 176 of the appendix.] " FOMC20080430meeting--172 170,MR. EVANS.," Thank you, Mr. Chairman. I, too, favor maintaining the federal funds rate at 2� percent today. The current real interest rate provides accommodative monetary conditions for an economy that is struggling near recession or is in mild recession. Our lending facilities are probably doing as much as can be expected to mitigate the serious and necessary financial adjustments that must be accomplished by the private markets. If the economy takes another serious leg down, our current funds rate setting is well positioned for us to respond promptly, appropriately, and aggressively, if circumstances warrant. A pause today affords us a unique opportunity to wait and see how our recent aggressive actions are influencing the trajectory of real activity. Since markets are putting substantial weight on a 25 basis point easing today, a pause will be a relatively small disappointment. As President Plosser pointed out, that was similar to our March disappointment, which seemed to be all right. I think it is important for us to understand how the economy will respond to a pause in rate-cutting when it does occur. With high food, energy, and commodity prices, the extended positive differential of headline inflation over core measures risks an increase in the public's inflation expectations. I agree with President Plosser's discussion of relative prices on that front. From a longer-term perspective, which we don't really talk about very often, I worry about the asymmetric response of policy to high inflation as opposed to when it is low. When headline inflation is above core inflation, we take on board the relative price adjustment, and then we are content, I would guess, to bring inflation down to our perceived inflation targets. But on the downside, when inflation gets low, we become uncomfortable with certain low inflation settings, and so I fear that we would respond more aggressively, as we did in 2003, which really was a positive productivity environment. If you have an asymmetric type of response, you are going to take on board increases in the price level because of that asymmetry. That's one reason that I am concerned about these types of behaviors. Although I expect emerging resource slack to temper any adverse inflation developments, the risk is simply growing in importance with every additional policy easing, compared with the economic risks, which presumably are abating as we respond to them with such easings. Calibrating the current policy stance against these divergent economic and inflation risks is important and challenging, as you pointed out yesterday, Mr. Chairman. I think that comparisons to the rate troughs in the previous cycles of recession policy are instructive. The current real fed funds rate is somewhere in the neighborhood of zero, or it could be lower if you choose a different way to deflate the funds rate by total inflation. I was very impressed with Dave Stockton's response to my question about what types of factors from financial market stress are embodied in the Greenbook-consistent real interest rate. It seems as though a tremendous amount of care has been taken to introduce some of these special factors in innovative ways, and while they may not capture all facets of that, I thought that they did quite a good job. So I feel a bit more comfortable in making those comparisons, but I do recognize that it is a treacherous period. That said, this is about the same place the real funds rate bottomed out during the jobless recovery with financial headwinds in the 1990�91 recession, and with the data we had in hand at the time during the disinflation concerns in 2003. Both periods were unique in suggesting a high degree of accommodation, and the factors that were at work in each of those episodes were unique. Our attempt to incorporate these factors has been quite useful, and so it's a reasonable, if not definitive, comparison. With our current lending facilities addressing financial stress, I think our current policy accommodation, now at 2� percent, is appropriately similar to those episodes. My final observation has to do with these end-of-cycle expectations and what they might mean for long-term interest rates. If 25 basis points is viewed as additional insurance against downside risks, I just don't think this action is significant enough to have much of an effect. We expect to take back some portion of the aggressive cuts, especially the ones that have been an attempt to respond to the financial stress. If the financial stress is mitigated to some extent, we should be expected to take that back. Expectations, as in the fed funds futures market, should limit the effect of those actions on long-term interest rates. After all, by the expectations hypothesis, you are going to be averaging these short-term paths into long-term rates. That is one reason that the Committee injected the language ""considerable period"" back in 2003, to try to convince people that we would do this for a longer period of time and affect long-term rates. So if there is an expectation of some type of rebound, these last insurance cuts might not have that large an effect. Again, I think our lending facilities are better geared for the financial stress. I think we have clearly demonstrated our willingness to provide appropriately accommodative policies in a timely fashion when the economic situation demanded it. For me, the public's expectation of these actions in that event argues against one further small insurance move. Because we are concerned about inflation risks and have indicated that we must flexibly move toward more-neutral policy stances once the economy and financial markets improve, a pause today is a small down payment on those difficult future actions. In terms of language, if it came to that, I would be comfortable with the language of alternative B with this particular rate action. Thank you, Mr. Chairman. " CHRG-110hhrg41184--3 Mr. Bachus," I thank the chairman. Chairman Frank, I appreciate you holding this hearing on monetary policy and the state of the economy. And I thank you, Chairman Bernanke, for being here today and for your service to the country. You testified last July concerning the state of the economy and monetary policy. At that time we had a problem in one segment of our economy, and that was subprime lending. And as we all know, since that time, because of what we sometimes refer as interconnectedness of the markets, it has mushroomed into a full-blown credit crisis. We have unemployment inching up, although it is still at historic lows. It is still very good. We have factory orders and durable goods showing weaknesses, some weaknesses in retail sales, and obviously we are concerned about our credit card and auto lending markets because of the credit crunch. While economic activity and growth have clearly slowed, and while any threats to our economy should not be minimized, I don't believe anything has transpired over the past 7 months that distracts from the competitive strength of U.S. businesses and their innovativeness, and the productivity of American workers still remains very high. I think our workers are unrivaled in the world as far as their abilities and their productivity. Moreover, productive steps by the Federal Reserve and other regulators, combined with responses from the private sector and the natural operations of the business cycle, I believe will help ensure that the current economic downturn is limited in both duration and severity. I believe your aggressive cuts in the Fed funds rates and the recently enacted stimulus package will help. Although I believe it may not have the effect that many claim, I do believe that it does serve as a tax cut for millions of hardworking Americans, and it, too, will help. And all of those should begin to have a positive effect on our economy, I believe, by this summer--and I would be interested in your views--laying the groundwork for a much stronger second half of 2008 and sustainable growth in 2009. At that point, I believe the Fed's primary challenge, and we saw it, I think last week and this week, with the CPI and the PPI numbers, your challenge will shift from avoiding a significant economic downturn to containing inflationary pressures in our economy. Particularly when I go home, people talk to me about the hardship of high gas prices. That's something that I'm not sure any of us have much control over, short term. Long term, there are obviously things, including nuclear power that I have said many times we need to take full advantage of. One lesson we have learned from the subprime contagion is just how highly interconnected our financial markets are. The chairman in his opening statement mentioned a lack of regulation. We have a system of functional regulation where different regulators function in different parts of the market. I'm not sure that part of our problem is not that this sometimes almost causes overregulation, but there may be gaps in the regulation. And I wonder if that is in fact the case, there may be areas where the regulation needs to be strengthened or regulation needs to be coordinated better between different regulators, both State and Federal. As painful as the process and the challenges we have, I think it is pretty evident that we have faced our problems and that we are solving them. I think what we have done is far preferable to the kind of decay and denial that mark the Japanese response to their financial turmoil in the 1990's. And it's the reason I continue to have great confidence in the resilience of the American economy. Chairman Bernanke, in closing, let me say there is perhaps no other public figure in America who has been subjected to as much Monday morning quarterbacking as you have over the last 7 months. But I believe on balance, any objective evaluation of your record would conclude that you have dealt with an exceedingly difficult set of economic circumstances with a steady hand and sound judgment. With that, Mr. Chairman, I yield back the balance of my time. " CHRG-111hhrg53021Oth--13 Chairman Frank," Thank you, Mr. Peterson and I begin with an apology to our friends in the media, there is no fight to cover between these two Committees. I know that that is an easier topic than the complexities of how to actually do something. But I believe that the besetting sin of the House of Representatives is jurisdictional fights, in which our egos get in the way of good public policy. I am very proud that Chairman Peterson and I and other Members of our Committee, as well as Chairman Gensler and Chairwoman Shapiro have made very extra special efforts to avoid that. And I believe we have achieved that. And there will be some disagreements, but they will be based on substance. There are some areas where there are no disagreements. Clearly we will be significantly expanding the regulation of derivatives. And I want to address the issue that was raised by the very thoughtful gentleman from Idaho, with whom I agree on most issues, but not on the question of the merger. I will say that if we were starting from scratch, I don't think we would have the current organizational structure. But we are not starting from scratch, and I don't think it is practical to talk about making those major changes. But I will also say this, there have been some complaints that what the Obama Administration has proposed, and they have a great deal of credit coming to them for the initiatives they are taking, the a broad range of financial restructuring, and some of what we are talking about. Some people have complained there is not enough structural change. Frankly, I think that is the wrong issue. What we should be held accountable for is making substantive changes in the rules. Who does these things is less important to me than what is done. And by the time we are through in the collaboration between these two Committees, in the work of the Congress as a whole, and in the work that the Financial Services Committee will do, we will, I believe, have substantially increased the authority of regulators to deal with these things. We have within our jurisdiction the question of hedge funds. I believe that hedge funds should be required to register. We will be talking about further expansion derivatives and undoing some of the decisions not to deal with them in the past. We will be talking about a number of other areas where we will be making some important substantive changes and giving the regulators the authority to do things. With regard to derivatives, clearly the gentleman from Oklahoma is correct, they play an important role. The problem we have is this: the role of the financial sector is to be an intermediary between people who are engaged in the productive activity of the economy, and people who have the money that they need to do that. The role of the intermediaries is to gather up money in reasonably small amounts from large numbers of people and have them available to those people who will do productive activity. I believe that one of the problems that we have seen in the past couple of decades is that there has become a confusion between ends and means, that is activity that is a very important means to the end of productive activity has become for some in our society an end in itself. Our job is to try and separate those things out. Where we have instruments, activities, entities that are an important means to gathering the funds that our private sector economy needs to do productive activity, we need to protect that. We need to make sure it is done with integrity, we need to give encouragement to investors who may be afraid to invest, that is why I regard sensible regulations of the market as very pro-market. You protect the people with integrity from those who might try to cut corners. You give some encouragement to those who should be investing. Our job is to reduce the extent to which there are things that go on for their own sake. I believe we are capable of doing that, and I am very pleased, Chairman Peterson and I, and our Committees are well on the way in cooperation with the Administration to adopting such rules. And I now recognize the Ranking Member of the Financial Services Committee, the gentleman from Alabama, Mr. Bachus. OPENING STATEMENT OF HON. SPENCER BACHUS, A REPRESENTATIVE IN CHRG-111hhrg53021--13 Chairman Frank," Thank you, Mr. Peterson and I begin with an apology to our friends in the media, there is no fight to cover between these two Committees. I know that that is an easier topic than the complexities of how to actually do something. But I believe that the besetting sin of the House of Representatives is jurisdictional fights, in which our egos get in the way of good public policy. I am very proud that Chairman Peterson and I and other Members of our Committee, as well as Chairman Gensler and Chairwoman Shapiro have made very extra special efforts to avoid that. And I believe we have achieved that. And there will be some disagreements, but they will be based on substance. There are some areas where there are no disagreements. Clearly we will be significantly expanding the regulation of derivatives. And I want to address the issue that was raised by the very thoughtful gentleman from Idaho, with whom I agree on most issues, but not on the question of the merger. I will say that if we were starting from scratch, I don't think we would have the current organizational structure. But we are not starting from scratch, and I don't think it is practical to talk about making those major changes. But I will also say this, there have been some complaints that what the Obama Administration has proposed, and they have a great deal of credit coming to them for the initiatives they are taking, the a broad range of financial restructuring, and some of what we are talking about. Some people have complained there is not enough structural change. Frankly, I think that is the wrong issue. What we should be held accountable for is making substantive changes in the rules. Who does these things is less important to me than what is done. And by the time we are through in the collaboration between these two Committees, in the work of the Congress as a whole, and in the work that the Financial Services Committee will do, we will, I believe, have substantially increased the authority of regulators to deal with these things. We have within our jurisdiction the question of hedge funds. I believe that hedge funds should be required to register. We will be talking about further expansion derivatives and undoing some of the decisions not to deal with them in the past. We will be talking about a number of other areas where we will be making some important substantive changes and giving the regulators the authority to do things. With regard to derivatives, clearly the gentleman from Oklahoma is correct, they play an important role. The problem we have is this: the role of the financial sector is to be an intermediary between people who are engaged in the productive activity of the economy, and people who have the money that they need to do that. The role of the intermediaries is to gather up money in reasonably small amounts from large numbers of people and have them available to those people who will do productive activity. I believe that one of the problems that we have seen in the past couple of decades is that there has become a confusion between ends and means, that is activity that is a very important means to the end of productive activity has become for some in our society an end in itself. Our job is to try and separate those things out. Where we have instruments, activities, entities that are an important means to gathering the funds that our private sector economy needs to do productive activity, we need to protect that. We need to make sure it is done with integrity, we need to give encouragement to investors who may be afraid to invest, that is why I regard sensible regulations of the market as very pro-market. You protect the people with integrity from those who might try to cut corners. You give some encouragement to those who should be investing. Our job is to reduce the extent to which there are things that go on for their own sake. I believe we are capable of doing that, and I am very pleased, Chairman Peterson and I, and our Committees are well on the way in cooperation with the Administration to adopting such rules. And I now recognize the Ranking Member of the Financial Services Committee, the gentleman from Alabama, Mr. Bachus. OPENING STATEMENT OF HON. SPENCER BACHUS, A REPRESENTATIVE IN 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-111hhrg51591--64 Mr. Webel," It is a little unclear. I mean, the securities came up out of the insurance-related subsidiaries. Presumably, the insurance regulators at some degree okayed those securities coming up. I have seen different suggestions from the State regulators as to exactly how little oversight they had once the securities came up out of the subs. But presumably they would have had to approve the securities coming up out of the subsidiaries. Ms. Bean. So given the complexities of the securities markets, do you believe that individual State regulators or the NAIC has the sophistication to evaluate these types of activities of the insurers that they regulate? And I am going to give you two other questions that you can answer as well. Did the passage of Gramm-Leach-Bliley enable AIG to get into the CDS market? And the last question for you is, is the State system able to properly regulate insurance holding companies and their non-insurance subsidiaries? " CHRG-110hhrg46596--4 Mr. Issa," Thank you, Mr. Chairman. I appreciate your indulgence in this. I know we are all on kind of a crazy schedule here in this extended, extended, extended Congress. Mr. Chairman, Ranking Member Bachus--if he was here--and members of the committee, I want to thank you for this opportunity to speak today. There is no more important issue before Congress now than ending the financial crisis that besets our country, whether it is in fact the financial crisis that we believed we were dealing with only weeks ago or it is the auto companies that were before you this week. As you know, I have been a critic of the bailout from its inception. I have stressed deliberate action and warned of potential failures. I think I have been vindicated in my objection to that spending of $700 billion of taxpayers' dollars, of which half already appears to have been spent. I am not pleased with that. I wish I had been wrong. After all, these are not private funds that companies can use freely. These are, in fact, the future tax dollars of Americans, and our children will be paying not just the principal but the interest for generations to come. To date, the oversight of the bailout has been severely lacking. Through no fault of the Congress, we were pushed to quickly pass a bill that only generally called for accounting. The Government Accountability Office--as we will hear more about today--the Washington Post and other media outlets, and most importantly, the American people have been critical of the lack of oversight and the inability to apply oversight. People want to know where their money is being spent and if it is having the impact that is intended, and few think that it is. While we know there are many bad actors and causes of financial crisis from lack of lending practices to insufficient regulatory scrutiny, substantial questions regarding the root causes still remain. Yesterday, in our Committee on Government Reform we dealt with Freddie Mac and Fannie Mae, and we came away with more unanswered questions than answered questions. Neither Congress nor officials within the Administration have sufficient expertise to gain a full understanding of the complex issues surrounding both how we got in and how we will get out of this. A Colombia University professor recently stated that any reform must begin with a dispassionate and informed assessment of what went wrong. And I agree. We must pass legislation to create a bipartisan or nonpartisan blue-ribbon panel that can give the American people an objective assessment of the causes and the handling of the financial crisis. Although no one bill would be perfect, and certainly mine is no different, in November, I introduced H.R. 7275, the Financial Oversight Commission Act of 2008. Modeled after the 9/11 Commission, the Financial Oversight Commission is designed to have experts examine the causes of this crisis, evaluate corrective measures taken thus far, and make recommendations for alternative measures. The commission should examine the missteps of we as Congress, the Administration, the private sector, nonprofit organizations, certainly the GSEs and all others have taken, and then make recommendations on the next step forward. Had we done this in the original legislation, we would already be halfway through the commission process. The commission could take up to a year to conduct its entire investigations, make findings, and report the recommendations to Congress and the President. However, as I am sure the Chair would agree, commissions in the first 90 days often accomplish a great deal of what they will accomplish in 1 year by bringing the type of focus and the type of individuals and the type of scrutiny that causes others to begin to volunteer changes. As economic conditions in the financial sector itself are not static, the panel will continue its review and would evaluate ongoing circumstances. In a report to Congress, the commission shall make a complete accounting of the circumstances surrounding the crisis, the private sector, the government role in causing the crisis, and the extent to which the United States preparedness for immediate response to a future crisis. The report should offer a conclusion and recommendations for corrective measures that can be taken to prevent further economic breakdown. Mr. Chairman, Ranking Member Bachus, it is time that we realize that we are a partisan organization; the next President will be a partisan organization; that we had a hand in the creation of this problem, whether it was a large hand or a small hand; whether it was in fact things we told the financial institutions to do or, quite frankly, oversight we failed to assert over them at both the executive and the congressional level. So Mr. Chairman, I strongly recommend that as you deliberate the current, you begin thinking about how we would put together, on a broad basis, a commission that would be a tool of this Congress. I thank you for this opportunity. " CHRG-111shrg382--43 PREPARED STATEMENT OF DANIEL K. TARULLO Member, Board of Governors of the Federal Reserve System September 30, 2009 Chairman Bayh, Ranking Member Corker, and other members of the Subcommittee, I appreciate the opportunity to testify today on the role of international cooperation in modernizing financial regulation. International cooperation is important for the interests of the United States because, as has been graphically illustrated in the past 2 years, financial instability can spread rapidly across national boundaries. Well-devised international financial regulatory standards can help encourage all nations to maintain effective domestic regulatory systems. Coordinated international supervisory arrangements can help ensure that every large, internationally active financial institution is effectively supervised. Both these forms of international cooperation can, at the same time, promote at least a roughly equivalent competitive environment for U.S. financial institutions with those from other nations. In my testimony this afternoon, I will review the responses of key international regulatory groups to the financial crisis, including both substantive policy responses and the organizational changes in membership and working methods in some of those groups. Next I will describe specifically the role of the Federal Reserve's participation and priorities in these international regulatory groups. I will conclude with some thoughts on the challenges for international regulatory cooperation as we move forward from the G-20 Pittsburgh Summit and the exceptionally active international coordination process that has preceded it.The Response of International Regulatory Groups to the Crisis Over the past few decades, international cooperation in financial regulation has generally been pursued in a number of groups that bring together national authorities with responsibility for regulating or supervising in a particular area, or that served as venues for informal discussion. Several of the functional regulatory groups have undertaken initiatives in response to the recent financial crisis. During this period, the Financial Stability Board (FSB) shifted from being more of a discussion forum to serving as a coordinator of these initiatives. The FSB was also the direct line of communication between these groups and the G-20. The Federal Reserve actively participates in the FSB as well as in the following international groups: In the Committee on Payment and Settlement Systems, we work with other central banks to promote sound and efficient payment and settlement systems. In the Committee on the Global Financial System, we work with other central banks to monitor developments in global financial markets, reporting to the central bank Governors of the G-10 countries. In the Basel Committee on Banking Supervision (Basel Committee), we and the other U.S. bank supervisors work with other central banks and bank supervisory agencies to promote sound banking supervision by developing standards for bank capital requirements and bank risk management, and by promulgating principles for effective bank supervision. The Basel Committee, which doubled its membership earlier this year, now includes supervisors from 27 jurisdictions, including both advanced and emerging markets.\1\--------------------------------------------------------------------------- \1\ The Basel Committee's members come from Argentina, Australia, Belgium, Brazil, Canada, China, France, Germany, Hong Kong SAR, India, Indonesia, Italy, Japan, Korea, Luxembourg, Mexico, the Netherlands, Russia, Saudi Arabia, Singapore, South Africa, Spain, Sweden, Switzerland, Turkey, the United Kingdom, and the United States. In the Joint Forum, we and other U.S. financial regulators--including bank, securities, and insurance regulators--work with financial regulators from other countries to enhance financial regulation that spans different financial --------------------------------------------------------------------------- sectors. In the Senior Supervisors Group, we and other U.S. supervisors have worked over the past few years with the supervisors of other major financial firms to share information and sponsor joint reviews of risk management and disclosure. In bilateral and regional supervisory groups, we have discussed regulatory issues with Europe, China, India, Japan and other supervisors from the Western Hemisphere. Some of these groups have quite a long history. Both the Committee on the Global Financial System and the Basel Committee date back to the 1970s. These groups are not formal international organizations. They have operated with only a modest support staff--often provided, along with a location for meetings, by the Bank for International Settlements (BIS). The bulk of their activity is conducted by officials from the national regulators themselves. The FSB is a relatively new group, established in the wake of the Asian financial crisis in 1999 as the Financial Stability Forum, with a broad mandate to promote global financial stability. The FSB is an unusual combination of international standard-setting bodies (including those mentioned above) and a range of national authorities responsible for financial stability: treasury departments and ministries of finance, central banks, and financial supervisory agencies.\2\ Major international organizations such as the BIS and the International Monetary Fund (IMF) also participate.\3\ At the request of the G-20 in April 2009, the Financial Stability Forum's name was changed to the Financial Stability Board, its membership was expanded to add the emerging market countries from the G-20, and its mandate was strengthened.--------------------------------------------------------------------------- \2\ International standard-setting bodies participating in the FSB are the Basel Committee, the Committee on the Global Financial System, the Committee on Payment and Settlement Systems, the International Association of Insurance Supervisors, the International Accounting Standards Board, and the International Organization of Securities Commissions. The jurisdictions represented on the FSB are: Argentina, Australia, Brazil, Canada, China, France, Germany, Hong Kong SAR, India, Indonesia, Italy, Japan, Mexico, the Netherlands, Russia, Saudi Arabia, Singapore, South Africa, South Korea, Spain, Switzerland, Turkey, the United Kingdom, and the United States. \3\ International organizations in the FSB are the BIS, the European Central Bank, the European Commission, the IMF, the Organisation for Economic Co-operation and Development, and The World Bank.--------------------------------------------------------------------------- The financial crisis has underscored the importance of the original motivation for creating what is now the FSB. The connections among financial market sectors, and between macroeconomic policy and financial markets, mean that efforts to ensure international financial stability must incorporate a breadth of perspectives and include communication among the various international groups in which regulatory cooperation takes place. In its work to increase international financial stability and to promote financial regulatory reform, the FSB has tried to identify priorities and agree upon high-level principles. It has then requested that the relevant standard-setting bodies formulate detailed proposals and report back to the FSB. All these international groups, including the FSB, operate by consensus. Although this institutional feature can create significant challenges in reaching agreement on complex topics, it also serves as a check on potentially undesirable policy directions. The process of developing proposals in the standard-setting bodies allows a variety of ideas to be explored and exposed to critical examination by expert staff. Like any other process, alternative viewpoints emerge and dissenting opinions are voiced. Once a consensus is reached, it is then up to individual members to implement any statutory changes, administrative rules, or guidance under local law. As already noted, the FSB has played a leading role in guiding the official response to the crisis. In April 2008, it made a range of recommendations to increase the resiliency of financial markets and institutions. These recommendations are broadly consistent with similar principles articulated by the President's Working Group on Financial Markets here in the United States. The FSB has acted upon priorities identified by the G-20 leaders and has delivered to those leaders a series of proposals that have been adopted by them, most recently at the Pittsburgh summit last week. With its role now expanded and in the process of being formalized in a charter, the FSB will have the ongoing mandate of identifying and addressing emerging vulnerabilities in the financial system. The activities of some other groups have also broadened in response to the crisis. The Basel Committee was formed in 1974 in an effort by national authorities to fill supervisory gaps exposed by problems in a number of internationally active banks. Beginning in the late 1980s, its focus shifted to setting capital standards for internationally active banks. That emphasis continues today, notably with respect to strengthening capital requirements for securitization exposures and trading book exposures as well as disclosure requirements related to these areas. The Basel Committee has now begun to address a wider range of issues aimed at improving standards for capital, liquidity, cross-border bank resolution, leverage, and macroprudential supervision. In March 2008, the Senior Supervisors Group released its first report on risk-management practices.\4\ The report, based on extensive discussions with large financial institutions, provided near-real-time analysis of the major failures in risk management and internal controls that led to outsized losses at a number of firms, and highlighted distinctions in practices that may have enabled some other institutions to better withstand the crisis. The group is now in the final phases of preparing a second report that will focus on the challenges that emerged as particularly critical last year, notably related to management of liquidity risk, and present the results of the self-assessments by the largest financial institutions regarding their responses to the riskmanagement and internal control issues highlighted by the crisis.--------------------------------------------------------------------------- \4\ See Senior Supervisors Group (2008), Observations on Risk Management Practices during the Recent Market Turbulence (Basel: SSG, March 6), available at Federal Reserve Bank of New York (2008), ``Senior Supervisors Group Issues Report on Risk Management Practices,'' press release, March 6, www.newyorkfed.org/newsevents/news/banking/2008/rp080306.html.--------------------------------------------------------------------------- International regulatory and supervisory bodies have been actively engaged in addressing a wide range of issues, many of which have been highlighted by the recent financial crisis. Let me now discuss in more detail a few of the areas that are most important from the perspective of the Federal Reserve.Capital The financial crisis has left little doubt that capital levels of many financial firms, including many in the United States, were insufficient to protect them and the financial system as a whole. The FSB has called for significantly stronger capital standards, to be agreed upon now and phased in as financial and economic conditions improve. The communiquE issued Friday by the G-20 leaders echoed and amplified the need for improvements in both the quantity and quality of capital. One critical area for improvement is that of increasing capital requirements for many forms of traded securities, including some securitized assets. Some work has already been completed. We place a high priority on undertaking a comprehensive review and reform of these requirements. The Basel Committee is also working on proposals for an international leverage ratio to act as a supplement to risk-based capital ratios. The FSB has also devoted considerable energies to exploring sources of procyclicality in the financial system, which are those practices and structures that tend to amplify rather than dampen the cycles characteristic of financial markets, and to identifying possible strategies to reduce their effects, which were often quite visible during the recent crisis. One such strategy is to include a countercyclical capital buffer in the capital requirements for financial firms. Work on such a buffer is under way, though the technical challenges of devising an effective buffering mechanism are significant. It will be important for the international regulatory community to carefully calibrate the aggregate effect of these initiatives to ensure that they protect against future crises while not raising capital requirements to such a degree that the availability of credit to support economic growth is unduly constrained. The Basel Committee plans a study of the overall calibration of these changes for early next year.Liquidity Liquidity risk is another key international agenda item. Although the Basel Committee had historically focused on capital standards, the crisis clearly demonstrated that adequate capital was a necessary but not always sufficient condition to ensure the ability of a financial institution to withstand market stress. We were reminded that the liquidity of a firm's assets is critical to its ability to meet its obligations in times of market dislocation. In particular, access to wholesale financing very quickly became severely constrained for many institutions that had grown quite dependent on it. The Basel Committee promulgated general guidance on liquidity risk management in June 2008 and is now in the process of incorporating those broad principles into specific quantitative requirements.Cross-Border Bank Resolution In the area of cross-border resolution authority, there is broad international agreement that existing frameworks simply do not allow for the orderly resolution of cross-border failures of large complex banking organizations and that changes are needed. Current frameworks focus on individual institutions rather than financial groups or the financial systems at large. These frameworks have proven problematic even at the national level. Policy differences and legal obstacles can magnify these shortcomings at the international level. The Basel Committee's Cross-Border Bank Resolution Group has developed 10 recommendations for national authorities.\5\ The recommendations, which aim at greater convergence of national resolution frameworks, should help strengthen cross-border crisis management. One key recommendation requires systemically important firms to have contingency plans that will allow for an orderly resolution should that prove necessary. Implementation of these recommendations is likely to require heightened cooperation throughout the international community.--------------------------------------------------------------------------- \5\ See Basel Committee on Banking Supervision, Cross-Border Bank Resolution Group (2009), Report and Recommendations of the Cross-Border Resolution Group (Basel: Basel Committee, September), available at www.bis.org/publ/bcbs162.htm.---------------------------------------------------------------------------Accounting Standards for Financial Institutions The FSB and the Basel Committee have an important role in supporting improved accounting standards for financial institutions. For example, the FSB has developed recommendations for improving the accounting for loan loss provisions. The Basel Committee consults frequently with those who set international accounting standards on these and other topics and provides comments on important accounting proposals affecting financial institutions.Future Initiatives A number of other initiatives are at an earlier stage of policy development. A good deal of attention right now is focused on mitigating the risks of systemically important financial firms. Two of the more promising ideas are particularly worth mentioning. One is for a requirement for contingent capital that converts from debt to equity in times of stress or for comparable arrangements that require firms themselves to provide for back-up sources of capital. The other is for a special capital or other charge to be applied on firms based on their degree of systemic importance. Many of these initiatives still require much work at the technical level before policy proposals will be ready for a thorough vetting in the national and international regulatory community.How the Federal Reserve Pursues Our Objectives in International Groups The Federal Reserve promotes U.S. interests in these international groups by actively participating and by coordinating with other U.S. participants. The international groups that I mentioned earlier all hold regular meetings. The FSB meets at least twice a year, and the Basel Committee typically meets four times a year. Between meetings of the main groups, subgroups of technical experts meet to discuss proposals and lay the groundwork for issues to be discussed at the main groups. The Federal Reserve actively participates in both the main groups and the subgroups. For practical purposes, not all members of a group can sit on each subgroup, although the United States is well represented on all major topics and chairs important subgroups. We have found that success in pursuing our objectives in these groups depends upon having well-developed ideas. One important basis for leadership in international groups is the quality of the intellectual and policy contributions that an organization can offer. To this end, we have tried to use the extensive economic and research resources of the Federal Reserve, as well as our regulatory experience, to produce well-considered proposals and useful feedback on the proposals of others. International groups operate on the basis of consensus. Policies are endorsed only when all members voice their support. This approach can make it challenging to come to agreement on complex topics. But international groups are made up of regulatory agencies or central banks, and they have particular responsibilities based on their own national laws. International groups are not empowered to create enforceable law, and agreements need to be implemented by member countries in the form of statutory changes, administrative rules, or supervisory guidance. Thus, the consensus orientation of the international policy development process is necessary to respect the domestic legal structures within which the various regulatory agencies operate. The President's Working Group on Financial Markets is the primary forum in which regulatory issues are discussed among the principals of the U.S. financial regulatory agencies. These discussions often cover the same issues being discussed in international groups. We strive to maintain a degree of intellectual rigor and collegiality in these discussions where consensus is again the norm, despite the sometimes different perspectives of the various agencies. In the past, there were some notable instances of significant disagreement among the U.S. agencies, but my observation since being appointed to the Federal Reserve is that the coordination process is working quite well. Indeed, it can sometimes be an advantage to have multiple U.S. agencies involved in international processes because of the complementary expertise we each bring to bear. In addition, at the international level, having multiple U.S. agencies at the table provides an appropriate counterweight to our European counterparts, who for historical reasons are usually overrepresented in international groups relative to their weight in the global financial system. Like other central banks, the Federal Reserve did not participate in the G-20 summit, which is attended by heads of state and finance ministers. However, we are involved in a significant part of the relevant preparatory and follow-up work, both through the FSB and in joint meetings of the G-20 finance ministers and central banks.\6\ In preparation for the Pittsburgh summit, as well as for the previous G-20 summits in London and Washington, the Federal Reserve has also collaborated with other U.S. financial regulatory agencies in considering the financial regulatory issues on the agendas for these meetings.--------------------------------------------------------------------------- \6\ The FSB prepared three documents that were presented to G-20 leaders at the summit: ``FSB Principles for Sound Compensation Practices,'' ``Improving Financial Regulation,'' and ``Overview of Progress in Implementing the London Summit Recommendations for Strengthening Financial Stability.''---------------------------------------------------------------------------Challenges for International Financial Cooperation The testimony that my colleagues and I have offered this afternoon reflects the breadth and depth of the tasks associated with improved regulation and supervision of financial markets, activities, and firms. An ambitious agenda has been developed through the interactions of the G-20, the FSB, and international standard-setting bodies, and much work toward completing that agenda is already under way. At the same time, there will inevitably be challenges as we all intensify and reorient the work of these groups. I will now discuss four of those challenges. First, for all the virtues of the consensus-based approach involving the relevant national authorities, some subjects will simply be very difficult to handle fully in this fashion. Crossborder resolution may prove to be one such issue. Although there is undoubtedly potential for achieving improvement in the current situation through the international processes I have described, the complexities involved because of the existence of differing national bankruptcy and bank resolution laws may limit what can be achieved. Second, there will likely be a period of working out the relationships among the various international bodies, particularly in light of the increased role of the FSB. We will need to determine how extensively the FSB and its newly constituted committees should themselves develop standards, particularly where an existing international standards-setting body has the expertise and mandate to address the topic. Similarly, while simultaneous consideration of the same issue in multiple international bodies can sometimes be a useful way to develop alternative proposals, there may also be potential for initiatives that are at odds with one another. Third, the significant expansion in membership of many of the more important of these bodies may require some innovation in organizational approaches in order to maintain the combination of flexibility and effectiveness that the FSB and some of the other groups have, at their best, possessed in the past. The substitution of the G-20 for the G-8 at the level of heads of government is the most visible manifestation of the salutary trend toward involving a number of emerging market economies in key international financial regulatory arrangements. As I mentioned earlier, the FSB and the Basel Committee have recently expanded their membership to the entire G-20. Important as this expansion is for the goal of global financial stability, the greater number of participants does have an impact upon the operation of those groups, and we will need to adapt accordingly. I hasten to add that this is not at all a comment on the capacities of the new members. On the contrary, I have been impressed with the quality of the participation from the new emerging market members. Finally, the financial crisis has understandably concentrated the attention and energies of many of these international regulatory groups on the new standards that will be necessary to protect financial stability in the future. Combined with the enlarged memberships of these groups, however, this focus on negotiating standards may unintentionally displace some of the traditional attention to fostering cooperative supervisory practices by the national regulators who participate in these international bodies. It is important that, even as we represent our national interests in these bodies, we also promote the shared interests we have in effective financial supervision.Conclusion Participating in international regulatory groups has helped the Federal Reserve and other U.S. agencies begin to shape an effective global regulatory response to the financial crisis. We look forward to continuing our collaboration in pursuit of effective, efficient financial regulation. Thank you for inviting me to present the Board's views on this very important subject. I look forward to continuing dialog with the Subcommittee on these issues. I would be pleased to answer any questions you may have. RESPONSES TO WRITTEN QUESTIONS OF SENATOR CORKER FROM MARK SOBELOn Resolution AuthorityQ.1. The Administration's proposal asks for significant and broad resolution authority that is, in effect, TARP on steroids. While some will still advance the theory that the bankruptcy courts with a few tweaks would be enough of a solution, the challenges we have seen with Lehman's resolution abroad question the theory that with no globally astute and integrated resolution regime, the court systems will not function cohesively and instead will be inclined to ring fence and protect for their own taxpayers. Explain to me how would the Administration's proposed resolution process work overseas? Do you think that is the optimal model? Propping up failed institutions around the globe at taxpayer's expense into perpetuity? Is the Treasury Department conducting any economic analysis so the impact of any proposal is fully understood before it is uniformly agreed to and adopted? And if so, when will you be willing to share this information to help us inform our policymaking?A.1. The United States, led by the Federal Depository Insurance Corporation (FDIC), is working closely with international counterparts within the Basel Committee, to study the important issue of resolutions at the international level. The Cross Border Bank Resolution Working Group has conducted serious analysis and published two reports with ten proposals to strengthen international and national frameworks for cross-border resolution of international institutions and, importantly, used the recent crisis as ``lessons learned.'' (Available at: http://www.bis.org/publ/bcbs162.htm) Recognizing that strictly national approaches are inefficient and global approaches may not be viable, the Group has recommended that major financial centers adopt comparable, consistent domestic resolution regimes similar to the FDIC approach. These proposals were issued for comment, with a deadline of December 31, 2009. The United States supports countries having strong and effective national resolution frameworks and an orderly resolution process, all of which will minimize the damage to the financial system and reduce cost to the taxpayer. As Secretary Geithner noted in his testimony before the House Financial Services Committee, the proposed resolution authority would not authorize the government to provide open-bank assistance to any failing firm. That is, the government would not be permitted to put money into a failing firm unless that firm is in FDIC receivership and on the path to being unwound, dismantled, sold, or liquidated. The receivership authority would facilitate the orderly demise of a failing firm, not ensure its survival, and would strengthen market discipline and reduce moral hazard risks, while protecting the financial system and taxpayers. It also is important that there are appropriate checks and balances and that the special resolution regime may be used only with the agreement of the Secretary of the Treasury and two-thirds of the boards of the Federal Reserve and the FDIC. In addition, any losses from a special resolution must be recouped with assessments on the largest non-bank financial firms.On Insurance IssuesQ.2. I want to ask you a couple of questions regarding the G-20 and the Financial Stability Board's cooperative efforts on regulatory reform. I am curious if insurance issues fall under this effort and how so? I ask because it has been a challenge for European regulators' to not having a counterpart in the U.S. Executive branch on insurance issues. They complain that our current system not only represents inefficiency, but is also a barrier to global coordination on regulatory reform efforts. They also fear this is a potential problem in any future crisis and in resolving failed firms that have insurance subsidiaries. Can you tell me specifically if cooperation on insurance regulation falls under the G-20 and FSB mandates, and if yes, does the U.S. Executive branch have adequate authority to take necessary actions under this mandate, or is the United States lacking the proper tools to address insurance issues as part of a comprehensive effort to address crises such as that which we have just lived through?A.2. The Treasury Department's International Affairs Office coordinates the USG position and participation in the Financial Stability Board (FSB), which is mandated to: deepen the resiliency of domestic financial systems; identify and address potential vulnerabilities in international financial systems; and enhance international crisis management. Senior-level officials from the Federal Reserve, Securities Exchange Commission, and the Treasury Department represent the United States in FSB meetings. Other Federal financial regulatory agencies (the Federal Deposit Insurance Corporation, the Office of the Comptroller of the Currency, the Commodity Futures Trading Commission), as well as the National Association of Insurance Commissioners participate in USG preparation for the FSB meetings and provide input. Treasury Secretary Geithner and Federal Reserve Chairman Bernanke represent the United States at meetings of the G-20 Finance Ministers and Central Bank Governors. At the Pittsburgh Summit in late September, Leaders designated the G-20 as the premier forum for our international economic cooperation. To date, neither the FSB nor the G-20 has offered regulatory guidance solely directed at the insurance sector. Certain cross-cutting issues, however, affect insurance, such as supervisory colleges, heightened prudential regulation for large, interconnected financial institutions, and cross-border resolution. The regulatory reform agenda in these fora largely reflects effective U.S. leadership and is consistent with the approach taken in the Administration's proposals, which are pending action by the Congress. As you have noted, some Europeans suggest that the absence of a Federal regulatory representative complicates their international dealings on insurance supervision, for example on issues of reinsurance collateral or Europe's evolving supervisory regime. The Administration's proposals would give the Treasury Department the authority to represent American interests in international fora regarding prudential measures for insurance. While the Office of National Insurance is not a regulator, it would provide a single coordinated USG voice on prudential matters related to insurance. It would serve as a Federal authority to represent U.S. interests to work with other nations within the International Association of Insurance Supervisors (IAIS) on prudential regulatory issues, cooperation and agreements.Transparency of the FSBQ.3. As it builds out to handle its new mandate, how will it be held accountable, to whom, how will input flow into the process?A.3. The FSB membership consists of national and regional authorities responsible for maintaining financial stability (ministries of finance, central banks, and regulatory authorities), international financial institutions, and international standard setting, regulatory, supervisory and central bank bodies. All members are entitled to attend and participate in the Plenary, which is the decisionmaking body of the FSB. Representation on the Plenary is at the level of: central bank Governor or immediate deputy, head or immediate deputy of the main regulatory agency, and deputy finance minister or deputy head of finance ministry. Representation by the international financial institutions and the international standard setting bodies is at a similar level. The U.S. delegation to the FSB, represented here today by Treasury, the Federal Reserve and the SEC, supports and encourages the publication of FSB reports on its work. Many reports on the FSB's work and the work of member organizations are available to the public on its website at www.financialstabilityboard.org. We are also pleased to make Treasury staff available to brief your Committee, Members, and staff at your convenience on any issue relating to the FSB.Q.4. I think it's important to talk about how our interactions with the FSB and Basel Committee will go with regard to the new regulations that they will recommend. We don't possess a treaty with these bodies, so in order for enactment to take place Congress will have to legislate and/or the independent regulatory agencies will have to adopt and adapt. The question that many are left with is if this will happen? How quickly? Will Congress end up leading the effort or lag? How is it all going to work? I think that the FSB/Basel agreements actually carry the force of law--or for conforming efforts--within the EU (hence the adoption of Basel II). Of course the United States did not adopt because small banks believed they were at a disadvantage. If this is indeed the case, won't a Basel III present a similar situation where the Europeans adopt the findings and we either do not adopt at all or adopt at a much slower pace. Quite frankly, the Europeans do not trust us to implement what we might agree to do, and they do not want to be put in a weakened position vis-a-vis the United States. All that said, I'd be interested in your thoughts on the role that the G-20 will play in the regulation writing process? Will it guide with specifics or simply bless proposals put forward?A.4. The U.S. banking regulators are members of the Basel Committee on Banking Supervision (Basel Committee), as are banking authorities of all of the other G-20 countries. The U.S. banking regulators have adopted the Advanced Approaches of Basel II by issuing regulations after notice and comment. The Basel Committee is currently considering changes to Basel II in light of the weaknesses in it exposed by the financial crisis. The Basel Committee normally issues international standards following a notice and comment process and we expect this to continue for changes to Basel II. The Basel Committee does not currently have plans for a Basel III. Neither the G-20 nor the FSB has any legally binding rulemaking authority. ------ RESPONSES TO WRITTEN QUESTIONS OF SENATOR CORKER FROM KATHLEEN L. CASEYCredit Rating AgenciesQ.1. It's clear that the Credit Rating Agencies have not been quite up to snuff over the last few years but it seems that the Basel accords and the regulatory regimes rely a lot on them. I know that you have discussed the idea of moving to simple leverage ratios, but how do you square the problem of continuing to rely on a system that has failed us in the past? Should we reform the agencies, reduce regulatory reliance or encourage a new system to evolve?A.1. In my view, the Securities and Exchange Commission (``SEC'' or ``Commission'') should continue its efforts to both reform the credit rating industry and reduce the regulatory reliance on credit ratings issued by Nationally Recognized Statistical Rating Organizations (``NRSROs''). Over the past 2 years, pursuant to authority granted by Congress under the Credit Rating Agency Reform Act of 2006 (``Rating Agency Act''), the SEC has adopted some significant reforms relating to credit rating agencies. These reforms are intended to further the Rating Agency Act's explicit goals of enhancing the transparency, accountability, and level of competition in the rating industry. But, in my view, the SEC needs to do more in this area. It is essential that the Commission finish its work with respect to the regulatory use of credit ratings. The Commission should adopt the remainder of its pending proposals to address overreliance on NRSRO ratings by removing the regulatory requirements embedded in numerous SEC rules. The considerable unintended consequences of the regulatory use of ratings--preserving a valuable franchise for the incumbent and dominant rating agencies, inoculating these government-preferred rating agencies from competition, promoting undue reliance and inadequate investor due diligence, and uneven ratings quality--have been evident for some time. It is vital that the Commission remove the government imprimatur from all SEC rules, particularly those relating to money market funds. The market, not the government, should decide which credit ratings have value.On RegulationQ.2. Other countries look to the United States for leadership in financial services regulation. I am especially, and increasingly, concerned about the potential for overregulation in the United States, not only for the effect on U.S. companies and the U.S. economy, but also for the example that it would set for regulators and policymakers in Europe and elsewhere. The financial crisis was not caused by deregulation. If anything, it was caused by too much government intervention with respect to entities such as Fannie Mae and Freddie Mac, artificially low interest rates by a hyperactive Federal Reserve, and so on. Now for my question: What would, in your view, be the dangers of overregulation in the United States? Let's take two issues that are mentioned in your testimony, hedge funds and credit rating agencies. What would be the practical impact on those two industries?A.2. I share your concerns relating to excessive regulation. Overregulation would not protect or benefit investors. Instead, it would only serve to harm the competitiveness of the U.S. capital markets. Such a result hurts every American who is looking for a job, investing his money, or paying taxes. In my view, too much regulation of hedge funds would have the predictable effect of moving fund assets to jurisdictions with a more favorable regulatory approach. Regulators and policymakers cannot lose sight of the fact that capital is highly mobile. We can protect investors and oversee hedge funds in a responsible way that does not harm the competitiveness of U.S. markets. Those goals are not necessarily mutually exclusive. With respect to too much regulation of credit rating agencies, it is my view that before adopting additional regulations that are not market-based, the Commission needs to step back and take stock of all the new rules it has adopted over the past 2 years. The simple fact is that rating agencies are highly regulated today. That is not to say that they will always issue accurate ratings for investors. Government regulation could never deliver such results. And it does not mean that we can second-guess their rating judgments or seek to regulate their rating methodologies. The Rating Agency Act precludes the Commission from such actions, and properly so, in my view. But what it does mean is that we have adopted comprehensive regulations in many key areas. We should seek to establish regulatory certainty. At some point, we need to be able to see if the rules we have on the books are having their intended effect. Too much regulation of rating agencies would not protect investors by improving ratings quality. In fact, it would only increase the regulatory costs and burdens associated with being or becoming an NRSRO, and lead to predictably anticompetitive results. Ironically, these costs are manageable for the incumbent rating agencies, but serve as a competitive barrier to those contemplating entering the NRSRO space. Avoiding too much regulation and enhancing competition would have another important effect: As the Commission noted recently, ``[R]educing the barriers to entry in the market for providing NRSRO ratings and, hence increasing competition, may, in fact, reduce conflicts of interest in substantive ways.'' ------ RESPONSES TO WRITTEN QUESTIONS OF SENATOR CORKER FROM DANIEL K. TARULLOOn the Financial Stability BoardQ.1. At the G-20, there was general agreement to match up the membership of the Financial Stability Board with that of the G-20 and a focus on the ``monitoring of the international economy'' for new points of weakness and instability, I am skeptical that the FSB would be able to actually enforce actions by its member nations in response to any emerging risk it perceives. In April, the Economist magazine even said that domestic political pressures would trump any FSB call to action. The article said ``But if it warns, who will listen? Imagine the scene in Congress in 2015. The economy is booming but Americans cannot get mortgages because some pen pusher in Basel says the banks are taking too much risk. The banks would be freed faster than you can say ``swing voter''.'' Governor, what can we do to ensure that these moments of pro-cyclicality and crisis response are measured and consistent from the top down, end to end across the globe if the crisis is global and systemic?A.1. Did not respond by printing deadline.On Trade FinanceQ.2. U.S. manufacturers continue to struggle in these credit markets to get trade finance and this is yet another example of regulatory treatment creating a self fulfilling prophecy that will slow down the economy. The rules of Basel II discourage banks from extending trade finance by forcing them to assign to it unreasonably high risk weighting and too long a maturity. The G-20 in April promised to ask their regulators to use discretion when applying the rules. There has been some limited flexibility from the U.K.'s Financial Services Authority, banks say that capital restrictions continue to hinder the market and that there is a disconnect between what the G-20 is saying and the effect of banking regulation on trade finance. Because of the nature of the trade finance market would you see the necessity of a program of this nature to be kept in place past the 2 years it is authorized for?A.2. Did not respond by printing deadline.Q.3. Is Basel II hindering the recovery of the trade finance market?A.3. Did not respond by printing deadline.Q.4. Is the G-20 asking regulators to ``use discretion'' enough to alleviate regulations that may make extending trade finance difficult? Or will the G-20 have to address this in a more formal manner? Is that something you would support?A.4. Did not respond by printing deadline.Q.5. Is there anything else that can be done in the international finance community to mitigate the risk of these markets seizing and to ensure liquidity? Is the use of the Export Import Bank and its guarantees appropriate here?A.5. Did not respond by printing deadline.Q.6. Is there anything more that can be done to assist developing countries, like Africa, in assisting with the current high cost of trade?A.6. Did not respond by printing deadline.On Bank RegulationQ.7. As we work on our regulatory structure and debate the merits of more or less regulators and the value or lack of value in friction and different sets of eyes and opinions looking at our regulated entities, I wonder if this plays out even more aggressively on the world stage. We worry about regulatory arbitrage . . . and should . . . but how do you avoid a rush for all regulators agreeing to the most draconian standards and then that be the way the contagion spreads? In other words, does the least common denominator equate to squeezing good risk and entrepreneurship out of the system.A.7. Did not respond by printing deadline.Transparency of the FSBQ.8. As it builds out to handle its new mandate, how will it be held accountable, to whom, how will input flow into the process?A.8. Did not respond by printing deadline.Q.9. I think it's important to talk about how our interactions with the FSB and Basel Committee will go with regard to the new regulations that they will recommend. We don't possess a treaty with these bodies, so in order for enactment to take place Congress will have to legislate and/or the independent regulatory agencies will have to adopt and adapt. The question that many are left with is if this will happen? How quickly? Will Congress end up leading the effort or lag? How is it all going to work? I think that the FSB/Basel agreements actually carry the force of law--or for conforming efforts--within the EU (hence the adoption of Basel II). Of course the United States did not adopt because small banks believed they were at a disadvantage. If this is indeed the case, won't a Basel III present a similar situation where the Europeans adopt the findings and we either do not adopt at all or adopt at a much slower pace. Quite frankly, the Europeans do not trust us to implement what we might agree to do, and they do not want to be put in a weakened position vis-a-vis the United States. All that said, I'd be interested in your thoughts on the role that the G-20 will play in the regulation writing process? Will it guide with specifics or simply bless proposals put forward?A.9. Did not respond by printing deadline." CHRG-111hhrg53238--99 Mr. Zywicki," A plain vanilla loan would be perfect for a plain vanilla consumer. I have never met that person, unfortunately. Every consumer seems to be completely different to me. And every consumer seems to have different needs and wants and different sorts of things. To think about plain vanilla products is being like credit cards 30 years ago. They were very simple. They were plain vanilla, and they were really lousy products. They had a $40 annual fee, a high fixed-interest rate, no benefits, nothing else that came along with it. Competition has intervened and credit cards have certainly gotten much more complex, but they have gotten much, much better for consumers. And if you think about the way in which consumers use credit cards to cash advances, to travel, to small businesses, all those sorts of things, there is no plain vanilla consumer. There is a plain vanilla loan. " CHRG-110hhrg46591--249 Mr. Lynch," Thank you, Mr. Chairman. I thank the panel for their willingness to help the committee with its work. At a very basic level, I think there are a couple of things we have to admit to in going into this whole idea of reforming our regulatory system. One is that we cannot and should not try to prevent every single failure. That is not the purpose of our regulatory framework. On the other hand, I think it is enormously important that we should devise a system that allows investors and market participants to have accurate and timely information in order to defend themselves and in order to make prudent and well-informed decisions. There are a couple of examples out here that we have seen in this whole crisis. I want to point to one which is really illustrated best in an article by Gretchen Morgenson of the New York Times a while back. She was talking about Bear Stearns. The article is on Bear Stearns. She was talking about--this was at the very end--on their way down, based on their annual report, they reported that they had $46 billion in mortgages and in mortgage-backed securities and in complex derivatives based on mortgages; $29 billion of them were valued--and this is a quote--``using computer models derived from or supported by some kind of observable market data.'' Then she goes on to say that the value of the remaining $17 billion, according to Bear Stearns, is estimated based on ``internally developed models or methodologies, utilizing significant inputs that are generally less readily observable.'' In other words--and these are her words--``your guess is as good as mine.'' We have another example in the Merrill Lynch situation where E. Stanley O'Neal, the CEO, went out on October 5th and said that the company had $4.5 billion in writedowns. On October 30th, 3 weeks later, he came out and said that they had $7.9 billion in writedowns. Then in November, he increased the amount to $11 billion. The bottom line here is that neither of these companies knew what was going on internally. They did not have internal transparency. Part of that reason is the complexity of these instruments, and with a system based on trust, it is extremely important. If we are ever going to get back to a system of normalcy, we have to have that type of transparency. Mr. Ryan, you mentioned earlier the clearinghouse and how we might deal with derivatives and how we might vet these things or have a clearinghouse to quantify the value of these. Is it not the case that we are going to have to bring these instruments that are outside the regulatory process into a tighter regulatory framework? " CHRG-111shrg54589--81 Mr. Hu," Yes, I think the prudential supervision of dealers is extremely important. I think that the experience with AIG and the decision-making errors that AIG had while acting as a CDS dealer tend to illustrate how it is important for the Federal Government to get involved as to how these decision-making errors can occur. As another example, the government should also consider the payoff structures, including highly asymmetric compensation structures sometimes seen within derivatives units. Sometimes, the rocket scientist gets a big payoff if some product works while, at most, may lose his job if it does not work. One might also ask about the financial literacy of the people who are supposed to be supervising the rocket scientists developing these products? Moreover, when do the risks arise? As we all know, in terms of the derivatives personnel, there tends to be high turnover. The risks may not arise until they are three banks away. So that as part of this process in terms of prudential supervision, I think that we really need to look very carefully in terms of how these errors can arise at ``sophisticated'' derivatives dealers. In fact, there are error issues as well--and this came up earlier--in connection with end users. In terms of end users, there has been a pattern throughout the history of OTC derivatives of very unsophisticated entities basically gambling and losing. We do not need to even look at the examples of some of today's municipalities getting into trouble as to complex products. There are some famous examples from the late 1980s involving English local councils such as Hammersmith and Fulham. These councils basically decided that the way to keep taxes down is by speculating on interest rates through interest rate swaps. So that I think in terms of this area, certainly one of the things that we ought to look at is the prudential supervision of derivatives dealers and suitability and related sales practice matters. But we also ought to look at the end-user side, including as to the adequacy of end-user disclosures of their derivatives activities and the like. Substantive questions can also arise. What was Procter & Gamble or what was Gibson Greetings doing engaged in LIBOR-squared interest rate swaps? So I think that there are issues all around in this area. " CHRG-111shrg55739--72 Mr. Barr," Senator Shelby, I think it is a central question. I think that, in our judgment, one of the reasons it is so critical to move on financial regulatory reform this year is precisely that. I do not think we are going to see a revitalization of our securitization markets unless we have a new foundation of regulation that permits transparency in the system, restores honesty and integrity to the process that was so sorely lacking in the last bit of time. So I think that, in our judgment, we need to move quickly on financial regulatory reform. We need to have transparency in the securitization structures. We need to improve regulation of credit rating agencies building on the 2006 law. We need to make sure we take care of the systemic risk problem and consumer protection. And we really have to move in a way that it is demonstrable to the markets that we are serious about reform. Senator Shelby. Thank you. Senator Reed. Thank you very much, Senator Shelby. Senator Schumer. Senator Schumer. Thank you. Thank you, Mr. Chairman. I want to thank you for holding this hearing. Thanks, Secretary Barr, for coming. Thanks, Senator Shelby, for asking that extra question. I appreciate it. I have a little statement with a little proposal in there, and I am going to ask your opinion of it. We had hoped, when we passed the Credit Rating Agency Act of 2006, the reform act of 2006, which required registration and oversight of credit rating agencies, that the rating agencies would be one of the cornerstones of strong credit markets. Instead, as has been said before, the credit rating agencies turned out to be one of the weakest links, and those need to be fixed, as you just said. What we found out was that rating systems were filled with conflicts of interest. The worst of these conflicts were that issuers went shopping for ratings like they were shopping for used cars. If they did not like the answer they heard, they went somewhere else. Because the revenues of the rating agencies grew with the massive expansion of the securitization market, the rating agencies had every incentive to help issuers structure their products to get the ratings they wanted. The result: Rating agencies rubber stamped complex products they did not understand as investment grade, using flawed analytical models and methodologies with inadequate historical data that did not include the possibility of high mortgage defaults. We cannot overestimate the impact this had on the financial crisis. Losses in structured finance securities alone led to $1.47 trillion in writedowns and losses at the largest financial institutions. And Senator Reed, our Chairman here, has introduced a bill on credit rating agencies, and the Administration has proposed new rules to address some of these conflicts of interest and the inability to evaluate ratings. And they are important proposals, but I wonder if the message is getting through. Last month, I read an article how Moody's downgraded--after Moody's downgraded a collateralized debt obligation because the default rate of loans in the CDO rose 7 percent. Morgan Stanley repackaged it into new securities with AAA ratings. How can you get a AAA rating based on a CDO that has just been downgraded six levels? Where are the checks in the system? That is why I am proposing, in addition to Senator Reed's bill and the Administration's proposal, which I think are very good, that for every ten rated products, the SEC would randomly assign a different rating agency, another rating agency to issue a second rating. I understand that issuers get two ratings, but this randomly assigned rating agency would act as a check on the first rating agency. Furthermore, this check would help discourage ratings shopping and other conflicts of interest inherent in the system. We would learn who is better at ratings and who is worse and get rid of at least the conflicts of interest. I would not want to do it for every issue. That is too many, but just a certain amount. We propose one out of ten, maybe it should be a little less, a little more, but a significant amount so we get a pool of knowledge. And I think it would be prophylactic. If an agency knew that there was a one in ten chance when they got paid by the issuer that someone else was doing an independent rating, they would be more careful. So the ratings are too much a part of our financial system to abandon them, but it is clear the system as it exists is broken, and I want to look forward to working with Chairman Dodd, Senator Reed on his excellent proposal, and the Administration to make sure that we can have faith that a AAA rating means what it says. So my only question to you, Assistant Secretary, is: What do you think of this proposal of having the SEC randomly assigning a second rating agency? That would be done, by the way, concurrently with the first and come out at about the same time. " CHRG-110shrg50420--234 Mr. Nardelli," Our share projection in our recovery plan to you is that our share is flat through the planning period. And quite honestly, while not as robust as my colleagues, our share has been about 10 percent of the industry for the last decade. We have had pretty much relatively flat share, again, for the past decade, and we are not assuming any share of growth in our plan or any positive pricing. Senator Shelby. Mr. Fleming, you testified--and one of your phrases was kind of troubling to me, and I believe I have got it right. You said, ``A bailout here would give us''--the automobile industry here--``some time to try to adjust.'' That would probably be true, some time to try to adjust. In other words, give you breathing room. But I think we have to have more than that here to try to balance the taxpayers' interest here with everything. Mr. Gettelfinger also said--and I thought you were tentative in this: ``Of course, if any plan works, there have got to be management concessions''--I am not a management expert, but I can tell you, if you are not making money, there is a problem. Is it in management? Is it in labor? You know, is it a combination of both? Is it lack of innovation in your products? I do not know this, but I know there is a deep structural problem here. But you said we may need--may need--to do so-and-so. I think that is ambiguous and kind of tentative. And I believe any plan to work, any plan, you are going to have to have restructuring of management, and you are going to have to get rid of a lot of people to save a lot of jobs. You are going to have to do the same thing at the UAW, and the question is--I hope that, you know, you realize you are in this together, and if you are not, if you are not going to give the concessions and the management is not going to give the concessions and suppliers are not going to give concessions, we are wasting our time and taxpayers' money big time. That is my thought of it. I want to ask you--this is just an aside, because there has been a lot of big talk about it. You flew up here before. I understand that. And you drove up here. Did you drive or did you have a driver? Did you drive a little and ride a little? And, second, I guess, are you going to drive back? And if so, if some of us wanted to ride to Detroit, could we ride with you? " CHRG-111shrg54789--140 Mr. Wallison," No. Thank you for the question, Senator, but that would not be my view. I think there are things that one could--the Senate could, the Congress could--forbid, and should, because some things can actually be abusive. But in general, what we are doing with this legislation is putting providers in a position where they have to make a judgment about the ability of the person sitting across the desk from them to understand all of the factors that go into a particular product that is being offered. And so what we are saying in this legislation essentially is, here is the plain-vanilla product. If you offer this product, you are not going to take many risks because it has been approved by the CFPA and here are the disclosures that the CFPA wants you to make about it. And the provider puts that product in front of the customer and says, ``I think you should take this product'' because the provider has made a judgment that this customer probably can't understand or might not be willing to understand the complexities of the other products that the provider could offer to customers who are more sophisticated and experienced. So the result of that, I think, is going to be only one thing, that many, many people who could understand, with adequate disclosure, products that are going to be better for them and their families will never have those products offered to them. Senator Warner. But in this example, I mean, in the normal marketplace, if we put out a symbol that says ``buyer beware,'' buyer makes the wrong choice and the market absorbs the consequences. But in this circumstance, at least we have seen in recent action there perhaps was not a ``buyer beware'' on some of these exotic financial mortgage products. I have got members of my family that I argued diligently against, don't take that product. You are going to get it. But they saw the up-front sticker price and they bought it anyway. Not everybody has got a wealthy brother to bail them out, although I guess we do have a wealthy Uncle Sam that is now indirectly bailing out. But if at the end of the day the ramifications of buyers making bad choices around the credit markets is that we, the taxpayers, are ultimately going to bail them out, don't we have some responsibility to perhaps put some either ring fencing or some parameters around this? I mean, are we in a different mix of products when we are at the end of the day maybe having the taxpayer be on the hook for bad choices made by consumers? Is there---- " CHRG-111shrg55278--119 RESPONSES TO WRITTEN QUESTIONS OF SENATOR VITTER FROM SHEILA C. BAIRQ.1. Chairwoman Bair, you recently released a proposal which, I believe, asks private equity to maintain a 15 percent Tier 1 capital ratio while well-capitalized banks only maintain a 5 percent ratio and newly established banks an 8 percent ratio. In May, the FDIC announced the successful purchase of Bank United which allowed almost $1 billion of private investment come in and successfully take over the bank's management. By all reports this has been a successful arrangement for both the FDIC and private investment company. Although I understand your policy concerns, I think that the current proposal goes too far in several respects. I am concerned that the FDIC's proposed policy deters private capital from entering the banking system, leaving the FDIC's insurance fund and, ultimately, the taxpayers with the final bill. With bank failures mounting this year, I would have liked see more private investment able to participate in cleaning up these troubled banks. What can the FDIC do to ensure that more private equity comes in to stem the tide of bank failures?A.1. 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.Q.2. Are you concerned that without attracting private capital, the FDIC's deposit insurance fund and, ultimately, taxpayers will foot the entire bill for the looming bank failures?A.2. We do not see a taxpayer exposure as a result of upcoming bank failures. Our latest publicly released information shows that the FDIC ended the second quarter of 2009 with a DIF balance of $10.4 billion and an additional $32 billion reserve for expected future failure losses. Updates to these numbers show the FDIC estimates that it ended the third quarter of 2009 with a negative fund balance. The contingent loss reserve for expected future losses from failures has grown, however. To date, the FDIC has required a special assessment to rebuild the DIF and we recently issued a notice of proposed rule making to require the prepayment of assessments for 3 years. Current projections are that assessment income will exceed expected losses from bank failures over the next several years. However, there is a timing problem as the bulk of bank failures are expected to occur in 2009 and 2010, while most assessment income will be booked in later years. Therefore, although the prepayment of assessments will not immediately rebuild the fund balance, it will provide the FDIC with the liquidity needed to fund projected bank failures. Further, even if it became necessary for the FDIC to borrow from the U.S. Treasury, any potential borrowing would be repaid by insured depository institutions.Q.3. If private equity does come in, what could the savings be to the deposit insurance fund?A.3. If, as expected, the FDIC increases the overall number of potential bidders for failed financial institutions by including more private equity firms, it would increase competition and potentially improve the quality of the bids.Q.4. Do you agree with the Secretary's assessment that the FDIC was created to address resolving small banks and thrifts and does not have the appropriate resources to deal with the failure of a major bank?A.4. The FDIC has substantial experience resolving large, complex, internationally active insured depository institutions. Continental Illinois National Bank and Trust, which required FDIC assistance in 1984 was the seventh largest commercial bank in the country at the time. More recently, in September 2008, the FDIC dealt with the failure of Washington Mutual Bank which had total assets of $307 billion. This was the fifth largest bank in the country at that time. This experience with conservatorships and receiverships has significant parallels for systemically important holding companies and for other types of financial companies, enabling the FDIC to take advantage of its experience in acting as receiver for thousands of insured depository institutions. Also, much of the Administration's special resolution authority proposal is based on the FDIC's current statutory authority. Therefore, expanding the FDIC's activities to systemically significant institutions will be consistent in many respects to its current scope of activities.Q.5. If there are limits on the FDIC's expertise and resources would keep the FDIC from resolving the biggest banks in the country, what are they?A.5. We believe the FDIC is prepared to handle the resolution of an insured depository institution of any size and complexity. Our testimony outlines limitations of our current resolution authority and recommends, on page 7 [see Page 66 of this hearing], principles to guide Congress in adopting a process that ensures an orderly and comprehensive resolution mechanism for systemically important financial firms.Q.6. What are the impediments, if any, that the FDIC would face in resolving the depository institutions associated with Bank of America or Citi?A.6. Although I cannot comment on supervisory matters involving open institutions, any large depository institution can pose special challenges. They typically have extensive foreign operations, higher-than-normal levels of uninsured deposits, expansive branch networks that can span multiple time zones and usually are heavily involved in derivative financial instruments. Further, the largest insured depository institutions are owned by holding companies that own other related entities. These holding companies manage operations by business line with little regard to the legal entities involved. The intertwined nature of the operations of a large bank holding company will present its own set of challenges. This is one reason it is important for the FDIC to have receivership authority over the entire financial services holding company, not just the insured depository institution. ------ CHRG-110hhrg44900--21 The Chairman," Thank you. Let me begin with the Secretary, because I was pleased to note in your statement that you understand that the regulator at OFHEO, of Fannie Mae and Freddie Mac, believe that they are now adequately capitalized. They were important institutions and I think that was--I'm pleased that you made that statement. I think that is important for people to understand. I said before that we are talking about more regulation done sensibly. Obviously there are still areas that the Secretary indicated where we could improve by simplifying regulation. That doesn't mean that it means more regulation everywhere. But there does seem to me to be emerging a consensus that we need a regulator concerned with threats to the systemic stability of the economy, that come from unconstrained risk-taking in a group of financial institutions outside the commercial banking system. And I was pleased, Mr. Secretary, that you mentioned hedge funds and investment banks. I think it would be a great mistake to talk about type of institution. That would give people an incentive to change their hats. We are talking about the impact of the activity, and we are talking I think, and a consensus appears to be emerging that it is going to be the Federal Reserve. I have to say that there are people who say, well, either you create a brand new regulator, it seems to me, which would be I think a mistake, or you give it to the Federal Reserve. And I agree with both of you, that in order to do that, the Federal Reserve needs more power. A situation in which the Federal Reserve is available and is under pressure to provide funding, but does not have the ability to act well before that time to diminish the need for that and to oppose conditions, that is unacceptable. We are talking, but we should be clear, about an increase in regulatory power. And let me say, you know, there was a time when the notion of requiring hedge funds to register was very controversial. It does seem to me that we have clearly gone beyond that. We are talking about giving the Federal Reserve the power to not just get information but to deal with various things which could include capital requirements and other factors. Now those are very important issues, and I think, as I said, there was a consensus emerging that it should be the Federal Reserve. And I have to say when people say, ``Well,'' they'll have this or that question about whether the Federal Reserve should do it, I invoke, as people have heard me do, the wisdom of a great 20th Century philosopher, Henny Youngman. The maxim was, ``How's your wife? Compared to what?'' And the Federal Reserve compared to what? I don't see any alternative to the Federal Reserve. But my question is this. I think this is an important task, and there's a great deal of agreement, that we should be moving to empower the Federal Reserve to have regulatory authority over a wide range of financial institutions in recognition in part of the fact that they have a systemic impact and that the current situation puts the Fed in an untenable position of being given a set of expectations to respond when it doesn't have the full panoply of tools to respond. But here is the question: How soon? Now we are where we are. It is July of an election year. This is a very complex subject. We don't want to do anything that would interfere with our wonderful financial system. And I mean our wonderful financial system, which has been so productive. We want to curb abuses without interfering with the productive function. Mr. Secretary, you said that they don't now have that authority, and we all agree with that. Is it essential that we move now? My sense is this--and I applaud the signing of the memorandum of understanding between the SEC and the Fed. That kind of cooperation has been useful. The cooperation between your two entities has been useful. I guess there are two options. One is that we have to try and legislate something now. And let me say we should distinguish. Mr. Secretary, you had a broader set of recommendations involving thrift institutions and credit unions, and a whole lot of things that no one in this institution is eager to deal with. So nobody is in any hurry on those. But we have I think taken out of that--and you have elaborated with the resolution issue--the question of macro-stability regulator, of the Federal Reserve being given powers to deal with the problems that could come to a system from someone too big or too unconnected to fail. Here is the question: Working together as we have within existing authorities, with yourselves, with I hope cooperation--that you understand cooperation with us--can we get by until the end of the year? We obviously will start working on this. Is it your view that immediate legislation is necessary? Or are we able to get by, given the cooperation we have had, given the kind of support we try to give you as much as possible, and begin working immediately together, so that early next year, one of the first items on the congressional agenda will be the legislation you talked about? Let me ask each of you to respond. " FOMC20080318meeting--158 156,MR. WARSH.," Thank you, Mr. Chairman. A couple of quick introductory points. First, I have total confidence in the Fed and the FOMC, certainly over the course of my couple of years here, in effectively handling these challenges, which is key to highlight at the outset of my remarks. I have total confidence in this institution's ability, in particular, to handle both sides of the dual mandate. Moreover, I would say that I have total confidence in our ability to have a really robust discussion here and recognize, as President Geithner pointed out, the fragility in these financial markets. A lot of our strength comes from being able to have very open, tough discussions with each other and recognize that, if they were in the public square, they could be misinterpreted and destabilizing. I think he is right that we all need to take that into account, particularly over this next intermeeting period, which we all hope lasts six weeks. Moreover, I think that the power of our tools, our creativity, and our innovative abilities over November, December, and these recent weeks has been incredibly impressive. I think that those will work in concert with monetary policy. I would underscore a point that the Chairman made, which is that we have taken a huge burden on ourselves and that the burden will have to be matched by others here in Washington--and I suspect before we get too much into the second and third quarter by others around the world--which will go a long way toward helping us accomplish our objectives. Second, I have total confidence in U.S. financial institutions over the medium term to deal with these issues. They will come out of this thing stronger, smarter, and faster and will be huge net exporters of services, but that is going to take a while. My own view is that the capitalraising is good and very important. If the tail is as fat as we have discussed, capital-raising by these institutions should help them stave off safety and soundness issues that could arise. So I think that it is good prudential management by them and us alike. To the task at hand on monetary policy, I will support alternative A, as the Chairman recommends, and I take particular comfort in the narrative and language in A as being a very important next step for us to guard against risks on the currency front and on the inflation front. Now, these words themselves won't do a ton in the short term, and they won't have an immediate effect, but I do think it is important for us to take these and build on them in our private and public statements. So that gives me some comfort. On the decision of 50 points versus 75 points, I would be kidding myself if I thought that those 25 basis points were completely consequential. I wouldn't ascribe virtue or vice to that sort of bid-asked spread. I would say that it is a hard call. I share the view expressed by some that these markets are going to need to be disappointed at some point here. That is the only way the words that we express will be properly understood and taken into account in the markets' judgments, and I worry that we are not going to have any great opportunities to disappoint them over the course of the upcoming meetings. Finally, let me say this. I will end where I started in this discussion, which is, at the end of the day, it is this institution's credibility that is paramount and that is increasingly the case at this point in the cycle. It strikes me that we have to continue to make the case in the upcoming months that we have the will, the wisdom, and the tools to tackle these issues. To the extent that monetary policy is perceived by pundits and Fed watchers as not working, it is important that we rebut those arguments and explain that our tools will work over time and that we are looking for assistance both in Washington and in other nations' capitals. Thank you, Mr. Chairman. " CHRG-111shrg52619--201 RESPONSE TO WRITTEN QUESTIONS OF SENATOR SHELBY FROM SCOTT M. POLAKOFFQ.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 key advantage of creating a separate agency for consumer protection would be its single-focus on consumer protection. One hundred percent of its resources would be devoted to consumer protection, regulations and the balance and tension between both aspects is extraordinarily beneficial, policies, and enforcement. However, safety and soundness and consumer protection concerns are interconnected. For example, requiring that a lender responsibly consider a borrower's repayment ability has implications for both areas. Consequently, if consumer protection and prudential supervision were separated, the new consumer protection agency would not be in a position to take into account the safety and soundness dimensions of consumer protection issues. Placing consumer compliance examination activities in a separate organization would reduce the effectiveness of both programs by removing the ability for regulators to evaluate an institution across both the safety and soundness and compliance functions. The same is true for rulemaking functions. With respect to consumer protection regulation, some may argue that assigning one agency responsibility for writing all consumer protection regulations would speed the process. However, past experience indicates that providing one agency such exclusive responsibility does not guarantee this result. Moreover, such a strategy may weaken the outcome because it deprives other agencies of the opportunity to make contributions based on their considerable expertise.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. OTS actions demonstrate that we had a progressive level of supervisory criticism of AIG's corporate governance. OTS criticisms addressed AIG's risk management, corporate oversight, and financial reporting. There was not a flawed assumption that AIG was adequately regulated. Instead, OTS did not recognize in time the extent of the liquidity risk to AIG of the ``super senior'' credit default swaps in AIG Financial Products' (AIGFP) portfolio. In hindsight, we focused too narrowly on the perceived creditworthiness of the underlying securities and did not sufficiently assess the susceptibility of highly illiquid, complex instruments to downgrades in the ratings of the company or the underlying securities, and to declines in the market value of the securities. No one predicted the amount of funds that would be required to meet collateral calls and cash demands on the credit default swap transactions.Q.3. Was there dialogue between the banking regulators and the state insurance regulators? What about the SEC?A.3. The OTS role in reaching out to insurance regulators (both domestic and foreign) was to obtain information regarding functionally regulated entities. This included information regarding examination efforts and results, requests for approval for transactions, market conduct activities and other items of a regulatory nature. In the U.S., state insurance departments conduct financial examinations of insurance companies every 3-5 years, depending on state law. In addition, regulatory approval is required for certain types of transactions or activities. OTS contact with state insurance regulators was done with the intent to identify issues with regulated insurance companies and to determine if regulatory actions were being taken. In addition, regulatory communications were maintained in an informal way to ensure that the lines of communication remained open. Annually, OTS hosted a supervisory conference that provided an opportunity for insurance (and banking) regulators to share information regarding the company. At each of the three annual conferences held, OTS provided general information regarding our examination approach, plans for our supervisory efforts and current concerns. Other regulators attending the sessions provided the same type of information and the session provided an opportunity to discuss these concerns. Collateralized debt obligation (CDO) activities at AIG were housed in AIGFP, an unregulated entity. AIGFP is not a regulated insurance company or depository institution. State insurance departments did not have the legal authority to examine or regulate AIGFP activities. Therefore, OTS did not engage in discussions with state insurance departments regarding AIGFP. The types of activities engaged in, and the products sold, are not the types of activities that insurance structures typically engage in within regulated insurance company subsidiaries. Also, since AIGFP was not a regulated insurance company, OTS did not contact state regulators to discuss AIGFP or its activities. Upon the announcement of Federal Reserve intervention in the company, OTS engaged in many calls with regulators in the U.S. and abroad. AIG did have a network of registered investment advisers, retail investment brokerage firms and mutual funds, all supervised by the SEC. OTS stayed abreast of AIG's compliance with SEC laws and regulations through a monthly regulatory issues report. OTS also interacted with an individual placed at AIG by the SEC and Department of Justice as an independent monitor in connection with the 2005 settlement regarding accounting irregularities. The independent monitor is still working within AIG, and he interacts directly with the Regulatory Group.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. There is no centralized exchange or clearing house for credit default swap (CDS) transactions. Currently, CDS trade as a bilateral contract between two counterparties that are done on the over-the-counter (OTC) market. They are not traded on an exchange and there are no specific record-keeping requirements of who traded, how much, and when. As a result, the market is opaque, lacking the transparency that would be expected for a market of its size, complexity, and importance. The lack of transparency creates significant opportunity for manipulation and insider trading in the CDS market as well as in the regulated markets for securities. Also, the lack of transparency allows the CDS market to be largely immune to market discipline. The creation of a central counterparty (CCP) would be an important first step in maintaining a fair, orderly, and efficient CDS market and thereby helping to mitigate systemic risk. It would help to reduce the counterparty risks inherent in CDS market. A central clearing house could further reduce systemic risk by novating trades to the CCP, which means that two dealers would no longer be exposed to each others' credit risk. Other benefits would include reducing the risk of collateral flows by netting positions in similar instruments, and by netting all gains and losses across different instruments; helping to ensure that eligible trades are cleared and settled in a timely manner, thereby reducing the operational risks associated with significant volumes of unconfirmed and failed trades; helping to reduce the negative effects of misinformation and rumors; and serving as a source of records for CDS transactions. Furthermore, this would likely allow for much greater market discipline, increased transparency, enhanced liquidity, and improved price discovery. The presence of an exchange with margin and daily position marking would have given regulators greater visibility into the dangerous concentration of posted collateral. Regulators could have had more time and flexibility to react through the firm's risk management and corporate governance units if a CDS exchange existed. Also, if a counterparty had failed to post required margin/collateral, its positions may have been liquidated sooner in the process. We have 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 regulation.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. Maturity mismatches are a significant supervisory concern from both a liquidity risk and interest rate risk standpoint. However, OTS does not believe that regulators should try to simply minimize the mismatch without consideration of different business models, portfolio structures, and mitigating factors. Furthermore, maturity mismatches are heavily affected by unknowns such as loan prepayments and deposit withdrawals which can have serious implications on an institution's cash needs and sources. The embedded optionality in some instruments can lead to a rapid shortening of stated maturities and can compromise the effectiveness of following a simple maturity gap measure in the management of liquidity risk. Given the thrift industry's heavy reliance on longer-term mortgages and shorter-term funding, however, OTS has always placed a heavy emphasis on maturity-mismatch risk management and we are constantly exploring ways to improve our supervisory process in light of the ongoing crisis. On an international basis, OTS is a member of the Basel Committee for Banking Supervision's Working Group on Liquidity which is currently seeking to identify a range of measures and metrics to better assess liquidity risk at regulated institutions. Metrics specifically dealing with maturity-mismatch are being considered as part of this work. On the domestic front, OTS's supervisory process has long stressed the need for OTS-regulated banks to identify and manage the maturity mismatch inherent in their operations; and OTS examiners routinely assess this aspect of a bank's operation during their on-site safety and soundness examinations. From an off-sight monitoring perspective, OTS utilizes information from the Thrift Financial Report to identify institutions with a heavy reliance on short-term or volatile sources of funding. In addition, OTS is exploring ways to better lever the information it collects from institutions for interest rate risk purposes. Each quarter, OTS collects detailed interest rate data, re-pricing characteristics, and maturity information from most of its thrifts through a specialized reporting schedule called Consolidated Maturity and Rate (Schedule CMR). The CMR data is fed into a proprietary interest rate risk model called the Net Portfolio Value (NPV) Model. The NPV Model was created in 1991, in response to the industry's significant interest rate risk problems which were a major contributor to the savings and loan crisis. The NPV Model provides a quarterly analysis of an institution's interest rate risk profile and plays an integral role in the examination process. Interest rate risk and ``maturity-mismatch'' risk are intimately related. Indeed, much of the same information that is used for interest rate risk purposes can also be used to provide a more structured view of liquidity risk and maturity mismatch. As a first step, OTS is using the model to generate individual Maturing Gap Reports for a large segment of the industry. This report provides a snapshot of a bank's current maturity-mismatch as well as how that mismatch changes under different interest rate stress scenarios.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. 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.6. No it does not. The OTS conducts its supervisory function in a professional, consistent, and fair manner. Ensuring the safety and soundness of the institutions that we supervise is always paramount. Moreover, the use of assessments on the industry to fund the agency has many advantages. It permits the agency to develop a budget that is based on the supervisory needs of the industry. The agency does not rely on the Congressional appropriations process and can assess the industry based on a number of factors including the number, size, and complexity of regulated institutions. Such a method of funding also provides the agency the ability to determine whether fees should be increased as a result of supervisory concerns. This funding mechanism permits the agency to sustain itself financially. Funding an agency differently may lead to conflicts of interest with congress or any other entity that determines the budget necessary to run the agency. As a result, political pressure or matters outside the control of the agency may negatively affect the agency's ability to supervise its regulated institutions. An agency that must supervise institutions on a regular basis needs to have more control over its funding and budget than is possible through an appropriations process. Funding through assessments also eliminates the concern that taxpayers are responsible for paying for the running of the agency.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?A.7. The events of the past year have put into stark focus the need to address whether a resolution regime is necessary for nonbank financial companies. Whatever resolution regime is adopted would address too big to fail issue but it may not bring it to a final conclusion. There currently exists a resolution mechanism for federally insured depository institutions and instances have arisen in which an insured institution has been found to be too big to fail. As the framers of the resolution develop the mechanism for nonbank financial companies, it will be important to establish whether there will be a circumstance in which such a company will not be allowed to fail or the circumstances under which it will be permitted. A resolution mechanism will make it less likely that a company will be determined to be too big to fail.Q.8. 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.8. There are two ways that the market can be convinced that systemically important institutions will not be protected by taxpayer resources. The first is if they are permitted to fail and do not receive the benefit of taxpayer funds. The second is through the establishment of a resolution mechanism that provides for funding through assessments on the institutions that may be resolved. Even the second alternative would not preclude that the taxpayer might not ultimately pay for part of the resolution. In the creation of the resolution mechanism, the funding of the entity and the process would need to be specifically addressed and communicated to the market.Q.9. 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.9. Different proposals have been raised to achieve a more counter-cyclical system of capital regulation. One of the most promising ideas would mandate that banks build up an additional capital buffer during good times that would be available to draw upon in bad times, essentially a rainy day fund. In our view, such a fund would be an amount of allocated retained earnings that would be over and above the bank's minimum capital requirement. Initially, it would appear that for an individual bank, the cost of such a requirement would be a decreased level of available retained earnings: fewer funds would be available for dividends and share buybacks for example. The benefit would be that the rainy day fund might save the bank from failing (or threat of failure) when economic conditions deteriorate and therefore help the bank remain in sound condition so that it can continue lending. Systemically, a restriction on banks' retained earnings would act as a restraint on bank activity during high points in the economic cycle and could diminish share prices when times are good. It might also curtail some lending at high points in the economic cycle. However, the availability of those funds when conditions deteriorate ought to allow banks to continue lending at more reasonable levels even when economic conditions deteriorate.Q.10. Do you see any circumstances under which your agencies would take a position on the merits of counter-cyclical regulatory policy?A.10. Yes, we support the concept of a counter-cyclical policy. There are a variety of ideas as to how to achieve this including the concept we have outlined above. Together with the other Federal Banking Agencies we are participating in international Basel Committee efforts to consider various counter-cyclical proposals with the goal of having a uniform method, not only within the United States, but internationally as well--so as to create a more level competitive environment for U.S. Banks and a sound counter-cyclical proposal.Q.11. 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.11. At the conclusion of the G20 summit, several documents were issued by G20 working groups and by the Financial Stability Forum (now renamed the Financial Stability Board). These laid out principles for international cooperation between supervisors and stressed the importance of coordinated supervisory action. With its largest firms, OTS has for some years held annual college meetings to foster communication between regulators, and understands the value of cross-border cooperation. OTS believes that insofar as the agreements coming out of the G20 summit encourage greater international cooperation, supervision overall will be enhanced.Q.12. Do you see any examples or areas where supranational regulation of financial services would be effective?A.12. As a member of the Basel Committee, OTS has been involved in the past efforts of that body to set capital and other regulatory standards. We believe there is value in coordinating such standards at the international level, primarily for two reasons. First, such coordination is a vehicle for enshrining high quality standards. In a globally interconnected capital market, it is important that all players be subject to basic requirements. Second, common standards foster a level playing field for U.S. institutions that must compete internationally.Q.13. How far do you see your agencies pushing for or against such supranational initiatives?A.13. As indicated above, OTS supports active cooperation among supervisors and the setting of international regulatory standards, where appropriate. Ultimately, of course, authority must be commensurate with responsibility, and OTS would not be supportive of initiatives that would diminish its capacity to carry out its responsibility to preserve the safety and soundness of the institutions it regulates or the rights and protections of the customers they serve.Q.14. Effectiveness of Functional Regulation \1\--Mr. Polakoff, in your testimony you point out that the OTS, as the holding company supervisor of AIG, relies on the specific functional regulators for information regarding regulated subsidiaries of AIG's holding company.--------------------------------------------------------------------------- \1\ Mr. Polakoff has been on leave from OTS since March 26, 2009, and will retire from the agency effective July 3, 2009. The answers to the Committee's supplemental questions were prepared by other OTS staff members.--------------------------------------------------------------------------- When did the OTS first learn of the problems related to AIG's securities lending program? Did any state insurance commissioner alert the OTS, as the holding company supervisor, of these problems?A.14. Annually, the OTS hosted a supervisory conference that provided an opportunity for regulators (insurance and banking) to share information regarding the AIG. At each of the three annual conferences held, the OTS provided general information regarding our examination approach, plans for our supervisory efforts and current concerns. Other regulators attending the sessions provided the same type of information and the session provided an opportunity to discuss these concerns. The OTS was first advised of potential financial problems in the AIG Securities Lending Program (SLP) during the OTS Annual AIG Supervisor's Conference on November 7, 2007, when the representative from the Texas Department of Insurance's (DOI) office raised the issue during the Supervisor's roundtable session. This representative stated the Texas DOI was looking into the exposure that the various Texas-based life companies had to the SLP and was seeking assurance from AIG that any market value losses would be covered by the corporate parent. Subsequently, on November 27, 2007, the OTS met with Price Waterhouse Coopers (PwC) as part of its regular supervisory process. During this meeting the SLP exposure topic was raised and a discussion ensued. PwC advised that as of Q3 2007, the exposure to market value decline in the portfolio was $1.3 billion and expected to worsen in Q4. PwC further advised that AIG was planning to indemnify its subsidiary companies for losses up to $5 billion. This was verified in the year end 2007 regulatory financial statement filings (required by state insurance departments) by the AIG life insurance subsidiaries. The disclosure went on to cite AIG's indemnification agreement to reimburse losses of up to $5 billion for all (not each) of AIG's impacted subsidiaries.Q.15. Holding Company Regulation--Mr. Polakoff, AIG's Financial Products subsidiary has been portrayed in the press as a renegade subsidiary that evaded regulation by operating from London. A closer examination reveals, however, that a majority of its employees and many of its officers were located in the United States. Did the OTS have adequate authority to supervise AIG's Financial Products subsidiary? If not why did the OTS fail to inform Congress about this hole in its regulatory authority, especially since your agency had identified serious deficiencies in Financial Products' risk management processes since 2005? How was the Financial Products subsidiary able to amass such a large, unhedged position on credit default swaps (CDS)?A.15. AIG became a savings and loan holding company in 2000. At that time. the OTS's supervision focused primarily on the impact of the holding company enterprise on the subsidiary savings association. With the passage of Gramm-Leach-Bliley, and not long before AIG became a savings and loan holding company, the OTS recognized that large corporate enterprises, made up of a number of different companies or legal entities, were changing the way they operated and needed to be supervised. These companies, commonly called conglomerates, began operating differently and in a more integrated fashion as compared to traditional holding companies. These conglomerates required a more enterprise-wide review of their operations. Consistent with changing business practices and how conglomerates were managed at that time, in late 2003 the OTS embraced a more enterprise-wide approach to supervising conglomerates. This approach aligned well with core supervisory principles adopted by the Basel Committee and with requirements implemented in 2005 by European Union (EU) regulators that required supplemental regulatory supervision at the conglomerate level. The OTS was recognized as an equivalent regulator for the purpose of AIG consolidated supervision within the EU, a process that was finalized with a determination of equivalence by AIG's French regulator, Commission Bancaire. AIG Financial Products' (AIGFP) CDS portfolio was largely originated in the 2003 to 2005 period and was facilitated by AIG's full and unconditional guarantee (extended to all AIGFP transactions since its creation), which enabled AIGFP to assume the AAA rating for market transactions and counterparty negotiations. AIGFP made the decision to stop origination of these derivatives in December 2005 based on the general observation that underwriting standards for mortgages backing securities were declining. At the time the decision was made, however, AIGFP already had $80 billion of CDS commitments. This activity stopped before the OTS targeted examination which commenced March 6, 2006. The OTS actions demonstrate a progressive level of supervisory criticism of AIG's corporate governance. The OTS criticisms addressed AIG's risk management, corporate oversight, and financial reporting. There was not a flawed assumption that AIG was adequately regulated. Instead, the OTS did not fully recognize the extent of the liquidity risk to AIG of the ``super senior'' credit default swaps in AIGFP's portfolio or the profound systemic impact of a nonregulated financial product. There was a narrow focus on the perceived creditworthiness of the underlying securities rather than an assessment of the susceptibility of highly illiquid, complex instruments to downgrades in the public ratings of the company or the underlying securities, and to declines in the market value of the securities. No one predicted the amount of funds that would be required to meet collateral calls and cash demands on the credit default swap transactions. CDS are financial products that are not regulated by any authority and impose serious challenges to the ability to supervise this risk proactively without any prudential derivatives regulator or standard market regulation. There is a need to fill the regulatory gaps the CDS market has exposed. There is a need for consistency and transparency in CDS contracts. The complexity of CDS contracts masked risks and weaknesses in the program that led to one type of CDS performing extremely poorly. The current regulatory means of measuring off-balance sheet risks do not fully capture the inherent risks of CDS. The OTS believes standardization of CDS contracts would provide more transparency to market participants and regulators. ------ 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-110shrg50415--99 Mr. Rokakis," Senator Casey touched on it, and I think it is so important, and we are going to look to you for leadership on this. We are being told now that we do not know what this format will look like when these mortgages get bought back, but we are being led to believe--we have been told that we cannot expect any additional leveraging or negotiating power once the Government steps in and buys these mortgages back because of the complex way in which these mortgages were held and sliced and because of the trust agreements in place and need to get cooperation from all the other bondholders. And I just have to ask you, if I could, Mr. Chairman, to please look more closely at this, because what Senator Casey has said is, in fact, true. We are getting a sense that the negotiations, which are so difficult--difficult? I run a program. We have done 4,000 mortgage saves since March of 2006. It is difficult as it is. It is often hand to hand combat. But the fact that we will have no additional leverage once these mortgages are purchased makes us very concerned. " CHRG-111shrg50815--31 Chairman Dodd," Thank you very much, and I appreciate your comments, and all of you here this morning for your counsel on this issue, which is, again, a complex one and one that deserves our attention. I want to also make two points. One is credit cards are a tremendously valuable and worthwhile tool for consumers. I think it is very important. This is not a Committee, or at least an individual here that is hostile to the notion of credit cards at all. Quite the contrary. Second, I respect immensely that Ben Bernanke and the Federal Reserve moved on the issue of regulation, and while there are gaps and problems I have with what they have done, he is the first Chairman of the Fed that has actually moved in this area, despite the issue having been raised for a long time, and I certainly want to reflect my appreciation for the steps they have taken. I am disappointed that you have got to wait until July of 2010 for them to become effective, but nonetheless I want the record to reflect it. I was very impressed, Mr. Levitin, with this study and I highly recommend to my colleagues. It is lengthy in some ways. It is a number of pages long, some 20 pages long, this analysis of the credit card industry and how it works. But one thing that struck me at the outset of the report is something I think we kind of blow through, and that is the credit instruments that we use as Americans are tremendously valuable--the home mortgage, the car loan, the student loan. And the point that you make, or that this report makes is, of course, the pricing points, and I think it is a very worthwhile point to make. In almost every one of these other transactions, pricing points are rather clear. They are one or two or three, maybe four, but you have a pretty clear idea. You know with almost certainty what your mortgage is going to be, what your car payments are going to be, what your other payments are regardless if you take credit. When you get into this area, it is exactly the opposite, and I was stunned at the pricing points and why, in terms of taking on this responsibility, knowing what your responsibilities are going to be, you are faced with the following, just on pricing points, an astounding array of points--annual fees, merchant fees, teaser interest rates, base interest rates, balance transfer interest rates, cash advance interest rates, overdraft interest rates, default interest rates, late fees, over-limit fees, balance transfer fees, cash advance fees, international transaction fees, telephone payment fees. These are all the pricing points in credit card negotiations. To expect a consumer to appreciate and absorb that many pricing points when you are trying to determine whether or not taking on that financial responsibility--now, again, we are not going to eliminate all of these, but the idea that a consumer is able to juggle and understand that many different pricing points when you are making a determination as to whether or not you ought to engage in a service or a product purchase. I was stunned, as well, on the issues of bankruptcy and the like in terms of driving these costs up and the complexity of dealing with it. Again, I draw my colleagues' attention to this report. I think it is extremely useful. It gets into the issue of the risk-based pricing issue, as well, that Dr. Ausubel referenced, but I think it is an important point, as well. It is an industry that started out making its money on interest rates, and that was where the money was made. It has transferred itself from interest rates to fees, and that is the $12 billion increase in fees that have occurred that have added so much cost and confusion. Mr. Clayton, thank you for being here. One of the issues that is obviously of concern to many of us is the universal default. I think most people understand it, but the idea that if you are current on your credit card responsibilities, but if you are late on an electrical bill or a phone bill or the like, that we have seen examples where the issuers will then raise fees or rates as a result of your late payments on unrelated responsibilities, financial responsibilities. Now, it is true that, in a sense, the new rule to some degree eliminates the universal default. But under the rule, as well, and having conversations with the Fed about this, issuers can still look to off-comp behavior to increase interest rates. And so while it talks about banning it on one hand, it still tolerates the issue of actually accounting for off-balance behavior to increase rates that consumers pay. I would still call that universal default. If, in fact, the issuer can raise rates by considering these late payments in unrelated matters to the credit card, then it still seems to me that universal default exists. How do you respond to that? " CHRG-110hhrg34673--34 Mr. Bernanke," I think it is very valuable for people to have the opportunity to own an account, to have some exposure to investment even if it is in index funds which you point out, so that people have the pride of knowing that they are providing for their own retirement. So I think it is a very good idea to encourage people to begin to build wealth, and to begin to hold assets. As you know, the Social Security aspect of this is a very complex debate. The diverting of funds the way you describe has some of the benefits of giving people the opportunity to have control over their own accounts, but it also doesn't really directly address the long-term imbalance on the fiscal side of the spending and revenues of the Social Security system. Another approach, which is related and might work better without addressing the Social Security concern directly would be to have add-on accounts where people would have the option to put in additional moneys that could be invested in-- " CHRG-111shrg56376--133 Chairman Dodd," So what we will do here is I will make a few opening comments and I will ask if either of my colleagues would like to be heard at all and we will get right to our witnesses. We thank them for joining us here today in this hearing on ``Prudential Bank Regulation: Should There Be Further Consolidation?'' I know we have had a lot of informal conversations with each other over many, many months on this subject and many others related to the reform of the financial regulatory structure. As I have said over and over again, while I think some of us are getting closer to firmer ideas, I believe most of us here are still very anxious to hear from people who bring a particular knowledge and expertise, as our witnesses do here today, on this subject matter. So we are interested in your thoughts. We all understand here how important this subject matter is. We also understand how important it is that we do it right and that we realize we are doing things here that have not been done in years, and so as we chart forward, we want to make sure that we are doing so carefully and thoughtfully. So while I know there are those who are impatient, that while we haven't answered all the questions, even though the problems that emerged a year ago have not been entirely solved, I think it is important that we do it carefully and right, and that is our determination on this Committee. This afternoon, we will have a chance to hear from four very knowledgeable witnesses on the subject matter. I have read all of your testimony. I think it has been tremendously helpful. I think you go beyond, in some cases, talking about the single prudential regulator or the consolidation of regulation to other areas, as well, so while we are talking about that subject matter, certainly my colleagues don't need any advice from me on the subject matter, but clearly, the expertise is at this table. We would invite questions regarding a wide subject matter, in addition to the one that is the title of the hearing today. So with that, this afternoon we examine how best to ensure the strength and security of our banking system. I would like to thank our witnesses again for returning to share your expertise after the last hearing was postponed. Today, we have a convoluted system of bank regulators created by an almost historical accident. I think most experts would agree that no one would have designed a system that worked like this. For over 60 years, Administrations of both political parties, Members of Congress across the political spectrum, 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 and 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 is a bad idea, but rather, consolidation is too politically difficult to achieve. That argument doesn't work terribly well with me, nor, I suspect, with many, if not most, of my colleagues. Just look what the status quo has given us. In the last year, some of our largest banks needed billions of dollars of taxpayer money to prop them up and dozens of smaller banks have failed outright. It is clear that we need to end charter shopping, where institutions look around for the regulator that will go easiest on them. It is 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 our Nation's banks. A single operator would ensure accountability and end, I think, the frustrating ``pass the bucket'' excuses that we have been faced with over these many, many months. We need to preserve our dual banking system, and I feel just as strongly about that point as I do the earlier point. State banks have been a source of innovation and a source of strength, tremendous strength, in our communities. A single bank regulator can work, I think, with the 50 State bank regulators. Any plan to consolidate bank regulations would have to ensure community banks are created appropriately. Community banks did not cause the 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 that large counterparts do. But we need to get this right, as I said a moment ago, which is why you are all here today. I am working again with Senator Shelby and other Members of the Committee and colleagues here to find a consensus that we can craft on this incredibly important bill. So with that, unless one of my other colleagues wants to be heard for a few minutes on opening up, I will turn to our witnesses. Our first witness--and I will introduce all of them briefly here--Eugene Ludwig, is the Chief Executive Officer of the Promontory Financial Group. Before assuming that responsibility, Gene served as the Vice Chairman and Senior Control Officer of Bankers Trust Corporation, which he joined in 1998. He served as the Comptroller of the Currency from 1993 to 1998, and prior to joining the OCC, was a partner in the law firm of Covington and Burling. Martin Baily is a Senior Fellow for Economics at the Brookings Institution. Dr. Baily also serves as the Cochair of the Pew Task Force on Financial Sector Reform and is a senior advisor to McKinsey and Company. He served as Chairman of the Council of Economic Advisors under the Clinton administration from 1999 to 2001, and prior to that was a member of the same Council from 1994 to 1996. Richard Carnell is an Associate Professor at the Fordham University School of Law. He previously served as the Assistant Secretary for Financial Institutions at the Treasury from 1993 to 1999. And prior to that, Mr. Carnell was also a Senior Counsel to this very Committee, from 1989 to 1993. Richard Hillman is the Managing Director of the Financial Markets and Community Investment Team of the U.S. Government Accountability Office. He has been with GAO for 31 years and his team looks at the effectiveness of regulatory oversight in the financial and housing markets and the management of community development programs. We are honored that all four of you are with us today. We thank you for your service, your past service, and your willingness to participate in today's conversation. All of you have been before this Committee many times in the past and I will not limit you in a strict fashion to the time, but if you would try to keep it in that 5 to 7 minutes--and I know your testimony goes on longer than that, and the testimony, the full testimony and comments and supporting data, we will include as part of the record, as well. Gene, we welcome you back to this Committee. FinancialCrisisInquiry--242 Right. Well, then the question is, does it include, for example, private-purpose tax- exempt debt for a multi-family couple with 4 percent tax credits, at 9 percent tax credits. There’s a number of CRA eligible activities. So what I’m going to suggest—which I think is important, and I want to say this to the commissioners—is I think one of the things we have to do here is get to actual numbers. And so I’m going to ask our staff to make sure that sooner than later we put together the best numbers from the most credible sources about what, in fact, does exist, for example, with the Fannie and Freddie portfolio. What’s the nature of it? And if there’s divergence, let’s get the facts on the table. I think we ought to get the best facts we can about the contour of loans made by CRA and non-CRA regulated institutions. And I just want to say, you know, I want to say let’s get the numbers and the facts on the table and make sure we’re dealing with apples to apples. I think that’s important. That was on my time. Ms. Born? BORN: Thank you. Listening to your testimony, it strikes me to ask where were the regulators. Mr. Rosen, you said that the Federal Reserve Board had a lot of data about the predatory lending that was going on. They had been given the authority and responsibility by statute to oversee and prevent predatory lending. Do you know why the Fed failed to act in this respect? ROSEN: It’s very puzzling because they wrote the right paper. A key Federal Reserve Board member was pushing it very hard. It was—and I don’t know why it didn’t happen. The chairman was a pretty strong guy, and I suspect that was it. But maybe read Ned Gramlich’s book because he’s written a whole book on this topic before he passed away. I think it would be worth it to find out why they didn’t do it. A lot of them did believe, though, there was—it wasn’t really happening; it was demographics. It wasn’t predatory; it was just market innovation at work. 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" FinancialCrisisReport--165 B. Background At the time of its collapse, Washington Mutual Savings Bank was a federally chartered thrift with over $188 billion in federal insured deposits. Its primary federal regulator was OTS. Due to its status as an insured depository institution, it was also overseen by the FDIC. (1) Office of Thrift Supervision The Office of Thrift Supervision was created in 1989, in response to the savings and loan crisis, to charter and regulate the thrift industry. 597 Thrifts are required by their charters to hold most of their assets in mortgage lending, and have traditionally focused on the issuance of home loans. 598 OTS was part of the U.S. Department of the Treasury and headed by a presidentially appointed director. Like other bank regulators, OTS was charged with ensuring the safety and soundness of the financial institutions it oversaw. Its operations were funded through semiannual fees assessed on the institutions it regulated, with the fee amount based on the size, condition, and complexity of each institution’s portfolio. Washington Mutual was the largest thrift overseen by OTS and, from 2003 to 2008, paid at least $30 million in fees annually to the agency, which comprised 12-15% of all OTS revenue. 599 597 Twenty years after its establishment, OTS was abolished by the Dodd-Frank Wall Street Reform and Consumer Protection Act, P.L. 111-203, (Dodd-Frank Act) which has transferred the agency’s responsibilities to the Office of the Comptroller of the Currency (OCC), and directed the agency to cease all operations by 2012. This Report focuses on OTS during the time period 2004 through 2008. 598 6/19/2002 OTS Regulatory Bulletin, “Thrift Activities Regulatory Handbook Update” (some educational loans, SBLs, and credit card loans also count towards qualifying as a thrift), http://files.ots.treas.gov/74081.pdf. 599 See April 16, 2010 Subcommittee Hearing at 11 (testimony of Treasury IG Eric Thorson). 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-111shrg55278--122 RESPONSES TO WRITTEN QUESTIONS OF SENATOR BUNNING FROM MARY L. SCHAPIROQ.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 in different ways. Under such a risk regulator, how would you make sure the rules were being enforced the same across the board?A.1. Any risk regulator's role should be in conjunction with a strong Financial Services Oversight Council (Council). The Council would promote greater uniformity by providing a forum for examining and discussing 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. In addition, the Council would have the role of identifying risks across the system, harmonizing rules to minimize systemic risk, and helping to ensure that future regulatory gaps--and arbitrage opportunities--are minimized or avoided. The Council would set policy if necessary to ensure that more rigorous standards than those of a primary regulator and/or the systemic risk regulator (SRR) are implemented. Such an approach would provide the best structure to ensure clear accountability for systemic risk, enable a strong, nimble response should adverse circumstances arise, and benefit from the broad and differing perspectives needed to best identify developing risks and minimize unintended consequences.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. In my view, systemic risk is the concentration of risk in a single firm or a collective accumulation of risk across firms that creates a risk of sudden, near-term systemic seizures in markets or cascading failures of other entities. In addressing systemic risk it is important that we are careful that our efforts to protect the system from near-term systemic seizures do not inadvertently result in a long-term systemic imbalance that unintentionally favors large systemically important institutions over smaller firms of equivalent creditworthiness, fueling greater risk.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. A systemic risk regulator should be empowered, among other things, with broad information-gathering authority to obtain adequate reporting from firms that are or may pose a risk to the financial system and from other regulators. Using the information obtained, the systemic risk regulator would identify emerging risks--whether market-oriented, infrastructure-related, or entity-specific. For example, concentrations in particular businesses or asset classes and off-balance sheet or other activities that may not be readily transparent to the public or primary regulators should be of particular concern. Given the breadth of the task, however, the Council, SRR, and primary regulators all have a role in identifying and addressing such risks. The Council and the SRR would need to rely heavily on primary regulators to implement policies. In that regard, the Council should play a key role in facilitating and emphasizing coordination among the SRR and primary regulators. Moreover, 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, and transparent markets that enable investors and other counterparties to better understand risks, established and maintained in coordination with primary regulators. 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.4. How do you propose we identify firms that pose systemic risks?A.4. The Council should have the authority to identify firms whose failure would pose a threat to the financial system due to their combination of size; leverage; interconnectedness; amount and nature of financial assets; nature of liabilities (such as reliance on short-term funding); importance as a source of credit for households, businesses, and Government; amount of cash, securities, or other types of customer assets held; and other factors the Council deems appropriate. One possible way to identify these firms would be to use a process similar to that used to select participants in the Treasury Department and Federal Reserve's Supervisory Capital Assessment Program, or stress tests, conducted earlier in 2009.Q.5. All of the largest financial institutions have international ties, and money can flow across borders easily. AIG is probably the best known example of how problems can cross borders. How do we deal with the risks created in our country by actions somewhere else, as well as the impact of actions in the U.S. on foreign firms?A.5. Globally active financial services firms may be geographically dispersed, but as we saw during this financial crisis, the holding company can become crippled by the failure of any one of its many material subsidiaries. Our experience has confirmed the need for cross-border coordination and dialogue, as well as for sound regulatory regimes for principal subsidiaries of international holding companies. These regulatory regimes should of course include capital and liquidity standards that are adequate, appropriate, and enforced for the type of financial institutions affected, as well as measures to address operational and reputational risks. The global nature of financial conglomerates such as AIG makes capital and liquidity standards appropriate topics for international coordination and cooperation. In general, the financial crisis has highlighted the need for regulators to work more closely together to better understand the risks posed by international financial companies and global market risks.Q.6. 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.6. This same issue exists in our current regulatory regime and there is an established framework of regulation to safeguard against the misuse of confidential information. It is a criminal violation to disclose confidential information generally. See 18 U.S.C. 1905, Disclosure of confidential information generally, which provides that any officer or employee of the United States or any of its department or agency who, in the course of his employment or official duties, discloses confidential information (unless authorized by law) will be subject to fines, imprisonment, or both and will be removed from office or employment. There also are express standards of ethical conduct for employees or executives of any executive agency of the United States (such as the Securities and Exchange Commission) that provide, among other things, that an employee shall not engage in financial transactions using nonpublic Government information or allow the improper use of such information to further any private interest. See 5 CFR Section 2635.101(b)(3); see also 5 CFR Section 2635.703(a), which states that ``[a]n employee shall not engage in a financial transaction using nonpublic information, nor allow the improper use of nonpublic information to further his own private interest or that of another, whether through advice or recommendation, or by knowing unauthorized disclosure.'' ------ CHRG-111hhrg58044--28 Mr. Snyder," Good morning. Chairman Gutierrez, Ranking Member Hensarling, Mr. Price, and members of the subcommittee, my name is Dave Snyder, and I am vice president and associate general counsel for the American Insurance Association. In the midst of the financial turmoil and its related chaos, the U.S. property and casualty insurance sector is stable, secure, and strong. There are good reasons for this. We, you and the States never lost sight of our fundamental shared goals, reduce risk where possible, accurately assess and assume the remaining risk, and provide effective coverage to the American people. As a result, auto and homeowner's insurance markets are by every measure financially sound, competitive, and affordable. Claims are being paid daily by solvent companies. The market is very competitive by any measure and insurance is taking less of a bite out of household incomes than in the past. This is good for the economy because this maximized competition forces prices down to the lowest feasible level so people have money to spend on other things. Insurance scoring has played a major role in creating this positive market for all concerned. By empowering more effective risk assessment and pricing, the majority of the population pays less. Insurance is more available and more people can receive reasonably priced coverage, instead of being relegated to the high-risk pools, because insurers have a cost-effective tool to assess and price for risk, giving them the certainty they need to provide coverage to nearly everyone. You have asked us to address certain issues relating to insurance scoring. In summary, it is race and income blind, and has repeatedly been proven to be an accurate predictor of risk, indeed, one of the most accurate. The States have actively regulated it and insurance commissioners have full access to all the information they desire. In response to your request for recommendations, we suggest that all States adopt the National Conference of Insurance Legislators' model law. Second, the States should make sure they capture and analyze all of the credit complaints they can and communicate with insurance companies about them, individually, and any trends. We note, for example, from Director McRaith's testimony, that the rate of complaints under the existing system for credit-based insurance scores is about 1 complaint out of every 1.5 million policies issued or renewed. In addition, we all need to work together more effectively on financial literacy to help the American people understand how insurance scores are used by insurance companies to provide them with coverage. There is one other recommendation we did not emphasize in our written statement, that is to make it more possible to innovate on a pilot basis. For example, to introduce more direct measures of driving performance, such as the ability to assess risk, based not only on mileage, but how, when, and where those miles were driven. One other factor in the strength of the personal lines insurance market is that we have collectively reduced risk. Thanks to your leadership and that of safety groups, the insurance industry, and the States, far fewer Americans are injured and killed on our highways than ever would have been expected. Using fatality rates of 1964, last year alone, we have collectively saved 120,000 lives and prevented millions of injuries. This has created a solid foundation of the healthy auto insurance system we have today. The insurance industry is focused on building safety as never before through advocacy of smoke detector laws and codes requiring sprinklers and disaster resistant buildings, and the eminent opening of a building construction test center with wind turbines powerful enough to test the structural integrity of buildings. We hope to see a pattern of positive change similar to that which we helped bring about in auto safety with your cooperation and assistance. Thank you for inviting me to speak with you today. I would be pleased to answer any questions you may have. [The prepared statement of Mr. Snyder can be found on page 147 of the appendix.] " CHRG-111shrg51395--277 RESPONSE TO WRITTEN QUESTIONS OF SENATOR DODD FROM LYNN E. TURNERQ.1. Transparency: Are there additional types of disclosures that Congress should require securities market participants to make for the benefit of investors and the markets? Also, would you recommend more transparency for investors: 1. LBy publicly held banks and other financial firms of off- balance sheet liabilities or other data? 2. LBy credit rating agencies of their ratings methodologies or other matters? 3. LBy municipal issuers of their periodic financial statements or other data? 4. LBy publicly held banks, securities firms and GSEs of their risk management policies and practices, with specificity and timeliness?A.1. Witness declined to respond to written questions for the record.Q.2. Conflicts of Interest: Concerns about the impact of conflicts of interest that are not properly managed have been frequently raised in many contexts--regarding accountants, compensation consultants, credit rating agencies, and others. For example, Mr. Turner pointed to the conflict of the board of FINRA including representatives of firms that it regulates. The Millstein Center for Corporate Governance and Performance at the Yale School of Management in New Haven, Connecticut on March 2 proposed an industry-wide code of professional conduct for proxy services that includes a ban on a vote advisor performing consulting work for a company about which it provides recommendations. In what ways do you see conflicts of interest affecting the integrity of the markets or investor protection? Are there conflicts affecting the securities markets and its participants that Congress should seek to limit or prohibit?A.2. Witness declined to respond to written questions for the record.Q.3. Credit Default Swaps: There seems to be a consensus among the financial industry, government officials, and industry observers that bringing derivative instruments such as credit default swaps under increased regulatory oversight would be beneficial to the nation's economy. Please summarize your recommendations on the best way to oversee these instruments.A.3. Witness declined to respond to written questions for the record.Q.4. Corporate Governance--Majority Vote for Directors, Proxy Access, Say on Pay: The Council of Institutional Investors, which represents public, union and corporate pension funds with combined assets that exceed $3 trillion, has called for ``meaningful investor oversight of management and boards'' and in a letter dated December 2, 2008, identified several corporate governance provisions that ``any financial markets regulatory reform legislation [should] include.'' Please explain your views on the following corporate governance issues: 1. LRequiring a majority shareholder vote for directors to be elected in uncontested elections; 2. LAllowing shareowners the right to submit amendment to proxy statements; 3. LAllowing advisory shareowner votes on executive cash compensation plans.A.4. Witness declined to respond to written questions for the record.Q.5. Credit Rating Agencies: Please identify any legislative or regulatory changes you believe are warranted to improve the oversight of credit rating agencies. In addition, I would like to ask your views on two specific proposals: 1. LThe Peterson Institute report on ``Reforming Financial Regulation, Supervision, and Oversight'' recommended reducing conflicts of interest in the major rating agencies by not permitting them to perform consulting activities for the firms they rate. 2. LThe G30 Report ``Financial Reform; A Framework for Financial Stability'' recommended that regulators should permit users of ratings to hold NRSROs accountable for the quality of their work product. Similarly, Professor Coffee recommended creating potential legal liability for recklessness when ``reasonable efforts'' have not been made to verify ``essential facts relied upon by its ratings methodology.''A.5. Witness declined to respond to written questions for the record.Q.6. Hedge Funds: On March 5, 2009, the Managed Funds Association testified before the House Subcommittee on Capital Markets and said: ``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.'' MFA supported the creation or designation of a ``single central systemic risk regulator'' that (1) has ``the authority to request and receive, on a confidential basis, from those entities that it determines . . . 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,'' (2) has a mandate of protection of the financial system, but not investor protection or market integrity and (3) has the authority to ensure that a failing market participant does not pose a risk to the entire financial system. Do you agree with MFA's position? Do you feel there should be regulation of hedge funds along these lines or otherwise?A.6. Witness declined to respond to written questions for the record.Q.7. Self-Regulatory Organizations: How do you feel the self-regulatory securities organizations have performed during the current financial crisis? Are there changes that should be made to the self-regulatory organizations to improve their performance? Do you feel there is still validity in maintaining the self-regulatory structure or that some powers should be moved to the SEC or elsewhere?A.7. Witness declined to respond to written questions for the record.Q.8. Structure of the SEC: Please share your views as to whether you feel that the current responsibilities and structure of the SEC should be changed. Please comment on the following specific proposals: 1. LGiving some of the SEC's duties to a systemic risk regulator or to a financial services consumer protection agency; 2. LCombining the SEC into a larger ``prudential'' financial services regulator; 3. LAdding another Federal regulators' or self-regulatory organizations' powers or duties to the SEC.A.8. Witness declined to respond to written questions for the record.Q.9. SEC Staffing, Funding, and Management: The SEC has a staff of about 3,500 full-time employees and a budget of $900 million. It has regulatory responsibilities with respect to approximately: 12,000 public companies whose securities are registered with it; 11,300 investment advisers; 950 mutual fund complexes; 5,500 broker-dealers (including 173,000 branch offices and 665,000 registered representatives); 600 transfer agents, 11 exchanges; 5 clearing agencies; 10 nationally recognized statistical rating organizations; SROs such as the Financial Industry Regulatory Authority, the Municipal Securities Rulemaking Board and the Public Company Accounting Oversight Board. To perform its mission effectively, do you feel that the SEC is appropriately staffed? funded? managed? How would you suggest that the Congress could improve the effectiveness of the SEC?A.9. Witness declined to respond to written questions for the record. ------ CHRG-111shrg51395--269 RESPONSE TO WRITTEN QUESTIONS OF SENATOR DODD FROM MERCER E. BULLARDQ.1. Transparency: Are there additional types of disclosures that Congress should require securities market participants to make for the benefit of investors and the markets? Also, would you recommend more transparency for investors: 1. LBy publicly held banks and other financial firms of off- balance sheet liabilities or other data? 2. LBy credit rating agencies of their ratings methodologies or other matters? 3. LBy municipal issuers of their periodic financial statements or other data? 4. LBy publicly held banks, securities firms and GSEs of their risk management policies and practices, with specificity and timeliness?A.1. Witness declined to respond to written questions for the record.Q.2. Conflicts of Interest: Concerns about the impact of conflicts of interest that are not properly managed have been frequently raised in many contexts--regarding accountants, compensation consultants, credit rating agencies, and others. For example, Mr. Turner pointed to the conflict of the board of FINRA including representatives of firms that it regulates. The Millstein Center for Corporate Governance and Performance at the Yale School of Management in New Haven, Connecticut on March 2 proposed an industry-wide code of professional conduct for proxy services that includes a ban on a vote advisor performing consulting work for a company about which it provides recommendations. In what ways do you see conflicts of interest affecting the integrity of the markets or investor protection? Are there conflicts affecting the securities markets and its participants that Congress should seek to limit or prohibit?A.2. Witness declined to respond to written questions for the record.Q.3. Credit Default Swaps: There seems to be a consensus among the financial industry, government officials, and industry observers that bringing derivative instruments such as credit default swaps under increased regulatory oversight would be beneficial to the nation's economy. Please summarize your recommendations on the best way to oversee these instruments.A.3. Witness declined to respond to written questions for the record.Q.4. Corporate Governance--Majority Vote for Directors, Proxy Access, Say on Pay: The Council of Institutional Investors, which represents public, union and corporate pension funds with combined assets that exceed $3 trillion, has called for ``meaningful investor oversight of management and boards'' and in a letter dated December 2, 2008, identified several corporate governance provisions that ``any financial markets regulatory reform legislation [should] include.'' Please explain your views on the following corporate governance issues: 1. LRequiring a majority shareholder vote for directors to be elected in uncontested elections; 2. LAllowing shareowners the right to submit amendment to proxy statements; 3. LAllowing advisory shareowner votes on executive cash compensation plans.A.4. Witness declined to respond to written questions for the record.Q.5. Credit Rating Agencies: Please identify any legislative or regulatory changes you believe are warranted to improve the oversight of credit rating agencies. In addition, I would like to ask your views on two specific proposals: 1. LThe Peterson Institute report on ``Reforming Financial Regulation, Supervision, and Oversight'' recommended reducing conflicts of interest in the major rating agencies by not permitting them to perform consulting activities for the firms they rate. 2. LThe G30 Report ``Financial Reform; A Framework for Financial Stability'' recommended that regulators should permit users of ratings to hold NRSROs accountable for the quality of their work product. Similarly, Professor Coffee recommended creating potential legal liability for recklessness when ``reasonable efforts'' have not been made to verify ``essential facts relied upon by its ratings methodology.''A.5. Witness declined to respond to written questions for the record.Q.6. Hedge Funds: On March 5, 2009, the Managed Funds Association testified before the House Subcommittee on Capital Markets and said: ``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.'' MFA supported the creation or designation of a ``single central systemic risk regulator'' that (1) has ``the authority to request and receive, on a confidential basis, from those entities that it determines . . . 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,'' (2) has a mandate of protection of the financial system, but not investor protection or market integrity and (3) has the authority to ensure that a failing market participant does not pose a risk to the entire financial system. Do you agree with MFA's position? Do you feel there should be regulation of hedge funds along these lines or otherwise?A.6. Witness declined to respond to written questions for the record.Q.7. Self-Regulatory Organizations: How do you feel the self-regulatory securities organizations have performed during the current financial crisis? Are there changes that should be made to the self-regulatory organizations to improve their performance? Do you feel there is still validity in maintaining the self-regulatory structure or that some powers should be moved to the SEC or elsewhere?A.7. Witness declined to respond to written questions for the record.Q.8. Structure of the SEC: Please share your views as to whether you feel that the current responsibilities and structure of the SEC should be changed. Please comment on the following specific proposals: 1. LGiving some of the SEC's duties to a systemic risk regulator or to a financial services consumer protection agency; 2. LCombining the SEC into a larger ``prudential'' financial services regulator; 3. LAdding another Federal regulators' or self-regulatory organizations' powers or duties to the SEC.A.8. Witness declined to respond to written questions for the record.Q.9. SEC Staffing, Funding, and Management: The SEC has a staff of about 3,500 full-time employees and a budget of $900 million. It has regulatory responsibilities with respect to approximately: 12,000 public companies whose securities are registered with it; 11,300 investment advisers; 950 mutual fund complexes; 5,500 broker-dealers (including 173,000 branch offices and 665,000 registered representatives); 600 transfer agents, 11 exchanges; 5 clearing agencies; 10 nationally recognized statistical rating organizations; SROs such as the Financial Industry Regulatory Authority, the Municipal Securities Rulemaking Board and the Public Company Accounting Oversight Board. To perform its mission effectively, do you feel that the SEC is appropriately staffed? funded? managed? How would you suggest that the Congress could improve the effectiveness of the SEC?A.9. Witness declined to respond to written questions for the record. ------ 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-111shrg52619--203 RESPONSE TO WRITTEN QUESTIONS OF SENATOR CRAPO FROM SCOTT M. POLAKOFFQ.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. There have been positive results of the convergence of financial services providers. Consumers and customers seeking financial products have benefited from products and services that are more varied and specifically targeted to meet their needs. At the same time, the regulatory oversight framework has not kept pace with the developments in all areas of the companies offering these products and services. If a systemic risk regulator had existed, it may not have filled in all of the gaps, but such a regulator would have looked at the entire organization with a view to identifying concerns in all areas of the company and would have identified how the operations of one line of business or business unit would affect the company as a whole. A systemic risk regulator with access to information about all aspects of a company's operations would be responsible for evaluating the overall condition and performance of the entity and the impact a possible failure would have on the rest of the market. Such a broad overview would enable the systemic regulator to work with the functional regulators to ensure that the risks of products and the interrelationships of the businesses are understood and monitored. The establishment of a systemic risk regulator need not eliminate functional regulators for the affiliated entities in a structure. Functional regulators are necessary to supervise the day to day activities of the entities and provide input on the entities and activities to the systemic risk regulator. Working together with the functional regulators and putting data and developments into a broader context would provide the ability to identify and close gaps in regulation and oversight. In order to benefit from having a framework with a systemic risk regulator and functional regulation of the actual activities and products, information sharing arrangements among the regulators must be established. Further, the systemic risk regulator would need access to information regarding nonsystemically important institutions in order to monitor trends, but would not regulate or supervise those entities.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 proposals to change the financial services regulatory framework have been issued in the past year. Some of these proposals would establish a new framework for financial services regulation and others would make changes by merging existing regulatory agencies. The proposals of recent months all have identified the supervision of conglomerates as a key element to be addressed in any restructuring. There are pros and cons to each of the proposals for supervision of conglomerates. Three recommendations represent different perspectives on how to accomplish the goals. The example of the single consolidated regulator similar to the Financial Services Authority has been highlighted by its proponents as a solution to the regulation of large conglomerates that offer a variety of products and services through a number of affiliates. Because the single regulator model using a principles based approach to regulation and supervision has been in place in the UK since 1997, the benefits and negative aspects of this type of regulatory framework can be viewed from the perspective of actual practice. A single regulator, instead of functional regulators for different substantive businesses, coupled with a principles based approach to regulation was not successful in avoiding a financial crisis in the UK. The causes of the crisis in the UK are similar to those identified as causes in the U.S., and elsewhere, and the FSA model for supervision did not fully eliminate the gaps in regulation or mitigate other risk factors that lead to the crisis. Several factors may have contributed to the shortcomings in the FSA model. The most frequently cited factor was principles based regulation. Critics of this framework have identified the lack of close supervision and enforcement over conglomerates, their component companies and other financial services companies. The FSA employed a system that did not adequately require ongoing supervision or account for changes in the risk profiles of the entities involved. Finally, in an effort to streamline the framework and eliminate regulatory overlap, important roles were not fulfilled. The Group of 30 issued a report on January 15, 2009, that included a number of recommendations for financial stability. The recommendations presented in the report respond to the same factors that have become the focus of the causes of the current crisis. The first core recommendation is that gaps and weaknesses in the coverage of prudential regulation and supervision must be eliminated, the second is that the quality and effectiveness of prudential regulation and supervision must be improved, the third is that institutional policies and standards must be strengthened, with particular emphasis on standards of governance, risk management, capital and liquidity and finally, financial markets and products must be more transparent with better aligned risk and prudential incentives. The first core recommendation is one about which there is little disagreement. The elimination of gaps and weakness in the coverage of prudential regulation and supervision is an important goal in a number of areas. Whether it is the unregulated participants in the mortgage origination process, hedge funds or creators and sellers of complex financial instruments changing the regulatory framework to include those entities is a priority for a number of groups making recommendations for change. The benefits of the adaptation of the current system are evident and the core principles proposed by the Group of 30 are common themes in addressing supervision of conglomerates. A final proposal is the Treasury Blueprint that was issued in March 2008. That document was a top to bottom review of the current regulatory framework, with result that financial institutions would be regulated by a market stability regulator, a prudential regulator and/or a business conduct regulator. In addition, an optional federal charter would be created for insurance companies, a regulator for payment systems would be established, and a corporate finance regulator would be created. This approach to regulation would move toward the idea that supervision should be product driven and not institution driven. The framework proposed would not use the positive features in the current system, but a systemic regulator would be created.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. Establishing the criteria by which financial institutions or other companies are identified as too big to fail is not easy. Establishing a test with which to judge whether an entity is of a size that makes it too big to fail, or the business is sufficiently interconnected, requires looking at a number of factors, including the business as a whole. The threshold is not simply one of size. The degree of integration of the company with the financial system also is a consideration. A company does not need to be a bank, an insurance company or a securities company to be systemically important. As we have seen in recent months, manufacturing companies as well as financial services conglomerates are viewed differently because of the impact that the failure would have on the economy as a whole. The identification of companies that are systemically important should be decided after a subjective analysis of the facts and circumstances of the company and not just based on the size of the entity. The factors used to make the determination might include: the risks presented by the other parties with which the company and its affiliates do business; liquidity risks, capital positions; interrelationships of the affiliates; relationships of the affiliates with nonaffiliated companies; and the prevalence of the product mix in the market.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 array of lessons learned from the crisis will be debated for years. One 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. 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 in banking, securities, and insurance. For systemically important institutions, the systemic risk regulator should supplement, not supplant, the holding company regulator and the primary federal bank supervisor. A systemic regulator should 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.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. In the context of AIG, OTS views the financial failure of a company as occurring when it can no longer repay its liabilities or satisfy other obligations from its liquid financial resources. OTS is not in a position to state whether AIG should have proceeded to a Chapter 11 bankruptcy. As stated in the March 18, 2009, testimony on Lessons Learned in Risk Management Oversight at Federal Financial Regulators and the March 19, 2009, testimony on Modernizing Bank Supervision and Regulation, OTS endorses establishing a systemic risk regulator with broad regulatory and monitoring authority of companies whose failure or activities could pose a risk to financial stability. Such a regulator should be able to access funds, which would present options to resolve problems at these institutions. ------ CHRG-111hhrg54873--42 Mr. Gellert," Thank you. On behalf of my colleagues at Rapid Ratings, I would like to thank Chairman Kanjorski, Ranking Member Garrett, and the members of the subcommittee for inviting me to provide testimony today. As the only non-NRSRO on this panel, we appreciate your invitation all the more as we and companies like us have what we believe is a critical voice in these debates. As with the new subscriber-paid NRSROs, we represent the potential for meaningful change to the status quo if we are not inadvertently hindered by the consequences of legislation and regulation along the way. Ours is a subscriber-paid firm. We utilize a proprietary software based system to rate the financial health of thousands of public and private companies quarterly. We use only financial statements, no market inputs, no analysts and have no contact in the ratings process with issuers, bankers or advisors. We have not applied for the NRSRO status. As I have testified to the SEC and the Senate in recent months, there are still too many deterrents for me to recommend to our shareholders that the designation enhances value as opposed to puts it at risk. That said, we believe that reform in our industry is necessary and time is of the essence for restoring credibility. However, we caution that some initiatives may have significant and counterproductive consequences. In short, we do not believe it is advisable to create more legislation for legislation sake. Although we did not necessarily agree with all of the elements of the Credit Rating Agency Reform Act of 2006. Its intent of appropriate to promote competition to transform this industry. Some say the Act has not had enough time to mature and others that it wasn't sufficient. Nevertheless, the Act is still the basis for constructive change and the SEC's recent initiatives have made good progress in adding reform and oversight to the prior legislation. These improvements have set a better stage for competition than we have had in years. The Commission has also been receptive to input from industry players. When recently faced with criticism about reading disclosure rules, adverse effect on subscriber paid firms, the SEC created different standards for issuer paid and subscriber paid NRSROs. This showed admirable flexibility and not applying a one-size-fits-all model to new rules. We encourage the subcommittee to be guided by this flexibility. The subcommittee's discussion draft joins a crowded field of rating agency reform initiatives currently underway. There are positive developments in the collection of initiatives, but even these do not yet go far enough, and the negative ones forge entirely new and unfortunately disturbing paths. Competition is key to transform this industry. But competition for competition's sake is not the answer. Competition that effects change will enhance the credibility of the ratings process. The new subscriber-based rating agencies are the best hope for achieving these goals but are the ones put most at risk by the discussion draft. For new players to want to register NRSRO status must have value and not carry massive compliance costs and legal liability. New players will want the designation if they see it as a business asset, not as a series of contingent liabilities. In order to achieve this, legislation must foster the following goals: accuracy in ratings; innovation in business models and rating methodology; encouraging, not discouraging, new players; equivalent disclosure of structured product information; and recognition that many initiatives tacitly support the status quo oligopoly. Sadly, the trend toward greater and more complex legislation and regulation will repel and not attract competition and, hence, preserve the status quo, the very problem you were hopefully trying to solve. In particular, the emphasize on liability I believe is being overdone. Should negligence and malfeasance be rooted out? Yes. Should a one-size-fits-all legal framework be enacted to punish all players jointly, irrespective of whether they have sinned in the past? No. A few specific notes on liability. Joint liability is a great disincentive to NRSRO status. In fact, it is simply a nonstarter for a potential applicant. Why would one want to be an NRSRO, joining a group dominated by three players who have an iceberg of lawsuits looming on their horizon? That would be like swimming towards the Titanic. Equivalent disclosure. The equivalent disclosure of data used in formulating a ratings decision among NRSROs is a boon to competition. If the perspective NRSRO sees the ability to expand into a new asset class of ratings, for instance, CDOs and CLOs, there is a material benefit to the designation. Moreover, expanding this disclosure to outstanding issues is critical. Likely no greater initiative could be taken to kick-start liquidity revival in structured products. Mandatory registration. Under current law, ratings firms have the option to apply for NRSRO status. Requiring registration while the hard and soft costs of being an NRSRO are currently unquantifiable is a major hurdle to new players and is likely a complete disincentive to the de novo firm. Add this to joint liability and the potential costs to a new player are astronomical. Removal of ratings, references, and regulations. In general, we are very supportive of removing references and regulations because they protect the status quo dominance of the ratings oligopoly. I will conclude with the issue of conflicts of interest. Central to the issuer-paid rating agencies argument for defending their conflicted business model is that the subscriber-paid rating agencies also conflicted, suggesting that a modified version of the status quo is the only real alternative. This is a red herring. Let's not miss the irony of these issuer-paid agencies shifting public attention away from their committed sins to the uncommitted sins of very small competitors paid by investors who are seeking protection from fiduciary irresponsibility. To address all of these issues, legislation and regulations must be flexible and not require a one-size-fits-all straitjacket, recalling that subscriber-based rating agencies are the future solution to the current problems, while issuer-paid rating agencies were the cause. Thank you very much. [The prepared statement of Mr. Gellert can be found on page 76 of the appendix.] " CHRG-111shrg57923--45 PREPARED STATEMENT OF JOHN C. LIECHTY Associate Professor of Marketing and Statistics, Smeal College of Business, Penn State University, and Founding Member, the Committee to Establish the National Institute of Finance February 12, 2010 Providing Financial Regulators with the Data and Tools Needed to Safeguard Our Financial System Mr. Chairman and Member of the Subcommittee: We thank you for the opportunity to appear before you on behalf of the Committee to Establish the National Institute of Finance (CE-NIF). The primary objective of the CE-NIF is to seek the passage of legislation to create a National Institute of Finance (NIF). In our testimony today we would like to provide the reasons why we see this as an urgent national need and the role we see for the proposed National Institute of Finance in strengthening the government's ability to effectively regulate financial institutions and markets and to respond to the challenges of systemic risk. The CE-NIF is unique. We are a volunteer group of concerned citizens brought together by a common view that the Federal Government and its financial regulators lack the necessary data and analytical capability to effectively monitor and respond to systemic risk and to effectively regulate financial firms and markets. The members of the CE-NIF consist of individuals from academia, the regulatory agencies, and the financial community. We have raised no money to support our effort, we represent no vested interests, and we have paid what few expenses we have incurred out of our own pockets. We share what we believe to be a legislative objective that is critical to the long-term well-being and prosperity of our nation.Lessons of the Credit Crisis: Critical Weaknesses in Financial Regulation Were RevealedGovernment Officials Lacked the Data To UnderstandThe Consequences of Alternative Options The events of the most recent financial crisis have laid bare the dire consequences that can flow form poorly understood and ineffectively regulated financial institutions and markets. In response to the crisis, a lot of attention has been paid to how to strengthen the legal authorities and organizational structure of the financial regulatory community. Unfortunately, far less attention has been paid to what data and analytical capability is needed to enable regulators to use those new powers effectively. Data and analytics are not the stuff of headlines and stump speeches; however, when they are deficient, they are the Achilles' heel of financial regulation. Unfortunately, we have ample evidence that the recent crisis was due in part to a lack of appropriate data and analytic tools. A review of key events from the recent crisis makes this point very clear. When Lehman Brothers tottered on the brink of bankruptcy in September, 2008 government officials were faced with a choice between two stark alternatives: save Lehman Brothers and signal to the markets and other large and highly inter-connected financial institutions that they could count on an implicit government safety net, irrespective of how risky their financial excesses might be; or let this large and important investment bank go under--reaffirming to the market that there are consequences to risky business practices--but run the risk of setting off a cascade of bankruptcies and market disruptions. Forced to make a quick decision, officials let Lehman go under, a decision that sparked a horrifying downward spiral of the financial markets and the economy. That decision was based, in part, on the belief at Treasury that participants in the financial markets had been aware of the problems at Lehman for a number of months and had ample time to prepare by limiting their exposure.\1\ Officials did not have access to the types of information that would have given them a better picture of how interconnected firms and the broader markets were to Lehman's fate. The day after the failure, the Reserve Fund--a $64.8 billion money market fund--`broke the buck' because of its exposure to Lehman. That is, its assets were no longer sufficient to support a $1.00 value for the price of its shares. This sparked a massive run on the $3.5 trillion money market industry and, because of the important role that the money market funds play in providing liquidity in the commercial paper market (a market for providing short-term corporate loans) the $2.2 trillion commercial paper market froze. When the broader economy was no longer able to access funding and credit, the crisis had become systemic.--------------------------------------------------------------------------- \1\ ``The view at Treasury . . . was that Lehman's management had been given abundant time to resolve their situation by raising additional capital or selling off the firm, and market participants were aware of this and had time to prepare.'' Phillip L. Swagel--Assistant Secretary for Economic Policy at the U.S. Treasury during crisis--Brookings Papers March, 2009.--------------------------------------------------------------------------- Whether the government could have done a better job of responding to that challenge or foreseen the catastrophic fallout of the Lehman decision is an open question. The point that is clear, however, is that at this critical moment in time they did not have the data needed to fully understand the counterparty relationships linking Lehman to the system, nor did they have in place the capacity to analyze such data to form a clear picture of the consequences of the alternatives they faced. Simply put, at this critical juncture, government officials were flying blind. Unfortunately, this lack of data was representative of the problems the government faced in understanding what was going on across the breadth of the market. At the very same time that Secretary of the Treasury was grappling with the problems at Lehman, he learned for the first time the extent of the problems at AIG caused by the excessively large concentration of Credit Default Swaps (CDSs) on the books of AIG's Financial Products unit. AIG had written $441 billion in CDSs--linked to Private Label Mortgage Backed Securities (PLMBSs). Those PLMBSs were rapidly becoming the `Toxic Assets' of this crisis and falling in value, sharply increasing the value of AGI's obligation to make good on those CDSs. Officials were apprised of the scale of the problem, but they faced two key problems that were evaporating trust in the market: the growing uncertainty over how to value these CDS and the fact that they had no way of understanding the Domino risks, i.e. the risk that the failure of one firm (AIG) would cause a cascade of failures throughout the system. Facing these uncertainties, government officials felt they had no choice but to provide massive government assistance to prevent AIG from failing. In addition to being an essential component of measuring and monitoring systemic risk, having or not having comprehensive counterparty data has important forensic consequences, as well. Bernie Madoff ran the largest and most damaging Ponzi scheme in history. He reported consistently high earnings based on a purported complex trading strategy that made ample use of derivative transactions. He was able to perpetrate this very long running fraud, in part, because officials did not have good data on the network of counterparties to derivative transactions. Madoff's consistently high reported earnings raised questions among a few in the financial community, and although the SEC investigated several times they found nothing amiss. If they would have had access to data on the counterparty network for derivative transactions the outcome of those investigations could have been very different because Madoff's reported derivatives trades were, of course, fictitious. A simple check of the counterparty data would have revealed that no one reported being on the other side of Madoff's trades, and that they had to be fictitious. That evidence would have confirmed the fraud.Critical Components of Effective Regulation Were ``Outsourced'' The extent to which the government lacked the necessary data and analytical capability to effectively regulate financial institutions and markets was hidden from view in some cases because of the extent to which the government has in effect outsourced critical regulatory capabilities. Some of that outsourcing enabled the creation of the toxic assets that became a central part of the crisis. When these private label subprime mortgage backed securities were initially issued, large tranches were rated triple-A or double-A by private rating agencies. Rating these securities and advising issuers on how to qualify for the desired rates was a large and profitable business for the rating agencies. These rating received the blessing of the financial regulators and that made it easy for investment and commercial banks to sell many ultimately troubled asses to highly regulated financial firms (such as insured depositories, insurance companies, pension funds, Federal Home Loan Banks, Fannie Mae and Freddie Mac). Comptroller of the Currency John Dugan in a speech in 2008 alluded to this outsourcing of responsibilities to the rating agencies. ``In a world of risk-based supervision,'' he said, ``supervisors pay proportionally more attention to the instruments that appear to present the greatest risk, which typically does not include triple-A-rated securities.'' In other words, the regulators were relying on the rating agencies to determine what ``appear(s) to present the greatest risk.'' The transformation of these assets from triple-A rated to Toxic Assets started when rising delinquencies and defaults in the underlying subprime mortgages forced the rating agencies to downgrade many of those securities. Those downgrades raised questions in the market about the credit quality of a whole range of structured investment products. However, in many, if not most, cases market participants lacked the ability to see through these complicated structured financial products to the underlying collateral and only a handful of market participants had the sophistication to allow them to independently assess their value and inherent riskiness. When the financial markets crashed and the major surviving financial firms teetered on the brink the Federal Government had to determine whether these firms were adequately capitalized. However, neither the Treasury nor the regulatory agencies were able to make such determinations completely on their own because they lacked the necessary data and analytical capacity to do so. The government turned to the banks themselves to do the assessments. Although the bank's systems were not designed to anticipate domino risks and deal with the lack of market liquidity, they were the best that was available. The Treasury posited a few economic stress scenarios and instructed the regulated banks to assess how they would fare under those scenarios. The banks were then to report the results of their analyses back to the Treasury and their regulators. It is an ironic twist that the regulators had to rely on the same models that were employed to manage banks' exposure to risk during the run-up to the crisis in order to perform this analysis. Of course, banks should have the capability to perform such analysis; it is part and parcel of competent corporate management and governance. However, this crisis demonstrates the importance of having a regulatory community that is capable of generating independent assessments of the credit quality of a security or the safety and soundness of a bank, market or the financial system that they regulate.Systemic Risk: the Whole is Greater Than the Sum of the Parts The capital markets exist to move capital from less efficient uses to more efficient uses. The capacity of the markets to intermediate risk and provide for these flows of capital was seriously threatened in the recent crisis, and there are several alternative ways of trying to prevent another crisis that are being looked at. One prevailing line of thinking is that systemic risk can be managed by identifying a relatively small number of systemically important institutions and regulating them especially well. There are critical conceptual errors in this thinking. When it comes to systemic risk, the whole is greater than the sum of the parts. Even if there were no large, systemically important institutions, there would still be the risk of systemic failure. A couple of representative examples follow, along with the identification of the type of data needed to monitor and respond to systemic risk related to these examples. Systemic risk may arise as a consequence of the way financial firms are tightly linked to one another by multiple complex contractual relationships. For example, when LTCM teetered on the brink of failure in 1998 the government organized a group of large financial institutions to step in and provide sufficient capital to prevent that failure. One investment bank, whose exposure to LTCM was about $100 million, was asked to contribute more than $150 million to support LTCM. As a narrowly defined business proposition it does not make much sense to put $150 million at risk to try to protect an exposure of $100 million. This was especially true when that institution could have withstood the loss of the $100 million without impacting its ability to continue operating. Why did they do it? Although a $100 million loss would not have caused that firm's failure, they did not know how exposed their other major trading partners were to LCTM. If one or more of their major counterparties failed as a result of their exposure to LTCM, they could have been dragged down as well. Financial regulators need detailed counterparty data to monitor the domino risks that comes from connectedness. Systemic risk may arise from excessively large concentrations of risk on the books of a financial institution or a group of firms. Concentrations in and of themselves are not necessarily a systemic risk. However, the interplay between concentrations and connectedness can create systemic risk. In this crisis the best example was the dangerously large concentration of CDSs on the books of AIG's Financial Products unit. Investors in Private Label Mortgage Backed Securities (PLMBS) turned to the CDS market to lower the credit risk of their investments. Issuers of PLMBS entered into CDS transactions to raise the credit ratings of the securities they were issuing. AIG aggregated that market-wide risk on their balance sheet by writing $441 billion of CDS contracts against the risk of loss associated in those PLMBS, without hedging that risk or having sufficient assets in reserve to cover the losses that developed. To stave off the consequences of a failure to those already fragile firms doing business with AIG, the Federal Government committed to put almost $200 billion in capital into AIG. Financial regulators need market-wide position data to monitor the buildup of systemic risk that may flow from such concentrations.What We Do Know About the Next Systemic Financial Crises No matter how much we improve the government's ability to understand and remediate systemic risk, that risk cannot be reduced to zero. Therefore, we must prepare for the next financial crises. And, in that regard, there are several things that we do know: The first is that while there may be some similarities with previous crises and lessons to be learned from them, the cause of tomorrow's crisis will likely be different than yesterday's crisis. The second is that you cannot prepare for tomorrow's crisis by simply collecting the data and building the models you needed to understand yesterday's crisis. You must cast a broader net. The third is that when a new crisis begins to unfold it will be too late to try to collect the additional data, build the analytics, and undertake the research needed to make better regulatory and policy decisions. Policy makers and regulators will be stuck using the data and the analytics that they have at hand to try to develop the best policy response.The National Institute of Finance: An Essential Response Most of the debate related to regulatory reform has focused on altering the regulatory organizational structure and providing regulators with new legal authorities. Very little attention has focused on providing the capacities (data, analytic tools and sustained research) needed to be able to measure and monitor systemic risk and correct the current deficiencies in regulatory capabilities. In order to address these weaknesses we propose the creation of a National Institute of Finance (NIF). The NIF would have the mandate to collect the data and develop the analytic tools needed to measure and understand systemic risk, and to strengthen the government's ability to effectively regulate financial institutions and markets. In addition, the NIF would provide a common resource for the entire regulatory community and the Congress.Key Components and Authorities The NIF would be an independent resource supporting the financial regulatory agencies. It would not be a regulatory agency itself. The only regulatory authority it would have would be to provide reference data, set data reporting standards, and compel the provision of data. The NIF would have two key organizational components: the Federal Financial Data Center (Data Center) and the Federal Financial Research and Analysis Center (Research Center). The Research Center would have the responsibility to build analytics, and sponsor and perform research. Last, the NIF would be funded by a direct assessment on the firms required to report to it. The Data Center will collect and mange transaction and position data for (1) U.S. based entities (including for example, banks, broker-dealers, hedge funds, insurance companies, investment advisors, private equity funds and other highly leveraged financial entities) and their affiliates; and (2) U.S.-based financial transactions conducted by non-U.S. based entities. In order to carry out this responsibility, the Data Center will develop and maintain standards for reporting transaction and position data, including the development and maintenance of reference databases of legal entity identifiers and financial products. It will also establish the format and structure for reporting individual transactions and positions. It will collect, clean, and maintain transaction and position data in secure databases. It will provide regulators access to the data, and it will provide public access to aggregated and/or delayed data to improve market transparency--providing no business confidential information is compromised. Keeping this data secure will be an important responsibility of the Data Center. In this regard, the Federal Government has a long-standing and excellent track record in maintaining the security of all kinds of very sensitive data, including financial, military, intelligence, tax and census data and the NIF would adhere to the same data security standards used for existing secure data centers. The Research Center will develop metrics to measure and monitor systemic risk and continually monitor, investigate and report on changes in system-wide risk levels. In addition, the Research Center will develop the capacity to assess the financial condition of large financial institutions and assess their capital adequacy in stress scenarios. The Research Center will be responsible for conducting, coordinating and sponsoring the long-term research needed to support systemic risk regulation. The Research Center will provide advice on the financial system and policies related to systemic risk. In addition, it will undertake assessments of financial disruptions in order to determine their causes, and make recommendations for appropriate regulatory and legislative action in response to those findings. An Independent Voice: It is critical that the NIF have the ability and responsibility to report its findings in a fully independent manner. Because the NIF does not have any financial regulatory authority, per se, its objectivity will not be diminished by a conflict of interest that could arise if it had to report on its own regulatory actions. In addition, it is structured in a way that helps insulate it from political pressures. This structure plays a key role in assuring that the NIF will offer its very best unbiased assessments of the risks facing the financial system and the broader economy, as well as its best unbiased recommendations for responding to those risks. Funding from Assessments: The NIF will be funded by assessments on reporting institutions. This method of funding is used by financial regulatory agencies and is appropriate for several reasons. First, the financial sector will benefit from an annual reduction in operating cost of tens of billions of dollars as a result of the standardization of data and reporting. Having the beneficiaries of these cost savings use some of those savings to fund the NIF is the fair thing to do. In addition, like the financial regulatory agencies, the use of industry assessments will make it possible for the NIF to pay salaries that are above the standard civil service pay scale and better enable the NIF to attract the highly skilled staff it will need to fulfill its responsibilities.Benefits of Establishing a National Institute of Finance Establishing a National Institute of Finance will bring substantial benefits to our financial system and the broader economy. The fundamental benefits of the NIF are many. It will improve the efficiency and effectiveness of financial regulation. The Institute will provide regulators with the ability to independently assess the safety and soundness of a bank, market or the financial system, stopping the outsourcing of critical capacity to banks and rating agencies. It will investigate market disruptions and conduct the fundamental research needed to improve regulation of financial institutions and markets. It will also ensure that these findings and advances are integrated into the systemic risk monitoring systems. In addition it will provide an invaluable resource for the analysis of proposed regulatory policy and monitoring of existing policy to help refine and strengthen the overall approach to regulation. It will reduce the likelihood of systemic crises and costly institutional failures. As the NIF develops models and metrics for systemic risk and collects the appropriate data, it will be able to provide a better understanding of system-wide aggregation, of the level of liquidity in the system, and gain a better understanding of potential for liquidity failures and fire sales, which are part of the early warning stages of a systemic failure. When it is fully mature, the NIF will have the ability to see through the entire counterparty network, allowing it to quantify Domino risks--the risk of a cascading failure that might result from the failure of other financial entities--and identify critical nodes in the counterparty network. Along with market participants, it will also have the ability to see through complex structured products down to the underlying collateral (e.g. loans or mortgages providing the cash-flows)--helping improve transparency and avoiding the rise of new types of toxic assets that could trigger a future crisis. It would create a safer and more competitive market. By helping improve individual firm risk management and providing better tools to the regulators to monitor and oversee systemic risk, the U.S. financial markets will be made safer, and will attract more business than competitors that are more prone to major shocks or collapses during times of economic stress. In addition, the NIF would actually benefit the U.S. financial services industry, as well. It would reduce operating costs. Standardizing data reporting will dramatically reduce back office costs (costs associated with verifying details of trades with counter parties) and costs associated with maintaining reference databases (legal entity and financial instrument databases). Morgan Stanley estimates that implementation of the NIF will result in 20 percent to 30 percent savings in operational costs. It would facilitate risk management. By requiring daily reporting of all positions to the NIF, firms will be able to present a complete picture of their positions to their own internal risk management groups. This will in turn ensure that senior management has a consistent and clear understanding of the firm's exposures--particularly their exposure to different counterparties during times of economic stress.Conclusion The Federal Government has responded to a number of threats to our national well-being by organizing major research and monitoring efforts. The threat of natural disasters led to the creation of the National Oceanic and Atmospheric Administration, containing the National Weather Service and National Hurricane Center, whose skill in forecasting the weather and warning of impending natural disasters has saved many lives. The Centers for Disease Control and the National Institutes of Health have advanced the state of medical research, developed new treatments for deadly diseases, and mobilized to protect the population from the threats of pandemics. The nation's national security has been greatly advanced by the outgrowth of the sustained research programs supported by DARPA. When we look at the financial losses suffered by the American public and the burden placed on U.S. taxpayers by the government's response to this most recent financial crisis, it is fair to ask why we have not created a similar sustained research and monitoring effort to protect the American people from the high costs of systemic risk and financial implosions. The regulatory reform legislation that recently passed in the House charges a new Financial Services Oversight Council (FSOC) with the task of monitoring systemic risk and provides some new legal authorities to intervene in a time of crisis. However, it fails to provide the tools necessary to carry out the systemic risk monitoring responsibility. That responsibility can only be carried out well if the proposed FSOC has a deep understanding of how our financial system works. Such an understanding can only be based on access to much better system-wide data and the analytic tools needed to turn that data into relevant information on systemic risk. This is something that is currently beyond the government's capability. Unfortunately, as set forth in the House bill, the FSOC would have no permanent staff and no specific authority to collect the many kinds of system-wide data needed. As it stands the FSOC represents little more than a hollow promise when it comes to its ability to monitor systemic risk and warm of future crises. Our nation's financial markets are a public good. The safety of our country and the well being of our population depend on well functioning financial markets. We have incurred very high costs in this recent crisis as a result of the failings of our current approach to regulating financial markets and institutions. This approach has relied on a fragmented, data poor, regulatory structure that despite its best efforts did not have the tools with which to understand and respond to the threat presented by systemic risk. The Senate has an opportunity to materially strengthen any proposed financial regulatory reform legislation by creating a National Institute of Finance that will equip regulators and a systemic risk regulator with the data and analytical tools needed to correct the deficiencies that were made so apparent in this recent crisis. The full capabilities of the NIF will take several years to realize, however, benefits will ensue from each stage of its development. Although it will take time and substantial effort to stand up the National Institute of Finance, the benefits should far outweigh the cost. Lastly, we were pleased to learn that on February 4, 2010 Sen. Jack Reed introduced S. 3005, ``The National Institute of Finance Act of 2010.'' This act lays out a strong case for the creation of the National Institute of Finance. Furthermore, it proposes the creation of the NIF in a way that insures its ability to fulfill the role envisioned by the CE-NIF. It would have the authority to collect the data necessary to monitor systemic risk. It would have the responsibility to establish a Research Center that will develop the metrics for monitoring systemic risk and to report on its monitoring of that risk. It would have the capacity to be a significant resource for the regulatory community. It would have the ability to fund itself in a way that insures that it will have adequate resources for its important mission, and it is structured so that it will be a truly independent and technically expert voice on matters relating to the regulation of financial institutions and markets and the threats of systemic risk. Mr. Chairman and Members of the Subcommittee, this concludes our prepared statement. Thank you for the opportunity to present the recommendations of the Committee to Establish the National Institute of Finance. We will be happy to answer any questions the committee may have. ______ CHRG-111shrg57322--90 Mr. Tourre," Can you repeat your question, Senator? Senator Collins. Mr. Chairman, I cannot help but get the feeling that a strategy of the witnesses is to try to burn through the time of each questioner. Mr. Tourre, the email that you sent on December 28, 2006, refers to a list of potential clients that might be most profitable in the coming year, and you say that the list should include fewer ``sophisticated hedge funds with which we should not expect to make too much money since (a) most of the time they will be on the same side of the trade as we will, and (b) they know exactly how things work and will not let us work for too much [money]. . . .'' And you refer instead to another kind of buyer, ``buy-and-hold rating-based buyers,'' who you can make more money from because they have less sophistication. This sounds like a deliberate strategy to sell products, complex products to less sophisticated clients who would not understand the products as well so that you can make more money? " FinancialCrisisReport--271 In 2005, in its 11th Annual Survey on Credit Underwriting Practices, the Office of the Comptroller of the Currency (OCC), which oversees nationally chartered banks, described a significant lowering of retail lending standards, noting it was the first time in the survey’s history that a net lowering of retail lending practices had been observed. The OCC wrote: “Retail lending has undergone a dramatic transformation in recent years as banks have aggressively moved into the retail arena to solidify market positions and gain market share. Higher credit limits and loan-to-value ratios, lower credit scores, lower minimum payments, more revolving debt, less documentation and verification, and lengthening amortizations - have introduced more risk to retail portfolios.” 1048 Starting in 2004, federal law enforcement agencies also issued multiple warnings about fraud in the mortgage marketplace. For example, the Federal Bureau of Investigation (FBI) made national headlines when it warned that mortgage fraud had the potential to be a national epidemic, 1049 and issued a 2004 report describing how mortgage fraud was becoming more prevalent. The report noted: “Criminal activity has become more complex and loan frauds are expanding to multitransactional frauds involving groups of people from top management to industry professionals who assist in the loan application process.” 1050 The FBI also testified about the problem before Congress: “The potential impact of mortgage fraud on financial institutions and the stock market is clear. If fraudulent practices become systemic within the mortgage industry and mortgage fraud is allowed to become unrestrained, it will ultimately place financial institutions at risk and have adverse effects on the stock market.” 1051 In 2006, the FBI reported that the number of Suspicious Activity Reports describing mortgage fraud had risen significantly since 2001. 1052 1047 “Housing Bubble Concerns and the Outlook for Mortgage Credit Quality,” FDIC Outlook (Spring 2004), available at http://www.fdic.gov/bank/analytical/regional/ro20041q/na/infocus.html. 1048 6/2005 “Survey of Credit Underwriting Practices,” report prepared by the Office of the Comptroller of the Currency, at 6, available at http://www.occ.gov/publications/publications-by-type/survey-credit-underwriting/pub- survey-cred-under-2005.pdf. 1049 “FBI: Mortgage Fraud Becoming an ‘Epidemic,’” USA Today (9/17/2004). 1050 FY 2004 “Financial Institution Fraud and Failure Report,” prepared by the Federal Bureau of Investigation, available at http://www.fbi.gov/stats-services/publications/fiff_04. 1051 Prepared statement of Chris Swecker, Assistant Director of the Criminal Investigative Division, Federal Bureau of Investigation, “Mortgage Fraud and Its Impact on Mortgage Lenders,” before the U.S. House of Representatives Financial Services Subcommittee on Housing and Community Opportunity, Cong.Hrg. 108-116 (10/7/2004), at 2. 1052 “Financial Crimes Report to the Public: Fiscal Year 2006, October 1, 2005 – September 30, 2006,” prepared by the Federal Bureau of Investigation, available at http://www.fbi.gov/stats- services/publications/fcs_report2006/financial-crimes-report-to-the-public-2006-pdf/view. CHRG-111shrg52966--8 Mr. Sirri," Chairman Reed, Ranking Member Bunning, and members of the Subcommittee, I am pleased to have the opportunity today to testify concerning insights gained from the SEC's administration of the Consolidated Supervised Entities, or CSE, program, as well as the SEC's long history of regulating the financial operation of broker-dealers and protecting customer funds and securities. The turmoil in the global financial system is unprecedented and has tested the resiliency of financial institutions and the assumptions underpinning many financial regulatory programs. I believe that hearings such as this, where supervisors reflect on and share their experiences from this past year, will enhance our collective efforts to improve risk management oversight of complex financial institutions. A registered broker-dealer entity within the CSE group was supervised by an extensive staff of folks at the SEC and at FINRA, the broker SRO. All U.S. broker-dealers are subject to the SEC's rigorous financial responsibility rules, including the net capital rules, the customer protection rules, and other rules designed to ensure that firms operate in a manner that permit them to meet all obligations to customers, counterparties, and market participants. The CSE program was designed to be broadly consistent with the Federal Reserve oversight of bank holding companies. Broker-dealers have to maintain the minimum of $5 billion of tentative net capital to qualify for the program and no firm fell below this requirement. The CSE regime was also tailored to reflect two fundamental differences between investment bank and commercial bank holding companies. First, the CSE regime reflected the resilience of securities firms on mark-to-market--the reliance of securities firms on mark-to-market accounting as a critical risk and governance control. Second, the CSE firms were required to engage in liquidity stress testing and hold substantial liquidity pools at the holding company. We also required firm-wide stress testing as a prerequisite to being allowed to enter the program, a requirement that was put in place well before the crisis started. For most firms, the stress testing comprised a series of historical or hypothetical scenarios that were applied across all positions, not just across one product or business line. While the set of scenarios did not cover every plausible scenario, they included major financial shocks or stresses to the market, such as the fall 1988 failure of long-term capital in the Russian default as well as the 1987 stock market crash. The CSE firms later expanded these scenarios or created others to stress their hedge fund counterparty credit risk exposures. I, too, appreciate the work that GAO did to review the supervision of financial institutions' risk management programs across the various regulators and find their observations on these programs very helpful. We are reviewing the recommendations and findings and we look forward to working with GAO as we fully consider their report. The SEC's supervision of investment banks has always recognized that capital is not synonymous with liquidity and the ability of a securities firm to withstand stress events depends on having sufficient liquid assets, cash and high-quality instruments, such as U.S. Treasuries, that can be used as collateral to meet their financial obligations as they arise. For this reason, the CSE program required stress testing of liquidity and substantial liquidity pools at the holding company to allow firms to continue to operate normally in stressed market environments. But what the CSE regulatory approach did not anticipate was the possibility that secured funding, even that funding backed by high-quality collateral, such as U.S. Treasury and agency securities, would become unavailable. Thus, one lesson of the SEC's oversight of CSEs, Bear Stearns in particular, is that no parent company liquidity pool can withstand a run on the bank. Such a liquidity pool would not suffice in an extended financial crisis of the magnitude we are now experiencing. In addition, these liquidity constraints are exacerbated when clearing agencies' sizable amounts of capital for clearing deposits to protect themselves against intraday exposures to the firm. Another lesson relates to the need for supervisory focus on the concentration of illiquid assets held by financial firms, particularly in entities other than a U.S.-registered broker-dealer. Such monitoring is relatively straightforward with larger U.S. broker-dealers, which must disclose illiquid assets on a monthly basis in financial reports that are filed with their regulators. For the consolidated entities, supervisors must be well acquainted with the quality of assets on a group-wide basis and monitor the amount of illiquid assets and drill down on their relative quality. Leverage tests are not accurate measures of financial strength for investment banks, in particular due to their sizable matchbook or derivatives business. Leverage tests do not account for the quality or liquidity of assets. Rather, they rely on overly simplistic measures of risk, such as leverage ratios. Regulators of financial firms have gone to a great deal of effort to develop and continue to refine capital rules that are risk sensitive and act as limiters on the amount of risk that can be taken by a firm. Finally, any regulator must have the ability to get information about the holding company and other affiliates, particularly about issues and transactions that impact capital and liquidity. As we have witnessed with Lehman Brothers, the bankruptcy filing of a material affiliate had a cascading effect that can bring down the other entities in the group. For these reasons and to protect the broker and its customer assets, the SEC would want not only to be consulted before any such liquidity drain occurs at the parent, but to have a say, likely in coordination with other interested regulators, in the risk, capital, and liquidity standards that the holding company must maintain. Our experience last year with the failure of Lehman's U.K. broker and the fact that the U.S.-registered broker-dealers were well capitalized and liquid throughout the turmoil has redoubled our belief that we must rely on and protect going forward the soundness and the regulatory regime of the principal subsidiaries. Thank you for this opportunity to discuss these important issues and I am happy to take your questions. Senator Reed. Thank you very much. Senator Bunning had to step out. He will rejoin us for his questioning, but let me begin. I want to address a question to all the regulators. first, let me say that I thought the GAO did a very responsible and thorough examination. Thank you and your colleagues Ms. Williams. But the basic questions are, and I will begin with Mr. Cole, just as you happen to be sitting next to Ms. Williams, but when did you first institutionally become aware of the significance of the risk difficulties in your supervised entities, and how did you communicate these concerns both to your supervisors, to your fellow regulators, and to a broader audience, and when did that communication become public? Mr. Cole? " CHRG-111shrg56262--5 Chairman Reed," Thank you very much. Now let me introduce our witnesses. Our first witness is Professor Patricia A. McCoy, the Director of the Insurance Law Center and the George J. and Helen M. England Professor of Law at the University of Connecticut Law School. Professor McCoy specializes in financial services law and market conduct regulation. Prior to her current role, Professor McCoy was a partner in the law firm of Mayer Brown in Washington, DC, and specialized in complex financial services and commercial litigation. Thank you, Professor McCoy. Our next witness is Mr. George P. Miller. Mr. Miller is the Executive Director of the American Securitization Forum, an association representing securitization market participants including insurers, investors, and rating agencies. Mr. Miller previously served as Deputy General Counsel of the Bond Market Association, now SIFMA, where he was responsible for securitization market advocacy initiatives. Prior to that, he was an attorney in the corporate department at Sidley, Austin, Brown & Wood, where he specialized in structured financial transactions, representing both issuers and underwriters of mortgage and asset-backed securities. Thank you, Mr. Miller. Mr. Andrew Davidson is the President of Andrew Davidson & Company, a New York firm which he founded in 1992 to specialize in the application of analytical tools to mortgage-backed securities. He is also a former managing director in charge of mortgage research at Merrill Lynch. Mr. Christopher Hoeffel is an Executive Committee member of the Commercial Mortgage Securities Association, the trade association representing the commercial real estate capital market finance industry. Mr. Hoeffel is also the Managing Director of the investment management firm Investcorp International, responsible for sourcing, structuring, financing, underwriting, and closing new debt investments for the group. Mr. Hoeffel joined Investcorp from JPMorgan Bear Stearns where he was a senior managing director and global cohead of commercial mortgages. Our final witness is Dr. William Irving, a portfolio manager for Fidelity Investments. Dr. Irving manages a number of Fidelity's funds, including its mortgage-backed security Central Fund, Government Income Fund, and Ginnie Mae Fund. Prior to joining Fidelity, Dr. Irving was a senior member of the technical staff at Alpha Tech in Burlington, Massachusetts, from 1995 to 1999 and was a member of the technical staff at MIT Lincoln Laboratory in Lexington, Massachusetts, from 1987 to 1995. Welcome, all of you. Professor McCoy, would you please begin?STATEMENT OF PATRICIA A. McCOY, GEORGE J. AND HELEN M. ENGLAND FOMC20070321meeting--290 288,MS. JOHNSON.," Well, it is complex. I would say “yes.” There are three things. First, people find the statement Rube Goldberg-ish. It just seems odd to say that it is less than 2 percent but close somehow, right? If you mean 1.9 percent, why don’t you say 1.9? Certainly criticism is directed there especially. Second, the fact is that the ECB hasn’t achieved it. On this back page, if you look at their 2 percent line, you’ll see that very seldom do they ever achieve it. That hasn’t helped the communication piece. Third, in general the ECB had communication problems. I can’t sort out those three, but I would say that my sense is that most people still see expressing it that way as a weak point." CHRG-111shrg53176--136 Mr. Baker," Thank you, Senator. It is a tremendously difficult question in that if you would go back in time, perhaps 24 months, and look at market conditions and the tremendous profitability that had existed for some number of years, and the expectation by many that it would continue into the foreseeable future, there was at the same time columns of regulatory authority that were constructed. Within each column, there may have been particular skill sets which could have been deployed, but because of the lack of information flows between those columns, complex instruments were created that did not fit neatly within a column and remained outside the transparency required for someone to make an informed decision. I would say that there were people in the market who exercised analytical skills and who did, in fact, predict that some of these very unfortunate circumstances possibly would occur. They, for the most part, were in the private sector, who were skilled analysts looking at the financial bubble that was growing in significant size. How we could construct a new systemic regulatory structure and enable a single person to be able to see the entire view of the market and come to an appropriate and timely decision would probably be almost impossible. Having an organization of some sort--there has been discussion this morning as to concerns about the SEC, the Federal Reserve, the existing entities. But I think we should be cognizant of the fact that none of those entities had access to the level of transparency that would have enabled them to make that collective, almost omniscient, insight into the coming storm. So I believe that, as we suggested in our testimony, the construction of a regulatory entity--I have been very careful not to say a particular agency--that has access to market information in a timely manner, while at the same time protecting the privacy of that disclosure by the registered entity, would perhaps--I am not sure it would guarantee--enable that entity to be able to take steps early on and perhaps limit the scale and scope of damage. Certainly, we would like to be a participant in that discussion going forward. We have specific ideas at the appropriate time that may be appropriate to consider. But we recognize that it is a very difficult problem. I am glad you are where you are, Senator, and I am glad I do not have that decision any longer. Senator Akaka. Thank you very much, Representative Baker. I want to direct my next question to Mr. Stack. In our last hearing on securities regulation, Thomas Doe, a former member of your board, stated, and I am quoting, that ``the 34-year era of the municipal industry self-regulation must come to an end.'' In advocating this position, Mr. Doe emphasized that MSRB structure, two-thirds of which is comprised of either bank dealers or securities dealers, has led to a situation of industry capture, where the issuers and other writers are then responsible for regulating their own conduct. What is your evaluation of these comments? " fcic_final_report_full--201 THE MADNESS CONTENTS CDO managers: “We are not a rent-a-manager” .............................................  Credit default swaps: “Dumb question” .............................................................  Citigroup: “I do not believe we were powerless” .................................................  AIG: “I’m not getting paid enough to stand on these tracks” .............................  Merrill: “Whatever it takes” ..............................................................................  Regulators: “Are undue concentrations of risk developing?” ..............................  Moody’s: “It was all about revenue” ...................................................................  The collateralized debt obligation machine could have sputtered to a natural end by the spring of . Housing prices peaked, and AIG started to slow down its business of insuring subprime-mortgage CDOs. But it turned out that Wall Street didn’t need its golden goose any more. Securities firms were starting to take on a significant share of the risks from their own deals, without AIG as the ultimate bearer of the risk of losses on super-senior CDO tranches. The machine kept humming throughout  and into . “That just seemed kind of odd, given everything we had seen and what we had concluded,” Gary Gorton, a Yale finance professor who had designed AIG’s model for analyzing its CDO positions, told the FCIC.  The CDO machine had become self-fueling. Senior executives—particularly at three of the leading promoters of CDOs, Citigroup, Merrill Lynch, and UBS— apparently did not accept or perhaps even understand the risks inherent in the products they were creating. More and more, the senior tranches were retained by the arranging securities firms, the mezzanine tranches were bought by other CDOs, and the equity tranches were bought by hedge funds that were often engaged in complex trading strategies: they made money when the CDOs performed, but could also make money if the market crashed. These factors helped keep the mortgage market going long after house prices had begun to fall and created massive expo- sures on the books of large financial institutions—exposures that would ultimately bring many of them to the brink of failure. The subprime mortgage securitization pioneer Lewis Ranieri called the willing suspension of prudent standards “the madness.” He told the FCIC, “You had the  breakdown of the standards, . . . because you break down the checks and balances that normally would have stopped them.”  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.] " FinancialCrisisReport--325 Over time, investment banks have devised, marketed, and sold increasingly complex financial instruments to investors, often referred to as “structured finance” products. These products include residential mortgage backed securities (RMBS), collateralized debt obligations (CDOs), and credit default swaps (CDS), including CDS contracts linked to the ABX Index, all of which played a central role in the financial crisis. RMBS and CDO Securities. RMBS and CDO securities are two common types of structured finance products. RMBS securities contain pools of mortgage loans, while CDOs contain or reference pools of RMBS securities and other assets. RMBS concentrate risk by including thousands of subprime and other high risk home loans, with similar characteristics and risks, in a single financial instrument. Mortgage related CDOs concentrate risk even more by including hundreds or thousands of RMBS securities, with similar characteristics and risks, in a single financial instrument. In addition, while some CDOs included only AAA rated RMBS securities, others known as “mezzanine” CDOs contained RMBS securities that carried the riskier BBB, BBB-, and even BB credit ratings and were more susceptible to losses if the underlying mortgages began to incur delinquencies or defaults. Some investment banks went a step farther and assembled CDO securities into pools and resecuritized them as so-called “CDO squared” instruments, which further concentrated the risk in the underlying CDOs. 1252 Some investment banks also assembled “synthetic CDOs,” which did not contain any actual RMBS securities or other assets, but merely referenced them. Some devised “hybrid CDOs,” which contained a mix of cash and synthetic assets. The securitization process generated billions of dollars in funds that allowed investment banks to supply financing to lenders to issue still more high risk mortgages and securities, which investment banks and others then sold or securitized in exchange for still more fees. This cycle was repeated again and again, introducing more and more risk to a wider and wider range of investors. Credit Default Swaps. Some investment banks modified still another structured finance product, a derivative known as a credit default swap (CDS), for use in the mortgage market. Much like an insurance contract, a CDS is a contract between two parties in which one party guarantees payment to the other if the assets referenced in the contract lose value or experience a negative credit event. The party selling the insurance is referred to as the “long” party, since it profits if the referenced asset performs well. The party buying the insurance protection is referred to as the “short” party, because it profits if the referenced asset performs poorly. 3 (suitability obligation to institutional customers). 1252 CDO squared transactions will generally be referred to in this Report as “CDO 2 . ” Some Goldman materials also use the term “CDO^2. ” CHRG-111hhrg51591--105 Mr. Webel," You know, we can't insure the future. But in looking--I have specifically in the past looked at the securities lending aspect of AIG, and into the sort of other insurance companies and what their securities lendings look like. And from what I have found, there wasn't anybody else who was approaching it nearly to the level that AIG did. And this was definitely a big way that they failed. So it doesn't look like this explosive failure is coming from that direction. Ms. Guinn. I would agree with Mr. Webel that in terms of participation in the credit default swap market and securities lending, coupled with the scope of AIG's operations, the complexity of it, the number of coverages it wrote, the number of legal entities, it is pretty unique in the industry. That is if there are other large companies and each company bears its own risks. So if there were--you know, the big quake came to California tomorrow, could other insurance companies, perhaps large ones, be impacted-- " CHRG-111shrg54789--189 RESPONSES TO WRITTEN QUESTIONS OF CHAIRMAN DODD FROM TRAVIS B. PLUNKETTQ.1. Both Mr. Yingling and Mr. Wallison testified repeatedly that the Administration's plan would result in credit being rationed to consumers, particularly consumers who need the credit the most. They also argued that the requirement that additional disclosures or warnings accompany products that are not ``plain-vanilla'' products would result in only those standard products being offered. Specifically, Mr. Wallison testified that `` . . . when a provider is confronted with the choice of whether to offer only the plain-vanilla product or the more complex product, he has to decide whether this particular consumer is going to be able to understand the product.'' Because lenders will be reluctant to make such judgments, they will, by default, offer the plain-vanilla product only, thereby constraining consumer choices. How do you respond to these arguments?A.1. Poor regulation of abusive credit products by Federal regulators over many years has led to exactly the result that Mr. Yingling and Mr. Wallison are concerned about: credit rationing. Deceptive and unsustainable lending practices by credit card companies and mortgage lenders led to record defaults and foreclosures by consumers, record losses by lenders, a crisis in the housing markets and the recession. These developments, in turn, have led to a ``credit crunch'' where credit card lenders, for example, have significantly reduced credit lines and sharply increase interest rates, even for borrowers with stellar credit scores. Had a Consumer Financial Protection Agency existed to prevent the excesses that occurred in the lending markets, there is a very good chance that this country could have avoided the worst aspects of the housing and economic crisis, and of the somewhat indiscriminate reduction in credit availability that has occurred. In other words, proper regulation will create the kind of stability in the credit markets that encourages lenders to offer credit to consumers, especially those who do not have perfect credit ratings. Similarly, the ``plain-vanilla'' requirement is designed to create choices in the credit marketplace that don't exist now, and certainly did not exist during the credit boom. ``Choices,'' such as prepayment penalties that lock consumers into unaffordable loans and ``exploding ARM'' loans that lenders knew many of their borrowers could not afford, crowded out less abusive options from the marketplace and ultimately harmed consumers and the economy. Lenders are quite capable of designing simple, understandable financial products that are profitable for them and useful for consumers, if they chose to do so." CHRG-110hhrg41184--35 Mr. Bernanke," Well, Congressman, as I mentioned in my testimony, the subprime problem was a trigger for all this, but there were other things that then began to kick in, including a pull-back from risk taking, concerns about valuation of these complex products, issues about liquidity and so on which, as you say, caused the problem to spread throughout the system. Right now, we are looking at solutions. The Federal Reserve, for example, is engaging in this lending process trying to reduce the pressure in the short-term money markets. I think, very importantly, the private sector has a role to play. I would encourage, for example, banks to continue to raise capital so they would be well able to continue to lend. They also need to increase transparency, to provide more information to the markets so the market could begin to understand what these assets are and what the balance sheets look like. " CHRG-111hhrg48875--191 Mr. Royce," And of course, the one thing the economists have really been fretting about in terms of the scheme is all of the moral hazard that goes with it, the overleveraging that could occur, all the borrowing that would be presumed in the market that any large institution could suddenly obtain because the concept would be, hey, at the end of the day, this is going to, you know, be under the auspices of this systemic risk regulator. And so at the end of the day, part of our investment here is going to be guaranteed, or our loan. And so they are going to be borrowing at a lower rate. They are not going to have the market discipline, as you said. They are going to be overleveraging. So it makes things more complex. Let's take GE, you know, GE Capital, if you have a problem. They own NBC, CNBC, MSNBC. Just to discuss for a minute the consequences of this becoming a political issue over at Treasury, and now you do have this power. You have this power over any large firm. You have this permanent TARP authority. How do you handle--have you thought through how you handle these decisions should this arise? " CHRG-111hhrg55811--22 Mr. Hu," Thank you, Mr. Chairman. Chairman Frank, Ranking Member Bachus, and members of the committee, thank you for the opportunity to testify on behalf of the Securities and Exchange Commission concerning the Over-the-Counter Derivatives Markets Act of 2009 proposed in August by the Treasury Department, and the discussion draft recently circulated by the chairman. I am especially pleased to appear with CFTC Chairman Gary Gensler, with whom the SEC has worked closely over the last several months on a variety of issues. Both of our Commissions are eager to address these issues and ensure that remaining differences are justified by meaningful distinctions between markets and products. As you know, the recent financial crisis revealed serious weaknesses in the U.S. financial regulation, including gaps in the regulatory structure. Both the SEC and the CFTC are fully committed to filling gaps and shoring-up the regulatory system. One significant gap is the lack of regulation of OTC derivatives, which were largely excluded from the regulatory framework in 2000 by the Commodity Futures Modernization Act. OTC derivatives present a number of risks. They can facilitate significant leverage, enable concentrations of risk, and behave unexpectedly in times of crisis. And while some derivatives can reduce certain risks, they can also cause others. Importantly, these risks are heightened by the lack of regulatory oversight of dealers and other market participants--a combination that can lead to insufficient capital, inadequate risk management standards, and associated failures cascading through the global financial system. Lastly, the largely unregulated derivatives market can also undermine the regulated securities and futures markets by luring participants to a less-regulated alternative. The discussion draft is an important step forward in improving transparency and establishing the necessary regulatory framework. While it would go a long way towards improving the regulation of OTC derivatives, I believe it should be strengthened in several ways. First, to minimize regulation arbitrage, swaps should be regulated like their underlying references. Market participants often view derivatives and the underlying assets they reference as substitutes. Whether the participation is direct or indirect, the same or similar economic effects can often be achieved. As a result, even subtle differences in the regulation of economic substitutes can lead to gaming advantages for any one participant. But that participant's regulatory arbitrage activity, and a general migration to the less-regulated derivatives markets, can undermine the interest of other participants, as well as everyone's interest in minimizing fraud and systemic risk. The easiest way to achieve this goal is to move over the existing securities regime to securities-related swaps. If Congress decides to retain the bill's existing rulemaking framework, it should include these swaps within the definition of securities within the Federal securities laws. This will ensure that existing protections and authority can automatically flow through to these products. Exemptions could be provided where needed. I believe it is better to start from an existing framework for substantially similar products than to start from scratch not knowing what might be missed in some cross reference, not knowing what future financial innovation may bring. Second, it is essential that the legislation address anti-fraud authority matters and provide the tools needed to appropriately enforce anti-fraud authority. The discussion draft seeks to retain certain existing anti-fraud authority over, for instance, certain broad-based swaps, but may have inadvertently weakened that authority over certain other related swaps. The SEC should also have the tools needed to effectively exercise the anti-fraud authority. The discussion draft recognizes the importance of inspections and examinations of swap dealers and major participants to the SEC. We recommend that this authority be extended to central counterparties and swap repositories, so that regulators can have quick access to comprehensive data. Third, the discussion draft should clarify that the definition of ``securities-based swap'' includes not only single and narrow-based credit default swaps but broad-based credit default swaps where payment is triggered by a single security or small group of securities. Fourth, the legislation should narrow the ``risk management'' exclusion for major swap participants. Regulation of major swap participants and dealers is a vital part of the OTC regulatory regime. We do understand that there may be entities that use swaps that should not fall into this new framework. The discussion draft, however, effectively provides an exclusion for major participants who hold positions, ``for risk management purposes.'' The term ``risk management'' is ambiguous and could cause a large number of important entities to fall outside this new regime. Finally, the legislation should direct regulators to adopt stronger business conduct rules to protect less sophisticated investors and end-users. In closing, this proposal makes significant strides towards addressing current problems in the OTC derivatives marketplace. I look forward to continuing to work with this committee, the Congress, the Treasury, and the CFTC to enact strong legislation in this area. Thank you for the opportunity to testify here today. I look forward to answering your questions. [The prepared statement of Mr. Hu can be found on page 147 of the appendix.] " CHRG-111shrg49488--13 Mr. Carmichael," Thank you, Chairman, and let me say what a pleasure it is to be here.--------------------------------------------------------------------------- \1\ The prepared statement of Mr. Carmichael appears in the Appendix on page 318.--------------------------------------------------------------------------- Our government implemented a new structure in the middle of 1998. Unlike the experience that Mr. Green just referred to where the United Kingdom Government did it very quickly, ours was the outcome of a committee that sat for almost 12 months looking at the options, and it was a great privilege for me to have been a member of that committee. The new structure that was put in place realigned a previous structure a little bit like your own. It was an institutionally based structure. It was a hybrid structure of bits and pieces. We had State regulation as well as Federal regulation. What came out of the reorganization is what has become known as an ``objectives-based'' or a twin peaks type model. We do not like the term twin peaks because we actually have four peaks, so we think that is undercounting. But the four agencies that were put in place were: First, a competition regulator that sat over the entire system, not only the financial sector but the whole economy; Second, a securities and investments commission, think of a combination of your SEC and the futures regulator. They had responsibility across all financial sectors for conduct, including financial institutions, markets, and participants; The third was the Australian Prudential Regulation Authority (APRA), the one with which I was involved. We had responsibility for the prudential soundness of all deposit taking, insurance, and pensions; And the fourth was the central bank, which was given, of course, systemic responsibility for monetary policy, liquidity support, and regulation of the payment system. Over the top of that was a coordinating body, called the Council of Financial Regulators, which includes the Department of Treasury as well, and that is a very important add-on. The defining characteristic of this architecture--and I should add this is in some ways very similar to your plan that was proposed by Former Treasury Secretary Henry Paulson earlier in 2008, but with a couple of important differences, which we can talk about later--is that it was unique in the world at the time it was put in place in Australia, and so far as we know, only one country--and that is the Netherlands--would claim to have the same structure in totality. The Canadian structure is similar, but a little bit less consistent. The Australian banks under this structure, for example, are subject to all four regulators. They have competition covered by the Australian Competition and Consumer Commission (ACCC), their conduct by the Australian Securities and Investments Commission (ASIC), their prudence by APRA, and if there is a liquidity support or payment system issue, they go to the Reserve Bank. So that is the defining characteristic of this model, that multiple agencies are responsible for each institution, but for a different part of their behavior or their activities. And there is a fairly clear dividing line between those activities. Some of the advantages that we see in this structure--and some of these, of course, are shared by other models such as the British one--include: First, by assigning each regulatory agency to a single objective--that is either competition or prudence--it avoids the conflict of objectives that you face under virtually any other system. So each regulator has just one thing to worry about, and that avoids getting into some of the issues, for example, that Northern Rock brought out, for the FSA. Second, in bringing all regulators of a particular objective together, you get synergies. We learned a lot when we brought banking and insurance regulation together, and we were able to develop an approach that took on the best of both of those systems and to develop synergies out of that. Likewise, ASIC, our conduct regulator, was one of the first in the world to introduce a single licensing regime for market participants. Third, this structure helped eliminate regulatory arbitrage or jurisdiction shopping of the type that you have seen here. Prior to the creation of APRA there were at least three different types of institutions that could issue deposits in Australia, and they were subject to nine different regulatory agencies, depending on where they were located. Following its creation, APRA introduced a fully harmonized regime. We now have a single class of ``deposit-taking institutions.'' We do not distinguish between banks, credit unions, or thrifts. They can take on that separate identity, but they are all regulated as deposit takers. Fourth, by bringing together all of the prudentially regulated institutions under the one regulatory roof, we have a more consistent and effective approach to regulating financial conglomerates, and along with countries like the United Kingdom and Canada, Australia has been at the forefront of developing the approach to conglomerate supervision. Fifth, allocating a single objective to each regulator minimizes the overlap between agencies and the inevitable turf wars that are associated with that, which I am sure you are very familiar with. Interesting for us in our experience was that the gray areas between the agencies have tended to diminish over time rather than to increase, and I think that has been a little bit of a surprise, but a very welcome surprise to those of us who were involved with the design. Sixth, the allocation of a single objective to each agency minimizes cultural clashes, and one of the issues that we were very conscious of in creating the distinction between prudential and conduct regulation was that, while conduct regulation tends to be carried out by lawyers, prudential regulation tends to be carried out in general by accountants and finance and economics experts--with the exception of the United States, where lawyers tend to do it all. So, culturally, we found it was very useful to separate these two types of regulators so that we did not have those cultural battles. Finally, by streamlining our old state-based, or partly state-based, regulatory system, we got a lot of cost efficiencies out of it, and we were able to facilitate strong financial sector development and innovation without having to reduce safety and soundness in the process. In terms of outcomes, our architecture has weathered the recent financial storm better than most. Indeed, I believe our four major banks are still among the few AA-rated banks left in the world. The resilience of our system was helped by exceptionally tough prudential standards, particularly in the areas of capital and securitization. There was also inevitably some good luck as well as good management. I am not going to claim it was all brilliance. In terms of crisis management, the coordination arrangements worked exceptionally well and, I am told, in speaking with each of the agencies recently, that they found the singularity of objectives helped them enormously in terms of coordination among the different agencies in the crisis. On the less positive side, like everyone else, we have learned that regulators and industry know much less about risk than we thought we did. We have had to think about the way risk is measured and regulated. Most importantly, we have learned that financial stability regulation is a much bigger challenge than we thought it was, and there is a lot still to be learned there. And to borrow the Churchillian phrase, we regulators have learned that ``we have much about which to be modest.'' In concluding, Mr. Chairman, I would like to offer two very general observations. The first echoes a point you made in your opening statement. There can be little dispute that regulatory architecture matters. It is very important. There is no perfect architecture. There is no one size fits all. But there are certainly some architectures that are virtually guaranteed to fail under sufficient pressure. That said, architecture is only half the story. A sound architecture is a necessary but not a sufficient condition for effective regulation. The other component, which you mentioned, is how you implement and enforce those regulations, and it is very important that these two components are considered in tandem and not in isolation. Finally, it is easier to tinker with the architecture than to do major reform. Major reform is largely about opportunity. The window for reform is usually only open very briefly. You have, arguably, the widest window for reform since the Great Depression. This crisis provides you with the public support and, I believe, the industry acquiescence to challenge the vested interests and inertia that normally make major reform of the type you have seen in some other countries all but impossible. And I am sure I speak for many of my colleagues in the international regulatory community, in hoping that this opportunity is not lost. Thank you. " CHRG-111shrg55739--64 Mr. Barr," Senator, you know, you will not be surprised to learn that in Treasury, as occasionally up on the Hill, there is some colorful language that is sometimes used. Senator Bunning. I have been accused of that. I understand that completely. OK. Let us get to the current thing. Everybody agrees that the current rating agency model has failed--I think everybody up here does--especially for complex structure products. There also seems to be agreement that better competition will improve ratings. How we get better competition is a little more difficult question, but we must break the hold of the top two or three agencies if we are going to fix the ratings. It seems to me that there are two changes that will go a long way to fixing the competition problem. First, we should eliminate any regulatory requirements to use rating agencies so that they will only be used if they add value. Second, we should require issuers to provide the same information about the securities to all investors and rating agencies, much like we do for publicly traded companies with regulatory FD. That way each agency will be able to compete based on the quality of their ratings, and we will break the monopoly of the issuer-pay model. Let me start first with the first point, that we should eliminate all requirements to use rating agencies. Do you agree with that or not? " CHRG-111hhrg51698--134 Mr. Cota," Congressman Thompson, you also asked the question about how much liquidity is liquidity. Talking about very dull commodities like energy, the heating oil market is about 8 billion gallons per year in the United States, 7 or 8 billion gallons. That amount in regulated U.S. exchanges is traded multiple times per day. There is no lack of liquidity in those markets. Now, it is a little bit more complex than that, because those trades also trade other types of commodities, but there continue to be huge amounts of commodities in these markets. The only time that they seem to be illiquid is when you have extreme volatility within these markets, and the last remaining portion of the floor-traded aspects, which are purely floor traded, are options trade. Options trading, because of the volatility, did dry up, and to me that meant that there was too much volatility in the markets because too much money was coming in and coming out. So I kind of argue the other side of that. " CHRG-110hhrg44900--164 Mr. Bernanke," What distinguishes the situation today from where it was before Bear Stearns is we have taken additional steps to try to prevent such a contingency in the first place. So, in particular, in conjunction with the SEC, we have pushed the investment banks to increase their capital and particularly liquidity, which they have been doing. We have opened up the window to provide a backstop source of liquidity so that reduces the chance of a run. So those things, I hope and expect, will make this contingency much less likely, and should it arise, we would have to deal with it in real time with what tools we have. With respect to timeframe, you know, again, it's really Congress's judgment about what is possible and in what period of time, if there is an appetite in Congress to work in some of the things for example that we have outlined in our various proposals. I'm sure we will be more than happy to facilitate that in any way possible, but it has just been our sense that given the complexity of these issues, it's probably going to take longer rather than what could be done in this year. " CHRG-110shrg38109--143 Chairman Bernanke," The general principle I was trying to address was the insecurity the people feel about job loss and job change. And I think it would be beneficial if we could reduce that insecurity. One way to do that would be to increase portability of benefits across jobs. There are many ways to do that, so I am not taking a specific means. Wage insurance is an interesting idea that has been advocated by a number of economists. Again, I am not sure I can take a specific position on it. One of the things I said, and I should reiterate, is that it is easy enough for me to say we should address these issues. The actual implementation is quite difficult. These are very complex problems. I just urge Congress to look at them and try to get as much good input and advice as they can in thinking about how to best address these issues. Senator Reed. A final issue, which is the Earned Income Tax Credit, which seems to me to be a very efficient way to deal with this issue that has been the constant source of our discussions this morning, inequality of wages, inequality of opportunity. Is that something that we should be looking at seriously, to expand it? " FOMC20080805meeting--134 132,MR. WARSH.," Thank you, Mr. Chairman. I have no material changes to report in my view on the overall state of financial stability, growth, or inflation; but as I talked about at the last meeting, it still is likely to be a long, hot summer, and we're only about half over with it. I'll talk first about financial institutions--make maybe four or five points--and then turn quickly to the economy and inflation. First, on financial institutions, I think the body blow that the financial markets and the real economy have taken because of the turmoil at the GSEs is not complete. It is easy for those of us in Washington to forget that bill signings don't always solve problems. I'd say, if the last thing that happens on GSEs is that the bill was signed two weeks ago and action isn't taken in the coming weeks and months, then I would be surprised if we could get through this period without more GSE turmoil finding its way onto the front pages. Second, in terms of financial market conditions, the fall in oil prices and the rest of the energy complex is, indeed, good news, but it strikes me that it has camouflaged an even tougher period for financial institutions than would otherwise be the case. That is, financial institutions somehow look a little more resilient, but I think part of that is only because of the negative correlation that's developed in recent times between equity prices of financials and oil prices. The financial institutions themselves strike me as being in worse condition than market prices would suggest. Third, capital raising, as we have long talked about, is essential to the fix among financial institutions. The way I best describe capital raising over maybe the last nine months is that the first round of capital raising, which was in November and December, was really the vanity round. This consisted of very limited due diligence, sovereign wealth funds signing up, issuers relying upon their vaunted global brands, and capital being raised in a matter of days. The second round probably took us to the spring, a round that I'd call the confessional round. [Laughter] In this round, financial institutions said, ""Oh my, look at these real write-downs that I have. Look at the need for this real capital raising, and here I'm telling you, the investors, all that I know."" But the second and third confessions usually have less credibility than the first. The third round is the round that we're in the middle of, which I think of as the liquidation and recap round, likely to be the hardest round to pull off. It is likely to force issuers of new shares or of new forms of preferred stock to be asking of themselves and their investors the toughest choices. They have to assess the strength and durability of their core franchises. I think that this will be happening in very real time. So the circumstance of an investment bank that Bill mentioned at the outset I don't think will be the sole case of this. This liquidation and recap round is later than would be ideal from the perspective of the broader economy, but it is absolutely needed. Until we see how it occurs, it's hard for me to be much more sanguine that the capital markets or the credit markets will be returning to anything like normal anytime soon. Let me make a fourth broad point about financial institutions. Because of these different phases of capital raise, I think management credibility among financial institutions is at least as suspect as it has ever been during this period. Even new management teams that have come in have in some ways used up a lot of their credibility. It would be nice to believe that they have taken all actions necessary to protect their franchises and their businesses, but most stakeholders are skeptical that they've taken significant or sufficient action. At the end of the day, no matter where policy comes out in terms of regulatory policy from the Fed and other bank regulators or accounting policy from the SEC or FASB, it strikes me that those changes in policy are less determinative of how things shake out. That is, management credibility is so in question that the cure is not likely to come from accounting rules or regulators but from the markets' believing that what management says is what management believes and will act on it. As a result, I think that many of these financial institutions are operating in a zero-defect world, which is posing risks to the real economy. Fifth, let me make a final point about financials. We've all talked a lot about the effect of different curves for housing prices on the financial institutions themselves. I don't mean to give short shrift to any of that, but I would say that the level of uncertainty and associated risks of their non-housing-related assets are now very much a focus. According to July 2008 data, of credit currently being extended by banks, only about 20 percent is for residential real estate. Only about 9 percent is for consumer credit. So that leaves the balance in areas where these financial institutions and their management teams have to be asking themselves whether the weaknesses that are emerging in the real economy will place uncertainty over assets that have nothing to do with housing. That's a major downside risk for financial institutions and has not been much of a focus of shareholder and stakeholder concerns. There are two open issues that will guide some of our thinking, at least with respect to these credit markets. First, as we talked about a little last night with the presidents, are the embedded losses so great at such a critical mass of institutions with management credibility so low that many more than currently expected might be unable to survive? This is a question that I'm not sure I know the answer to. Second, despite the concerns about the effect of the credit markets on the broader economy that I talked about, our monetary policy may not be terribly well suited to be fixing those problems, and financial institutions may not be terribly sensitive to the extent we decide that we should change the stance of policy. Taking all that into account, let me say a couple of words about growth and inflation. First, on the economic growth front, given my views of what's happening in the credit markets, it's very hard for me to believe that the economy will get back to potential anytime soon. There are continued financial stresses that could last through year-end, and in there could be an upside surprise. Still, all things considered, my base case has second-half growth still above staff estimates owing in part to the productivity we've seen in recent months and the remarkable resiliency of this economy. If we look beyond that horizon, though, toward the Greenbook forecast in 2009 and beyond, I must say I don't really see the inflection point to take us back to economic growth of 2.2 percent or whatever the Greenbook suggests. I think we're going to be in this period of belowtrend growth for quite some time. My own view is that, when the Congress comes back after its August recess, we will be in the middle of a big debate on ""Son of Stimulus"" and that the stimulus probabilities have moved up quite materially. However, it is not at all obvious to me that it will do much in terms of helping the real economy. Outside the United States, I share the view of Governor Kohn, which is that I'd expect global GDP, particularly GDP among advanced foreign economies, our major trading partners, to continue to disappoint, making the remarkable addition of net export growth to our own GDP likely to dissipate. Turning finally to inflation, my view is that inflation risks are very real, and I believe that these risks are higher than growth risks. I don't take that much comfort from the move in commodity prices since we last met. If that trend continues, then that would certainly be good news; but I must say I don't feel as though inflation risks have moved down noticeably since we last had this discussion. The staff expects food prices to continue to be challenging; that is certainly my view. The staff also expects core import prices to fall rather precipitously. I'm a little skeptical of that view. I think it's possible, but I don't really see the catalyst for that given what we see about changes in input prices overseas and given expectations of the dollar in foreign exchange markets. So with that, I think that the inflation risks are real, and I'll save the balance of my remarks for the next round. Thank you, Mr. Chairman. " CHRG-111shrg54675--88 Principles for Financial and Regulatory Reform 1. Responsibility: Financial Institutions must offer financial products and services that are appropriate and suitable to the needs and abilities of the consumers. Regulators must regulate financial institutions so as to ensure that they are providing access to responsible and fair credit and loans. 2. Accountability: Financial institutions must refrain from, and be held accountable for, offering harmful financial products and services and engaging in practices that harm individuals and communities. Regulators must be held to high standards for their regulation and oversight of financial institutions and accurately report to the public on a regular basis. Laws and regulations must provide strong enforcement mechanisms to ensure accountability and provide meaningful redress to those harmed by irresponsible actions of financial instructions. Regulators must vigorously enforce these laws and rules. Federal regulations must establish a minimum floor for consumer protections that may be exceeded by States and localities. 3. Transparency: Financial institutions must fully, fairly, and clearly disclose all costs, terms and risks of financial products and services and avoid or disclose any conflicts of interests with other financial institutions, actors, or regulators. Regulators must demand transparency from regulated institutions and be transparent about their role in regulating financial institutions. 4. Avoid conflicts of interest: Financial institutions must avoid all conflicts of interest with other financial players and regulators. Where potential conflicts are allowed, financial institutions must fully, fairly and clearly disclose the conflict to consumers and regulators. Regulators must be objective in their regulation and oversight of financial institutions, act in the public interest (not the interest of the financial institutions they regulate), and prohibit financial institutions from engaging in conflicts of interest. Regulatory policies and financial practices that create an inherent conflict of interest that could harm consumers or the economy must be prohibited or, at a minimum, closely regulated. 5. Avoid systemic risk: Financial institutions must not engage in practices that create unreasonable risk to the financial system. Regulators must provide comprehensive and effective regulation and oversight of financial institutions and activities that create systemic risk to individuals, communities and the economy. Policymakers and regulators must implement changes in their oversight policies based on the reality that financial institutions that are ``too-big-to-fail'' are too big to exist. 6. Equal access: Financial institutions must offer appropriate and suitable financial products and services to all persons and communities without regard to race, color, national origin, religion, gender, familial status, disability, or sexual orientation. Regulators must monitor whether all persons and communities have equal access to mainstream financial products and services and hold financial institutions accountable by vigorously enforcing nondiscrimination laws and rules. CHRG-111shrg51303--176 PREPARED STATEMENT OF SCOTT M. POLAKOFF Acting Director, Office of Thrift Supervision March 5, 2009 Good morning, Chairman Dodd, Ranking Member Shelby, and Members of the Committee. Thank you for inviting me to testify regarding the Office of Thrift Supervision's (OTS) examination and supervisory program and its oversight of American International Group, Inc. (AIG). I appreciate the opportunity to familiarize the Committee with the complex, international operations of AIG as well as the steps the OTS took to oversee the company. At the Committee's request, in my testimony today, I will discuss the complicated set of circumstances that led to the government intervention in AIG. I will provide details on our role as the consolidated supervisor of AIG, the nature and extent of AIG's operations, the risk exposure that it accepted, and the excessive concentration by one of its companies in particularly intricate, new, and unregulated financial instruments. I will also outline the Agency's supervisory and enforcement activities. I will describe some lessons learned from the rise and fall of AIG, and offer my opinion, in hindsight, on what we might have done differently. Finally, I will outline some needed changes that could prevent similar financial companies from repeating AIG's errors in managing its risk, as well as actions Congress might consider in the realm of regulatory reform.History of AIG AIG is a huge international conglomerate that operates in 130 countries worldwide. As of year-end 2007, the combined assets of the AIG group were $1 trillion. The AIG group's primary business is insurance. AIG's core business segments fall under four general categories (e.g., General Insurance, Life Insurance and Retirement Services, Financial Services, and Asset Management). AIG's core business of insurance is functionally regulated by various U.S. State regulators, with the lead role assumed by the New York and Pennsylvania Departments of Insurance, and by foreign regulators throughout the 130 countries in which AIG operates. My testimony will focus primarily on AIG, the holding company, and AIG Financial Products (AIGFP). Many of the initial problems in the AIG group were centered in AIGFP and AIG's Securities Lending Business. It is critically important to note that AIG's crisis was caused by liquidity problems, not capital inadequacy. AIG's liquidity was impaired as a result of two of AIG's business lines: (1) AIGFP's ``super senior'' credit default swaps (CDS) associated with collateralized debt obligations (CDO), backed primarily by U.S. subprime mortgage securities and (2) AIG's securities lending commitments. While much of AIG's liquidity problems were the result of the collateral call requirements on the CDS transactions, the cash requirements of the company's securities lending program also were a significant factor. AIG's securities lending activities began prior to 2000, Its securities lending portfolio is owned pro-rata by its participating, regulated insurance companies. At its highest point, the portfolio's $90 billion in assets comprised approximately 9 percent of the group's total assets. AIG Securities Lending Corp., a registered broker-dealer in the U.S., managed the much larger, domestic piece of the securities lending program as agent for the insurance companies in accordance with investment agreements approved by the insurance companies and their functional regulators. The securities lending program was designed to provide the opportunity to earn an incremental yield on the securities housed in the investment portfolios of AIG's insurance entities. These entities loaned their securities to various third parties, in return for cash collateral, most of which AIG was obligated to repay or roll over every two weeks, on average. While a typical securities lending program reinvests its cash in short duration investments, such as treasuries and commercial paper, AIG's insurance entities invested much of their cash collateral in AAA-rated residential mortgage-backed securities with longer durations. Similar to the declines in market value of AIGFP's credit default swaps, AIG's residential mortgage investments declined sharply with the turmoil in the housing and mortgage markets. Eventually, this created a tremendous shortfall in the program's assets relative to its liabilities. Requirements by the securities lending program's counterparties to meet margin requirements and return the cash AIG had received as collateral then placed tremendous stress on AIG's liquidity. AIGFP had been in operation since the early 1990s and operated independently from AIG's regulated insurance entities and insured depository institution. AIGFP's $100 billion in assets comprises approximately 10 percent of the AIG group's total assets of $1 trillion. AIGFP's CDS portfolio was largely originated in the 2003 to 2005 period and was facilitated by AIG's full and unconditional guarantee (extended to all AIGFP transactions since its creation), which enabled AIGFP to assume the AAA rating for market transactions and counterparty negotiations. AIGFP's CDS provide credit protection to counterparties on designated portfolios of loans or debt securities. AIGFP provided such credit protection on a ``second loss'' basis, under which it repeatedly reported and disclosed that its payment obligations would arise only after credit losses in the designated portfolio exceeded a specified threshold amount or level of ``first losses.'' Also known as ``super senior,'' AIGFP provided protection on the layer of credit risk senior to the AAA risk layer. The AIGFP CDS were on the safest portion of the security from a credit perspective. In fact, even today, there have not been credit losses on the AAA risk layer. AIGFP made an internal decision to stop origination of these derivatives in December 2005 based on their general observation that underwriting standards for mortgages backing securities were declining. At this time, however, AIGFP already had $80 billion of CDS commitments. The housing market began to unravel starting with subprime defaults in 2007, triggering a chain of events that eventually led to government intervention in AIG.OTS's Supervisory Role and ActionsSupervisory Responsibilities Mr. Chairman, I would like next to provide an overview of OTS' responsibilities in supervising a savings and loan holding company (SLHC). In doing so, I will describe many of the criticisms and corrective actions OTS directed to AIG management and its board of directors, especially after the most recent examinations conducted in 2005, 2006, and 2007. As you will see, our actions reveal a progressive level of severity in our supervisory criticism of AIG's corporate governance. OTS criticisms addressed AIG's risk management, corporate oversight, and financial reporting, culminating in the Supervisory Letter issued by OTS in March 2008, which downgraded AIG's examination rating. You will also see that where OTS fell short, as did others, was in the failure to recognize in time the extent of the liquidity risk to AIG of the ``super senior'' credit default swaps in AIGFP's portfolio. In hindsight, we focused too narrowly on the perceived creditworthiness of the underlying securities and did not sufficiently assess the susceptibility of highly illiquid, complex instruments (both CDS and CDOs) to downgrades in the ratings of the company or the underlying securities, and to declines in the market value of the securities. No one predicted, including OTS; the amount of funds that would be required to meet collateral calls and cash demands on the credit default swap transactions. In retrospect, if we had identified the absolute magnitude of AIGFP's CDS exposures as a liquidity risk, we could have requested that AIGFP reduce its exposure to this concentration. OTS' interaction with AIG began in 1999 when the conglomerate applied to form a Federal Savings Bank (FSB). AIG received approval in 2000, and the AIG FSB commenced operations on May 15, 2000. OTS is the consolidated supervisor of AIG, which is a savings and loan holding company by virtue of its ownership of AIG Federal Savings Bank. OTS supervises savings associations and their holding companies to maintain their safety, soundness, and compliance with consumer laws, and to encourage a competitive industry that meets America's financial services needs. As the primary Federal regulator of savings and loan holding companies, OTS has the authority to supervise and examine each holding company enterprise, but relies on the specific functional regulators for information and findings regarding the specific entity for which the functional regulator is responsible. Once created, a holding company is subject to ongoing monitoring and examination. Managerial resources, financial resources and future prospects continue to be evaluated through the CORE holding company examination components (i.e., Capital, Organizational Structure, Risk Management and Earnings). The OTS holding company examination assesses capital and earnings in relation to the unique organizational structure and risk profile of each holding company. During OTS's review of capital adequacy, OTS considers the risk inherent in an enterprise's activities and the ability of the enterprise's capital to absorb unanticipated losses, support the level and composition of the parent company's and subsidiaries' debt, and support business plans and strategies. The focus of this authority is the consolidated health and stability of the holding company enterprise and its effect on the subsidiary savings association. OTS oversees the enterprise to identify systemic issues or weaknesses, as well as ensure compliance with regulations that govern permissible activities and transactions. The examination goal is consistent across all types of holding company enterprises; however, the level of review and amount of resources needed to assess a complex structure such as AIG's is vastly deeper and more resource-intensive than what would be required for a less complex holding company.OTS Supervisory Actions OTS's approach to holding company supervision has continually evolved to address new developments in the financial services industry and supervisory best practices. At the time AIG became a savings and loan holding company in 2000, OTS focused primarily on the impact of the holding company enterprise on the subsidiary savings association. With the passage of Gramm-Leach-Bliley, not long before AIG became a savings and loan holding company, OTS recognized that large corporate enterprises, made up of a number of different companies or legal entities, were changing the way such enterprises operated and would need to be supervised. These companies, commonly called conglomerates, began operating differently from traditional holding companies and in a more integrated fashion, requiring a more enterprise-wide review of their operations. In short, these companies shifted from managing along legal entity lines to managing along functional lines. Consistent with changing business practices and how conglomerates then were managed, in late 2003 OTS embraced a more enterprise-wide approach to supervising conglomerates. This shift aligned well with core supervisory principles adopted by the Basel Committee and with requirements adopted by European Union (EU) regulators that took effect in 2005, which required supplemental regulatory supervision at the conglomerate level. OTS was recognized as an equivalent regulator for the purposes of AIG consolidated supervision within the EU, a process that was finalized with a determination of equivalence by the French regulator, Commission Bancaire. Under OTS's approach of classifying holding companies by complexity, as well as the EU's definition of a financial conglomerate, AIG was supervised, and assessed, as a conglomerate. OTS exercises its supervisory responsibilities with respect to complex holding companies by communicating with other functional regulators and supervisors who share jurisdiction over portions of these entities and through our own set of specialized procedures. With respect to communication, OTS is committed to the framework of functional supervision Congress established in Gramm-Leach-Bliley. Under Gramm-Leach-Bliley, the consolidated supervisors are required to consult on an ongoing basis with other functional regulators to ensure those findings and competencies are appropriately integrated into our own assessment of the consolidated enterprise and, by extension, the insured depository institution we regulate. Consistent with this commitment and as part of its comprehensive, consolidated supervisory program for AIG, OTS began in 2005 to convene annual supervisory college meetings. Key foreign supervisory agencies, as well as U.S. State insurance regulators, participated in these conferences. During the part of the meetings devoted to presentations from the company, supervisors have an opportunity to question the company about any supervisory or risk issues. Approximately 85 percent of AIG, as measured by allocated capital, is contained within entities regulated or licensed by other supervisors. Another part of the meeting includes a ``supervisors-only'' session, which provides a venue for participants to ask questions of each other and to discuss issues of common concern regarding AIG. OTS also uses the occasion of the college meetings to arrange one-on-one side meetings with foreign regulators to discuss in more depth significant risk in their home jurisdictions. As OTS began its early supervision of AIG as a conglomerate, our first step was to better understand its organizational structure and to identify the interested regulators throughout the world. In this regard, AIG had a multitude of regulators in over 100 countries involved in supervising pieces of the AIG corporate family. OTS established relationships with these regulators, executed information sharing agreements where appropriate, and obtained these regulators' assessments and concerns for the segment of the organization regulated. As OTS gained experience supervising AIG and other conglomerates, we recognized that a dedicated examination team and continuous onsite presence was essential to overseeing the dynamic and often fast-paced changes that occur in these complex structures. In 2006, OTS formally adopted a risk-focused continuous supervision program for the oversight of large and complex holding companies. This program combines on- and off-site planning, monitoring, communication, and analysis into an ongoing examination process. OTS's continuous supervision and examination program comprises development and maintenance of a comprehensive risk assessment, which consists of: an annual supervisory plan; risk-focused targeted reviews; coordination with other domestic and foreign regulators; an annual examination process and reporting framework; routine management meetings; and an annual board of directors meeting. OTS conducted continuous consolidated supervision of the AIG group, including an onsite examination team at AIG headquarters in New York. Through frequent, ongoing dialogue with company management, OTS maintained a contemporaneous understanding of all material parts of the AIG group, including their domestic and cross-border operations. OTS's primary point of contact with the holding company was through AIG departments that dealt with corporate control functions, such as Enterprise Risk Management (ERM), Internal Audit, Legal/Compliance, Comptroller, and Treasury. OTS held monthly meetings with AIG's Regulatory and Compliance Group, Internal Audit Director, and external auditors. In addition, OTS held quarterly meetings with the Chief Risk Officer, the Treasury Group, and senior management, and annually with the board of directors. OTS reviewed and monitored risk concentrations, intra-group transactions, and consolidated capital at AIG, and also directed corrective actions against AIG's Enterprise Risk Management. OTS also met regularly with Price Waterhouse Coopers (PwC), the company's independent auditor. Key to the continuous supervision process is the risk assessment, resulting supervisory plan, and targeted areas of review for each year. OTS focused on the corporate governance, risk management, and internal control centers within the company and completed targeted reviews of non-functionally regulated affiliates within the holding company structure. In 2005, OTS conducted several targeted, risk-focused reviews of various lines of business, including AIGFP, and made numerous recommendations to AIG senior management and the board with respect to risk management oversight, financial reporting transparency and corporate governance. The findings, recommendations, and corrective action points of the 2005 examination were communicated in a report to the AIG Board in March 2006. With respect to AIGFP, OTS identified and reported to AIG's board weaknesses in AIGFP's documentation of complex structures transactions, in policies and procedures regarding accounting, in stress testing, in communication of risk tolerances, and in the company's outline of lines of authority, credit risk management and measurement. Our report of examination also identified weaknesses related to American General Finance (AGF), another non-functionally regulated subsidiary in the AIG family that is a major provider of consumer finance products in the U.S. These weaknesses included deficiencies regarding accounting for repurchased loans, evaluation of the allowance for loan losses: Credit Strategy Policy Committee reporting, information system data fields, and failure to forward copies of State examination reports and management response to the Internal Audit Division. The examination report also noted weaknesses in AIG's management and internal relationships, especially with the Corporate Legal Compliance Group and the Internal Audit Division, as well as its anti-money laundering program. In 2006 OTS noted nominal progress on implementing corrective measures on the weaknesses noted in the prior examination; however, the Agency identified additional weaknesses requiring the board of directors to take corrective action. Most notably, OTS required the board to establish timely and accurate accounting and reconciliation processes, enhance and validate business line capital models, address compliance-related matters, adopt mortgage loan industry best practices, and assess the adequacy of its fraud detection and remediation processes. During 2007, when there were signs of deterioration in the U.S. mortgage finance markets, OTS increased surveillance of AGF and AIGFP. OTS selected AGF for review because of its significant size and scope of consumer operations, and to follow up on the problems noted in prior examinations. OTS also has supervisory responsibility for AIG Federal Savings Bank. OTS took action against AIG FSB in June, 2007, in the form of a Supervisory Agreement for its failure to manage and control in a safe and sound manner the loan origination services outsourced to its affiliate, Wilmington Finance, Inc. (WFI). The Agreement addressed loan origination activities and required AIG FSB to identify and provide timely assistance to borrowers who were at risk of losing their homes because of the thrift's loan origination and lending practices. OTS also required a $128 million reserve to be established to cover costs associated with providing affordable loans to borrowers. Later, in light of AIG's growing liquidity needs to support its collateral obligations, OTS took action in September 2008 at the FSB level to ensure that depositors and the insurance fund were not placed at risk. OTS actions precluded the bank from engaging in transactions with affiliates without OTS knowledge and lack of objection; restricted capital distributions; required maintenance of minimum liquidity and borrowing capacity sensitive to the unfolding situation; and required retention of counsel to advise the board in matters involving corporate reorganization and attendant risks related thereto. AIG FSB continues to be well capitalized and maintains adequate levels of liquidity. After a 2007 targeted review of AIGFP, OTS instructed the company to revisit its modeling assumptions in light of deteriorating subprime market conditions. In the summer of 2007, after continued market deterioration, OTS questioned AIG about the valuation of CDS backed by subprime mortgages. In the last quarter of 2007, OTS increased the frequency of meetings with AIG's risk managers and PwC. Due to the Agency's progressive concern with corporate oversight and risk management, in October 2007 we required AIG's Board to: Monitor remediation efforts with respect to certain material control weaknesses and deficiencies; Ensure implementation of a long-term approach to solving organizational weaknesses and increasing resources dedicated to solving identified deficiencies; Monitor the continued improvement of corporate control group ability to identify and monitor risk; Complete the holding company level risk assessment, risk metrics, and reporting initiatives and fully develop risk reporting; Increase involvement in the oversight of the firm's overall risk appetite and profile and be fully informed as to AIG Catastrophic Risk exposures, on a full-spectrum (credit, market, insurance, and operational) basis; and Ensure the prompt, thorough, and accountable development of the Global Compliance program, a critical risk control function where organizational structure impediments have delayed program enhancements. OTS further emphasized to AIG management and the board that it should give the highest priority to the financial reporting process remediation and the related long-term solution to financial reporting weaknesses. In connection with the 2007 annual examination, the Organizational Structure component of the CORE rating was downgraded to reflect identified weakness in the company's control environment. Shortly after OTS issued the 2007 report, AIG disclosed its third quarter 2007 financial results, which indicated for the first time a material problem in the Multi Sector CDS portfolio evidenced by a $352 million valuation charge to earnings and the disclosure that collateral was being posted with various counterparties to address further market value erosion in the CDS portfolio. As PwC was about to issue the accounting opinions on the 2007 financial statements, the independent auditor concluded that a material control weakness existed in AIGFP's valuation processes and that a significant control deficiency existed with Enterprise Risk Management's access to AIGFP's valuation models and assumptions. Due to intense pressure from PwC, in February 2008, AIG filed an SEC Form 8K announcing the presence of the material weakness. AIG pledged to implement complete remediation efforts immediately. OTS's subsequent supervisory review and discussions with PwC revealed that AIGFP was allowed to limit access of key risk control groups while material questions relating to the valuation of super senior CDS portfolio were mounting. As a result of this gap, corporate management did not obtain sufficient information to completely assess the valuation methodology. In response to these matters, AIG's Audit Committee commissioned an internal investigation headed by Special Counsel to the Audit Committee to review the facts and circumstances leading to the events disclosed in the SEC Form 8K. The Special Counsel worked with OTS to evaluate the breakdown in internal controls and financial reporting. Regulatory entities such as the Securities Exchange Commission and Department of Justice then also commenced inquiries. The OTS met with AIG senior management on March 3, 2008, and communicated significant supervisory problems over the disclosures in the SEC Form 8K and the unsatisfactory handling of the Enterprise Risk Management relationship with AIGFP. OTS downgraded AIG's CORE ratings and communicated the OTS's view of the company's risk management failure in a letter to AIG's General Counsel on March 10, 2008. As part of this remediation process and to bolster corporate liquidity and oversight, AIG successfully accessed the capital markets in May of 2008 and raised roughly $20 billion in a combination of common equity and equity hybrid securities. This action coupled with existing liquidity at the AIG parent, provided management with reasonable comfort that it could fund the forecasted collateral needs of AIGFP. AIG also added a Liquidity Manager to its corporate Enterprise Risk Management unit to provide senior management with more timely stress scenario reporting and formed a liquidity monitoring committee composed of risk managers, corporate treasury personnel, and business unit members to provide oversight. On July 28, 2008, AIG submitted a final comprehensive remediation plan, which OTS reviewed and ultimately accepted on August 28, 2008. The AIG audit committee approved the company's remediation plan, which also was used by PwC to assess AIG's progress in resolving the material control weakness covering the valuation of the CDS portfolio and the significant control deficiency attributable to AIG's corporate risk oversight of AIGFP, AGF, and International Lease Finance Corporation (ILFC). OTS continues to monitor these remediation efforts to this day, notwithstanding AIG's September 2008 liquidity crisis. As AIG's liquidity position became more precarious, OTS initiated heightened communications with domestic and international financial regulators. Through constant communication, OTS monitored breaking events in geographic areas where AIG operates, kept regulators in those jurisdictions informed of events in the U.S. and clarified the nature of AIG's stresses. OTS's identification of AIGFP as the focal point of AIG's problems added perspective that allowed foreign regulators to more accurately assess the impact on their regulated entities and to make informed supervisory decisions. In September 2008 the Federal Reserve Bank of New York (FRB-NY) extended an $85 billion loan to AIG and the government took an 80 percent stake in AIG. On the closure of this transaction? Federal statute no longer defined AIG as a savings and loan holding company subject to regulation as such. This result would be true whether AIG had been a savings and loan holding or bank holding company subject to regulation by the Federal Reserve Board. Nonetheless, OTS has continued in the role of equivalent regulator for EU and international purposes. FRB-NY's intervention had no impact on OTS's continued regulation and supervision of AIG FSB. Although OTS has scaled back some regulatory activities with regard to AIG, the Agency continues to meet regularly with key corporate control units and receive weekly reports on various exposures and committee activities. OTS closely monitors the activities at AIGFP to reduce risk, as well as the divesture efforts of the holding company. OTS will continue to focus on Residential Mortgage Backed Securities exposures and the ultimate performance of underlying mortgage assets. OTS is tracking AIG's remediation efforts. Finally, OTS continues to work with global functional regulators to keep them apprised of conditions at the holding company, as well as to learn of emerging issues in local jurisdictions.Lessons Learned Despite OTS's efforts to point out AIGFP's weaknesses to the company and to its Board of Directors, OTS did not foresee the extent of the risk concentration and the profound systemic impact CDS products caused within AIG. By the time AIGFP stopped originating these derivatives in December 2005, they already had $65 billion on their books. These toxic products posed significant liquidity risk to the holding company. Companies that are successful have greater opportunities for growth. AIG was successful in many regards for many years, but it had issues and challenges. OTS identified many of these issues and attempted to initiate corrective actions, but these actions were not sufficient to avoid the September market collapse. It is worth noting that AIGFP's role was not underwriting, securitizing, or investing in subprime mortgages. Instead; AIGFP simply provided insurance-like protection against declines in the values of underlying securities. Nevertheless, in hindsight, OTS should have directed the company to stop originating CDS products before December 2005. OTS should also have directed AIG to try to divest a portion of this portfolio. The pace of change and deterioration of the housing market outpaced our supervisory remediation measures for the company. By the time the extent of the CDS liquidity exposure was recognized, there was no orderly way to reduce or unwind these positions and the exposure was magnified due to the concentration level. The CDS market needs more consistent terms and conditions and greater depth in market participants to avoid future concentration risks similar to AIG. I believe it is important for the Committee to understand the confluence of market factors that exposed the true risk of the CDS in AIGFP's portfolio. OTS saw breakdowns in market discipline, which was an important element of our supervisory assessment. Areas that we now know were flawed included: overreliance on financial models, rating agency influence on structured products, lack of due diligence in the packaging of asset-backed securities, underwriting weaknesses in originate-to-distribute models, and lack of controls over third party (brokers, conduits, wholesalers) loan originators. Shortcomings in modeling CDS products camouflaged some of the risk. AIGFP underwrote its super senior CDS using proprietary modeling similar to that used by rating agencies for rating structured securities. AIGFP's procedures required modeling based on simulated periods of extended recessionary environments (i.e., ratings downgrade, default, loss, recovery). Up until June 2007, the results of the AIGFP models indicated that the risk of loss was a remote possibility, even under worst-case scenarios. The model used mainstream assumptions that were generally acceptable to the rating agencies, PwC, and AIG. Following a targeted review of AIGFP in early 2007, OTS recommended that the company revisit its modeling assumptions in light of deteriorating subprime market conditions. In hindsight, the banking industry, the rating agencies and prudential supervisors, including OTS, relied too heavily on stress parameters that were based on historical data. This led to an underestimation of the unprecedented economic shock and misjudgment of stress test parameters. Approximately 6 months after OTS's March 2008 downgrade of AIG's examination rating, the credit rating agencies also downgraded AIG on September 15, 2008. That precipitated calls that required AIGFP to post huge amounts of collateral for which it had insufficient funds. The holding company capital was frozen and AIGFP could not meet the calls.Recommendations From the lessons learned during our involvement with supervising AIG, we would like you to consider two suggestions in your future exploration of regulatory reform.Systemic Risk Regulator First, 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.Regulation of Credit Default Swaps--Consistency and Transparency CDS are financial products that are not regulated by any authority and impose serious challenges to the ability to supervise this risk proactively without any prudential derivatives regulator or standard market regulation. We are aware of and support the recent efforts by the Federal Reserve Bank of New York to develop a common global framework for cooperation. There is a need to fill the regulatory gaps the CDS market has exposed. We have also learned there is a need for consistency and transparency in CDS contracts. The complexity of CDS contracts masked risks and weaknesses in the program that led to one type of CDS performing extremely poorly. The current regulatory means of measuring off-balance sheet risks do not fully capture the inherent risks of CDS. OTS believes standardization of CDS would provide more transparency to market participants and regulators. In the case of AIG, there was heavy reliance on rating agencies and in-house models to assess the risks associated with these extremely complicated and unregulated products. I believe that Congress should consider legislation to bring CDS under regulatory oversight, considering the disruption these instruments caused in the marketplace. Prudential supervision is needed to promote a better understanding of the risks and best practices to manage these risks, enhance transparency, and standardization of contracts and settlements. More and better regulatory tools are needed to bring all potential instruments that could cause a recurrence of our present problems under appropriate oversight and legal authority. A multiplicity of events led to the downfall of AIG. An understanding of the control weaknesses and events that transpired at AIG provides an opportunity to learn to identify weaknesses and strengthen regulatory oversight of complex financial products and companies. OTS has absorbed these lessons and has issued risk-focused guidance and policies to promote a more updated and responsive supervisory program. Thank you, Chairman Dodd, Ranking Member Shelby, and Members of the Committee, for the opportunity to testify on behalf of the OTS on the collapse of AIG. We look forward to working with the Committee to ensure that, in these challenging times, thrifts and consolidated holding companies operate in a safe and sound manner. ______ CHRG-111hhrg54867--71 Mr. Garrett," Thank you, Mr. Chairman. Thank you, Mr. Secretary. You know, Mr. Secretary, I just heard you say something that actually harkens back to last time you were here, and that is talking about the goodness of having independent agencies and regulators out there on the one hand, but on the other hand that you sort of expect them to take the actions that they did. Because that was actually something that you said, and I remember what you said, that institutions have this authority to regulate, and they are not enthusiastic about giving up that authority. They would just defend their traditional prerogatives of their agencies. And I think, frankly, all arguments need to be viewed through that basic prism. We will have a hearing later on, and I guess that is the prism where we will have to take their testimony at that point in time, that they are doing it just to represent their own turf as opposed to what we are looking to you for, for the benefit of the country. One of my opening comments was the timeline, and you heard that whole perspective. Very quickly, with the immensity of this issue, the complexity of the problems, is it realistic that we can resolve all this and all of our differences in the next 7 weeks and get it done and get it done right that would not have any negative consequences in the future? " CHRG-111hhrg48674--3 Mr. Bachus," Thank you, Mr. Chairman. And welcome, Chairman Bernanke. When historians look back at the financial crisis and the ensuing economic evil of the last half of the first decade of the 21st Century, what will be the story line? I submit it will be that while the public was focused on the tax rebate program, then on the $700 billion TARP, and finally on the $100 trillion economic stimulus package, a much larger drama was unfolding below the surface. While the public was distracted and focused on these high-profile activities and events, other programs and activities, some 5 times larger than those debated and discussed in open forums, were being enacted by a select few unelected Federal regulators who were making commitments of trillions of dollars backed by taxpayer guarantees and loans. Perhaps much like the analogy of an iceberg, only the tip of which is visible, the public, and we as elected representatives, are left merely to speculate as to the exact nature and composition of these complex financial transactions, which have been made and entered into out of public view. By using an obscure and seldom utilized provision of the Federal Reserve Act of 1913, the Federal Reserve, with Treasury's cooperation, has made unprecedented interventions into the financial markets. Not only has there been no disclosure or little oversight or accountability, there has actually been an active resistance on the part of these agencies to explain their actions or disclose the terms. At this time, because we know almost nothing about these transactions, we can only guess as to their ultimate success or failure. In future years, I am sure those who write of these days will be intrigued and captivated by the question, how could such an unprecedented action have occurred without the consent of the government? In many of these transactions that have been undertaken so far, we have been told we could not be given the specifics or details or terms because it was proprietary information of the companies involved. We have been left to guess as to the terms, the conditions, the size in many cases, the results expected, the consequences, the criteria for eligibility, or even the identity of all the parties. What is unknown pales in comparison to what we know. Perhaps of all the troubling aspects of these what I will call iceberg transactions, I am most troubled by what appears above the surface to be a total lack of guiding principles in entering these agreements and arrangements. This perception is only heightened by a series of ad hoc decisions and seeming policy reversals which gives an indication that there is, in fact, no detailed plan to navigate us through what we all agree are troubling times. Let me close by suggesting a missing but essential guiding principle. I believe in a democracy it should be a requirement in any agreement or transaction involving the government. The principle is simple: In the event that our governing officials come to the conclusion that a commitment of public funds is necessary, if a commitment of taxpayer funds or guarantees cannot be disclosed because of the circumstances involved, it cannot and should not be made. If a private party to a transaction not involving national security is unwilling to enter into an agreement open to public scrutiny and examination, the agreement should not be made. Thank you, Mr. Bernanke, and thank you, Mr. Chairman. " 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-111shrg55278--121 RESPONSES TO WRITTEN QUESTIONS OF SENATOR REED FROM MARY L. SCHAPIROQ.1. You discussed regulatory arbitrage in your written statement 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. Establishing a robust and multidisciplinary Financial Services Oversight Council (Council) would be an important step toward closing regulatory gaps. Because financial participants currently can use different vehicles or jurisdictions from which to engage in the same activity, participants can sometimes ``choose'' their regulatory framework. This choice can sometimes result in a race to the bottom among competing regulators and jurisdictions, lowering standards and increasing systemic risk. A strong Council could provide a forum for examining and discussing regulatory standards across markets, ensuring that adequate and appropriate capital and liquidity standards for financial institutions in the marketplace and the activities they conduct are in place and being enforced. In addition, the Council would have the role of identifying risks across the system, harmonizing rules to minimize systemic risk, and helping to ensure that future regulatory gaps--and arbitrage opportunities--are minimized or avoided. In general, all regulatory tools available should be considered, including strong enforcement, additional measures to improve transparency, and appropriate activities restrictions. The Council should set policy if necessary to ensure that more rigorous standards than those of a primary regulator and/or the systemic risk regulator (SRR) are implemented. The Council should provide a different, impartial perspective relative to a single regulator having a daily oversight role. In general, I would expect the Council and SRR to work with and through the primary regulators. The primary regulators understand the markets, products, and activities of their regulated entities. The SRR can provide a second layer of review over the activities, capital, and risk management procedures of systemically important institutions from a macroprudential perspective, considering risk to the system as a whole. 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. 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, general policy should be set by the Council, and only then to implement a more rigorous policy than that of a primary regulator. The Council's responsibilities, lines of authority, and consultations with other regulators during both emergency and nonemergency situations should be explicitly delineated. Voting, quorum, and other governance requirements, including consultations with other regulators, should be carefully considered in advance for exigencies such as the ability to invoke resolution authority or overrule a primary regulator--as well as for designating systemically important institutions or setting policies as a matter of course.Q.2. What factors should Congress consider as it weighs the benefits and drawbacks of expanding the Federal Reserve's authority to oversee the safety and soundness of systemically important payment, clearing, and settlement systems? Would it interfere with the SEC's authority over any of these systems?A.2. While we believe it is appropriate for Congress to establish a single SRR to focus on macroprudential oversight and to identify systemic risk, it is important for Congress to consider the existing framework for the regulation and oversight of clearing agencies under the Exchange Act. Accordingly, we believe that any expansion of the Federal Reserve's authority should supplement rather than replace the existing regulatory framework for clearing agencies. Confidence that the financial markets are both safe and fair is promoted by the risk management standards applicable to clearing agencies under Section 17A of the Exchange Act, including that clearing agencies must provide for the safeguarding of securities and funds and for the prompt and accurate clearance and settlement of securities transactions. The current risk management procedures for clearing agencies have shown remarkable robustness and resiliency both historically and through the recent period of financial stress. For example, no clearing agency incurred a loss following the Lehman bankruptcy last year. Furthermore, in the event of a participant default, one of a clearing agency's primary lines of defense is its substantial collateral pool, or clearing fund, that is comprised of substantial contributions from its participants. As a result, participants have a strong incentive to ensure the clearing agency maintains highly effective risk management policies and procedures. In addition to the requirements regarding risk management, Section 17A also imposes a number of requirements to facilitate a national system for clearance and settlement of securities transactions. The regulation of the securities markets is inextricably tied to the regulation of the entities that provide clearance and settlement services. Clearance and settlement has an effect on almost every facet of the securities markets, including: characteristics of the products traded, trading partners, competition among trading venues, proxy and dividend distributions, and collaterization of ongoing transactions such as repurchase agreements and stock lending. In addition, regulation of many aspects of the securities market, such as the monitoring and regulation of ``short selling,'' is accomplished through use of the clearance and settlement infrastructure. The standards that promote fairness and innovation in the securities markets have elements related to risk management, such as participant eligibility for clearing services, and could be compromised if another regulator could simply ignore the investor protections available under Section 17A or other laws. For these reasons, there should be a coordinated approach between the Council, functional regulators, and SRR in order to fully utilize the expertise and experience of all regulators and maintain the existing standards that are crucial to supporting the securities markets.Q.3. 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.3. Please see my response to your first question.Q.4. What are the other unresolved aspects of establishing a framework for systemic risk regulation?A.4. The Administration's white paper on Financial Regulatory Reform and recent legislation extensively address the additional supervisory, capital, leverage, and other requirements to which Tier 1 Financial Holding Companies (FHCs) would be subject. Consistent with the need to minimize regulatory arbitrage and close regulatory loopholes, attention is also due to firms that would not be considered Tier 1 FHCs and are not supervised as bank holding companies but nonetheless have a substantial presence in the securities markets or carry substantial customer assets. The failure of such ``Tier 2'' firms could have a disruptive or harmful impact on orderly and efficient markets and on customers, even if not necessarily at a global level. Moreover, it may be appropriate to impose graduated limits and capital charges, as well as increased supervisory attention, on these financial institutions as they grow.Q.5. How should Tier 1 FHCs be identified? Which regulator(s) should have this responsibility?A.5. The Council should have the authority to identify Tier 1 FHCs whose failure would pose a threat to the financial system due to their combination of size; leverage; interconnectedness; amount and nature of financial assets; nature of liabilities (such as reliance on short-term funding); importance as a source of credit for households, businesses, and Government; amount of cash, securities, or other types of customer assets held; and other factors the Council deems appropriate. One possible way to identify Tier 1 FHCs would be to use a process similar to that used to select participants in the Treasury Department and Federal Reserve's Supervisory Capital Assessment Program, or stress tests, conducted in 2009.Q.6. 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.6. I believe the approach laid out above, where policy is set by a strong Council and implemented through functional regulators with a SRR overlay, would help address limitations associated with any individual regulators' mission or expertise.Q.7. 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.7. Large financial institutions may enjoy a competitive advantage in the form of a lower cost of capital because the possibility of a Government backstop has been priced in. Accordingly, some have suggested that appropriate financial and risk management requirements be imposed on these large institutions to level the playing field for smaller competitors and to provide additional protection against their failure. I agree with the effort to establish a mechanism for macroprudential oversight and consolidated supervision of systemically important firms. Moreover, 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 credible resolution regime can also help address these risks by giving policy makers the option of a controlled unwinding of a large, interconnected institution over time. ------ fcic_final_report_full--70 As Congress began fashioning legislation, the banks were close at hand. In , the financial sector spent  million lobbying at the federal level, and individuals and political action committees (PACs) in the sector donated  million to federal election campaigns in the  election cycle. From  through , federal lob- bying by the financial sector reached . billion; campaign donations from individ- uals and PACs topped  billion.  In November , Congress passed and President Clinton signed the Gramm- Leach-Bliley Act (GLBA), which lifted most of the remaining Glass-Steagall-era re- strictions. The new law embodied many of the measures Treasury had previously advocated.  The New York Times reported that Citigroup CEO Sandy Weill hung in his office “a hunk of wood—at least  feet wide—etched with his portrait and the words ‘The Shatterer of Glass-Steagall.’”  Now, as long as bank holding companies satisfied certain safety and soundness conditions, they could underwrite and sell banking, securities, and insurance prod- ucts and services. Their securities affiliates were no longer bound by the Fed’s  limit—their primary regulator, the SEC, set their only boundaries. Supporters of the legislation argued that the new holding companies would be more profitable (due to economies of scale and scope), safer (through a broader diversification of risks), more useful to consumers (thanks to the convenience of one-stop shopping for finan- cial services), and more competitive with large foreign banks, which already offered loans, securities, and insurance products. The legislation’s opponents warned that al- lowing banks to combine with securities firms would promote excessive speculation and could trigger a crisis like the crash of . John Reed, former co-CEO of Citi- group, acknowledged to the FCIC that, in hindsight, “the compartmentalization that was created by Glass-Steagall would be a positive factor,” making less likely a “cata- strophic failure” of the financial system.  To win the securities industry’s support, the new law left in place two exceptions that let securities firms own thrifts and industrial loan companies, a type of deposi- tory institution with stricter limits on its activities. Through them, securities firms could access FDIC-insured deposits without supervision by the Fed. Some securities firms immediately expanded their industrial loan company and thrift subsidiaries. Merrill’s industrial loan company grew from less than  billion in assets in  to  billion in , and to  billion in . Lehman’s thrift grew from  million in  to  billion in , and its assets rose as high as  billion in .  For institutions regulated by the Fed, the new law also established a hybrid regula- tory structure known colloquially as “Fed-Lite.” The Fed supervised financial holding companies as a whole, looking only for risks that cut across the various subsidiaries owned by the holding company. To avoid duplicating other regulators’ work, the Fed was required to rely “to the fullest extent possible” on examinations and reports of those agencies regarding subsidiaries of the holding company, including banks, secu- rities firms, and insurance companies. The expressed intent of Fed-Lite was to elimi- nate excessive or duplicative regulation.  However, Fed Chairman Ben Bernanke told the FCIC that Fed-Lite “made it difficult for any single regulator to reliably see the whole picture of activities and risks of large, complex banking institutions.”  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-111shrg51395--267 RESPONSE TO WRITTEN QUESTIONS OF SENATOR DODD FROM PAUL SCHOTT STEVENSQ.1. Transparency: Are there additional types of disclosures that Congress should require securities market participants to make for the benefit of investors and the markets? Also, would you recommend more transparency for investors: LBy publicly held banks and other financial firms of off-balance sheet liabilities or other data? LBy credit rating agencies of their ratings methodologies or other matters? LBy municipal issuers of their periodic financial statements or other data? LBy publicly held banks, securities firms and GSEs of their risk management policies and practices, with specificity and timeliness?A.1. Investment companies provide extensive disclosures and are highly transparent, especially as compared to many other investment products. As investors, investment companies generally favor efforts to increase transparency in the securities markets, unless countervailing policy objectives dictate otherwise or the information would not be meaningful to investors. Two specific areas in which ICI believes additional disclosure should be required are credit rating agencies and municipal securities. We strongly supported the Securities and Exchange Commission's recent credit rating agency proposals--which would impose additional disclosure, reporting, and recordkeeping requirements on rating agencies for rating structured finance products--as an important first step to restoring investor confidence in the integrity of credit ratings and, ultimately, the market as a whole. We believe, however, that more must be done to increase disclosure and transparency not only in the area of structured finance products but also with respect to other debt securities, particularly municipal securities. We have urged the SEC to expand many of its proposed requirements for credit rating agencies to include these additional categories of securities, and to support legislation that would extend increased disclosure requirements to the issuers of these instruments. We also have recommended a number of additional disclosures to be made by rating agencies and issuers that should enhance disclosure for investors in a meaningful way. \1\ We believe the SEC currently has authority to implement many of our recommendations. Others (such as the repeal of the Tower Amendment and certain changes to improve municipal securities disclosure, discussed below) would require Congressional action.--------------------------------------------------------------------------- \1\ See Letter from Karrie McMillan, General Counsel, Investment Company Institute, to Florence Harmon, Acting Secretary, U.S. Securities and Exchange Commission, dated July 25, 2008; Letter from Karrie McMillan, General Counsel, Investment Company Institute, to Elizabeth M. Murphy, Secretary, U.S. Securities and Exchange Commission, dated March 26, 2009.--------------------------------------------------------------------------- Rating Agency Disclosure: ICI recommends the following additional disclosures, which go beyond the SEC's recent proposals, to improve the transparency of ratings and the rating process: LRating agencies should be required to provide public disclosure of any material deviations between the credit rating implied by a rating model and the final credit rating issued. LRating agencies should make more timely disclosure of their rating actions. LRating agencies should disclose additional information regarding staffing issues, including personnel turnover and resource levels. LRating agencies should disclose certain information about the ongoing review of their ratings. LRating agencies should disclose additional information regarding rating stability, including when and how downgrades are conducted and the severity of potential downgrades. LRating agencies should disclose additional information regarding conflicts of interest. LRating agencies should be required to use standardized performance measurement statistics to facilitate comparability of these statistics. LRating agencies should be required to conduct due diligence on the information they review to issue ratings and to provide related disclosure. We also recommend that the SEC apply these suggested disclosure requirements in a consistent manner to all types of rating agencies. In addition, to realize the full potential of a meaningful and effective disclosure regime, we recommend that the SEC require the standardized presentation of disclosure information in a presale report issued by the rating agencies. Municipal Securities Issuer Disclosure: ICI strongly urges Congress and the SEC to improve the content and timing of required disclosures regarding municipal securities. The Tower Amendment, adopted by Congress in 1975, prohibits the SEC and the Municipal Securities Rulemaking Board from directly or indirectly requiring issuers of municipal securities to file documents with them before the securities are sold. As we have stated numerous times, because of these restrictions, the disclosure regime for municipal securities is woefully inadequate, and the regulatory framework is insufficient for investors in today's complex marketplace. \2\--------------------------------------------------------------------------- \2\ See, e.g., Letter from Karrie McMillan, General Counsel, Investment Company Institute, to Florence Harmon, Acting Secretary, U.S. Securities and Exchange Commission, dated September 22, 2008.--------------------------------------------------------------------------- Legislative action regarding the Tower Amendment will be necessary to fully develop an adequate disclosure regime for municipal securities, including imposing certain disclosure requirements directly on municipal issuers. We would strongly support such action. We also recommend that Congress clarify the legal responsibilities of officials of municipal issuers for the disclosure documents that they authorize. In particular, Congress should spell out the responsibilities of underwriters with respect to municipal securities offering statements and the responsibilities of bond counsel and other participants in municipal offerings. In the meantime, important steps can be taken to improve municipal securities disclosure without legislative action. In particular, ICI recommends that the SEC expand the list of information that is required to be disclosed under current SEC rules. \3\ For example, the rule provision concerning notice of material events should be modified to more fully reflect the types of events that are material to today's investors. These events should include, among others, material litigation or regulatory action, pending or threatened, or failure to meet any financial covenants contained in the bond documents (especially the failure to make any monthly/quarterly payments due under the bond documents).--------------------------------------------------------------------------- \3\ ICI is not advocating a wholesale replication of the corporate disclosure framework for municipal securities. Instead, we are recommending a regulatory regime designed expressly for the needs of the municipal securities market.--------------------------------------------------------------------------- We also recommend changes to ensure that issuer financial information is provided to the public on a timely basis. \4\ Specifically, the SEC should establish meaningful timeframes for the delivery of information required pursuant to the undertakings in an issuer's continuing disclosure agreement. For example, issuers should be required to file financial reports within 180 days of the end of the fiscal year, instead of the more common practice of 270 days after fiscal year end. Also, if audited financial statements are not available within the recommended timeframe, issuers should be required to issue unaudited financials in the interim, as appropriate, in accordance with guidelines established by the National Federation of Municipal Analysts. Timely reporting would enhance the usefulness of the information reported, including by alerting investors to those issuers that may be experiencing problems that could affect the credit quality or other characteristics of their securities.--------------------------------------------------------------------------- \4\ Rule 15c2-12 under the Securities Exchange Act of 1934 currently requires information about municipal securities issuers to be provided only annually. In contrast, corporate issuers are subject to quarterly reporting requirements. Moreover, the rule does not provide any outside deadline for the disclosure of financial information, thus leaving the timing completely to the discretion of the issuer. As a result, investors often receive financial information anywhere from three months to twelve months, or even longer, following the end of a fiscal year.--------------------------------------------------------------------------- Other Matters: In response to the question posed, ICI has no specific recommendations to offer regarding disclosure by publicly held banks or other financial institutions of off-balance sheet liabilities or other data. As a general matter, however, we would support additional transparency of off-balance sheet entities and activities. Such transparency should provide investment companies and other investors with important information about potential risk exposures faced by the companies in which they invest and should help avoid the market inefficiencies and other adverse consequences that the current lack of transparency has engendered. \5\ We understand that the Financial Accounting Standards Board is working on revisions to two of its standards (FAS 140 and FIN 46) that are intended to address deficiencies in the accounting and disclosure of risks associated with off-balance sheet entities (e.g., structured investment vehicles) that were revealed during the current financial crisis. We look forward to the implementation of these improvements.--------------------------------------------------------------------------- \5\ See Written Testimony of Elizabeth F. Mooney, CFA, CPA, Accounting Analyst, Capital Group Companies, before the U.S. Senate Committee on Banking, Housing, and Urban Affairs, Subcommittee on Securities, Insurance, and Investment, Hearing on ``Transparency in Accounting: Proposed Changes in Accounting for Off-Balance Sheet Entities'' (September 18, 2008).--------------------------------------------------------------------------- ICI likewise has no formal position on whether publicly held banks, securities firms, and GSEs should be required to disclose their risk management policies and practices. We would caution, however, that ``risk management'' means different things to different people and can also have varying connotations depending on the context. General disclosure would be of little value, and specific disclosure could create opportunities for exploitation. Disclosure describing policies and practices also would not convey how effective (or ineffective) any particular set of policies and practices are likely to be. Such disclosure therefore might create a false sense of security about an entity's ability to cope with various risks. We do not intend to suggest that sound risk management policies and practices are not important; we merely question the usefulness of required public disclosure concerning such policies and practices.Q.2. Conflicts of Interest: Concerns about the impact of conflicts of interest that are not properly managed have been frequently raised in many contexts--regarding accountants, compensation consultants, credit rating agencies, and others. For example, Mr. Turner pointed to the conflict of the board of FINRA including representatives of firms that it regulates. The Millstein Center for Corporate Governance and Performance at the Yale School of Management in New Haven, Connecticut on March 2 proposed an industry-wide code of professional conduct for proxy services that includes a ban on a vote advisor performing consulting work for a company about which it provides recommendations. In what ways do you see conflicts of interest affecting the integrity of the markets or investor protection? Are there conflicts affecting the securities markets and its participants that Congress should seek to limit or prohibit?A.2. Conflicts of interest that are unknown or not properly managed can have a negative impact on financial markets and market participants. ICI agrees, therefore, that it is important to identify conflicts or potential conflicts and determine how they can best be addressed, including through regulation. The appropriate solution may vary depending on the nature and extent of the conflict as well as the context in which it arises. For example, sometimes disclosure can be an effective tool for addressing conflicts, by putting investors and the marketplace on notice and allowing them to evaluate the significance and impact of the conflict. In other circumstances, different measures may be called for, such as restricting or prohibiting conduct or transactions that present conflicts. The laws governing investment advisers and investment companies have employed both of these approaches. Under the Investment Advisers Act of 1940, an investment adviser must disclose conflicts to clients, and often must seek their consent to proceed with a transaction notwithstanding a conflict. By contrast, the Investment Company Act of 1940 addresses potential conflicts of interest in the context of investment company (fund) operations by prohibiting certain transactions between a fund and fund insiders or affiliated organizations (such as the corporate parent of the fund's adviser). The Investment Company Act authorizes the Securities and Exchange Commission (SEC) to grant exemptions by rule or order to the extent such exemptions are consistent with the underlying objectives of the statute. Pursuant to this authority, the SEC has issued exemptive rules and orders containing conditions designed to ensure that the interests of fund investors are amply protected. The restrictions on affiliated transactions under the Investment Company Act are widely viewed as a core investor protection and one that has served funds and their investors very well over nearly 70 years. Congress may wish to consider whether it would be appropriate and beneficial to apply similar restrictions to other financial market participants or activities, coupled with exemptive authority similar to that granted to the SEC. At the same time, as noted above, ICI recognizes that this approach does not fit every situation that involves conflicts of interest. \6\--------------------------------------------------------------------------- \6\ Likewise, a disclosure and consent model would be impracticable in the context of a pooled investment vehicle if each investor in the pooled vehicle were required to provide consent.--------------------------------------------------------------------------- While ICI does not have any specific legislative recommendations at this time regarding conflicts of interest that may affect the integrity of the markets or investor protection, we have commented extensively in the debate over possible regulatory actions to address conflicts of interest involving credit rating agencies--one of the issues mentioned in the question above. \7\ We provide our comments on that topic below.--------------------------------------------------------------------------- \7\ ICI believes that the SEC currently has authority under the Credit Rating Agency Reform Act of 2006 to implement the necessary regulatory reforms to address rating agency conflicts of interest.--------------------------------------------------------------------------- The SEC has recently increased the list of conflicts of interest that must be disclosed and managed by rating agencies or, alternatively, that are prohibited. ICI supported these amendments but we believe that more should be done in this area. \8\ We recommend that the SEC require additional disclosures by rating agencies regarding their conflicts of interest including, for example, the number of other products rated by a rating agency for a particular issuer. In addition, the SEC recently adopted a requirement that rating agencies disclose information regarding the conflict of being paid by certain parties to rate structured finance products. The targeted conflict of interest, however, is not confined to the ratings of these instruments. The disclosure requirement therefore should be extended to ratings of municipal securities.--------------------------------------------------------------------------- \8\ See Letter from Karrie McMillan, General Counsel, Investment Company Institute, to Florence Harmon, Acting Secretary, U.S. Securities and Exchange Commission, dated July 25, 2008; Letter from Karrie McMillan, General Counsel, Investment Company Institute, to Elizabeth M. Murphy, Secretary, U.S. Securities and Exchange Commission, dated March 26, 2009.--------------------------------------------------------------------------- Public disclosure of conflict of interest information should improve transparency surrounding the information and processes used by rating agencies for rating products. It will provide users of ratings with a more complete picture of a rating agency's rating process and expose that process to greater scrutiny. This exposure, in turn, should promote the issuance of more accurate, high-quality ratings, and could prevent rating agencies from being unduly influenced to produce higher than warranted ratings. It should also assist investors and other market professionals in performing an independent assessment of these products. To achieve these goals, it is critical that the SEC's rules governing conflicts of interest be actively enforced and that rating agencies be held accountable for any failures to comply with the rules and their policies and procedures adopted under the rules. Moreover, to fully and properly address concerns about conflicts of interest, ICI believes the government should ensure that regulatory reforms for rating agencies are applied in a uniform and consistent manner equally to all types of credit rating agencies. Each type of rating agency business model--be it issuer-paid, subscriber-paid, or other \9\--poses concerns and harbors conflicts of interest. Indeed, it is not clear that one model poses fewer risks of conflicts or invariably produces higher quality ratings.--------------------------------------------------------------------------- \9\ While the focus of the current debate has been on issuer-paid versus subscriber-paid models, we recognize that there may be other compensation models worthy of consideration that may better incentivize rating agencies to produce high quality ratings. For example, payment for public ratings could be linked to ``quality provided'' as determined by the end user--the investors. We believe these or other models should be subject to the same regulatory oversight as the more common issuer-paid and subscriber-paid models.Q.3. Credit Default Swaps: There seems to be a consensus among the financial industry, government officials, and industry observers that bringing derivative instruments such as credit default swaps under increased regulatory oversight would be beneficial to the nation's economy. Please summarize your ---------------------------------------------------------------------------recommendations on the best way to oversee these instruments.A.3. As we stated in our testimony, we believe that a single independent Federal regulator should be responsible for oversight of U.S. capital markets, market participants, and all financial investment products. We envision this ``Capital Markets Regulator'' as a new regulator that would encompass the combined functions of the Securities and Exchange Commission (SEC) and those of the Commodity Futures Trading Commission that are not agriculture-related. The Capital Markets Regulator should have express authority to regulate derivatives, including credit default swaps (CDS), including clear authority to adopt measures to increase transparency and reduce counterparty risk, while not unduly stifling innovation. \10\--------------------------------------------------------------------------- \10\ To the extent that no Capital Markets Regulator is formed, we believe that the SEC is the regulator best suited to provide effective oversight of financial derivatives, including CDS.--------------------------------------------------------------------------- The current initiatives toward centralized clearing for CDS are a positive step in this regard. Central clearing of CDS should help reduce counterparty risk and bring transparency to trading in the types of CDS that can be standardized. We support these initiatives. Not all CDS are sufficiently standardized to be centrally cleared, however, and institutional investors will continue to need to conduct over-the-counter transactions in CDS. Accordingly, we do not support efforts to require the mandatory clearing of all CDS. We do support, however, reasonable reporting requirements for these CDS transactions in order to allow the Capital Markets Regulator to have enough data on the CDS market to provide effective oversight. Institutional market participants should also be required to make periodic public disclosure of their CDS positions. SEC registered investment companies currently make these types of periodic public disclosures. To the extent that registered funds buy or sell CDS, they provide extensive quarterly financial statement disclosures that typically include both textual note disclosure on the nature and operation of CDS and tabular disclosure describing the terms of outstanding CDS at the report date. Textual note disclosures typically include: objectives, strategies, risks, cash flows, and credit events requiring performance. Tabular disclosures typically include: the reference entity, the counterparty, the pay/receive fixed rate, the expiration date, the notional amount, and the unrealized appreciation/depreciation (i.e., the fair value of the position). The Financial Accounting Standards Board (FASB) has recently taken steps to improve disclosures by the sellers of credit derivatives. \11\ We fully supported that effort, and will continue to support similar initiatives that we believe will improve marketplace transparency in derivatives.--------------------------------------------------------------------------- \11\ See FASB Staff Position No. 133-1 and FIN 45-4, Disclosures about Credit Derivatives and Certain Guarantees: An Amendment of FASB Statement No. 133 and FASB Interpretation No. 45; and Clarification of the Effective Date of FASB Statement No. 161 (Sept. 12, 2008), available at http://fasb.org/pdf/fsp_fas133-1&fin45-4.pdfQ.4. Corporate Governance--Majority Vote for Directors, Proxy Access, Say on Pay: The Council of Institutional Investors, which represents public, union and corporate pension funds with combined assets that exceed $3 trillion, has called for ``meaningful investor oversight of management and boards'' and in a letter dated December 2, 2008, identified several corporate governance provisions that ``any financial markets regulatory reform legislation [should] include'' Please explain ---------------------------------------------------------------------------your views on the following corporate governance issues: 1. LRequiring a majority shareholder vote for directors to be elected in uncontested elections; 2. LAllowing shareowners the right to submit amendment to proxy statements; 3. LAllowing advisory shareowner votes on executive cash compensation plans.A.4. Investment companies (funds) are major shareholders in public companies and support strong governance and effective management of all companies whose shares they own. Funds typically are charged with seeking to maximize returns on behalf of fund investors, and they use a variety of methods to influence corporate conduct to this end. These methods include deciding whether to invest in a company, or to continue to hold shares; engaging directly with company management; and voting proxies for the shares they own. Since 2004, funds--alone among all institutional investors--have been required to publicly disclose their proxy votes. As a result of this unique disclosure requirement, the manner in which fund firms vote proxies has been intensely scrutinized, and critics have sought to politicize fund portfolio management. While critics have mischaracterized the data, the availability of fund voting records demonstrates how funds use the corporate franchise to promote the interests of their shareholders. ICI published a report last year on a study we conducted of more than 3.5 million votes cast by funds in the 12-month period ended June 30, 2007. Our report, Proxy Voting by Registered Investment Companies: Promoting the Interests of Fund Shareholders, made numerous important findings including, among others, that: (1) funds devote substantial resources to proxy voting; (2) funds vote proxies in accordance with their board-approved guidelines; and (3) funds do not reflexively vote ``with management,'' as some critics claim, but rather make nuanced judgments in determining how to vote on both management and shareholder proposals. \12\--------------------------------------------------------------------------- \12\ The report is available at http://www.ici.org/stats/res/per14-01.pdf--------------------------------------------------------------------------- ICI has recommended that Congress extend proxy vote disclosure requirements to other institutional investors, and we reiterate that recommendation here. Greater transparency around proxy voting by institutional investors should enhance the quality of the debate concerning how the corporate franchise is used. We are not the only proponents for increased transparency about the proxy votes of other institutional investors. Senator Edward M. Kennedy (D-MA) commissioned a 2004 GAO study entitled ``Pension Plans: Additional Transparency and Other Actions Needed in Connection with Proxy Voting,'' which concluded, among other things, that workers and retirees would benefit from increased transparency in proxy voting by pension plans. Similarly, in his testimony for the March 10, 2009, Senate Banking Committee hearing, former Securities and Exchange Commission Chief Accountant Lynn Turner expressed support for legislation to ``require all institutional investors, including public, corporate and labor pension funds to disclose their votes, just as mutual funds currently are required to disclose their votes.'' \13\ House Financial Services Committee Chairman Barney Frank (D-MA) also has expressed interest in considering this issue. \14\ If disclosure of proxy votes promotes important public policy objectives, then similar requirements should apply to all institutional investors.--------------------------------------------------------------------------- \13\ See Statement of Lynn E. Turner Before the Senate Committee on Banking, Housing, and Urban Affairs on Enhancing Investor Protection and the Regulation of the Securities Markets (March 10, 2009) at 13. \14\ See Siobhan Hughes, Rep. Frank Plans Hearing on Disclosure of Proxy Votes, Dow Jones News Service, March 22, 2007.--------------------------------------------------------------------------- Below we provide our views on shareholder access to company proxy materials for director-related bylaw amendments and shareholder advisory votes on executive pay. Proxy Access: In their dual role as major, long-term investors in securities of public companies and as issuers with their own shareholders and boards of directors, funds have a valuable perspective to offer on the topic of shareholder access to company proxy materials and the need to appropriately balance the interests of shareholders with those of company management. ICI generally supports affording certain shareholders direct access to a company's proxy materials for director-related bylaw amendments. \15\ We agree that long-term shareholders with a significant stake in a company have a legitimate interest in having a voice in the company's corporate governance. We believe that the ability to submit bylaw amendments concerning director nomination procedures could be an effective additional tool for use by funds and others to enhance shareholder value.--------------------------------------------------------------------------- \15\ ICI has presented its views on this matter in Congressional testimony and in a comment letter to the SEC. See Statement of Paul Schott Stevens, President and CEO, Investment Company Institute, Before the Committee on Financial Services, United States House of Representatives on ``SEC Proxy Access Proposals: Implications for Investors'' (September 27, 2007); Letter from Karrie McMillan, General Counsel, Investment Company Institute, to Ms. Nancy M. Morris, Secretary, U.S. Securities and Exchange Commission, dated October 2, 2007, available at http://www.ici.org/statements/cmltr/07_sec_proxy_access_com.html#TopOfPage--------------------------------------------------------------------------- At the same time, the privilege of proxy access should not be granted lightly. The Federal securities laws should not facilitate efforts to use a company's proxy machinery--at company expense--to advance parochial or short-term interests not shared by the company's other shareholders. Instead, the regulatory scheme should be crafted to afford access to a company's proxy only when the interests of shareholder proponents are demonstrably aligned with those of long-term shareholders. To achieve this objective, appropriate limits on the ability to use company resources to propose changes to a company's governing documents are critically important. In our view, these limits should include: LRestricting the privilege of proxy access to shareholders who do not acquire or hold the securities for the purpose of changing or influencing control of the company. Shareholders seeking to change or influence control of the company should be required to follow the regulatory framework for proxy contests and bear the related costs. LRequiring shareholder proponents to demonstrate that they are long-term stakeholders with a significant ownership interest. We recommend that there be a meaningful required holding period, such as two years, to provide assurance that shareholder proponents are committed to the long-term mission of the company, rather than seeking the opportunity for personal gain and quick profits or advancement of parochial interests at the expense of the company and other shareholders. Similarly, we support establishing a relative high minimum ownership threshold that would encourage shareholders to come together to effect change. We believe a five percent ownership threshold may not be sufficiently high to assure that the company's proxy machinery would be used to advance the common interests of many shareholders in addressing legitimate concerns about the management and operation of the company. Consideration should be given to varying the required ownership threshold based on factors such as the company's market capitalization. The Securities and Exchange Commission (SEC) should study share ownership and holding period information to arrive at well- reasoned criteria that will encourage would-be shareholder proponents to work together to achieve goals that benefit all shareholders. LExcluding borrowed shares from the determination of ownership level and holding period. Beneficial ownership of shares should be required to assure that the proponents' interests truly are aligned with those of long-term shareholders. Another important element of proxy access is disclosure. Shareholder proponents should be required to provide disclosure for inclusion in proxy materials that would allow a company's other shareholders to make informed voting decisions (e.g., information about their background, intentions, and course of dealing with the company). SEC rules also should hold shareholder proponents--and not companies--responsible for the disclosure those shareholders provide. SEC Chairman Mary Schapiro recently indicated that the SEC will soon consider a proposal ``to ensure that a company's owners have a meaningful opportunity to nominate directors.'' \16\ We look forward to reviewing and commenting on the SEC's proposal.--------------------------------------------------------------------------- \16\ See SEC Speech: Address to the Council of Institutional Investors, by Chairman Mary L. Schapiro, U.S. Securities and Exchange Commission (May 6, 2009), available at http://www.sec.gov/news/speech/2009/spch040609mls.htm--------------------------------------------------------------------------- Say on Pay: As noted above, funds are significant holders of public companies. When deciding whether to invest in a company or to continue to hold its stock, funds consider many factors, including how the company compensates its top executives. This information is important because it allows funds to decide whether (1) there is an alignment of interests between the executives running the company and the shareholders who own the company and (2) executives have incentives to maximize value for shareholders. ICI has supported SEC efforts to ensure that investors receive clear and complete disclosure regarding executive pay packages. The financial crisis has fanned the flames of public outrage over executive compensation, particularly where such compensation appears to be grossly excessive in light of a company's performance or where the compensation seems to promote the short-term interests of managers over the longer-term interests of shareholders. Funds are deeply mindful of these issues. ICI would not oppose requiring public companies to put the compensation packages of their key executive officers to a non-binding advisory vote of shareholders as an additional way to encourage sound decision-making by companies regarding the composition of executive pay packages. We strongly urge, however, that any such requirement be coupled with requiring other institutional investors to disclose their proxy votes, as we recommend above. Otherwise, the votes of funds on executive compensation, but not those of any other institutional investor, would be subject to scrutiny and, often we feel, unfair second-guessing. Moreover, the potential benefits of greater transparency of the proxy voting process would seem to be particularly evident here, where the public disclosure of executive compensation votes would maximize their influence over management.Q.5. Credit Rating Agencies: A. Please identify any legislative or regulatory changes you believe are warranted to improve the oversight of credit rating agencies. In addition, I would like to ask your views on two specific proposals: 1. LThe Peterson Institute report on ``Reforming Financial Regulation, Supervision, and Oversight'' recommended reducing conflicts of interest in the major rating agencies by not permitting them to perform consulting activities for the firms they rate. 2. LThe G30 Report ``Financial Reform; A Framework for Financial Stability'' recommended that regulators should permit users of ratings to hold NRSROs accountable for the quality of their work product. Similarly, Professor Coffee recommended creating potential legal liability for recklessness when ``reasonable efforts'' have not been made to verify ``essential facts relied upon by its ratings methodology.''A.5. Measures To Improve the Oversight of Rating Agencies: ICI is committed to the objective of improving the rating process to make ratings more accurate and useful to investors and to promote the sound functioning of our capital markets. \17\ We recommend several regulatory measures to enhance the oversight of credit rating agencies and thereby improve the quality, accuracy, and integrity of ratings and the rating process. \18\ Generally speaking, our recommendations would enhance disclosure, address conflicts of interest, and hold rating agencies accountable for their ratings. \19\--------------------------------------------------------------------------- \17\ ICI recently participated in the SEC's Roundtable on the oversight of credit rating agencies in an effort to further the discussion on ways in which to improve ratings and the ratings process. See Statement of Paul Schott Stevens, President and CEO, Investment Company Institute, SEC Roundtable on Oversight of Credit Rating Agencies, dated April 15, 2009, available at http://www.ici.org/home/09_oversight_stevens_stmt.html#TopOfPage. See also Statements of Paul Schott Stevens, President, Investment Company Institute, on the ``Credit Rating Agency Duopoly Relief Act of 2005,'' before the Committee on Financial Services, U.S. House of Representatives (November 29, 2005) and on ``Assessing the Current Oversight and Operation of Credit Rating Agencies,'' before the Committee on Banking, Housing, and Urban Affairs, U.S. Senate (March 7, 2006). \18\ See Letter from Karrie McMillan, General Counsel, Investment Company Institute, to Florence Harmon, Acting Secretary, U.S. Securities and Exchange Commission, dated July 25, 2008; Letter from Karrie McMillan, General Counsel, Investment Company Institute, to Elizabeth M. Murphy, Secretary, U.S. Securities and Exchange Commission, dated March 26, 2009. \19\ We believe the SEC currently has authority to implement many of our recommendations. Others (such as certain changes to improve municipal securities disclosure, discussed below) would require Congressional action.--------------------------------------------------------------------------- Specifically, we recommend that the Securities and Exchange Commission (SEC) improve disclosure about credit ratings and the rating process for structured finance securities and other debt securities. Public disclosure of information about a credit rating agency's policies, procedures, and other practices relating to rating decisions will allow investors to evaluate more effectively a rating agency's independence, objectivity, capability, and operations. Disclosure will serve as a powerful additional mechanism for ensuring the integrity and quality of the credit ratings themselves. To realize the full potential of such a disclosure regime, the SEC should require the standardized presentation of this information in a presale report issued by the rating agencies. The SEC also should take steps to strengthen the incentives to produce quality ratings, because such incentives are clearly insufficient in the current system. To this end, the SEC should require rating agencies to conduct ``due diligence'' assessments of the information they review to issue ratings. This should help build investor confidence in ratings and the rating process over time, by enabling users of ratings to gauge both the accuracy of the information being analyzed by the rating agency and the rating agency's ability to assess the creditworthiness of the underlying security. We also recommend that rating agencies have greater legal accountability to investors for their ratings. Both of these recommendations should encourage rating agencies to improve the quality of their ratings. Today's rating system is hampered by deep concerns about conflicts of interest, poor disclosure, and lack of accountability. To address these concerns effectively, the SEC should apply necessary regulatory reforms in a consistent manner to all types of credit rating agencies. A consistent approach is not only critical to improving ratings quality and allowing investors to identify and assess potential conflicts of interest, but also to increasing competition among rating agencies. The SEC must also employ a consistent and active approach to enforcement of the oversight regime, holding rating agencies accountable for any failures to comply with the SEC's rules and the rating agency's own policies and procedures adopted under the rules. Finally, we recommend that the SEC address the need for better disclosure by certain issuers (e.g., expand issuer disclosure for structured finance products, expand and standardize issuer disclosure for asset-backed securities, and require that disclosure for asset-backed securities be ongoing). In addition, we recommend that the SEC improve issuer disclosure for municipal securities. \20\ Better disclosure will assist investors in making their own risk assessments and should foster better quality ratings.--------------------------------------------------------------------------- \20\ See Letter from Karrie McMillan, General Counsel, Investment Company Institute, to Florence Harmon, Acting Secretary, U.S. Securities and Exchange Commission, dated September 22, 2008.--------------------------------------------------------------------------- Controlling Conflicts of Interest--Limiting or Prohibiting Consulting Activities: Addressing conflicts of interest at rating agencies is particularly important given the role that ratings play in today's capital markets. For this reason, ICI has recommended that the SEC require rating agencies to disclose information, including: (1) any material ancillary business relationships between a rating agency and an issuer and (2) information regarding the separation of a rating agency's consulting and rating activities. \21\ If such information is available, we believe that it is unnecessary to prohibit rating agencies from performing any consulting activities for the firms they rate. The SEC already has prohibited rating agencies from rating a product in which the rating agency has been consulted on the structure of the product. We believe that this measure, in combination with the disclosure we have recommended, should curtail opportunities for questionable conduct. In addition, it should put investors on notice regarding potential conflicts of interest arising from a rating agency's consulting business and provide investors with the information needed to assess the ability and effectiveness of a rating agency to manage those conflicts of interest.--------------------------------------------------------------------------- \21\ See Letter from Karrie McMillan, General Counsel, Investment Company Institute, to Florence Harmon, Acting Secretary, U.S. Securities and Exchange Commission, dated July 25, 2008.--------------------------------------------------------------------------- Enhancing Accountability, Due Diligence, and Legal Liability of Rating Agencies: Given the role of ratings in the investment process and the use of ratings by investors, ICI agrees with the recommendation in the G30 Report and by Professor Coffee: credit rating agencies should have greater legal accountability for their ratings. Currently, investors do not have sufficient legal recourse against rating agencies if, for example, a rating agency issues an erroneous rating. We believe that the exemption for nationally recognized statistical rating organizations (NRSROs) from Section 11 of the Securities Act of 1933 should be reconsidered. \22\ Under current regulations, the SEC exempts NRSROs, but not other rating agencies, from treatment as experts subject to liability under Section 11 and, thus, allows NRSRO ratings in prospectuses and financial reports. Although the SEC has stated that NRSROs remain subject to antifraud rules, the NRSROs have steadfastly maintained that, under the First Amendment, they cannot be held liable for erroneous ratings absent a finding of malice.--------------------------------------------------------------------------- \22\ Section 11 under the Securities Act creates liability for issuers and certain professionals who prepared or certified any part of a registration statement for any materially false statements or omissions in the registration statement.--------------------------------------------------------------------------- While it may be argued that rating agencies should not be liable for an erroneous rating as such, they should, at a minimum, have some accountability for ratings issued in contravention of their own disclosed procedures and standards. As we have stated in the past, even if the First Amendment applies to credit ratings, it should not immunize rating agencies for false or misleading disclosures to the SEC and to the investing public. Quite simply, if a rating agency obtains an NRSRO designation based on, for example, a specific ratings process, it should be held accountable to the SEC and to investors if it fails to follow that process. A rating agency's ability to continue to claim First Amendment rights also has been questioned based on the business decisions and the roles undertaken by rating agencies over the last decade. Rating agencies have abandoned their former practice of rating most or all securities whether or not hired to do so, and rating agencies have become deeply involved in the structuring of complex securities, which are normally not sold to retail investors. These changes warrant serious attention when considering whether rating agencies still merit the protection that the First Amendment may have provided to them in their more traditional role. \23\--------------------------------------------------------------------------- \23\ Rating agencies have cited the First Amendment in statements to Congress, the courts, and the investing public, stating that their ratings are opinions only--not ``recommendations or commentary on the suitability of a particular investment.'' See, e.g., Statement of Deven Sharma, President, Standard & Poor's, on ``Credit Rating Agencies and the Financial Crisis,'' before the Committee on Oversight and Government Reform, U.S. House of Representatives (October 22, 2008). See also Not ``The World's Shortest Editorial'': Why the First Amendment Does Not Shield Rating Agencies From Liability for Over-Rating CDOs, David J. Grais and Kostas D. Katsiris, Grais & Ellsworth, Bloomberg Law Reports (November 2007).--------------------------------------------------------------------------- In addition to increasing legal accountability for rating agencies, we believe that rating agencies would have greater ability to produce high quality and more reliable ratings if they were required to conduct better due diligence and verification. Under current SEC rules, it is difficult for a user of a rating to gauge the accuracy of the information being analyzed by the rating agency and, thus, evaluate the rating agency's ability to assess the creditworthiness of a structured finance product. \24\ Rating agencies are required neither to verify the information underlying a structured finance product received from an issuer nor to compel issuers to perform due diligence or to obtain reports concerning the level of due diligence performed by issuers of structured finance products.--------------------------------------------------------------------------- \24\ Current rules only require that rating agencies provide a description of: (1) the public and nonpublic sources of information used in determining credit ratings, including information and analysis provided by third-party vendors; (2) whether and how information about verification performed on assets underlying structured finance securities is relied upon in determining credit ratings; and (3) whether and how assessments of the quality of originators of structured finance securities factor into the determination of credit ratings.--------------------------------------------------------------------------- To address these concerns, we recommend that credit rating agencies be required to conduct due diligence on the information they review to issue ratings. In addition, to raise investor confidence in the quality of ratings and the rating process as a whole, the due diligence requirements should apply (as appropriate) to all rated debt securities, not only structured finance products. Specifically, we recommend that: LRating agencies be required to have policies and procedures in place reasonably sufficient to assess the credibility of the information they receive from issuers and underwriters. LRating agencies disclose these policies and procedures, the specific steps taken to verify information about the assets underlying a security, and the results of the verification process. LRating agencies disclose the limitations of the available information or data, any actions they take to compensate for any missing information or data, and any risks involved with the assumptions and methodologies they use in providing a rating. LRating agencies be required to certify that the rating agency has satisfied its stated policies and procedures for performing due diligence on the security being rated.Q.6. Hedge Funds: On March 5, 2009, the Managed Funds Association testified before the House Subcommittee on Capital Markets and said: ``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.'' MFA supported the creation or designation of a ``single central systemic risk regulator'' that (1) has ``the authority to request and receive, on a confidential basis, from those entities that it determines . . . 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,'' (2) has a mandate of protection of the financial system, but not investor protection or market integrity and (3) has the authority to ensure that a failing market participant does not pose a risk to the entire financial system. Do you agree with MFA's position? Do you feel there should be regulation of hedge funds along these lines or otherwise?A.6. Systemic Risk Regulation: Over the past year, various policymakers and other commentators have called for the establishment of a formal mechanism for identifying, monitoring, and managing risks to the financial system as a whole. ICI concurs with those commentators and with the Managed Funds Association (MFA) that creation of such a mechanism is necessary. The ongoing financial crisis has highlighted the vulnerability of our financial system to risks that have the potential to spread rapidly throughout the system and cause significant damage. A mechanism that will allow Federal regulators to look across the system should equip them to better anticipate and address such risks. Generally speaking, MFA's statement about a ``single central systemic risk regulator'' touches on some of the same themes that ICI addressed in its March 3, 2009, white paper, Financial Services Regulatory Reform: Discussion and Recommendations. \25\ In our white paper, we endorsed the designation of a new or existing agency or inter-agency body as a ``Systemic Risk Regulator.'' Broadly stated, the goal in establishing a Systemic Risk Regulator should be to provide greater overall stability to the financial system as a whole. The Systemic Risk Regulator should have responsibility for: (1) monitoring the financial markets broadly; (2) analyzing changing conditions in domestic and overseas markets; (3) evaluating the risks of practices as they evolve and identifying those that are of such nature and extent that they implicate the health of the financial system at large; and (4) acting to mitigate such risks in coordination with other responsible regulators.--------------------------------------------------------------------------- \25\ See Financial Services Regulatory Reform: Discussion and Recommendations, which is available at http://www.ici.org/pdf/ppr_09_reg_reform.pdf. We note that the white paper was included as an attachment to ICI's written testimony.--------------------------------------------------------------------------- In ICI's view, Congress should determine the composition and authority of the Systemic Risk Regulator with two important cautions in mind. First, the legislation establishing the Systemic Risk Regulator should be crafted to avoid imposing undue constraints or inapposite forms of regulation on normally functioning elements of the financial system, or stifling innovations, competition or efficiencies. By way of example, it has been suggested that a Systemic Risk Regulator could be given the authority to identify financial institutions that are ``systemically significant'' and to oversee those institutions directly. Such an approach could have very serious anticompetitive effects if the identified institutions were viewed as ``too big to fail'' and thus judged by the marketplace as safer bets than their smaller, ``less significant'' competitors. \26\--------------------------------------------------------------------------- \26\ See, e.g., Peter J. Wallison, Regulation Without Reason: The Group of Thirty Report, AEI Financial Services Outlook (Jan. 2009), available at http://www.aei.org/publications/pubID.29285/pub_detail.asp--------------------------------------------------------------------------- Second, the 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. We strongly concur with MFA that the Systemic Risk Regulator should focus principally on protecting the financial system--as discussed in detail in our white paper, we believe that a strong and independent Capital Markets Regulator (or, until such agency is established by Congress, the Securities and Exchange Commission) should focus principally on the equally important mandates of protecting investors and maintaining market integrity. Legislation establishing the Systemic Risk Regulator should define the nature of the relationship between this new regulator and the primary regulator(s) for each industry sector. This should involve carefully defining the extent of the authority granted to the Systemic Risk Regulator, as well as identifying 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 have a critical role to play by acting as the first line of defense with regard to detecting potential risks within their spheres of expertise. In view of the two cautions outlined above, ICI believes that the Systemic Risk Regulator would be best structured as a statutory council comprised of senior Federal regulators. Membership should include, at a minimum, the Secretary of the Treasury, Chairman of the Federal Reserve Board of Governors, and the heads of the Federal bank and capital markets regulators (and insurance regulator, if one emerges at the Federal level). Regulation of the Hedge Fund Industry--Appropriate Focus of Regulatory Oversight: In 2004, the Securities and Exchange Commission (SEC) adopted a rule to require hedge fund advisers to register with the SEC as investment advisers. ICI supported this registration requirement as a way to provide the SEC with reliable, current, and meaningful information about this significant segment of the capital markets without adversely impacting the legitimate operations of hedge fund advisers. Many ICI member firms--all of whom are registered with the SEC--currently operate hedge funds and have found that registration is not overly burdensome and does not interfere with their investment activities. In June 2006, the SEC's hedge fund adviser registration rule was struck down by the U.S. Court of Appeals for the D.C. Circuit. The following month, in testimony before this Committee, then SEC Chairman Christopher Cox commented that the rule's invalidation had forced the SEC ``back to the drawing board to devise a workable means of acquiring even basic census data that would be necessary to monitor hedge fund activity in a way that could mitigate systemic risk.'' \27\--------------------------------------------------------------------------- \27\ See Written Testimony of SEC Chairman Before the U.S. Senate Committee on Banking, Housing and Urban Affairs (July 25, 2006) (concerning the regulation of hedge funds), available at http://www.sec.gov/news/testimony/2006/ts072506cc.htm--------------------------------------------------------------------------- In our white paper, we call for this regulatory gap to be closed. Specifically, ICI recommends that the Capital Markets Regulator (or SEC) have express regulatory authority to provide oversight over hedge funds (through their advisers) with respect to, at a minimum, their potential impact on the capital markets. \28\ For example, similar to MFA's recommendation, we state that the regulator could require nonpublic reporting of information such as investment positions and strategies that could bear on systemic risk and adversely impact other market participants.--------------------------------------------------------------------------- \28\ It is imperative, of course, that the Capital Markets Regulator (or SEC) be organized and staffed, and have sufficient resources, to effectively perform this oversight function.--------------------------------------------------------------------------- We continue to believe that hedge fund adviser registration is an appropriate response to address the risks that hedge funds can pose to the capital markets and other market participants. In this regard, the Capital Markets Regulator (or SEC) may wish to consider the adoption of specific rules under the Investment Advisers Act of 1940 that are tailored to the specific business practices of, and market risks posed by, hedge funds. Areas of focus for such rulemaking should include, for example, disclosure regarding valuation practices and the calculation of investment performance; both of these areas have been criticized as lacking transparency and presenting the potential for abuse. ICI does not support, however, requiring the registration of individual hedge funds with the SEC. Rather, as discussed in detail below, ICI believes there must continue to be a strict dividing line between registered, highly regulated investment companies and unregistered, lightly regulated hedge funds. A registration requirement for hedge funds would blur this line, invariably causing confusion for both investors and the marketplace. This confusion would likely exacerbate already imprecise uses of the term ``fund'' to refer to investment pools, whether registered or not. Further, we believe it is imperative to keep any problems in the hedge fund area from bleeding over in the public's mind to include mutual funds, which are owned by almost half of all U.S. households. Maintaining the distinctions between investment companies and hedge funds--Compared to registered investment companies, which are subject to the comprehensive and rigorous regulatory regime set forth in the Investment Company Act of 1940 and related rules, hedge funds are lightly regulated investment products. Hedge funds are effectively outside the purview of the Investment Company Act by reason of Sections 3(c)(1) and 3(c)(7), which require that the hedge fund is not making or proposing to make a public offer of its securities and that those securities be sold only to certain specific groups of investors. These provisions thus place express statutory limits on both the offer and the sale of securities issued by a hedge fund. ICI firmly believes that these limits must be preserved and should be reconfirmed in any legislation enacted to regulate hedge funds or their advisers. No general solicitation or public advertising by hedge funds--Despite clear statutory language precluding a hedge fund from ``making or proposing to make a public offer of its securities,'' there have been several occasions in the recent past where the hedge fund industry has argued that it should be able to advertise through the public media, while remaining free from the regulatory restrictions and shareholder protections imposed by the Investment Company Act. Additionally, in 2003, the SEC staff recommended that the SEC consider eliminating the prohibition on general solicitation in offerings by certain hedge funds. ICI emphatically opposes any such efforts, because allowing hedge funds organized pursuant to Sections 3(c)(1) and 3(c)(7) to engage in any form of general solicitation or public advertising is fundamentally inconsistent with hedge funds' exclusion from regulation under the Investment Company Act. Section 3(c)(7) was added to the Investment Company Act in 1996, in apparent recognition that the full panoply of investment company regulation is not necessary for hedge funds (and other private investment pools) offered and sold only to financially sophisticated investors able to bear the risk of loss associated with their investment. The ``no public offering'' language used by Congress in Section 3(c)(7) generally tracks the language in Section 4(2) of the Securities Act of 1933. For almost five decades, the SEC has taken the position that public advertising is inconsistent with a nonpublic offering of securities under Section 4(2). \29\--------------------------------------------------------------------------- \29\ See Non-Public Offering Exemption, SEC Rel. No. 33-4552 (Nov. 6, 1962) at text preceding n.2, text preceding n.3 (``Consideration must be given not only to the identity of the actual purchasers but also to the offerees. Negotiations or conversations with or general solicitations of an unrestricted and unrelated group of prospective purchasers for the purpose of ascertaining who would be willing to accept an offer of securities is inconsistent with a claim that the transaction does not involve a public offering even though ultimately there may only be a few knowledgeable purchasers . . . . Public advertising of the offerings would, of course, be incompatible with a claim of a private offering.'').--------------------------------------------------------------------------- In its rulemaking to implement Section 3(c)(7) and related provisions, the SEC observed that ``while the legislative history . . . does not explicitly discuss Section 3(c)(7)'s limitation on public offerings by Section 3(c)(7) funds, the limitation appears to reflect Congress's concerns that unsophisticated individuals not be inadvertently drawn into [such] funds.'' \30\ A member of Congress intimately involved in this debate later concurred with the SEC's interpretation in a letter to then SEC Chairman Arthur Levitt. His letter further explained:--------------------------------------------------------------------------- \30\ See Privately Offered Investment Companies, SEC Rel. No. IC-22597 (April 3, 1997), at n.5. In 1996, as part of the National Securities Markets Improvement Act, Congress reaffirmed that hedge funds should not be publicly marketed, specifically adding this restriction to a modernized hedge fund exemption that was included in the final bill. As you will recall, I was one of the authors of this provision . . . I believe that the Congress has appropriately drawn the lines regarding hedge fund marketing, and intend to strongly oppose any effort to liberalize them. \31\--------------------------------------------------------------------------- \31\ See Letter from Rep. Edward J. Markey (D-Mass.) to SEC Chairman Arthur Levitt, dated Dec. 18, 2000. Any form of general solicitation or public advertising of unregistered hedge funds would surely cause investors to confuse such funds with registered, highly regulated investment companies. It also would present greater opportunities for perpetrators of securities fraud to identify and target unsophisticated investors. This potential for investor confusion and fraudulent activity would be compounded by the fact that the SEC simply would not have the resources to monitor advertisements by hedge funds--whether legitimate or fraudulent--in any meaningful way. For all of these reasons, ICI firmly believes that there must continue to be a strict prohibition on any form of general solicitation or public advertising in connection with hedge fund offerings. Limitations on who may invest in hedge funds--No less critical is the need to ensure that interests in hedge funds are sold only to financially sophisticated investors able to bear the economic risk of their investment. To this end, ICI believes that the accredited investor standards in Regulation D under the Securities Act of 1933 (which determine investor eligibility to participate in unregistered securities offerings by hedge funds and other issuers) should be immediately adjusted to correct for the substantial erosion in those standards since their adoption in 1982. This one-time adjustment should be coupled with periodic future adjustments to keep pace with inflation. Specifically, ICI has recommended that the SEC's Office of Economic Analysis be required to reset the accredited investor thresholds every 5 years, so that the percentage of the population qualifying as accredited investors would remain stable over time. This would entail a straightforward economic analysis that could be performed using widely available government databases. \32\--------------------------------------------------------------------------- \32\ For a detailed discussion of the Institute's views on these issues, see Letter from Paul Schott Stevens, President and CEO, Investment Company Institute, to Nancy M. Morris, Secretary, U.S. Securities and Exchange Commission, dated Oct. 9, 2007, available at http://www.sec.gov/comments/s7-18-07/s71807-37.pdf--------------------------------------------------------------------------- Also in this regard, ICI continues to support the SEC's 2006 proposal to raise the eligibility threshold for individuals wishing to invest in hedge funds (and other private investment pools) organized under Section 3(c)(1) of the Investment Company Act. Specifically, an individual would need to be an ``accredited investor'' based upon specified net worth or income levels, as is now required, and own at least $2.5 million in investments. According to the SEC, this new two-step approach would mirror the existing eligibility requirements that Congress determined were appropriate for investors in hedge funds organized under Section 3(c)(7).Q.7. Self-Regulatory Organizations: How do you feel the self-regulatory securities organizations have performed during the current financial crisis? Are there changes that should be made to the self-regulatory organizations to improve their performance? Do you feel there is still validity in maintaining the self-regulatory structure or that some powers should be moved to the SEC or elsewhere?A.7. Self-regulatory organizations (SROs) form an integral part of the current system of securities markets oversight. ICI has had a longstanding interest in the effective and efficient operation of SROs, and we support an examination of their role and operations. We believe there may be several ways to improve SROs' performance and operations, particularly through enhancements to their rules and rulemaking processes, and their governance structure. SRO rules should be crafted both to protect investors and to promote efficiency, competition and capital formation. To achieve these objectives, it is critically important that SROs consider the relative costs and benefits of their rules. We have recommended on several occasions that Congress by law, or the SEC by rule, require that all SROs evaluate the costs and benefits of their rule proposals prior to submission to the SEC and establish a process for reexamining certain existing rules. \33\ This process should be designed to determine whether the rules are working as intended, whether there are satisfactory alternatives of a less burdensome nature, and whether changes should be made.--------------------------------------------------------------------------- \33\ See Statement of the Investment Company Institute on the Review of the U.S. Financial Markets and Global Markets Competitiveness, Submitted to the Senate Republican Capital Markets Task Force, U.S. Senate (February 25, 2008) and Submission of the Investment Company Institute to the Department of the Treasury, Review of the Regulatory Structure Associated with Financial Institutions (December 7, 2007).--------------------------------------------------------------------------- The SRO rulemaking process itself serves important policy goals, including, among other things, assuring that interested persons have an opportunity to provide input regarding SRO actions that could have a significant effect on the market and market participants. ICI has supported amendments that would improve the ability of interested persons to submit comments on SRO actions. In particular, we have recommended extending the length of the comment period for any significant SRO proposal. \34\--------------------------------------------------------------------------- \34\ See Letters from Craig S. Tyle, General Counsel, Investment Company Institute, to Jonathan G. Katz, Secretary, U.S. Securities and Exchange Commission, dated April 6, 2001, and Dorothy M. Donohue, Associate Counsel, Investment Company Institute, to Jonathan G. Katz, Secretary, U.S. Securities and Exchange Commission, dated June 4, 2004.--------------------------------------------------------------------------- Finally, ICI supports efforts to strengthen SRO governance processes. \35\ For example, to ensure that the views of investors are adequately represented, we have recommended that SROs be required to have sufficient representation from funds and other institutional investors in their governance structures. In addition, to address concerns that SROs are inherently subject to conflicts of interest, consideration should be given to requiring SRO boards to have an appropriate balance between public members and members with industry expertise. \36\--------------------------------------------------------------------------- \35\ See, e.g., Letter from Ari Burstein, Associate Counsel, Investment Company Institute, to Jonathan G. Katz, Secretary, U.S. Securities and Exchange Commission, dated March 8, 2005. \36\ See Regulating Broker-Dealers and Investment Advisers: Demarcation or Harmonization?, Speech by SEC Commissioner Elisse B. Walter Before the Mutual Fund Directors Forum Ninth Annual Policy Conference (May 5, 2009), available at http://www.sec.gov/news/speech/2009/spch050509ebw.htmQ.8. Structure of the SEC: Please share your views as to whether you feel that the current responsibilities and structure of the SEC should be changed. Please comment on the following specific proposals: 1. LGiving some of the SEC's duties to a systemic risk regulator or to a financial services consumer protection agency; 2. LCombining the SEC into a larger ``prudential'' financial services regulator; 3. LAdding another Federal regulators' or self-regulatory organizations' powers or duties to the SEC.A.8. Investment companies (funds) are both major holders of securities issued by public companies and issuers of securities (fund shares) held by almost half of all U.S. households. As such, they have a vested interest in the effective regulation of the capital markets by a strong and independent regulator. Funds and their shareholders stand to benefit if that regulator has the tools it needs to fulfill important policy objectives, such as: preserving the integrity of the capital markets; ensuring the adequacy and accuracy of periodic disclosures by public issuers; and promoting fund regulation that protects investors, encourages innovation, and does not hinder market competition. As discussed in its March 3, 2009, white paper, Financial Services Regulatory Reform: Discussion and Recommendations, \37\ ICI supports the creation of a new Capital Markets Regulator that would encompass the combined functions of the Securities and Exchange Commission (SEC) and those of the Commodity Futures Trading Commission (CFTC) that are not agriculture-related. In our response below to part A of the question, we briefly discuss this recommendation and our suggestions relating to the Capital Markets Regulator's responsibilities and structure. Pending, or in the absence of, Congressional action to create a Capital Markets Regulator, most of our recommendations just as appropriately could be applied to the SEC. Where appropriate for ease of discussion, we use the term ``agency'' to refer equally to the SEC or a new Capital Markets Regulator.--------------------------------------------------------------------------- \37\ See Financial Services Regulatory Reform: Discussion and Recommendations, which is available at http://www.ici.org/pdf/ppr_09_reg_reform.pdf. We note that the white paper was included as an attachment to ICI's written testimony.--------------------------------------------------------------------------- We then address the issues outlined in part B of the question in the context of a discussion about how the SEC or a new Capital Markets Regulator should fit within the broader financial services regulatory framework. Reforming the Responsibilities and Structure of the SEC: To bring a consistent policy focus to U.S. capital markets, ICI strongly recommends the creation of a new Capital Markets Regulator. Currently, securities and futures are subject to separate regulatory regimes under different Federal regulators. This system reflects historical circumstances that have changed significantly. As recently as the mid-1970s, for example, agricultural products accounted for most of the total U.S. futures exchange trading volume. By the late 1980s, a shift from the predominance of agricultural products to financial instruments and currencies was readily apparent in the volume of trading on U.S. futures exchanges. In addition, as new, innovative financial instruments were developed, the lines between securities and futures often became blurred. The existing, divided regulatory approach has resulted in jurisdictional disputes between the SEC and the CFTC, regulatory inefficiency, and gaps in investor protection and market oversight. With the increasing convergence of securities and futures products, markets, and market participants, the current system simply makes no sense. As envisioned by ICI, the Capital Markets Regulator would be a single, independent Federal regulator responsible for oversight of U.S. capital markets, market participants, and all financial investment products. It would have an express statutory mission and the rulemaking and enforcement powers necessary to carry out that mission. \38\ From the perspective of the fund industry, the mission of the Capital Markets Regulator must involve maintaining a sharp focus on investor protection, supported by a comprehensive enforcement program. This core feature of the SEC's mission has consistently distinguished the SEC from the banking regulators, who are principally concerned with the safety and soundness of the financial institutions they regulate, and it has generally served investors well over the years.--------------------------------------------------------------------------- \38\ Currently, regulatory oversight of both the securities and futures industries involves various self-regulatory organizations. In establishing a Capital Markets Regulator, Congress would need to determine the appropriate role for any such organization(s).--------------------------------------------------------------------------- Examination of the recent financial crisis has prompted calls for Congress to close regulatory gaps to ensure appropriate oversight of all market participants and investment products. In our white paper, we recommend that the Capital Markets Regulator (or SEC) have express regulatory authority to provide oversight with regard to hedge funds, derivatives, and municipal securities. We further recommend that the agency be given explicit authority to harmonize the legal standards applicable to investment advisers and broker-dealers. How a regulatory agency is managed, and the details of its organizational structure, can have significant implications for the agency's effectiveness. In our white paper, we offer the following suggestions with regard to management and organization of the Capital Markets Regulator (or SEC). LEnsure high-level focus on agency management. One approach would be to designate a Chief Operating Officer for this purpose. LImplement a comprehensive process for setting regulatory priorities and assessing progress. It may be helpful to draw upon the experience of the United Kingdom's Financial Services Authority, which seeks to follow a methodical approach that includes developing a detailed annual business plan establishing agency priorities and then reporting annually the agency's progress in meeting prescribed benchmarks. LPromote open and effective lines of communication among the Commissioners and between the Commissioners and staff. Such communication is critical to fostering awareness of issues and problems as they arise, thus increasing the likelihood that the agency will be able to act promptly and effectively. A range of approaches may be appropriate to consider in meeting this goal, including whether sufficient flexibility is provided under the Government in the Sunshine Act, and whether the number of Commissioners should be greater than the current number at the SEC (five). LAlign the inspections and examinations functions and the policymaking divisions. This approach would have the benefit of keeping staff in the policymaking divisions updated on current market and industry developments, as well as precluding any de facto rulemaking by the agency's inspections staff. LDevelop mechanisms to facilitate coordination and information sharing among the policymaking divisions. These mechanisms would help to ensure that the agency speaks with one voice. How the SEC (or a New Capital Markets Regulator) Fits Within the Broader Financial Services Regulatory Framework: Today's financial crisis has demonstrated that the current system for oversight of U.S. financial institutions is insufficient to address modern financial markets. In its white paper, ICI recommends changes to create a regulatory framework that enhances regulatory efficiency, limits duplication, closes regulatory gaps, and emphasizes the national character of the financial services industry. In brief, ICI supports: LCreating a consolidated Capital Markets Regulator, as discussed above; LEstablishing a ``Systemic Risk Regulator'' that would identify, monitor and manage risks to the financial system as a whole; LConsidering consolidation of the regulatory structure for the banking sector; LAuthorizing an optional Federal charter for insurance companies; and LPromoting effective coordination and information sharing among the various financial regulators, including in particular the new Systemic Risk Regulator. Increased consolidation of financial services regulators, combined with the establishment of a Systemic Risk Regulator and more robust inter-agency coordination and information sharing, should facilitate monitoring and mitigation of risks across the financial system. We believe that consolidation of regulatory agencies also may further the competitive posture of the U.S. financial markets and could make it easier, when appropriate, to harmonize U.S. regulations with regulations in other jurisdictions. Reducing the number of U.S. regulatory agencies, while also strengthening the culture of cooperation and dialogue among senior officials of the agencies, will likely facilitate coordinated interaction with regulators around the world. By providing for one or more dedicated regulators to oversee each major financial services sector, this proposed structure would maintain the specialized focus and expertise that is a hallmark of effective regulation. This structure also would allow appropriate tailoring of regulation to accommodate fundamental differences in regulated entities, products and activities. Additionally, it would avoid the potential for one industry sector to take precedence over the others in terms of regulatory priorities or approaches or the allocation of regulatory resources. In particular, the regulatory structure favored by ICI would preserve the important distinctions between the mission of the Capital Markets Regulator (or SEC), which is sharply focused on investor protection, and that of the banking regulators, which is principally concerned with the safety and soundness of the banking system. Both regulatory approaches have a critical role to play in ensuring a successful and vibrant financial system, but neither should be allowed to trump the other. For this reason, we believe it would be inappropriate to combine the SEC into a larger ``prudential'' financial services regulator, a move that could result in diminished investor protections. Preserving regulatory balance, and bringing to bear different perspectives, is a theme that has influenced ICI's thinking on how to structure a Systemic Risk Regulator. In our white paper, we suggested that very careful consideration must be given to the specifics of how a Systemic Risk Regulator would be authorized to perform its functions. We offered two important cautions in that regard. First, we recommended that the legislation establishing the Systemic Risk Regulator should be crafted to avoid imposing undue constraints or inapposite forms of regulation on normally functioning elements of the financial system, or stifling innovations, competition or efficiencies. Second, we recommended that the 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. Legislation establishing the Systemic Risk Regulator thus should define the nature of the relationship between this new regulator and the primary regulator(s) for each industry sector. This should involve carefully defining the extent of the authority granted to the Systemic Risk Regulator, as well as identifying 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 have a critical role to play by acting as the first line of defense with regard to detecting potential risks within their spheres of expertise. In view of the two cautions outlined above, ICI believes that the Systemic Risk Regulator would be best structured as a statutory council comprised of senior Federal regulators. Membership should include, at a minimum, the Secretary of the Treasury, Chairman of the Federal Reserve Board of Governors, and the heads of the Federal bank and capital markets regulators (and insurance regulator, if one emerges at the Federal level). Finally, we note that the question requests comment on whether some of the SEC's duties should be given to a financial services consumer protection agency. As a general matter, we observe that Federal regulators must improve their ability to keep up with new market developments. This will require both nimbleness at the regulatory level and Congressional willingness to close regulatory gaps, provide new authority where appropriate, and even provide additional resources. ICI does not believe, however, that it would be helpful to create a new ``financial products safety commission'' or ``financial services consumer protection agency.'' Financial products and services arise and exist in the context of a larger marketplace, and they need to be understood in that context. The primary regulator is best positioned to perform this function.Q.9. SEC Staffing, Funding, and Management: The SEC has a staff of about 3,500 full-time employees and a budget of $900 million. It has regulatory responsibilities with respect to approximately: 12,000 public companies whose securities are registered with it; 11,300 investment advisers; 950 mutual fund complexes; 5,500 broker-dealers (including 173,000 branch offices and 665,000 registered representatives); 600 transfer agents, 11 exchanges; 5 clearing agencies; 10 nationally recognized statistical rating organizations; SROs such as the Financial Industry Regulatory Authority, the Municipal Securities Rulemaking Board and the Public Company Accounting Oversight Board. To perform its mission effectively, do you feel that the SEC is appropriately staffed? funded? managed? How would you suggest that the Congress could improve the effectiveness of the SEC?A.9. Investment companies (funds) are both major holders of securities issued by public companies and issuers of securities (fund shares) that are held by almost half of all U.S. households. As such, they have a vested interest in effective regulation of the capital markets by a strong and independent regulator. Funds, and therefore their shareholders, stand to benefit if that regulator has the tools it needs to fulfill important policy objectives, such as: preserving the integrity of the capital markets; ensuring the adequacy and accuracy of periodic disclosures by public issuers; and promoting fund regulation that protects our investors, encourages innovation, and does not hinder market competition. As discussed in our March 3, 2009, white paper, Financial Services Regulatory Reform: Discussion and Recommendations, \39\ ICI supports the creation of a new Capital Markets Regulator that would encompass the combined functions of the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC). The white paper makes a series of recommendations--including several concerning the staffing, funding, and management of the Capital Markets Regulator--aimed at maximizing this regulator's ability to perform its mission effectively. Pending, or in the absence of, Congressional action to create a Capital Markets Regulator, most of our recommendations just as appropriately could be applied to the SEC. An outline of those recommendations is included in the response below. Where appropriate for ease of discussion, we use the term ``agency'' to refer equally to the SEC or a new Capital Markets Regulator.--------------------------------------------------------------------------- \39\ See Financial Services Regulatory Reform: Discussion and Recommendations, which is available at http://www.ici.org/pdf/ppr_09_reg_reform.pdf. We note that the white paper was included as an attachment to ICI's written testimony.--------------------------------------------------------------------------- Agency Funding, and Staffing: ICI consistently has called for adequate funding for the SEC in order to support its critical regulatory functions. We note that, in testimony before the House Financial Services Committee in March of this year, SEC Commissioner Elisse Walter stated that the SEC's examination and enforcement resources are inadequate to keep pace with the growth and innovation in the securities markets. \40\ We believe that Congress must seriously consider any suggestion from senior SEC officials that additional resources are required. We were pleased, therefore, to hear about the recent bipartisan effort, led by Senators Charles Schumer (D-NY) and Richard Shelby (R-AL) and endorsed by SEC Chairman Mary Schapiro, to increase the SEC's budget by $20 million for fiscal years 2010 and 2011 in order to add enforcement staff and fund needed technology upgrades.--------------------------------------------------------------------------- \40\ See Testimony of Elisse B. Walter, Commissioner, U.S. Securities and Exchange Commission, Before the House Committee on Financial Services, Concerning Securities Law Enforcement in the Current Financial Crisis (March 20, 2009) at 30-31.--------------------------------------------------------------------------- ICI believes that the agency also must have greater ability (and resources) to attract and retain professional staff having significant prior industry experience. Their practical perspectives would enhance the agency's ability to keep current with market and industry developments and better understand the impact of such developments on regulatory policy. The SEC's announcement of a new Industry and Market Fellows Program is an encouraging step in the right direction. \41\ As discussed further below, the agency also should build strong economic research and analytical capabilities and should consider having economists resident in each division.--------------------------------------------------------------------------- \41\ See SEC Announces New Initiative to Identify and Assess Risks in Financial Markets (April 30, 2009), available at http://www.sec.gov/news/press/2009/2009-98.htm--------------------------------------------------------------------------- Examination of the recent financial crisis has prompted calls for Congress to close regulatory gaps to ensure appropriate oversight of all market participants and investment products. In our white paper, we recommend that the Capital Markets Regulator (or SEC) have express regulatory authority to provide oversight with regard to hedge funds, derivatives, and municipal securities. To the extent that the scope of the agency's responsibilities is expanded, it will be imperative that it have sufficient staffing and resources to effectively perform all of its oversight functions. Agency Management and Organization: How a regulatory agency is managed, and the details of its organizational structure, can have significant implications for the agency's effectiveness. In our white paper, we offer the following suggestions with regard to agency management and organization. LEnsure high-level focus on agency management. One approach would be to designate a Chief Operating Officer for this purpose. LImplement a comprehensive process for setting regulatory priorities and assessing progress. It may be helpful to draw upon the experience of the United Kingdom's Financial Services Authority, which seeks to follow a methodical approach that includes developing a detailed annual business plan establishing agency priorities and then reporting annually the agency's progress in meeting prescribed benchmarks. LPromote open and effective lines of communication among the Commissioners and between the Commissioners and staff. Such communication is critical to fostering awareness of issues and problems as they arise, thus increasing the likelihood that the agency will be able to act promptly and effectively. A range of approaches may be appropriate to consider in meeting this goal, including whether sufficient flexibility is provided under the Government in the Sunshine Act, and whether the number of Commissioners should be greater than the current number at the SEC (five). LAlign the inspections and examinations functions and the policymaking divisions. This approach would have the benefit of keeping staff in the policymaking divisions updated on current market and industry developments, as well as precluding any de facto rulemaking by the agency's inspections staff. LDevelop mechanisms to facilitate coordination and information sharing among the policymaking divisions. These mechanisms would help to ensure that the agency speaks with one voice. Improving Agency Effectiveness: Our white paper recommends the following additional ways to enhance the agency's ability to fulfill its mission successfully when carrying out its regulatory responsibilities: 1. LEstablish the conditions necessary for constructive, ongoing dialogue with the regulated industry: The agency should seek to facilitate closer, cooperative interaction with the entities it regulates to identify and resolve problems, to determine the impact of problems or practices on investors and the market, and to cooperatively develop best practices that can be shared broadly with market participants. Incorporating a more preventative approach would likely encourage firms to step forward with self-identified problems and proposed resolutions. The net result is that the agency would pursue its investor protection responsibilities through various means not always involving enforcement measures, although strong enforcement must remain an important weapon in the agency's arsenal. 2. LEstablish mechanisms to stay abreast of market and industry developments: The agency would benefit from the establishment of one or more external mechanisms designed to help it stay abreast of market and industry issues and developments, including developments and practices in non-U.S. jurisdictions as appropriate. For example, several Federal agencies--including both the SEC and CFTC--utilize a range of advisory committees. Such committees, which generally have significant private sector representation, may be established to provide recommendations on a discrete set of issues facing the agency (e.g., the SEC's Advisory Committee on Improvements to Financial Reporting) or to provide regular information and guidance to the agency (e.g., the CFTC's Agricultural Advisory Committee). LICI believes that a multidisciplinary ``Capital Markets Advisory Committee'' could be a very effective mechanism for providing the agency with ``real world'' perspectives and insights on an ongoing basis. We recommend that such a committee be comprised primarily of private sector representatives from all major sectors of the capital markets, and include one or more members representing funds and asset managers. Additionally, the Capital Markets Advisory Committee should be specifically established in, and required by, legislation. Such a statutory mandate would emphasize the importance of this advisory committee to the agency's successful fulfillment of its mission. LThe establishment of an advisory committee would complement other efforts by the agency to monitor developments affecting the capital markets and market participants. These efforts should include, first and foremost, hiring more staff members with significant prior industry experience. As indicated above, their practical perspectives would enhance the agency's ability to keep current with market and industry developments and better understand the impact of such developments on regulatory policy. 3. LApply reasonably comparable regulation to like products and services: Different investment products often are subject to different regulatory requirements, often with good reason. At times, however, heavier regulatory burdens have been placed on some investment products or services than on others, even where they share similar features and are sold to the same customer base. It does not serve investors well if the regulatory requirements placed on funds--which serve over 93 million investors--end up discouraging investment advisers from entering or remaining in the fund business, dissuading portfolio managers from managing funds as opposed to other investment products, or creating disincentives for brokers and other intermediaries to sell fund shares. It is critically important for the agency to be sensitive to this dynamic in its rulemakings. LAmong other things, in analyzing potential new regulatory requirements for funds or in other situations as appropriate, the agency should consider whether other investment products raise similar policy concerns and thus should be subject to comparable requirements. In this regard, we note that separately managed accounts sometimes are operated much like mutual funds and other investment companies and yet do not offer the same level of investor protection. For example, as the fallout from the Ponzi scheme perpetrated by Bernard Madoff has highlighted, separately managed accounts are not subject to all of the restrictions on custody arrangements that serve to protect fund assets, and existing rules leave room for abuse. \42\--------------------------------------------------------------------------- \42\ The SEC has scheduled an open meeting on May 14, 2009, at which it will consider proposed rule amendments designed to enhance the protections provided to advisory clients when they entrust their funds and securities to an investment adviser. The SEC's meeting announcement indicates that if adopted, the amendments would require investment advisers having custody of client funds and securities to obtain a surprise examination by an independent public accountant, and, unless the client assets are maintained with an independent custodian, obtain a review of custodial controls from an independent public accountant. See SEC News Digest (May 7, 2009), available at http://www.sec.gov/news/digest/2009/dig050709.htm 4. LDevelop strong capability to conduct economic analysis to support sound rulemaking and oversight: The agency will be best positioned to accomplish its mission if it conducts economic analysis in various aspects of the agency's work, including rulemaking, examinations, and enforcement. Building strong economic research and analytical capabilities is an important way to enhance the mix of disciplines that will inform the agency's activities. From helping the agency look at broad trends that shed light on how markets or individual firms are operating to enabling it to demonstrate that specific policy initiatives are well-grounded, developing the agency's capability to conduct economic analysis will be well worth the long-term effort required. The agency should consider having economists resident in each division to bring additional, important perspectives to bear on regulatory --------------------------------------------------------------------------- challenges. LIt is important that economic analysis play an integral role in the rulemaking process, because many regulatory costs ultimately are borne by investors. When new regulations are required, or existing regulations are amended, the agency should thoroughly examine all possible options and choose the alternative that reflects the best trade-off between costs to, and benefits for, investors. Effective cost benefit analysis does not mean compromising protections for investors or the capital markets. Rather, it challenges the regulator to consider alternative proposals and think creatively to achieve appropriate protections while minimizing regulatory burdens, or to demonstrate that a proposal's costs and burdens are justified in light of the nature and extent of the benefits that will be achieved. \43\--------------------------------------------------------------------------- \43\ See, e.g., Special Report on Regulatory Reform, Congressional Oversight Panel (submitted under Section 125(b)(2) of Title I of the Emergency Economic Stabilization Act of 2008) (Jan. 2009) (``In tailoring regulatory responses . . . the goal should always be to strike a reasonable balance between the costs of regulation and its benefits. Just as speed limits are more stringent on busy city streets than on open highways, financial regulation should be strictest where the threats-especially the threats to other citizens--are greatest, and it should be more moderate elsewhere.''). 5. LModernize regulations that no longer reflect current market structures and practices: Financial markets and related services are constantly evolving, frequently at a pace that can make the regulations governing them (or the rationale behind those regulations) become less than optimal, if not entirely obsolete. Requiring industry participants to comply with outmoded regulations imposes unnecessary costs on both firms and investors, may impede innovation, and, most troubling of all, could result in inadequate protection of investors. It is thus important that the agency engage in periodic reviews of its existing regulations to determine whether any such regulations should be --------------------------------------------------------------------------- modernized or eliminated. 6. LGive heightened attention to investor education: The recent turmoil in the financial markets has underscored how important it is that investors be knowledgeable and understand their investments. Well-informed investors are more likely to develop realistic expectations, take a long-term perspective, and understand the trade-off between risk and reward. They are less likely to panic and make mistakes. LTo better equip investors to make good decisions about their investments, the agency should assign a high priority to pursuing regulatory initiatives that will help educate investors. The SEC has an Office of Investor Education and Advocacy and provides some investor education resources on its Web site. These types of efforts should be expanded, possibly in partnership with other governmental or private entities, and better publicized. Many industry participants, too, have developed materials and other tools to help educate investors; additional investor outreach efforts should be encouraged.Q.10. Systemic Risk Regulatory Structure: You have put forth the idea of a systemic risk regulator that is organized as a committee of financial regulatory heads. Could you please elaborate on the structure and organization of such a systemic risk regulatory you are suggesting? Also, please describe the positives and negatives of such an arrangement and the reasons why it would be superior to other possibilities.A.10. In light of the financial crisis, it is imperative that Congress establish in statute responsibility to address risks to the financial system at large. For certain specific and identifiable purposes, such as assuring effective consolidated global supervision of the largest bank holding companies and overseeing the robust functioning of the payment and settlement system as appropriate, this systemic risk management responsibility might be lodged with the Federal Reserve Board. Beyond this context, however, I recommend that systemic risk management responsibility should be assigned to a statutory council comprised of senior Federal regulators. In concept, such a council would be similar to the National Security Council (NSC), 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 utilized by Presidents to address the increasingly complex and multi-faceted challenges of national security policy. It was my honor from 1987-89 to serve as statutory head (i.e., Executive Secretary) of the NSC. As with national security, addressing risks to the financial system at large requires, in my view, diverse inputs and perspectives. Membership of such a council accordingly should draw upon a broad base of expertise, and should include at a minimum the Secretary of the Treasury, Chairman of the Board of Governors of the Federal Reserve System, and the heads of the Federal bank and capital markets regulators (and insurance regulator, if one emerges at the Federal level). As with the NSC, flexibility should exist to enlist other regulators into the work of the council on specific issues as required--including, for example, State insurance regulators and self-regulatory organizations. By statute, the council should have a mandate to monitor conditions and developments in the domestic and international financial markets, to assess their implications for the health of the financial system at large, to identify regulatory actions to be taken to address systemic risks as they emerge, to assess the effectiveness of these actions, and to advise the President and the Congress on emerging risks and necessary legislative or regulatory responses. The council would be responsible for coordinating and integrating the national response to systemic financial risks, but it would not have a direct operating role (much 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, who would act pursuant to their normal statutory authorities but under the council's direction. The Secretary of the Treasury, as 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, finance and law) and should consist of individuals seconded from government departments and agencies (Federal and state), as well as recruited from the private sector with a business, professional or academic background. As with the NSC, the staff's focus would be to support the work of the council as such, and thus the staff would operate independently from the functional regulators. Nonetheless, the background and experience of the staff 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 such a staff should be on quality, not quantity, and the council's staff accordingly should not and need not be large. Such a council structure has many advantages to recommend it: LSystemic 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. Creating such an all-purpose systemic risk manager would be a long and complex undertaking, and would involve developing expertise that duplicates that which exists in today's functional regulators. The council structure by contrast would enlist the expertise of the entire regulatory community in identifying and devising strategies to mitigate systemic risks. It also could be established and begin operation much more quickly. LThe council structure would avoid risks inherent in the leading alternative that has been proposed--i.e., designating an existing agency like the Federal Reserve Board to serve as an all-purpose systemic risk regulator. In this role, the Federal Reserve understandably may tend to view risks and risk mitigation through its lens as a bank regulator focused on prudential regulation and ``safety and soundness'' concerns, potentially to the detriment of consumer and investor protection concerns and of non-bank financial institutions. In my view, a council such as I have outlined would bring all these competing perspectives to bear and, as a result, would seem far more likely to strike the proper balance. LSuch a 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. LWith 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. Moreover, by virtue of their participation on the council, the various functional regulators are themselves likely to 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 would assist in identifying and promoting political consensus about significant regulatory gaps and necessary policy responses. LThe council model anticipates that 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 will have the greatest in depth knowledge of their respective regulated industries. Nonetheless, the council and its staff will 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. LA potential criticism of the council structure is that it may diffuse responsibility and pose difficulties in assuring proper follow-through by the functional regulators. I agree it is important that the council have ``teeth,'' and this can be accomplished, in crafting the legislation, through appropriate amendments to the organic statutes governing the functional regulators. ------ 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. " FOMC20070131meeting--402 400,MR. FISHER.," Mr. Chairman, we talked briefly about the Norges Bank and Norway, which is a country of 4.6 million people, a constitutional monarchy, and my mother’s homeland. My mother taught me a wonderful phrase, which I want to repeat here as an antecedent to this discussion. It’s actually a quote from Santayana: Skepticism, like chastity, should not be relinquished too readily. [Laughter] I admit to being quite skeptical about this exercise, and I will reveal my cards up front in terms of being sensitive to the arguments that President Minehan and President Poole have made as to the predicate question, which is, Is there a compelling reason to do this? Not only is the discussion charming, but I am almost overwhelmed by the encyclopedic knowledge of some of my colleagues. I don’t possess that knowledge, and I listen to it very, very carefully. But I have not yet heard a satisfactory answer. Yes, we have had an evolutionary process over thirty years, but is there a compelling reason to change the way we do our business? If you go back to David’s exhibit 1, it says that we presumably would undertake this effort with an eye toward “advancing the goals of economic performance, public discourse, internal discourse, and efficient operations.” I think of this in a broader context, which is maintaining and building or, using President Lacker’s word, enhancing the public’s faith and confidence in the Federal Reserve, and I think the faith and confidence in the Federal Reserve right now is pretty high. Now, two words are being thrown around constantly in this discussion. One is the “public,” and the other is the “markets.” By the way, I’m not going to get to the eight questions—I want you to be relieved right up front. [Laughter] I can’t get there yet because I haven’t answered the predicate question. But I would ask the Committee to consider what “the public” is and what “the markets” are. Governor Kohn said something during our discussion of policy with regard to the market operators—I actually spent three-quarters of my life being one of them—that I thought was quite complimentary and summarized the current state. He said that nothing we have been saying is getting in the way of the stabilizing properties of the market. I really like that. So my question is, What is wrong with the way we’re doing things if we’re not getting in the way of the stabilizing properties of the market? I agree with Cathy’s point that, with regard to the market, our actions speak louder than our words. Day to day there may be variance, but in the long term that’s what counts. I believe that the markets may have had a difference of view, they may have been testing us, but they’ve come around, and our actions have spoken much louder than our words. If the definition of “public” is the academic community, I understand their insatiable appetites in the pursuit of knowledge. I respect that, but I think there may be other ways of assisting that pursuit of knowledge than by increasing the frequency of our forecasts or the complexity of our forecasts. I want to apologize to my friend from Philadelphia in advance, but are we talking about those who operate the economy—the women and men who run the businesses that create the microeconomy (and many micros make the macro), whether they are $2 million businesses or big businesses? I went back and counted. Since I had the good fortune of coming on this Committee, I have spoken on 236 occasions to managers of big and small operations—CEOs mostly, some CFOs. Not once have I been asked by them for more-frequent forecasts or for all the variables that we consider or anything that projects the kind of complexity that we’ve been talking about today at this table. I’m a former Rotarian. I may be one of the few here. I speak to Rotary Clubs all the time. The only question they want to know is where rates are going to go. [Laughter] I don’t think they care one whit about the complexity of our forecast models. But that’s not the group I’m worried about in terms of the public. President Poole raised an excellent point, which is that we do have to be mindful of the elected representatives of the people who created our charter and who in the end we all serve, and that’s the politicians. I would just ask you to consider the argument that we’re having against that background and the risks that it poses. This is a one-way street. We see this from the excellent work that the staff did. There’s no going back once you go down this path. Vince mentioned our semiannual schedule set by the Congress. Need we do more? Have they asked us to do more? Should we do more before they ask us to do more? Shouldn’t we think of this in terms of negotiating with the political class rather than giving them something for which they may not even be asking. If we give it to them, it may lead to still more questions that we cannot satisfactorily answer. So I would beg the Committee to consider what we’re talking about when we’re talking about the public and the markets and whether this is a compelling thing that needs to be done now. I’d like to emphasize a second thing. Obviously, being a Bank president, I do not wish to be party to anything that emasculates the Banks. Indeed, whatever we do and however we do it, if we do it—and I’m not convinced that we should—we need to respect the Banks not only for their research capacity and the diversity of views and, what Governor Mishkin and President Yellen correctly mentioned, their geographic diversity but also as vital links to the public, whether the public is the elected leaders, the Rotarians, the economic operators, the financial markets, or even the academics. A third point, and then I’ll stop, is that I ask that we be practical in the way that we do this. President Minehan mentioned that we do a lot. I have no doubt that we could do more, but we have constraints on our time. In being practical, we also have to be wary of what other questions we raise by providing more information. Some elements may not be interested in our preserving our independence or may be a threat to our independence—I won’t mention who those might be since I don’t want that on the record. Mr. Chairman, those are my three concerns, and I’ll spare you my answers to the eight questions, which I hope I’ll have a chance to give at a later date." CHRG-109shrg21981--122 Chairman Greenspan," Yes, Senator, I agree with that. Let me just reiterate that what obscures the discussion is how to handle the transition costs, which are the equivalent in one form of a huge unfunded liability. But if you set that aside as a consequence of the past and you merely ask which type of vehicle has the greater probability of adding to national savings in the example that you gave, clearly one which is forced savings and, therefore, reduced consumption will add to household or personal savings and, therefore, to national savings. If, however, you put it into the existing system and for the moment leave aside the question of changes in the trust fund, it is essentially a pay-as-you-go system, which does not create national savings. And, therefore, the two models are fundamentally different, and the complexity is how you go from here to a differing system, and to a very large extent, one's capacity to do that does rest with that issue of to what extent of the financial markets taking the $10 trillion-plus contingent liability and assumed its a cost or debt of the Government and have set long-term U.S. Treasury interest rates in the context that that is their target of what the supply of debt is and, hence, that which moves the price and not the $4 trillion, which is the debt to the public, which is what changes with the unified budget balance. Senator Bennett. Well, I run a business, and you focus on cashflow. And I remember very clearly the speech by the President of the United States who said we are going to include surpluses in the Social Security account as part of the overall cashflow. His name was Lyndon Johnson, and it was during the time he was discussing the Great Society. And Republicans were claiming that he was running a budget deficit, and he said, No, we are not running a budget deficit because we have this extra money coming into Social Security. I remember that speech very clearly because I was in town and involved in that at the time. And ever since we went to a unified budget, on a cashflow basis the surpluses in Social Security have reduced the cash needs of the Government to meet its obligations. Starting in 2008, that will begin to stop as the Social Security surplus will begin to fall in the face of the demographic arrival of the baby-boomers. " 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. ______ FOMC20050920meeting--29 27,MR. STOCKTON.," In terms of how the price forecast has evolved over the last couple of years, the single biggest factor is the higher energy prices. But we’ve also had to contend with an acceleration—of modest dimension, but an acceleration—in import prices and an increase in September 20, 2005 19 of 117 price inflation numbers, those are the main contributors. Beyond that, we haven’t really seen any other innovations on the cost structure on the side of businesses that we think have lifted core prices. But in our view, the persistence of higher headline and core inflation over the last few years will cause—and we do think there has been a little bit of evidence—some small deterioration in inflation expectations, and we have built that into our forecast. The way that shows up, as I think you were hinting, comes through some prospective acceleration in nominal hourly labor compensation. We haven’t seen it yet to any significant degree. But in our forecast we think there will be some indirect effects working through higher labor costs going forward. As for the time dimension over which that will occur, we think that process is probably under way. There may be some evidence of it in the TIPS-based measures that Dino cited, and the survey evidence suggests that the process may now be beginning. We’re starting to see a small but gradual erosion in inflation expectations, and that persists through our forecast horizon. Now, looking farther out, with energy prices projected to start declining and headline inflation coming down from the 3-plus percent area to more like 2 percent going forward, we would expect that process to reverse a bit in the period beyond the current forecast horizon. So those inflation pressures probably will diminish a little at that point." CHRG-110shrg50414--108 Secretary Paulson," In terms of that, I would say you have pointed to the complexity and the difficulty. I would very respectfully say that if the Federal Government tried to legislate a prescriptive solution, it almost certainly would not work when you are getting into the market mechanisms. Again, you are asking me about free markets and how the Government is going to work better than free markets, and, listen, I have never been a proponent of intervention. And I just think we have an unprecedented situation here, and it calls for unprecedented action. And there is no way to stabilize the markets and deal with the situation other than through Government intervention. And so what we are going to do, we have put forward something we have thought about for a long time in terms of the issue and different ways of dealing with the issue. And so what we are asking for is some broad powers with some good, strong oversight, and we think that is the best way to protect the taxpayer. That is our view. Senator Enzi. I want to get into something a bit more specific on that because I am concerned about the small banks in this reverse auction situation. A lot of the details are left out. As you say, you do not want it to be prescriptive. But the reverse auction that you described in your testimony---- " 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-110shrg50414--224 Mr. Bernanke," I would say I have a number of concerns. That is clearly not the biggest one, because the private capital has come in two or three times during this difficult period, this turmoil in the markets, and each time, it has been overwhelmed by the leverage in the system, and so private capital isn't coming into the system. And I would also say to you that these securities--we never said that under certain circumstances, they wouldn't--you wouldn't do things where we pay above the mark. We are doing--because these securities are marked with different marks and different types of institutions. So this is a very complicated process and so--and it is going to be difficult to get our arms around valuation, but that is why it is so important that we cast our net broadly. Senator Corker. Let me pick up on that comment. I know you have said several times how excessively complex this is. We talk about these auctions as if we are auctioning off securities that are like one another when, in fact, they are not. I mean, these securities are very different. The collateral that backs them up is very different. And so to talk about the due diligence--and I am going to lead up to something, if I could--the due diligence that one would have to go about to actually even buy these at anywhere close to an appropriate rate is going to be massive. Is that true? Would you say yes or no to that? And that is why you are employing another---- " CHRG-111shrg50815--116 LEVITIN Q.1. Access to Credit: A potential outcome of the new rules could be that consumers with less than a 620 FICO score could be denied access to a credit card. Such an exclusion could affect 45.5 million individuals or over 20 percent of the U.S. population. Without access to traditional credit, where do you believe that individuals would turn to finance their consumer needs? A.2. I am unsure to which ``rules'' the question refers; I assume it refers to the recent unfair and deceptive acts and practices regulations adopted by the Federal Reserve, Office of Thrift Supervision, and National Credit Union Administration under section 5 of the Federal Trade Commission Act. If so, I strongly but respectfully dispute the premise of the question; the scenario that is presented is exceedingly alarmist. The question wrongly implies that all individuals with FICO scores of 620 or lower currently have access to ``traditional'' credit cards. They assuredly do not. First, nearly 10 percent of the United States adult population is ``unbanked,'' and that means almost by definition that they do not have credit cards; card penetration into the unbanked market is de minimis. Thus, at least half of the impact implied by the scenario is not possible. For the remaining 10 percent or so who have FICOs under 620, many do not currently have access to ``traditional'' credit. Instead, they have access to predatory new credit products like ``fee harvester'' or ``secured'' credit cards. Even if these non-traditional products were included in the term ``traditional,'' I think it is also dubious that all or even most of them would cease to be able to get ``traditional'' credit; nothing in the proposed regulations limits issuers' ability to protect against credit risk through either lower credit limits or higher interest rates or other fees. To the extent that these individuals are not able to get credit cards or choose not to accept them because of onerously high interest rates, the answer to where they would turn for financing needs depends on the particular circumstances of the individual, but I believe that many consumers would first cut down or eliminate non-essential expenses, which would reduce their financing needs. Demand for credit is not entirely inelastic. For these consumers' remaining financing needs, many would turn to family and friends for assistance. See Angela Littwin, Testing the Substitution Hypothesis: Would Credit Card Regulations Force Low-Income Borrowers into Less Desirable Lending Alternatives? 2009 Ill. L. Rev. 403, 434-35 (2009) (noting that borrowing from family and friends is the most frequent form of borrowing for low-income women). It is also important to note that empirical evidence suggests that ``credit cards are actually among low-income consumers' least-preferred sources of credit, meaning that there is no ``worse'' alternative to which they would turn if credit card access were reduced.'' Id. at 454. Beyond family and friends, there are also other legitimate, high-cost sources of credit besides credit cards--pawn shops, rent-to-own, and overdraft protection, e.g. There, of course, is a possibility that some low-income consumers will turn to illegitimate sources of credit, such as loan sharks, but this possibility could be tempered by community-based small loan programs. Indeed, given that the Federal Government is currently subsidizing credit card lending through the Term Asset-Backed Securities Lending Facility (TALF), it seems quite reasonable to support other forms of consumer credit lending. Indeed, in Japan, where there is a 20 percent usury cap, credit rationing and product substitution are significantly tempered by a government-supported small loan system. Nor is it clear that the terms on which ``loan sharks'' lend are actually worse than some subprime credit card products. As Woody Guthrie sang in the Ballad of Pretty Boy Floyd: Now as through this world I ramble I see lots of funny men Some will rob you with a Six gun And some with a fountain pen. But as through your life you travel As through your life you roam You won't never see an outlaw Drive a family from their home.Woody Guthrie, American Folksong 27 (1961). Finally, given the terms on which individuals with FICO scores of under 620 are able to obtain ``traditional'' credit, I think it is quite debatable whether ``traditional'' credit is in any way beneficial to them; fee-harvester cards and other subprime credit card products are as likely to harm consumers with poor credit ratings as they are to help them; these cards can improve consumers' credit scores over time, if the consumer is able to make all the payments in full and on time, but by definition a consumer with a FICO of under 620 is someone who is unlikely to be able to do that. Q.2. Risk-Based Pricing: Banks need to make judgments about the credit-worthiness of consumers and then price the risk accordingly. Credit cards differ from closed-end consumer transactions, such as mortgages or car loans, because the relationship is ongoing. I am concerned by the Federal Reserve's new rules on risk-based repricing for a couple of reasons. First, without the ability to price for risks, banks will be forced to treat everyone with equally stringent terms, even though many of these individuals perform quite differently over time. Second, without a mechanism to reprice according to risk as a consumer's risk profile changes, many lenders will simply refuse to extend credit to a large portion of the population. Do you believe that consumers will have access to less credit and fewer choices because of the Fed's new rule? If so, is this a desirable outcome? A.2. Again, I respectfully disagree with the premise of the question. The new uniform Unfair and Deceptive Act and Practices regulations adopted by the Federal Reserve Board, the Office of Thrift Supervision and National Credit Union Administration under section 5 of the Federal Trade Commission Act (``Reg AA'') do not prohibit risk-based pricing. Reg AA only prohibits retroactive repricing of existing balances. Card issuers remain free to increase interest rates prospectively with proper notice or to protect themselves immediately by closing off credit lines. That said, I would expect that Reg AA would likely reduce credit availability to some degree, although perhaps not to all consumers. This is not necessarily a bad outcome. Credit is a double-edged sword. It can be a great boon that fuels economic growth, but that is only when credit does not exceed a borrower's ability to repay. Credit can also be a millstone around the neck of a borrower when it exceeds the ability to repay. Overleverage is just as bad for consumers as it is for financial institutions. To the extent that Reg AA reduces credit availability, it might be a good thing by bringing credit availability more in line with consumers' ability to repay. Q.3. Consumer Disclosure: You state that the sheer number of price mechanisms make it difficult for consumers to accurately and easily gauge the cost of credit. You cite things such as annual fees, merchant fees, over-the-limit fees, and cash advance fees. You seem to suggest that credit cards should become much more plain vanilla because people simply can't understand the different uses and costs for those uses. Don't these different pricing mechanisms also provide more choices for consumers as they make purchasing decisions? A.3. That depends on the particular pricing mechanism. Many of them provide dubious choices or value for consumers. Consider over-limit fees, late fees, cash advance interest rates, and residual interest and double cycle billing. (1). LOverlimit fees. A consumer has no right to go overlimit and cannot assume that an over-limit transaction will be allowed. Moreover, overlimit can be the result of the application of fees, rather than of purchases. Therefore, overlimit is not exactly a ``choice.'' (2). LA late fee is no different than interest, just applied in a lump sum. I am doubtful that most consumers would prefer an up-front lump sum late fee rather than a higher interest rate. For the large number of ``sloppy payers'' who pay their bills a few days late, a higher interest rate is much better than a large flat late fee, but because consumers systematically underestimate the likelihood that they will pay late, they are less concerned about the late fee than the interest rate. (3). LMost cards charge a higher interest rate for ``cash advances.'' A cash advance, however, is not necessarily the payment of cash to the consumer. Instead, cash advances include the use of so-called ``convenience checks'' that card issuers send to consumers with their billing statements. (Incidentally, convenience checks present a considerable identity theft problem because they lack cards' security features and the cardholder has no way of knowing if they have been stolen. They expose issuers to significant fraud losses and should be prohibited as an unsafe and unsound banking practice.) Convenience checks permit cardholders to use their card to pay merchants that do not accept cards, like landlords, utilities, and insurers. This allows consumers to pay these bills even when they do not have funds in their bank account. But convenience checks carry the cash advance interest rate plus a fee (often a flat 3 percent with a minimum amount). These terms are usually disclosed on the convenience checks only partially and by reference to the cardholder agreement. It is doubtful that most consumers retain their cardholder agreement, so whether consumers understand the cost of using convenience checks is a dubious proposition. (4). LSimilarly, billing tricks and traps like residual interest or double cycle billing are hardly a ``choice'' for consumers; these are not product differentiations that are tailored to consumer preferences, as few consumers know about them, let alone understand them. Restricting card pricing could limit innovation in the card market, but it is important to recognize that not all innovation is good. There has been very little innovation in the card industry over the last twenty years, either in terms of technology or in terms of product. Cards still operate on the same old magnetic stripe technology they had in the 1970s. The card product still performs the same basic service. To the extent there has been innovation, it has been in the business model, and it has frequently not been good for consumers. Even things like the 0 percent teaser rate are hardly unambiguous goods. While 0 percent teasers are great for consumers who can pay off the balance, they also encourage consumers to load up on credit card debt, and if there is a shock to the consumer's income, such as a death, an illness, a divorce, or unemployment, the consumer is much more exposed than otherwise. I recognize that it is important to protect the ability of the card industry to innovate in the future, and that is why I believe the best solution is to set a default rule that simplifies credit card pricing, but to allow a regulatory agency, such as the Federal consumer financial product safety commission proposed by Senators Durbin, Kennedy, and Schumer and Representative Delahunt (S. 566/H.R. 1705, the Financial Product Safety Commission Act of 2009) to have the power to card issuers to introduce new products and product features provided that they meet regulatory consumer safety standards. Q.4. Bankruptcy Filings: As the recession worsens, many American families will likely rely on credit cards to bridge the gap for many of their consumer finance needs. Mr. Levitin and Mr. Zywicki, you seem to have contrasting points of view on whether credit cards actually force more consumers into bankruptcy, or whether credit cards help consumers avoid bankruptcy. Could both of you briefly explain whether the newly enacted credit card rules will help consumers avoid bankruptcy or push more consumers into bankruptcy? A.4. The newly enacted Federal Reserve credit card regulations will not have any impact on bankruptcy filings presently, as they do not go into effect until summer of 2010. When they do go into effect, their impact on consumer bankruptcy filings will likely be mixed. Credit card debt has a stronger correlation with bankruptcy filings than other types of debt. But this is not necessarily a function of credit card billing practices. Card debt reflects the macroeconomic problems of the American family--rising costs of health care, education, and housing but stagnant wages and depleted savings. The card billing tricks and traps targeted by the Fed's rules amplify this distress, but the Fed's rules will not solve the fundamental problems of the American family. To the extent that they limit the amplifying effect that card billing tricks and traps have on card debt levels, it will help some consumers avoid bankruptcy. If the rules result in contraction of credit availability, it might push consumers into bankruptcy, but that would have to be netted out against the number that are helped by a reduction in the amplification effect, and I am skeptical that there would be much contraction. I agree with Professor Zywicki that credit cards can help some consumers avoid bankruptcy. If a consumer has a temporary setback in income, credit cards can provide the consumer with enough funds to hang on until their financial situation reverses. But credit cards can also exacerbate financial difficulties, and even if the consumer's fortunes pick up, it might be impossible to service the card debt. Moreover, there are many consumers whose financial situations are not going to pick up, and for these consumers, card debt just adds to their distress. Q.5. Safety and Soundness and Consumer Protection: I believe firmly that safety and soundness and consumer protection go hand-in-hand. One needs only to look at the disaster in our mortgage markets, for clear evidence of what happens when regulators and lenders divorce these two concepts. A prudent loan is one where the financial institution fully believes that the consumer has a reasonable ability to repay. Do you agree that prudential regulation and consumer protection should both be rigorously pursued together by regulators? A.5. Yes, but not by the same regulators. There is an essential conflict between safety-and-soundness and consumer protection. A financial institution can only be safe and sound if it is profitable. And abusive and predatory lending practices can often be extremely profitable, especially in the short term, and can compensate for the lender's other less profitable activities. The experience of the past decade shows that when Federal regulators like the Office of Comptroller of the Currency, the Office of Thrift Supervision, and the Federal Reserve are charged with both safety-and-soundness and consumer protection, they inevitably (and perhaps rightly) favor safety-and-soundness at the expense of consumer protection. These functions cannot coexist in the same agency, and consumer protection responsibilities for financial products should be shifted to a single independent Federal agency (which would not claim preemptive authority over state consumer protection actions) to protect consumer protection. Q.6. Subsidization of High-Risk Customers: I have been receiving letters and calls from constituents of mine who have seen the interest rates on their credit cards rise sharply in recent weeks. Many of these people have not missed payments. Mr. Clayton, in your testimony you note that credit card lenders have increased interest rates across the board and lowered credit lines for many consumers, including low-risk customers who have never missed a payment. Why are banks raising interest rates and limiting credit apparently so arbitrarily? A.6. Banks are raising interest rates on consumers and limiting credit to cover for their own inability to appropriately price for risk in mortgage, securities, and derivatives markets has resulted in their solvency being threatened. Therefore, banks are trying to limit their credit card exposures and are trying to increase revenue from credit card accounts by raising rates. If banks are unable to competently price for risk for mortgages, where there is often robust underwriting, what confidence should we have in their ability to price for risk for credit cards where every loan is a stated income ``liar'' loan? The current financial debacle should cause us to seriously question banks' claims of risk-based pricing for credit cards. The original pricing failed to properly account for risk and the new arbitrary repricing certainly fails to account for risk on an individualized level. The only risk being reflected in the new pricing is the bank's default risk, not the consumer's. Does this result in low-risk customers subsidizing people who are high-risk due to a track record of high-risk behavior? Yes, it probably does because it is being done so arbitrarily. Q.7. Effects on Low-income Consumers: I want to put forward a scenario for the witnesses. Suppose a credit card customer has a low income and a low credit limit, but a strong credit history. They use their credit card for unexpected expenses and pay it off as soon as possible, never incurring late fees. With the new regulations approved by the Federal Reserve, banks will be restricted in their use of risk-based pricing. This means our cardholder could see his or her interest rates and fees increased to pay for the actions of other card holders, many of whom have higher incomes. Do any of the witnesses have concerns that moving away from risk-based pricing could result in the subsidization of credit to wealthy yet riskier borrowers, by poorer but lower-risk borrowers? A.7. No. The issue is a red-herring. As an initial matter, it is important to emphasize that the Federal Reserve's new regulations do not prohibit risk-based pricing. They only prohibit retroactive repricing of existing balances. In other words, they say that card issuers only get one bit at the risk pricing apple, just like any normal contract counterparty. Card issuers remain free to price however they want prospectively or to reduce or cutoff credit lines if they are concerned about risk. Second, it is important to underscore that to the extent that card issuers engage in risk-based pricing, it is only a small component of the cost of credit. I discuss this at length in my written testimony, but I will note that Professor Zywicki has himself written that 87 percent of the cost of credit cards has nothing to do with consumer risk; it is entirely a function of the cost of operations and the cost of funds. Todd J. Zywicki, The Economics of Credit Cards, 3 Chap. L. Rev. 79, 121 (2000). The remaining 13 percent represents both a risk premium and opportunity pricing. In many cases the opportunity-pricing component predominates. Therefore, there to the extent that credit card issuers do risk based pricing, it only has a marginal impact on the total cost of cards. As Professor Ausubel demonstrated in his written and oral testimony, a significant component of some credit card fees, like late fees, are opportunity costs. Likewise, in my written testimony, the section comparing my own credit cards, three of which are from the same issuer, but which have different rates that do not correspond with credit limits, indicates that there is significant opportunity pricing in the card market. Regulations that make cards fairer and more transparent would be unlikely to have much impact on consumer pricing. Third, it is not clear why cross subsidization should be a particular concern. It is a common fact of life. Consider flat-fee parking lots. Those consumers who park for 5 minutes subsidize those who park for hours. Similarly, at by-the-pound salad bars, consumers who eat only carrots subsidize those who eat only truffles. When cross-subsidization is regressive, it elicits additional concerns, but there are far more serious regressive price structures, not the least of which is the Internal Revenue Code. That said, I believe the cross-subsidization in the scenario to be unlikely because the risk that matters to card issuers is nonpayment risk, not late payment risk, and income and wealth generally correlate with low nonpayment risk. In sum, then, I think the cross-subsidization scenario presented is unlikely, and to the extent it occurs, the cross-subsidization will only be de minimis because of the limited extent of risk-based pricing. The problem presented by the scenario is a red herring concern and not a reason to shy away from regulating credit cards. ------ RESPONSE TO WRITTEN QUESTIONS OF SENATOR SHELBY FROM KENNETH J. CHRG-110shrg50418--322 PREPARED STATEMENT OF PETER MORICI Professor, Robert H. Smith School of Business, University of Maryland November 18, 2008 My name is Peter Morici, economist and professor at the University of Maryland School of Business. Thank you for inviting me to provide testimony today. The domestic automobile industry has two major components--the Detroit Three and the Japanese, Asian, and European transplants that also assemble and source components in the United States and Canada. Both contribute importantly to the vitality of our national economy. Ensuring these companies have the means to compete globally is vitally important. The gradual erosion of the market shares of the Detroit Three over the last several decades stems from higher labor costs--having origins in wages, benefits, and work rules--poor management decisions, and less than fully supportive government policies. Although the U.S. government has been sympathetic to the needs of the industry, the industry has fallen victim to currency manipulation and other forms of protectionism in Japan, Korea, India, and China. The Detroit Three are rapidly running out of cash and face filing for Chapter 11 reorganization. It would be better to let them go through that process and reemerge with new labor agreements, reduced debt and strengthened management that would permit these companies to produce cars at costs comparable to those enjoyed by their Japanese and other foreign competitors assembling vehicles in the United States. Circumstances are dramatically different today than in 1979 when Chrysler received assistance from the Federal Government. In those days, the challenge at Chrysler was to become competitive with Ford and GM, and Lee Iacocca had a clear plan to achieve that objective and succeeded. Today, the Detroit Three, though improved in productivity and with lower labor costs thanks to concessions from the United Auto Workers, are still not as competitive as the Japanese transplants. Margins in automobile manufacturing are thin and there is no such thing as being competitive enough. Either a company is competitive or it is not--either it accomplishes the cost structure enjoyed by Toyota and Honda, operating in the United States, or it will continually cede market share and run into financial difficulties. By assisting the Detroit Three, Congress can delay one or all of them going through Chapter 11 reorganization but sooner or later one or all will face reorganization. The communities and suppliers dependent on these companies would be better off going through that process now than by delaying it with assistance from the Federal Government. Without a new labor agreement that brings wages, benefits and work rules in line with those at the most competitive transplant factories, and without reduced debt and other liabilities, the Detroit Three will continue to lag in product innovation and field too few attractive new vehicles, because their higher costs, debt and other liabilities require them to spend less on new productive development than they should. Also, they are inclined to field products with less desirable content to compensate for higher costs. As consumers find vehicles made by Japanese and other transplants more attractive, like those imported from Korea and eventually from China, the Detroit Three will cede market share of one or a few percentage points each year. If Chapter 11 is put off, the successors to GM, Ford, and Chrysler that emerge from a bankruptcy reorganization process will be smaller and support fewer jobs than if these companies endure this difficult transition in 2009. More jobs can be saved among GM, Ford, and Chrysler and their suppliers if bankruptcy reorganization is endured now than in the future. When Americans buy automobiles from the Detroit Three, more is contributed to the vitality of the U.S. economy than when Americans buy vehicles assembled here by transplants or imports. These vehicles have more U.S. content in terms of jobs, engineering, and profits than do foreign nameplate vehicles. The Congress could take steps to improve the attractiveness of making cars and parts in the United States by improving the public policy environment. This would include finally addressing, directly and forthrightly, undervalued currencies in Asia--currencies kept cheap by intervention by foreign monetary authorities in China and elsewhere. In addition, assertive efforts to develop fuel efficient vehicles could strengthen the industry and create export strength. For example, Congress could offer an incentive for car buyers to trade in their gas guzzlers--the newer and the bigger the clunker, the more the car buyer would receive under the condition the vehicle is destroyed. This would raise the price car makers receive from selling smaller vehicles. Congress could provide substantial product development assistance to U.S.-based auto makers and suppliers. The latter includes Toyota, Nissan, and Honda, as well as the Detroit Three, battery makers and other suppliers to accelerate the production of innovative, high-mileage cars. The condition for assistance would be that beneficiaries do their R&D and first large production runs in the United States, and share their patents at reasonable costs with other companies manufacturing in the United States. The huge U.S. market would help attract producers from around the world and rejuvenate the U.S. auto supply chain. ______ FOMC20080318meeting--86 84,MR. KOHN.," Thank you Mr. Chairman. I agree with the others around the table who have said that the prospects for economic activity have taken another sizable leg down over the intermeeting period. I think we have been, for a time, in that adverse feedback loop between financial markets and spending that everybody--Governor Mishkin and others--has been talking about. That is not an unusual kind of loop to be in during a soft economic period. I think it is probably characteristic of a lot of slow growth and recessionary periods. But certainly it has been more intense this time because the financial turmoil has spread well beyond housing and has intensified significantly over the intermeeting period. The incoming data on spending, employment, and production were weaker than expected. House prices are moving lower by more than we or the markets expected. All of these data have accentuated concerns about the creditworthiness of households and businesses and, hence, about the creditworthiness of the people who lend to them, especially those who lend in the mortgage market. As perceptions of risk and risk aversion rose, there was a flight to safety and liquidity. I think we see that a little in the growth of M2 over the past couple of months, which has been very, very strong and suggests that households are retreating to money market funds, probably the ones that hold government securities, and to insured deposits. In wholesale markets there has been unwillingness to take positions and rising concerns about an array of intermediaries. Bill described this process much better than I could--illiquid markets, extreme volatility, deleveraging, margin calls, forced sales, especially in mortgage-backed securities, wider spreads, equity prices falling, and lending and funding tenors collapsing toward the overnight, again. So financial conditions have tightened for everybody but the government--and some of the European governments have seen them tighten, I guess. Mortgage rates have risen, and business bond yields have risen as well, even with Treasury rates going down. Tighter credit and declining equity and house prices are reducing wealth, and all of this weakens spending further. Now, to this process, the staff has judged that the economy has entered a recessionary state in which we can expect household and business spending to fall short of normal levels, given income and interest rates. I am not sure how much weight to put on this. I am a bit uncomfortable with constructs that don't have a clear story behind them. But I must say that, looking at the sentiment indicators and listening to what I have heard around the table today from almost every Federal Reserve District reporting, I now put more credence in Dave's recessionary state than I did before the meeting started. Obviously, something is going on that is undermining confidence and making people much more cautious than you would think, given the exogenous variables. I do think talking about the recessionary state underlines the extraordinary uncertainty we are dealing with. President Stern pointed out the 1990-91 precedent. There are some precedents for some aspects of this, but we don't have many; and I think it is really difficult to know how financial markets will evolve and how that will feed through to the variables that affect household and business spending--the reaction of households, businesses, and state and local governments to tighter credit conditions. I agree with President Stern, President Evans, and others who said they thought that the financial stresses are deeper and will last longer than we thought and will, therefore, put more restraint on spending. Until markets stabilize on a sustained basis, the risk to satisfactory economic performance by the U.S. economy will remain skewed very much to the downside. Now, Federal Reserve liquidity tools that we have used are necessary to reduce the odds on even more-intense, downward-spiral crises and market liquidity feeding back onto spending. So I think our innovations here have been useful to reduce the downside risks a little and thereby to promote spending. But I agree with the others who say that they don't directly deal with the underlying macro risk, which is really a story about capital, solvency, wealth, and prices. I think monetary policy easing is a necessary aspect of addressing these macroeconomic risks. I agree with President Fisher, President Plosser, and others that there is more going on and that monetary policy easing may not be a sufficient way of addressing these risks. But I do think, as long as the economy is weakening the way it is and we have these risks, that easing monetary policy will be helpful. It will help bolster asset prices. It will make the cost of capital lower than it otherwise would be. It may not be sufficient to turn the thing around, but I do think that without the easing that we have done-- and that I hope that we do today--the situation would be far worse than it otherwise would be. We need to ease to compensate for the substantial headwinds that we are facing. Now, the forecast for inflation has not been marked down despite the greater output gap. As others have remarked, this output gap is offset, to a considerable extent, by the upward pressure on prices from oil and commodities and import prices as the dollar has fallen and prices have risen in our exporting partners--China, for example. I have to confess that I don't really understand what has been happening to commodity prices in recent months. I don't think the rise has been justified by the news on the underlying conditions of supply and demand. It is much larger than the dollar weakness has been, and the dollar�commodity price has always been a weak relationship. So, in fact, commodity prices are rising in a bunch of currencies. This isn't just a dollar weakness problem. I have to believe that there is a speculative element here. Partly as a consequence, I am comfortable with the forecast of a flattening commodity price picture in the future--it might even decline, but at least a flattening out. I do think a shift from financial assets, especially dollar assets, into commodities is going on, and mostly this has been triggered by concerns about the U.S. economy and financial markets. In some sense, that shift is okay. It is driving down the dollar, and that is helping to stabilize the economy. The decline that we saw in oil prices yesterday suggests that, when people get more confidence about where those financial markets are going, some of those commodity prices will actually fall as the concerns about the U.S. economy are alleviated. It is sort of an upside-down relationship, but I do think we saw a bit of it that way. But I also sense that some of the rise in commodity prices and the fall in the dollar reflects concerns about the inflation outlook here. It is not surprising to me, in a very volatile and uncertain environment, that inflation expectations are not as well anchored and that they fluctuate a lot in response to new information. I expect that inflation will come down as commodity prices level off; then the output gap will increase, and that in turn will keep inflation expectations down. Still, navigating this appreciably weaker economic outlook for the real economy and the threats to financial stability, on the one hand, and the tenderness of inflation expectations, on the other, will require some discussion in the next section of our meeting, Mr. Chairman. " fcic_final_report_full--25 Cioffi’s investors and others like them wanted high-yielding mortgage securities. That, in turn, required high-yielding mortgages. An advertising barrage bombarded potential borrowers, urging them to buy or refinance homes. Direct-mail solicita- tions flooded people’s mailboxes.  Dancing figures, depicting happy homeowners, boogied on computer monitors. Telephones began ringing off the hook with calls from loan officers offering the latest loan products: One percent loan! (But only for the first year.) No money down! (Leaving no equity if home prices fell.) No income documentation needed! (Mortgages soon dubbed “liar loans” by the industry itself.) Borrowers answered the call, many believing that with ever-rising prices, housing was the investment that couldn’t lose. In Washington, four intermingled issues came into play that made it difficult to ac- knowledge the looming threats. First, efforts to boost homeownership had broad po- litical support—from Presidents Bill Clinton and George W. Bush and successive Congresses—even though in reality the homeownership rate had peaked in the spring of . Second, the real estate boom was generating a lot of cash on Wall Street and creating a lot of jobs in the housing industry at a time when performance in other sec- tors of the economy was dreary. Third, many top officials and regulators were reluc- tant to challenge the profitable and powerful financial industry. And finally, policy makers believed that even if the housing market tanked, the broader financial system and economy would hold up. As the mortgage market began its transformation in the late s, consumer ad- vocates and front-line local government officials were among the first to spot the changes: homeowners began streaming into their offices to seek help in dealing with mortgages they could not afford to pay. They began raising the issue with the Federal Reserve and other banking regulators.  Bob Gnaizda, the general counsel and policy director of the Greenlining Institute, a California-based nonprofit housing group, told the Commission that he began meeting with Greenspan at least once a year starting in , each time highlighting to him the growth of predatory lending prac- tices and discussing with him the social and economic problems they were creating.  One of the first places to see the bad lending practices envelop an entire market was Cleveland, Ohio. From  to , home prices in Cleveland rose , climb- ing from a median of , to ,, while home prices nationally rose about  in those same years; at the same time, the city’s unemployment rate, ranging from . in  to . in , more or less tracked the broader U.S. pattern. James Rokakis, the longtime county treasurer of Cuyahoga County, where Cleveland is located, told the Commission that the region’s housing market was juiced by “flip- ping on mega-steroids,” with rings of real estate agents, appraisers, and loan origina- tors earning fees on each transaction and feeding the securitized loans to Wall Street. City officials began to hear reports that these activities were being propelled by new kinds of nontraditional loans that enabled investors to buy properties with little or no money down and gave homeowners the ability to refinance their houses, regardless of whether they could afford to repay the loans. Foreclosures shot up in Cuyahoga County from , a year in  to , a year in .  Rokakis and other public officials watched as families who had lived for years in modest residences lost their homes. After they were gone, many homes were ultimately abandoned, vandalized, and then stripped bare, as scavengers ripped away their copper pipes and aluminum siding to sell for scrap. “Securitization was one of the most brilliant financial innovations of the th cen- tury,” Rokakis told the Commission. “It freed up a lot of capital. If it had been done responsibly, it would have been a wondrous thing because nothing is more stable, there’s nothing safer, than the American mortgage market. . . . It worked for years. But then people realized they could scam it.”  CHRG-111shrg55479--68 Mr. Castellani," I think, Senator, for your first question, what you are reflecting may have been the experience when you served on the boards. But what I think it does not reflect is the tremendous change that has occurred in the boardrooms over the last 8 years. We now see boards of directors, in the case of Business Roundtable companies, that are at least 80 percent independent, and that is, the directors are independent of the company management. Indeed, the governance committees or the nominating committees that nominate the directors by requirement of the listing standards and the SEC are made up entirely of independent directors. So the nomination of a board member, a prospective board member, is no longer--if it indeed every was--controlled by the chief executive officer. And then, third, I would point out particularly the amount of time that is involved and the amount of expertise that is involved. It is not only the specific requirement of the expertise that is in the listing standards and the SEC requirements, but indeed what boards themselves are demanding and what companies and their shareholders are demanding has resulted in not only greater expertise in specific areas, but a tremendous increase in the amount of time. For example, I was recently talking to the chair of the audit committee of a large U.S. company. That chair spent 800 hours of, in this case, his time as the chair of an audit committee over the last year because of some very complex financial issues. So the board members are spending more and more time. So I would submit to you, sir, that it is very different than when you served on the boards. And in terms of the boards being able to have the CEO as a member of the board, the CEO as a member of a board, in fact, the CEO and chairman where companies choose it, is a very, very important nexus between the governance of a corporation and the management of a corporation. We have found and experience has shown over a long period of time that if you separate the governance from the management, you get precisely the kinds of problems that this Committee is trying to avoid. So having the CEO on the board is a very, very important nexus. In many cases, companies and boards believe that having the CEO as chairman of the board is also very important. Again, my point would be what I have said in my testimony: That is up to every company to decide, and their board of directors representing the shareholders to decide, rather than be prescriptive, because it is not always right, but it is always right for the company that makes the right decision, and they should be allowed to make that decision. Senator Corker. Thank you. " 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. FinancialCrisisReport--318 CASE STUDY OF GOLDMAN SACHS AND DEUTSCHE BANK A key factor in the recent financial crisis was the role played by complex financial instruments, often referred to as structured finance products, such as residential mortgage backed securities (RMBS), collateralized debt obligations (CDOs), and credit default swaps (CDS), including CDS contracts linked to the ABX Index. These financial products were envisioned, engineered, sold, and traded by major U.S. investment banks. From 2004 to 2008, U.S. financial institutions issued nearly $2.5 trillion in RMBS securities and over $1.4 trillion in CDOs securitizing primarily mortgage related products. 1237 Investment banks charged fees ranging from $1 to $8 million to act as the underwriter of an RMBS securitization, 1238 and from $5 to $10 million to act as the placement agent for a CDO securitization. 1239 Those fees contributed substantial revenues to the investment banks which set up structured finance groups, and a variety of RMBS and CDO origination and trading desks within those groups, to handle mortgage related securitizations. Investment banks placed these securities with investors around the world, and helped develop a secondary market where private RMBS and CDO securities could be bought and sold. The investment banks’ trading desks participated in those secondary markets, buying and selling RMBS and CDO securities either for their customers or for themselves. Some of these financial products allowed investors to profit, not only from the success of an RMBS or CDO securitization, but also from its failure. CDS contracts, for example, allowed counterparties to wager on the rise or fall in the value of a specific RMBS security or on a collection of RMBS and other assets contained or referenced in a CDO. Major investment banks also developed standardized CDS contracts that could be traded on a secondary market. In 1237 3/4/2011 “U.S. Mortgage-Related Securities Issuance ” and 1/1/2011 “Global CDO Issuance,” charts prepared by Securities Industry and Financial Markets Association, www.sifma.org/research/statistics.aspx. The RMBS total does not include about $6.6 trillion in RM BS securities issued by government sponsored enterprises like Fannie Mae and Freddie Mac. 1238 See, e.g., 2/2011 chart, “Goldman Sachs Expected Profit from RM BS Securitizations,” prepared by the U.S. Senate Permanent Subcommittee on Investigations using Goldman-produced documents for securitizations from 2005-2007 (underlying documents retained in Subcommittee file); 3/21/2011 letter from Deutsche Bank counsel, PSI-Deutsche_Bank-32-0001. 1239 See “Banks ’ Self-Dealing Super-Charged Financial Crisis,” ProPublica (8/26/2010), http://www.propublica.org/article/banks-self-dealing-super-charged-financial-crisis ( “A typical CDO could net the bank that created it between $5 million and $10 million – about half of which usually ended up as employee bonuses. Indeed, W all Street awarded record bonuses in 2006, a hefty chunk of which came from the CDO business.”). Fee information obtained by the Subcommittee is consistent with this range of CDO fees. For example, Deutsche Bank received nearly $5 million in fees for Gemstone 7, and the head of its CDO Group said that Deutsche Bank received typically between $5 and 10 million in fees, while Goldman Sachs charged a range of $5 to $30 million in fees for Camber 7, Fort Denison, and the Hudson Mezzanine 1 and 2 CDOs. 12/20/2006 Gemstone 7 Securitization Credit Report, DB_PSI_00237655-71 and 3/15/2007 Gemstone CDO VII Ltd. Closing Memorandum, DB_PSI_00133536- 41; Subcommittee interview of Michael Lamont (9/29/2010); and Goldman Sachs response to Subcommittee QFRs at PSI-QFR-GS0249. addition, they established the ABX Index which allowed counterparties to wager on the rise or fall in the value of a basket of subprime RMBS securities, and which could be used to reflect the state of the subprime mortgage market as a whole. 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-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. ------ FOMC20070628meeting--134 132,MR. WARSH.," Thank you, Mr. Chairman. Regarding overall economic growth, my own macroeconomic views are not inconsistent with the central tendency of the projections that were pulled together for this meeting. I think the staff and the participants around the table deserve significant credit for being stubborn about the moderate-growth hypothesis while markets have been on all sides of it. The markets appear ready to look through the second-quarter GDP growth number, which appears to be a bit above trend. I’d say that we have gotten some credit from the markets for being stubborn and stubbornly right on our economic forecast, but they certainly haven’t given us their proxy, and I would not expect them to do so. They happen to share our views for now is what I would say, and I wouldn’t expect that situation to remain over the forecast period. Again, neither should our intention be to somehow get these curves to match over the coming several quarters. On the inflation picture, though it has improved a bit—and I am trying not to disregard very good news—I must say that it strikes me as thoroughly unconvincing. To me, inflation, in our old statement language, remains the predominant risk. I am less certain that core will continue the recent trend. I do believe that headline inflation may be telling us something in terms of secular trends around energy and food that we can’t dismiss, and the warnings from some of the other signals that we would see as rough proxies for inflation are still very real. Regarding what the financial conditions are telling us about growth, it strikes me that, from all the data we have received between our last meeting and this, financial conditions might be as different as any other sets of data that we received. My view is that financial conditions are still supportive of growth, but somewhat less so. It is hard to determine at this point how much, but let me take a stab at doing just that. Since we last met, as Bill said at the outset, we witnessed ten-year Treasury yields increase on the order of between 30 and 50 basis points. I am not uncomfortable with that incremental tightening of policy in the financial markets, but we have to be careful of what we wish for. I think the explanation from our staff here in Washington and Bill and the staff in New York is right, which is that markets have not come to a rosier view of the future. All they have really done is to take out the downside risk that came out of the first quarter. As the data came in a bit above expectations, that insurance bet that they had—that we were wrong and would have to cut rates—really lost credibility. I think their central view of the economy now is not one that roars back but one that is quite consistent with the moderate growth story. The financial markets have indeed tightened policy somewhat. Even since the time that the Bluebook was produced last week, spreads have apparently widened in addition to the risk-free rate being somewhat higher. But this is all happening in very real time, and my report a week ago would have sounded quite a bit different from the one today. We have witnessed increased term premiums and greater volatility across many, if not all, financial markets. Both the MOVE index for Treasuries and the VIX for equities are high relative to the averages of the past year but are still fairly reasonable over a somewhat broader period—say, the last five years. Term premiums I would characterize as returning to more-normal levels—but, again, not out of line with history. We have seen in the Bluebook that credit default swap (CDS) spreads and other spreads had widened, but that yet hadn’t happened in the high-yield market, where apparently there was some narrowing of spreads. That has changed rather dramatically in the past four or five trading days. I’m sure Vince will share more information on this tomorrow. But the CDS spreads really occurred first; then there was a lag to high-yield spreads. In the past two weeks, investment-grade CDS spreads have widened about 7 basis points, high-yield CDS spreads have widened about 20; a relatively new index of loan CDS spreads has widened about 65 basis points; and most, if not all, structured products, even assets wholly unrelated to the housing markets, have been undergoing some spread widening. As I mentioned, high-yield spreads appear to be catching up to CDS spreads, and with the incredible flow of deals in the market, I would guess that the trend continues. We’re seeing higher financing costs and slightly tougher terms for LBOs; the latter is a remarkable new development. M&A prices, probably for the first time since I have been sitting at this table, appear in the markets to be coming off their levels. So when auctions for properties of publicly traded companies are occurring, the price between initial indications of interest and final bids for the first time may actually be coming down. Why is that? Interest coverage ratios cannot go much below where they have been in this cycle. It is 1.2 or 1.3 times, but again, as the risk-free rate has gone up, as spreads have widened, you can buy just a little less debt for that. As a result, equity players that do not want to compromise their equity returns can pay a little less for these properties. Whether this phenomenon is very short term, like the phenomena we heard about after the tumult in late February and we returned to in the heady days of the capital markets, I do not know. This may just be a temporary preference shift toward quality and toward higher volatility and a return to the “glory” days, but I tend to think not. It is a tough call, and I reserve the right to change my judgment. I think that the new supply that’s coming into the markets, most of which needs to get priced before the markets slow down in August, will test the markets’ resilience, will test prices, and will test terms. Up to this point we have seen very little reduction in liquidity, but we are seeing a few deals being pulled from the market. Pricing power appears to be coming back to investors, and negotiations around prices and terms seem significantly more balanced than they have been in a very long time. Some of the instruments that we have sort of giggled about around this table—the pay-in-kind notes with optional cash payment— seem to have lost some traction in the market in the past week. I do not know whether they will return, but I take this new discipline in the markets as an encouraging sign. So what is going to be the resulting effect on prices, terms, and conditions? That is something we will have to judge; but financial conditions, as I said at the outset, are perhaps somewhat more restrictive than they were, but they should still be quite supportive of growth. At the outset I talked about the risk on the inflation front. Let me build on a couple of remarks that Vice Chairman Geithner made about risks now in the financial markets. If the problems that we have seen around structured products that have come out of the Bear Stearns scenario are really about the subprime markets and subprime collateral and housing, there’s not much to worry about. But to the extent that the story is really about structured products—products that have not been significantly stress-tested—then there is a risk that the financial markets may react and overreact. That scenario will bring up reputational risk issues. Even financial intermediaries that are in the agency business are relearning the lesson that agency business is not free—that there are, in fact, dissynergies from being in the principal investment business and the agency business under one marketing name. We are learning a lot about what the markets believe about the transparency of prices, particularly in times of financial distress. Of course, in times of distress, the correlations among all these assets do not look as they do in models, and that is something that will play itself out. I think that Tim rightly referenced the role of gatekeepers in the credit agencies, who I suspect are going to have a fairly rude awakening over the next six to nine months. As I also said, regarding this financial innovation, which on net is of great benefit to us, we will really see some of the products tested. Along with the products, moreover, the market participants’ behavior will be tested, perhaps in this upcoming period, as never before. So the financial markets are a friend on this, but there is greater risk than there was when we last met. Thank you, Mr. Chairman." CHRG-111shrg50815--97 Mr. Ausubel," Oh, the complexity. So here is a way to think about the business model in the credit card market. What happens is there is a certain number of terms of the credit card account that people pay the most attention to. So, for example, at a certain point, people might have been paying attention to annual fees. Competition steps in and annual fees get competed down. But simultaneously, the banks add new fees which are not on consumers' radar screens which generate real revenues and which take a while for consumers to catch up to. So if you ask, why has the number of fees multiplied, it is to have new revenue sources that are not on consumer radar screens. Can I give you one quick example that is unambiguous? Most issuers have 3 percent fees if you purchase anything in foreign currency. Note that there is absolutely no cost associated with this because the currency conversion fees are already built into the whole operation. Senator Merkley. Thank you. I am out of time. Can we allow another person to respond? " CHRG-111hhrg55811--3 Mr. Bachus," I thank the chairman. And we do have two gentlemen here with us, so I am not seeing double. I thank the chairman for convening the hearing. And as the chairman said, derivatives are an essential tool used by countless American companies to help them manage risk associated with doing business both at home and abroad. Derivatives allow companies to hedge against risk, deploy capital effectively, lower costs, and offer protection against fluctuating prices. There is nothing inherently wrong with derivatives. It is when they are abused. Congress must take steps to ensure increased transparency and enhance oversight of the derivatives market. However, any new regulation should not hamper the ability of businesses to control costs, manage risk, compete in the global marketplace, and create jobs. Last Friday, the chairman released draft derivatives legislation which represents a significant improvement over the proposal that the Obama Administration submitted to Congress in August. I commend him for that. The chairman's draft wisely omits provisions from the Administration's proposal which would have severely restricted access to the derivatives marketplace and had the effect of magnifying rather than mitigating systemic risk. However, while the chairman should be commented for addressing several of the serious flaws in the Administration's approach, there are a number of issues, I think, that still require careful attention. For example, the chairman's draft would still require that some over-the-counter products be shifted onto venues like clearinghouses and exchanges. I think he has acknowledged today that may not always be possible. The bill also calls on the regulators to classify some actors in the derivatives marketplace as major swap participants. This vague classification could force thousands of companies to divert millions of dollars of capital away from business investment for use as cash collateral. It seems counterintuitive during a recession, with unemployment approaching 10 percent, to leave companies exposed to greater risk, raise their cost to capital, and make economic recovery more difficult to achieve. Another potentially troublesome provision of the discussion draft, and the chairman discussed this, was prohibiting certain swap transactions. Restriction on credit default swap contracts limits the ability of investors to appropriately calculate risk as it has become apparent that CDS spreads are often a more accurate reflection of credit risk than credit ratings. There is nothing inherently wrong with credit default swaps. And even in the last year I think that has been confirmed. It is when they are abused, as in the case of subprime mortgage securities, which were improperly rated and underwritten, that problems arise. It was the subprime loans that made up the securitizations, not the credit default swaps themselves, that caused the problem. Mr. Chairman, as we move forward with regulatory reform, we should make every effort to strike the right balance between maintaining market stability and preserving useful innovations in the U.S. financial services industry. While the government certainly has a role in policing the derivative marketplace, it must be noted that there are private sector initiatives already under way to clear standardized derivative contracts and establish trade repositories that will furnish the information regulators and investors need to make informed judgments about potential systemic risk and counterparty exposures. Legislation in this area should seek to facilitate and, where appropriate, codify these market-based solutions while not subjecting U.S. companies that operate far from Wall Street to damaging new regulatory burden. I thank the chairman, and I welcome our two witnesses. " CHRG-111shrg53822--41 Mr. Stern," Well, I think with the benefit of hindsight, the answer to that is no. But, occasionally--usually I think it is fair to say, especially if it is a relatively small, straightforward institution, the problems are well recognized in a timely way. I think the problem is with large, complex institutions that is a much more significant challenge, especially to do it in a timely way. And even if you identify the problems in a timely way, taking corrective action in a timely way is a very significant challenge, in my judgment. Senator Shelby. To both of you, is there really in the banking business any substitute for capital, real capital? Ms. Bair. Well, I think capital is absolutely central in its importance, and we need more capital now and in the future. And we need countercyclical capital requirements, and I like the contingent debt concept. It is a good idea as well. I think you need market discipline, too. If an institution is undertaking very high risk activities, even at a 20-percent capital level--and we have seen this in smaller institutions--it can go pretty fast. So I think you need good, common-sense oversight, but you also need that complemented by market discipline, which, again, ``too big to fail'' has diluted. " CHRG-111hhrg53246--2 The Chairman," The hearing will begin. We are very happy today to have before us two Presidential appointees who head important agencies: the Chair of the SEC, Mary Schapiro; and the Chair of the Commodity Futures Trading Commission, Gary Gensler. I want to begin by saying I am very happy that both agency heads are here. I strongly believe that if we were starting from scratch, we would not have two separate agencies, with the extent to which they share a mission. But we do have the two separate agencies. There is no point in wasting energy in trying to consolidate them when there would be no chance of that happening. I am encouraged by the fact that the two Chairs here today have, from the beginning of their appointment, worked closely together to try and avoid friction. I have to say that in my view, jurisdictional fights--whether between congressional committees or among congressional committees or between or among Federal agencies--represent Washington at our worst, because the job getting done well ought to be the issue. And people who insist that--people's egos get too tied up with their positions. We are working hard to avoid that. I have also been working closely with Chairman Peterson of the Agriculture Committee because there is a shared jurisdiction here. And we have come to a very good agreement on substance. We had the hearing a week ago with the Secretary of the Treasury an unusual hearing with two major full committees. We intend to keep doing this. There will be some disagreements I believe at the edges--I am reluctant to say margins here because it will get too doubly interpreted--but at the edges, there may be some disagreements. They clearly are outweighed by the substantial agreement that we have. So one of the questions will be on derivatives. Another will be in our jurisdiction which, we should be clear, is primarily the SEC. I appreciate the fact that Mr. Gensler is here. This committee is not the committee of jurisdiction for him. Mr. Peterson, in the spirit of cooperation, understands that. If Mr. Peterson would ask Chair Schapiro to appear before Agriculture, I don't know if you have yet, but we would encourage that as well, because we don't want these jurisdictional issues to be there. With regard to derivatives, I will tell you the conceptual approach that Mr. Peterson and I have taken, Mr. Peterson's committee has the jurisdiction over those for whom hedging is a part of their business. That is, the Agriculture Committee are more the end users of this who have a product to sell and who hedge because they want to deal with price volatility. Our jurisdiction is more over the people who do some of the hedging and are in the financial area. The concept, it seems to me, we ought to be guided by here is what we ought to be thinking about with the financial institution in general. Their role is to be intermediaries, not to be ends in and of themselves. When there is a breakdown in the financial sector, we call it disintermediation. Their job is to be a very important, I was going to say bridge, but bridge understates the creativity involved. There is nothing passive about their role, but their job is to link up essentially people in the end of the economy who are producing goods and services of value and the people with money to invest in them. Their job is to help us in this society agglomerate investment funds so that they are made available to the end users. Obviously, people aren't going to do that unless they make a profit off it. That is a very important and sometimes complex business. People aren't going to make their money available unless they make a profit. But I do think that over the past couple of decades, there are some examples in the financial sector of the means becoming the ends. We have had people tell us that we should not restrict or regulate this or that because then certain entities would not be able to make money. Yes, it is important that they make money as a by-product of the intermediation function they perform. The fact that a given institution won't make money is, in itself, no reason to be opposed to this. And, in fact, activities whose major justification is that they make a profit for some entity unconnected to that intermediation function are not going to be well received by us. I will now add, finally, this is not just about derivatives, we have other issues, this committee has been very interested in the whole question of mark-to-market. The gentleman from Pennsylvania has played a major role there. And there is also continued interest in the question of short sale and corporate governance. I will say that two of our members, the gentleman from California, Mr. Campbell, and the gentleman from Michigan, Mr. Peters, in a bipartisan way, have a great interest in corporate governance issues. And I expect the committee will turn to them this fall after we have done some of the major regulatory stuff. But both of those issues are, particularly the short sale and the mark-to-market, are going to be before us today. The gentleman from New Jersey is recognized for 3 minutes. " CHRG-111shrg54789--176 PREPARED STATEMENT OF TRAVIS B. PLUNKETT Legislative Director, Consumer Federation of America July 14, 2009Summary Thank you, Chairman Dodd, Ranking Member Shelby, and Members of the Committee. My name is Travis Plunkett and I am the Legislative Director of the Consumer Federation of America (CFA). \1\ I am pleased to be able to offer the views of leading consumer, community, and civil rights groups \2\ in support of the establishment of a Consumer Financial Protection Agency, as proposed first by Senators Durbin, Schumer, and Kennedy and most recently by President Obama. In addition to CFA, I am testifying on behalf of, Americans for Fairness in Lending, \3\ Americans for Financial Reform, \4\ A New Way Forward, \5\ the Association of Community Organizations for Reform Now (ACORN), \6\ Center for Responsible Lending, \7\ Community Reinvestment Association of North Carolina, \8\ Consumer Action, \9\ Consumers Union, \10\ Demos, \12\ Florida PIRG, \13\ The International Brotherhood of Teamsters, \14\ National Association of Consumer Advocates, \15\ National Community Reinvestment Coalition, \16\ National Consumer Law Center (on behalf of its low-income clients), \17\ National Consumers League, \18\ National Fair Housing Alliance, \19\ Neighborhood Economic Development Advocacy Project, \21\ Public Citizen, \22\ Sargent Shriver National Center on Poverty Law, \23\ Service Employees International Union, \24\ USAction, \25\ and U.S. PIRG. \26\--------------------------------------------------------------------------- \1\ The Consumer Federation of America is a nonprofit association of over 280 proconsumer groups, with a combined membership of 50 million people. CFA was founded in 1968 to advance consumers' interests through advocacy and education. \2\ The testimony was drafted by Travis Plunkett and Jean Ann Fox of the Consumer Federation of America, Gail Hillebrand of Consumers Union, Lauren Saunders of the National Consumer Law Center, and Ed Mierzwinski of U.S. PIRG. \3\ Americans for Fairness in Lending works to reform the lending industry to protect Americans' financial assets. AFFIL works with its national Partner organizations, local ally organizations, and individual members to advocate for reform of the lending industry. \4\ Americans for Financial Reform is a coalition of close to 200 national State and local organizations representing people from every walk of life, including homeowners, shareowners, workers, and low and moderate income community residents dedicated to making sure that the ``main street'' voice is heard in the debate on financial regulatory reform. \5\ A New Way Forward is a movement of citizens, started in March 2009. It harnesses the voice of citizens to stop the excessive and dangerous partnership between Government and the largest institutions of the financial sector in order to reinvigorate the public sphere. ANWF organizers are letting the world know that the way Congress is handling the financial crisis rewards the wrong people, is likely to fail, and doesn't get at the core structural problems in our economy. ANWF helped organize 60 protests ad 25 educational forums in the past 4 months. \6\ ACORN, the Association of Community Organizations for Reform Now, is the Nation's largest community organization of low- and moderate-income families, working together for social justice and stronger communities. \7\ The Center for Responsible Lending (CRL) is a not-for-profit, nonpartisan research and policy organization dedicated to protecting homeownership and family wealth by working to eliminate abusive financial practices. CRL is an affiliate of Self-Help, which consists of a credit union and a nonprofit loan fund focused on creating ownership opportunities for low-wealth families, primarily through financing home loans to low-income and minority families who otherwise might not have been able to purchase homes. Self-Help has provided over $5 billion in financing to more than 60,000 low-wealth families, small businesses and nonprofit organizations in North Carolina and across the United States. Another affiliate, Self-Help Credit Union, offers a full range of retail products, and services over 3,500 checking accounts and approximately 20,000 other deposit accounts, and recently inaugurated a credit card program. \8\ The Community Reinvestment Association of North Carolina's mission is to promote and protect community wealth through advocacy, research, financial literacy and community development. \9\ Consumer Action is a national nonprofit education and advocacy organization serving more than 9,000 community based organizations with training, educational modules, and multilingual consumer publications since 1971. Consumer Action's advocacy work centers on credit, banking, and housing issues. \10\ Consumers Union is a nonprofit membership organization chartered in 1936 under the laws of the State of New York to provide consumers with information, education and counsel about good, services, health and personal finance, and to initiate and cooperate with individual and group efforts to maintain and enhance the quality of life for consumers. Consumers Union's income is solely derived from the sale of Consumer Reports, its other publications and from noncommercial contributions, grants and fees. In addition to reports on Consumers Union's own product testing, Consumer Reports with more than 5 million paid circulation, regularly, carries articles on health, product safety, marketplace economics and legislative, judicial, and regulatory actions which affect consumer welfare. Consumers Union's publications carry no advertising and receive no commercial support. \12\ Demos is a New York City-based nonpartisan public policy research and advocacy organization founded in 2000. A multi-issue national organization, Demos combines research, policy development, and advocacy to influence public debates and catalyze change. \13\ Florida PIRG takes on powerful interests on behalf of Florida's citizens, working to win concrete results for our health and our well-being. With a strong network of researchers, advocates, organizers and students across the State, we stand up to powerful special interests on issues to stop identity theft, fight political corruption, provide safe and affordable prescription drugs, and strengthen voting rights. \14\ The Teamsters union represents more than 1.4 million workers in North America. Teamsters work from ports to airlines, from road to rail, from food processing to waste and recycling, from manufacturing to public services. The Union fights to improve the lives of workers, their families and their communities across the global supply chain. \15\ The National Association of Consumer Advocates, Inc., is a nonprofit 501(c)(3) organization founded in 1994. NACA's mission is to provide legal assistance and education to victims of consumer abuse. NACA, through educational programs and outreach initiatives protects consumers, particularly low income consumers, from fraudulent, abusive and predatory business practices. NACA also trains and mentors a national network of over 1400 attorneys in representing consumers' rights. \16\ National Community Reinvestment Coalition is an association of more than 600 community-based organizations that promotes access to basic banking services, including credit and savings, to create and sustain affordable housing, job development, and vibrant communities for America's working families. \17\ The National Consumer Law Center, Inc. is a nonprofit corporation, founded in 1969, specializing in low-income consumer issues, with an emphasis on consumer credit. On a daily basis, NCLC provides legal and technical consulting and assistance on consumer law issues to legal services, Government, and private attorneys representing low-income consumers across the country. NCLC publishes and regularly updates a series of 16 practice treatises and annual supplements on consumer credit laws, including Truth In Lending, Cost of Credit, Consumer Banking and Payments Law, Foreclosures, and Consumer Bankruptcy Law and Practice, as well as bimonthly newsletters on a range of topics related to consumer credit issues and low-income consumers. NCLC attorneys have written and advocated extensively on all aspects of consumer law affecting low income people, conducted training for tens of thousands of legal services and private attorneys on the law and litigation strategies to deal predatory lending and other consumer law problems, and provided extensive oral and written testimony to numerous Congressional committees on these topics. NCLC's attorneys have been closely involved with the enactment of the all Federal laws affecting consumer credit since the 1970s, and regularly provide comprehensive comments to the Federal agencies on the regulations under these laws. \18\ The National Consumers League has been fighting for the rights of consumers and workers since its founding in 1899. The League was instrumental in seeking a safety net for Americans during the Great Depression and in the New Deal years, writing legislation to gain passage of minimum wage laws, unemployment insurance, workers compensation, social security and health care programs like medicare and medicaid. The League continues to champion the fair treatment and protections for all consumers in today's marketplace. \19\ Founded in 1988, the National Fair Housing Alliance is a consortium of more than 220 private, nonprofit fair housing organizations, State and local civil rights agencies, and individuals from throughout the United States. Headquartered in Washington, DC, the National Fair Housing Alliance, through comprehensive education, advocacy and enforcement programs, provides equal access to apartments, houses, mortgage loans and insurance policies for all residents of the Nation. \21\ Neighborhood Economic Development Advocacy Project (NEDAP) is a resource and advocacy center for community groups in New York City. Their mission is to promote community economic justice and to eliminate discriminatory economic practices that harm communities and perpetuate inequality and poverty. \22\ Public Citizen is a national nonprofit membership organization that has advanced consumer rights in administrative agencies, the courts, and the Congress, for 38 years. \23\ Founded by Sargent Shriver in 1967, the mission of the Sargent Shriver National Center on Poverty Law is to provide national leadership in identifying, developing, and supporting creative and collaborative approaches to achieve social and economic justice for low-income people. The Community Investment Unit of the Shriver Center advances the mission of the organization through innovative and collaborative public policy advocacy to enable low-income people and communities to move from poverty to prosperity. \24\ The Service Employees International Union is North America's largest union with more than 2 million members. SEIU has taken a lead in holding financial institutions, including private equity and big banks, accountable for their impact on working families. \25\ USAction builds power by uniting people locally and nationally, on the ground and online, to win a more just and progressive America. We create and participate the Nation's leading progressive coalitions making democracy work by organizing issue campaigns to improve people's lives. Our 28 State affiliates and partners, and our True Majority online members, bring the voices and concerns of the grassroots inside the Beltway. \26\ The U.S. Public Interest Research Group serves as the federation of and Federal advocacy office for the State PIROs, which are nonprofit, nonpartisan public interest advocacy groups that take on powerful interests on behalf of their members.--------------------------------------------------------------------------- In this testimony, we outline the case for establishment of a robust, independent Federal Consumer Financial Protection Agency to 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 the prudential regulator for that company or bank. We describe the many failures of the current Federal financial regulators. We discuss the need for a return to a system where Federal financial protection law serves as a floor not as a ceiling, and consumers are again protected by the three-legged stool of Federal protection, State enforcement and private enforcement. We rebut anticipated opposition to the proposal, which we expect will come from the companies and regulators that are part of the system that has failed to protect us. We offer detailed suggestions to shape the development of the agency in the legislative process. We believe that, properly implemented, a Consumer Financial Protection Agency will encourage innovation by financial actors, increase competition in the marketplace, and lead to better choices for consumers. We look forward to working with you and Committee Members to enact a strong Consumer Financial Protection Agency bill through the Senate and into law. We also look forward to working with you on other necessary aspects of financial regulatory reform to restore the faith and confidence of American families that the financial system will protect their homes and their economic security.SECTION 1. LEARNING FROM EXPERIENCE TO CREATE A FEDERAL CONSUMER FOMC20080121confcall--41 39,MR. KOHN.," Thank you, Mr. Chairman. I strongly support your proposal. As I noted in our conference call a couple of weeks ago, I think our reaction to the incoming data and to the change in financial conditions, even as of a couple of weeks ago, was much smaller than it needed to be to stabilize the economy. We had a long way to go, and the situation has deteriorated since then, a little bit on the data side--the consumption data were a little weaker than we expected--but much more in the financial markets. We have a vicious cycle in housing between the financial markets and the housing markets, where the decline in the housing markets is feeding into the credit markets, which is feeding back on the housing market. I think there is evidence, as others have cited, that it is spreading geographically a bit to other countries, which means that the export support that we were counting on may not be as strong as it was, and spreading to other markets like the consumer credit markets. I agree that the equity markets per se aren't our goal, but declines in equity prices destroy wealth. I think they are symptomatic, as you indicated, Mr. Chairman, of a fear and a declining confidence in where this economy is going. That dynamic of declining confidence and growing fear argues for early action despite a number of reasons to wait for the next meeting. I agree with President Poole that no one can be certain what the market reaction will be and what kind of responses we will get now and in the future. We could look panicky. We could set up expectations in the future that we would regret. But I think the greater risk would be in not acting. Given the dynamic out there, living through another nine days before the next meeting has a very high degree of risk that we could come into that meeting in a very, very adverse spot in terms of where the markets are and what is expected of us. So there is no guarantee of success here. That is for sure. But if I were going to place my bets--and I guess I am as a voting member of the Committee--I would place it on acting now rather than later. President Lockhart talked about the potential positive effects on psychology. I think that is part of it. There are also just the normal channels through which monetary policy works on the economy. Lowering interest rates will help in terms of asset prices, and it will help financing costs; and given the risk of waiting, I think we should get to that right away. I agree that it is not going to do anything directly for the monolines or for the other institutions that need capital. But part of what is driving this fear and eroding confidence is the concern about recession. I think lowering interest rates, doing it promptly, and doing it emphatically with 75 basis points, as well as acting through the usual channels, will help ameliorate that fear. In terms of taking it back, the point that President Hoenig made, I think the history of what we have done is pretty complicated and more complex maybe than that we are always too late taking it back. If we were always too late, we would have seen an upward trend in inflation. But we haven't. We have seen a downward trend in inflation for the past 25 years. So it seems to me that the proof of the pudding is in the inflation eating, and I don't think we have been reluctant to--I mean, yes, you can argue that we should have done it one meeting sooner or that sort of thing. That is all 20/20 hindsight. You know, you can always make that argument. But I think basically monetary policy has accomplished its objectives pretty darn well over this period, reacting to financial market distress and then taking it back when we see the distress being alleviated. I think, President Hoenig, if we keep our eye on the inflation forecast, if we make sure that we are forward-looking in that regard, that we will take it back in a timely way. Even if we get started a meeting or two too late, we can move up faster after we start. So I don't think our history is so unambiguous that we are always late taking things back. I don't think the results support that kind of assertion. I agree with you, Mr. Chairman, that we cannot take our eyes off inflation, particularly inflation expectations. If we had a build in inflation expectations, that would set into motion a very serious and destructive dynamic, especially with the dollar. But I do think that declining resource utilization, a soft economy, even if it's not in recession, will exert competitive pressures on both workers and businesses as they consider raising prices. Our focus right now, as several of you have remarked, given the risk to the economy, must be on financial stability and its implications for the economy. That is where we need to focus our attention at the moment. Thank you, Mr. Chairman. " CHRG-111shrg55739--137 Mr. Gellert," I would just like to point out that if you look at the newer agencies, or firms, be they NRSROs or not, they are almost entirely subscription-based or user-based businesses. No one else is coming into the market and saying, let us startup a new issuer-paid. And the reason for that is that the market share is so unbelievably tightly held by three players. So for competitive reasons, for all of the regulatory reasons that we have already discussed, breaking into that business as a new player is a relatively futile effort. But I would just add to Professor Coffee's comments that one of the reasons that we start out as--a firm like us, like Rapid Ratings--starts out rating individual corporations, is, yes, they are simpler than trying to rate structured products, but the availability of information is completely different. We rate entirely based on disclosed, publicly available financial information for public companies, and private companies, it is the data that is provided to us by our customers under contract and confidentiality agreement, with full understanding on a bilateral basis that we are not conducting due diligence for them, but if they are a bank that has a lending relationship, they supply that information, if it is a corporation that has a counterparty risk relationship, they are receiving that information, they supply it to us. It is about availability of information. So new competitors, regardless of the revenue model, are not going to break into--with a couple of very small exceptions, and Real Point happens to be one of them--are going to break into the structured business when the payment, as Professor Coffee just mentioned, needs to be a front-loaded payment and the information is simply not being shared. Senator Corker. I appreciate your comments earlier about the unintended consequences of making everyone register. I think that was a valuable contribution. But let us move down that path just a little bit, the one you are on. We visited the offices of Second Market. I know that they are setting up a sort of a public auction process for securities and they are doing a great job and they are being very successful, and I hope they are because they have come up with a brilliant idea. At the same time, as I looked at what they were disclosing on some of these--again, as you have just mentioned, there is not as much information as one would like--if one--and I have read op-eds recently and publications where disclosure on these securities ought to be broadly given--if that was the case, are you saying that an entity like yours actually would rate many of these more complex securities? I mean, that is a lot of work for all these securities being offered. Is that something you say you would pursue? " 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-109hhrg22160--3 The Chairman," Gentleman's time has expired. Now, recognize the chairwoman of the Domestic and International Monetary committee, the gentlelady from Ohio, Mrs. Pryce. Ms. Pryce. Thanks, Chairman Oxley. Welcome, Chairman Greenspan, and thank you for taking the time to discuss with us your insights on monetary policy and many other things I am sure we will hear from you. I am especially happy to be returning to the committee for these very special opportunities. This will be an exciting and very busy year for us. As you know, the President has outlined an aggressive second-term agenda, which includes Social Security, tax and legal reform. Social Security is an issue that, if addressed today, could safeguard the future of millions of young people, and, if ignored, could become the biggest shortcoming of a generation. As you noted yesterday, the existing structure isn't working, and I am sure that this committee will have plenty of questions on this issue, and I look forward to hearing your answers later in the morning. Last month, the Bureau of Labor Statistics released revised data showing gains of 2.7 million jobs for 20 straight months, with those gains beginning of June of 2003, which was 3 months earlier than previously estimated. My home state of Ohio, which has been hit hard by manufacturing job loss over the last 2 years, has recently seen an increase in workers returning to the job market, and Ohio is not alone in that recovery. The national unemployment rate ticked down 0.2 percentage points in January, the lowest rate since September of 2001. Mr. Chairman, reflection on the measured rise in inflation taken by FOMC and the role you had in it, I am particularly interested in hearing you address the role raising rates will have on manufacturing states like Ohio, where the manufacturing sector is a large part of the economy. Also, I would like to hear how you feel it will affect the housing market, which has been such a stable influence in the economy over the last several years. I appreciate, Mr. Chairman, your support and encouragement of deregulation and technological innovation. You have said before that continued movement on these fronts, along with maintenance of a rigorous and evolving education system, will drive our economy into the future. I am particularly interested to hear you speak in more length on the demands put on our education system. You have voiced concern in the past that while our fourth graders outperform their peers around the world in math and science, our eighth graders are about average, and our 12th graders rank near the bottom. How can this happen? I hope to discuss with you now and in the future possible reasons for this failure and how best we resolve our education system to graduate more skilled workers and how that will affect our economy. I am also concerned about the state of financial literacy among all Americans. I am concerned over the state of our nation's savings rate, something I was glad to hear you address in yesterday's hearing and I hope you discuss further today. We must grow our economy and not our government, and we must change the current system of Social Security to ensure its solvency for our children. Through fiscal discipline and by implementing policies that increase the rate of personal savings and retirement security, we can provide financial freedom to all Americans and allow them to take ownership over their families' future and prosperity. I thank you, Mr. Chairman, for your appearance today. I look forward to your testimony. And with that, I yield back, Mr. Chairman. " CHRG-111hhrg49968--4 Chairman Spratt," Thank you, Mr. Ryan. Now, before proceeding with Chairman Bernanke, let me, as a housekeeping detail, ask for unanimous consent that all members be allowed to submit an opening statement for the record at this point. So ordered. [The statement of Mr. Connolly follows:] Prepared Statement of Hon. Gerald E. Connolly, a Representative in Congress From the State of Virginia Mr. Chairman, thank you for holding this hearing and thank you, Chairman Bernanke, for your testimony on the state of our economy. I understand the complexity of issues affecting our economy and I respect the Federal Reserve's various efforts to stabilize the current crisis. There is, however, one critical area in which I believe the Fed has failed to act--the municipal bond market. Municipal bonds are the primary funding mechanism for state and local capital projects, including the repair or construction of our schools, fire and police stations, libraries, water treatment plants and critically needed transportation infrastructure. Traditionally, state and local governments have sold an average of $280 billion in bonds each year. The capital programs of our state and local governments, primarily funded by municipal bonds, have been one of the most effective engines for job creation throughout the country. Yet, despite the historically solid performance and low default rate of municipal bonds, investors fled from the muni market to U.S. Treasury notes following the economic meltdown last fall. As a result, the nation's 55,000 state and local governments are experiencing limited access to the capital markets. Further complicating the issue is the fact that the private insurance market virtually disappeared overnight, eliminating a viable means of credit enhancement for many issuers. If we do not address this serious problem, we could wind up in a situation where this squeezing of the municipal bond market has a counteractive effect on the benefits of our hard-fought economic recovery package. Municipal bonds are and have always been a tremendous source of economic stimulus that we cannot ignore. Chairman Bernanke, you stated in your March 31st letter to Members of Congress that although fixed-rate municipal debt is available to the larger municipalities, the costs to those localities are elevated, and thousands of smaller entities remain unable to access credit. You further noted the additional stress on the floating rate debt. According to Section 2a of the Federal Reserve Act, the Fed is required ``to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.'' To that effect, during the current recession, the Fed extended more than $2.1 trillion in credit through additional lending facilities to help spur the credit market. Earlier this year I introduced H.R. 1669, the Federal Municipal Bond Marketing Support and Securitization Act, as a way to begin to address the problem. At its core, my proposal directed the Secretary of the Treasury and Federal Reserve Board to work together to strategically intervene in the municipal bond market to restore liquidity and spark local job creation. The Congress now is considering several options, including authorizing a federal reinsurance program and a liquidity enhancement proposal to give the Federal Reserve the authority to fund a new liquidity facility for the purchase of variable rate demand notes. The Federal Reserve is empowered to conduct Open Market Operations. I understand the Fed's traditional reluctance to purchase municipal securities; however, the current recession is truly an extraordinary and historic situation, requiring new and innovative tools to address. Chairman Bernanke, you stated in your October 28, 2008 letter to Congressman Paul Kanjorski, ``the Federal Reserve Act provides the Federal Reserve with only limited ability to purchase directly the obligations of states and municipalities.'' If we are serious about promoting economic stimulus and recovery, then we must address the credit crisis that is paralyzing our state and local governments' capital programs--programs which represent one of the most significant job creation engines in the nation. " 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-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-111hhrg46820--104 Mr. Roth," Thank you, Madam Chairwoman. Madam Chairwoman, Ranking Member Graves, members of the committee, as you said, the USTelecom Association is the Nation's leading broadband industry trade group, representing service providers, manufacturers, and suppliers of advanced communications, applications and entertainment. We appreciate the opportunity to share with you our perspectives on the emerging American reinvestment and recovery plan, and on what policy approaches in that package can encourage the deployment and adoption of broadband and thus provide consumers with its many life enhancing benefits while stimulating job creation and the growth of small businesses. And, Madam Chairwoman, like you and Ms. Clarke, I come from Brooklyn, New York, and my mother grew up in your district. So I especially appreciate the opportunity to appear here today before you. You are no doubt familiar with our two largest members, Verizon and AT&T. But we are also proud to count many more midsized companies and hundreds of small ones in our membership ranks. Indeed, the vast majority of the companies we represent are rural providers. They are generally small businesses serving small communities. Collectively they are at the forefront of building America's broadband infrastructure, and they are united by a shared determination to deliver innovative voice, video and data services to their customers, including in turn the small business customers they serve, a commitment we know this committee shares. Page 2 of my written testimony includes three stories from a remote community in the Pacific Northwest that illustrate how broadband can be used to start or grow small businesses anywhere in America. I encourage you to study those examples more closely because they explain why broadband has emerged as an essential driver in 21st century American life. Like the telephone networks, electrical grids and pipelines of the 20th century, broadband is now propelling forward virtually every category of the U.S. economy. Achieving the objective of universally accessible broadband--an objective we support--requires policies that encourage vigorous investment in the sophistication and capacity of the Nation's broadband networks, as well as innovative public-private partnerships to reach every pocket of our geographically vast Nation. We are delighted that policymakers in both branches and on both sides of the aisle have recognized the importance of broadband to the Nation's economic health. Let me hasten to note that as an industry, we are not asking Congress for financial help to fund our ongoing operations or to execute our business plans, which do call for the continued investment of very substantial sums in broadband buildout. But in response to the interest the President-elect and leading Members of Congress have shown in using the economic recovery package to stimulate increased broadband deployment and adoption, particularly in unserved areas of the country that are sparsely populated and hardest to reach, we have developed a series of ideas and approaches calculated to accomplish those desired ends. First, we encourage the 111th Congress to fund two of the 110th Congress' major accomplishments, the Broadband Data Improvement Act, commonly known as Broadband Mapping bill, and the Rural Utilities Service Broadband Loan Program, which was significantly reformed in the 2008 Farm bill. Next, some of our member companies, particularly those in areas where the population density is very low so that the cost of buildout and operations are conversely very high, have suggested the creation of a one-time grant program to assist in the cost of initial deployment to unserved areas for which reliance on private capital alone cannot suffice. In the tax area, a refundable consumer tax credit of up to $30 per month per household to offset the cost of broadband subscriptions for low-income, unemployed, and rural Americans would expand opportunities for those individuals who currently are least likely to be connected to the Internet. An investment tax credit targeted to incentivize more, and more rapid, broadband deployment will also help to increase the availability of affordable broadband to small businesses and residential consumers across the country. And extending the bonus depreciation provision that expired on December 31st would encourage companies to accelerate their capex plans, including broadband deployment projects. Broadband and small business are each an essential building block in our economy. If we want those businesses and their communities to thrive, we must ensure that broadband's many benefits, such as better health care, education, and a cleaner environment, are made accessible to all Americans. So whether you adopt the specific ideas we have set forth or look at proposals being suggested by others, we hope you will incorporate three basic principles into your consideration. First, maintain an economic and regulatory climate that continues to encourage private sector investment in broadband infrastructure; second, look carefully at the consumer side of the equation by addressing barriers to broadband adoption; and, third, make sure broadband deployment policies are focused on remaining unserved, underserved and high cost areas. Adherence to those principles will contribute to both the short-term recovery and long-term prosperity we all seek. We thank you for your invitation and your consideration of our views. [The statement of Mr. Roth is included in the appendix at page 112.] " CHRG-111shrg54533--92 RESPONSES TO WRITTEN QUESTIONS OF CHAIRMAN DODD FROM TIMOTHY GEITHNERQ.1. One key issue that will need to be resolved is how the Consumer Financial Protection Agency (CFPA) and the National Bank Supervisor (NBS) will be funded. Would you subject their funding to the appropriations process? Would you rely solely on fees charged to the regulated entities? Would you use the deposit insurance fund? Do you believe there should be parity between State and national charters with respect to the costs of their supervision? If so, how would you achieve that?A.1. Under Treasury's proposed legislation, the CFPA is authorized to appropriate ``such sums as are necessary'' for it to fully discharge its duties under the statute, and recover these appropriations through fees on covered entities. Such fees could be assessed only after promulgating rules with respect to such fees, which is consistent with methods employed by other independent regulators. That rulemaking process would include publishing any proposed fees for public notice and comment. The Office of Management and Budget (OMB) will exercise apportionment authority over the CFPA. This authority will provide OMB the opportunity for review and discussion with the Agency to ensure that CFPA spending is planned and executed according to law. The CFPA's budget will include the resources used by the existing regulators to carry out their financial consumer protection functions, which will all be transferred to the new agency. The agencies that will transfer functions to the CFPA include the Federal Reserve Board and Federal Reserve Banks, the Office of the Comptroller of the Currency (OCC), the Office of Thrift Supervision (OTS), the Federal Deposit Insurance Corporation (FDIC), the National Credit Union Administration (NCUA), the Federal Trade Commission (FTC), and the Department of Housing and Urban Development. In addition to these resources, the CFPA will need funding to provide a level playing field by extending the reach of Federal oversight to the nonbank providers of consumer financial products and services. Under Section 1024 of the legislation, the CFPA would have a mandate to allocate more of its resources to institutions that pose more risks to consumers. Community banks are close to their customers and have often provided simpler, easier-to-understand products with greater care and transparency than other segments of the market. Such banks will receive proportionally less oversight from the CFPA. Moreover, the Administration proposes that community banks will pay no more for Federal consumer protection supervision after the establishment of the CFPA than they do today. Like the OCC, the newly constituted NBS, which will be created through the consolidation of the activities of the OCC and OTS, will continue to collect fees to cover the cost of safety and soundness supervision of institutions with a national charter.Q.2. The Administration's proposal would fund the resolution of a large nonbank financial company initially through the Treasury, with any losses to the government recouped through an assessment on holding companies. Other proposals have called for an ex ante funding approach: financial organizations would pay assessments into a fund that would be available to cover all or part of the costs of resolving a systemically important financial institution. Proponents of an ex ante approach argue that the fund would reinforce the commitment of the government to unwind troubled large financial organizations rather than propping them up with taxpayer funds. The assessments, like the Administration's proposed higher capital requirements, would also provide a disincentive for a company to grow in size or complexity to a level that could create systemic risk. Can you elaborate on why the Administration instead proposes ex post funding with initial reliance on Treasury funds?A.2. Our proposal for a special resolution regime is intended for use only in extraordinary circumstances and subject to very high procedural hurdles. It is modeled on the existing systemic risk exception under FDIC Improvement Act of 1991 (FDICIA). By way of example, that exception was not used at all from the time FDICIA became law until the current crisis. Under our proposal, the special resolution regime would not replace bankruptcy procedures in the normal course of business. Bankruptcy is and will remain the dominant tool for handling the failure of a bank holding company. The special resolution regime would only be triggered by a threat to financial stability. Because this regime will be used only in exceptional circumstances when the system is at risk, we believe that the creation of an ex ante fund is not necessary. Moreover, the ex ante regime could actually make intervention more likely because firms that had paid into the fund would expect to be able to access the monies held by the fund and because the government may be more likely to expend money to stabilize a firm if a readily available fund was accessible for that purpose. In our proposal, the high procedural hurdles will help ensure that these powers are only used when appropriate. An ex post funding mechanism provides large financial firms with stronger incentives to monitor the risk taking of systemic firms. The funding mechanism entails no assessments on the large firms if no systemic firms fail but potentially large assessments on the firms if one or more systemic firms fail. As such, ex post funding promotes ex ante market discipline of the systemic firms. Ex post funding provides large financial firms with strong incentives to support a private sector recapitalization of a systemic firm in severe distress--rather than a government resolution with substantial assistance. If large financial firms understand that they must pay after-the-fact for the clean-up of a systemic firm if it fails, the large firms, which will collectively make up a substantial portion of the counterparties of the failing systemic firm, will have strong incentives to arrange a private sector solution to the problems of the failing firm (including, for example, by consenting to debt-for-equity swaps). ------ CHRG-109hhrg23738--74 Mr. Greenspan," Yes. I would certainly say this, that this issue has to be resolved. I mean, it cannot fester, because I think we will have some serious consequences. It has not, really, yet, but it could. And I do not deny that where issues of legality are involved statutes are required for clarification and understanding whose rights are in what particular area. I have heard some incredibly complex stories of people who, for example, had outsourced certain types of projects with a huge number of names which they had collected which got lost, and they are responsible. So the question of ``Who is legally responsible under those sorts of conditions?'' is a critical issue which the law has to address. I am just basically saying what I am a little concerned about, is that we all of a sudden have this major advance in technology--which is the whole electronic system--and that it is making major incursions into many areas where huge progress is occurring, and I am a little worried that we will stifle the process if we overdo it. But if you are getting at the issue on responsibility, on who has responsibility in the event of event X---- " 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. CHRG-110hhrg45625--52 Secretary Paulson," Okay. Mr. Chairman, I thank you. A note of levity always helps. First of all, thank you very much. Thank you, Congressman Bachus, and members of the committee. Thank you for the opportunity to appear here today. I appreciate that we are here to discuss an unprecedented program, but these are unprecedented times for the American people and for our economy. I also appreciate that the Congress and the Administration are working closely together and we have been for a number of days now so that we can help the American people by quickly enacting a program to stabilize our financial system. We must do so in order to avoid a continuing serial of financial institution failures and frozen credit markets that threaten American families' financial wellbeing, the viability of businesses both small and large, and the very health of our economy. The events leading us here began many years ago, starting with bad lending practices by banks and financial institutions and by borrowers taking out mortgages they couldn't afford. We have seen the results on homeowners, higher foreclosure rates affecting individuals and neighborhoods, and now we are seeing the impact on financial institutions. These bad loans have created a chain reaction, and last week our credit markets froze up. Even some Main Street nonfinancial companies had trouble financing their normal business operations. If that situation were to persist, it would threaten all parts of our economy. Every business in America relies on money flowing through the financial system smoothly every day, not only to borrow, expand, and create jobs, but to finance their normal business operations and preserve existing jobs. Since the housing correction began last summer, the Treasury has examined many proposals as potential remedies for the turmoil that the correction has caused to the banking system. At the Federal Reserve, we have sought to address financial market stresses with as minimal exposure for the U.S. taxpayer as possible. This Federal Reserve took bold steps to increase liquidity in the markets and we have worked together on a case-by-case basis addressing problems at Fannie Mae and Freddie Mac, working with market participants to prepare for the failure of Lehman Brothers and lending to AIG so it can sell some of its assets in an orderly manner. We have also taken a number of powerful tactical steps to increase confidence in the system, including a temporary guarantee program for the U.S. money market mutual fund industry. These steps have all been necessary but not sufficient. More is needed. We saw the financial market turmoil reach a new level last week and spill over into the rest of the economy. We must now take further decisive action to fundamentally and comprehensively address the root cause of the turmoil. And that root cause is the housing correction which has resulted in illiquid mortgage related assets that are choking off the flow of credit which is so vitally important to our economy. We must address this underlying problem and restore confidence in our financial markets and financial institutions so that they can perform their mission of supporting future prosperity and growth. We have proposed a program to remove troubled assets from the system, a program we analyzed internally for many months and had hoped would never, ever be necessary. Under our proposal, we would use market mechanisms available to small banks, credit unions and thrifts, large banks, and financial institutions of all size across the country. These mechanisms will help set values of complex illiquid mortgage and mortgage-related securities to unclog our credit and capital markets and make it easier for private investors to purchase these securities and for financial institutions to then raise more capital. This troubled asset purchase program has to be properly designed for immediate implementation and be sufficiently large to have maximum impact and restore market confidence. It must also protect the taxpayer to the maximum extent possible, include provisions that ensure transparency and oversight while ensuring the program can be implemented quickly and run effectively as it needs to get the job done. The American people are angry about executive compensation and rightfully so. Many of you cite this as a serious problem and I agree. We must find a way to address this in the legislation, but without undermining the effectiveness of this program. I understand the view that I have heard from many of you on both sides of the aisle urging that the taxpayer should share in the benefits of this program to our financial system. Let me make clear this entire proposal is about benefiting the American people because today's fragile financial system puts their economic wellbeing at risk. When local banks and thrifts aren't able to function as they should, Americans' personal savings and the ability of consumers and businesses to finance spending, investment, and job creation are threatened. The ultimate taxpayer protection will be stabilizing our system so that all Americans can turn to financial institutions to meet their needs financing a home improvement or a car or a college education, building retirement savings, or starting a new business. The $700 billion program we have proposed is not a spending program. It is an asset purchase program. And the assets which are bought and held will ultimately be resold with the proceeds coming back to the government. Depending on the rate at which our housing market and economy recover, the loss to the taxpayer should be minimal, and a number of experts believe the government should actually break even on this program. I am convinced that this bold approach will cost American families far less than the alternative, a continuing series of financial institution failures and frozen credit markets unable to fund day needs and economic expansion. As you can imagine, I have been talking a lot lately and sometimes the words don't--they never do come out that smoothly for me, but it has been a long couple of days. But anyway, I understand this is an extraordinary thing to ask, but these are extraordinary times. I am encouraged by bipartisan consensus for an urgent legislative solution. We need to enact this bill quickly and cleanly and avoid slowing it down with unrelated provisions or provisions that don't have broad support. This troubled asset purchase program on its own is the single most effective thing we can do to help homeowners, the American people, and to stimulate our economy. Earlier this year, Congress and the Administration came together quickly and effectively to enact a stimulus package that has helped hard working Americans and boosted our economy. We acted cooperatively and faster than anyone thought possible. Today we face a much, much more challenging situation that requires bipartisan discipline and urgency. When we get through this difficult period, which we will, our next task must be to address the problems in our financial system through a reform program that fixes our outdated financial regulatory structure and provides strong measures to address other flaws and excesses. I have already put forward my recommendations on this subject. Many of you here also have strong views. And we must have that critical debate, but we must get through this period first. Right now, all of us are focused on the immediate need to stabilize our financial system and I believe we share the conviction that this is in the best interest of all Americans. Now, let us work together and get it done. Thank you. [The prepared statement of Secretary Paulson can be found on page 87 of the appendix.] " CHRG-111shrg56376--129 RESPONSES TO WRITTEN QUESTIONS OF SENATOR BUNNING FROM JOHN E. BOWMANQ.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. There are several ways to decrease the concentration in the banking industry, including: 1. Restricting further increases in concentrations. The largest banks in the U.S. have principally achieved their concentration dominance by mergers and acquisitions. Hence, slight changes to the current rules regarding the regulatory review and approval of mergers/acquisitions could play a large part in restricting further concentration. There could be modest changes made to the Herfindahl Hirschman Index (HHI) analysis when reviewing merger/acquisition applications of very large banks to restrict increases in concentrations. 2. Reduce current concentrations. Options could range from severe, such as forced break-ups, to less severe such as requiring largest banks to increase their regulatory capital and/or tangible capital levels. 3. Reduce the advantages of ``Too Big To Fail'' (TBTF). Having the U.S. Government as an implicit backstop for liquidity and capital reserves allowed the largest banks to raise capital at less expensive rates than could smaller, community banks. Large banks were able to use that capital to fund the acquisition of other banks. Removing the U.S. Government as a backstop by implementing explicit take over authority and procedures for TBTF institutions would help eliminate this moral hazard. 4. Improve the outlook for community banks and thrifts. Efforts to make it easier to organize new or de novo banks and thrifts, as well as for smaller institutions to increase capital levels, would help level the playing field between community institutions and large banks.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. OTS has stated publicly that it does not support the elimination of the thrift charter or 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. However, if a new NBS is established to be the Federal chartering and supervisory authority for Federal depository institutions, such new agency should be independent from the Department of Treasury rather than bureau of the Department. Among the Federal banking agencies, the Board of Governors of the Federal Reserve System and the Federal Deposit Insurance Corporation each are independent from Treasury for all purposes. A similar separation for any new banking regulator would assure that the agency would be free from any possible constraints on rulemaking, enforcement, or litigation matters. An example of recently established agency that is independent of the Department of Treasury or any other Department is the Federal Housing Finance Agency, which was created by the Housing and Economic Recovery Act in July 2008. To the extent that it is determined that the new NBS should be part of the Department of Treasury, if it is granted explicit independence in a number of areas, it would be insulated from political influence to the same degree that the OTS currently is. Examples of the type of activities of the new supervisor that must remain independent include the ability of the agency to testify and to make legislative recommendations. Another important area of independence is the agency's authority to litigate. The current OTS authority provides that Secretary of Treasury may not intervene in any matter or proceeding before OTS, including enforcement matters, and not prevent the issuance of any rule or regulation by the agency. Any new agency should have the same authority that OTS currently does. The operations of the NBS should be funded by assessments and not through the appropriations process.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 we need a separate consumer protection agency?A.3. The OTS examines institutions to ensure that they are operating in a safe and sound manner. OTS does not believe that Federal regulators should dictate the types of products that lenders must offer. Although we believe strongly that Government regulators should prohibit products or practices that are unfair to consumers, the Government should not be overly prescriptive in defining lenders' business plans or mandating that certain products be offered to consumers. Defining standards for financial products would put a Government seal of approval on certain favored products and would effectively steer lenders toward products. It could have the unintended consequence of fewer choices for consumers by stifling innovation and inhibiting the creation of products that could benefit consumers and financial institutions. We are concerned about the consumer protection agency defining standards for financial products and services that would require institutions to offer certain products (e.g., 30-year fixed rate mortgages). The imposition of such a requirement could result in safety and soundness concerns and stifle credit availability and innovation. The OTS supports consolidating rulemaking authority over all consumer protection regulation in one Federal regulator such as the proposed consumer protection agency. This regulator should be responsible for promulgating all consumer protection regulations that would apply uniformly to all entities that offer financial products, whether an insured depository institution, State-licensed mortgage broker or mortgage company. Any new framework should be to ensure that similar bank or bank-like products, services, and activities are treated in the same way in a regulation, 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. To balance the safety and soundness requirements of depository institutions with these important functions of the consumer protection agency, the OTS recommends retaining primary consumer-protection-related examination and supervision authority for insured depository institutions with the FBAs and the NCUA. The OTS believes that the CFPA should have primary examination and enforcement power over entities engaged in consumer lending that are not under the jurisdiction of the FBAs. Safety and soundness and consumer protection examination and enforcement powers should not be separated for insured depository institutions because safety-and-soundness examinations complement and strengthen consumer protection. By separating safety-and-soundness functions from consumer protection, the CFPA and an FBA could each have gaps in their information concerning an institution.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. Beginning with the enactment of the Home Owners Loan Act. Congress has several times acted to reinforce a national housing policy. Over the years, Congress has taken steps to ensure that a specialized housing lender is retained among the charter options available tor insured institutions. The causes of any banking crisis are difficult to identify because of the interconnected nature of financial services. The crisis that we currently are working through is different in several important ways from the banking crisis of the 1980s and early 1990s. In the early months of the current crisis, there appeared to be similarities in its origins to the crisis of the 1980s and appeared to have been caused by mortgage lending. Even if the early obvious causes of the current crisis are found in the mortgage market, the industry has evolved and changed since the earlier crisis. The elimination of a dedicated mortgage lending charter would not have eliminated the current crisis. In the 1980s, the thrift industry was more limited in the activities in which it could engage and in the loan products institutions could offer to consumers. In a period of rapidly rising interest rates, many thrift institutions held long term fixed rate mortgages on their books while at the same time paying high rates on deposits to meet competition. The mortgage banking industry was not mature and the use of the secondary mortgage market was not widespread, therefore the long term fixed rate assets originated by thrifts created an interest rate mismatch on the books of the institutions. As a result of the earlier crisis, the OTS developed a proprietary interest rate risk model and expertise in supervision of institutions likely to have interest rate risk concerns. Throughout varied interest rate environments, the industry has not experienced the problems of the 1980s. However, interest rate risk was not a primary cause of the current crisis and the mortgage related causes of the current crisis are already the subject of revised guidance at the OTS and the other Federal banking agencies. Unlike the problems of the 1980s, there are a number of causes of the mortgage related problems that surfaced in the current crisis. First, during the recent housing boom, credit was extended to too many borrowers who lacked the ability to repay their loans when interest rates rose on the adjustable rate loans. For home mortgages, some consumers received loans based on their ability to pay introductory teaser rates, an unfounded expectation that home prices would continue to rise, inflated income figures, or other underwriting practices that were not as prudent as they should have been. In addition, mortgage related problems are in part the result of inadequate supervision of State entities that had no Federal oversight. Another factor was the growth of the secondary market and the ability of lenders of any charter type or organizational form to fund lending activities with sales of originated loans. Whether it was the entities that originated the loans or the numerous entities that packaged the loans and sold them as part of securities, the entities involved were not always supervised by Federal banking regulators and that lack of supervision is a more direct contributor to the crisis than the existence of a charter that focuses on mortgage lending. There are many lessons learned from the current crisis, but one of them is not that Congress should eliminate the thrift charter or a charter that focuses on housing finance. Homeownership continues to be an important policy objective for Congress. Consumers deserve to have the option of obtaining a loan from a dedicated home and consumer lender that is able to offer products that meet that consumer's needs.Q.5. Should banking regulators continue to be funded by fees on the regulated firms, or is there a better way?A.5. As a general matter, we believe that bank regulatory agencies (agencies) be funded by the institutions that they regulate. The alternative, funding the agencies with tax payer dollars through the appropriations process, is inherently problematic. Funding the agencies in this manner creates a taxpayer subsidy for the institutions. Moreover, subjecting the agencies to the appropriations process will make the agencies more vulnerable to political influence. Now more than ever it is critical that the agencies be independent and free of political influence. However, funding the agencies through appropriations will do just the opposite. The Office of Federal Housing Enterprise Oversight (OFHEO) was subject to the appropriations process and as such was very vulnerable to political influence. For example, in 2004 OFHEO investigated accounting improprieties at Fannie Mae and that entity used the appropriations process to hinder the agency, portraying it as over its head on complex financial matters. This resulted in the Senate Appropriations Committee voting to hold back $10 million of a proposed funding increase until OFHEO got a new director. (S. Rep. No. 108-353, at 71.) It is critical that the agencies have the resources necessary to effectively regulate institutions. As was the case with OFHEO, Congress can withhold or threaten to withhold such funds. Even in the absence of such actions, Continuing Resolutions (CR) and other appropriations law requirements may hinder the agencies in achieving their mission. Beginning in October of every year and until a yearly appropriations bill is passed, agencies under the appropriations process are typically under a hiring freeze and are severely restricted in their expenditures under a CR. On January 21, 2004, Annando Falcon, then Director of OFHEO testified that Congress' protracted FY04 appropriations process placed ``severe constraints'' on OFHEO's capacity to implement reforms at Freddie Mac and carry out other oversight responsibilities. Director Falcon told the House Financial Services Capital Markets Subcommittee that ``[t]he short-term continuing resolutions we are operating under prevent us from hiring the additional examiners, accountants and analysts we need to strengthen our oversight. In addition, we are unable to hire the help we need to conduct our review of Fannie Mae. If the long term [continuing resolution] is enacted which freezes our budget at 2003 levels, we will need to scale back oversight at a time when greater oversight has never been more urgent.'' (Special Examination of Freddie Mac: Hearing Before the Subcommittee on Capital Markets, Insurance and Government Sponsored Enterprises of the H. Comm. on Financial Services, 108th Cong. 8-9 (January 21, 2004) (statement of Armando Falcon, Director of Office of Federal Housing Enterprise Oversight.)) Some believe that a banking agency may supervise an institution less vigorously if it fears that the institution will switch charters and the agency will lose a funding source. However, there is no evidence that this is the case and we strongly disagree with this suggestion.Q.6. Why should we have a different regulator for holding companies than for the banks themselves?A.6. Since the establishment of the savings and loan holding company, the OTS and its predecessor have regulated savings associations and their holding companies. Regulators have greater oversight into an institution and the holding company if they have the same supervisor. OTS disagrees that the institution and the holding company should have a different regulator. An exception to this general statement is if the holding company is so large or interconnected with other financial services companies that a systemic regulator also will provide oversight. OTS has long had authority to charter and regulate thrift institutions and the companies that own or control them. The agency has a comprehensive program for assessing and rating the overall enterprise as well as the adequacy of capital, the effectiveness of the organizational structure, the effectiveness of the risk management framework for the firm and the strength and sustainability of earnings. OTS performs capital adequacy assessments on an individualized basis for the firms under our purview with requirements as necessary, depending on the company's risk profile, its unique circumstances and its financial condition. The net effect of this approach has been a strong capital cushion for the holding companies OTS supervises and the ability for the firms under our purview to support the insured depositories within their corporate structures. It is because the agency supervises the institution and the holding company that the impact of the holding company activities on the institution can be assessed on a regular basis.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. As explained more fully in the answer above, thrifts and thrift holding companies should continue to have the same supervisor. The regulatory framework that has been developed for the institution and its holding company provides a seamless supervisory process for savings associations and their holding companies. The benefits of having the same regulator for the institution and the holding company include the supervisor's ability to view the institution and the holding company as a whole and judgments based on all of the information.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 Administration has proposed the creation of the Financial Services Oversight Council (Council) to be chaired by the Secretary of the Treasury and to include the heads of the Federal banking agencies and other agencies involved in the regulation of financial services. The Council will make recommendations to the Board of Governors of the Federal Reserve System (FRB) concerning entities that should be designated as systemically significant (Tier 1 FHCs). The FRB will consult the Council in setting material prudential standards for Tier 1 FHCs and in setting risk management standards for systemically important payment, clearing, and settlement systems and activities. The Council will also facilitate information sharing, provide a forum for discussion of cross-cutting issues and prepare an annual report to Congress on market developments and emerging risks. Under the Administration's proposal, the Council would not be authorized to promulgate rules.Q.9. Mr. Bowman, in your statement you defend your agency's regulation of thrifts and thrift holding companies, however you never mention AIG. How do you defend your agency's performance with that company?A.9. Commencing in 2005, OTS actions demonstrated a progressive level of supervisory criticism of AIG's corporate governance culminating in a communication to the company in 2008 which discussed the supervisory rating downgrade and a requirement to provide OTS with a remediation plan to address the risk management failures. OTS criticisms addressed AIG's risk management, corporate oversight, and financial reporting. It is critically important to note that AIG's crisis was caused by liquidity problems, not capital inadequacy. AIG's liquidity was impaired as a result of two of AIG's business lines: (1) AIGFP's ``super senior'' credit default swaps (CDS) associated with collateralized debt obligations (CDO), backed primarily by U.S. subprime mortgage securities and (2) AIG's securities lending commitments. While much of AIG's liquidity problems were the result of the collateral call requirements on the CDS transactions, the cash requirements of the company's securities lending program also were a significant factor. AIG's securities lending activities began prior to 2000. Its securities lending portfolio is owned pro rata by its participating, regulated insurance companies. At its highest point, the portfolio's $90 billion in assets comprised approximately 9 percent of the group's total assets. AIG Securities Lending Corp, a registered broker-dealer in the U.S., managed a much larger, domestic securities lending program as agent for the insurance companies in accordance with investment agreements approved by the insurance companies and their functional regulators. The securities lending program was designed to provide the opportunity to earn an incremental yield on the securities housed in the investment portfolios of AIG's insurance entities. These entities loaned their securities to various third parties, in return for cash collateral, most of which AIG was obligated to repay or roll over every 2 weeks, on average. While a typical securities lending program reinvests its cash in short duration investments, such as treasuries and commercial paper, AIG's insurance entities invested much of their cash collateral in AAA-rated residential mortgage-backed securities with longer durations. Similar to the declines in market value of AIGFP's credit default swaps, AIG's residential mortgage investments declined sharply with the turmoil in the housing and mortgage markets. Eventually, this created a tremendous shortfall in the program's assets relative to its liabilities. Requirements by the securities lending program's counterparties to meet margin requirements and return the cash AIG had received as collateral then placed tremendous stress on AIG's liquidity.Q.10. I asked Chairman Bair this question a few weeks ago, so this is for the rest of you. All of the largest financial institutions have international ties, and money can flow across borders easily. AIG is probably the best known example of how problems can cross borders. How do we deal with the risks created in our country by actions somewhere else, as well as the impact of actions in the U.S. on foreign firms?A.10. OTS exercises its supervisory responsibilities with respect to complex holding companies by communicating with other functional regulators and supervisors who share jurisdiction over portions of these entities and through our own set of specialized procedures. With respect to communication, OTS is committed to the framework of functional supervision Congress established in Gramm-Leach-Bliley. Under Gramm-Leach-Bliley, the consolidated supervisors are required to consult on an ongoing basis with other functional regulators to ensure those findings and competencies are appropriately integrated into the assessment of the consolidated enterprise and, by extension, the insured depository institution. As a consolidated supervisor, OTS relies on effective communication and strong cooperative relationships with the relevant primary supervisors and functional regulators. Exchanging information is one of the primary regulatory tools to analyze a holding company and to ensure that global activities are supervised on a consolidated basis. Approximately 85 percent of AIG, as measured by allocated capital, is contained within entities regulated or licensed by other supervisors. AIG had a multitude of regulators in over 100 countries involved in supervising pieces of the AIG corporate family. OTS established relationships with these regulators, executed information sharing agreements where appropriate, and obtained these regulators' assessments and concerns for the segment of the organization regulated. As part of our supervisory program for AIG, OTS began in 2005 to convene annual supervisory college meetings. Key foreign supervisory agencies, as well as U.S. State insurance regulators, participated in these conferences. Part of the meetings was devoted to presentations from the company. In this portion, supervisors had an opportunity to question the company about any supervisory or risk issues. Another part of the meeting included a ``supervisors-only'' session, which provides a venue for participants to ask questions of each other and to discuss issues of common concern regarding AIG. OTS also used the occasion of the college meetings to arrange one-on-one side meetings with foreign regulators to discuss in more depth significant risk in their home jurisdictions. This notion of consolidated supervision in a cross-border context is a widely accepted global standard implemented by most prudential supervisors. The key concepts of cross-border consolidated supervision have been supported by the Basel Committee on Banking and reflected in numerous publications. This framework has been embraced by the International Monetary Fund and World Bank and utilized in connection with their Financial Sector Assessment Program (FSAP) which is an assessment of countries' financial supervisory regimes. 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-111hhrg54873--34 Mr. Sharma," Chairman Kanjorski, Ranking Member Garrett, and members of the subcommittee, good afternoon. My name is Deven Sharma. I am the president of Standard & Poor's, and I am pleased to appear before you today. Let me start by saying that at S&P, we appreciate your goal to reinvigorate the economy and job growth through stability and innovation. This is an important point in history as a regulatory reform is being considered that will shape the future of capital markets and economic growth for many years to come. Since our founding more than a century ago, we have tried to learn from experience to improve and strengthen our analytics and criteria and to review processes when appropriate. Thus in 2008, we announced a series of initiatives aimed at improving checks and balances in our organization. These measures are designed to promote the integrity of the rating process and enhance analytical quality, provide greater transparency to investors, and more effectively educate investors about ratings. Let me assure you that these improvements are substantive and will go a long way to restoring confidence in our ratings. Another way to restore confidence in ratings is to pursue effective regulation of credit rating agencies. Although we are already subject to a broad and robust regulatory scheme, S&P shares the view that further regulation appropriately crafted can serve the goal of restoring and maintaining investor confidence. Indeed, we support many recent proposals for greater regulatory oversight and enhanced internal processes to promote integrity in the ratings process. These include increased accountability through SEC authority to oversee NRSRO and impose steep fines and other sanctions for noncompliance with SEC rules or NRSRO rules, internal procedures and to require disclosure around issues such as data quality. There are other proposed measures that would seriously disrupt the capital markets by encouraging less diversity of opinions, providing strong disincentives for analytical innovation and creating global inconsistency. One such proposal would seek to lower the threshold, legal requirements for bringing a securities fraud claim against NRSROs. Such a measure, if enacted, would cause some NRSROs to rate only those entities and securities that are the least likely to default or be downgraded. As a result, issuers who are relatively new to the debt markets may have a difficult time getting rated and therefore greater difficulty accessing capital and contributing to economic recovery. Since small and medium enterprises as well as new technology companies, for example, green companies or broadband providers, represent critical and emerging elements in our national production and employment basis, this result could have detrimental effects on economic growth. Another proposal would subject each NRSRO to collective liability for legal judgments against any NRSRO. No NRSRO should be required to act as an insurer for its competitors. We are also concerned about a proposal providing that rating opinions shall not be deemed forward looking statements under the Federal securities laws. This proposal ignores that the very essence of a rating is forward looking; that is, ratings speak to the likelihood that an obligor will pay back principal and interest in the future. At S&P, we have heard consistently from investors that ratings must be forward looking in order to have value. Another proposal would dictate that ratings could only measure likelihood of default. At S&P, our analysis includes additional important factors such as credit stability, which addresses whether an issuer or security would have a likelihood of experiencing large declines in credit quality in certain stressful situations. These are analytical considerations that investors have told us repeatedly that they want. Any government mandate that would dictate how NRSROs form their rating opinions and which factors they may or may not consider would deprive investors of the full breadth and diversity of NRSROs' opinions. It could also lead to undue investor reliance on rating opinions based on the perception that the government has endorsed NRSROs' methodologies and their written opinions, a result counter to the goal of recent proposals that would remove the NRSRO designation from existing laws and rules. In sum, we agree completely with the goal of improving the integrity, quality, and transparency of credit rating analysis to better inform investors in their decisionmaking. However, we urge caution in the crafting of proposals that will result in less comprehensive and informative ratings to the detriment of investors, business enterprises large and small and the capital markets as a whole. I thank you for the opportunity to participate in this hearing and would be happy to answer any questions you may have. [The prepared statement of Mr. Sharma can be found on page 129 of the appendix.] " CHRG-111hhrg53238--47 AFFAIRS, NATIONAL ASSOCIATION OF MORTGAGE BROKERS Ms. Leonard. Good morning, Chairman Frank, distinguished members of the committee. I am Denise Leonard, vice president of government affairs for the National Association of Mortgage Brokers. In addition to being vice president, I am also a mortgage broker in Massachusetts and have been for the past 19-plus years. I would like to thank you for the opportunity to testify before you here today. We applaud this committee's response to the current problems in our financial markets and we share a resolute commitment to a simpler, clearer, more uniform and valid approach relative to financial products, most specifically with regard to obtaining mortgages and to protecting consumers throughout the process. As such, NAMB is generally supportive of the tenet behind the plan and conceptually agrees with the establishment of an independent agency that focuses on consumer financial products protection, but believes some changes are necessary. Before I address some specific areas of concern, I must first extinguish the false allegations targeted at mortgage brokers for years. We do not put consumers into loan products. We provide mortgage options to consumers and work with them throughout the process. We don't create loan products. We don't assess the risk on those products or approve the borrower. We don't fund the loan, and we are regulated. Our testimony will focus on the Consumer Financial Protection Agency and how it affects us, as well as H.R. 3126. In order for the CFPA to be effective, the structure must adequately protect consumers and account for the complexity of the modern mortgage market, and it must be in disparate treatment of any market participants. Any agency, whether new or existing, must act prudently when promulgating and enforcing rules to ensure real protections are afforded to consumers, and not provide merely the illusion of protection that comes from incomplete or unequal regulation of similar products, services, or providers. To the extent that the CFPA will enhance uniformity in the application of those rules, regulations, disclosures, and laws that provide for consumer protection, NAMB supports such an objective, although we do believe that there should be added limitations on the CFPA's powers. Whereas the purpose of the agency is to promote transparency, simplicity, fairness, accountability, and access in the market for consumer financial products and to ensure the markets operate fairly and efficiently, it is imperative that the creation of new disclosures or the revision of antiquated disclosures be achieved through an effective and even-handed approach and consumer testing. It is not the ``who'' but the ``what'' that must be addressed in order to ensure true consumer protection and success with this type of initiative. To ensure that all consumers are protected under the CFPA, there should be no exemption from its regulatory purview or limited exemptions that pick winners and losers in the industry. We are very supportive of H.R. 3126's requirement that the CFPA propose a single integrated model disclosure for mortgage transactions that combine those currently under TILA and RESPA. Consumers would greatly benefit from a uniform disclosure that clearly and simply explains critical loan terms and costs. Therefore, NAMB strongly encourages this committee to consider imposing a moratorium on the implementation of any new regulations or disclosures issued by HUD and the Federal Reserve Board for at least a year after the designated transfer date. This would help to avoid consumer confusion and minimize the increased costs and unnecessary burden borne by industry participants to manage and administer multiple significant changes to mandatory disclosures over a very short period of time. We strongly support empowering the CFPA to take a comprehensive review of new and existing regulations, including the new Home Valuation Code of Conduct. Too often, in the wake of our current financial crisis, we have seen new rules promulgated through the use of existing regulations that run afoul of the purpose and objectives of the Administration that do not reflect measured, balanced, and effective solutions to the problems facing our markets and consumers. The HVCC provides the most notable recent example of that flawed method and, as such, should be revealed during the CFPA's review of existing rules. We also believe that the SAFE Act should be amended to ensure that the CFPA possesses complete and exclusive authority to implement it in its entirety. In addition, we support a Federal standard of care based on good faith and fair dealing for all originators as defined under the SAFE Act. We believe such a standard would greatly enhance consumer protections. Finally, with regard to the board makeup as it is proposed, the committee would be anything but independent, and we recommend that its makeup be expanded and consistent with other agencies such as the FTC with regard to political affiliation. There should be no more than three members of the same party as the President who appoints them. We appreciate this opportunity to appear before you, and we look forward to continuing to work with you, and I am available for any questions. [The prepared statement of Ms. Leonard can be found on page 145 of the appendix.] " CHRG-111shrg51395--100 Mr. Silvers," Senator, these are very acute observations you have made about this set of questions. First, I am pleased to see that a moment of disagreement has emerged. My colleagues on the panel who wish to put the burden of regulating unregulated markets, like hedge funds and derivatives, on the systemic risk regulator are, in my opinion, making a grave mistake. What we need is routine regulation in those areas. That is what closing the Swiss cheese system is about, is routine regulation, not emergency regulation, not, you know, looking at will they kick off a systemic crisis. Just an observation about that. I think that the Fed's refusal to regulate mortgages was rooted somehow in the sense that consumer protection was a kind of--something that was not really a serious subject for serious people. It turned out to be, of course, the thread that unraveled the system. I think that we should learn something from that. When we talk about routine regulation in these areas, I think to your question, we have got to understand that it is more than one thing. For example, a credit default swap contract is effectively a kind of insurance. And if someone is writing that insurance, they should probably have some capital behind the promise they are making. That is what we learned not just in the New Deal but long before it about insurance itself, which was once an exotic innovation. But we learned we had to have capital behind it. But that is not the extent of what we need to do. If, for example, there are transparency issues, there are disclosure issues associated with these kinds of contracts, for contracts in which public securities are the underlying asset, it is clear that we need to have those kinds of disclosures, because if we do not, then we have essentially taken away the transparency from our securities markets. Now--two final points. One, derivatives and hedge funds have something profound in common. They do not have any substantive content as terms. They are legal vehicles for undertaking anything imaginable. You can write a derivative contract against anything. You can write it against the weather, against credit risk, against currency risk, against securities, against equity, against debt. It is just a legal vehicle for doing things in an unregulated fashion. A hedge fund is the same thing. The hedge fund is not an investment strategy. It is just a legal vehicle, and it is a legal vehicle for managing money any way you can imagine, in a way that essentially evades the limits that have historically been placed on bank trusts and mutual funds and so on and so forth. What is smart regulation here is not specific to those terms. It is specific to those activities. It is specific to money management. It is specific to insurance. It is specific to securities. And that is why it is so important that when we talk about filling these regulatory gaps, we do so in a manner that is routine, not extraordinary. Thank you. " CHRG-111hhrg51698--506 Mr. Concannon," I will try to answer that. Well, obviously, we stated that we support the provision mandating clearing. I think it is critical that the CFTC, who does have the expertise to create exemptions, does in fact create exemptions. We don't believe all things OTC can be centrally cleared. Obviously, there are numerous complexities and unique products that will never be able to be cleared centrally. I think there are a number of ways, similar to the one you referenced, that will entice end-users to use a cleared product. But when they need the unique nature of the OTC product, they will pay the cost of using the OTC product. So, whether it is the capital charges that currently exist and increasing capital charges for carrying an OTC position, whether it is tax treatment and tax benefits to the extent you move to a cleared versus an OTC treatment. There are numerous ways outside of mandating that can strongly encourage central clearing. " CHRG-111hhrg51698--12 Mr. Damgard," Thank you very much, Mr. Chairman. Chairman Peterson, Ranking Member Lucas, and Members of the Committee, I am John Damgard, President of the Futures Industry Association; and, as the principal spokesman for the U.S. futures industry, FIA is pleased to be able to testify on the Derivatives Markets Transparency and Accountability Act of 2009. But before addressing the far-reaching legislation, I want to step back and try to put it in some context. In recent months, our economy has faced unprecedented financial turbulence, leading to bankruptcies and bailouts. During that time, U.S. futures markets have performed flawlessly. Fair and reliable prices have been discovered transparently, hedgers have managed price risks in liquid markets, all trades have been cleared, customers have been paid. Not a blip. This record of excellence is the best evidence possible that the regulatory system established by this Committee works superbly well. It is also the best evidence that the Commodity Futures Trading Commission has done its job, and done it well. The Committee should take pride in both the regulatory structures you put in place and the agency that you created years ago. Other agencies should learn from the CFTC. But, in any event, a simple merger is not the answer; and, in that regard, I agree with both the Chairman and the Ranking Member. The legislation before you would build on existing regulatory structure to enhance the CFTC's current powers. We support additional special call and other transparency provisions to allow the CFTC to strengthen its market surveillance capabilities, we support additional resources for the CFTC, we support coordinated oversight of linked competitive markets, and we support looking at further ways to adapt CFTC regulation to the ever-increasing pace of market innovation. But, despite our support in those areas, FIA cannot support the bill as a whole. Our major objections rest in three areas: number one, the hedge exemption; number two, mandatory clearing of all OTC instruments; and number three, the ban on naked credit default swaps. The bill's narrow hedging definition erases decades of progress to expand the use of regulated futures markets by businesses that use futures in an economically appropriate way to manage their price risks. Those companies are not anticipating higher or lower prices. They are managing a risk of higher or lower prices that they already face. In fact, if the companies do not manage that risk, they would be speculating. But if this bill becomes law and constraining positions are imposed, then automakers could not hedge gasoline prices, agribusiness could not hedge currency prices, airlines could not hedge interest rates, and utilities could not hedge weather risk. This would be bad economic policy at a time when we need stability, not uncertainty. Mandating clearing of all OTC derivatives would lead to market uncertainty or worse. You might think that I would support clearing everything, because my regular members are the clearing members whose businesses would increase if everything were cleared. But we don't support mandatory clearing for all OTC derivatives. Some derivatives are too customized and their pricing too opaque to be cleared safely and efficiently. Making it illegal not to clear an OTC derivative would, therefore, be a recipe for economic instability and litigation. FIA believes clearing should be encouraged through capital treatment or other regulatory measures. FIA also believes that if the Committee insists on a clearing mandate, it should be coupled with a flexible CFTC power to exempt classes of instruments from that mandate. Unfortunately, the draft bill's exemptive powers are so limited we fear the CFTC would only be able to exempt a sliver of the current OTC market, leaving the rest facing intolerable legal uncertainty or the ability to do this business somewhere outside the United States. Last, we oppose the ban on naked credit default swaps. The ban would remove important liquidity from our credit markets at just the wrong time for many struggling businesses. FIA would prefer to see Congress encourage clearing of CDS instruments and provide more effective, systemic risk protections through oversight of the institutions that enter into these transactions. Mr. Chairman, FIA thanks you very much for the opportunity to testify this afternoon, and I look forward to answering any questions. [The prepared statement of Mr. Damgard follows:] Prepared Statement of John M. Damgard, President, Futures Industry Association, Washington, D.C. Chairman Peterson, Ranking Member Lucas and Members of the House Agriculture Committee, I am John Damgard, President of the Futures Industry Association. The FIA is pleased to be able to testify on the discussion draft of the Derivatives Markets Transparency and Accountability Act of 2009.Introduction FIA understands well the interest of Chairman Peterson and others in crafting this draft bill. Financial derivatives are now an integral part of our national economy and have been used by many businesses to reduce the multi-faceted price risks they face. Some of these derivatives and related market structures have evolved since Congress considered major changes to the Commodity Exchange Act in 2000. Some have even become more prominent since Congress adopted important changes to the Act as part of the 2008 Farm Bill. Given this Committee's experience and history with derivatives regulation, FIA welcomes discussion with the Committee on whether we need to bolster existing regulatory systems at this time. The draft bill is far-reaching. It would make substantial revisions to the Commodity Exchange Act that would affect trading on exchange markets as well as over-the-counter transactions. While FIA is the trade association for the futures industry,\1\ and its traditional focus has been on exchange markets, we try to take a holistic view of futures and other derivatives markets in order to advise the Committee on what our members believe would be the best public policy for our country and our industry.--------------------------------------------------------------------------- \1\ FIA is a principal spokesman for the commodity futures and options industry. Our regular membership is comprised of 30 of the largest futures commission merchants in the United States. Among our associate members are representatives from virtually all other segments of the futures industry, both national and international. Reflecting the scope and diversity of its membership, FIA estimates that its members serve as brokers for more than ninety percent of all customer transactions executed on United States contract markets.---------------------------------------------------------------------------Draft Bill FIA has analyzed the draft bill through the prism of the congressional findings that form the foundation of the Commodity Exchange Act. Congress has found that the Act serves the public interest by promoting the use of liquid and fair trading markets to assume and manage price risks in all facets of our economy, while discovering prices that may be disseminated widely. CFTC regulation fosters those interests through four core objectives: preventing price manipulation, avoiding systemic risk and counterparty defaults through clearing, protecting customers, and encouraging competition and innovation. FIA supports these Congressional findings and objectives. They are valid today as they were when first enacted. In FIA's view, some of the draft bill's provisions are consistent with these findings and objectives. We support those provisions which would strengthen CFTC market surveillance capabilities and deter price manipulation, by adapting the current regulatory systems to ever evolving market innovations. We also support the pro-competition decisions embodied or implicit in the bill's provisions. But many of the draft bill's provisions would disserve the very public interests and economic policies Congress designed the CEA to serve by draining market liquidity, making hedging more costly, curbing innovation and discouraging trading in the U.S. We can not support those sections of the bill. Attached to this testimony FIA has included a section-by-section review of the draft bill which describes our positions on its specific sections.FIA's Principal Objections To summarize our objections, FIA fears the bill would: (1) increase the cost of hedging and price risk management for U.S. businesses, a bad result at any time, but one that is particularly harmful when those same businesses are struggling to cope with a deepening recession; (2) increase price volatility by removing vital market liquidity through artificial limits or outright prohibitions on participation in regulated exchange trading and OTC transactions; (3) disadvantage U.S. markets and firms by creating inadvertent incentives to trade overseas both exchange-traded and OTC derivatives; and (4) weaken CFTC regulation by saddling the agency with responsibilities that would be resource-intensive to perform with little corresponding public benefit. Our major concerns center on provisions in sections 6, 13 and 16 of the bill. Section 6 would require the CFTC, under a cumbersome and costly advisory committee system, to impose fixed speculative position limits on all commodities traded on regulated exchanges. Today those limits are set by the exchanges for all non-agricultural commodities. No evidence exists that this position limit system has caused any market surveillance difficulties or failed to stop any market manipulation. But the bill not only usurps the exchange's powers to set the limits, it would greatly expand the application of those limits by transforming into speculators many businesses that use futures in an economically appropriate manner to reduce price risks they face. Under the bill, any business becomes a speculator if its futures position is not a substitute for a transaction in the physical marketing channel or does not arise from a change in value in an asset or liability the business owns or service it provides. Under this restrictive test, for example, automobile manufacturers will not be able to hedge gasoline prices. Yet gasoline prices often play a major role in determining what cars consumers will buy and, hopefully, manufacturers will make. No one will be able to use weather derivatives to hedge climate changes of any kind (weather is not in the physical marketing channel). Agribusinesses will be unable to hedge their foreign currency risk and airlines will be unable to hedge their interest rate risk. The list of increased, unmanaged (speculative) price risk to our economy goes on and on. FIA understands that many Members of the Committee are concerned that speculation may have artificially influenced market prices in some commodities in the last year. We are still awaiting any objective fact-finding that would support that conclusion. For now, FIA has seen no evidence to distrust the market surveillance capabilities of the CFTC, especially when armed with the new special call reporting authority as the bill provides. FIA does not believe that restricting the ability of businesses to hedge or manage price risks on regulated exchange markets is an appropriate response in any event. We do not believe it is sound economic policy to force businesses that want to use U.S. futures markets to manage their price risks to trade on overseas markets or enter into OTC derivative positions. FIA urges Chairman Peterson and the Committee to reconsider section 6. Section 13 of the bill mandates clearing of all OTC derivative transactions, unless exempted by the CFTC under strict criteria. As the Committee well knows, all derivatives transactions involve counterparty credit risk. Different methods exist to deal with that risk. One of those methods is the futures-style clearing system. FIA is a strong supporter of clearing systems. Clearing removes each party's risk that its counterparty may default. As I testified before the Committee in December, FIA's regular members--the clearing firms--provide the financial backbone for futures clearing. Our members guarantee the financial performance of every trade in the system. FIA believes the futures clearing system works exceptionally well to remove counterparty risk and to reduce systemic risk. Increasing the number of transactions submitted for clearing also should be good for my members' bottom lines. In that sense, the Committee might expect FIA to support mandatory clearing of all OTC derivatives. But we don't. While a clearing mandate may have some superficial appeal, FIA is concerned that section 13 could promote economic instability in the U.S. Most directly of concern to FIA clearing members, a mandate may force derivatives clearing organizations to clear OTC products that are not sufficiently standardized to be cleared safely. Not every derivative can be cleared. The DCOs will surely try to clear what they can clear, consistent with their risk management systems. But as the experience with CDS clearing shows, developing appropriate clearing systems takes time and an indiscriminate statutory mandate for immediate clearing of OTC products would add financial risk to clearing members as well as the financial system as a whole. In addition, mandatory clearing of credit and other derivatives could lead to uncertainty in credit and other markets at a time when we are struggling to stabilize or restart those vital economic functions. It is true section 13 authorizes the CFTC to exempt classes of OTC derivatives from the clearing mandate. As drafted, however, section 13 would severely constrict the CFTC's ability to exempt OTC transactions. FIA trusts the CFTC's experience and expertise. If clearing is to be mandated at all for any transactions, we believe the CFTC could craft a workable and specific exemption if the statutory exemption criteria are sufficiently flexible. We believe that flexibility will lead to the best national economic policy. Otherwise we fear mandatory clearing of OTC derivatives could trigger a rush to overseas OTC markets that would be counter-productive to our national economic interests. FIA strongly supports one policy decision that is implicit in section 13. We know that some would mandate exchange trading of all derivatives in the U.S. FIA opposes that anti-competitive, anti-innovation approach and is pleased the draft bill does not go down that road. Consistent with section 13, FIA believes in an open, competitive system whereby classes of derivatives are first executed on exchange or dealer trading platforms as well as bilaterally and then submitted for clearing. Exchange and dealer competition for executing derivatives trades will serve well the interests of all market participants. FIA supports that approach. Unlike section 13, the provisions of section 16 are anti-competitive and anti-innovation. It appears to ban so-called naked credit default swaps in OTC dealer markets (where all CDS transactions now occur), while allowing them on exchange markets (where today none occurs). In addition to the unfair competition feature of section 16, it would remove important liquidity from our credit markets and could operate to make credit itself more expensive for those in struggling businesses that now thirst for credit. History teaches that removing liquidity provided by speculators leads to increased price volatility and costs for hedgers. Without speculators, hedgers may be forced to pay higher prices, rather than prices discovered by competitive market forces. The ban also would invite parties to the CDS market to conduct this business overseas, outside the jurisdictional reach of the U.S. financial regulatory system. That transactional exodus would complicate the job of Federal financial regulators, making it harder, if not impossible, to monitor systemic risk. FIA understands Chairman Peterson's concern that trading in credit derivative swaps could add substantial counterparty credit risks to our economy. But developing and implementing appropriate clearing systems for these instruments should address that concern. In fact, section 13 of the bill is based on that premise. FIA believes the Committee should focus on improving the clearing provisions of section 13 of the bill, rather than banning liquidity providers from the CDS market or favoring exchanges over OTC dealers.CFTC Regulation FIA understands that Congress soon may receive proposals on financial market regulatory restructuring. In that regard, one aspect of the recent financial market turmoil must be highlighted. Despite unprecedented financial turbulence that has led to bankruptcies and bailouts, the U.S. futures markets have performed flawlessly. Fair and reliable prices have been discovered transparently. Hedgers have managed price risks in liquid markets. All trades have been cleared. Customers have been paid. Not a blip. This record of excellence in an unprecedented crisis is the best evidence possible that the regulatory system this Committee has authored for decades works superbly well. It is also the best evidence that the Commodity Futures Trading Commission has done its job and done it well. This Committee should take pride in the record of the regulatory structures you put in place and the agency you created decades ago. Any efforts to rationalize Federal financial regulation should learn from the CFTC's example and make certain to preserve the best features of the futures regulatory system. One feature of the current regulatory system that must be preserved is the exclusive jurisdiction of the CFTC over all facets of futures trading and related activities. Congress long ago determined that other Federal or state regulation should not duplicate or conflict with the CFTC's regulation of the futures markets. We know this Committee has been vigilant in protecting this important public policy which has allowed CFTC-regulated futures markets to prosper for many years. The decision by this Committee to establish an experienced and specialized agency to oversee U.S. futures markets also has worked well for decades. Yet, there is always talk that simply merging the CFTC into the SEC will cure all regulatory ills. FIA knows this Committee appreciates that such a merger would not promote the public interests served by the Commodity Exchange Act and would not resolve the public policy issues that have arisen out of the latest credit market stress. We thank the Committee for its leadership in this area.Conclusion FIA thanks Chairman Peterson and the Committee for this opportunity to share our views. We would be pleased to assist your deliberations in any way we can and to answer any questions you may have. AttachmentAnalysis of Derivatives Markets Transparency and Accountability Act of 2009Section 3--Speculative Limits and Transparency of Off-Shore Trading Section 3 has three subsections. FIA opposes the first subsection and supports the other two subsections which parallel provisions in H.R. 6604 passed by the House last year. FIA supports coordinated market surveillance for linked products offered by competing U.S. and foreign exchanges. Last session, Rep. Moran offered legislation that would have addressed these issues in a comprehensive and reciprocal manner. FIA supports that approach. section 3(a), however, could spark retaliation by foreign regulators against U.S. firms and exchanges. The Moran approach is less likely to trigger that response and has broader application. FIA supports subsections 3(b) and 3(c) which afford a safe harbor and legal certainty to CFTC-registered firms that execute or clear trades for customers on foreign exchanges even if those exchanges themselves do not comply with each and every CFTC requirement. U.S. firms should not be liable for any non-compliance by foreign exchanges. Last session, H.R. 6604 contained these provisions in a form that achieved the stated objectives. In the draft bill, important language has been inadvertently dropped from subsection 3(b). FIA would support the provision if the language from H.R. 6604 is restored.Section 4--Detailed Reporting and Disaggregation of Market Data Section 4 would add a new 4(g) of the Commodity Exchange Act. FIA has no objection to having the CFTC define index traders and swap dealers. FIA also does not oppose monthly public reporting by the CFTC of the aggregate open positions held by index traders as a group and by swap dealers as a group using the data reported under the CFTC's large trader reporting system. FIA believes the CFTC also should consider other ways to make their Commitment of Trader Reports more granular and meaningful to all market participants. FIA opposes requiring index traders and swap dealers to file ``routine detailed'' reports with the CFTC. (7:18) No other large traders--speculators or commercials--are subject to such a requirement. It should be sufficient to treat index traders and swap dealers that qualify as large traders like all other large traders for reporting purposes. FIA would also recommend the deletion of the language ``in all markets to the extent such information is available.'' (8:11-12) The aggregate information included in the COT reports should be for futures and options positions only. Otherwise market participants that refer to the COT reports will receive a distorted view of the open interest and volume composition in futures and options markets.Section 5--Transparency and Recordkeeping Authorities Section 5 has three subsections. Subsection 5(a) would require a CFTC-registered futures commission merchant, introducing broker, floor trader or floor broker to make reports and keep records as required by the CFTC for ``transactions and positions traded'' by those registered professionals or their customers in, generally, OTC derivatives transactions that are exempted from the CEA and CFTC rules. FIA does not object to giving the CFTC this authority but questions whether it is at least partially duplicative of the special call provisions provided in the second part of the section. Subsection 5(b) has two parts. First, Subsection 5(b) would require any large trader of futures contracts in a commodity to maintain books and records of transactions and positions in that commodity which are otherwise generally exempt and excluded from the CEA. FIA does not object to this provision. Second, Subsection 5(b) would codify the CFTC's power to issue special calls for books and records relating to otherwise excluded or exempt transactions under the CEA when the CFTC determines it would be appropriate for market integrity purposes. FIA supports giving the CFTC this standby authority to enhance its market surveillance capabilities as circumstances require. Subsection 5(b) also requires large traders to retain the required books and record for 5 years. These required books and records shall include the ``complete details'' of all ``such transactions, positions, inventories, and commitments, including the names and addresses of all persons having an interest therein.'' (10:8-12) FIA questions whether these statutory requirements are necessary or whether it would be preferable to grant the CFTC general authority to adopt appropriate record-keeping rules for large traders that engage in otherwise exempt or excluded transactions. Subsection 5(c) contains conforming amendments to codify that the amendments in Subsections 5(a) and 5(b) create explicit exceptions to the statutory exclusions and exemptions in the CEA. FIA supports this legal certainty.Section 6--Trading Limits to Prevent Excessive Speculation. FIA opposes section 6. FIA sees no reason to repeal the exchanges' current authority to set position limits for their markets. (Today the CFTC sets position limits only for agricultural commodities.) The CFTC retains the power to review and amend any position limit set by an exchange if those limits are set in a manner that invites price manipulation or other market integrity concerns. Any member of the public is free to submit to the CFTC at any time a recommendation for changes to an exchange set position limit or accountability level. A formal advisory committee process is costly and unwarranted. The major deficiency in section 6 is its restrictive hedging definition. If a business establishes a futures position ``which is economically appropriate to the reduction of risks in the conduct and management of the commercial enterprise,'' that business is not a speculator. Instead, the business is managing an economic risk it faces in its business. Section 6 would misclassify that business as a speculator unless it also meets the ``substitute transaction'' and ``change of held assets/liabilities'' tests to become a physical hedger. These restrictions are bad economic policy and would impose unwarranted restrictions on businesses that want to use futures markets to hedge. Section 6 also would consider a swaps dealer to be a speculator if its futures positions are established to reduce the dealer's price risk on its net swaps position simply because some of its swaps counterparties are not physical hedgers. The swaps dealer is managing its price risk prudently and doing so in a transparent market through transactions without counterparty credit risk. That swaps dealer should be subject to all the market surveillance oversight faced by all large traders. But it should not be treated as a speculator because it is not speculating; it is trading futures to reduce its price risk in an economically appropriate manner. Section 6 conflicts with the policy of promoting price risk management through exchange-traded and cleared markets. FIA strongly recommends that the Committee drop the hedging definition in section 6 and instead direct the CFTC to conduct a rulemaking to define, for position limit purposes, speculation, hedging and price risk management consistent with the public interests to be served by the CEA.Section 7--CFTC Administration FIA supports section 7's authorization of at least 200 new full time employees for the CFTC.Section 8--Review of Prior Actions FIA opposes requiring the CFTC to spend its resources reconsidering all of its currently effective regulatory actions as well as those of the exchanges to determine if they are consistent with the provisions of the bill. CFTC has not yet adopted regulations to implement the provisions enacted in the farm bill in 2008, which would enhance customer protection and market surveillance. Before reviewing past actions, FIA believes the CFTC should implement the farm bill's reforms. FIA appreciates that the CFTC is given no deadline for completing this ``prior action'' review. We are sure the CFTC will move expeditiously to implement this bill's regulatory provisions, if enacted, as well as the farm bill provisions from last year. The key is providing the CFTC with adequate resources to do the job and section 7 is an important step in this direction.Section 9--Review of Over-the-Counter Markets FIA does not oppose having the CFTC study eventually whether position limits should be imposed on exempt transactions in physically-based agricultural or energy commodities when those transactions are fungible with regulated futures contracts and significant price discovery contracts. FIA also does not oppose including in that study whether it would be good policy for the CFTC to adopt umbrella limits for futures, swaps and any other fungible transactions in such commodities. FIA would urge the Committee, however, to remove the deadlines and timelines for such studies. The CFTC should be able first to adopt and implement its rules for Significant Price Discovery Contracts as required in the 2008 Farm Bill. Then, after it has had experience with such rules, the CFTC could tackle the required study. At this point, it seems to be premature to study what contracts are fungible with SPDC contracts, especially where the CFTC has not yet implemented its SPDC authority.Section 10--Study Relating to International Regulation of Energy Commodity Markets FIA does not oppose having the Comptroller General study the international regime for regulating the trading of energy commodity futures and derivatives. Some of the terms used in the study outline should be clarified. For example, it is not clear what is meant by ``commercial and noncommercial trading'' (21:8-9). It is also not clear what constitutes ``excessive speculation'' (21:23-24) or ``price volatility'' (21:25). Last, the study contemplates a proper functioning market ``that protects consumers in the United States.'' (22:34) The phrase suggests that markets should have a downward price bias to serve the interests of consumers. FIA instead believes that markets should reflect accurately market fundamentals, including the forces of supply and demand. FIA recommends that the Committee adjust the study outline to ensure it will provide beneficial, not skewed, results for further deliberations.Section 11--Over-The-Counter Authority FIA has no objection to having the CFTC analyze whether any exempt or excluded transaction is fungible with transactions traded on a registered entity, including an electronic facility that lists a Significant Price Discovery Contract. If such fungible contracts are found, and if the CFTC also finds that such contracts have the potential to harm the price discovery process on a registered entity, section 11 provides that the CFTC may use its existing emergency authority in section 8a(9) to impose position limits on such fungible contracts. This new authority would parallel the CFTC's new Significant Price Discovery Contract authority provided in the 2008 Farm Bill. As written, however, FIA can not support this provision. FIA is concerned about the breadth of the language ``have the potential to'' (22:24) harm market integrity on registered entities. The CFTC should be empowered to use these regulatory authorities only if it finds an actual emergency condition to exist which affects trading on registered entities. Otherwise the CFTC could use a mere possibility of an impact on a registered entity to restrain or prevent competition from arising among trading facilities or dealer markets with exchange markets. FIA also believes the Committee should make clear in section 11 that the CFTC should not apply its authority to restrict fair competition.Section 12--Expedited Process FIA has no objection generally to allowing the CFTC to use expedited procedures to implement the authorities in this bill if the CFTC deems it to be necessary. FIA does not believe the authority in section 12 itself is necessary because the Administrative Procedure Act provides the CFTC and other agencies with appropriate powers to expedite the kinds of rule making actions the bill contemplates. FIA does object to this provision if it is misread to authorize the CFTC to expedite and disregard APA or even Constitutionally-required procedural protections whenever the CFTC believes it to be necessary. That sweeping and standardless grant of authority could allow the agency to disregard well-established administrative procedural protections that have been adopted for many years to ensure reasoned and impartial agency decisions.Section 13--Certain Exemptions and Exclusions Available Only for Certain Transactions Settled and Cleared Through Registered Derivatives Clearing Organizations FIA supports encouraging market participants to clear appropriately standardized derivatives transactions. But FIA does not believe that mandatory clearing of all OTC derivatives is sound public policy. Clearing should only be available to those instruments that regulated clearing facilities decide they can safely clear. To date, no clearing facility believes it could or should clear all OTC derivatives. And even if a clearing facility believed it could clear a particular class or type of OTC derivative (and some do now), FIA would want that private entity's judgment confirmed by an expert Federal regulatory body, like the CFTC. FIA believes that clearing should be encouraged with incentives, not mandates, and only when the clearing entity and its government regulator agree that the particular class of OTC derivative could be submitted safely for clearing. Mandating clearing in a vacuum and without the necessary safety and soundness predicates, as section 13 appears to do, would be most unwise. Section 13 does grant to the CFTC the authority to declare spot and forward contracts immune from the mandatory clearing requirement. (31:12-17) The CFTC's authority is appropriately broad and flexible. But given the structure of section 13 and the traditional meanings of the terms spot and forward contracts, FIA is uncertain whether most or all OTC derivatives could fall into the spot or forward category. If not, the provisions in section 13 granting the CFTC the power to exempt classes of OTC transactions from the clearing mandate become particularly important. Unfortunately, the criteria in section 13 that would guide the CFTC's exemption decisions are much too rigid and constraining. As written, the CFTC would have to find a class of derivatives is ``highly customized;'' ``transacted infrequently;'' ``serves no price discovery function;'' and ``being entered into by parties with demonstrated financial integrity.'' (29:23-30:9) It would be difficult, if not impossible, for the CFTC to craft an appropriate exemption under these mandatory criteria. The result would be that section 13 would operate as a ban on all non-cleared OTC derivatives transactions in the U.S. and an invitation to market participants to enter into OTC transactions outside the jurisdictional reach of the CEA. Removing that significant market liquidity and making transactions more opaque to U.S. regulators would be detrimental to the public interest. FIA strongly opposes section 13.Section 14--Treatment of Emission Allowances and Off-Set Credits FIA supports defining emission allowances and off-set credits as ``exempt commodities'' like all other energy-related commodities. Section 14, however, excludes these commodities from the ``exempt commodity'' definition and would treat them like agricultural commodities. FIA does not know of any public policy reason to constrain the development of market innovations, including multilateral electronic trading facilities or clearing, for trading in these instruments in these energy commodities. Achieving energy policy goals will require promoting and expanding innovation, not restricting it. The Committee should reconsider the policy implications of treating these energy commodities like agricultural commodities.Section 15--Inspector General of the CFTC FIA has no objection to creating the Inspector General of the CFTC as a Presidential appointment, subject to Senate confirmation. At the same time, we do not believe the absence of an IG appointed by the President is a weakness in the current CFTC structure.Section 16--Limitation on Eligibility to Purchase a Credit Default Swap FIA opposes the ban on naked credit default swaps. Section 16 will effectively terminate the U.S. CDS market and send it overseas. CDS transactions have fostered many economic benefits and it would be better to improve regulation and oversight of this market rather than jettisoning it to foreign shores. FIA does support the provision that defines a credit default swap and allows registered entities that list for trading or clear CDS instruments to operate without having to comply with regulatory conditions imposed by the SEC. (38:1-9) " CHRG-111hhrg53241--55 Mr. Hensarling," Mr. Taylor, it is my time. But, with all due respect, you are giving an agency the power to ban products, taking away consumer choice. How do you protect the consumer by taking away their choice? You may disagree, but others believe that you will squash innovation. We will not see the next ATM. We will not see the next set of frequent flyer miles. And so if you think that the members of your organizations are having trouble getting credit now, wait until this legislation is passed, and then you will see real problems. I see my time is up. I yield back. Ms. Waters. [presiding] Thank you very much. I will recognize myself for 5 minutes. Yesterday, in talking with representatives of the banking community, we were admonished for not supporting adjustable rate mortgages. And basically what they said is, you guys don't understand adjustable rate mortgages and how they have helped so many people. It is the same argument we get a lot when people say we don't understand subprime lending. We have never said we are against subprime lending, but there are so many iterations on the subjects. I would like to ask--perhaps you could help me, Mr. Mierzwinski--for a definition of these adjustable rate mortgages. As I understand it, there are option ARMs, and there are products that could reset 6 months, 1 year, 2 years, and when the mortgage is negotiated--and many of these adjustable rate mortgages. They don't look at whether or not the homeowner will be able to afford the mortgage 1 year or 5 months or 5 years from the time that they sign on to these mortgages. And the formula for the increase possibly in interest rates allows something called a margin on top of the interest rates. So you could have an increase in interest rate, plus they can mark up this mortgage another 2, 3, 4 percent. Could you help us with a description of the harmful adjustable rate mortgages? " CHRG-111hhrg53242--43 Mr. Royce," Let me ask you a question here that is on my mind. Because, in the hearing, it became very clear that there was no one at the SEC who understood the Ponzi scheme strategy. There was no one who could undercover that. There was one in the Boston office, but in the over-lawyered SEC, he didn't have a seat at the table. Under that kind of culture, are you going to have anyone who can understand how an OTC derivatives contract is structured? Are you going to have anybody who understands how a hedge fund engages in quantitative analysis and complex trading strategies? I just wonder about what the SEC has already proven itself incapable of handling, and now we transfer this on top of the SEC. A story just broke, I think yesterday, about another example of another Bernie Madoff-type swindle that the SEC had missed, where, again, the information allegedly had been turned over to them. They had not even been able to decipher that with the information that was given them. Hence my thoughts on that. I would also ask if any of the other panelists, maybe Mr. Stevens or Mr. Baker or anybody, would have any thoughts on this front? Mr. Stevens? " FinancialCrisisReport--332 Gemstone 7 also demonstrated how CDOs magnified risk by including or referencing within itself 115 different RMBS securities containing thousands of high risk, poor quality subprime loans. Many of those RMBS securities carried BB ratings, which are non-investment grade credit ratings and were among the highest risk securities in the CDO. Gemstone 7 also included CDO securities that, in themselves, concentrated the risk of their underlying assets. Over 75% of Gemstone’s assets consisted of RMBS securities with ratings of BBB or lower, including approximately 33% with non-investment grade ratings, yet Gemstone’s top three tranches were given AAA ratings by the credit rating agencies. The next three tranches were given investment grade ratings as well. Those investment grade ratings enabled investors like pension funds, insurance companies, university endowments, and municipalities, some of which were required by law, regulation, or their investment plans to put their funds in safe investments, to consider buying Gemstone securities. Eight investors actually purchased them. Within eight months, the Gemstone securities began incurring rating downgrades. By July 2008, all seven tranches in the CDO had been downgraded to junk status, and the long investors were almost completely wiped out. Today, the Gemstone 7 securities are nearly worthless. Deutsche Bank was, in Mr. Lippmann’s words, part of a “CDO machine” run by investment banks that produced hundreds of billions of high risk CDO securities. Because the fees to design and market CDOs ranged from $5 to $10 million per CDO, investment bankers had a strong financial incentive to continue issuing them, even in the face of waning investor interest and poor quality assets, since reduced CDO activity would have led to less income for structured finance units, smaller bonuses for executives, and even the disappearance of CDO departments, which is eventually what occurred. The Deutsche Bank case history provides a cautionary tale for both market participants and regulators about how complex structured finance products gain advocates within an organization committed to pushing the products through the pipeline to maintain revenues and jobs, regardless of the financial risks or possible impact on the marketplace. 1259 See Sections 11 and 12 of Securities Act of 1933. See also Rule 10b-5 of the Securities Exchange Act of 1934. For a more detailed discussion of the legal obligations of underwriters, placement agents, and broker-dealers, see Section C(6) on conflicts of interest analysis, below. (1) Subcommittee Investigation and Findings of Fact CHRG-111hhrg55814--503 Mr. Himes," Thank you, Mr. Chairman. I have two kind of esoteric questions, which may or may not elicit a response. I hope they do. The first is on the topic of securitizations. Securitization structured products, like so much of what we're talking about, are real double-edged swords, inasmuch as, used correctly, they increased credit and liquidity. Used incorrectly, or kept off balance sheet, or poorly rated, they contributed to the place we find ourselves in today. I am a big believer in the idea incorporated in this proposed legislation of retention, that you keep a piece of whatever it is that you create. I think it's very elegant. It prevents us or the regulators from having to try to sort through securities, because, really, the creator of a structured product, to some extent, will eat his or her own cooking. I do have real concerns, though, about the stipulated level. The legislation says that you will hold 10 percent of a structured product, perhaps down to 5 percent, no lower than 5 percent. And my problem with that is that I think structured products can have wildly different credit characteristics. You could have a structured product full of agency and treasuries, you could have a structured product full of high-risk stuff. So, I am really--and I am thinking about, is there some way to link the retention to the credit risk of the product, or to the fees associated with the product, which presumably are higher, if the product is more complex. I am wondering if there is any comment on what is proposed, vis-a-vis the 5 to 10 percent retention, and whether these ideas I have thrown out maybe have any merit. " CHRG-111shrg50815--24 Mr. Zywicki," Mr. Chairman and members of the Committee, it is a pleasure to appear before you today. Let me make clear at the outset, I have no relationship with the credit card industry. I fight with them just like everybody else does. I disagree with them, just like any other company from which I buy goods and services, and you may find this hard to believe, but sometimes I even disagree with my elected representatives on various issues. And I am really quite ruthless and not the slightest bit sentimental about leaving one card and switching to another if a better deal comes along. I don't care whether the industry makes a lot of money or a little bit of money. What I care about is maximizing consumer choice and maximizing competition in a manner that will be consumer welfare-enhancing, and I fear there are many provisions in this legislation that may have unintended consequences that will lead to higher interest rates for consumers, will stifle market and regulatory innovation, and will restrict consumer access to credit at a particularly inopportune time. Unlike almost any other good or service, credit card issuers are forced to compete for my loyalty every time I pull out my wallet to make a payment. I have got four credit cards. I decide at any given time which one is the best one for me to use, whether I am buying gasoline or shopping online. In such a competitive environment, credit card issuers face relentless competition to retain my loyalty, and as I said, I am not the slightest bit sentimental about switching if a better deal comes along. Federal Reserve surveys indicate that 90 percent of credit card owners report that they are very or somewhat satisfied with their credit cards, versus 5 percent who are somewhat dissatisfied and only 1 percent, that is one out of 100, who say that they are very dissatisfied with their credit cards. Moreover, two-thirds of respondents in a Federal Reserve survey also reported that credit card companies usually provide enough information to enable them to use credit cards wisely, and 73 percent stated that the option to revolve balances on their credit cards made it easier to manage their finances, versus 10 percent who said this made it more difficult. So let us not throw out the baby with the bath water. Nonetheless, the myriad uses of credit cards and the increasing heterogeneity of credit card owners has spawned increasingly complexity in credit card terms and concerns about confusion that may reduce consumer welfare. Nonetheless, we should not sacrifice just for the sake of making credit card simpler some of the benefits that we have generated from credit cards. Consider some of the more troubling provisions in the legislation to my mind. First, there are some provisions that will likely lead to higher interest rates and other costs for consumers. For instance, and many of these are in the Federal Reserve rules but I still am troubled by them, and to the extent that they are phased in rather than posed immediately, I believe that will be better for consumers. First, for instance, it prohibits the application of any rate increases on an outstanding balance on credit cards, often called retroactive rate increases. The way credit cards operate is they are revolving credit. They are month-to-month loans. That means at any given time, I can cancel my card and go to a lower interest rate card. To the extent that issuers are unable to raise the interest rate when situations change but I am allowed to switch to a lower interest rate when situations change, the end result of that is that issuers are going to be less likely to offer lower interest rates on the front end. If I can lower my interest rate but it can't be raised if circumstances change, they are going to be less likely to offer lower rate interest cards. Second, the provision that has to do with application on outstanding balances suffers from the same sort of problem. Second, I am concerned that some of the things in this legislation will stifle innovation. For instance, the provision that requires an ongoing payoff, a timing disclosure that includes, for instance, a statement to the consumers how long it would take to pay off the card balance by only making the minimum payment. This would go on every billing statement. According to research by Federal Reserve economist Thomas Durkin, this provision would be of interest to approximately 4 percent of credit card users, being those who intend to pay off their balance by making the minimum payment and intend to stop using the card. It is an open question whether or not it is worth mandating a brand new disclosure for 4 percent of consumers, much less one that would be conspicuously disclosed. Why is that a problem? Because the more things that you require to be disclosed and the bigger you require it to be disclosed, the more distracting and more difficult it becomes for consumers to find out what they actually want. More fundamentally, I think this illustrates a one-size-fits-all strategy to consumer protection that is not accurate in the context of credit cards. The reason why credit cards are so complicated today is because consumer use of credit cards is so multi-faceted. Consumer cards offer an endless array of terms that respond to the endless array of demands of different consumers. Some consumers never revolve. Some consumers revolve sometimes. Some consumers revolve all the time. I never revolve. I have no idea what my credit card interest rate is. I don't care. I don't shop for a card on those terms. I care about what my annual fee is and what my benefits are. To the extent that we mandate certain disclosures, it makes it more difficult for consumers to shop on the terms that they actually want, and the empirical evidence on this is clear. Consumers do shop on the terms that they want. Those who revolve, unlike me, do know what their interest rate is, by and large, and they shop very aggressively on that. The best evidence we have is that those who revolve balances actually have a lower interest rate on their credit card than those like me who don't pay interest and so don't shop on that particular term. To the extent, then, that we also place limits on penalty fees and that sort of thing, we are going to reduce risk-based pricing by requiring interest rate raises for everybody else. The final thing I would like to close on is the concern that this might reduce credit access. We know what has happened during this past year as credit card access has dried up and credit limits have declined. Reports indicate that middle-class--some people have been forced to go without things they wanted. Other reports indicate that those who are unable to get credit cards have been, for instance, forced to turn to layaway plans. They brought back layaway this fall because people couldn't get credit cards. Other people have had to turn to payday lenders. Other middle-class people have turned to pawn shops. To the extent that the impact of this law is to reduce access to credit, it will harm those who we intend to help, and in particular, I would urge caution, although it is obvious college students often misuse credit cards, I would urge caution at this particular time at doing things that might limit access to credit for college students. We know that the student loan markets are not performing very well right now either, and we know that a lot of college students drop out when they can't get access to credit. So it may be that on net, some of those are appropriate, so let us not be overzealous in a way that might lead to reduced access to credit. Thank you. " CHRG-111shrg54589--126 PREPARED STATEMENT OF PATRICIA WHITE Associate Director, Division of Research and Statistics, Board of Governors of the Federal Reserve System June 22, 2009 Chairman Reed, Ranking Member Bunning, and other Members of the Subcommittee, I appreciate this opportunity to provide the Federal Reserve Board's views on the development of a new regulatory structure for the over-the-counter (OTC) derivatives market. The Board brings to this policy debate both its interest in ensuring financial stability and its role as a supervisor of banking institutions. Today, I will describe the broad objectives that the Board believes should guide policy makers as they devise the new structure and identify key elements that will support those objectives. Supervision of derivative dealers is a fundamental element of the oversight of OTC derivative markets, and I also will discuss the steps necessary to ensure these firms employ adequate risk management.Policy ObjectivesMitigation of Systemic Risk The events of the last 2 years have demonstrated the potential for difficulties in one part of the financial system to create problems in other sectors and in the macroeconomy more broadly. OTC derivatives appear to have amplified or transmitted shocks. An important objective of regulatory initiatives related to OTC derivatives is to ensure that improvements to the infrastructure supporting these products reduce the likelihood of such transmissions and make the financial system as a whole more resilient to future shocks. Centralized clearing of standardized OTC products is a key component of efforts to mitigate such systemic risk. One method of achieving centralized clearing is to establish central counterparties, or CCPs, for OTC products. Market participants have already established several CCPs to provide clearing services for some OTC interest rate, energy, and credit derivative contracts. Regulators both in the United States and abroad are seeking to speed the development of new CCPs and to broaden the product line of existing CCPs. The Board believes that moving toward centralized clearing for most or all standardized OTC products would have significant benefits. If properly designed, managed, and overseen, CCPs offer an important tool for managing counterparty credit risk, and thus they can reduce risk to market participants and to the financial system. The benefits from centralized clearing will be greatest if CCPs are structured so as to allow participation by end users within a framework that ensures protection of their positions and collateral. Infrastructure changes in OTC markets will be required to move most standardized OTC contracts into centralized clearing systems in a way that ensures the risk-reducing benefits of clearing are realized. Such changes include agreement on the key terms that constitute ``standardization'' and the development of electronic systems for feeding trade data to CCPs--in other words, building better pipes to the CCPs. For their part, CCPs must have in place systems to manage the risk from this new business. Of particular importance are procedures to handle defaults in OTC products that are cleared, because these products are likely to be less liquid than the exchange-traded products that CCPs most commonly handle. Although implementation challenges no doubt lie ahead, the Board will work to ensure that these challenges are addressed quickly and constructively. Major dealers have committed to making improvements in back-office processes such as increased electronic processing of trades and speedier confirmation of trades for equity, interest rate, commodity, foreign exchange, and credit products. These back-office improvements are important prerequisites for centralized clearing, and efforts by supervisors to require dealers to improve these practices have helped lay the groundwork for developing clearing more quickly. Dealers also have committed to clearing standardized OTC products, and they will be expected to demonstrate progress on this commitment even as the broader regulatory reform debate evolves. Clearly there is much to be done, and we are committed to ensuring that the industry moves promptly. An important role of policy makers may be establishing priorities so that efforts are directed first at the areas that offer the greatest risk-reduction potential. Some market observers feel strongly that all OTC derivative contracts--not just the standardized contracts--should be cleared. Requiring CCPs to clear nonstandard instruments that pose valuation and risk-management challenges may not reduce risk for the system as a whole. If, for example, the CCPs have difficulty designing margin and default procedures for such products, they will not be able to effectively manage their own counterparty credit risk to clearing members. In addition, there are legitimate economic reasons why standardized contracts may not meet the risk-management needs of some users of these instruments. A flexible approach that addresses systemic risk with respect to standardized and nonstandardized OTC derivatives, albeit in different ways, is most likely to preserve the benefits of these products for businesses and investors. That said, however, it is particularly important that the counterparties to nonstandardized contracts have robust risk-management procedures for this activity. Nonstandard products pose significant risk-management challenges because they can be complex, opaque, illiquid, and difficult to value. Supervisors must ensure that their own policies with respect to risk management and capital for firms active in nonstandardized products fully reflect the risks such products create. If supervisors are not comfortable with their ability to set and enforce appropriate standards, then the activity should be discouraged. I will return to a broader discussion of supervision and risk management later.Improving the Transparency and Preventing the Manipulation of Markets Throughout the debates about reform of the OTC derivatives market, a persistent theme has been concern that the market is opaque. Discussions of market transparency generally recognize the multiple audiences that seek information about a market--market participants, the public, and authorities--and the multiple dimensions of transparency itself--prices, volumes, and positions. Participants, the public, and authorities seek different information for different purposes. Transparency is a tool for addressing their needs and, in the process, fostering multiple policy objectives. Transparency to market participants supports investor protection as well as the exercise of market discipline, which has sometimes clearly been lacking. Transparency to the public helps to demystify these markets and to build support for sound public policies. Transparency to authorities supports efforts to pursue market manipulation, to address systemic risk through ongoing monitoring, and, when necessary, to manage crises. Substantial progress in improving the transparency of volumes and positions in the credit default swap (CDS) market occurred with the creation of the Depository Trust Clearing Corporation's Trade Information Warehouse, a contract repository that contains an electronic record of a large and growing share of CDS trades. Participation in that repository is voluntary, however, and its present coverage is limited to credit products. Nevertheless, major dealers, who are counterparties to the vast majority of CDS trades, have recently committed to supervisors that they will record all their CDS trades in the warehouse by mid-July. The Board supports creating contract repositories for all asset classes and requiring a record of all OTC derivative contracts that are not centrally cleared to be stored in these repositories. The Trade Information Warehouse currently makes aggregate data on CDS contracts public. Aggregate data on volumes and open interest should be made public by other repositories that are created, and more detailed data should be made available to authorities to support policy objectives related to the prevention of manipulation and systemic risk. Enhancing price transparency to the broader public through post-trade reporting of transaction details is also an important goal. Even where contracts are not traded on exchanges or on regulated electronic trading systems, the prompt dissemination of information can provide significant benefits to market participants on a range of valuation and risk-management issues. The Board believes that policy makers should pursue the goal of prompt dissemination of prices and other trade information for standardized contracts, regardless of the trading venue.Supervision and Risk Management Although the creation of CCPs will provide an important new tool for managing counterparty credit risk, enhancements to the risk-management policies and procedures for individual market participants will continue to be a high priority for supervisors. If the reforms outlined here are implemented, the firms currently most active in bilateral OTC markets will become the firms most active as clearing members of CCPs. As such, the quality of their internal risk management is important to the CCP because sound risk management by all clearing members is critical if centralized clearing is to deliver risk-reducing benefits. Supervisors have recognized that financial institutions must make changes in their risk-management practices for OTC derivatives by improving internal processes and controls and by ensuring that traditional credit risk-management disciplines are in place for complex products, regardless of the form they take. Efforts already under way include improving collateralization practices to limit counterparty credit risk exposures and examining whether the current capital regime can be improved to increase incentives for sound risk management. An important parallel process involves ensuring that firms that are large and complex enough to pose risks to the broader system are subject to appropriate oversight and resolution authority, even if they operate outside the traditional regulated banking system. The Board believes that all systemically critical firms should have a consolidated supervisor, as well as be subject to the oversight of any systemic regulator that might be created. The scope of a firm's activities in the OTC derivatives market will likely be an important factor in making that assessment.Conclusion Policy issues associated with OTC derivatives are not limited to the United States. The markets are global. Past work to strengthen OTC derivatives markets has often involved a large measure of international coordination, and the current policy issues are unlikely to be fully and effectively addressed without broad-based input. Despite the problems that have been associated with OTC derivatives during the financial crisis, these instruments remain integral to the smooth functioning of today's financial markets. Much work must be done to strengthen the market further. But with effective oversight by supervisors, prudent risk management by end users and dealers, and appropriate changes in the regulatory structure, the systemic risks stemming from OTC derivatives can be reduced, and derivatives can continue to provide significant benefits to the businesses and investors who use them to manage financial market risks. ______ 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-109shrg24852--39 Chairman Greenspan," Well, that is a good question. First of all, the portfolios did not exist in any substantial form prior to, say, 1990. Yesterday, I was asked why I have not previously raised the issue. Let me answer this very simply. It has taken me quite a good deal of time to disentangle the very complex structure of these institutions to really understand how they work, what motivates them, and where the sensitive points are. When I first looked at this situation, I knew what the stock of the debt was and the types of risks that held. But I was not aware of how sensitive their profitability was between securitizing and selling mortgages that they purchased and the amount that they accumulated in their portfolio. It is only fairly recently that it finally became clear to me that that was basically how the system works, and I must say that it was a revelation in certain respects. The more I have looked at it since, I am impressed at how quickly, once they realized in the early 1990's how important a vehicle this was to profitability, how aggressively they pursued it. Senator Bunning. Last question. Do you believe energy prices have stabilized, or do you believe consumers and businesses can expect lower or higher energy prices? " CHRG-111hhrg51698--488 The Chairman," Well, my time has expired. But, I mean, we may be ham-handed or not understand what we are doing here, but I think that the problem we are having is because we have one regulator out there that is trying to operate under circumstances that were in place 40 years ago when the market was a lot less complex. One of the things we have done in this Committee is we have moved to a principles-based regulation scheme, which is what we need to do with all the regulators. We need to have the regulations follow the marketplace, and have a system whereby this risk is brought into view. That is what we are trying to do here. I have no confidence if you are going to give this to the SEC or the Fed and a bunch of bureaucrats are going to figure this out. This is way too complicated. They are not going to know what is going on. And you guys will be so far ahead of them that it wouldn't make any difference. So what we are trying to do is to force the risk out into the open as we go through, and not rely on the people that are doing it to do that, but have somebody independent making that decision. That is kind of what we are trying to do here. Now, how we get there, that is the question. But something is going to happen here. And we are hoping on this Committee to help make it the most reasonable, and effective. If we are not successful, I guarantee what is going to come out is going to be a hell of a lot worse. So, I hope you will work with us, and we look forward to that. I had a couple other questions, but I burned up all my time. So I recognize the Ranking Member, the gentleman from Oklahoma, Mr. Lucas. " CHRG-111shrg49488--57 Mr. Clark," And as I pointed out earlier, Canadian banks collectively took $18 billion (CAD) in writedowns. So in U.S. terms, that is $180 billion, given the size of the country, so it is not an insignificant amount. So we cannot stand here and say there are no problems in Canada. I think that would be a misnomer. I think this is a very difficult area because I think the reality is that people were aware of this and they were aware that the products were getting bigger and more complex. But as we were talking during the break, the reality is that people were making a lot of money on it, and it looked like it was very profitable. And I would say in its initial evolution, credit derivatives were actually a positive factor, and so for us as a bank, we were able to lay off a significant amount of our risk by buying credit protection, and in that sense we saw it as a good thing, not a bad thing. And it is only as a later evolution that in a sense it ended up causing, I think, some of the problems. I think it underscores the capability issue, the one we talked earlier about AIG, that in this war, if you will, or race for knowledge, you have a very profitable and highly sophisticated industry in the banking system around the world. I think it does mean that you cannot afford to have three or four regulators trying to go up the scale of knowledge. You do have to have a concentrated knowledge in order to attract the people to try to have a counter-push to these ideas. Senator Collins. Mr. Carmichael, any thoughts on how to prevent regulatory black holes as new products emerge? " CHRG-111hhrg46820--34 Mr. Allison," Congressman Graves, I appreciate the opportunity to address that. I agree government should not be the primary creator of quality jobs. Obviously, you need great people working in government; and we appreciate their dedication. However, the private sector is what makes that possible. What we have going on right now is a crisis in not only access to capital, not only a problem with our energy sector, a consumer confidence crisis. We can go on and on. Let's not forget really what this great country has been most known for throughout history is creativity, it is innovation capacity, it is entrepreneurial spirit; and that still exists, that still exists. There are people out there today in laboratories all across America that have products they are trying to bring forward. They often have laboratory incubator environments around them. They have assistance from a myriad of different resources. However, just look at public policy. 2.5 percent of Federal R&D dollars are going to SBIR grants. What about the other 97.5 percent? As I said earlier, small businesses--in particular those with SBIR grants--are far more productive in obtaining patents for new products and bringing those to market than big business and/or universities. If I had to pick from the 16 components that I have recommended today, I would say that that is probably the first starting point. Because if you do, if you raise that to even 5 percent, that still leaves big business and universities, the other 95 percent. Then I think we have taken a major leap in assisting the entrepreneurs in bringing their products to market. And if they do and they are successful and the percentage of success is very high, then they are going to be building buildings, they are going to be buying equipment and employing people in quality jobs with health care benefits. Aren't those the goals we are trying to pursue? I just think too often we have neglected the golden goose here. Nothing against big business. Obviously, we have great challenges with the auto industries and aerospace and so forth. We must maintain those industries. But Main Street cannot be forgotten. We have people as we speak that are waiting to see what Congress and the new administration are going to do. And if you want to know what the real vacuum has been, it is leadership. They are waiting for a signal. So I ask you to give them that signal. Thank you. " CHRG-111shrg56262--98 PREPARED STATEMENT OF WILLIAM W. IRVING Portfolio Manager, Fidelity Investments October 7, 2009 Good afternoon Chairman Reed, Ranking Member Bunning, and Members of the Subcommittee. I am Bill Irving, an employee of Fidelity Investments, \1\ where I manage a number of fixed-income portfolios and play a leading role in our investment process in residential mortgage-backed securities (RMBS). This experience has certainly shaped my perspective on the role of securitization in the financial crisis, the condition of the securitization markets today, and policy changes needed going forward. I thank you for the opportunity to share that perspective with you in this hearing. At the outset, I want to emphasize that the views I will be expressing are my own, and do not necessarily represent the views of my employer, Fidelity Investments.--------------------------------------------------------------------------- \1\ Fidelity Investments is one of the world's largest providers of financial services, with assets under Administration of $3.0 trillion, including assets under management of more than $1.4 trillion as of August 31, 2009. Fidelity offers investment management, retirement planning, brokerage, and human resources and benefits outsourcing services to over 20 million individuals and institutions as well as through 5,000 financial intermediary firms. The firm is the largest mutual fund company in the United States, the number one provider of workplace retirement savings plans, the largest mutual fund supermarket and a leading online brokerage firm. For more information about Fidelity Investments, visit Fidelity.com.---------------------------------------------------------------------------Summary I will make three main points. First, the securitized markets provide an important mechanism for bringing together investors and borrowers to provide credit to the American people for the financing of residential property, automobiles, and retail purchases. Securitization also provides a major source of funding for American businesses for commercial property, agricultural equipment, and small-business investment. My second point is that the rapid growth of the markets led to some poor securitization practices. For example, loan underwriting standards got too loose as the interests of issuers and investors became misaligned. Furthermore, liquidity was hindered by a proliferation of securities that were excessively complex and customized. My third and final point is that in spite of these demonstrated problems, the concept of asset securitization is not inherently flawed; with proper reforms to prevent weak practices, we can harness the full potential of the securitization markets to benefit the U.S. economy.Brief Review of the Financial Crisis To set context, I will begin with a brief review of the financial crisis. This view is necessarily retrospective; I do not mean to imply that investors, financial institutions or regulators understood all these dynamics at the time. In the middle of 2007, the end of the U.S. housing boom revealed serious deficiencies in the underwriting of many recently originated mortgages, including subprime loans, limited-documentation loans, and loans with exotic features like negative amortization. Many of these loans had been packaged into complex and opaque mortgage-backed securities (MBS) that were distributed around the world to investors, some of whom relied heavily on the opinion of the rating agencies and did not sufficiently appreciate the risks to which they were exposed. \2\--------------------------------------------------------------------------- \2\ At Fidelity, we consider the opinions of the rating agencies, but we also do independent credit research on each issuer or security we purchase.--------------------------------------------------------------------------- The problems of poorly understood risks in these complex securities were amplified by the leverage in the financial system. For example, in 2007, large U.S. investment banks had about $16 of net assets for each dollar of capital. \3\ Thus, a seemingly innocuous hiccup in the mortgage market in August 2007 had ripple effects that quickly led to a radical reassessment of what is an acceptable amount of leverage. What investors once deemed safe levels of capital and liquidity were suddenly considered far too thin. As a result, assets had to be sold to reduce leverage. This selling shrank the supply of new credit and raised borrowing costs. In fact, the selling of complex securities was more than the market could bear, resulting in joint problems of liquidity and solvency. Suddenly, a problem that had started on Wall Street spread to Main Street. Companies that were shut off from credit had to cancel investments, lay off employees and/or hoard cash. Many individuals who were delinquent on their mortgage could no longer sell their property at a gain or refinance; instead, they had to seek loan modifications or default.--------------------------------------------------------------------------- \3\ Source: SNL Financial, and company financials.--------------------------------------------------------------------------- This de-leveraging process created a vicious cycle. Inability to borrow created more defaults, which led to lower asset values, which caused more insolvency, which caused more de-leveraging, and so forth. Home foreclosures and credit-card delinquencies rose, and job layoffs increased, helping to create the worst recession since the Great Depression.Role Played by Asset Securitization in the Crisis Without a doubt, securitization played a role in this crisis. Most importantly, the ``originate-to-distribute'' model of credit provision seemed to spiral out of control. Under this model, intermediaries found a way to lend money profitably without worrying if the loans were paid back. The loan originator, the warehouse facilitator, the security designer, the credit rater, and the marketing and product-placement professionals all received a fee for their part in helping to create and distribute the securities. These fees were generally linked to the size of the transaction and most of them were paid up front. So long as there were willing buyers, this situation created enormous incentive to originate mortgage loans solely for the purpose of realizing that up-front intermediation profit. Common sense would suggest that securitized assets will perform better when originators, such as mortgage brokers and bankers, have an incentive to undertake careful underwriting. A recent study by the Federal Reserve Bank of Philadelphia supports this conjecture. \4\ The study found evidence that for prime mortgages, private-label securitized loans have worse credit performance than loans retained in bank portfolios. Specifically, the study found that for loans originated in 2006, the 2-year default rate on the securitized loans was on average 15 percent higher than on loans retained in bank portfolios. This observation does not necessarily mean that issuers should be required to retain a portion of their securities, but in some fashion, the interests of the issuers and the investors have to be kept aligned.--------------------------------------------------------------------------- \4\ Elul, Ronel, ``Working Paper No. 09-21 Securitization and Mortgage Default: Reputation vs. Adverse Selection'', Federal Reserve Bank of Philadelphia. September 22, 2009.--------------------------------------------------------------------------- Flawed security design also played a role in the crisis. In its simplest form, securitization involves two basic steps. First, many individual loans are bundled together into a reference pool. Second, the pool is cut up into a collection of securities, each having a distinct bundle of risks, including interest-rate risk, prepayment risk, and credit risk. For example, in a simple sequential structure, the most senior bond receives all available principal payments until it is retired; only then does the second most senior bond begin to receive principal; and so on. In the early days of securitization, the process was kept simple, and there were fewer problems. But over time, cash-flow rules grew increasingly complex and additional structuring was employed. For example, the securities from many simple structures were rebundled into a new reference pool, which could then be cut into a new set of securities. In theory, there is no limit to the amount of customization that is possible. The result was excessive complexity and customization. The complexity increased the challenge of determining relative value among securities, and the nonuniformity hurt liquidity when the financial system was stressed. One example of poor RMBS design is the proliferation of securities with complex rules on the allocation of principal between the senior and subordinate bonds. Such rules can lead to counter-intuitive outcomes in which senior bonds take write-downs while certain subordinate bonds are paid off in full. A second example of poor design is borrower ability to take out a second-lien mortgage without notifying the first-lien holder. This ability leads to a variety of thorny issues, one of which is simply the credit analysis of the borrower. If a corporation levered further, the senior unsecured debt holder would surely be notified, but that is not so in RMBS.Other Factors Contributing to the Crisis Securitization of assets played a role in the crisis, but there were several additional drivers. Low interest rates and a bubble mentality in the real estate market also contributed to the problem. Furthermore, in the case of securitized assets, there were plenty of willing buyers, many of them highly levered. In hindsight, this high demand put investors in the position of competing with each other, making it difficult for any of them to demand better underwriting, more disclosure, simpler product structures, or other favorable terms. Under-estimation of risk is always a possibility in capital markets, as the history of the stock market amply demonstrates. That possibility does not mean that capital markets, or asset securitization, should be discarded.Benefits of Asset Securitization When executed properly, there are many potential benefits of allowing financial intermediaries to sell the loans they originate into the broader capital markets via the securitization process. For one, this process provides loan originators much wider sources of funding than they could obtain through conventional sources like retail deposits. For example, I manage the Fidelity Ginnie Mae Fund, which has doubled in size in the past year to over $7 billion in assets; the MBS market effectively brings together shareholders in this Ginnie Mae Fund with individuals all over the country who want to purchase a home or refinance a mortgage. In this manner, securitization breaks down geographic barriers between lenders and borrowers, thereby improving the availability and cost of credit across regions. A second benefit of securitization is it generally provides term financing which matches assets against liabilities; this stands in contrast to the bank model, a substantial mismatch can exist between short-term retail deposits and long-term loans. Third, it expands the availability of credit across the country's socio-economic spectrum, and provides a mechanism through which higher credit risks can be mitigated with structural enhancements. Finally, it fosters competition among capital providers to ensure more efficient pricing of credit to borrowers.Current Conditions of Consumer ABS and Residential MBS Markets At present, the RMBS and ABS markets are sharply bifurcated. On one side are the sectors that have received Government support, including consumer ABS and Agency MBS (i.e., MBS guaranteed by Fannie Mae, Freddie Mac, and Ginnie Mae); these sectors are, for the most part, functioning well. On the other side are the sectors that have received little or no such support, such as the new-issue private-label RMBS market, which remains stressed, resulting in a lack of fresh mortgage capital for a large segment of the housing market.Consumer ABS The overall size of the consumer debt market is approximately $2.5 trillion; \5\ this total includes both revolving debt (i.e., credit-card loans) and nonrevolving debt (e.g., auto and student loans). Approximately 75 percent takes the form of loans on balance sheets of financial institutions, while the other 25 percent has been securitized. \6\--------------------------------------------------------------------------- \5\ Source: Federal Reserve, www.federalreserve.gov/releases/g19/current/g19.htm. \6\ Source: Federal Reserve, www.federalreserve.gov/releases/g19/current/g19.htm.--------------------------------------------------------------------------- From 2005 through the third quarter of 2008, auto and credit card ABS issuance ranged between $160 billion and $180 billion per year. \7\ However, after the collapse of Lehman Brothers in September 2008, new issuance came to a virtual halt. With the ABS market effectively shut down, lenders tightened credit standards to where only the most credit worthy borrowers had access to credit. As a result, the average interest rate on new-car loans provided by finance companies increased from 3.28 percent at end of July 2008 to 8.42 percent by the end of 2008. \8\--------------------------------------------------------------------------- \7\ Source: Bloomberg. \8\ Federal Reserve, www.federalreserve.gov/releases/g19/hist/cc_hist_tc.html.--------------------------------------------------------------------------- Issuance did not resume until March 2009 when the Term Asset-Backed Securities Loan Facility (TALF) program began. Thanks to TALF, between March and September of this year, there has been $91 billion of card and auto ABS issuance. \9\ Coincident with the resumption of a functioning auto ABS market, the new-car financing rate fell back into the 3 percent range and consumer access to auto credit has improved, although credit conditions are still more restrictive than prior to the crisis. While TALF successfully encouraged the funding of substantial volumes of credit card receivables in the ABS market, it is worth noting that credit card ABS issuance has recently been suspended due to market uncertainty regarding the future regulatory treatment of the sector.--------------------------------------------------------------------------- \9\ Source: Bloomberg.--------------------------------------------------------------------------- While interest rates on top tier New Issue ABS are no longer attractive for investors to utilize the TALF program, TALF is still serving a constructive role by allowing more difficult asset types to be financed through securitization. Examples include auto dealer floorplans, equipment loans to small businesses, retail credit cards, nonprime auto loans, and so forth.Residential MBS The overall size of the residential mortgage market is approximately $10.5 trillion, which can be decomposed into three main categories: 1. Loans on bank balance sheets: \10\ $3.5 trillion.--------------------------------------------------------------------------- \10\ Source: Federal Reserve, www.federalreserve.gov/econresdata/releases/mortoutstand/current.htm. 2. Agency MBS: \11\ $5.2 trillion.--------------------------------------------------------------------------- \11\ Source: eMBS, www.embs.com.--------------------------------------------------------------------------- a. Fannie Mae: $2.7 trillion. b. Freddie Mac: $1.8 trillion. c. Ginnie Mae: $0.7 trillion. 3. Private-Label MBS: \12\ $1.9 trillion.--------------------------------------------------------------------------- \12\ Source: Loan Performance.--------------------------------------------------------------------------- a. Prime: $0.6 trillion. b. Alt-A: $0.8 trillion. c. Subprime: $0.5 trillion. Thanks to the extraordinary Government intervention over the past year, the Agency MBS market is performing very well. This intervention had two crucial components. First, on September 7, 2008, the director of the Federal Housing Finance Agency (FHFA) placed Fannie Mae and Freddie Mac into conservatorship. This action helped reassure tens of thousands of investors in Agency unsecured debt and mortgage-backed securities that their investments were supported by the Federal Government, in spite of the sharp declines in home prices across the country. The second component of the Government intervention was the Federal Reserve's pledge to purchase $1.25 trillion of Agency MBS by the end of 2009. Year to date, as of the end of September 2009, the Fed had purchased $905 billion Agency MBS, while net supply was only $448 billion. \13\ Thus, the Fed has purchased roughly 200 percent of the year-to-date net supply. Naturally, this purchase program has reduced the spread between the yields on Agency MBS and Treasuries; we estimate the reduction to be roughly 50 basis points. As of this week, the conforming-balance \14\ 30-year fixed mortgage rate is approximately 4.85 percent, which is very close to a generational low. \15\--------------------------------------------------------------------------- \13\ Source: JPMorgan, ``Fact Sheet: Federal Reserve Agency Mortgage-Backed Securities Purchase Program''. \14\ As of 2009, for the contiguous States, the District of Columbia and Puerto Rico, the general conforming limit is $417,000; for high-cost areas, it can be as high as $729,500. \15\ Source: HSH Associates, Financial Publishers.--------------------------------------------------------------------------- In contrast, the new-issue private-label MBS market has received no Government support and is effectively shut down. From 2001 to 2006, issuance in this market had increased almost four-fold from $269 billion to $1,206 billion. \16\ But when the financial crisis hit, the issuance quickly fell to zero. Issuance in 2007, 2008 and 2009 has been $759 billion, $44 billion and $0, respectively. \17\ Virtually the only source of financing for mortgage above the conforming-loan limit (so-called ``Jumbo loans'') is a bank loan. As a result, for borrowers with high-credit quality, the Jumbo mortgage rate is about 1 percentage point higher than its conforming counterpart. \18\--------------------------------------------------------------------------- \16\ Source: Loan Performance. \17\ Source: Loan Performance. \18\ Source: HSH Associates, Financial Publishers.--------------------------------------------------------------------------- At first glance, the higher cost of Jumbo financing may not seem to be an issue that should concern policymakers, but what is bad for this part of the mortgage market may have implications for other sectors. If the cost of Jumbo financing puts downward pressure on the price of homes costing (say) $800,000, then quite likely there will be downward pressure on the price of homes costing $700,000, and so forth. Pretty soon, there is downward pressure on homes priced below the conforming limit. In my opinion, at the same time that policymakers deliberate the future of the Fannie Mae and Freddie Mac, they should consider the future of the mortgage financing in all price and credit-quality tiers.Recommended Legislative and Regulatory Changes The breakdown in the securitization process can be traced to four root causes: aggressive underwriting, overly complex securities, excessive leverage, and an over-reliance on the rating agencies by some investors. Such flaws in the process have contributed to the current financial crisis. However, when executed properly, securitization can be a very effective mechanism to channel capital into our economy to benefit the consumer and commercial sectors. Keep in mind that securitization began with the agency mortgage market, which has successfully provided affordable mortgage financing to millions of U.S. citizens for over 35 years. \19\ To ensure that the lapses of the recent past are not repeated, I recommend that regulatory and legislative efforts be concentrated in four key areas.--------------------------------------------------------------------------- \19\ Fannie Mae, Freddie Mac, and Ginnie Mae issued their first MBS in 1981, 1971, and 1970, respectively. Source: ``Fannie Mae and Freddie Mac: Analysis of Options for Revising the Housing Enterprises Long-term Structures'', GAO Report to Congressional Committees, September, 2009.--------------------------------------------------------------------------- First, promote improved disclosure to investors at the initial marketing of transactions as well as during the life of the deal. For example, originators should provide detailed disclosure on the collateral characteristics and on exceptions to stated underwriting procedures. Furthermore, there should be ample time before a deal is priced for investors to review and analyze a full prospectus, not just a term sheet. Second, strong credit underwriting standards are needed in the origination process. One way to support this goal is to discourage the up-front realization of issuers' profits. Instead, issuers' compensation should be aligned with the performance of the security over its full life. This issue is complex, and will likely require specialized rules, tailored to each market sector. Third, facilitate greater transparency of the methodology and assumptions used by the rating agencies to determine credit ratings. In particular, there should be public disclosure of the main assumptions behind rating methodologies and models. Furthermore, when those models change or errors are discovered, the market should be notified. Fourth, support simpler, more uniform capital structures in securitization deals. This goal may not readily be amenable to legislative action, but should be a focus of industry best practices. Taking such steps to correct the defects of recent securitization practices will restore much-needed confidence to this critical part of our capital markets, thereby providing improved liquidity and capital to foster continued growth in the U.S. economy. Additional Material Supplied for the Record Prepared Statement of the Mortgage Bankers Association The Mortgage Bankers Association (MBA) \1\ appreciates the opportunity to provide this statement for the record of the Senate Banking Securities, Insurance, and Investment Subcommittee hearing on the securitization of assets.--------------------------------------------------------------------------- \1\ The Mortgage Bankers Association (MBA) is the national association representing the real estate finance industry, an industry that employs more than 280,000 people in virtually every community in the country. Headquartered in Washington, DC, the association works to ensure the continued strength of the Nation's residential and commercial real estate markets; to expand homeownership and extend access to affordable housing to all Americans. MBA promotes fair and ethical lending practices and fosters professional excellence among real estate finance employees through a wide range of educational programs and a variety of publications. Its membership of over 2,400 companies includes all elements of real estate finance: mortgage companies, mortgage brokers, commercial banks, thrifts, Wall Street conduits, life insurance companies and others in the mortgage lending field. For additional information, visit MBA's Web site: www.mortgagebankers.org.--------------------------------------------------------------------------- Asset-backed securities are a fundamental component of the financial services system because they enable consumers and businesses to access funding, organize capital for new investment opportunities, and protect and hedge against risks. As policymakers evaluate securitization's role in the recent housing finance system's disruptions, MBA believes it is important to keep in mind the benefits associated with securitization when it is used prudently by market participants. Securitization describes the process in which relatively illiquid assets are packaged in a way that removes them from the institution's balance sheet and sold as more liquid securities. Securities backed by residential or commercial mortgages are an example of asset securitization. Securitization is an effective means of risk management for many institutions. For example, the accumulation of many loans in a single asset sector creates concentration risk on a financial institution's balance sheet. If that sector becomes distressed, these large concentrations could place the solvency of the financial institution at risk. However, securitization provides a remedy to avoid concentration risk by disbursing the exposure more widely across the portfolios of many investors. In this way, the exposure of any one investor is minimized. As demonstrated by the current business cycle however, if the entire system is hit by a significant systemic shock, all investors will face losses from these exposures, as diversification does not protect investors from systemic events. Securitization also enables various market sectors to create synergies by combining their particular areas of expertise. For example, community-based financial institutions are known for their proficiency in originating loans because of their relationships with local businesses and consumers, and their knowledge of local economic conditions. Securitization links these financial institutions to others that may be more adept at matching asset risks with investor appetites. As the last 2 or 3 years have demonstrated, when it is not understood, or poorly underwritten, securitization can cause meaningful harm to investors, lenders, borrowers and other segments of the financial services system. Since the economic and housing finance crisis began, investors have shunned securitization products, including mortgage-backed securities (MBS), particularly those issued by private entities. As a result, central banks and governments have taken up the slack with various programs to support securitization markets. MBA believes this has been an important, yet ultimately unsustainable, course of action. One key to the process is to create an environment where investors can accurately evaluate the risks in the various investment opportunities available to them, and have confidence that their analysis of the risk is consistent with what the underlying risk will turn out to be. No investments are risk-free. But reliable instruments allow responsible investors to evaluate whether the instrument's risk profile is within the boundaries of an investor's risk tolerance. When considering how to reestablish a safe and sound environment for securitization of real estate-related assets, MBA believes the following components must be addressed: Risk Assessment: Risk assessment is an imperfect science, but it is crucial for securitization to enable accurate, effective, and stable risk assessment. Equally important, third-party assessments of risk must be highly credible to be widely used or adopted. Aligning Risks, Rewards, and Penalties: A key consideration for the market going forward will be ensuring the alignment of risks with rewards and penalties. Loan attributes, such as whether a loan is adjustable-rate or fixed rate, or does or does not have a prepayment restriction, shift risks between the borrower and the investors. If investors or other market participants are not accountable for the risks they take on, they are prone to act irresponsibly by taking on greater risks than they otherwise would. Aligning Rewards With Long-Term Performance: Given the long-term nature of a mortgage contract, as well as the imperfect state of risk assessment, some risks inherent in a mortgage asset may not appear for some time after the asset has changed hands. It is important to consider the degree to which participants in the mortgage process can be held accountable for the long-term performance of an asset. Ensuring Capital Adequacy of Participants: Participants throughout the market need adequate levels of capital to protect against losses. Capital adequacy is keenly dependent on the assessment of risks outlined above. The greater the risks, as assessed, the greater the capital needed. In times of rapid market deterioration, when model and risk assumptions change dramatically, capital needs may change dramatically as well. If market participants that have taken on certain risks become undercapitalized, they may not be able to absorb those risks when necessary--forcing others to take on unanticipated risks and losses. Controlling Fraud Between Parties in the System: A key consideration for effective securitization is the degree to which fraud can be minimized. Key considerations include the ability to identify and prosecute fraud, and the degree to which fraud is deterred. Transparency: In order to attract investors, another key consideration for securitization is transparency. The less transparent a market is, the more poorly understood it will be by investors, and the higher will be the yield those investors demand to compensate for the uncertainty. The task of improving transparency and accountability involves both policy and operational issues. Public debate typically focuses on the policy issues--what general types of information should be disclosed, and who should share and receive this information. However, the operational issues are equally important to establishing and implementing a functional system that promotes and supports the goals of transparency and accountability. We are submitting testimony today to stress the importance to market transparency and investor confidence of better loan tracking and more accessible, complete, and reliable loan and security data across the primary and secondary mortgage markets.Loan and Security Tracking Improving transparency in the real estate finance system is considered essential to restoring investor confidence in the securitization market. Because the real estate finance system embraces multiple parties--loan originators, loan aggregators (servicers) and securitizers--we need transparency solutions that flow from and span the complete mortgage value chain. The goal, we think, is relatively easy to state: key information about mortgages, the securities built upon those mortgages, and the people and companies that create them, should all be linked and tracked over time, so our financial system is more transparent and the strengths and risks of various products can be properly assessed and appreciated. Loans need to be tracked, for example, to help identify fraud and distinguish the performance of various mortgage products and securities types. Just as the vehicle identification number, or ``VIN,'' has evolved from a simple serial number into a valuable tool for consumers, enabling a potential purchaser to research the history of any car or truck, a comprehensive mortgage/security numbering system would be the key to tracking MBS history and performance. Achieving such a goal is very doable because the essential components are already in place. With relatively minor modifications these existing systems can evolve into the tools necessary to meet the challenge of transparency and accountability. On the mortgage end of the value chain there is MERS. \2\ This national loan registry is already used by virtually all mortgage originators, aggregators, and securitizers to track individual mortgages by means of a unique, 18-digit Mortgage Identification Number, or ``MIN.'' For each registered mortgage, the MIN and the MERS database tracks information regarding the originator, the borrower, the property, the loan servicer, the investors, and any changes of ownership for the life of the loan. MERS currently tracks more than 60 million loans and is embedded in every major loan origination system, servicing system, and delivery system in the United States, so total adoption would be swift and inexpensive.--------------------------------------------------------------------------- \2\ ``MERS'' is formally known as MERSCORP, Inc., and is the owner and operator of the MERS System. MBA, along with Fannie Mae, Freddie Mac, and other industry participants, is a shareholder in MERS.--------------------------------------------------------------------------- On the securitization end of the value chain, the American Bankers Association has a product called CUSIP that generates a 9-digit identification number for most types of securities, including MBS. The CUSIP number uniquely identifies the company or issuer and the type of security instrument. Together, these two identifiers solve the loan and security tracking problem, with the MIN tracking millions of individual mortgage loans and the CUSIP tracking thousands of unique financial instruments created each year in the United States. Loan-level information for every mortgage and mortgage-backed security would be available at the touch of a button, for example, the credit rating agencies would have needed information to assess more accurately the risk of a given security and track its performance relative to other securities over time. As the Congress looks to reform the capital markets, it should require that these two complementary identification systems be linked and that they be expanded in scope to track the decisions of all market participants--originators, aggregators and securitizers. In this way, throughout the value chain, participants that contributed to the creation of high-risk mortgages and selling of high-risk securities may be identified and held accountable. With a system like this in place, the Congress, regulators and the market as a whole would have a means of distinguishing with much more precision the quality of financial products and could enforce the discipline that has not been previously possible.Data Standards The Mortgage Industry Standards Maintenance Organization, Inc. (``MISMO'') \3\ has been engaged for the past 8 years in developing electronic data standards for the commercial and residential real estate finance industries. These standards, which have been developed through a structured consensus-building process, are grounded in the following principles that we believe characterize a robust, transparent system of data reporting:--------------------------------------------------------------------------- \3\ MISMO is a wholly owned subsidiary of the Mortgage Bankers Association. First, there must be concrete definitions of the data elements that are going to be collected, and these definitions must be common across all the related products in the market. Different products (such as conforming and nonconforming loans) may require different data elements, but any data elements that are required for both products should have the same --------------------------------------------------------------------------- definitions. Second, there should be a standardized electronic reporting format by which these data elements are shared across the mortgage and security value chain and with investors. The standards should be designed so that information can freely flow across operating systems and programs with a minimum of reformatting or rekeying of data to facilitate desired analytics. Rekeying results in errors, undermining the reliability of data. MISMO's standards are written in the XML (Web based) computer language. This is the language used in the relaunch earlier this week of the Federal Register's Web site. As reported in The Washington Post on October 5, 2009, this Web site has been received with great praise for allowing researchers and other users to extract information readily from the Register for further analysis and reuse without rekeying. Mortgage and securities data transmitted using MISMO's data standards can similarly be extracted and used by investors and regulators for customized analytics. XML is also related to and compatible with the XBRL web language that the Securities and Exchange Commission (SEC) is implementing for financial reporting. Third, the definitions and the standards should be nonproprietary and available on a royalty-free basis, so that third-parties can easily access and incorporate those standards into their work, whether it be in the form of a new loan origination software package or an improved analytical tool for assessing loan and security performance or fraud detection. Fourth, to the extent that the data includes nonpublic personal information, the system must maintain the highest degree of confidentiality and protect the privacy of that information. True transparency requires that information is not only available, but also understandable and usable. The incorporation of these four principles into any new data reporting regime will help ensure that the goal of transparency and accountability is realized. We believe that the standards of MISMO and MERS satisfy these elements for the conforming mortgage market. Their relative positions in the real estate finance process provide them with unique insight and an objective perspective that we believe could be very useful to improving transparency and accountability in the nonconforming market. Increasing the quality and transparency of loan-level mortgage and MBS-related data is an essential step so that investor confidence may be restored and the risk of a similar securitization crisis of the kind we are experiencing in the future can be minimized. This objective is paramount to all market participants, and as such all participants have an interest in achieving a solution. However, because it is so critical, the ultimate solution must also be able to withstand the scrutiny of investors, Government regulators, and academics. It must be widely perceived as a fair, appropriate, and comprehensive response to the challenges at hand. In conclusion, MBA reiterates its request for Congress and other policymakers to be mindful of the important role of securitization to housing finance and the entire financial services system. As the Congress looks to reform the capital markets, we look forward to working with you to developing a framework with a solid foundation based on the key considerations outlined above." CHRG-111shrg53176--134 Mr. Ketchum," Well, I appreciate that. As you know, the FINRA Investor Education Foundation is the largest foundation solely focused on investor education, and given that we both feel good about the progress we have made and recognize the enormity of the task, we have tried to, as best we can, both through placing a rich series of informative efforts on our Web site at finra.org and efforts to try to attract investors to look at those various different pieces of information, efforts to identify everything from questions to ask with respect to complex products to things to be concerned about with respect to potential scams, as well working very closely with some of the most vulnerable constituencies, particularly from the standpoint of our seniors, our military, et cetera. I think the only answer with respect to investor education is to keep on going on with more and more resources and more and more cooperation between enterprises that have constituencies and concern with respect to this area. And you are right. It can't just be with respect to investors that exist today. It has to be a strong effort from the standpoint of our schools, as well. But we are very much committed to be part of that process. It is something that deserves more attention from a governmental standpoint and more attention across any of us that cares deeply about the quality of our securities markets. Senator Akaka. Thank you very much for that. I want to pose this next question to a person that I knew in the House, Representative Baker. I think you left there, or you were there when I left there, in the House and moved to the Senate. But it is good to see you again. " CHRG-110shrg38109--43 Chairman Bernanke," Senator, you are quite correct that productivity began to grow more quickly in the United States about a decade ago, and that has been a very important factor in the strength of our economy. In 1995, we saw a step-up in productivity growth from 1.5 to 2.5 percent, which seems to have been driven primarily by improved and more efficient methods of producing high-tech equipment--faster computers, stronger, better communications equipment, and the like. Over the succeeding few years--and, in fact, we saw productivity growth step up further around 2000--those technological innovations had been diffused through the economy and helping industries across the economy manage their production and distribute their output more efficiently, and reduce costs and increase productivity. So in some sense, the underlying factor is the technological change, the investment in information and communications technologies, and the diffusion of those technologies throughout the economy. Now, you ask, quite properly, why we have seen better results here in the United States than in some other countries, and I have given some speeches on that subject. I do believe that it is the interaction of the new technologies and our flexible dynamic economic system. That includes flexible labor markets that can adjust to changes in the market associated with technological change. That includes deep and liquid capital markets that can allocate capital toward new ventures, toward new technologies. And I believe that flexibility has been essential in helping us take technological advances and create from them economic benefits. This relates to my answer to Chairman Dodd that we need to maintain that flexibility in our economy and that providing broad opportunity and education is one way to support that going forward. Senator Shelby. Mr. Chairman, I want to get to another part of your responsibilities, and that is, bank regulation. Regulation Z, Senator Dodd has already referred to this. The Banking Committee held a hearing on the credit card industry that was widely followed. Witnesses at the hearing highlighted a number of troubling industry practices, many of which are subject to Federal Reserve oversight. I understand that the Federal Reserve Board is currently reviewing its Regulation Z, which implements the Truth in Lending Act. What is the status of the Board's Regulation Z review? And does the Board intend to use this review to address any of the questionable industry practices raised in the Committee's hearing? " CHRG-111hhrg51698--459 Mr. Concannon," Thank you, Chairman Peterson, Ranking Member Lucas, and other Members of the Committee, for the invitation to speak today on this important legislation. You may be wondering why NASDAQ OMX, the operator of the largest equities exchange in the world, is testifying on OTC derivatives. Well, we currently own and operate 17 markets and eight clearinghouses in trade equities, fixed income, derivatives, and energy products around the globe. While I must admit that we have some self-interest in the reform of OTC derivatives, our interest is the product of almost 4 decades of experience in delivering efficient and transparent markets to investors. Over the past several years, trillions of dollars of investment instruments have been crafted through an unregulated web of interconnected counterparty relationships. Because these instruments are not valued in a transparent, efficient market with the opportunity for centralized clearing, unrecognized risk continues to be piled upon unrecognized risk. We at NASDAQ are confident of the beneficial effects of centralized clearing, transparency, and regulation for the OTC markets. It is possible to transform an OTC market to one that is centrally cleared and visible to all. We have done it. When NASDAQ was founded 37 years ago, our primary mission was to bring order, discipline, and fairness to the over-the-counter equities market. What we know from our experience is simple yet revolutionary for this market. These OTC instruments need to be centrally cleared to better distribute or mutualize the risk. Central clearing fundamentally means more parties are backing a transaction versus one or just a few. NASDAQ OMX recently became the majority owner of the International Derivatives Clearing Group, IDCG, a CFTC-registered clearing organization. IDCG has developed an integrated derivatives trading and clearing platform that will allow members to convert their OTC interest rate swaps into a cleared future product with the full benefits of centralized clearing. Building on decades of experience, NASDAQ OMX is bringing the values of organized markets, including central clearing, standardized margin, transparency, and real valuations, to what is a $458 trillion interest rate swap market. While there has been much discussion around the CDS market, you should be aware that the interest rate swap market is six times larger. IDCG is live today, operating a highly efficient market to clear and settle U.S. dollar-denominated interest rate swaps. I must commend the CFTC for its thorough review and professional timeliness in approving IDCG's operation December of last year. Thus, NASDAQ OMX is highly supportive of provisions in section 13 of your legislation that would protect our financial system and investors by requiring most OTC derivatives to be settled and cleared. In addition, we support the need to set some limited exemptions for derivatives that may contain complex contractual aspects rendering them inappropriate for clearing. Let me highlight one benefit of central clearing of interest rate swaps within the banking system. Current regulatory capital treatment for derivatives applies a higher capital charge for bilateral uncleared holdings. Simply, under accounting rules and international treaties such as BASEL I and BASEL II, bilateral trading of OTC derivatives introduces systemic risk while creating an extremely inefficient use of capital. We believe the entire financial system would benefit from a large capital infusion as a result of simply mandating centralized clearing. Capital efficiency is also greatly enhanced by the process of netting. With central clearing, financial institutions can net out their positions across the entire market and further reduce their required capital reserves, while at the same time reducing the complexity and risk of the bilateral world. We also support the efforts by the Federal Reserve, the FDIC, and the Office of Comptroller to evaluate the need for enhanced regulatory capital charges for non-cleared OTC transactions. We think that customers that use these derivatives should also demand that their transactions be subjected to clearing. According to a recent Bloomberg story, several State Attorneys General are investigating the opaque fees several local governments paid to obtain interest rate and other derivatives to hedge swings in borrowing costs for schools, states, and cities. We know that the larger issues of financial regulatory reform are beginning to receive consideration. We believe that it is important to apply modern regulatory concepts like principle-based regulation, practiced successfully by the CFTC and regulators around the world. Finally, we must be mindful that these OTC instruments ignore international borders. So we agree with President Obama that these issues cannot be handled with domestic action alone. For many reasons, working through multilateral structures like the G20 will ensure that global markets work together in what is a global problem. In this way, we will ensure that regulatory arbitrage is minimized and market participants are not driven to engage in jurisdiction shopping. Again, thank you for the invitation. I am happy to take questions. [The prepared statement of Mr. Concannon follows:] Prepared Statement of Christoper R. Concannon, Executive Vice President, Transaction Services, NASDAQ OMX, New York, NY Thank you Chairman Peterson and Ranking Member Lucas for the invitation to speak to you this morning regarding your legislation, the Derivatives Markets Transparency and Accountability Act of 2009. Some of you may be wondering why NASDAQ OMX, the operator of the world's largest cash equities exchange, is testifying regarding OTC derivatives. Well, NASDAQ OMX owns and operates 17 markets and eight clearing houses around the globe. Our markets trade equities, derivatives and fixed income products. Not only do we pride ourselves in operating our markets efficiently, but we are exceptionally proud of the efficiencies that we have delivered to these markets. In regards to OTC derivatives, I will admit that we have self interest in the reform of these markets. But this self interest is the product of almost 4 decades of experience in delivering efficiency and transparency to the financial markets. When we examine your legislation we see a policy initiative that will bring fundamental change to a market that is defined by counterparty risk, unknown systemic risk and opaque markets. While we continue to deal with the worst financial crisis since World War II, we can't simply wait for it to end before we study and implement needed reforms. Reforms can and should be implemented now. As your legislation recognizes, over the past several years and throughout the economy, trillions of dollars in investment instruments have been crafted through an unregulated web of interconnected, counterparty relationships. Even after all the billions in Federal subsidies, the books of banks and businesses are littered with these complex instruments whose value is opaque and potentially mispriced. These particular credit instruments continue to be traded in what's known as the over-the-counter or OTC market. Because these instruments are not valued in a transparent, efficient market with the opportunity for centralized clearing, unrecognized risk continues to be piled upon unrecognized risk. The negative aspects of the over-the-counter market have been documented well by the hearings of this Committee. There is no need to further expand on those findings. It is now time to implement change both by government action and by the markets themselves. The markets and clearing houses that sit before you today are here to explain how our markets worked throughout this horrible crisis. Very few people can sit before Congress today and explain how their systems discovered prices everyday; how their clearing houses absorbed the impact of major defaults such as Lehman; or how they were able to settle each and every trade. We represent the markets that worked while the OTC markets represent the opaque market that tied these unsuspecting victims into a complex web of financial disaster. The point is--centralized clearing worked as designed and it worked in many asset classes around the globe. We at NASDAQ are confident of the beneficial effects of centralized clearing, transparency and regulation for the OTC markets. NASDAQ made its name by being a pioneer in the over-the-counter cash equities market. Until NASDAQ came on the scene, the cash equities market also once operated similar to the current OTC derivatives market. NASDAQ was born out of a need to share information about stock trading in a central fashion, accessible to all, with a system designed to protect investors and facilitate discovery of the right price for each stock. We continue to operate on a simple principle that is the foundation of all markets: An informed and willing buyer and an informed and willing seller agreeing to trade is the best valid price discovery mechanism. It is possible to transform an over-the-counter market to one that is centrally cleared and visible to all. We have done it; when NASDAQ was founded 37 years ago our primary mission was to bring order, discipline and fairness to the over-the-counter equities market. What we know from our experience is simple, yet revolutionary for this market: These OTC instruments need to be centrally cleared to better distribute or mutualize the risk. Central clearing fundamentally means more parties are backing a transaction versus one or just a few. Centralized clearing gathers strength from more parties while delivering capital efficiency through the benefits of netting multiple risk exposures. Building on the decades of experience, NASDAQ OMX is bringing the values of organized markets including central clearing, standardized margin, transparency, and real valuations to what the Bank for International Settlements estimates is a $458 trillion over-the-counter interest rate swap market. While there has been much discussion about the credit default swap market, you should be aware that the interest rate swap market is six times larger than the credit default swap market. As you may know, NASDAQ OMX recently became the majority owner of the International Derivatives Clearing Group (IDCG). IDCG, an independently operated subsidiary of The NASDAQ OMX Group, has developed an integrated derivatives trading and clearing platform. IDCG is transforming the interest rate swap marketplace, allowing members to convert their OTC swaps into a cleared future product with the full benefits of central clearing. This CFTC approved platform will provide an efficient and transparent venue to trade, clear and settle interest rate swap (IRS) futures. One of the most compelling attributes of our IDCG endeavor is that it allows for all forms of execution. We have the ability to allow customers the flexibility to operate their business as they have, but with an independent and standardized view of the risk. This independence is the absolute core of a centrally cleared market place. By concentrating its focus on risk, IDCG can be open to multiple forms of execution. This flexibility allows for more of the market to participate in an open and consistent manner while all of the risk is marked-to-market by the same benchmark. I must commend the Commodity Futures Trading Commission (CFTC) for its thorough review coupled with professional timeliness in approving the application for IDCG to operate. With CFTC approval of IDCG's Derivatives Clearing Organization (DCO) license on December 22, 2008, IDCG is ``live'' today; operating a highly efficient market to clear and settle U.S. dollar denominated interest rate swap futures. We, along with IDCG, look forward to the day when vast parts of the over-the-counter market are no longer stored in the back-rooms of brokerage houses but are held in well-capitalized clearing houses transparent to all--including the regulators and public policymakers. Thus, NASDAQ OMX is highly supportive of provisions in section 13 of your legislation that would protect our financial system and investors by requiring most OTC derivatives be settled and cleared. We believe this section is good public policy and hope to see it enacted into law. In addition, we support the ability of the CFTC to set some limited exemptions for derivatives that may contain complex contractual aspects rendering them inappropriate for clearing. Let me offer one benefit of clearing in the interest rate swap space that will have an immediate and direct positive impact on the banking system. Current regulatory capital treatment for derivatives held by banks and other financial institutions applies a higher capital charge for bilateral, uncleared, holdings. If existing banks cleared their interest rate swap transactions through a central clearing house, significant capital would be released for the banks to apply to new lending or against other assets. Simply, under the current accounting rules, insolvency laws and international treaties (such as BASEL I & II), the current method of bilateral trading is not only less efficient--it is a more expensive use of capital. We believe the entire financial system would benefit from a capital infusion as a result of mandating centralized clearing. To put it as succinctly as I can, centralized clearing reduces the market, counterparty, and operational risk of a portfolio. In addition, it can also reduce capital requirements that today, unfortunately, are often being supplied with non-performing taxpayer money. Capital efficiency is greatly enhanced in conjunction with another benefit of central clearing: the process of netting. With central clearing, financial institutions can ``net'' out their positions across the entire market and further reduce their required capital reserves while at the same time reducing the complexities and risk of the bilateral world. We also support efforts by the Federal Reserve, the FDIC and the Office of the Comptroller to evaluate the need for enhanced regulatory capital charges for non-cleared OTC transactions. We, at NASDAQ, believe it is critical that all forms of risk are appropriately priced, and that regulatory capital rules provide meaningful incentives to drive OTC derivatives on to central clearing houses. We think that customers that use these derivatives should also demand that their transactions be subjected to clearing. According to a recent Bloomberg story, several State Attorneys General are investigating the opaque fees several local governments paid to obtain interest rate and other derivatives to hedge swings in borrowing costs for schools, states and cities--fees which were more difficult to challenge when neither information about execution pricing nor pricing of risk were publicly available. Certainly, if state and local governments adopted the mandate to only transact cleared products, the trend for clearing would be enhanced. The Bloomberg article is an addendum to my written testimony. We know that the larger issues of financial regulatory reform are beginning to receive consideration by you and your colleagues here in Congress. While we don't have detailed views on regulatory reform, we believe the key concept to keep in mind is to apply modern regulatory concepts like the principles-based approach to regulation practiced successfully by the CFTC and regulators around the world. We hope that the process of updating U.S. regulation will retain the CFTC's principle-based approach and expand that approach throughout our regulatory framework where appropriate. Mr. Chairman, NASDAQ OMX supports your interest in prohibiting over-the-counter trading of carbon offset credit futures. NASDAQ owns a carbon trading facility in Europe called NordPool. NordPool was the pioneer in carbon products--the first exchange worldwide to list carbon allowances (EUA) and carbon credits (CER). And, although NordPool is the number two marketplace for carbon in Europe, 70% of all trading now takes place in the OTC space, away from effective regulation and supervision. Therefore, it is impossible to know the exact volumes that are traded. Our experience in Europe suggest that the opaque use of OTC derivatives in the European Cap and Trade experiment contributed to the chaos and failure of that marketplace. We want NordPool to be part of the U.S. market solution for greenhouse gas emission reductions and look forward to working with you and the Committee towards ensuring that your legislation allows that expertise to be part of the equation. Finally, Mr. Chairman, we must be mindful that these OTC instruments ignore international borders and jurisdictions. So we agree with President Obama that these issues can not be handled only with domestic action. For many reasons, working through multilateral structures like the G20 will ensure that the global markets work together on what is a global problem. In this way we will ensure that regulatory arbitrage is minimized and market participants are not driven to engage in ``jurisdiction shopping.'' We understand that President Obama hopes to make these issues, and a coordinated global response, a key aspect of the G20 meeting in April and NASDAQ OMX supports the President's leadership on this matter. Again, thank you for inviting NASDAQ OMX to testify and for your efforts to bring transparency and order to these important marketplaces. We look forward to working with you and the full Committee membership as you seek to tackle these important public policy challenges. Additional ExhibitCalifornia Probes Muni Derivatives as Deficit Mounts (Update1)By William Selway and Martin Z. Braun[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT] The investigations center on the investments that schools, states and cities buy with the proceeds of some of the $400 billion of municipal bonds they sell annually and on the interest-rate swaps designed to guard against swings in borrowing costs, authorities have said. Financial advisers are hired to solicit bids for the investments and to determine if their government clients pay fair rates in swaps, which are unregulated instruments not traded on exchanges. States ``almost have no choice but to join in because it involves their towns and cities and maybe even the states themselves,'' said Christopher ``Kit'' Taylor, the former executive director of the Municipal Securities Rulemaking Board, the municipal bond industry regulator. ``They're sitting there saying this is a situation where we may have been taken.''Continuing Probes Christine Gasparac, a spokeswoman for California Attorney General Jerry Brown, confirmed California's participation. She declined to comment further. The probe comes as the most populous U.S. state and the biggest issuer of municipal debt struggles to close a record $42 billion deficit through next year and faces credit rating cuts on $67 billion of debt. Connecticut has had a continuing probe. ``Our investigation is active and ongoing,'' Connecticut Attorney General Richard Blumenthal said in a statement. Florida Attorney General Bill McCollum has sent out 38 subpoenas asking firms for information on sales of derivatives, including guaranteed investment contracts, where governments place money raised from bond sales until it is needed for projects, said Sandi Copes, a spokeswoman for McCollum. Among the documents Florida requested were bids and communications between the firms and financial advisers related to the purchase or sale of municipal derivatives, according to the subpoena. Copes declined to comment further, citing the pending investigation. U.S. prosecutors and the Securities and Exchange Commission have searched for more than 2 years for evidence of collusion between banks and brokers to overcharge cities, states and local government agencies.Winning Leniency In February 2007, Charlotte, North Carolina-based Bank of America Corp. was granted leniency by the Justice Department for its cooperation in a national investigation of bid-rigging and price fixing involving municipal derivatives. In exchange for voluntarily providing information and offering continuing cooperation, the Justice Department agreed not to bring criminal antitrust charges against the bank. Derivatives are contracts whose value is derived from assets including stocks, bonds, currencies and commodities, or from events such as changes in interest rates or the weather. ``This is a trillion-dollar market, and this goes back to the 1980s,'' said Michael D. Hausfeld, an antitrust lawyer representing municipalities, including Fairfax County, Virginia, in a class-action case against 30 banks.Rigged Bids Investigators are looking into whether bidding for guaranteed investment contracts was rigged. U.S. Internal Revenue Service rules require that the agreements be awarded by competitive bidding from at least three banks. Eight California municipalities, including Los Angeles, Fresno and San Diego County, filed civil class-action, or group lawsuits. The suits, most of which were consolidated with others in U.S. District Court in New York City, allege that banks colluded by deliberately losing bids in exchange for winning one in the future, providing so-called courtesy bids, secretly compensating losing bidders and allowing banks to see other bids. Brokers participated in the collusion by facilitating communication among banks and sharing in illegal profits, the civil class-action suits allege. Three advisers to local governments, CDR Financial Products Inc., Sound Capital Management Inc. and Investment Management Advisory Group Inc., were searched by the FBI in November 2006. More than a dozen banks and insurers were subpoenaed and former bankers at New York-based JPMorgan Chase & Co., Bear Stearns & Cos. and UBS AG of Zurich were advised over the past year that they may face criminal charges.New Mexico Now, Federal prosecutors are investigating whether New Mexico Governor Bill Richardson's Administration steered about $1.5 million in bond advisory work to CDR, which donated $100,000 to Richardson's political committees. CDR also advised Jefferson County, Alabama, on more than $5 billion of municipal bond and derivative deals. A combination of soaring rates on the bonds and interest-rate swaps is threatening the county with a bankruptcy that would exceed Orange County, California's default in 1994. Jefferson County paid JPMorgan and a group of banks $120.2 million in fees for derivatives that were supposed to protect it from the risk of rising interest rates. Those fees were about $100 million more than they should have been based on prevailing rates, according to James White, an adviser the county hired in 2007, after the SEC said it was investigating the deals. CDR spokesman Allan Ripp has said the company stands by the pricing of the swaps and said White's estimates were incorrect because they didn't take into account the county's credit profile, collateral provisions between the county and the banks and the precise time of the derivative trades. To contact the reporters on this story: Martin Z. Braun in New York at [Redacted].Last Updated: January 23, 2009 09:34 EST " CHRG-110shrg50414--30 STATEMENT OF SENATOR ROBERT P. CASEY Senator Casey. Mr. Chairman, thank you very much. I want to thank Secretary Paulson, Chairman Bernanke, Chairman Cox, and Director Lockhart for your presence here today. I think my reaction to the proposal that was sent by the Administration this weekend was similar to not just members of this Committee and others, but I think the American people, in a couple of ways. One was I thought it was far too broad a grant of authority to the Treasury Department, and I will talk more about that. But I think in terms of what was missing from it were a couple of basic features. First of all, I think it missed completely the idea of addressing directly the root cause of this problem, which you know started with foreclosures. And I know there has been work done this weekend to try to fill in that hole, fill in that blank. On Friday, I sent a letter both to you, Secretary Paulson and Chairman Bernanke, outlining a couple of things on housing. First of all, HOPE for Homeowners is a way to further amplify or expand our efforts in that area. The moratorium issue that Senator Brown, Senator Menendez, and Senator Schumer and I proposed. And also, an innovative way in the city of Philadelphia, where literally the city government, the court system intervened, to try to prevent foreclosures. And it is a very successful model. And I think there are other ideas that we will hear. I know that Chairman Dodd has made a series of proposals just in the last couple of days that I think are very instructive here and very helpful on transparency and accountability, the idea of oversight, certainly in the area of assistance for homeowners. So we are going to have a chance to review those today and in the next couple of days. I think overall, people are looking for--taxpayers and families are looking for a couple of things. They are looking for more oversight. They want to know that if a department of their Federal Government is given the opportunity to exercise power which involves the expenditure of maybe $700 billion, that there is some oversight by the elected officials and others who are charged with that responsibility. I think taxpayers have a real concern, obviously, a deep abiding concern about their own savings. What will this mean to their own livelihood, any kind of short-term livelihood, but especially long-term, in terms of their own personal savings. I think they know that we need more performing loans, not loans that are headed to foreclosure. And I think the bankruptcy strategy here, in terms of that enhancing our ability to modify loans, is central to achieving that kind of result where you have more performing loans instead of loans headed to foreclosure. But I think in the end what people are most concerned about is staying in their homes. We have got to do everything possible with limited time, I realize, and under duress and urgency, to do everything possible to keep people in their homes. And I think that is, in the end, what most Americans are concerned about. They are concerned about not just their own family, but their own neighborhoods. And it really comes down to peace of mind in so many ways. I would hope that in your efforts, and I know that you are trying to do this, but in your efforts to explain what has to happen to support financial institutions and other entities which will, in turn, strengthen our economy and help on Main Street, that you keep in mind what individual families are up against. In my home State of Pennsylvania, which has been spared somewhat, in a relative sense, what other States have gone through, the foreclosure crisis got a lot worse in August of 2008 compared to August of 2007, up 60 percent, a much higher rate than the rest of the country. And then if you add the foreclosure problem in a State like Pennsylvania and add the other challenges that people have, with gas prices, health care costs, the costs of education. One that stood out for me is child care. If you are a family in Pennsylvania and you have got two kids, your monthly cost for child care is $1,311. That is weighing on people as they worry about making the house payment this month and next month and all these months ahead of us. So I would urge you, as we finalize a proposal, I know we are trying to work together to make this happen, that we keep in mind those families and their peace of mind and their economic security. Thank you very much. " FinancialCrisisReport--294 The lack of performance data for high risk residential mortgage products, the lack of mortgage performance data in an era of stagnating or declining housing prices, the failure to expend resources to improve their model analytics, and incorrect correlation assumptions meant that the RMBS and CDO models used by Moody’s and S&P were out of date, technically deficient, and could not provide accurate default and loss predictions to support the credit ratings being issued. Yet Moody’s and S&P analysts told the Subcommittee that their analysts relied heavily on their model outputs to project the default and loss rates for RMBS and CDO pools and rate RMBS and CDO securities. (b) Unclear and Subjective Ratings Process Obtaining expected default and loss analysis from the Moody’s and S&P credit rating models was only one aspect of the work performed by RMBS and CDO analysts. Equally important was their effort to analyze a proposed transaction’s legal structure, cash flow, allocation of revenues, the size and nature of its tranches, and its credit enhancements. Analyzing each of these elements involved often complex judgments about how a transaction would work and what impact various factors would have on credit risk. Although both Moody’s and S&P published a number of criteria, methodologies, and guidance on how to handle a variety of credit risk factors, the novelty and complexity of the RMBS and CDO transactions, the volume and speed of the ratings process, and inconsistent applications of the various rules, meant that CRA analysts were continuously faced with issues that were difficult to resolve about how to analyze a transaction and apply the company’s standards. Evidence obtained by the Subcommittee indicates that, at times, ratings personnel acted with limited guidance, unclear criteria, and a limited understanding of the complex deals they were asked to rate. Many documents obtained by the Subcommittee disclosed confusion and a high level of frustration from RMBS and CDO analysts about how to handle ratings issues and how the ratings process actually worked. In May 2007, for example, one S&P employee wrote: “[N]o body gives a straight answer about anything around here …. [H]ow about we come out with new [criteria] or a new stress and ac[tu]ally have clear cut parameters on what the hell we are supposed to do.” 1143 Two years earlier, in May 2005, an S&P analyst complaining about a rating decision wrote: “Chui told me that while the three of us voted ‘no’, in writing, that there were 4 other ‘yes’ votes. … [T]his is a great example of how the criteria process is NOT supposed to work. Being out-voted is one thing (and a good thing, in my view), but being out-voted by mystery voters with no ‘logic trail’ to refer to is another. ... Again, this is exactly the kind of backroom decision-making that leads to inconsistent criteria, confused analysts, and pissed-off clients.” 1144 1143 5/8/2007 instant message exchange between Shannon Mooney and Andrew Loken, Hearing Exhibit 4/23-30b. 1144 5/12/2005 email from Michael Drexler to Kenneth Cheng and others, Hearing Exhibit 4/23-10c. In a similar email, S&P employees discuss questionable and inconsistent application of criteria. 8/7/2007 email from Andrew Loken to Shannon Mooney, Hearing Exhibit 4/23-96a (“Back in May, the deal had 2 assets default, which caused it to fail. We tried some things, and it never passed anything I ran. Next thing I know, I’m told that because it had 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-111hhrg46820--119 Chairwoman Velazquez," Ms. Clarke? Ms. Clarke. I think you took my question, Mr. Schrader, but I will try. Ms. Dorfman, I just want to thank you for testifying today because I believe the U.S. Women's Chamber of Commerce is a great organization and is always in the forefront of fighting for women-owned businesses. On October 28th of 2008, you had testified before this committee that Congress should take legislative action to help restore the flow of credit and capital to small business owners as soon as possible. In particular, you mentioned that the SBA should relax the rules on credit worthiness and job creation requirements. Can you give us a little bit more insight into--and give us some guidance as to how we can achieve this? Ms. Dorfman. Sure. Thank you very much. What we see out there is that--I mentioned the credit cards--small businesses, women-owned firms in particular, rely heavily on using their credit cards when they have a shortfall of funding. Additionally, when we look at the housing market, the loans that have been given to them have relied on their equity in their home or, if they are looking to get a new loan, it always attaches their home to it. So the equity that might have been there in the past won't be there now. So those are some of the issues. If we can allow some of the SBA funding to be used for maybe the credit card debt that they have already taken out, which in the past has not been the case, doing some of those innovative funding for the loans, I think that would ease the pain greatly. Ms. Clarke. Can you just quickly speak to the job creation requirement? Ms. Dorfman. Sure. Right now what we are seeing is our members are struggling to keep their doors open and keep the employees that they already have. If you were to say we will give you some money, but you have to hire--and I think there is something out there about a $3,000 and then you get--but you need to hire somebody if we have that. And we are talking about a job that might be $50,000 for an employee. That doesn't even cut it and they are struggling to keep their doors open. It doesn't make a lot of sense right now. Ms. Clarke. So would you then think or say that if we incentivized employee retention-- Ms. Dorfman. Yes. Ms. Clarke. --that would help at least to just sort of stabilize things, and were the SBA able to do some sort of refinancing-- Ms. Dorfman. Yes. Ms. Clarke. --for those businesses, this that would be a helpful tool. Ms. Dorfman. Absolutely. That would be great. Thank you. Ms. Clarke. Thank you, Madam Chair. " CHRG-111hhrg63105--24 Mr. Chilton," Thank you, Mr. Chairman. I can say I just want to thank and congratulate Senator-elect Moran. It has been a pleasure working with you over the years, sir, and I look forward to continuing that. I look forward to the scrutiny we will get from Chairman Lucas in the future. I did want to say a special thanks to Chairman Peterson. You guys passed back in 2008 legislation dealing with speculation. You may have passed it twice in a bipartisan way. I know you brought it up on the floor twice in 2008. So I appreciate your foresight and your oversight of this agency over the years. I also want to thank my friend, Chairman Gensler, for being so helpful. His expertise of the markets and of finance has really helped us. The other Commissioners are pretty much folks that came from here, came from the Hill and we have ag backgrounds and we have some other backgrounds, too, but having Chairman Gensler there has made us better Commissioners and a better Commission. So I thank him. If you look back at just the last 10 years, the futures industry around the world has increased three-fold. Yet in the U.S. it increased five-fold. So a lot was going on. Between 2005 and 2008, we saw roughly $200 billion of speculative money, index money, hedge funds, pension funds; $200 billion came into these markets. Now, that happened to coincide with this commodity bubble. Wheat is around $7\1/2\-$8 now. It was at $24 then. Gasoline is--crude is like $87, $90 now. It went up to $147.27 in June 2008. As we all know and your constituents told you, they had concerns because gasoline was over $4. Whether or not that increase in the speculative interest, that $200 billion, caused that bubble is a point that obviously can be debated. Some people say, move along folks, nothing here. Some people say it drove the prices. I come out sort of in the middle and say that--agree with MIT and Oxford and Rice and Princeton and even Lincoln University in Missouri. They all say that it had some impact. So, how much you can debate. The increase in speculative limits since that time, if it was a concern in 2008 with the amount of speculation in the market, if it was a concern when Congress passed the law in July, it is even more of a concern now. Now, before I give you some new statistics, don't get me wrong: We don't have speculators, we don't have a market. They are critical. Full stop. We have to have them. But if you look at what is going on between June of 2008 and where we are today or where we were in October, we see more speculative positions in the futures markets than at any time in history, $149 billion. That is an increase in the energy complex of 47 percent since 2008, an increase in the metals complex of 20 percent, and an increase in the agriculture complex by 18 percent. So there has been this large influx. Now, the Chairman talked about all the rules and a number of Members have talked about the rules. There has been a flurry of activity. We have been going gangbusters. And the staff at the CFTC has been real inspirational. We all sort of talk about it every time we meet. At the same time, by and large, while these rules have been sort of trains that are on time, position limits have sort of derailed. And the reason is exactly what Congressman Moran alluded to, whether or not we have this data on swaps in order to meet the deadline of January. And there are a couple of points; first, I am not sure we do have the authority to delay. And this as appropriate language, Congressman Moran, I appreciate your point but to say that as appropriate is expansive enough of a definition to render the provision moot and meaningless, I think begs the question a little bit. I think we are required to implement it. I see no authority for us to delay, no legal authority. I asked the attorneys why we would delay. Second, I think it is needed now more than ever, because of those statistics I just cited to you. And third, there are ways that we can do this. There are things that we can do as Chairman-elect Lucas said in a deliberate fashion, not ad hoc and not hasty, sir, that we can do to start doing what Congress set as our goals in January. It may not be the full Committee but there are things that we can do now. I agree we don't want something hasty. We don't want to mess up markets. There are ways to go about this. So far what we have been talking about is how we just go ahead and wait, and we are talking about a delay, we are talking about not getting this data until next September or October. So I am just trying to do what Congress told us to do. You can have different interpretations. I have mine, and I am trying to do the best, I don't think we are--as I said, we are going to have a meeting tomorrow, we are not quite back on the track, but we can get there. Thank you Mr. Chairman. [The prepared statement of Mr. Chilton follows:] Prepared Statement of Hon. Bart Chilton, Commissioner, Commodity Futures Trading Commission, Washington, D.C. Mr. Chairman, Ranking Member Moran, Members of the Subcommittee, thank you for the opportunity to be with you today. In the last decade, we saw the U.S. futures industry grow five-fold when the rest of the world grew three-fold. In several years we saw over $200 billion come into regulated U.S. futures markets. This new money was primarily from speculators, much of which was held by speculators I call ``massive passives,'' those with a known, fairly price-insensitive trading strategy. Then, in 2008, we saw a huge commodity bubble. Wheat was at $24. Today it is around $8. Crude oil spiked to $147.27 and gas was at $4 per gallon. Then the economy and commodity prices all fell off a cliff. Did the new speculators, including the massive passives, contribute to that price volatility-volatility that had farmers and ranchers, small and large agribusinesses and other businesses alike all paying higher prices than they should? Researchers at Oxford, MIT, Princeton and Rice all say speculative interests had an impact on prices. Some have said the speculators drove prices. In fairness, some on the other side of the issue say there was no impact whatsoever. My take is somewhere in the middle. Speculators didn't drive prices, but they tagged along and helped to push them to levels, high and then low, that we would not have seen without them. Futures prices should, by and large, be based upon the fundamentals of supply and demand. We saw delinked commodity prices in 2008, and some of us are concerned that we see that taking place this year. Congress passed the Wall Street Reform and Consumer Protection Act in July. With more than 40 rules to be promulgated by our agency, Congress gave us expedited implementation dates for only nine regulations. For example, speculative position limits for energy and metals are to be implemented within 180 days and for the agricultural complex within 270 days. As someone who has been calling for these limits, and who appreciates the work of the Committee in this regard since 2008, the early implementation deadline is important. Large and small agribusinesses and other commercial businesses rely upon these markets to hedge their risks. They are having an increasingly difficult time doing so, in part I believe, because of large position concentrations of speculators. Don't get me wrong, without speculators there isn't a market. We need them. We want them. Too much concentration, however, can be problematic and has the possibility of contorting markets. Now today, we see even larger speculative positions than in 2008. In total, there is $149 billion in speculative money in these markets, representing an increase since June of 2008 of 47% in the energy complex, where we have seen a single trader with positions as high as 20%. In the metals markets, we've witnessed an increase in speculative contracts of 20% and one silver trader with roughly 40% of the market earlier this year. In the agricultural complex, speculative interests grew by 18% since June of 2008. All of this makes the implementation of position limits as Congress mandated important. Some have suggested, however, that we not implement the limits on time because we don't have all the swaps data we need. There is a point there. Congress didn't require that we promulgate the swaps data rule until next July, so how do we come up with a reasonable limit, particularly an aggregate limit, without that data? While this is a worthy point, there are ways to address it. I'd be pleased to explain several options. Some, however, inside and outside the agency have suggested we simply find a way around the law's implementation deadline. They suggest, for example, that we ``implement'' the position limit rule, but not make it ``effective'' until sometime much later. First, we have no such legal authority to do so. Second, that is exactly the type of dancing on the head of a legal pin Washington-speak that folks in the country are all too tired of--and they should be. We shouldn't be about getting around the law. We should be about working to do what we were instructed to do, to protect markets and help consumers. Congress passed the new law. We must implement it in a thoughtful manner. End of story in my book. Thank you for the opportunity to be with you. I'd be pleased to try to answer any questions. " CHRG-111hhrg48867--28 Mr. Ryan," Thank you, Chairman Frank, Ranking Member Bachus, and members of the committee. My testimony will detail the Securities Industry and Financial Markets Association's view on the financial market stability regulator, including the mission, purpose, powers, and duties of such a regulator. Systemic risk has been at the heart of the current financial crisis. While there is no single commonly accepted definition of systemic risk, we think of systemic risk as the risk of a systemwide financial breakdown characterized by a probability of the contemporaneous failure of a substantial number of financial institutions or of financial institutions or a financial market controlling a significant amount of financial resources that could result in a severe contraction of credit in the United States or have other serious adverse effects on global economic conditions or financial stability. There is an emerging consensus among our members that we need a financial market stability regulator as a first step in addressing the challenges facing our overall financial regulatory structure. We believe that the mission of a financial market stability regulator should consist of mitigating systemic risk, maintaining financial stability, and addressing any financial crisis. Specifically, the financial market stability regulator should have authority over all financial institutions in markets regardless of charter, functional regulator, or unregulated status. We agree with Chairman Bernanke that its mission should include monitoring systemic risk across firms and markets rather than only at the level of individual firms or sectors, assessing the potential for practices or products to increase systemic risk, and identifying regulatory gaps that have systemic impact. One of the lessons learned from recent experience is that sectors of the market, such as the mortgage brokerage industry, can be systemically important even though no single institution in that sector is a significant player. The financial market stability regulator should have authority to gather information from all financial institutions and markets, adopt uniform regulations related to systemic risk, and act as a lender of last resort. In carrying out its duties, the financial market stability regulator should coordinate with the relevant functional regulators, as well as the President's Working Group, in order to avoid duplicative or conflicting regulation and supervision. It should also coordinate with regulators responsible for systemic risk in other countries. Although the financial market stability regulator's role would be distinct from that of the functional regulators, it should have a more direct role in the oversight of systemically important financial organizations, including the power to conduct examinations, take prompt corrective action, and appoint or act as the receiver or conservator of such systemically important groups. These are more direct powers that would end if a financial group were no longer systemically important. We believe that all systemically important financial institutions that are not currently subject to Federal functional regulation, such as insurance companies and hedge funds, should be subject to such regulation. We do not believe the financial market stability regulator should play the day-to-day role for those entities. The ICI has suggested that hedge funds could be appropriately regulated by a merger of SEC and CFTC. We agree with that viewpoint. The collapse of AIG has highlighted the importance of robust insurance holding company oversight. We believe the time has come for adoption of an operational Federal insurance charter for insurance companies. In a regulatory system where functional regulation is overlaid by financial stability oversight, how the financial market stability regulator coordinates with the functional regulators is an important issue to consider. As a general principle we believe that the financial markets regulator should coordinate with the relevant functional regulators in order to avoid duplicative or conflicting regulation and supervision. We also believe the Federal regulator for systemic risk should have a tiebreaker, should have the ultimate final decision where there are conflicts between the Federal functional regulators. There are a number of options for who might be the financial market stability regulator. Who is selected as the financial stability regulator should have the right balance between accountability to and independence from the political process, it needs to have credibility in the markets and with regulators in other countries and, most importantly, with the U.S. citizens. Thank you, Mr. Chairman. [The prepared statement of Mr. Ryan can be found on page 115 of the appendix.] " CHRG-111hhrg56778--17 INSURANCE Ms. Frohman. Thank you, Chairman Kanjorski, and members of the subcommittee. Thank you for inviting me to testify today. My name is Ann Frohman and I am the director of insurance for the State of Nebraska. I am here today to testify on behalf of the National Association of Insurance Commissioners. I am in the areas of group supervision of insurance companies. Before delving into group supervision, I should note that a cornerstone of our system, which is critical to the supervising insurance groups, is our financial standards and accreditation program. The accreditation program is a set of strong baseline standards, practices, and required skill sets for effective solvency supervision. All 50 States are currently accredited, and to stay accredited, States must adopt any changes made to the program by insurance regulators. State insurance departments are periodically reviewed by a team of their peers to ensure compliance with the 40 specific standards and 226 specific elements necessary for accreditation. Out of necessity and for the sake of efficiency, the States have developed a strong system of cross-border supervision and coordination. Multiple jurisdictions provide peer review for insurance groups that contribute to a race-to-the-top approach. There is also routine coordination with lead State regulators of insurer groups as well as free coordination with other functional regulators when insurers are affiliated with other financial sectors. All States and the District of Columbia have adopted the NAIC's Insurance Holding Company System Regulatory Act, designed to regulate transactions among insurers and other affiliated entities. This Act also regulates mergers and acquisitions, standards for transactions, and holding company information. This Holding Company Act requires annual filings regarding the holding company systems major transactions. These include such items as material changes to reinsurance contracts, major investments, management agreements, cost-sharing, and requests for extraordinary dividends. The Holding Company Act outlines specific filing requirements for persons wishing to acquire control of or merge with a domestic insurer. It further requires each insured to give notice of certain material affiliated transactions so we may determine if they are fair and reasonable to the interest of the insurer. Another important feature of the Act is that it also requires insurers to obtain prior regulatory approval for dividend transactions meeting certain thresholds in order to monitor the capital flows within a holding company system. Recent experience has shown that the activities of entities within a broader group with no connection to the insurers can still impact those insurers through contagion and reputation risk. Our system is ensuring the solvency of each individual insurance entity within an insurance group to minimize the risk to policyholders posed by these other entities within the group. State regulators have the ability to wall-off insurers to essentially block the interconnectedness that otherwise allows risk to spread unchecked throughout a broader group. In response to the recent global financial crisis, however, U.S. regulators and international standard-setting organizations have all taken steps to improve the financial services regulatory system and encourage more frequent communications and coordination among supervisors, including State regulators. States coordinate frequently and with other functional regulators, our Federal counterparts. We meet periodically with the Fed and the OTS prior to our NAIC meetings, as well as engage in discussions of particular companies, which is required as part of our financial analysis handbook directives. Fed and OTS representatives often attend NAIC working sessions. Additionally, the States have memorandums of understanding agreements with these agencies to share information; however, more can be done to ensure a two-way flow of information. State insurance regulators participate regularly in supervisory colleges for insurance-related entities around the world. This is a fairly recent phenomenon for us. For instance, my State of Nebraska, along with Delaware and Maryland, convened a supervisory college of Berkshire Hathaway a year ago. We'll have an in-person meeting in April here in Washington to gain a common understanding of the risk profile of the group and thereby strengthen our solo supervision efforts. Additionally, we have recently enacted special legislation in Nebraska to further enhance group supervision of a major, internationally active insurer operating in the State. Group supervision of complex entities is important, but our system also demands robust supervision of individual entities, whether the parent is an insurer or not. Information sharing and supervisory collaboration are improving and the NAIC is taking further steps to strengthening its Holding Company Act. Taken together, these steps will help ensure the continued stability of the insurance sector. Thank you for the opportunity to testify, and I would be happy to answer any questions. [The prepared statement of Ms. Frohman can be found on page 47 of the appendix.] " CHRG-111shrg54589--142 RESPONSES TO WRITTEN QUESTIONS OF SENATOR SCHUMER FROM PATRICIA WHITEQ.1. Ms. White, I am very concerned by efforts by the European Commission to implement protectionist restrictions on derivatives trading and clearing. A letter signed by many of the world's largest financial institutions earlier this year under significant pressure from European Commissions, commits them to clearing any European-referenced credit default swap exclusively in a European clearinghouse. This kind of nationalistic protectionism has no place in the 21st-century financial marketplace. What steps can you and will you take to combat these efforts to limit free trade protect free access to markets? If Europe refuses to alter its position, what steps can be taken to protect the United States' position in the global derivatives market?A.1. The Federal Reserve is working with authorities in Europe and other jurisdictions to improve international cooperation regarding the regulation of OTC derivatives markets. Current areas of focus include developing common reporting systems and frameworks for coordination of oversight. The goal of these efforts is to avoid duplicative and possibly conflicting requirements from different regulators. In addition, these efforts lay a foundation for broader recognition that policy concerns can be addressed even when market utilities are located in other jurisdictions.Q.2. Ms. White, one of many important lessons from the financial panic last fall following the collapse of Lehman Brothers and AIG, it is that regulators need direct and easier access to trade and risk information across the financial markets to be able to effectively monitor how much risk is being held by various market participants, and to be able to credibly reassure the markets in times of panic that the situation is being properly managed. A consolidated trade reporting facility, such as the Trade Information Warehouse run by the Depository Trust and Clearing Corporation for the credit default swaps markets, is the critical link in giving regulators access to the information this kind of information. Currently, there is no consensus on how trade reporting will be accomplished in domestic and international derivatives markets, and it is possible that reporting will be fragmented across standards established by various central counterparties and over-the-counter derivatives dealers. Do yon agree that a standardized and centralized trade reporting facility would improve regulators' understanding of the markets, and do you believe that DTCC is currently best equipped to perform this function?A.2. A standardized and centralized trade reporting facility serving a particular OTC derivatives market would improve regulators' understanding by providing them with a consolidated view of participant positions in that market. In general, a centralized reporting infrastructure for OTC derivatives markets is unavailable. An exception is the credit derivatives market, for which the DTCC Trade Information Warehouse (TIW) serves as the de facto standard trade repository. It provides a bookkeeping function, similar to the role of central securities depositories in the cash securities markets. The TIW registers most standardized CDS contracts and has begun registering more complex credit derivatives transactions in accordance with collective industry commitments to supervisors. While no other OTC derivatives markets are presently served by a trade repository, several CCPs serve an analogous function for limited segments of OTC derivatives markets such as LCH.Clearnet for interest rate derivatives and NYMEX Clearport for some commodity derivatives. There may be benefits to a single entity providing trade reporting services for OTC derivatives, but the Board does not believe that there is a good policy reason to force that result. Through collective supervisory efforts, major industry participants have committed to building centralized reporting infrastructure for both the OTC equity and interest rate derivatives markets. The industry has committed to creation of a repository for interest rate contracts by December 31, 2009, and for equity contracts by July 31, 2010. ------ CHRG-111hhrg63105--57 Mr. Johnson," I guess my comment would be this. As we all know--and I'll try to say that knowledge is power, terminology in some ways is power. And I would only surmise that certainly the average Member of Congress, and probably the average Member of this Committee--I can only speak for myself--has maybe a general understanding but only a general understanding about first, terminology; and second, the mechanism by which all this works. I think your being here today, Chairman, calling this hearing is important. But I also think it is important to have a mechanism, have a mechanism by which the public and the Members of Congress frankly can understand very, very complex and very difficult concepts. I don't have the answer. But, it is a legitimate question, and it is something that I think is real important. I deal with constituents back home, and I am probably speaking for everybody in this room, we have constituents who come to us every day; almost all of us represent rural areas. ``Speculators are doing this, and the Commission is inadequate,'' if they even know the Commission exists, and I think having an ability for those people to understand, the public to understand and us to understand is really important. " CHRG-110hhrg34673--189 Mr. Bernanke," To some extent, the declining relative position of the American exchanges reflects the natural growth and development of exchanges abroad, in London, in Asia and so on, and as those economies, those exchanges become larger, more efficient, and deeper; that is actually not a bad thing because it gives, for example, American companies more alternatives for raising money. On the other hand, to the extent that business is being driven offshore by high regulatory costs, which was the conclusion of these two recent studies on capital market competitiveness, then that is a problem and we need to begin to address those costs. The Sarbanes-Oxley issue that you raised earlier has been cited by a number of these studies, and the SEC and the Public Company Accounting Oversight Board have recently issued a new audit standard which will attempt to reduce the costs of implementing Sarbanes-Oxley's Section 404 on internal controls and, in particular, to make it more focused on the most important matters rather than on trivial matters and also more appropriate for smaller and less complex firms. So I think that is going to be an important step in reducing that particular set of costs. There are many other issues, some of which Congress could address--issues of tort reform and litigation, the CFIUS bill about foreign investment coming to the United States, and striking the appropriate balance there between keeping a flow of foreign investment into the United States versus appropriate national security considerations. The Federal Reserve is working on the Basel II bank capital accord regulation, and we are working on that, and we want to make sure that does not put American banks at a capital disadvantage in the capital markets. So it is certainly important for us across a whole variety of regulatory areas to try to keep those costs down and to keep working to reduce the burden of regulation on American public companies. " CHRG-110shrg46629--43 Chairman Dodd," I appreciate that response, as well. It will give us a chance to move on this. Senator Reed. Senator Reed. Thank you, Mr. Chairman. And thank you, Chairman Bernanke. I want to return to the topic that I broached in my opening statement and Senator Shelby addressed. And that is the issue of the valuation of CDOs. What you have is an illiquid market, basically. There is a thinly traded, very complex instruments, asset valuation is difficult to determine. As a result, what we have is something described as mark to ratings. Senator Shelby alluded to that. How comfortable are you with this approach? What are you doing specifically to engage the rating agencies to ensure that they are, and the originators of these products are, valuing their assets accurately? As I pointed out in my opening statement, there seems to be a growing wave and realization that these assets are overvalued. Some people have suggested billions and billions of dollars. What appears to be the motivating factor in the workout of the Bear Stearns funds was the extreme reluctance to try to have the market evaluate these assets and that would cause a value of mark to market for everything else they held and probably through the whole system. This is potentially a very serious problem. So specifically what are you doing with the rating agencies and the originators of these products to make sure they are valued effectively? " CHRG-111shrg50564--121 Mr. Volcker," You shouldn't leave them hung up in between, because it is confusing and when you got into trouble, were they public agencies or were they not? And if they were acting in the public interest, were they doing right for their fiduciary responsibility to the stockholder? I think they got placed in an impossible position. They were supposed to be important constructive factors in the mortgage market. The crisis came along and they were so over-extended in pursuit of their stockholder interests that they couldn't perform the public function. And if they performed the public function, their stockholders would squawk. And you shouldn't permit that to happen. Senator Crapo. Thank you very much. Just one last question, and really, this is sort of a summary to go back to what we have already talked about and that you have already expressed a comment on, but I would just like to explore it a little further with you, and that is it seems to me that right now, depending on whether you count the FDIC, there are six or seven Federal regulators with overlapping responsibilities in some cases, and as I said earlier, gaps in some places and so forth. It seems to me that regardless of the specifics, that Secretary Paulson's blueprint, the Group of 30 report, even though it didn't get into the details, and a number of the other reports that have dealt with this same issue have all concluded that we have too complex a system that needs unifying and simplification. Now, whether we go to a single regulator or whether we go to a smaller number than the seven that we have now, that we need to simplify and reduce the number of regulators and clearly identify the functions they are regulating and then move forward from there. Is that general statement something you could agree with? " CHRG-111hhrg52261--14 Mr. Hirschmann," Thank you, Chairwoman Velazquez, Ranking Member Graves, members of the committee. I really think this is a very timely hearing. Today, what I would like to do is talk specifically about an issue of great concern to many of our members, especially our small business members, the proposed Consumer Financial Protection Agency. The U.S. Chamber supports the goal of enhancing consumer protection. In fact, the Capital Markets Center that I run was founded 3 years ago before the financial crisis to advocate for comprehensive reform and modernization of our regulatory structure, including strong consumer protection. Consumers, including small businesses, need reforms that will ensure clear disclosure, better information; they need vigorous enforcement against predatory practices and other consumer frauds, and we need to close the gaps in current regulation. However, the proposed Consumer Protection Agency is the wrong way to enhance protections. It will have significant unintended consequences for consumers, small businesses, and for the overall economy. Today, the Chamber will release a study that examines the impact of CFPA on small business access to credit. The study is authored by Thomas Durkin, an economist who spent more than 20 years at the Federal Reserve Board. My remarks draw on the findings of that study to make the following points. [The study is included in the appendix] Small businesses, including those that we traditionally count on to be the first to add jobs in the early stages of an economic recovery, need access to credit to survive, meet expenses, and grow. Small businesses often have difficulty obtaining commercial credit and, therefore, turn to consumer credit and consumer financial products to supplement their short-term capital needs. The CFPA will reduce the availability and increase the costs of consumer credit. As users of consumer credit products, small businesses will see the same result despite being fundamentally different than the average consumer. The proposed CFPA will likely restrict, and in many cases eliminate, small business access to credit and increase the cost of credit they would be able to obtain. This CFPA ""credit squeeze"" could result in business closures, fewer start-ups, and slower growth, ultimately costing a significant number of jobs that would be lost or simply not created. Finally, the CFPA will only exacerbate the weaknesses of our current regulatory system without enhancing consumer protections. In 2006, 800,000 businesses created new jobs in this country; 642,000 of them had fewer than 20 employees. Small businesses generally have trouble borrowing money. Either they can't borrow or they cannot borrow as much as they need, and almost certainly they cannot secure long-term financing available to larger companies. To supplement the reduced access to traditional loans, small businesses rely extensively on consumer lending products, and they use them as a source of credit very differently than consumers. In other words, personal credit is the lifeline that sustains small businesses, particularly start-ups. Many of the products that small businesses rely on may be considered to some as fringe products, but they are the very products that small business owners use to meet their short-term capital needs. As one example, auto title loans provide small business owners immediate access to cash and no upfront fees or prepayment penalties, and therefore can be useful meeting short-term business expense. However, the CFPA in its approach failed to recognize the difference between small businesses and average consumers both in terms of need and sophistication and their appetite for risk. As proposed, the CFPA will likely reduce the availability of these products and increase their costs. It will make it harder for financial firms to meet the needs of small businesses. The CFPA will create considerable new risks to lenders in terms of regulatory fines and litigation risks from extending credit to small businesses. H.R. 3126 is the wrong approach. It simply adds a new government agency on top of an already flawed regulatory structure. As one example, rather than streamline consumer protections to eliminate gaps, regulatory arbitration, and create uniform national standards for key issues like disclosure, the legislation would foster a complex and confusing patchwork of 51-plus States regulation in addition to new Federal rules. As we begin to see signs of economic recovery, we need to be especially careful to fully understand the impact of a new regulatory layer on small businesses, both as consumers and as providers of financial products. We look forward to working with the members of the committee on the modernization of our regulatory structure and appreciate your holding this hearing today. " CHRG-110hhrg44900--239 The Chairman," Let me say--and I have to wind this up. I am very appreciative of the witnesses' time; they have stayed over time and it has been helpful. We have a hearing in 2 weeks with Chairman Cox and the President of the New York Federal Reserve, Mr. Geithner, to go over many of these same issues, and that obviously will be something that we will expect Mr. Cox to be addressing. I would just say for the purposes of the members on the Democratic side of the aisle, or others listening, we will begin the questioning there with those who didn't get to ask a question today, as we will next week on Humphrey-Hawkins begin the questioning with those who didn't have a chance. Some other substantive points I wanted to make: One, I disagree with the gentleman from California, Mr. Sherman. Obviously we have a different view here. I do not think that competitive bidding would have made any sense in the crisis atmosphere regarding Bear Stearns with Black Rock. Two, I don't think that people thought this was the most desirable assignment ever set up. And three, to now disrupt what Black Rock is doing and put it out to bid, I think, would be very disruptive. So I think--I would also add that the Government Operations Committee had requested some information about this, and the Chairman of the Federal Reserve did respond very appropriately to their inquiries. I understand that there are questions about urgency. I guess a lot of people believe in urgency in principle, but not on paper. And you can't be urgent in theory. You have to be urgent with very specific legislation. I do not believe that it is either necessary or possible to deal with this complex set of issues with the appropriate degree of certainty or at least assuredness, and to do it and then have to re-do it or amend it a few months later, I think would be a terrible idea. But this is what I want to make very clear. No one should think that we here in the Congress are available for end-runs. We have a situation where the SEC and the Federal Reserve and the Treasury and other regulators will be putting together their various powers, so that if crises arise they can be met. I believe we have sufficient power now to get through the crisis. We don't have sufficient power, frankly, to avoid some of the crises. And that, I think, is a distinction. We have the power to respond if there are crises. What we are looking for are rules that will make the crises less likely. And I think that is a very high priority. We will begin working on this. Work we begin now--frankly if we were to decide to do it now, I don't think we could get it finished just in terms of the complexity of the issues and the hearings and the bills in both Houses. But we are going to start now, and I hope that early next year we will able to complete it. But I don't want anyone to think that there are somehow loopholes that they can run through, and that they might get some cooperation here. I think we have all worked together very cooperatively when it comes to the crisis situation, and I believe that we will be able to continue to do that. I thank the Chairman and the Secretary, and the hearing is now adjourned. [Whereupon, at 1:17 p.m., the hearing was adjourned.] CHRG-111shrg56262--28 Mr. Irving," I will make four comments. First of all, I think uncertainty about home prices and how borrowers behave when they are underwater on their mortgage, when the loan-to-value ratio is greater than 100, has increased the risk premium in the market. And the second facet of uncertainty which is causing skittishness about these securities is just uncertainty about Government policy. The Government in some sense has been in the position inadvertently of picking winners and losers in terms of which investments do well and which do not. Those that get the Government support perform better than those that do not, so it becomes less of an intrinsic relative value of the cash-flows and more an assessment of how the Government policy is going to go. The third would be the equity-like price volatility that we have seen exhibited in many of these marketplaces, again causes there to need to be an increased risk premium, that is, prices go down. And then finally, the complexity. We have sort of a rule of thumb on our trading room floor that for every additional sentence I need to describe to my boss the structure of the security I am buying, the price has to be lower by about a point, and---- " CHRG-111shrg51395--266 RESPONSE TO WRITTEN QUESTIONS OF SENATOR CRAPO FROM T. TIMOTHY RYAN, 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.A.1. We agree with Chairman Bernanke's remarks and support the proposal to establish a financial markets stability regulator. At present, no single regulator (or collection of coordinated regulators) has the authority or the resources to collect information system-wide or to use that information to take corrective action across all financial institutions and markets regardless of charter. The financial markets stability regulator will help fill these gaps. We have proposed that the financial markets stability regulator should have authority over all financial institutions and markets, regardless of charter, functional regulator or unregulated status, including the authority to gather information from all financial institutions and markets, and to make uniform regulations related to systemic risk. This could include review of regulatory policies and rules to ensure that they do not induce excessive procyclicality. We have proposed that the financial markets stability regulator should probably have a more direct role in supervising systemically important financial institutions or groups. This would address the risks associated with financial institutions that may be deemed ``too big to fail.'' Such systemically important financial institutions or groups could also include primary dealers, securities clearing agencies, derivatives clearing organizations and payment system operators, which would help strengthen the financial infrastructure, another key element of Chairman Bernanke's proposal for regulatory reform.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. We have testified that we are in support of a merger of the SEC and the CFTC. The U.S. is the only jurisdiction that splits the oversight of securities and futures activities between two separate regulatory bodies. When the CFTC was formed, financial futures represented a very small percentage of futures activity. Now, an overwhelming majority of futures that trade today are financial futures. These products are nearly identical to SEC regulated securities options from an economic standpoint, yet they are regulated by the CFTC under a very different regulatory regime. This disparate regulatory treatment detracts from the goal of investor protection. An entity that combines the functions of both agencies could be better positioned to apply consistent rules to securities and futures. We would support legislation to accomplish such a merger.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. We believe the problems at AIG resulted from a combination of several factors. Its affiliate, AIG Financial Products, sold large amounts of credit protection in the form of credit default swaps on collateralized debt obligations with exposure to subprime mortgages, without hedging the risk it was taking on. At the same time, AIG's top credit rating gave many of its counterparties a false sense of security. Accordingly, many of the CDS agreements it negotiated provided that AIG would not be required to post collateral so long as it maintained a specified credit rating. AIG apparently believed its credit rating would never be downgraded, which enabled it to ignore the risk it would ever have to post collateral. Moreover, AIG appears to have under-estimated the default risk of the CDOs on which it sold credit protection, thus underestimating the size of its obligation to post large amounts of collateral in the event of its credit rating downgrade. While others might have made similar errors, it seems AIG in particular did not adequately account for the correlation of default risk among the different geographic areas where the mortgage assets underlying the CDOs originated. The market value of those CDOs fell by much more than AIG anticipated, leading to much greater collateral demands than it could possibly meet. It also appears that AIG Financial Products was not subject to adequate, effective regulatory oversight. All these factors are specific to AIG; its problems did not result from an inherent defect in CDS as a product.Q.4. How should we update our rules and guidelines to address the potential failure of a systematically critical firm?A.4. One of the most important gaps exposed during the current financial crisis was the lack of Federal resolution powers for systemically important financial groups. We believe that the proposed financial stability regulator should have the authority to appoint itself or another Federal regulatory agency as the conservator or receiver of any systemically important financial institution and all of its affiliates. Such conservator or receiver should have resolution powers similar to those contained in Sections 11 and 13 of the Federal Deposit Insurance Act. But because the avoidance powers, priorities and distribution schemes of the FDIA are very different from those in the Bankruptcy Code or other specialized insolvency laws that would otherwise apply to various companies in a systemically important financial group, the proposed resolution authority needs to be harmonized with the Bankruptcy Code and such other laws to avoid disrupting the reasonable expectations of creditors, counterparties and other stakeholders. Otherwise, the new resolution authority itself could create legal uncertainty and systemic risk. The Treasury's proposed resolution authority for systemically significant financial companies is a good first start, but its scope needs to be expanded to apply to all of the companies that comprise a systemically important financial group while the gap between its substantive provisions and those in the Bankruptcy Code and other specialized insolvency codes that would otherwise apply needs to be reduced in order to protect the reasonable expectations of creditors, counterparties and other stakeholders. ------ 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-111hhrg54872--275 Mr. Menzies," Congressman, the simple answer is that it could cause small issuers just to exit the business and sell portfolios to the larger issuers, which would create more consolidation in the industry, which we don't believe is healthy. The more detailed answer is that the new legislation is complex and comprehensive when it comes to dealing with changing the statements, changing the disclosures, testing the new systems. It represents a major reconfiguration of the credit card requirements. And we are hopeful that community banks can make it by July of next year, which, if I am correct, is the currently scheduled kick-in date for this new legislation. If the legislation is moved forward too quickly and community banks are unable to reconfigure to deal with an advancement of the legislation, then that part of the business could result in them saying, well, I will just exit the portfolio business and sell it to a larger aggregator, which we don't belive is in the interest of the consumer. " FOMC20070321meeting--115 113,MR. WARSH.," Thank you, Mr. Chairman. Let me say at the outset that I believe the moderate-growth scenario is the most likely for 2007. But as many of you have already discussed, I had thought that business fixed investment particularly was a very real upside opportunity and now consider it a very real downside risk. The Greenbook marked down BFI over the next couple of quarters, but I think there’s further reason to be concerned about it. Let me confine the rest of my remarks to the market tumult of the past several weeks and give you my views on that, which are broadly consistent with what Bill said at the outset. First, my sense of what the markets seem to be telling us is that the real economy is weaker. The first-quarter earnings numbers that Bill showed us very much reflect a trend that we could be seeing more of and that suggests some downside risk in the equity markets that Governor Kohn referred to a moment ago. A markdown of data in the fourth quarter of 2006, disappointing data regarding business fixed investment, the weakness in the subprime market, and so forth suggest to me that perhaps the markets have been reacting to a U.S. domestic economy that is in somewhat weaker shape than we could have expected even a couple of months ago. What was the cause of the market tumult of the past several weeks? When markets cannot single out a proximate cause, they have a tendency either to construct one or to be completely dismissive. In my view, some subset of rather sophisticated investors over the past six months or so have been looking for an opportunity, or maybe I should say an excuse, to pull back from certain markets in which credit-risk spreads have been unusually low; and over the past several weeks, they found one. There has been a generalized discomfort with markets priced for perfection and levels of volatility that seem uncorrelated with the real world which we’re all trying to analyze. Many of us have noted in speeches during the past couple of quarters that we have been surprised by the level of certainty implied in market prices, and I think that message is now starting to find its way into the marketplace. So the tumult and volatility that we’ve seen in the past several weeks will, as it continues, make it more difficult for us to gauge what’s going on. Might this financial market tumult then actually affect the real economy going forward? Generally, I would have said that these financial market activities are quite distinct from the real economy. But in the case of business fixed investment, I can’t help but believe that the market uncertainty, the talk of recession, the animal spirits that certainly have been negatively affected—all might affect some boards of directors and management teams that are trying to decide about whether to step on the gas on cap-ex or might get them to retreat even further. Given strong balance sheets, incredibly strong operating cash flows, and all of the momentum that they should have, I’m as puzzled as Tim Geithner as to why we haven’t seen that capital investment. The tumult in the markets in recent weeks gives me more reason to be concerned there. Perhaps these management teams are going to find share buybacks to be even more compelling compared with the alternative of capital investment. In general, I took the volatility of the markets at first blush as probably being a proper wake- up call to folks who had gotten perhaps a little too complacent about what was going on, particularly in the credit markets. Having spent a lot of time in New York in the past several weeks, I think that, if that was a wake-up call, many market participants seem to have hit the snooze button. [Laughter] Many are reviewing their portfolios and risk positions certainly, and we are seeing a bit more caution. Perhaps that’s justified by real economic fundamentals or by some lemming phenomenon. That is, most of these investment banks and other asset managers have in front of them as they’re making decisions a credit-risk button and a client-risk button. Over the past couple of years, they have always hit the client-risk button—that is, I don’t want to take client risk; I don’t want to lose this business. So they have hit that button, and the credit markets have been so accommodative and the syndicated markets so strong that they’ve been able to make some free money there. For a short, short window after February 27, they seem poised to hit the credit-risk button. One senior credit-risk officer at a major institution told me that he was very popular again. People wanted him in every meeting as they were making underwriting commitments. He called me back a few days later and said, “No one wants to talk to me again.” [Laughter] So I worry whether that wake-up call has actually been felt. Now, could this market volatility of recent weeks spread beyond the subprime market and lead to the kind of credit crunch that would have meaningful downside risks to the economy? I tried to imagine the circumstances in which that would come. First, I looked at financial intermediaries, and rather than trying to distinguish between commercial banks and investment banks, hedge funds, and other private equity, I tried to think about them as being creators of credit, distributors of credit, or holders of credit, forgetting all other labels that are associated with them. Typically, before the rather robust capital markets of the past several years, most of these institutions would decide which of those areas they would be in. Do they create products and get them off their books, or do they make big bets by deciding what to hold and not? Many of them have now decided that they could be in all three businesses. All three businesses were profitable. To the extent that a portfolio position no longer fit, they could sell it or syndicate it very quickly. In this new environment, however, with new volatility, these portfolio holdings over time may prove harder to liquidate, and the out-of-the-money options that the creators of structured products have been writing may no longer be free. A couple of weeks ago, Warren Buffett described one of these financial hedge fund phenomena. He described the groups as the “innovators, the imitators, and then the swarming masses of incompetents.” [Laughter] I won’t describe who is in what category in these markets, but many financial institutions seem to be following one particular premier investment bank that has managed to be a creator of products, to be a syndicator, and to be taking very large principal positions. What happens if these other financial institutions get uncomfortable as these markets tighten, to the extent that they decide that they no longer want to be in the equity bridge business? To cite one example, which President Fisher raised, in a very large, highly leveraged transaction recently, a couple of the investment banks decided to put up a couple billion dollars of capital, and they were short some equity checks. Typically, they would then go to a series of other banks, bring them into the deal, and then try to syndicate that quickly. But the first investment banks that were involved wanted to make sure that there was no competition in the syndicated market. So three non-U.S. financial institutions wrote $1 billion checks for an extremely small fee and agreed to hold that billion dollars of equity on their own balance sheets for a term of not less than 365 days and to syndicate it later only to those who would be satisfactory to the lead investment banks. To what extent over the next twelve months will they and others feel uncomfortable in this new business environment with that kind of equity exposure? If that process ends up being disorderly, there could be a rapid turn to risk aversion. Of course, I think the more likely case is that this is orderly and supportive of sustainable growth, but that’s the financial situation in which I would get very nervous very quickly. I think a second mechanism by which the situation could become worse involves a whole set of legal risks around the subprime markets and uncertainty generally over where liability rests. Through the good intentions of policymakers in the Congress and in state legislatures, some uncertainty could be introduced into the foreclosure market and into the syndication markets. Many enterprising state attorneys general seem poised to do just the same, and that kind of legal risk could be very dangerous for these credit markets. Finally, what does that situation mean for us? I suspect that, besides our needing to keep a focus on these financial markets, it is what’s happening in the real economy. As we’ll discuss a bit more tomorrow, our statement should be and will necessarily be read in the context of our reaction to incoming real data as opposed to our reaction to what’s happening in the financial markets. Thank you, Mr. Chairman." FinancialCrisisReport--295 When asked by the SEC to compile a list of its rating criteria in 2007, S&P was unable to identify all of its criteria for making rating decisions. The head of criteria for the structured finance department, for example, who was tasked with gathering information for the SEC, wrote in an email to colleagues: “[O]ur published criteria as it currently stands is a bit too unwieldy and all over the map in terms of being current or comprehensive. ... [O]ur SF [Structured Finance] rating approach is inherently flexible and subjective, while much of our written criteria is detailed and prescriptive. Doing a complete inventory of our criteria and documenting all of the areas where it is out of date or inaccurate would appear to be a huge job ....” 1145 The confused and subjective state of S&P criteria, including when the criteria had to be applied, is also evident in a May 2007 email sent by an S&P senior director to colleagues discussing whether to apply a default stress test to certain CDOs: “[T]he cash-flow criteria from 2004 (see below), actually states [using a default stress test when additional concerns about the CDO are raised] ... in the usual vague S&P’s way .... Still, consistency is key for me and if we decide we do not need that, fine but I would recommend we do something. Unless we have too many deals in [the] US where this could hurt.” 1146 Moody’s ratings criteria were equally subjective, changeable, and inconsistent. In an October 2007 internal email, for example, Moody’s Chief Risk Officer wrote: “Methodologies & criteria are published and thus put boundaries on rating committee discretion. (However, there is usually plenty of latitude within those boundaries to register market influence.)” 1147 Another factor was that ratings analysts were also under constant pressure to quickly analyze and rate complex RMBS and CDO transactions. To enable RMBS or CDO transactions to meet projected closing dates, it was not uncommon, as shown above, for CRA analysts to grant exceptions to established methodologies and criteria, put off analysis of complex issues to later transactions, and create precedents that investment banks invoked in subsequent gone effective already, it was surveillance’s responsibility, and I never heard about it again. Anyway, because of that, I never created a new monitor.”). 1145 3/14/2007 email from Calvin Wong to Tom Gillis, Hearing Exhibit 4/23-29. See also 2008 SEC Examination Report for Standard and Poor’s Ratings Services, Inc., PSI-SEC (S&P Exam Report)-14-0001-24, at 6-7 (“[C]ertain significant aspects of the rating processes and the methodologies used to rate RMBS and CDOs were not always disclosed, or were not fully disclosed …. [S]everal communications by S&P employees to outside parties related to the application of unpublished criteria, such as ‘not all our criteria is published. [F]or example, we have no published criteria on hybrid deals, which doesn’t mean that we have no criteria,’” citing an 8/2006 email from the S&P Director of the Analytical Pool for the Global CDO Group.). 1146 5/24/2007 email from Lapo Guadagnuolo to Belinda Ghetti, and others, Hearing Exhibit 4/23-31. 1147 10/21/2007 Moody’s internal email, Hearing Exhibit 4/23-24b. Although this email is addressed to and from the CEO, the Chief Credit Officer told the Subcommittee that he wrote the memorandum attached to the email. Subcommittee interview of Andy Kimball (4/15/2010). securitizations. CRA analysts were then compelled to decide whether to follow an earlier exception, revert to the published methodology and criteria, or devise still another compromise. The result was additional confusion over how to rate complex RMBS and CDO securities. fcic_final_report_full--285 On February , , PwC auditors met with Robert Willumstad, the chairman of AIG’s board of directors. They informed him that the “negative basis adjustment” used to reach the . billion estimate disclosed on the December  investor call had been improper and unsupported, and was a sign that “controls over the AIG Finan- cial Products super senior credit default swap portfolio valuation process and over- sight thereof were not effective.” PwC concluded that “this deficiency was a material weakness as of December , .”  In other words, PwC would have to announce that the numbers AIG had already publicly reported were wrong. Why the auditors waited so long to make this pronouncement is unclear, particularly given that PwC had known about the adjustment in November. In the meeting with Willumstad, the auditors were broadly critical of Sullivan; Bensinger, whom they deemed unable to compensate for Sullivan’s weaknesses; and Lewis, who might not have “the skill sets” to run an enterprise-wide risk manage- ment department. The auditors concluded that “a lack of leadership, unwillingness to make difficult decisions regarding [Financial Products] in the past and inexperience in dealing with these complex matters” had contributed to the problems.  Despite PwC’s findings, Sullivan received  million over four years in compensation from AIG, including a severance package of  million. When asked about these figures at a FCIC hearing, he said, “I have no knowledge or recollection of those numbers whatsoever, sir. . . . I certainly don’t recall earning that amount of money, sir.”  The following day, PwC met with the entire AIG Audit Committee and repeated the analysis presented to Willumstad. The auditors said they could complete AIG’s audit, but only if Cassano “did not interfere in the process.” Retaining Cassano was a “management judgment, but the culture needed to change at FP.”  On February , AIG disclosed in an SEC filing that its auditor had identified the material weakness, acknowledging that it had reduced its December valuation loss estimates by . bil- lion—that is, the difference between the estimates of . billion and . billion— because of the unsupportable negative basis adjustment. The rating agencies responded immediately. Moody’s and S&P announced down- grades, and Fitch placed AIG on “Ratings Watch Negative,” suggesting that a future downgrade was possible. AIG’s stock declined  for the day, closing at .. At the end of February, Goldman held  billion in cash collateral, was demand- ing an additional . billion, and had upped to . billion its CDS protection against an AIG failure. On February , AIG disappointed Wall Street again—this time with dismal fourth-quarter and fiscal year  earnings. The company re- ported a net loss of . billion, largely due to . billion in valuation losses re- lated to the super-senior CDO credit default swap exposure and more than . billion in losses relating to the securities-lending business’s mortgage-backed pur- chases. Along with the losses, Sullivan announced Cassano’s retirement, but the news wasn’t all bad for the former Financial Products chief: He made more than  mil- lion from the time he joined AIG Financial Products in January of  until his re- tirement in , including a  million-a-month consulting agreement after his retirement.  CHRG-111hhrg55811--272 Mr. Sleyster," Thank you. Members of the committee, my name is Scott Sleyster. I am the chief investment officer of Prudential Financial's U.S. operations, and I appear here today as a representative of the American Council of Life Insurers, also known as the ACLI. The ACLI is a national trade association of 340 member companies who serve as the leading providers of financial security and retirement products for both the individual and group insurance markets. Prudential Financial is a financial services leader, providing compelling asset growth and protection solutions for the ever-increasing retirement needs of individuals in businesses in the United States and abroad. I would like to thank the committee for its invitation to appear today and to present the ACLI's view on the new discussion draft of the Over-the-Counter Derivatives Markets Act of 2009. In my capacity as Prudential's CIO, I am responsible for asset liability management, a critical function at all life insurance companies. The business of selling life insurance policies and annuities contracts requires us to match our asset portfolios with those of our liabilities so that we have the future cash flows necessary to meet the long-term financial promises that we make to our policyholders. The protections we provide often cover an extensive time horizon that does not correspond neatly to available investments. OTC derivatives allow us to effectively tailor the payment streams of our assets to match those of our expected liabilities. Customized derivatives in particular help to stabilize prices and mitigate risk within our industry's annuity business. For example, Prudential and other life insurers offer annuity products with custom guarantees that protect against downside risks of the underlying equity exposures of our clients. Our ability to provide principal guarantees, which are often accompanied with minimum retirement income guarantees, collectively protected retirees and consumers from an estimated $230 billion in losses during the most recent equity market collapse. Given the critical role that OTC derivatives play in the life insurance industry's asset liability management, the ACLI would like to offer the following six observations regarding the discussion draft released last week. First, we applaud the discussion draft's call for comprehensive Federal regulation of over-the-counter derivative markets. The proper operation of these markets and continued availability of OTC products remains a top priority to ACLI members. We remain concerned, however, that the draft's current definition of ``swaps'' and ``security-based swaps'' could be misunderstood to include certain insurance products such as annuities with optionlike features, which we feel should be explicitly excluded. Second, we appreciate that the draft does not establish a hard distinction between so-called standardized and customized OTC derivatives. We agree that it makes sense for responsible agencies to develop rules governing which derivatives should be centrally clear and those that should remain OTC. Third, we thank the committee for the significant improvement in the draft's new definitions of ``major swap participant'' and ``major securities-based swap participant,'' which now exclude end-users employing OTC derivatives for nonspeculative reasons, such as hedging and risk management. State-regulated life insurers are required to limit our use of derivatives to nonspeculative activity, providing us comfort that we would fall outside of both definitions. This is in sharp contrast to AIG, whose Financial Products Division was an OTC derivative dealer functioning outside the limitations of a State-regulated insurance company. Fourth, we strongly agree with the draft's proposal that non-cash assets should be acceptable collateral for derivatives transactions. As the largest class of investors of debt of U.S. corporations, insurers frequently use corporate securities as collateral subject to appropriate haircuts. The provision of the draft may need further refinement if the intent is to be fully realized, and we would welcome the opportunity to work with the committee on this matter. Fifth, we do remain concerned that the draft bill adopts Treasury's recommendation that the CFTC and the SEC be stripped of their customary authority. Given the complexity of this legislation, coupled with the dynamic aspects of the insurance and derivatives markets, we believe that businesses and consumers will be best served if the CFTC and the SEC have the flexibility to deal with matters as they emerge in real time. Finally, the ACLI endorses proposals to bring greater transparency to the OTC derivatives markets through trade reporting and centralized clearing of standardized products. Likewise, we support efforts to regulate derivatives dealers to ensure sound and efficient markets prevail. We thank the committee for this opportunity to share our perspective, and I look forward to answering any questions you may have. [The prepared statement of Mr. Sleyster can be found on page 168 of the appendix.] Ms. Bean. Thank you very much. And now Mr. David Hall, chief operating officer of Chatham Financial Corp. STATEMENT OF DAVID HALL, CHIEF OPERATING OFFICER, CHATHAM CHRG-111shrg54533--2 Chairman Dodd," The Committee will come to order. Again, I want to welcome my colleagues, welcome the Secretary. We are pleased to have you before us again, Mr. Secretary, this morning. I welcome our audience that is here this morning. We will proceed in the following manner: I will make some opening remarks. I will ask Senator Shelby as well if he would care to make any opening remarks. And then to move things along, unless any Member here is so compelled, I would like to get right to the Secretary for his comments, then get right to the questioning if we can as well. So that is the manner in which we will proceed, but I thank everyone for making it here this morning. Again, Mr. Secretary, thank you for being with us. This morning we are going to conduct this hearing on the administration's proposal to modernize the financial regulatory system, and for those of us--I was there yesterday at the White House to hear the President make his presentation, along with many others. So good morning and thank you again for being with us. I would like to welcome the Secretary, who is here to discuss the administration's proposal. Mr. Secretary, we applaud your leadership on a very complex set of issues intended to restore confidence and stability in our financial system, and I, along with my colleagues, look forward to exploring the details of your plan and working with you and our colleagues here and the other body on this truly historic endeavor. In my home State of Connecticut and around the Nation, working men and women who did nothing wrong have watched the economy fall through the floor, taking with it their jobs, in many cases their homes, their life savings, and the economic security that has always been the cherished promise of the American middle class. These people, our constituents across the contractor, the American taxpayer, are hurting. They are very angry and they are worried, and they are wondering who is looking out for them. I have seen firsthand how hard people work in my State, as I know my colleagues here--and you have, too, Mr. Secretary, what they do to support their families, to build financial security for themselves. I have seen, as well as my colleagues have, how devastating this economic crisis has been for them. And I firmly believe that someone should ``have their backs,'' as the expression goes. So as we work together to rebuild and reform the regulatory structures whose failures led us to this crisis, I, along with my colleagues here, will continue to insist that improving consumer protection be a first principle and an urgent priority. I welcome the administration's adoption of this principle, and I am pleased to see it reflected in the plans that we will be discussing this morning. At the center of this effort will be a new, independent consumer protection agency to protect Americans from poisonous financial products. This is a very simple, common-sense idea. We do not allow toy manufacturers to sell toys that could hurt our children. We do not allow electronic companies to sell defective appliances. Why should a usurious payday loan be treated any differently than we treat an unsafe toy or a malfunctioning toaster? Why should an unscrupulous lender be allowed to dupe a borrower into a loan the lender knows cannot be repaid? There is no excuse for allowing a financial services company to take advantage of American consumers by selling them dangerous financial products. Let us put a cop on the beat so that this spectacular failure of consumer protection at the root of this mess is never repeated again. We have been engaged in an examination of just what went wrong in the lead-up to this crisis since February of 2007 when experts and regulators from across the spectrum testified before this very Committee that poorly underwritten mortgages would create a tsunami of foreclosures. Those mortgages were securitized and sold around the globe. The market is supposed to distribute risk, but because for years no one was minding the store, these toxic assets served to amplify risk in our system. Everything associated with these securities--the credit ratings applied to them, the solvency of the institutions holding them, and the creditworthiness of the underlying borrowers--became suspect. And as the financial system tried to pull back from these securities, it took down some of the country's most venerable institutions--firms that had survived world wars, great depressions, down for decades and decades, and wiped out over $6 trillion in household wealth since last fall alone. Stronger consumer protection I believe would have stopped this crisis before it started. Consumers were sold subprime and exotic loans they could not afford to repay and were, frankly, cheated. They should have been the canaries in the coal mine. But instead of heeding the warnings of many experts, regulators turned a blind eye, and it was regulatory neglect that allowed the crisis to spread to the point where the basic economic security of my constituents and millions more around the country here, including folks who have never seen or heard of mortgage-backed securities, was threatened by the greed of some bad actors on Wall Street and elsewhere and the failure of our regulatory system. To rebuild confidence in our financial system, both here at home and around the world, we must reconstruct our regulatory framework to ensure that our financial institutions are properly capitalized, regulated, and supervised. The institutions and products that make up our financial system must act to generate wealth, not destroy it. In November, I announced five principles which would guide the Banking Committee's efforts in the coming weeks and months. First and foremost, regulators must be focused and empowered aggressive watchdogs rather than passive enablers of reckless practices. Second, we have to remove the gaps and overlaps in our regulatory structure that have encouraged charter shopping and a race to the bottom in an effort to win over bank and thrift clients. Third, we must ensure that any part of our financial system that poses a systemic wide risk is carefully and sensibly supervised. A firm too big to fail is a firm too big to leave unmonitored. Fourth, we cannot have effective regulation without more transparency. Our economy has suffered from the lack of information about trillion-dollar markets and the migration of risks within them. And, fifth, our actions must help Americans remain prosperous and competitive in a global marketplace. These principles will guide my consideration of the plan that you bring to our Committee this morning, Mr. Secretary, and I believe that we can find common ground in a number of the areas contained in your proposal. And I want to thank you again for your leadership on these issues as well as for your willingness to consider different perspectives in forging this plan. I hope you will view this as a continuation of the dialogue that you have had with Members of this Committee, both Democrats and Republicans, as we work together to shape a regulatory framework that will serve our Nation well into the 21st century. I want to thank all of my colleagues on this Committee as well, by the way, who have demonstrated a strong interest in this issue and are determined to work together. Senator Shelby will obviously give his own opening remarks, but he and I have talked on numerous occasions about how this issue that we will grapple with here as a Committee may be the most important thing this Committee will have done in the last 60 or 70 years or the most important thing any one of us is going to do as a Members of this Committee for years to come--getting this right. I do not sense on this Committee any great ideological divides. What I do sense is a determination to figure out what works best, to get it right, and to get the job done. So I am really excited about the opportunity that is being posed by the proposal you have put forward and the work in front of us. And I want to urge everyone on our Committee and elsewhere to remember that at the end of the day, at the end of all of this, the success of what we attempt will be measured by its effect on the borrower, on the shareholder, on the investor, the depositor, the consumers, and taxpayers seeking not to attain extravagant wealth but simply to grow a small business, pay for college, buy a home, and pass on something to their children. That is the American dream, and that is what we are gathered to restore. Let me just say, while it is not part of my remarks I prepared for this morning, when I pick up the morning newspaper and I read the first headline here, ``Fault Lines Emerge as Industry Groups Blast Plan to Create Consumer Agency,'' what planet are you living on? The very people who created the damn mess are the ones now arguing that consumers ought not to be protected. They are the people who have paid this price. And the idea that you are going to first want to attack the very clients and customers who depend upon you every day is not the place to begin. And so I am somewhat upset when I see those kinds of remarks when we are trying to look for cooperation and building some common ideas. With that, I turn to Senator Shelby. FinancialCrisisReport--167 For the eight largest insured institutions at the time, the FDIC assigned at least one Dedicated Examiner to work on-site at the institution. The examiner’s obligation is to evaluate the institution’s risk to the Deposit Insurance Fund and work with the primary regulator to lower that risk. During the period covered by this Report, Washington Mutual was one of the eight and had an FDIC-assigned Dedicated Examiner who worked with OTS examiners to oversee the bank. During the years examined by the Subcommittee, the FDIC Chairman was Sheila Bair; the Acting Deputy Director for the FDIC’s Division of Supervision and Consumer Protection’s Complex Financial Institution Branch was John Corston; in the San Francisco Region, the Director was John Carter and later Stan Ivie, and the Assistant Director was George Doerr. At WaMu, the FDIC’s Dedicated Examiner was Stephen Funaro. (3) Examination Process The stated mission of OTS was “[t]o supervise savings associations and their holding companies in order to maintain their safety and soundness and compliance with consumer laws, and to encourage a competitive industry that meets America’s financial services needs.” The OTS Examination Handbook required “[p]roactive regulatory supervision” with a focus on evaluation of “future needs and potential risks to ensure the success of the thrift system in the long term.” 604 OTS, like other bank regulators, had special access to the financial information of the thrifts under its regulation, which was otherwise kept confidential from the market and other parties. To carry out its mission, OTS traditionally conducted an examination of each of the thrifts within its jurisdiction every 12 to 18 months and provided the results in a Report of Examination (ROE). In 2006, OTS initiated a “continuous exam” program for its largest thrifts, requiring its examiners to conduct a series of specialized examinations during the year with the results from all of those examinations included in an annual ROE. The Examiner-in-Charge led the examination activities which were organized around the CAMELS rating system used by all federal bank regulators. The CAMELS rating system evaluates a bank’s: (C) capital adequacy, (A) asset quality, (M) management, (E) earnings, (L) liquidity, and (S) sensitivity to market risk. A CAMELS rating of 1 is the best rating, while 5 is the worst. In the annual ROE, OTS provided its thrifts with an evaluation and rating for each CAMELS component, as well as an overall composite rating on the bank’s safety and soundness. 605 At Washington Mutual, OTS examiners conducted both on-site and off-site activities to review bank operations, and maintained frequent communication with bank management through emails, telephone conferences, and meetings. During certain periods of the year, OTS examiners 604 2004 OTS Examination Handbook, Section 010.2, OTSWMEF-0000031969, Hearing Exhibit 4/16-2. 605 A 1 composite rating in the CAMELS system means “sound in every respect”; a 2 rating means “fundamentally sound”; a 3 rating means “exhibits some degree of supervisory concern in one or more of the component areas”; a 4 rating means “generally exhibits unsafe and unsound practices or conditions”; and a 5 rating means “exhibits extremely unsafe and unsound practices or conditions” and is of “greatest supervisory concern.” See chart in the prepared statement of Treasury IG Eric Thorson at 7, reprinted in April 16, 2010 Subcommittee Hearing at 107. had temporary offices at Washington Mutual for accessing bank information, collecting data from bank employees, performing analyses, and conducting other exam activities. Washington Mutual formed a Regulatory Relations office charged with overseeing its interactions and managing its relationships with personnel at OTS, the FDIC, and other regulators. CHRG-111hhrg51592--27 Mr. Dobilas," Thank you for the opportunity to participate in this hearing. The rating agency legislation passed by Congress in 2006 was an important step forward. It greatly improved the regulatory process by which a rating agency can receive a national designation from the SEC, and it has in fact increased the number of competitors. But given the worldwide collapse of the credit markets, and the loss of trillions of dollars by individuals, companies, and governmental entities, it is now clear that Congress needs to take further action addressing the conflicts of interest which have arisen in the context of having rating agencies paid by the corporations whose debt they are evaluating. As the Congressional Oversight Panel has stated, the major credit rating agencies played an important and perhaps decisive role in enabling and validating much of the behavior and decisionmaking that now appears to have put the broader financial statements at risk. Realpoint uses a different business model than S&P, Moody's, and Fitch. We are an independent, investor-paid business, which means our revenues come from investors, portfolio managers, analysts, broker dealers, and other market participants who typically buy a subscription to our services. We produce in-depth monthly rating reports on all current commercial mortgage-backed securities. Moody's, S&P, and Fitch, on the other hand, are paid by the issuers of the securities. They are paid substantial upfront fees on a pre-sale basis by the corporations selling securities or investment banks which are underwriting the sales. The fees can exceed $1 million in a single transaction. In a word, the results of the issuer-paid business model have been miserable. The SEC recently published data showing that Moody's has had to downgrade 94.2 percent of all the subprime residential mortgage-backed securities it rated in 2006. This is the equivalent of a major league baseball player striking out 19 out of 20 times at bat. We see a similar trend developing now in the CMBS market. In contrast, Realpoint's ratings were lower from the outset, and have proven to be more stable than those of the issuer-paid agencies. Even during these unprecedented times, downgrades at Realpoint are less than 30 percent on all current CMBS transactions, and have generally taken place 6 to 12 months sooner than the corresponding rating actions taken by other rating agencies. The core problem with the issuer-paid system, and the most important message I would like to leave with the subcommittee today, is that the integrity of the rating process is undermined by the pervasive practice of rating shopping. When an issuer decides to bring a new security to market, it generally begins the process by providing data to the three rating agencies. The three rating agencies are more than willing to provide preliminary levels on ratings, knowing that the issuer will tend to hire the agencies that provide the highest ratings. We hear a lot about complexities of modern finance, but the rating process is hardly complex. The solution is equally simple, and it only takes one step. Let all the designated rating companies have the same information and prepare their own pre-sell ratings, regardless of whether or not they are ultimately paid by issuers or by investors. In our view, there is simply no better or more straightforward way to enhance the integrity of the ratings process than to share the information with all agencies which the SEC has deemed as worthy of being a nationally recognized agency. In fact, the SEC has already proposed precisely such a rule, through an amendment to its fair disclosure rules. The public benefits of taking this simple step are immediate and manifestly obvious. Last year, the Federal Reserve began implementing the Term Asset-Backed Securities Loan Facility, or TALF Program. Initially, the ratings component of TALF was limited to Moody's, S&P and Fitch. We are pleased to learn that the Federal Reserve is now taking steps to increase the number of rating agencies eligible to participate in this program. As a matter of fact, we just learned that Realpoint and DBRS are now part of the TALF program. We believe that this will increase competition and lead to more accurate ratings behind the taxpayer guarantees which stand behind these programs. TALF and other comparable programs utilize the standard industry practice of requiring two ratings in order for securities to be deemed suitable collateral. There is likewise no valid public policy reason for not insisting that at least one of these ratings be an independent investor-based rating. In this manner, the TALF program serves not only as a catalyst for restarting the securitization market, but as a vanguard to reform the credit rating industry. A mandate to have TALF and other government assisted programs utilize the ratings of at least one independent rating agency would enhance investor confidence in those programs and set the stage for ultimately resurrecting reliable ratings in the private sector. In short, the American taxpayers should not be subject to the same failed rating shopping syndrome I described earlier. In conclusion, the integrity of the ratings process is deeply flawed, but this is not a complex problem, and, in fact, it is not that different from when we were all in high school and everyone sought out the teachers who were known as easy graders. We simply need to put an end to the rating shopping process that encourages issuer-paid rating agencies to inflate their ratings. Thank you very much for your time. [The prepared statement of Mr. Dobilas can be found on page 58 of the appendix.] " CHRG-111shrg382--28 Mr. Tarullo," No, it is not that so much. It is just that the way I have thought about this is we really need a third alternative, somewhere between bailout and bankruptcy--or an uncontrolled bankruptcy, I should put it, a ``disorderly bankruptcy,'' as it is called. And that, it seems to me, should be the starting point for thinking about a resolution mechanism. Now, with respect to the complexities, for the reasons I indicated earlier, there is not going to be--and Senator Shelby's intermediate question I think emphasized that--an international treaty that says everybody has the same resolution mechanism, certainly not anytime in the foreseeable future. So there will be some potential discontinuities between the systems in each country. But I think a resolution mechanism can provide tools to each national government that could allow a more orderly or less disorderly resolution of a failed institution. For example, it may permit the creation of a bridge bank. It may create the possibility for dividing into a good bank or a bad bank, where right now you do not really have the legal capacity to do that. In your words, there will be complications and complexities because the rules may still be somewhat different elsewhere, and there may be assets located in other countries that you are not sure can be subject to the same legal treatment. But I think it gets you at least a step down the road. And, again, keeping in mind that the domestic or overarching purpose, this ought to be as an element of a broad-based response to the problems of moral hazard and too big to fail. So we need multiple instruments, I think, to contain moral hazard, and that means that a resolution mechanism should be moving us toward more market discipline, not less market discipline. Senator Corker. Any comments by the other witnesses? [No response.] Senator Corker. A very complete answer. I will say--and I know this is the end of my time here. I can tell by the body language of our Chairman. Senator Bayh. Take your time. Senator Corker. But the procyclical issue, it sounded to me that the answers, which I very much appreciate were thoughtful, really do not come to a conclusion; that as you try to avoid, you know, an unnecessary steaming up of the economy, there are issues there as to what is happening right now. I mean, I think we are unnecessarily driving it into the ground. We talk about Main Street all the time. I do not even like that kind of terminology, and I cannot believe I let it come out of my mouth, where you separate the two because it is all intertwined. But the fact is that at local levels around our country today, there is no question that banks are doing things that are not in their best interest, and they are being driven there by regulators and a herd mentality. I mean, they are doing things that happen every time these cycles occur. There are absolutely ignorant things that are being done. They are hurting shareholder value. They are hurting their communities. And it is being driven by regulators who--you know, it is kind of like you yell ``Fire'' and everybody leaves. You yell ``commercial real estate'' or you yell some kind of--and everybody--it is the same exact thing that happens in every cycle. And yet I have not heard a response--I am not criticizing you. I have not heard a response as to how to deal with that other than maybe the regulators acting sensibly. But I do not know how you put that in a formula, if you will, and then try to cause that to occur. And that is just one example. There are all kinds of procyclical issues, I understand. But I think that is going to be maybe the most important thing that occurs. I mean, the whole issue is to keep us from having a systemic failure, and so you have to sort of work on those procyclical things, which are tough to do when times are good. But, anyway, I have taken too long. I thank each of you for your testimony. And when you figure that out, if you would send us a memo, we would appreciate it. Senator Bayh. Thank you very much, Senator Corker. Senator Shelby. Senator Shelby. I would like to ask the Governor a question, picking up on what Senator Corker is talking about, and that is, resolution authority. We have got this ``too big to fail'' mentality, and maybe it is more than that, which a lot of people disagree with, and the majority of the American people definitely disagree with. But we have got it in Europe, too, and so forth. But there has to be an end to something sooner or later, and if we do not have some type of legislation with something definite for the regulators, whoever the systemic regulator comes up to be, where if something does get so bad you need to close it up, you need to sell it off, that you do it. What is bothering me is Citicorp has had all this money pumped into it. We have 36 percent of the stock, more or less, I guess. There is no resolution to that a year later. AIG, I do not know if we are getting our arms around--I hear we are getting our arms around them. There are going to have to be some long arms, some big arms to get your arms around that. But what is going to be the ultimate resolution of that? How long is it going to take, too, all of these things? Because as I look at a regulator that is going to wind down something, I think--and oftentimes, FDIC, you have got to give them credit for one thing. They can wind down an institution, sometimes faster than a lot of people would want. But they can wind it down. But can the Fed wind them down? Questionable. " CHRG-109shrg21981--61 Chairman Greenspan," Senator, it is an extraordinary part of a phenomenon which has been going on for the last decade worldwide. Prior to 1995, there was a very major grossing up of exports and imports around the world, leaving as a consequence on average imports as a percent of GDP growing every year virtually. We nonetheless did not find that there was any evident consistent increase in the dispersion of trade or current account surpluses and deficits. In other words, there was what economists call a very considerable amount of home bias, meaning that countries tended to use their domestic savings to very largely finance their domestic investment. But since 1995, there has been a very pronounced change in which cross-border use of savings to invest in foreign countries all over the world has increased dramatically, which has meant that the dispersion of current account balances, both as surpluses on the one hand and deficits on the other, with the United States as the largest deficit, has increased. That phenomenon has given us the capacity to create a very large deficit, and indeed it has been a major source of financing to our domestic investment. But as I also said, and I think you pointed out, over the longer-run it is just not credible that it could go on without change because you will get an undue concentration of dollar claims on U.S. residents, which even though they are considered a highly valuable, and have high rates of return and the like, they lack the diversification of a good portfolio, and foreign investors would therefore start to ease off. And if you cannot finance a current account deficit, it will not exist. So that is surely the case. But I have also said that the degree of flexibility, owing to deregulation, owing to technology, owing to lots of innovation, has created a degree of flexibility and therefore resilience in this economy that has in the past and is very likely in the future to defuse this large current account balance without undue negative economic effects on the American economy. So what I said in the last several weeks is, one, this is a problem; we are approaching it and I think coming to grips with it in the marketplace, and the evidence is that for the first time we are beginning to see the impact of stable margins of foreign exporters at very low levels now beginning to produce increases in import prices in the United States, which is the first stage in the adjustment process. Senator Bunning. As you know, the SEC has proposed a new Regulation B to Section 2 of the Gramm-Leach-Bliley Act. The Fed, along with the FDIC and the OCC, wrote a very strong letter to the SEC opposing their proposed regulation. Would you comment on how this proposed regulation could affect the bankers? " 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-110shrg50414--45 Secretary Paulson," I also share the comments that you all made about the importance of the situation and the importance of this hearing. This is a difficult period for the American people. I very much appreciate the fact that congressional leaders and the administration are working closely together so that we can help the American people by quickly enacting a program to stabilize our financial system. We must do so in order to avoid a continuing series of financial institution failures and frozen credit markets that threaten American families' financial well-being, the viability of businesses both small and large, and the very health of our economy. The events leading us here begin many years ago, starting with band lending practices by banks and financial institutions and by borrowers taking out mortgages they could not afford. We have seen the results on homeowners--higher foreclosure rates affecting individuals and neighborhoods. And now we are seeing the impact on financial institutions. These loans have created a chain reaction, and last week our credit markets froze. Even some Main Street non-financial institutions--or, excuse me, some non-financial companies had trouble financing their normal business operations. If that situation were to persist, it would threaten all parts of our economy. Every American business depends on money flowing through our system every day, not only to expand their business and create jobs, but to maintain normal business operations and to sustain jobs. As we have worked through this period of market turmoil, we have acted on a case-by-case basis, addressing problems at Fannie Mae and Freddie Mac, working with market participants to prepare for the failure of Lehman Brothers, and lending to AIG so it can sell some of its assets in an orderly manner. And here I would make the comment, you know, I have heard your comments on executive compensation. I share your frustrations. I feel those frustrations. Practices throughout America also upset me. Let me just say that, with regard to Freddie and Fannie and AIG, in case you or your constituents do not know, in those cases CEOs were replaced, the Government got warrants for 79.9 percent of the equity, golden parachutes were eliminated, strong action was taken. I will also say to the comments made about Freddie and Fannie and the bazooka, you all can be darn glad you gave us the bazooka, because we needed it. Let me tell you something. The root of that problem was in congressional charters started many, many years ago. We were living up to our obligations here. There are ambiguities. There are obligations around those charters. And what we did was we came in, we stabilized the market, mortgage rates went down so that capital could flow through our system. And I can just say I for one--and I know that the other witnesses feel very glad about this--thank goodness that was done and they were stabilized before we had some investment banks report their earnings, or let me tell you, this would be a much more serious situation than it is today. So there is an example of broad authorities working the way they were supposed to work to stabilize our system. Sorry for that ad hoc response, but we have also taken a number of powerful tactical steps to increase confidence in the system, including a temporary guaranty program for the U.S. money market mutual fund industry. These steps have been necessary but not sufficient. More is needed. We saw market turmoil reach a new level last week and spill over into the rest of the economy. We must now take further, decisive action to fundamentally and comprehensively address the root cause of this turmoil. And that root cause is the housing correction, as you have all pointed out, which has resulted in illiquid mortgage assets that are choking off the flow of credit which is so vitally important to our economy. We must address this underlying problem and restore confidence in our financial markets and financial institutions so they can perform their mission of supporting future prosperity and growth. We have proposed a program to remove troubled assets from the system. We would do this through market mechanisms available to thousands of financial institutions throughout America--big banks, small banks, savings and loans, credit unions--to help set values of complex, illiquid mortgage and mortgage-related securities to unclog our credit and capital markets and make it easier for private investors to purchase these securities and for the financial institutions to raise more capital after the market learns more about the underlying value of these hard-to-value, complicated mortgage-related securities on their balance sheets. This Troubled Asset Relief Program has to be properly designed for immediate implementation and be sufficiently large to have maximum impact and restore market confidence. It must also protect the taxpayer to the maximum extent possible and include provisions that ensure transparency and oversight while also ensuring the program can be implemented quickly and effectively. And let me give you another ad hoc comment there. When we all met Thursday night, as you will recall, Chairman, with the leaders of Congress, you all said to us, ``Don't give us a fait accompli. Come in and work with us.'' We gave you a simple three-page legislative outline, and I thought it would have been presumptuous for us on that outline to come up with an oversight mechanism. That is the role of Congress. That is something we are going to work on together. So if any of you felt that I did not believe that we needed oversight, I believe we need oversight. We need oversight. We need protection. We need transparency. I want it, we all want it. And we need to do that in a way that lets this system, lets this program work effectively, quickly, because it needs to work effectively and quickly, and it needs to get the job done. Now, the market turmoil we are experiencing today poses great risk to U.S. taxpayers. When the financial system does not work as it should, Americans' personal savings and the ability of consumers and businesses to finance spending, investment, and job creation are threatened. The ultimate taxpayer protection will be the market stability provided as we remove the troubled assets from our financial system. Don't forget that. This system has to work, and has to work right, and that will be the ultimate market protection. I am convinced that this bold approach will cost American families far less than the alternative--a continuing series of financial institution failures and frozen credit markets unable to fund everyday needs and economic expansion. Again, I am frustrated. The taxpayer is on the hook. The taxpayer is already on the hook. The taxpayer is going to suffer the consequences if things do not work the way they should work. And so the best protection for the taxpayer and the first protection for the taxpayer is to have this work. Over these past days, it has become clear that there is a bipartisan consensus for an urgent legislative solution. We need to build upon this spirit to enact this bill quickly and cleanly, and avoid slowing it down with provisions that are unrelated or do not have broad support. This troubled asset purchase program on its own is the single most effective thing we can do to help homeowners, the American people, and to stimulate our economy. Earlier this year, Congress and the administration came together quickly and effectively to enact a stimulus package that has helped hard-working Americans and boosted our economy. We acted cooperatively and faster than anyone thought possible. Today we face a much more challenging situation that requires bipartisan discipline and urgency. When we get through this difficult period, which we will, our next task must be to address the problems in our financial system through something you have all talked about. We need reform that fixes this outdated financial regulatory structure. You have all heard me talk about that a lot. And we need other strong measures to address other flaws and excesses in the system. And there are plenty, and we have all talked about them, and they cannot be addressed this week. We need to take time to address these. I have already put forward my recommendations on this subject. Many of you have strong views based on your expertise. We must have that critical debate, but we must get through this period first. Right now, all of us are focused on the immediate need to stabilize our financial system, and I believe we share the conviction that this is in the best interest of all Americans. Now let's work together to get it done. Thank you. " CHRG-111hhrg52406--190 Mr. Tyler," Thank you, sir. Good afternoon. Mr. Chairman, my name is Ralph Tyler. I am the Maryland Insurance Commissioner, and I appear today on behalf of the National Association of Insurance Commissioners. My comments will be directed to the question posed by the committee regarding the applicability of this proposed new agency to insurance. While separating consumer protection from financial oversight may be an appropriate structure for other sectors, not so with insurance. Insurance is a promise to pay in the future if a covered loss occurs. Thus, solvency is the bedrock consumer protection. With an insurance contract, consumer protections are embedded in the product design, and product design directly affects solvency. As a result, we do not think the supervision of these areas should be separated or shared with a competing regulator. There is currently a continuum of interaction between the insurance regulator and the insurance industry. It extends from licensing a company or a producer through product design and financial assessment to market conduct and claims payment. Breaking apart the links in that process will create gaps and inconsistencies, and it will do nothing to address the problems we collectively seek to resolve. In the area of insurance regulation, the States have developed a wide range of consumer protection tools, which are detailed in my written testimony, all of which are designed around complex products and unique interactions between insurers and policyholders. The basic purpose of market regulation is to protect consumers by identifying and correcting practices that are in conflict with contract provisions and State law requirements. For example, all States have unfair trade practices laws and unfair claims settlement protections based on models developed through the National Association of Insurance Commissioners. These laws provide a framework of consumer protection that gives States broad authority to intervene on behalf of policyholders. The first link in the insurance regulatory chain is licensing an insurer to do business in the State. This process begins by examining the insurer's financial solvency, management capacity, expertise, and other factors. We also assess insurance producers through examinations, background checks, and continuing education requirements to ensure that consumers are protected at the point of sale. Regulators then ensure the adequacy and appropriateness of the products offered to consumers. Insurance policies are complicated contracts, so insurance departments review policy forms to ensure that consumers are getting the coverage for which they have paid and that the policy provisions comply with the law. Likewise, because insurance is a product whose ultimate value is not known at the time of purchase and is dependent on risk assumptions that are difficult for a consumer to verify, States have some form of rate review to assure that rates are adequate but not excessive or discriminatory. Additionally, 36 States, including Maryland, from where I come, are now part of the Interstate Insurance Product Regulation Commission, which allows an insurer offering life insurance, annuities, long-term care, and disability products to get product approval directly through the Commission, using one set of uniform standards while leaving market conduct enforcement and consumer protection to the States. In total, the States have approximately 1,600 consumer service personnel monitoring the marketplace, handling in the aggregate 2.3 million consumer inquiries and 370,000 formal consumer complaints each year. To deal with criminal activity related to insurance, there are over 1,200 State personnel devoted to these activities. The States have developed a sophisticated system of consumer protection, and we would respectfully urge the committee not to change that system in the name of consumer protection. Simply put, federalizing insurance regulation in the name of consumer protection would weaken consumer protection. Thank you very much. [The prepared statement of Mr. Tyler can be found on page 189 of the appendix.] " CHRG-111shrg51395--19 Mr. Ryan," Good morning. Thank you for inviting me. I appreciate being here. Our current financial crisis, which has affected nearly every American family, underscores the imperative to modernize our financial regulatory system. Our regulatory structure and the plethora of regulations applicable to financial institutions are based on historical distinctions between banks, securities firms, insurance companies, and other financial institutions--distinctions that no longer conform to the way business is conducted. The negative consequences to the investing public of this patchwork of regulatory oversight are real and pervasive. Investors do not have comparable protections across the same or similar financial products. Rather, the disclosures, standards of care, and other key investor protections vary based on the legal status of the intermediary or the product or service being offered. In light of these concerns, SIFMA advocates simplifying and reforming the financial regulatory structure to maximize and enhance investor protection and market integrity and efficiency. Systemic risk, as Professor Coffee noted, has been at the heart of the current financial crisis. As I have previously testified, we at SIFMA believe that a single, accountable financial markets stability regulator, a systemic regulator, will improve upon the current system. While our position on the mission of the financial markets stability regulator is still evolving, we currently believe that its mission should consist of mitigating systemic risk, maintaining financial stability, and addressing any financial crisis, all of which will benefit the investing public. It should have authority over all markets and market participants, regardless of charter, functional regulator, or unregulated status. It should have the authority to gather information from all financial institutions and markets, adopt uniform regulations related to systemic risk, and act as a lender of last resort. It should probably have a more direct role in supervising systemically important financial organizations, including the power to conduct examinations, take prompt corrective action, and appoint or act as the receiver or conservator of all or part of systemically important organizations. We also believe, as a second step, that we must work to rationalize the broader regulatory framework to eliminate regulatory gaps and imbalances that contribute to systemic risk by regulating similar activities and firms in a similar manner and by consolidating certain financial regulators. SIFMA has long advocated the modernization and harmonization of the disparate regulatory regimes for investment advisory, brokerage, and other financial services in order to promote investor protection. SIFMA recommends the adoption of a ``universal standard of care'' that avoids the use of labels that tend to confuse the investing public and expresses, in plain English, the fundamental principles of fair dealing that individual investors can expect from all of their financial services providers. Such a standard could provide a uniform code of conduct applicable to all financial professionals. It would make clear to all individual investors that their financial professionals are obligated to treat them fairly by employing the same core standards whether the firm is a financial planner, an investment adviser, a securities dealer, a bank, an insurance agency, or any other type of financial service provider. The U.S. is the only jurisdiction that splits the oversight of securities and futures activities between two separate regulatory bodies. We support the merger of the SEC and the CFTC. We believe that the development of a clearinghouse for credit derivatives is an effective way to reduce counterparty credit risk, facilitate regulatory oversight, and, thus, promote market stability. In particular, we strongly support our members' initiative to establish a clearinghouse of CDS, and we are pleased to note that ICE US Trust opened its doors for clearing CDS transactions yesterday. Finally, the current financial crisis reminds us that markets are global in nature, and so are the risks of contagion. To promote investor protection through effective regulation and the elimination of disparate regulatory treatment, we believe that common regulatory standards should be applied consistently across markets. Accordingly, we urge that steps be taken to foster greater cooperation and coordination among regulators in all major markets. Thank you. " CHRG-111shrg57923--38 Mr. Horne," I have known that there has been a national housing problem since the first time that our partners--we have over 900 data partners that we work with. One of our largest data partners is First American CoreLogic, which is the largest collector of deed, tax, and mortgage roll property information in the country. So when I started analyzing their data and combining it with Dow Jones information about the individual market segments and the tremendous volumes--I mean, we collect terabytes and terabytes of information--and start looking at the various factors that we call trigger events--these are things that occur that show an action taking place that is either positive or potentially adverse actions--we saw this occurring, frankly, before 2007. We actually saw the bubble before the bubble and could tell some of these things were starting to happen. The problem, again, is this is macro data. When they roll it up and look at it, they usually look at it within the housing market, within the specific segment of the database that they have, and we haven't brought it together with our unemployment findings, with our bankruptcy findings, with our commercial real estate information to separate it from the residential real estate information. And this disaggregation of information in these individual silos prevent us from being able to do, except through very extensive manual efforts, the ability to bring this data together in a way so we actually can build real models on the symbiosis, the systemic issues that are occurring between all these different factors in the marketplace. The systemic issues that occur within an institution and institutions, which I think we are talking about here, between the majors, the Citicorps, the JPMorgans, the AIGs, are extensive and we understand that they are very complex and the counterparty risks there are very difficult to track, particularly if you don't have access to all of the other pieces of information. Now, we have large amounts of information regarding derivative data, regarding all sorts of different kinds of financial instruments, but it is only segments of the market. We don't have all of it because not all of it is available, even in public or private data. So part of the issue here is the investment that needs to be done to actually build the database. Senator Reed. Well, I don't--we have taken a great deal of your time and it has been extremely valuable, so thank you. But I don't sense there is a mutually exclusive sort of agenda here. I think we are talking about the same thing, which is building in the short term an information gathering and an analytical capability that will help us, but in the longer term, getting to the point where it is just not prediction, there might be even some treatment involved, which is the point you made. Dr. Mendelowitz, a final point. " CHRG-111hhrg53238--2 The Chairman," The hearing will come to order. As people know, we are in a very, very serious examination of the financial regulations of the country. It is the intention of myself as Chair to--that is pretty pompous--it is my intention to begin marking up a couple of aspects of this. Most of the complex, systemic ones will be coming in September. But we do have a very heavy schedule of hearings, and I want to invite anyone listening in the audience today or through any other means, please feel free to submit information. We have a serious set of issues here. They are interconnected. We really do welcome information. The hearing today is to receive the views of people in the financial services industry on various regulatory proposals. And I invite people to talk about the full range. Obviously, there is a certain amount of concern about the proposal for a financial customer protection agency, but we also are going to be dealing with the questions of systemic risk for those institutions which are not banks, the question of the resolving authority and how we can extend that. We did have a separate hearing on compensation, but that will be one of the topics. We obviously will also be dealing with questions of derivatives and how much we are going to tighten regulation on that, and the answer is a significant amount. And I do want to note that on this coming Monday, after the Chairman of the Federal Reserve testifies, we are going to have a hearing specifically on the question of ``too-big-to-fail.'' That has become a very important issue that people are concerned about. My own view is that the Administration's approach deals with that in a reasonable way, but it is important that we both be doing it right and be seen to be doing it right. And so on Monday, we are going to be having a hearing specifically to address how we can avoid the danger of a too-big-to-fail regime. How do we have a situation--obviously, the hope is you want to keep them from getting too big and, particularly, you hope to keep them from failing. But how do you deal with that if it happens? So I do recommend to anyone--and I almost want to have an essay contest, except we are not allowed to give anybody anything except through an appropriations bill, and that has gotten tougher than it used to be. But anyone who has any proposal for what we should be doing to substantially diminish the likelihood of any institutions being treated as too-big-to-fail--I am serious--please feel free to let us have them, in writing in particular, because I think there is a general consensus that one of the things we want to come out of this with is a substantial diminution, at the very least, of that problem. Now let me begin my statement. Today's hearing is about the whole set of issues. Obviously, the financial consumer protection issue has attracted a lot of attention, and that is the one that I believe we will be able to mark-up before we go. I just want to read a memo I got from my staff. It is a memo summarizing the large number of complaints we have received both directly from consumers and from Members on both sides of the aisle who have heard from their constituents objecting to practices that the credit card companies are engaging in now that we have passed the bill. Essentially, the argument is that in anticipation of the legislation, a number of things are happening. Senator Dodd, in fact, sent a letter to the Chairman of the Federal Reserve talking about this. As you know, in a compromise with people in the banking industry, we agreed to hold off the effective date. But we were concerned that the effective date being held off might lead people to kind of flood the zone before we could get there. We have had complaints about significant increases in the monthly minimum payment, for example, from 2 percent to 5 percent on existing balances. Again, I want to make clear, in my own mind, there is a distinction between what you do with existing balances and what you do going forward. And I don't think an increase in the minimum monthly payment is a bad thing in every case; and maybe it discourages people from getting too deeply in over their heads. But to raise the monthly minimum on an existing balance is changing the rules after people have started playing. And people could rightly say, ``Well, if I had known that, I would have altered my behavior at the outset.'' One of my colleagues told me that he had people complain that JPMorgan Chase had told him that it was Federal law requiring such increases. That is, of course, not true; and I have no reason to disbelieve people saying that is what they were told by various bank employees. We have other changes being made, some of which are within the law, some of which I think would be prevented by the law. But that, I must tell you, is what strengthens the case for this Agency. We cannot and should not try to pass a law every time there is a set of complaints. What we need is for there to be rules. And it is not our experience that the existing regulators have used statutory authority given to them very vigorously. But this, this flood of complaints--and I must tell you the complaints about the credit card issuance, the credit card-issuing banks--has become a very significant one. There are a couple other points I will make with regard to financial customer protection. I know there will be people who won't want it in any case. I certainly agree that it should not be a situation in which any bank could ever be given contradictory orders. We can guarantee that this law will be written, if it becomes law, to prevent that. I previously expressed my view that the Administration made a mistake in including the Community Reinvestment Act here. I think that is a different order of activity. One other concern that came because, as the Administration sent it, they, of necessity, talked about their plans to abolish--well, to merge the OTS and the OCC and to--I know there are people who think merging the OCC and the OTS is kind of like merging Latvia with the Soviet Union, but we do really see this as a merger because we think there is a very important thrift function that has to be preserved. And in that conjunction, I do not think this committee is going to abolish the thrift charter. I think it is important that we preserve the thrift charter. The problem with the thrift charter is that it is both a charter to engage in thrift activity and, to some extent, a hunting license to go and do other things with less regulation. I believe we are capable of rewriting that so that it is a thrift charter and a thrift charter only and will not get into that. And while I am on thrifts, I just want to have one--we are often criticized, and good things happen and people don't notice, I was pleased to read in the report of the Federal Home Loan Banks, not that they had lost money; they lost money, as we expect for people in the housing business, but they made a point of noting that their losses were significantly less than they would have been had it not been for the alterations that had been made in the mark-to-market rules; that their ability to distinguish between instruments held for trading and instruments that they plan to hold until maturity, which are fully paying, minimize their losses. When you minimize the losses of the Federal Home Loan Banks, you increase their ability to make home loans at a time when we need them. So I do want to take credit, because this committee had a major role in an advocacy capacity on both sides in urging that change in mark-to-market. And we have just had some evidence that it was the right thing to do. The gentleman from Alabama is recognized for how much time? " CHRG-111shrg382--41 PREPARED STATEMENT OF KATHLEEN L. CASEY Commissioner, Securities and Exchange Commission September 30, 2009 Chairman Bayh, Ranking Member Corker, and distinguished members of the Committee, thank you for inviting me to testify about the international cooperation to modernize financial regulation.Why International Cooperation is Necessary I am pleased to have the opportunity to testify on behalf of the Securities and Exchange Commission on this very important topic. International cooperation is critical for the effectiveness of financial regulatory reform efforts. In reaffirming their commitment to strengthening the global financial system, the G-20 Finance Ministers and Bank Governors recently set forth a number of actions to ``maintain momentum [and] make the system more resilient.'' The G-20 banking statement correctly recognizes that due to the mobility of capital in today's world of interconnected financial markets, activity can easily shift from one market to another. Only collective regulatory action can be effective in fully addressing cross-border activity in our global financial system. As an SEC Commissioner and Chairman of the Technical Committee of the International Organization of Securities Commissions (IOSCO), I bring the perspective of both a national securities market regulator and a member of the international organization charged with developing the global response to the challenges posed to securities markets by the financial crisis. I also represent the SEC and IOSCO in the Financial Stability Board (FSB), where the U.S. financial regulatory policy representation is led by the Department of Treasury, with the SEC and the Federal Reserve Board both serving as members. The financial crisis has made it clear that we must address regulatory gaps and overlaps. The Commission has recently proposed action to this end in a number of different areas, recognizing, however, that some regulatory gaps and market issues cannot be fully addressed without legislative action. The Commission already is working to achieve consistency on the domestic and international levels, including through IOSCO and the FSB, with banking, insurance, futures, and other financial market regulators. In this vein, the Commission also is working to ensure respect in the global regulatory environment for the integrity of independent accounting and auditing standard-setting processes for the benefit of investors. The Commission looks forward to continuing and improving on this cooperation as part of a reformed regulatory landscape.Mechanisms for International Cooperation in Securities Market Regulation The Commission has actively worked to achieve consistency in regulatory policy and implementation on an international basis through multilateral, regional, and bilateral mechanisms for many years. The SEC was a founding member of IOSCO, and has maintained a leading role in the organization. The Commission's commitment to international cooperation has become increasingly important to its mission in recent years in response to the increasingly global nature of financial markets. In addition to my chairmanship of IOSCO's Technical Committee, Commission staff leads or is very active in IOSCO's standing committees and taskforces. Commission staff also represents IOSCO in the Joint Forum on Financial Conglomerates, which was established by the Basel Committee on Banking Supervision, IOSCO and the International Association of Insurance Supervisors (IAIS) to deal with issues that cut across the banking, securities and insurance sectors. For example, SEC staff participates in the Joint Forum's Working Group on Risk Assessment and Capital, which has undertaken a number of cross-sectoral initiatives that have arisen out of the financial crisis. While IOSCO represents the primary vehicle for development of common international approaches to securities market regulation, the FSB is a key mechanism for the Commission to engage internationally on broader financial market issues. The FSB has a broader scope, with membership comprised of national regulatory and supervisory authorities, standard setting bodies and international financial institutions. In addition, its mission is to address vulnerabilities and to encourage the development of strong regulatory, supervisory and other policies in the interest of financial stability. The Commission also is represented in oversight bodies charged with maintaining the public accountability of international accounting and auditing standard-setters. SEC Chairman Schapiro is a member of the Monitoring Board of the International Accounting Standards Committee Foundation. Through this Board, the SEC and other capital market authorities that permit, have proposed to permit, or require the use of International Financial Reporting Standards in their jurisdictions have a means to carry out more effectively their mandates regarding investor protection, market integrity, and capital formation. The Commission also is represented through IOSCO in the Monitoring Group for the Public Interest Oversight Board, which serves as a mechanism for promoting the public interest in the development of international standards for auditing by the International Federation of Accountants. In addition to multilateral, global engagement, the Commission participates in regional and bilateral mechanisms for discussion and promotion of common approaches to regulation. SEC Commissioner Aguilar is the Commission's liaison to the Council of Securities Regulators of the Americas, or COSRA, which aims to develop high quality and compatible regulatory structures among authorities in the Western hemisphere. Commission staff, alongside staff of the Federal Reserve Board, the Commodity Futures Trading Commission, and other U.S. Government agencies, also participates in a number of Treasury-led financial regulatory dialogues, including with the European Commission, Japan, China and India, as well as Australia and our North American partners, Canada and Mexico. Securities-regulatory-focused bilateral dialogues between Commission staff and our counterpart securities regulators in these and other jurisdictions also complement the broader financial sector dialogues; we are engaged in such bilateral efforts with, among others, the U.K. Financial Services Authority and the Japan Financial Services Agency, the Committee of European Securities Regulators (CESR), and the China Securities Regulatory Commission, Securities and Exchange Board of India, and Korea Financial Supervisory Commission. Furthermore, the Commission and a number of other securities regulators have recently entered into bilateral ``supervisory'' memoranda of understanding that go well beyond sharing information on enforcement investigations. These supervisory MOUs, such as those the SEC has signed with the U.K.'s Financial Services Authority and the German consolidated financial services regulator (known as the ``BaFin''), represent groundbreaking efforts by national securities regulators to work together to cooperate in their oversight of financial firms that increasingly operate across borders. Thus, the infrastructure for international cooperation on securities regulatory policy is well-developed, and the Commission plays a key role in promoting rising levels of cooperation. These efforts build on the success the Commission has achieved in raising standards of cross-border enforcement cooperation. Over two decades ago, the Commission entered into its first bilateral memoranda of understanding for the sharing of information in securities enforcement matters. To date, the Commission has concluded bilateral agreements with 20 jurisdictions that remain in force today. These bilateral agreements were the impetus for the creation of the IOSCO Multilateral Memorandum of Understanding (MMoU) in 2002. Since then, authorities in 55 jurisdictions, including the SEC, have already implemented the principles for cross-border enforcement cooperation contained in the MMoU and another 27 jurisdictions have committed to do so. With each additional MMoU signatory, the scope and ability of the SEC to pursue wrongdoers across borders significantly increases. This ability is increasingly important as more and more SEC investigations involve some international component. In addition to continuing to work to increase the number of jurisdictions that share information pursuant to the MMoU, the Commission also is continually working to increase the level of enforcement cooperation that it provides foreign counterparts as well as the level of cooperation provided by our global counterparts. The SEC was among the first securities regulators to receive the legal authority to assist foreign counterparts in investigations of securities fraud. Today, the SEC has broad authority to share supervisory information as well as assist foreign securities authorities in their investigations using a variety of tools, including exercising the SEC's compulsory powers to obtain documents and testimony. To further facilitate international cooperation, the SEC supports the passage of H.R. 3346 that would give authority to the Public Company Accounting Oversight Board, which the SEC oversees, to share confidential supervisory information with foreign auditor oversight bodies. The Commission believes that granting this authority to the PCAOB would enhance auditor oversight, audit quality and, ultimately, investor protection.Key Securities Regulatory Reform Issues and International Cooperation The Commission has led or supported the development of a number of international securities market regulatory initiatives to support the strengthening of the global financial system in the wake of the financial crisis. These initiatives, developed through IOSCO, its joint working group with the Committee on Payment and Settlement Systems (CPSS), and the Joint Forum, have been developed in conjunction with calls from the G-20 and FSB to ensure that all systemically important financial institutions, markets, and instruments are subject to an appropriate degree of regulation and oversight.IOSCO IOSCO's Subprime Task Force issued its report in 2008, examining the underlying causes of the financial crisis and the implications for international capital markets. IOSCO launched a number of ongoing projects in response to recommendations in this report, including in key areas such as issuer transparency and investor due diligence; firm risk management and prudential supervision; valuation and accounting issues. Last fall, following on concerns highlighted by the G-20 Leaders, IOSCO also established task forces on unregulated entities, unregulated financial markets and products, and supervisory cooperation, each of which is discussed in greater depth below. The Commission has contributed significantly to these projects with a view to ensuring that global capital markets address issues relating to the current turmoil in a sound and aligned way.Credit Rating Agencies With regard to credit rating agencies, in February of this year, IOSCO established a permanent standing committee to continually evaluate and seek cross-border consensus for CRA regulation. IOSCO has built on the early work in this area that resulted in the IOSCO CRA Principles and Code of Conduct Fundamentals first adopted in 2003 and 2004. The Code Fundamentals, as amended in 2008 as a consequence of ``lessons learned'' during the early ``subprime crisis,'' has already been substantially adopted by at least seven rating agencies, including the largest ones. Staff of the SEC chair this committee.Unregulated Entities With regard to unregulated entities, following extensive consultation, IOSCO agreed to a set of high-level principles for hedge fund regulation in June of this year. The six principles include requirements on mandatory registration for funds or their advisers, ongoing regulation and provision of information for systemic risk assessment purposes. They also state that regulators should cooperate and share information to facilitate efficient and effective oversight of globally active hedge fund managers and hedge funds. Work continues in IOSCO on defining what type of information should be provided by the hedge fund sector (and their counterparties) to allow regulators to assess the systemic importance of individual actors and identify possible financial stability risks.Unregulated Markets and Products Earlier this month, IOSCO's Task Force on Unregulated Financial Markets and Products issued a number of recommendations concerning regulatory approaches that may be implemented with respect to the securitization and credit default swap (CDS) markets, as these two markets were key elements of the global financial crisis. The Task Force continues to consider whether additional work should be undertaken regarding implementation of the recommendations. In addition, the Commission has worked closely over the past year with international regulators and central banks in gaining first-hand experience in applying the Recommendations for Central Counterparties (RCCPs) to proposed arrangements for OTC credit derivatives transactions. This has highlighted some challenges regarding the application of RCCPs to credit default swaps (CDSs), particularly with respect to valuation models. The CPSS, under the leadership of New York Federal Reserve Bank President William Dudley, and IOSCO have created a joint working group (co-chaired by the European Central Bank) to propose guidance on how central counterparties for OTC derivatives may meet the standards set out by the RCCP and will identify any areas in which the RCCP might be strengthened or expanded to better address risks associated with the central clearing of OTC derivatives. This working group will complete its report by the middle of 2010.Supervisory Cooperation As operations globalize, oversight and supervision require increased cross border cooperation. Supervisory cooperation is a critical tool in gathering information about risks and trends within institutions and across markets. To this end, IOSCO established a Task Force on Supervisory Cooperation this spring to develop principles on regulatory cooperation in the supervision and oversight of market participants, such as exchanges, funds, brokers, and advisers, whose operations cross international borders. Final principles are expected to be published in February 2010.Commodity Futures Markets IOSCO's Task Force on Commodity Futures Markets, which was formed following concerns relating to price and volatility increases in agricultural and energy commodities in 2008, focused on whether futures market regulators' supervisory approaches were appropriate in light of market developments. The Task Force issued its report in March 2009 with recommendations aimed at ensuring that regulators have the appropriate information and tools available to them to monitor futures markets effectively and act against any market manipulation. The Task Force was recently revived, with CFTC Chairman Gary Gensler and U.K. Financial Services Authority Chairman Adair Turner as co-chairs, to continue to address concerns about access to relevant information for effective market surveillance and to promote improvements to regulatory frameworks that may inhibit the ability to detect and enforce market manipulation cases.Joint Forum Cross-Sectoral Projects The Commission, participating through IOSCO in the Joint Forum, which is led by Comptroller of the Currency John Dugan, is taking part in a review of the scope of financial regulation, with a special emphasis on institutions, instruments, and markets that are currently unregulated. The group's focus is on the differentiated nature of regulation in the banking, securities and insurance sectors; current consolidated supervision and unregulated entities or unregulated activities within a conglomerate structure; and the regulation of hedge funds; among other issues. The main deliverable of this workstream will be a report to the FSB and G-20 Finance Ministers and Governors, and is expected by the end of this year. In addition, the Joint Forum's Working Group on Risk Assessment and Capital (JFRAC) recently finalized its report examining the range of various Special Purpose Entities (SPEs) used by financial firms to transfer risk for capital and liquidity management purposes as well as derivatives vehicles and transformer vehicles. Finally, in recognition of the reality that prudential supervision is becoming increasingly risk-sensitive in the different sectors, JFRAC has also undertaken a project to consider methods for risk aggregation that incorporate a characterization and quantification of diversification effects within financial firms. The primary focus of this work will be on aggregation across different types of risk--such as credit, market, insurance, and operational risk--and on similarities and differences between the commercial banking, investment banking, and insurance sectors. A preliminary draft paper will be discussed at the October Joint Forum meeting.FSB / G-20 Participation and U.S. Government Coordination With regard to my role at the FSB, I represent both the Commission and the IOSCO Technical Committee alongside the other U.S. Government participants, namely Governor Tarullo of the Federal Reserve Board and the Under Secretary for International Affairs of the Department of Treasury. The Commission places a high priority on coordinating the U.S. position with its fellow agencies and presenting a strong and unified position in policy discussions at the FSB level. This is accomplished through extensive and informal communication between the staffs of our agencies, including the Office of the Comptroller of the Currency (OCC), the Commodity Futures Trading Commission (CFTC), the Federal Deposit Insurance Corporation (FDIC) and the National Association of Insurance Commissioners (NAIC), among others, and has been highly effective. In this regard, the work that Comptroller of Currency Dugan and I jointly led, under theauspices of the Financial Stability Forum's efforts to reduce procyclicality of regulation, to explore possible improvements to the accounting for loan loss provisioning is particularly noteworthy.Importance of the Role of Technical Experts and Independent, Consultative Rulemaking The international financial regulatory architecture that I have just outlined has proven its robustness in the level of cooperation since the outbreak of the financial crisis. The G-20 leaders' focus on financial regulation has provided more high-level and political attention to these ongoing efforts. With the conversion of the Financial Stability Forum into the FSB and expansion of its membership to the G-20, the architecture is evolving to reflect the growing importance of emerging markets and international cooperation in light of the interconnectedness of the global financial system. While the Commission supports and participates in the work of all of these international organizations, I would like to take this opportunity to highlight the different roles that these international organizations should play as nations increasingly seek to cooperate with regard to international financial regulatory policy. The FSB, for example, comprises officials from across the spectrum of financial regulation, and so is very useful as a discussion forum to determine broad trends in the financial system. Through FSB discussions, gaps in regulation can be more readily identified and prioritized. The G-20 focus on these results also is helpful in ensuring that the pace of reform is maintained and that a clear international framework emerges. Given the complexity of the financial markets, however, it is critical that technical regulatory bodies such as those represented in IOSCO, as well as statutorily mandated independent regulators, such as the Commission, have control over their agendas and the ultimate outcomes of their regulatory and standard-setting work. The regulators and supervisors of each financial sector have specific goals for regulation, which may differ slightly from sector to sector, but are all important. For example, a key goal of securities regulators is investor protection; this goal is not the focus of bank or insurance supervisors, who have other priorities. Only by allowing the technical experts to develop regulatory approaches to address areas of concern in their sector can we ensure that all regulatory goals are being met. Moreover, implementation and enforcement depend on legal mechanisms and processes that vary jurisdiction by jurisdiction, and sector by sector. One example where this approach has been successful is raising standards for international securities law enforcement cooperation. The development of the IOSCO MMoU, and the push to further expand the number of jurisdictions providing cooperation as well as deepen the level of cooperation they provide, has significantly raised standards of cooperation in the securities sector over the past decade. The FSB's effort to promote standards in non-cooperative jurisdictions will provide opportunities to raise the level of cooperation across a broad range of financial regulatory enforcement concerns. The Commission looks forward to continuing the constructive dialog with our colleagues at the Fed, Treasury, and other agencies, in continuing to develop the common U.S. position in the future. For more specifics on the outcome of the recent G-20 meeting, I defer to Mark Sobel of the Treasury Department, as the Commission did not directly participate in the Summit or the G-20 process leading to Pittsburgh.Conclusion While the Commission's particular focus--and that of IOSCO--on investor protection and efficient and fair markets has remained constant and somewhat distinct from that of banking supervisors and regulators of other market segments, our recent collaborative work--both at home and internationally--has shown significant progress in strengthening the global financial regulatory system. It remains the case that investor protection and a focus on efforts to enhance investor confidence are vital to interests of financial stability on national and global levels. In its June White Paper, the Administration named as one of its five key objectives of financial regulatory reform the raising of international regulatory standards and improvement of international cooperation. The Commission, through IOSCO, the FSB, other cross-border mechanisms, and coordinating domestically with fellow financial regulators, stands ready to continue its collaborative work with the aim of enhancing our ability to identify and address systemic risks early across the world's financial markets. International cooperation is essential to the success of any financial regulatory reform that we undertake. Thank you for this opportunity to address such timely and relevant global regulatory issues. ______ fcic_final_report_full--404 The performance of the stock market in the wake of the crisis also reduced wealth. The Standard and Poor’s  Index fell by a third in —the largest single- year decline since —as big institutional investors moved to Treasury securities and other investments that they perceived as safe. Individuals felt these effects not only in their current budgets but also in their prospects for retirement. By one calcu- lation, assets in retirement accounts such as (k)s lost . trillion, or about a third of their value, between September  and December .  While the stock mar- ket has recovered somewhat, the S&P  as of December , , was still about  below where it was at the start of . Similarly, stock prices worldwide plum- meted more than  in  but rebounded by  in , according to the MSCI World Index stock fund (which represents a collection of , global stocks). The financial market fallout jeopardized some public pension plans—many of which were already troubled before the crisis. In Colorado, state budget officials warned that losses of  billion, unaddressed, could cause the Public Employees Re- tirement Association plan—which covers , public workers and teachers—to go bust in two decades. The state cut retiree benefits to adjust for the losses.  Mon- tana’s public pension funds lost  billion, or a fourth of their value, in the six months following the  downturn, in part because of investments in complex Wall Street securities.  Even before the fall of , consumer confidence had been on a downward slope for months. The Conference Board reported in May  that its measure of con- sumer confidence fell to the lowest point since late .  By early , confidence had plummeted to a new low; it has recovered somewhat since then but has remained stubbornly bleak.  “[We find] nobody willing to make a decision.  .  .  . nobody willing to take a chance, because of the uncertainty in the economic environment, and that goes for both the state and the federal level,” the commercial real estate developer and ap- praiser Gregory Bynum testified at the FCIC’s Bakersfield hearing.  Influenced by the dramatic loss in wealth and by job insecurity, households have cut back on debt. Total credit card debt expanded every year for two decades until it peaked at  billion at the end of . Almost two years later, that total had fallen , to  billion. The actions of banks have also played an important role: since , they have tightened lending standards, reduced lines of credit on credit cards, and increased fees and interest rates. In the third quarter of ,  of banks im- posed standards on credit cards that were tighter than those in place in the previous quarter. In the fourth quarter,  did so, meaning that many banks tightened again. In fact, a significant number of banks tightened credit card standards quarter after quarter until the summer of . Only in the latest surveys have even a small num- bers of banks begun to loosen them.  Faced with financial difficulties, over . mil- lion households declared bankruptcy in , up from approximately . million in .  fcic_final_report_full--162 The other major rating agencies followed a similar approach.  Academics, in- cluding some who worked at regulatory agencies, cautioned investors that assump- tion-heavy CDO credit ratings could be dangerous. “The complexity of structured finance transactions may lead to situations where investors tend to rely more heavily on ratings than for other types of rated securities. On this basis, the transformation of risk involved in structured finance gives rise to a number of questions with important potential implications. One such question is whether tranched instruments might re- sult in unanticipated concentrations of risk in institutions’ portfolios,” a report from the Bank for International Settlements, an international financial organization spon- sored by the world’s regulators and central banks, warned in June .  CDO managers and underwriters relied on the ratings to promote the bonds. For each new CDO, they created marketing material, including a pitch book that in- vestors used to decide whether to subscribe to a new CDO. Each book described the types of assets that would make up the portfolio without providing details.  With- out exception, every pitch book examined by the FCIC staff cited an analysis from ei- ther Moody’s or S&P that contrasted the historical “stability” of these new products’ ratings with the stability of corporate bonds. Statistics that made this case included the fact that between  and ,  of these new products did not experience any rating changes over a twelve-month period while only  of corporate bonds maintained their ratings. Over a longer time period, however, structured finance rat- ings were not so stable. Between  and , only  of triple-A-rated struc- tured finance securities retained their original rating after five years.  Underwriters continued to sell CDOs using these statistics in their pitch books during  and , after mortgage defaults had started to rise but before the rating agencies had downgraded large numbers of mortgage-backed securities. Of course, each pitch book did include the disclaimer that “past performance is not a guarantee of future performance” and encouraged investors to perform their own due diligence. As Kyle Bass of Dallas-based Hayman Capital Advisors testified before the House Financial Services Committee, CDOs that purchased lower-rated tranches of mort- gage-backed securities “are arcane structured finance products that were designed specifically to make dangerous, lowly rated tranches of subprime debt deceptively at- tractive to investors. This was achieved through some alchemy and some negligence in adapting unrealistic correlation assumptions on behalf of the ratings agencies. They convinced investors that  of a collection of toxic subprime tranches were the ratings equivalent of U.S. Government bonds.”  When housing prices started to fall nationwide and defaults increased, it turned out that the mortgage-backed securities were in fact much more highly correlated than the rating agencies had estimated—that is, they stopped performing at roughly the same time. These losses led to massive downgrades in the ratings of the CDOs. In ,  of U.S. CDO securities would be downgraded. In ,  would.  CHRG-111shrg51395--262 RESPONSE TO WRITTEN QUESTIONS OF SENATOR DODD FROM JOHN C. COFFEE, JR.Q.1. Transparency: Are there additional types of disclosures that Congress should require securities market participants to make for the benefit of investors and the markets? Also, would you recommend more transparency for investors: 1. By publicly held banks and other financial firms of off- balance sheet liabilities or other data? 2. By credit rating agencies of their ratings methodologies or other matters? 3. By municipal issuers of their periodic financial statements or other data? 4. By publicly held banks, securities firms and GSEs of their risk management policies and practices, with specificity and timeliness?A.1. Very simply, my answer is yes. In the case of financial institutions, recent experience has shown that, despite the Enron-era reforms, the major banks underwriting asset-backed securitizations entered into ``liquidity puts'' with preferred customers under which they agreed to repurchase those offerings if liquidity was lost in the secondary market--and they did not disclose these obligations on the face of their balance sheets. This was the same use of off balance sheet financing as Enron employed--all over again. Accounting regulators acquiesced to pressure from banks, and once again the result endangered the financial well being of the entire economy. Credit rating agencies should disclose their methodologies and assumptions (more or less as Senator Reed's bill (S. 1073) would require). In general, financial institutions do need to provide better and more timely disclosure of risk management practices on a continuing basis. Here, rather than listing specific disclosures that should be made, I would suggest that Congress instruct the SEC to study the recent failures and tighten its disclosure requirements in light of such study.Q.2. Conflicts of Interest: Concerns about the impact of conflicts of interest that are not properly managed have been frequently raised in many contexts--regarding accountants, compensation consultants, credit rating agencies, and others. For example, Mr. Turner pointed to the conflict of the board of FINRA including representatives of firms that it regulates. The Millstein Center for Corporate Governance and Performance at the Yale School of Management in New Haven, Connecticut on March 2 proposed an industry-wide code of professional conduct for proxy services that includes a ban on a vote advisor performing consulting work for a company about which it provides recommendations. In what ways do you see conflicts of interest affecting the integrity of the markets or investor protection? Are there conflicts affecting the securities markets and its participants that Congress should seek to limit or prohibit?A.2. In particular, conflicts of interest have affected the practices of the credit rating agencies, as they both ``consult'' with issuers and rate them, and only a thin (and possibly permeable) Chinese Wall separates the two functions and staffs. In addition, there is the problem of forum-shopping, as the issuer pays an initial fee to several agencies, but only uses the higher or highest ratings (after paying a second fee). Proxy advisors (including Risk Metrics) are similarly subject to the same conflicts of interest, as they also advise both their client base of institutional investors and issuers who specially hire them. At a minimum, such conflicts should be disclosed to investors along with all fees received by the proxy advisor from the issuer.Q.3. Credit Default Swaps: There seems to be a consensus among the financial industry, government officials, and industry observers that bringing derivative instruments such as credit default swaps under increased regulatory oversight would be beneficial to the nation's economy. Please summarize your recommendations on the best way to oversee these instruments.A.3. The best response is to mandate the use of clearinghouses in the trading of over-the-counter derivatives. Such clearinghouses would in turn specify margin and mark-to-market procedures for such instruments, subject to the general oversight of the Fed or the SEC/CFTC (depending on the instrument). The industry will respond to this proposal by saying such a rule should only apply to ``standardized'' derivatives. But there is no clear line between ``standardized'' and ``customized'' derivatives, and good lawyers can make any derivative customized in about 10 minutes if it will enable the issuer to escape additional regulatory costs. Thus, Congress or the SEC must draw a careful line so as not to permit the clearinghouse requirement to be trivialized.Q.4. Corporate Governance--Majority Vote for Directors, Proxy Access, Say on Pay: The Council of Institutional Investors, which represents public, union and corporate pension funds with combined assets that exceed $3 trillion, has called for ``meaningful investor oversight of management and boards'' and in a letter dated December 2, 2008, identified several corporate governance provisions that ``any financial markets regulatory reform legislation [should] include.'' Please explain your views on the following corporate governance issues: 1. Requiring a majority shareholder vote for directors to be elected in uncontested elections; 2. Allowing shareowners the right to submit amendment to proxy statements; 3. Allowing advisory shareowner votes on executive cash compensation plans.A.4. I support the SEC's proposals on access to the proxy statement and would require ``say on pay'' (i.e., an advisory shareholder vote on compensation) by legislation. I would urge Congress to expressly authorize the SEC to adopt its proposals on shareholder access to the proxy litigation, as otherwise there is certain to be litigation about the SEC's authority. Nor is the outcome of this litigation free from doubt. With respect to majority voting, I do not think it is necessary to overrule state law by mandating majority voting on directors, as the majority of the Fortune 1000 already follow this practice.Q.5. Credit Rating Agencies: Please identify any legislative or regulatory changes you believe are warranted to improve the oversight of credit rating agencies. In addition, I would like to ask your views on two specific proposals: 1. The Peterson Institute report on ``Reforming Financial Regulation, Supervision, and Oversight'' recommended reducing conflicts of interest in the major rating agencies by not permitting them to perform consulting activities for the firms they rate. 2. The G30 Report ``Financial Reform; A Framework for Financial Stability'' recommended that regulators should permit users of ratings to hold NRSROs accountable for the quality of their work product. Similarly, Professor Coffee recommended creating potential legal liability for recklessness when ``reasonable efforts'' have not been made to verify ``essential facts relied upon by its ratings methodology.''A.5. I favor the provisions set forth in the Reed Bill (S. 1073) and in the more recent proposals made by the Bipartisan Policy Counsel's Credit Rating Agency Task Force. I agree that the rating agencies face a conflict when they perform consulting services for companies that they rate. Liability for ``recklessness'' makes sense, but should be accompanied by a safe harbor that establishes clear standards that will enable the rating agency to avoid liability (as the Reed Bill does). Although Congress cannot resolve the First Amendment issues that the rating agencies raise in their defense, Congress can make legislative findings of fact (to which most courts do give deference) that find that credit ratings (particularly those on structured finance products) do not relate to matters of public concern and so do not merit constitutional protection beyond that normally accorded ``commercial speech.'' Finally, I would urge a statutory ceiling on the liability of a credit rating agency for any one rating or transaction, which ceiling would apply in both Federal and State court actions.Q.6. Hedge Funds: On March 5, 2009, the Managed Funds Association testified before the House Subcommittee on Capital Markets and said: ``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.'' MFA supported the creation or designation of a ``single central systemic risk regulator'' that (1) has ``the authority to request and receive, on a confidential basis, from those entities that it determines . . . 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,'' (2) has a mandate of protection of the financial system, but not investor protection or market integrity and (3) has the authority to ensure that a failing market participant does not pose a risk to the entire financial system. Do you agree with MFA's position? Do you feel there should be regulation of hedge funds along these lines or otherwise?A.6. I agree with the MFA's position. Systemic risk should be delegated to a different agency than the agency charged with consumer protection, as there are potential conflicts between these two roles. In short, a ``twin peaks'' model should be followed. Hedge funds are not inherently different than AIG in that any large financial institution could potentially fail in a manner that endangered counterparties and could therefore pose a systemic risk to the financial system.Q.7. Self-Regulatory Organizations: How do you feel the self-regulatory securities organizations have performed during the current financial crisis? Are there changes that should be made to the self-regulatory organizations to improve their performance? Do you feel there is still validity in maintaining the self-regulatory structure or that some powers should be moved to the SEC or elsewhere?A.7. Principally, I believe that pre-dispute arbitration agreements should be limited, as the process is often unfair to investors. Beyond that, the position of investment advisers, who have no SRO, is anomalous and should be re-examined. I express no view on whether they should form their own SRO or be brought under FINRA. In overview, the SROs did not cause (but did little to prevent) the 2008 financial crisis. Conceivably, they could have discovered Mr. Madoff's fraud (but the SEC bears the greater responsibility). The SRO structure has some value, particularly because SROs are self-funding and can tax the industry. Also, they enforce ``fair and equitable'' rules that are far broader than the SEC's typically narrower anti-fraud rules.Q.8. Structure of the SEC: Please share your views as to whether you feel that the current responsibilities and structure of the SEC should be changed. Please comment on the following specific proposals: 1. Giving some of the SEC's duties to a systemic risk regulator or to a financial services consumer protection agency; 2. Combining the SEC into a larger ``prudential'' financial services regulator; 3. Adding another Federal regulators' or self-regulatory organizations' powers or duties to the SEC.A.8. I do not believe that merging the SEC with another regulator is sensible or politically feasible in the short run. Nor do I think that the SEC should (at least over the short-run) assume any of the duties of other regulators. However, the SEC's ``Consolidated Supervised Entity'' Program, which was begun in 2004, clearly failed in 2008 and should not in any form be re-created. Large financial institutions (such as Goldman, Sachs or Morgan Stanley) are better monitored by the Federal Reserve as Tier One Bank Holding Companies, and the capital markets have greater confidence in the Fed's monitoring ability.Q.9. SEC Staffing, Funding, and Management: The SEC has a staff of about 3,500 full-time employees and a budget of $900 million. It has regulatory responsibilities with respect to approximately: 12,000 public companies whose securities are registered with it; 11,300 investment advisers; 950 mutual fund complexes; 5,500 broker-dealers (including 173,000 branch offices and 665,000 registered representatives); 600 transfer agents, 11 exchanges; 5 clearing agencies; 10 nationally recognized statistical rating organizations; SROs such as the Financial Industry Regulatory Authority, the Municipal Securities Rulemaking Board and the Public Company Accounting Oversight Board. To perform its mission effectively, do you feel that the SEC is appropriately staffed? funded? managed? How would you suggest that the Congress could improve the effectiveness of the SEC?A.9. The SEC needs more funds and more staff. This is best accomplished by making the SEC at least partially ``self-funding,'' specifically by allowing the SEC to keep the fees and other charges that it levies on issuers, brokers and other regulated entities. I would not, however, recommend that the SEC keep civil penalties and fines, as this would raise both due process and ``appearance of justice'' issues that are best avoided. ------ FOMC20080130meeting--339 337,MS. HIRTLE.," Mike has described how the rating agencies treated structuredcredit products; a closely related issue is how investors used these ratings. Did investors rely too much on ratings in making their investment decisions? Did they take false comfort from ratings and not really appreciate the risks they were assuming, leading to excessive growth of the market for subprime structured credit? As noted in the top panel of exhibit 7, our approach was to examine these questions through the lens of one representative type of institutional investor: public pension funds. Public pension funds are an informative example of investor use (and misuse) of credit ratings for several reasons. First, public pension boards of directors are composed largely of representatives of the employees and retirees covered by the pension plan and have only limited financial expertise in some cases. Second, survey evidence suggests that a high portion of these funds use credit ratings in their investment guidelines. Finally, relative to some other investors, many public pension funds provide significant public information about their activities. While we need to be cautious in generalizing, we believe that practices in the pension fund sector reflect the tensions faced by other institutional investors in making risk assessments and investment decisions. We examined the investment practices and fund governance of 11 public pension plans. These plans ranged from the largest fund--CalPERS, with $250 billion in assets--to six much smaller plans with assets of $6 billion to $11 billion. We used the funds' 2006 comprehensive annual financial reports, which were generally the most recent available, and the funds' websites to generate our information. We focused specifically on the funds' fixed-income segments, since this is the asset class in which structured-credit products would likely be held and for which credit ratings are used. The middle panel lists some key conclusions from this review. The first is that these funds have developed workable market solutions to address inexperience or lack of financial sophistication among their managers and board members. These include hiring professional investment managers to make investment decisions on their behalf and, perhaps as significantly, hiring investment consultants to structure asset-allocation strategies, to select investment managers and develop mandates guiding their actions, and to monitor and assess fund performance. While these funds clearly obtain significant professional advice in managing their investments, our review suggests several ways in which these arrangements could be improved in light of recent financial innovation. Specifically, the mandates guiding investment managers have not always kept pace with the growth of structured-credit markets. These mandates typically require managers to meet or exceed returns on a benchmark index or of a peer group of investment managers, while constraining the risk the managers may assume. Credit ratings play an important role in these risk constraints--for instance, by imposing a minimum average rating for the portfolio or a minimum rating on individual securities. However, few of the funds we profiled made significant distinctions between structured-credit and other securities in these credit-rating-based constraints, although there were sometimes other limits on the aggregate share of asset-backed positions. The failure to make this distinction provides scope for investment managers to generate higher returns by moving into structured-credit products, without raising warning signals about the additional risk these positions entail. This is not necessarily a ""na�ve"" use of credit ratings by investment managers, as they could well have recognized that higher-yielding structured-credit products embodied significant additional risk relative to similarly rated corporate debt. Instead, it reflects a previously effective mechanism used by fund boards to convey risk appetite to these managers falling out-of-date with the emergence and rapid growth of a new form of credit instrument. As indicated in the bottom panel, our key recommendation is that the pension fund industry and other investors should re-evaluate the use of credit ratings in investment mandates. In a narrow sense, these mandates should distinguish between ratings on structured credit and those on more traditional corporate credit. However, the more fundamental point is that mandates would do a better job of enforcing desired risk limits on the overall portfolio if they acknowledged differences in risk, return, and correlation across instruments rather than relying on generic credit ratings. A second important point is that investors should ensure that their investment consultants have independent views of the quality and adequacy of credit ratings for the types of positions in their portfolios. This is particularly important if mandates guiding investment manager behavior feature credit ratings as a key risk constraint. That completes our prepared remarks. We would be happy to take your questions before we proceed to the final presentation. " 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-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-111shrg55479--67 Mr. Coates," So it has been true for a long time that shareholders cannot force a reincorporation from one State to another on their own. They need the board to go along with it. And the board cannot do it on their own; it has got to be a joint decision. And as a result, there is actually relatively little movement between States once they have chosen their initial State of incorporation. At the moment before they go public, that is really the crucial decision point, and for that reason I think that fact that Delaware has a 70-percent share of the market, so to speak, it reflects well on Delaware. I think it is actually a reasonably healthy sign that Delaware is being responsive, as best it can, to balancing the interests of both shareholders and the managers that have to run them. One thing, however, I would note about Delaware and its permissiveness toward a little bit of activism is it only passed that enabling legislation in the past year, and it did it in response to the threat of Federal intervention coming from this body. And so I do not think you should think about Delaware acting on its own to help shareholders. I think you should think about Delaware acting in relationship to this body, and things that you do are going to very much impact it. Senator Corker. Mr. Castellani, I have served on several public company boards, certainly not of the size of AIG or some of the other companies we have had troubles with. But I do not think there is any question that boards in many cases--not all, and yours, I am sure, is not this way. But it ends up being sort of a social thing. I mean, you are on the board because the CEO of this company and the CEO of that company is on the board, and, you know, it is sort of a status thing in many cases. The CEO in many cases helps select who those board members are. And most of the time these board--many of the times, these board members have their own fish to fry. They have companies that they run, they are busy with, and, for instance, a complex financial institution, there is no way, like no possible way that most board members of these institutions really understand some of the risks that are taking place. With the limited number of board meetings, even if they are on the audit committee, very difficult to do. So some of these things need to be addressed certainly by governance issues that we might address here, hopefully not too many. Some of them need to be addressed, obviously, internally at the companies. I know you have advocated that in the office. But that issue of sort of the culture of the way boards in many cases are. Not in every case. I wonder if you might have a comment there, and then add to that--I am familiar with a company that makes investments in large companies, and one of the rules they have is they do not allow the CEO himself to actually serve on the board. They report to the board. They are at the meeting. But they do not allow them to serve on the board. So I would love for you to respond to both of those inquiries. " CHRG-111shrg56262--13 Mr. Davidson," Good afternoon, Chairman Reed, Ranking Member Bunning, Members of the Subcommittee. More than 2 years since the collapse of the Bear Stearns high-grade structured credit enhanced leverage fund, its name a virtual litany of woes, we are still in the midst of a wrenching economic crisis, brought on at least in part by the flawed structure of our securitization markets. I appreciate the opportunity to share my views on what regulatory and legislative actions could reduce the risk of such a future crisis. I believe that securitization contributed to the current economic crisis in two ways: First, poor underwriting led to unsustainably low mortgage payments and excessive leverage, especially in the subprime and Alt-A markets. This in turn contributed to the bubble and subsequent house price drop. Second, the complexity and obfuscation of some structured products such as collateralized debt obligations caused massive losses and created uncertainty about the viability of key financial institutions. Now to solutions. Boiled down to the essentials, I believe that for the securitization market to work effectively, bondholders must ensure that there is sufficient capital ahead of them to bear the first loss risks of underlying assets; that the information provided to them is correct; that the rights granted to them in securitization contracts are enforceable; that they fully understand the investment structures; and that any remaining risks they bear are within acceptable bounds. If these conditions are not met, investors should refrain from participating in these markets. If bondholders act responsibly, leverage will be limited and capital providers will be more motivated to manage and monitor risks. If this is the obligation of investors, what then should be the role of Government? First, Government should encourage all investors and mandate that regulated investors exercise appropriate caution and diligence. To achieve this goal, regulators should reduce or eliminate their reliance on ratings. As an alternative to ratings, I believe regulators should place greater emphasis or reliance on analytical measures of risk, such as computations of expected loss and portfolio stress tests. Second, Government should promote standardization and transparency in securitization markets. While the SEC, the ASF, and the rating agencies may all have a role in this process, I believe that transforming Fannie Mae and Freddie Mac into member-owned securitization utilities would be the best way to achieve this goal. Third, Government can help eliminate fraud and misrepresentation. Licensing and bonding of mortgage brokers and lenders, along with establishing a clear mechanism for enforcing the rights of borrowers and investors for violations of legal and contractual obligations, would be beneficial to the securitization market. However, I believe that there are superior alternatives to the Administration's recommendation of retention of 5 percent of credit risk to achieve this goal. I would recommend an origination certificate that provides a direct guarantee of the obligations of the originator to the investors and the obligation of the originator to the borrowers coupled with penalties for violations even in good markets and requires evidence of financial backing. This would be a more effective solution. If the flaws that led to the current crisis are addressed by Government and by industry, securitization can once again make valuable contributions to our economy. I look forward to your questions. Thank you. " FinancialCrisisReport--36 This inventory or portfolio of long-term assets is typically designated as “held for investment,” and is not used in day-to-day transactions. Investment banks that carry out market-making and proprietary trading activities are required – by their banking regulator in the case of banks and bank holding companies 61 and by the SEC in the case of broker-dealers 62 – to track their investments and maintain sufficient capital to meet their regulatory requirements and financial obligations . These capital requirements typically vary based on how the positions are held and how they are classified. For example, assets that are “held for sale” or are in the “trading account” typically have lower capital requirements than those that are “held for investment,” because of the expected lower risks associated with what are expected to be shorter term holdings. Many investment banks use complex automated systems to analyze the “Value at Risk” (VaR) associated with their holdings. To reduce the VaR attached to their holdings, investment banks employ a variety of methods to offset or “hedge” their risk. These methods can include diversifying their assets, taking a short position on related financial products, purchasing loss protection through insurance or credit default swaps, or taking positions in derivatives whose values move inversely to the value of the assets being hedged. Shorting the Mortgage Market. Prior to the financial crisis, investors commonly purchased RMBS or CDO securities as long-term investments that produced a steady income. In 2006, however, the high risk mortgages underlying these securities began to incur record levels of delinquencies. Some investors, worried about the value of their holdings, sought to sell their RMBS or CDO securities, but had a difficult time doing so due to the lack of an active market. Some managed to sell their high risk RMBS securities to investment banks assembling cash CDOs. Some investors, instead of selling their RMBS or CDO securities, purchased “insurance” against a loss by buying a credit default swap (CDS) that would pay off if the specified securities incurred losses or other negative credit events. By 2005, investment banks had standardized CDS contracts for RMBS and CDO securities, making this a practical alternative. Much like insurance, the buyer of a CDS contract paid a periodic premium to the CDS seller, who guaranteed the referenced security against loss. CDS contracts referencing a single security or corporate bond became known as “single name” CDS contracts. If the referenced security later incurred a loss, the CDS seller had to pay an agreed-upon amount to the CDS buyer to cover the loss. Some investors began to purchase single name CDS contracts, not as a hedge to offset losses from RMBS or CDO securities they owned, but as a way to profit from particular RMBS or CDO securities they predicted would lose money. CDS contracts that paid off on securities that were not owned by the CDS buyer were known as “naked credit default swaps.” 61 See, e.g., 12 CFR part 3, Appendix A (for the Office of the Comptroller of the Currency), 12 CFR part 208, Appendix A and 12 CFR part 225, Appendix A (for the Federal Reserve Board of Governors) and 12 CFR part 325, Appendix A (for the Federal Deposit Insurance Corporation). 62 Securities Exchange Act of 1934, Rule 15c3-1. CHRG-111hhrg63105--152 Mr. Newman," Chairman Boswell, Ranking Member Moran, and Members, thank you for the opportunity to testify before you today. The American Feed Industry Association is the largest organization devoted exclusively to represent the business, legislative, and regulatory interests of the U.S. animal feed industry and its suppliers. AFIA applauds this Subcommittee, its Members, and the full Committee for calling today's hearing. AFIA members manufacture more than 70 percent of the animal feed in the United States, which amounts to over 160 million tons annually. Feed also represents roughly 70 percent of the cost of producing meat, milk, and eggs. With the majority of our industry input supplies priced directly on, or in reference to, regulated commodity markets, we depend significantly on an efficient and well-functioning futures market for both price discovery and also risk management. Agricultural commodity markets were established to provide an efficient price discovery mechanism and a hedging risk management tool for producers and end-users. While this system encourages and requires speculative participants to provide liquidity, the significant increase of financial investors, as well as the special exemptions from speculative position limits that have been granted over time to Wall Street banks and others who are not end-users, has distorted the function of these markets. The agriculture commodity markets functioned effectively for over 60 years after the 1936 Commodity Exchange Act first implemented speculative position limits. However, this changed in 2000 when Congress codified earlier CFTC regulatory actions granting Wall Street banks and other financial institutions an exemption from speculative position limits for hedging over-the-counter swaps and index transactions. While there are several factors that have led to increased volatility and price swings in agricultural commodities, excess speculation by index funds is certainly one of these factors. As you are aware, the size and influence of these large financial players was never contemplated during the development of the original Commodity Exchange Act. Most of the index speculators tend to hold their positions rather than sell. This allows them to create artificial demands through their long-only positions and in essence really are bets on higher prices. The magnitude of this scenario is clear in the numbers. In 2003, index speculator investment in 25 physical commodities was $13 billion. In 2008, these investments jumped to $260 billion, an 1,800 percent increase in 5 years. In 2010, these investments remain at $265 billion, with three index funds representing 94 percent of that amount and one fund representing 52 percent of those investments. Earlier this year, we applauded the work by Congress to include provisions in the Act that would authorize CFTC to set reportable position limits on commodity contracts, as well as for aggregate and exchange-specific position limits. Within this process, AFIA members support the following items: First, speculative position limits that enhance market performance and the appropriate narrowing of cash and futures market values as they near contract delivery period; the retention and equal application of the existing speculative position limits for agricultural commodities; retaining the current bona fide hedge definition which is in place; the removal of speculative position limit exemptions for financial institutions and other nontraditional participants in agricultural commodity markets. While CFTC now has this authority, without removing these exemptions the speculative position limits will have a much more limited effect when they are put in place. Given the strong relationship between crude oil and corn futures markets brought on by the dramatic and rapid expansion of the ethanol industry, establishing and enforcing energy speculative position limits is also important to secure the reliability of the entire agricultural commodity complex. We support effective speculative position limits that work for both the bona fide hedger and the speculator. However, there is rarely a perfect solution to complex issues and waiting for a perfect solution before setting speculative position limits or taking other actions will only delay that much-needed transparency and controls required in these commodity markets. Therefore, we support implementation of interim limits where data is available and which can also be adjusted by CFTC with further data to confirm and support those changes. I would be remiss if I didn't express AFIA's appreciation to Chairman Gensler, Commissioner Chilton, and the other CFTC Commissioners for their extensive outreach during this entire process. Thank you for inviting me to participate in today's hearing. AFIA and its members stand ready to assist you in these efforts. I look forward to any questions. [The prepared statement of Mr. Newman follows:]Prepared Statement of Joel G. Newman, President and CEO, American Feed Industry Association, Arlington, VA Chairman Boswell, Ranking Member Moran and Members, thank you for the opportunity to testify before General Farm Commodities and Risk Management Subcommittee as you review implementation of provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 relating to speculation limits. I am Joel Newman, President and Chief Executive Officer of the American Feed Industry Association (AFIA), based in Arlington, Virginia. AFIA is the world's largest organization devoted exclusively to representing the business, legislative and regulatory interests of the U.S. animal feed industry and its suppliers. Founded in 1909, AFIA is also the recognized leader on international industry developments with more than 500 domestic and international members, as well as nearly 40 state, regional and national association members. Our members are livestock feed and pet food manufacturers, integrators, pharmaceutical companies, ingredient suppliers, equipment manufacturers and companies that provide support services to the industry. AFIA members manufacture more than 70% of the animal feed in the U.S., which amounts to over 160 million tons annually. Because feed represents roughly 70% of the cost of producing meat, milk and eggs, AFIA members are major contributors to food safety, nutrition and the environment, playing a critical role in the production of healthy, wholesome meat, poultry, milk, fish, eggs and pets. AFIA is a member of the Commodity Markets Oversight Coalition, which was formed in 2007, and is a broad coalition of organizations committed to protecting the interests of bona fide hedgers and derivatives end-users. We thank the Subcommittee for including Jim Collura in this hearing to speak on behalf of CMOC. His leadership has been invaluable to the Coalition. Your review of implementation of the Dodd-Frank Act by the Commodity Futures Trading Commission (CFTC) is both timely and appreciated by the men and women of the feed industry. As I have stated, feed represents approximately 70% of the on-farm cost of raising livestock and poultry. With the majority of our industry's input supplies priced directly on or in reference to regulated commodity markets, we depend significantly on an efficient and well-functioning futures market for both price discovery and risk management. Agriculture commodity markets were established to provide an efficient price discovery mechanism and a hedging/risk management tool for producers and end-users. While this system encourages and requires speculative participants to provide liquidity, the significant increase of financial investors, permitted by special exemption from speculative position limits, has distorted the function of these markets. Speculators are an important part of the commodity markets--without them there is no market. The agriculture commodity markets functioned effectively for 64 years after the 1936 Commodity Exchange Act first implemented speculative position limits. With these limits in place, the process of physical commodity customers using the futures markets as a price discovery and risk mitigation tool were able to rely on traditional speculator participation to provide a clear buyer/seller relationship and market liquidity. However, this changed in 2000, when Congress codified earlier CFTC regulatory actions granting Wall Street banks an exemption from speculative position limits for hedging over-the-counter swaps and index transactions. While there are several factors that have lead to increased volatility and price swings of agriculture commodities, excessive speculation by index funds is certainly one of these factors. As CFTC has recognized, speculator participation in these markets without position limits does have an impact on prices. These banks, which represent institutional investors, used the guise of ``hedging'' their invested capital to take advantage of the exemption. But in fact, their initial investments were speculative and were not hedging future needs or commitments for the underlying commodities. AFIA strongly supported ending this exemption, and we were very pleased when Congress took steps to address our concerns. Over the past few years, as the volatility and instability in the stock and financial markets exploded, speculative activity in the agricultural commodity futures markets grew substantially. In some crop contracts, there were times when the daily speculator trading volume was nearly equal to, or in the case of wheat, was more than the entire U.S. annual production volume of these same crops. This not only added to extreme price volatility as bona fide hedgers scrambled to mitigate their risks, but in many cases it pushed end-users out of the market. In at least one situation, this speculator activity pushed an organization into bankruptcy when the impact of margin calls caused by the extreme price run-ups drained the company's liquidity to unsustainable levels. As you are aware, from the Committee's analysis, when considering reforms for the futures markets and products, the size and influence of these very large financial players was never contemplated during development of the original Commodity Exchange Act (CEA). The recent dramatic increases in nearly all physical commodities values actually increased speculator demand, with the net result of commodity prices reaching unrealistic levels relative to true demand. Most of the index speculators tended to hold their positions rather than sell, which exacerbated the situation by producing artificially high demand accompanied by higher prices that negatively impacted nearly all end-users of the physical commodities. The magnitude of this scenario is clear in the numbers: In 2003, index speculator investment in 25 physical commodities was $13 billion; in 2008, these investments jumped to $260 billion--an 1,800% increase. In 2010, these investments remain at $180 billion, with three index funds representing 92% of these investments and one fund representing 61% of these investments. (Illustration 2) As a result, the feed industry was forced to pay higher prices for grains and other inputs, which were passed along to livestock, dairy and poultry producers and feed costs soared. Farmers, although receiving substantially higher prices for their commodities, were also hit by soaring costs for fertilizer and fuel, as similar speculator activities artificially further drove up oil prices. Simply put, agriculture, from farm to retail, had to deal with extreme price volatility on a number of fronts without the effective support of our primary risk mitigation tool--the futures markets--because those markets were severely compromised by Wall Street banks ability to avoid speculative position limits and invest substantial levels of monies in the physical commodity markets. This not only allowed them to avoid the volatility of the dust storm on Wall Street, it provided them a significant return on those speculative ``hedges'' because of their ability to influence the escalation of market prices by creating artificial demand. Earlier this year, we applauded the work by Congress to include provisions in the Act that would authorize the CFTC to set position limits on commodity contracts, as well as for aggregate and exchange specific position limits. Also, when commenting on CFTC's proposed position limits for energy contracts in March of this year, AFIA encouraged the Commission to consider such actions for other hard commodities to similarly protect agricultural commodities from the very large financial speculators that were masquerading as hedgers, parking their resources in physical commodity markets to ride out the extreme volatility then present in the stock and financial markets. By including clear authority for the CFTC to set a variety of reportable position limits, Congress took a solid and welcomed step toward our mutual goal of ensuring these commodity markets and products effectively serve their primary role of providing bona fide commercial hedgers reliable tools to manage their economic risks. With the expanded authority in place relative to speculation limits, AFIA is anxiously waiting for the CFTC to finalize its regulations and to put speculative limits into effect. We know this will take time and are hopeful the combination of the various categories of speculation position limits, combined with full implementation of the Act's other provisions, such as enhanced transparency and expanded regulation of nearly all derivatives, will assure bona fide hedgers of the viability of their futures-based risk management strategies. I would be remiss if I did not extend AFIA's appreciation to Chairman Gary Gensler and his fellow CFTC Commissioners for their openness and diligence in addressing our concerns, particularly during the time Congress was developing its package of reforms. Through frequent meetings, they provided frank and candid overviews of their established authorities. When Congress was deliberating its reform legislation, the CFTC team also provided regular updates on progress toward the reform goals we and others were supporting. Just as important, they helped us understand how certain provisions in the Act addressed our concerns while approaching them in a different manner than we had proposed. Importantly, the CFTC has been aggressive in its outreach over the past few months as it works to implement the Act. Like most supporters of reform in the futures industry, particularly as it relates to the topic of this hearing, AFIA would very much like to have speculation position limits set and in place today, as well the additional regulatory and transparency provisions. But we need the CFTC to ensure that when it sets limits, they also are ready to monitor and report trading activity, and ready to ensure compliance with and enforcement of the new law. It is critical for all bona fide end-users to know we are on a level playing field with speculators and each other. Modern production agriculture is complex. The linkages between producers, end-users and uses of physical commodities are constantly evolving. The feed industry, for example, is still adjusting to the dramatic and rapid expansion of ethanol and other bioenergy industries. The intersection of corn, soybeans and other oilseeds for feed, food and energy--not mention other industrial uses for these crops--is our new reality, one that poses additional competition and risk management challenges for each of our respective industry sectors. This has also had the effect of linking corn futures to crude oil futures, adding further volatility to the entire commodity complex. We are confident the CFTC is prudently moving as efficiently as it can to implement the speculative limits and other provisions of the Dodd-Frank Act under its existing and new authorities while making sure it clearly and fully understands the complexities of the derivatives markets. While being patient with the rulemaking process does produce certain levels of stress, we remain confident in and appreciative of the CFTC's efforts to date, and hope to remain so. This brings me back to the beginning of my testimony. AFIA again applauds the Subcommittee, its Members and the full Committee for calling today's hearing to check in on the CFTC's progress on speculation limits. Your individual and collective interest in making sure progress toward implementation is both steady and correct does a great deal to reduce stress levels among AFIA's members. I urge you to consider additional hearings on the Commission's progress toward implementing all provisions of the Act. Thank you for inviting me to participate in today's hearing. AFIA and its members stand ready to assist you in these efforts. I look forward to answering any questions you may have. Attachment Marshall [presiding.] Thank you, Mr. Newman.Mr. Sprecher. CHRG-111shrg55278--52 Mr. Tarullo," And there, the choices, I think, are several. Basically you have got three choices. Choice one is you say here are the group of institutions which we think under stressed conditions would pose a systemic risk under some set of criteria. Two, here is a set of institutions about which we would not say that with that level of assurance, but it at least would be in the ballpark to think about them in this way. Either of those requires you to draw a line somewhere. The third option, of course, is to say that basically every financial firm, no matter what it calls itself, has to be subject to basic rules and regulations. But that, of course, is itself a change from our current circumstance because we do not have that kind of perimeter. I do not think any of those is a clean choice. There are advantages and disadvantages to each, and that is why I think the question you raised is one that we are going to have to address as best we can no, matter which road people choose to go down. Senator Bennett. Sheila, you wanted to comment. Ms. Bair. I did. We are suggesting that the resolution authority be applicable to any bank holding company, so for resolution purposes, you would not have to differentiate up front. And whether it was used I think would be a determination made by the primary supervisor about whether to avoid systemic ramifications from a normal bankruptcy process by employing the special resolution process, which still has the same claims priority that bankruptcy has with unsecured creditors and shareholders taking losses before the Government. It is a way that we can plan and use additional powers we have to set up bridge banks or to accept or repudiate contracts. The special powers we have really work better for financial intermediaries. But you do not have to make that determination in advance. I think the dollar threshold I mentioned, in the context of whether there would be an assessment to fund a large institution resolution fund, would really determine who is not systemic as opposed to who is. So for maybe anybody below--pick a number--$25 billion, you can safely assume they are not systemic, so they would not be caught in this assessment. But even those caught in the assessment, the amount of the assessment would be risk based. So if you are a plain vanilla regional bank, you take deposits, you make loans, you do not do much else, you are probably not going to have much of an assessment. If you are a complex bank holding company with a lot of proprietary trading, OTC dealmaking, et cetera, you are probably going to have a higher assessment. As Governor Tarullo said, really the only time where you would need to do it in advance is if there was a large systemically important institution that is not already under consolidated Federal supervision. I do think the council should have the flexibility and authority to define those institutions and bring them under prudential supervision if that is the case. I think that is something the council should do. It would be a tremendous power, and I think it would benefit from the multiplicity of views that would be on the council. Senator Bennett. The power to define becomes ultimately the power that controls everything. Ms. Bair. In terms of institutions, especially if you do away with the thrift charter, there are only a few institutions--I am not going to name any specific institutions--that come to mind that would not already be under Federal prudential supervision. So I am not sure actually if that piece of it in practice would be that profound. As a result of the crisis, pretty much everybody has become a bank holding company or are on their way to doing so. So I am not sure in practical terms that it would be that huge of a change. Senator Bennett. Thank you, Mr. Chairman. Senator Warner. Well, I want to thank the panel for hanging in, and I think it is down to Senator Martinez and me for the last two on this, and we have actually a second panel. I have a slew of questions, and I will try to ask them very quickly, again, so that Senator Martinez can get his questions in, and we can respect the second panel if we could try to answer fairly quickly. I strongly, as I made clear, believe that the council is the right approach. I guess I would ask for rather quick responses here--if possible, even kind of yes/no. I would love to--should that council have an independently appointed, Presidential appointment with congressional approval chair? Should it have the ability to look across all financial markets? Should it be able to be the aggregator of data from all of the prudential regulators up to with an independent staff that could aggregate and assess this data? Should it have, as I think we have heard you say, the power to issue rules, require enhanced leverage, or capital rules? And should it be able to force the day-to-day prudential regulators to take action and, if not, have backup authority to take action if the prudential regulator does not? I want to try to--I think Senator Bennett asked very appropriate questions about how we define. I am trying now to get into how we structure if we went forward with this council approach, recognizing that Professor Tarullo may not concur on the---- " CHRG-111shrg53176--168 RESPONSE TO WRITTEN QUESTIONS OF SENATOR REED FROM JAMES CHANOSQ.1. You summarized the failures we have seen during this downturn in the financial markets. From your perspective, what led to such a disintegration of market discipline?A.1. While all market participants bear some degree of responsibility for where we are today in the global equity, credit and asset-backed markets, the root cause of the severe difficulties we face can be found in the massive debt and the large volume of unsound loans made and secured beyond any reasonable level by heavily regulated organizations. This created a massive credit bubble that could but only burst. Market discipline was lost as businesses sought ever-increasing returns in a highly competitive market, and rating agencies made the implausible seem highly possible which in turn created higher returns which fed the bubble in prices for assets. Transparency of value and pricing was lost which also played a role in the disintegration of market discipline.Q.2. If market discipline needs to be coupled with regulatory oversight, as you state in your testimony, what is the industry doing to improve market discipline--as the government is working to improve the regulatory structure?A.2. The recommendations for hedge fund best practices of the President's Working Group Asset Managers' Committee and the Institutional Investors' Committee represent an important step by industry participants to raise the bar on disclosure, transparency and valuation. These best practices in many areas such as valuation exceed the norms of other market participants engaged in similar activities.Q.3. Does the concept of the sophisticated investor, which sets certain income and asset-sized limitations on investors in hedge funds, need to be revisited? Is so, how should it be revisited?A.3. That is a complex question which also opens up a discussion of funds of funds registered under the Investment Company Act that invest only in hedge funds. Since they are registered, they are open to retail investors without any minimum financial qualifications. CPIC did not oppose the SEC proposal to revise 3(c)(1) eligibility levels for individuals. For a full discussion please see our comment letter to the SEC dated March 9, 2007, a copy of which is attached.Q.4. What level of standardization of disclosures might help investors in hedge funds? What is the balance between disclosure for the protection of investors and the protection of hedge funds' intellectual property?A.4. Better transparency, particularly for investors, is a good thing. Having recently served on one of the President's Working Group's Committees to develop best practices for asset managers and institutional investors, there are enhanced disclosures that could be adopted or, if necessary, codified. For example, managers should disclose more data regarding how their funds derive income and losses from FAS 157 Level 1, 2, and 3 assets. A fund's annual financial statement should be audited by an independent audit firm subject to PCAOB oversight. Additionally, provisions could be adopted to assure that potential investors are provided with specified disclosures relating to the fund and its management before any investment is accepted. This information should include any disciplinary history and pending or concluded litigation or enforcement actions, fees and expense structure, the use of commissions to pay broker-dealers for research (``soft dollars''), the fund's methodology for valuation of assets and liabilities, any side-letters and side-arrangements, conflicts of interest and material financial arrangements with interested parties (including investment managers, custodians, portfolio brokers and placement agents), and policies as to investment and trade allocations. Required disclosures to regulators and counterparties could also include information regarding counterparty risk, lender risk and systemic risk. Finally, Congress also should require safeguards that I have advocated for many years--simple, common-sense protections relating to custody of fund assets and periodic audits. As for disclosure of a fund's positions, particularly short positions, it is not problematic to disclose positions on a confidential basis to the prudential or systemic risk regulator. Such information could also be aggregated on a confidential basis and used by the regulators. Public disclosure, however, even on a delayed basis, would jeopardize proprietary information/intellectual property and drastically undercut liquidity in the market along with the financial detective role played by short sellers. Short sellers also would be exposed to retaliation and trading could move to less transparent markets.Q.5. Is the ideal regulator someone from the industry, who understands how it works? If so, who is willing to perform this public service at this point in our country's economic turmoil?A.5. It is imperative that regulatory staff, from examiners to enforcement, have more experience and training in the day-to-day operations of the markets they are overseeing. Staff should either be--or be trained by--people who have sat on trading desks, who have run hedge funds or who have run investment firms. While the pool of potential trainers may not be large, there may be some seasoned, possibly retired, Wall Street professionals who could serve the nation by teaching the well-schooled and well-meaning staff what to look for now and what to look for in the future in order to safeguard investments and the financial system.Q.6. Is it reasonable that regulators could review detailed information such as trading positions of hedge funds overall to see where there might be concentrations, or is this level of analysis too difficult? If so, why?A.6. It is possible, dependent on the criteria used to select the funds or trading strategies to be targeted. And all market participants with similar investments, from commercial and investment banks to mutual funds, should be subject to the same level of scrutiny. CHRG-111hhrg55811--279 Mr. Ferreri," Madam Chairwoman, members of the committee, thank you for inviting me to testify today on the reform of the over-the-counter derivatives market. My name is Chris Ferreri, and I am testifying today in my capacity as chairman of the Wholesale Markets Brokers Association, Americas, an independent industry body representing the largest wholesale and interdealer brokers operating in the North American markets across a broad range of financial products. I am also managing director at ICAP, one of the founding member firms of the WMBA. Interdealer brokers serve as intermediaries for broker-dealers and other financial institutions that facilitate access to a full range of OTC and exchange-traded products and their associated derivatives forms. For relevant markets interdealer brokers are registered broker-dealers and are regulated by numerous agencies, including the SEC, the Federal Reserve, and the CFTC. It is estimated that each day, IDBs handle on average 2 million OTC trades globally, corresponding to about $5 trillion in notional amounts across the range of FX securities, interest rate, credit, equity and commodity asset classes in both cash and derivative form. Mr. Chairman, the WMBA is supportive of the efforts to more effectively oversee the OTC markets for derivative financial products. We believe that our current practices will integrate smoothly with many of the requirements in the discussion draft as well as the Treasury Department's proposal. We support the efforts taken thus far by the Administration and Congress to broaden the roles of the CFTC and the SEC in increasing the safety and soundness of the OTC markets. Today, we would like to focus on two particular issues: the characteristics and responsibilities of the swap execution facilities; and the protection of open, neutral, and nondiscriminatory access to central clearing. It is clear that the interdealer brokers would currently fulfill many of the criteria of the swap execution facilities described under the draft legislation or the alternative swap execution facilities under the Treasury Department's proposal. Much of what is contemplated for these facilities is already well within the capabilities of our member firms. Our technology-based reporting systems can provide the relevant regulators with real-time trading information. The WMBA is concerned with the requirement that swap execution facilities must undertake certain SRO enforcement-type responsibilities, including discretionary supervision and approval of particular swap contracts as suitable for trading and the general oversight of the trading activities of our customers. This is not to diminish the capabilities we currently possess to monitor for suspicious or manipulative trading activity and to report such activity to regulators. This is consistent with our concerns about the requirements set forth in the Treasury Department's proposed legislation for alternative swap execution facilities to adopt position limitations or position accountability for our customers. We therefore appreciate the committee not including such a provision in the chairman's discussion draft, recognizing that each WMBA member firm can only monitor the activities taking place within its own execution facility. Multiple and competitive execution platforms have demonstrated their ability to create efficient, liquid and innovative markets. Yet with the expansion and requirement of central clearing, there is serious risk that central clearinghouses will create, modify, and ultimately favor their own execution facilities over competing execution facilities by access fees, access technologies or cross-subsidization of execution and clearing fees. The WMBA would respectfully ask that you consider whether this is sufficient to promote and protect competition among execution platforms. As the Justice Department observed in a 2008 comment letter to the Treasury Department, a vertically integrated derivatives market, where a central counterparty providing clearing services also provides trade execution services, will limit competition, increase costs, and ultimately hurt end-users and larger market participants. One only needs to look at the securities and options markets compared to the futures markets. The WMBA is encouraged that this is consistent with CFTC Chairman Gary Gensler, who remarked at a House Agriculture Committee several weeks ago that, ``A clearinghouse should not be vertically integrated in such a way with an exchange or trading platform so that the only product they accept is from that exchange or trading platform.'' Frankly, if the clearing entity also provides execution services, there is not only an opportunity, but also an incentive for them to structure their services to squeeze out competition. The WMBA would ask that the legislation include language to protect against such behavior. In closing, Madam Chairwoman, we congratulate you on your work on the discussion draft and the Treasury Department's proposed legislation. The WMBA looks forward to working with you to achieve these goals. Thank you for the invitation to participate in today's hearing. [The prepared statement of Mr. Ferreri can be found on page 79 of the appendix.] Ms. Bean. Thank you for your testimony. And our final witness is Rob Johnson, director of economic policy for the Roosevelt Institute in New York, on behalf of Americans for Financial Reform. STATEMENT OF ROB JOHNSON, DIRECTOR OF ECONOMIC POLICY FOR THE ROOSEVELT INSTITUTE IN NEW YORK, ON BEHALF OF AMERICANS FOR CHRG-111hhrg51591--74 Mr. Royce," Thank you very much, Mr. Chairman. And I am going to pick up on some of the questions that Congresswoman Bean had asked. And I appreciate, Mr. Webel, your responses to that. I would also ask this of Mr. Grace and Mr. Harrington: Much of the focus of AIG's failure has been on their speculative use of CDS. There has been a lot of discussion as to whether CDS are insurance products, and it should have been regulated as such. There is no dispute, though, that State regulation failed to detect and address a number of these major problems with AIG. And in February of this year, a report surfaced from the Wall Street Journal, and I will quote from that: ``From $1 billion in 1999, AIG's securities lending portfolio ballooned to $30 billion in 2003, and then 60 billion.'' And as Melissa shared with you, it then went to $70 billion. ``Much of that growth came from lending out corporate bonds owned by AIG's large life insurance and retirement services subsidiaries.'' So over a period of about 7 years, AIG bled the assets of its insurance division, shifting these investments into an overseas casino-like CDS operation, while going completely undetected by the State insurance commissioners responsible for ensuring the solvency of its operations. Now, here is the punch line. Only when the company was on the brink of collapse, after multiple publicly-reported restatements of earnings, did the New York State insurance commissioner and governor propose to redirect $20 billion from the surplus of AIG's insurance company to its parent holding company. Now, fortunately, that plan was aborted. But that is the type--that is the scale of regulation and due diligence and oversight that existed. It turns out the problem was much bigger than State officials realized. And of course, the Federal Government intervened, and the American taxpayers are asked to cover one of the most expensive corporate bailouts in our history. Now, surely there was failure throughout AIG and throughout the regulatory structure overseeing AIG. But doesn't this tragic episode underscore the inability of State insurance regulators to exercise effective oversight of today's large, complex insurance companies? And I again think that Congresswoman Bean is on the right track, and I am a cosponsor of her bill, when we try to give a world-class Federal regulator here not only the authority but also the information to look at the entire financial institution that is involved in insurance and all of its affiliates. It just seems to me, Mr. Harrington, that in the wake of this mess, on top of all of the other arguments, as I say before--you know, we have a national market in everything else and a Balkanized one in this product. But now, on top of it, we deal with this product. So I would ask you, Mr. Harrington, your observations on that, and Mr. Grace as well. " 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-110shrg50418--18 STATEMENT OF SENATOR ROBERT MENENDEZ Senator Menendez. Well, thank you, Mr. Chairman. First, let me say that if I was a Michigander or this industry, I would not have any greater advocates than Senator Levin and Senator Stabenow. They are both passionate and eloquent, and if I lived in Michigan, I would want them to be my Senators. You know, Mr. Chairman, a former chairman of General Motors once quipped very famously that what is good for General Motors is good for America. And we would like to believe that is still true today, but many of us believe, unfortunately, that General Motors has lost sight of what is good for General Motors or for America. I read through the testimony of our witnesses, and what we will not hear is that any of the industry's problems are at the hands of any of the witnesses who will come before us. They will tell us that it is totally some other set of circumstances that they are affected by, very similar to what mortgage lenders and brokers did here a year ago in this very room. But I do hope that when you have an opportunity to answer questions, you will take some responsibility and work with us to find a constructive solution. Our Nation is in the midst of an energy security crisis, and our planet is in the midst of a climate crisis. And the fact that these twin crises would have an enormous impact on your industry should not come as a surprise. For decades, leaders here on Capitol Hill have asked our domestic auto manufacturers to look beyond the next quarter and take into account the looming threats of energy and climate security. But all we have seen in response is a concerted effort to block progress. I think we are all, frankly, looking for some assurances that we will not continue to be here again year after year lamenting the fact that our domestic auto makers have chosen to lobby against changed regulation rather than to innovate and meet new circumstances. We have to make sure that we are making a wise investment with taxpayer money. Quite simply, Mr. Chairman, I think there needs to be strings attached. We need to see some type of guarantee that fuel economy standards will continue to rise beyond the year 2020. We need to ensure that the California waiver can be granted without spending money by the industry in opposition to that effort. What we need is for the Big Three to become part of the solution for energy security and fighting global warming rather than being part of the problem. That having been said, Mr. Chairman, I do worry--I do worry--about protecting the workers, not those in the executive offices but those on the manufacturing line, the suppliers, the dealers, the several million people whose fates are intricately--fellow Americans--who are intricately tied with this industry, and how we try to meet this challenge of giving the assistance necessary to keep the industry alive, but with the assurances that must come--not a blank check. It must come with some assurances along the way that hopefully can not only save the industry but move it into a new era for both America, for those workers, and for our future. With that, Mr. Chairman, I ask that the rest of my statement be included in the record. " FOMC20070807meeting--107 105,CHAIRMAN BERNANKE.," Thank you for the useful discussion. As usual, I am going to very briefly summarize what I heard. I will be happy to take any comments on that. Then I just want to make a few short points. Again, most of the key points have been made. Most participants expect growth to remain moderate over the forecast period. Despite lower household wealth resulting from weaker house and stock prices, consumption is likely to continue to grow as labor markets remain strong, real incomes increase, and gasoline prices moderate. Business investment should also grow moderately, although lower productivity and higher volatility could be drags on investment. Commercial real estate, in particular, may be slackening, but it retains good fundamentals. The global economy is strong. Industrial production is expanding at a reasonable pace. However, downside risks to growth were noted and perhaps received somewhat greater emphasis than at past meetings. Most notably, housing appears to have weakened further, with sales of new and existing homes declining and inventories of unsold homes remaining high. Homebuilders are experiencing financial strains, and there is downward pressure on home prices. Spillover on consumption spending is not yet evident but is a possible risk. In this regard, developments in credit markets received considerable attention. On the positive side, the repricing of risk and the reevaluation of underwriting standards seem appropriate. Liquidity still exists, credit is still being extended, and markets may work out their problems on their own. A lower dollar and lower long-term Treasury rates also tend to offset financial tightening. However, higher risk premiums, tougher underwriting, and greater uncertainty may constrain housing and investment spending, leading to broader macroeconomic effects. In more-pessimistic scenarios, dislocations in credit markets may last awhile and have a more substantial effect on credit availability and costs for businesses as well as for homebuyers. The possibility of contagion or severe financial instability also exists. Many participants took note of the NIPA revisions and their implications for productivity growth, consumer saving, and unit labor costs. Meeting participants tend to put potential growth at higher rates than the Greenbook. Views on inflation are similar to those in previous meetings. Recent readings are viewed as reasonably favorable. However, risks to inflation remain, including the possible reversal of transitory factors, tight labor markets, the high price of commodities, and higher unit labor costs resulting from lower productivity growth. In all, the risks to inflation remain to the upside. That is my summary of what I heard. I’m sure a lot more could be said. Any comments? If not, let me just make a few additional comments. There have been two very important developments since the last meeting. The first was the downward revision to the NIPA growth numbers. It’s not obvious yet, of course, how much of that reflects a permanent decline in productivity and how much is transitory. But certainly the best guess is that some of it is more long term in nature. I think the main point I’d like to make is that the implications of this downward revision for inflation and monetary policy, except perhaps in the very short run, are not obvious. The question is, What is the effect of the lower productivity growth on aggregate demand? We have examples of both types of phenomena. In the late ’90s, the pickup in productivity growth stimulated a very strong boom working through the stock market, consumption, and investment, so it led to an overheating economy, whereas in the earlier part of this decade, productivity growth picked up again but with weak aggregate demand. We had a jobless recovery associated with that. So it remains to be seen exactly how aggregate demand will respond to these developments. I do think that perhaps that in the very short run, given wage behavior and unit labor costs, if I had to choose, I would say that there is a slight bias toward higher inflation and tighter money. In the longer run, you would expect to see lower long-term rates because of slower growth. The second issue that has been widely discussed around the table is the financial market. It is an interesting question why what looks like $100 billion or so of credit losses in the subprime market has been reflected in multiple trillions of dollars of losses in paper wealth. So it’s an interesting question about what is going on there. I think there are three reasons that the financial markets have moved in the direction they have. First, there has been a widespread repricing of risk. That is, obviously, a healthy development, particularly if there is no overshoot, which is a possibility. But all else being equal, it is restrictive in terms of aggregate demand, and it makes our policy tighter than it otherwise would be. The second reason for the changes in markets is that there has been a loss of confidence in the ability of investors to evaluate credit quality, particularly in structured products. There is an information fog, as I have heard it described. This is very much associated with the loss of confidence in the credit-rating agencies. I think one of the implications of this is that some of the innovations we have seen in financial markets are going to get rolled back. We are going to see more lending taken out of originate-to- distribute vehicles and put back onto portfolio balance sheets. So the question is how much effect this adjustment process will have on the availability of credit. The third reason that I think the markets have reacted as much as they have is concern about the macroeconomic implications of what is happening. In particular, there is a fear that subprime losses, repricing, and the tightening of underwriting standards will have adverse effects on the housing market and will feed through to consumption, and we will get into a vicious cycle. That certainly is reflected in the expectations of policy. I am not going to go through all the things that are going on now in the markets. You have had very good reviews of that. Obviously, the markets right now are not functioning normally. Some conduits of credit are simply closed or frozen. A number of companies are having difficulties with short-term finance, and so, per President Fisher’s comment, we are watching those things very carefully. We are prepared to use the tools that we have to address a short-term financial crisis, should one occur. In the longer term, of course, our policy should be directed not toward protecting financial investors but, rather, toward our macroeconomic objectives. That is very important. Then the question is what the long-run implications of the financial market adjustment will be for the economy. I think the odds are that the market will stabilize. Most credits are pretty strong except for parts of the mortgage market. But even so there will be notably tighter credit, tighter standards, probably some loss of confidence in markets, and higher risk premiums that will on net be restrictive. This restrictive effect could come in various magnitudes. It could be moderate, or it could be more severe, and we are just going to have to monitor how it adjusts over time. Again, there is a bit of a risk—and tail risk has been mentioned not only in a financial sense but also in the macro sense—that, if credit is severely restricted so that we get feedback from lower house prices, for example, into the financial markets, that situation would be difficult to deal with. Those are the two major issues that people have talked about. Just very briefly on the overall assessment—on the output side, economic growth looks a little softer to me, mostly because of housing. There are also some slightly worrying developments in terms of automobile demand, which suggest some weakening in consumer spending. But there are some strong elements as well. Also the labor market has marginally softened. The unemployment rate is about 25 basis points above its recent low; so there has been some movement, and I still expect to see some reduction in construction employment. So I think there is a bit more softness and there are a few more downside risks to output than at our last meeting. Like others, I think the recent inflation data are moderately encouraging. I continue to see risks. If you’re not satiated with risks, I’ll add one more, which is that if the housing market really weakens and people go back to renting, we could get the same phenomenon that we saw last year, by which rents are driven up and we get an effect working through shelter costs. So I agree with those who still view the risk to inflation as being tilted to the upside. If there are no comments or questions, let me turn now to Brian to discuss the policy action." fcic_final_report_full--203 Another development also changed the CDOs: in  and , CDO managers were less likely to put their own money into their deals. Early in the decade, investors had taken the managers’ investment in the equity tranche of their own CDOs to be an assurance of quality, believing that if the managers were sharing the risk of loss, they would have an incentive to pick collateral wisely. But this fail-safe lost force as the amount of managers’ investment per transaction declined over time. ACA Man- agement, a unit of the financial guarantor ACA Capital, provides a good illustration of this trend. ACA held  of the equity in the CDOs it originated in  and ,  and  of two deals it originated in , between  and  of deals in , and between  and  of deals in .  And synthetic CDOs, as we will see, had no fail-safe at all with regard to the man- agers’ incentives. By the very nature of the credit default swaps bundled into these synthetics, customers on the short side of the deal were betting that the assets would fail. CREDIT DEFAULT SWAPS: “DUMB QUESTION ” In June , derivatives dealers introduced the “pay-as-you-go” credit default swap, a complex instrument that mimicked the timing of the cash flows of real mortgage- backed securities.  Because of this feature, the synthetic CDOs into which these new swaps were bundled were much easier to issue and sell. The pay-as-you-go swap also enabled a second major development, introduced in January : the first index based on the prices of credit default swaps on mortgage- backed securities. Known as the ABX.HE, it was really a series of indices, meant to act as a sort of Dow Jones Industrial Average for the nonprime mortgage market, and it became a popular way to bet on the performance of the market. Every six months, a consortium of securities firms would select  credit default swaps on mortgage- backed securities in each of five ratings-based tranches: AAA, AA, A, BBB, and BBB-. Investors who believed that the bonds in any given category would fall behind in their payments could buy protection through credit default swaps. As demand for protec- tion rose, the index would fall. The index was therefore a barometer recording the confidence of the market. CHRG-111shrg57321--54 Mr. Raiter," Well, I would say if you have developed a model in the house that shows that it is much better than anything you are running and it shows that you have been too optimistic with the ratings you have assigned, and you do not immediately start to use it and go back and re-rate the old deals so you can warn the investors that we have been wrong, then that is not doing the right thing. And I will point out from a cultural perspective, there were two mantras that we heard at Standard & Poor's all the time after I joined, and I am sure they went on before that. One was a AAA is a AAA is a AAA, and it did not matter if it was a corporate, a municipal, or the new structured products. And they used the transition studies to prove that by saying, look, here is the transition of a AAA corporate, what is the probability it might be downgraded? What is the probability it might go from AAA to default, as in Penn Central? There had never been a AAA mortgage-backed that had gone to default from AAA until this latest debacle. In the transition of AAA mortgage-backed's compared to AAA corporates, it was much better. All right? So AAAs were all the same. The other thing that was heard constantly--and it was in one of these emails--if we change, everybody will think that we have been wrong. And that just put a real anchor on any new ideas quickly going through the process because they were afraid somebody would suggest that they had not been right before and they would have liability or they would lose some market share. That was not doing the right thing, and they do not have a referee or anyone to tell them when they have crossed that line. Senator Kaufman. Well, the other thing is, look, everybody--there is not a single thing that has been raised here this morning in terms of what the behavior was. As an elected official, you hate to change your position on anything because it admits that you did something wrong. I mean, everybody does--these are all common things. I think the fact that there are no penalties is key, and I would like to get at least a little bit of questions in the second round about grandfathering, and exactly what you said, why there was not more grandfathering with all the witnesses. So with that, I yield to the Chairman. Senator Levin. There is always going to be a debate on how to cure a system, but we know there are a lot of things that should not have happened that did happen, and we are going to debate those cures as to what the remedies are legislatively in the week coming up. But I want to go back to some of the things that it is pretty obvious to me were wrong, wrong at the time, and as complex as some of the remedies are, some of these issues are not complex at all. Market share should not be driving ratings. Would you all agree with that? [Witnesses nodding affirmatively.] Senator Levin. Let us take a look at what drove the ratings here. Let us look at some more evidence. Exhibit 5, an email dated March 23, 2005, between S&P employees that I think you worked with, Mr. Raiter. Here is Exhibit 5.\1\--------------------------------------------------------------------------- \1\ See Exhibit No. 5, which appears in the Appendix on page 258.--------------------------------------------------------------------------- ``When we first reviewed 6.0 results `a year ago' we saw the sub-prime and Alt-A numbers going up and that was a major point of contention which led to all the model tweaking we've done since. Version 6.0 could've been released months ago and resources assigned elsewhere if we didn't have to massage the sub-prime and Alt-A numbers to preserve market share.'' Should those numbers be massaged to preserve market share? Does anyone believe that? Mr. Raiter. " 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. " CHRG-111shrg51395--278 RESPONSE TO WRITTEN QUESTIONS OF SENATOR CRAPO FROM LYNN E. TURNERQ.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. Witness declined to respond to written questions for the record. ------ CHRG-111shrg51395--276 RESPONSE TO WRITTEN QUESTIONS OF SENATOR CRAPO FROM THOMAS DOEQ.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. Witness declined to respond to written questions for the record. ------ CHRG-111shrg51395--270 RESPONSE TO WRITTEN QUESTIONS OF SENATOR CRAPO FROM MERCER E. BULLARDQ.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. Witness declined to respond to written questions for the record. ------ CHRG-111shrg56262--95 PREPARED STATEMENT OF ANDREW DAVIDSON President, Andrew Davidson and Company October 7, 2009 Mr. Chairman and Members of the Subcommittee, I appreciate the opportunity to testify before you today about securitization. My expertise is primarily in the securitization of residential mortgages and my comments will be primarily directed toward those markets. Securitization has been a force for both good and bad in our economy. A well functioning securitization market expands the availability of credit for economic activity and home ownership. It allows banks and other financial institutions to access capital and reduces risk. On the other hand a poorly functioning securitization market may lead to misallocation of capital and exacerbate risk. \1\--------------------------------------------------------------------------- \1\ Portions of this statement are derived from ``Securitization: After the Fall'', Anthony Sanders and Andrew Davidson, forthcoming.--------------------------------------------------------------------------- Before delving into a discussion of the current crisis, I would like to distinguish three types of capital markets activities that are often discussed together: Securitization, Structuring, and Derivatives. \2\--------------------------------------------------------------------------- \2\ See, Andrew Davidson, Anthony Sanders, Lan-Ling Wolff, and Anne Ching, ``Securitization'', 2003, for a detailed discussion of securitization and valuation of securitized products.--------------------------------------------------------------------------- Securitization is the process of converting individual loans into securities that can be freely transferred. Securitization serves to separate origination and investment functions. Without securitization investors would need to go through a very complex process of transferring the ownership of individual loans. The agency mortgage-backed securities (MBS) from Ginnie Mae, Fannie Mae, and Freddie Mac are one of the most successful financial innovations. However, as the last years have taught us, the so-called, ``originate to sell'' model, especially as reflected in private-label (nonagency) MBS, has serious shortcomings. Structuring is the process of segmenting the cash flows of one set of financial instruments into several bonds which are often called tranches. The collateralized mortgage obligation or CMO is a classic example of structuring. The CMO transforms mortgage cash flows into a variety of bonds that appeal to investors from short-term stable bonds, to long-term investments. Private label MBS use a second form of structuring to allocate credit risk. A typical structure uses subordination, or over-collateralization, to create bonds with different degrees of credit risk. The collateralized debt obligation or CDO is a third form of structuring. In this case, bonds, rather than loans, are the underlying collateral for the CDO bonds which are segmented by credit risk. Structuring allows for the expansion of the investor base for mortgage cash flows, by tailoring the bonds characteristics to investor requirements. Unfortunately, structuring has also been used to design bonds that obfuscate risk and return. Derivatives, or indexed contracts, are used to transfer risk from one party to another. Derivatives are a zero sum game in that one investor's gain is another's loss. While typically people think of swaps markets and futures markets when they mention derivatives, the TBA (to be announced) market for agency pass-through mortgages is a large successful derivative market. The TBA market allows for trading in pass-through MBS without the need to specify which pool of mortgages will be delivered. More recently a large market in mortgage credit risk has developed. The instruments in this market are credit default swaps (CDS) and ABX, an over-the-counter index based on subprime mortgage CDS. Derivatives allow for risk transfer and can be powerful vehicles for risk management. On the other hand, derivatives may lead to the creation of more risk in the economy as derivate volume may exceed the underlying asset by substantial orders of magnitude. For any of these products to be economically useful they should address one or more of the underlying investment risks of mortgages: funding, interest rate risk, prepayment risk, credit risk, and liquidity. More than anything else mortgages represent the funding of home purchases. The twelve trillion of mortgages represents funding for the residential real estate of the country. Interest rate risk arises due to the fixed coupon on mortgages. For adjustable rate mortgages it arises from the caps, floors and other coupon limitations present in residential mortgage products. Interest rate risk is compounded by prepayment risk. Prepayment risk reflects both a systematic component that arises from the option to refinance (creating the option features of MBS) as well as the additional uncertainty created by the difficulty in accurately forecasting the behavior of borrowers. Credit risk represents the possibility that borrowers will be unable or unwilling to make their contractual payments. Credit risk reflects the borrower's financial situation, the terms of the loan and the value of the home. Credit risk has systematic components related to the performance of the economy, idiosyncratic risks related to individual borrowers and operational risks related to underwriting and monitoring. Finally, liquidity represents the ability to transfer the funding obligation and/or the risks of the mortgages. In addition to the financial characteristics of these financial tools, they all have tax, regulatory and accounting features that affect their viability. In some cases tax, regulatory and accounting outcomes rather than financial benefit are the primary purpose of a transaction. In developing policy alternatives each of these activities: securitization, structuring and derivatives, pose distinct but interrelated challenges.Role of Securitization in the Current Financial Crisis The current economic crisis represents a combination of many factors and blame can be laid far and wide. Additional analysis may be required to truly assess the causes of the crisis. Nevertheless I believe that securitization contributed to the crisis in two important ways. It contributed to the excessive rise in home prices and it created instability once the crisis began. First, the process of securitization as implemented during the period leading up to the crisis allowed a decline in underwriting standards and excessive leverage in home ownership. The excess lending likely contributed to the rapid rise in home prices leading up to the crisis. In addition to the well documented growth in subprime and Alt-A lending, we find that the quality of loans declined during the period from 2003 to 2005, even after adjusting for loan to value ratios, FICO scores, documentation type, home prices and other factors reflected in data available to investors. The results of our analysis are shown in Figure 1. It shows that the rate of delinquency for loans originated in 2006 is more than 50 percent higher than loans originated in 2003. The implication is that the quality of underwriting declined significantly during this period, and this decline was not reflected in the data provided to investors. As such it could reflect fraud, misrepresentations and lower standard for verifying borrower and collateral data. The net impact of this is that borrowers were granted credit at greater leverage and at lower cost than in prior years.[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT] In concrete terms, the securitization market during 2005 and 2006 was pricing mortgage loans to an expected lifetime loss of about 5 percent. Our view is that even if home prices had remained stable, these losses would have been 10 percent or more. Given the structure of many of these loans, with a 2-year initial coupon and an expected payoff by the borrower at reset, the rate on the loans should have been 200 or 300 basis points higher. That is, initial coupons should have been over 10 percent rather than near 8 percent. Our analysis further indicates that this lower cost of credit inflated home prices. The combination of relaxed underwriting standards and affordability products, such as option-arms, effectively lowered the required payment on mortgages. The lower payment served to increase the price of homes that borrowers could afford. Figure 2 shows the rapid rise in the perceived price that borrowers could afford in the Los Angeles area due to these reduced payment requirements. Actual home prices then followed this pattern. Generally we find that securitization of subprime loans and other affordability products such as option arms were more prevalent in the areas with high amounts of home price appreciation during 2003 to 2006. To be clear, not all of the affordability loans were driven by securitization, as many of the option arms remained on the balance sheet of lending institutions.[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT] Figure 3 provides an indication of the magnitude of home price increases that may have resulted from these products on a national basis. Based on our home price model, we estimate that home prices may have risen by 15 percent at the national level due to lower effective interest rates. In the chart, the gap between the solid blue line and the dashed blue line reflects the impact of easy credit on home prices.[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT] On the flip side, we believe that the shutting down of these markets and the reduced availability of mortgage credit contributed to the sharp decline in home prices we have seen since 2006 as shown in Figure 4. Without an increase in effective mortgage rates, home prices might have sustained their inflated values as shown by the dashed blue line. \3\--------------------------------------------------------------------------- \3\ See, http://www.ad-co.com/newsletters/2009/Jun2009/Valuation_Jun09.pdf for more details.[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT] Thus the reduced focus on underwriting quality lead to an unsustainable level of excess leverage and reduced borrowing costs which helped to inflate home prices. When these ``affordability'' products were no longer sustainable in the market, they contributed to the deflation of the housing bubble. The way securitization was implemented during this period fostered high home prices through poor underwriting, and the end of that era may have led to the sharp decline in home prices and the sharp decline in home prices helped to spread the financial crisis beyond the subprime market. The second way that securitization contributed to the current economic crisis is through the obfuscation of risk. For many structures in the securitization market: especially collateralized debt obligations, structured investment vehicles and other resecuritizations, there is and was insufficient information for investors to formulate an independent judgment of the risks and value of the investment. As markets began to decline in late 2007, investors in all of these instruments and investors in the institutions that held or issued these instruments were unable to assess the level of risk they bore. This lack of information quickly became a lack of confidence and led to a massive deleveraging of our financial system. This deleveraging further depressed the value of these complex securities and led to real declines in economic value as the economy entered a severe recession. In addition, regulators lacked the ability to assess the level of risk in regulated entities, perhaps delaying corrective action or other steps that could have reduced risk levels earlier.Limitations of Securitization Revealed To understand how the current market structure could lead to undisciplined lending and obfuscation of risk it is useful to look at a simplified schematic of the market. \4\--------------------------------------------------------------------------- \4\ Adapted from ``Six Degrees of Separation'', August 2007, by Andrew Davidson http://www.securitization.net/pdf/content/ADC_SixDegrees_1Aug07.pdf.[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT] In the simplest terms, what went wrong in the subprime mortgage in particular and the securitization market in general is that the people responsible for making loans had too little financial interest in the performance of those loans and the people with financial interest in the loans had too little involvement in the how the loans were made. The secondary market for nonagency mortgages, including subprime mortgages, has many participants and a great separation of the origination process from the investment process. Each participant has a specialized role. Specialization serves the market well, as it allows each function to be performed efficiently. Specialization, however also means that risk creation and risk taking are separated. In simplified form the process can be described as involving: A borrower--who wants a loan for home purchase or refinance A broker--who works with the borrower and lenders to arrange a loan A mortgage banker--who funds the loan and then sells the loan An aggregator--(often a broker-dealer) who buys loans and then packages the loans into a securitization, whose bonds are sold to investors. A CDO manager--who buys a portfolio of mortgage-backed securities and issues debt An investor--who buys the CDO debt Two additional participants are also involved: A servicer--who keeps the loan documents and collects the payments from the borrower A rating agency--that places a rating on the mortgage securities and on the CDO debt This chart is obviously a simplification of a more complex process. For example, CDOs were not the only purchasers of risk in the subprime market. They were however a dominant player, with some estimating that they bought about 70 percent of the lower rated classes of subprime mortgage securitizations. What is clear even from this simplified process is that contact between the provider of risk capital and the borrower was very attenuated. A central problem with the securitization market, especially for subprime loans was that no one was the gate keeper, shutting the door on uneconomic loans. The ultimate CDO bond investor placed his trust in the first loss investor, the rating agencies, and the CDO manager, and in each case that trust was misplaced. Ideally mortgage transactions are generally structured so that someone close to the origination process would take the first slice of credit risk and thus insure that loans were originated properly. In the subprime market, however it was possible to originate loans and sell them at such a high price, that even if the mortgage banker or aggregator retained a first loss piece (or residual) the transaction could be profitable even if the loans did not perform well. Furthermore, the terms of the residuals were set so that the owner of the residual might receive a substantial portion of their cash flows before the full extent of losses were known. Rating agencies set criteria to establish credit enhancement levels that ultimately led to ratings on bonds. The rating agencies generally rely on historical statistical analysis to set ratings. The rating agencies also depend on numeric descriptions of loans like loan-to-value ratios and debt-to-income ratios to make their determinations. Rating agencies usually do not review loans files or ``re-underwrite'' loans. Rating agencies also do not share in the economic costs of loan defaults. The rating agencies methodology allowed for the inclusion of loans of dubious quality into subprime and Alt-A mortgage pools, including low documentation loans for borrowers with poor payment histories, without the offsetting requirement of high down payments. To help assure investors of the reliability of information about the risks of purchased loans, the mortgage market has developed the practice of requiring ``representations and warranties'' on purchased loans. These reps and warrants as they are called, are designed to insure that the loans sold meet the guidelines of the purchasers. This is because mortgage market participants have long recognized that there is substantial risk in acquiring loans originated by someone else. An essential component in having valuable reps and warrants is that the provider of those promises has sufficient capital to back up their obligations to repurchase loans subsequently determined to be inconsistent with the reps and warrants. A financial guarantee from an insolvent provider has no value. Representations and warranties are the glue that holds the process together; if the glue is weak the system can collapse. The rating agencies also established criteria for Collateralized Debt Obligations that allowed CDO managers to produce very highly leveraged portfolios of subprime mortgage securities. The basic mechanism for this was a model that predicted the performance of subprime mortgage pools were not likely to be highly correlated. That is defaults in one pool were not likely to occur at the same time as defaults in another pool. This assumption was at best optimistic and most likely just wrong. In the CDO market the rating agencies have a unique position. In most of their other ratings business, a company or a transaction exists or is likely to occur and the rating agency reviews that company or transaction and establishes ratings. In the CDO market, the criteria of the rating agency determine whether or not the transaction will occur. A CDO is like a financial institution. It buys assets and issues debt. If the rating agency establishes criteria that allow the institution to borrow money at a low enough rate or at high enough leverage, then the CDO can purchase assets more competitively than other financial institutions. If the CDO has a higher cost of debt or lower leverage, then it will be at a disadvantage to other buyers and will not be brought into existence. If the CDO is created, the rating agency is compensated for its ratings. If the CDO is not created, there is no compensation. My view is that there are very few institutions that can remain objective given such a compensation scheme. CDO bond investors also relied upon the CDO manager to guide them in the dangerous waters of mortgage investing. Here again investors were not well served by the compensation scheme. In many cases CDO managers receive fees that are independent of the performance of the deals they manage. While CDO managers sometimes keep an equity interest in the transactions they manage, the deals are often structured in such a way that that the deal can return the initial equity investment even if some of the bonds have losses. Moreover, many of the CDOs were managed by start-up firms with little or no capital. Nevertheless, much of the responsibility should rest with the investors. CDO bond investors were not blind to the additional risks posed by CDO investing. CDOs generally provided higher yields than similarly rated bonds, and it is an extremely naive, and to my mind, rare, investor who thinks they get higher returns without incremental risk. It is not unusual, however, for investors not to realize the magnitude of additional risk they bear for a modest incremental return. Ultimately it is investors who will bear the losses, and investors must bear the bulk of the burden in evaluating their investments. There were clear warning signs for several years as to the problems and risk of investing in subprime mortgages. Nevertheless, investors continued to participate in this sector as the risks grew and reward decreased. As expressed herein, the primary problem facing securitization is a failure of industrial organization. The key risk allocators in the market, the CDO managers, were too far from the origination process and, at best, they believed the originators and the rating agencies were responsible for limiting risk. At the origination end, without the discipline of a skeptical buyer, abuses grew. The buyer was not sufficiently concerned with the process of loan origination and the broker was not subject to sufficient constraints.Current Conditions of the Mortgage-backed Securities Market More than 2 years after the announcement of the collapse of the Bear Stearns High Grade Structured Credit Enhanced Leverage Fund the mortgage market remains in a distressed state. Little of the mortgage market is functioning without the direct involvement of the U.S. Government, and access to financing for mortgage originators and investors is still limited. Fortunately there are the beginning signs of stabilization of home prices, but rising unemployment threatens the recovery. In the secondary market for mortgage-backed securities there has been considerable recovery in price in some sectors, but overall demand is being propped up by large purchases of MBS by the Federal Reserve Bank. In addition, we find that many of our clients are primarily focused on accounting and regulatory concerns related to legacy positions, and less effort is focused on the economic analysis of current and future opportunities. That situation may be changing as over the past few months we have seen some firms begin to focus on longer term goals.The Effectiveness of Government Action I have not performed an independent analysis of the effectiveness of Government actions, so by comments are limited to my impressions. Government involvement has been beneficial in a number of significant respects. Without Government involvement in Fannie Mae, Freddie Mac, and FHA lending programs, virtually all mortgage lending could have stalled. What lending would have existed would have been for only the absolute highest quality borrowers and at restrictive rates. In addition Government programs to provide liquidity have also been beneficial to the market as private lending was reduced to extremely low levels. Government and Federal Reserve purchases of MBS have kept mortgage rates low. This has probably helped to bolster home prices. On the other hand the start/stop nature of the buying programs under TARP and PPIP has probably been a net negative for the market. Market participants have held back on investments in anticipation of Government programs that either did not materialize or were substantially smaller in scope than expected. Furthermore Government efforts to influence loan modifications, while beneficial for some home owners, and possibly even investors, have created confusion and distrust. Investors are more reluctant to commit capital when the rules are uncertain. In my opinion there has been excessive focus on loan modifications as a solution to the current crisis. Loan modifications make sense for a certain portion of borrowers whose income has been temporarily disrupted or have sufficient income to support a modestly reduce loan amount and the willingness to make those payments. However for many borrowers, loan modifications cannot produce sustainable outcomes. In addition, loan modifications must deal with the complexities of multiple liens and complex ownership structures of mortgage loans. Short sales, short payoffs, and relocation assistance for borrowers are other alternatives that should be given greater weight in policy development. The extensive Government involvement in the mortgage market has likely produced significant positive benefits to the economy. However unwinding the Government role will be quite complex and could be disruptive to the recovery. Government programs need to be reduced and legislative and regulatory uncertainties need to be addressed to attract private capital back into these markets.Legislative and Regulatory Recommendations I believe that the problems in the securitization market were essentially due to a failure of industrial organization. Solutions should address these industrial organization failures. While some may seek to limit the risks in the economy, I believe a better solution is to make sure the risks are borne by parties who have the capacity to manage the risks or the capital to bear those risks. In practical terms, this means that ultimately bond investors, as the creators of leverage, must be responsible for limiting leverage to economically sustainable levels that do not create excessive risk to their stakeholders. Moreover, lenders should not allow equity investors to have tremendous upside with little exposure to downside risk. Equity investors who have sufficient capital at risk are more likely to act prudently. Consequently, all the information needed to assess and manage risks must be adequately disclosed and investors should have assurances that the information they rely upon is accurate and timely. Likewise when the Government acts as a guarantor, whether explicitly or implicitly, it must insure that it is not encouraging excessive risk taking and must have access to critical information on the risks borne by regulated entities. In this light, I would like to comment on the Administration proposals on Securitization in the white paper: ``Financial Regulatory Reform: A New Foundation.'' \5\ Recommendations 1 and 2 cover similar ground:--------------------------------------------------------------------------- \5\ http://www.financialstability.gov/docs/regs/FinalReport_web.pdf pp. 44-46. 1. Federal banking agencies should promulgate regulations that require originators or sponsors to retain an economic interest in a material portion of the credit risk of securitized credit --------------------------------------------------------------------------- exposures. The Federal banking agencies should promulgate regulations that require loan originators or sponsors to retain 5 percent of the credit risk of securitized exposures. 2. Regulators should promulgate additional regulations to align compensation of market participants with longer term performance of the underlying loans. Sponsors of securitizations should be required to provide assurances to investors, in the form of strong, standardized representations and warranties, regarding the risk associated with the origination and underwriting practices for the securitized loans underlying ABS. Clearly excessive leverage and lack of economic discipline was at the heart of the problems with securitization. As described above the market failed to adequately protect investors from weakened underwriting standards. Additional capital requirements certainly should be part of the solution. However, such requirements need to be constructed carefully. Too little capital and it will not have any effect; too much and it will inhibit lending and lead to higher mortgage costs. The current recommendation for retention of 5 percent of the credit risk does not seem to strike that balance appropriately. When a loan is originated there are several kinds of credit related risks that are created. In addition to systematic risks related to future events such as changes in home prices and idiosyncratic risks such as changes in the income of the borrower, there are also operational risks related to the quality of the underwriting and servicing. An example of an underwriting risk is whether or not the borrower's income and current value of their home were verified appropriately. Originators are well positioned to reduce the operational risks associated with underwriting and fight fraud, but they may be less well positioned to bear the long term systematic and idiosyncratic risks associated with mortgage lending. Investors are well positioned to bear systemic risks and diversify idiosyncratic risks, but are not able to assess the risks of poor underwriting and servicing. The securitization process should ensure that there is sufficient motivation and capital for originators to manage and bear the risks of underwriting and sufficient information made available to investors to assess the risks they take on. The current form of representations and warranties is flawed in that it does not provide a direct obligation from the originator to the investor. Instead representations and warranties pass through a chain of ownership and are often limited by ``knowledge'' and capital. In addition current remedies are tied to damages and in a rising home price market calculated damages may be limited. Thus a period of rising home prices can mask declining credit quality and rising violations of representations and warranties. Therefore, incentives and penalties should be established to limit unacceptable behavior such as fraud, misrepresentations, predatory lending. If the goal is to prevent fraud, abuse and misrepresentations rather than to limit risk transfer then there needs to be a better system to enforce the rights of borrowers and investors than simply requiring a originators to retain a set percentage of credit risk. I have proposed \6\ a ``securitization certificate'' which would travel with the loan and would be accompanied by appropriate assurances of financial responsibility. The certificate would replace representations and warranties, which travel through the chain of buyers and sellers and are often unenforced or weakened by the successive loan transfers. The certificate could also serve to protect borrowers from fraudulent origination practices in the place of assignee liability. Furthermore the certificate should be structured so that there are penalties for violations regardless of whether or not the investor or the borrower has experienced financial loss. The record of violations of these origination responsibilities should publically available.--------------------------------------------------------------------------- \6\ http://www.ad-co.com/newsletters/2008/Feb2008/Credit_Feb08.pdf and ``Securitization: After the Fall'', Anthony Sanders and Andrew Davidson, forthcoming.--------------------------------------------------------------------------- I have constructed a simple model of monitoring fraudulent loans. \7\ Some preliminary results are shown in Table 1. These simulations show the impact of increasing the required capital for a seller and of instituting a fine for fraudulent loans beyond the losses incurred. These results show that under the model assumptions, without a fine for fraud, sellers benefit from originating fraudulent loans. The best results are obtained when the seller faces fines for fraud and has sufficient capital to pay those fines. The table below shows the profitability of the seller and buyer for various levels of fraudulent loans. In the example below, the profits of the seller increase from .75 with no fraudulent loans to .77 with 10 percent fraudulent loans, even when the originator retains 5 percent capital against 5 percent of the credit risk. On the other hand, the sellers profit falls from .75 to .44 with 10 percent fraudulent loans even though the retained capital is only 1 percent, but there is a penalty for fraudulent loans. Thus the use of appropriate incentives can reduce capital costs, while increasing loan quality.--------------------------------------------------------------------------- \7\ The IMF has produced a similar analysis and reached similar conclusions. http://www.imf.org/external/pubs/ft/gfsr/2009/02/pdf/chap2.pdf.[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT] Under this analysis the Treasury proposals would not have a direct effect on fraud. In fact, there is substantial risk the recommended approach of requiring minimum capital requirements for originators to bear credit risk would lead to either higher mortgage rates or increased risk taking. A better solution is to create new mechanisms to monitor and enforce the representations and warranties of originators. With adequate disclosure of risks and a workable mechanism for enforcing quality controls the securitization market can more effectively price and manage risk. Recommendation 3 addresses the information available to investors: 3. The SEC should continue its efforts to increase the transparency and standardization of securitization markets and be given clear authority to require robust reporting by issuers of asset backed securities (ABS). Increased transparency and standardization of securitization markets would likely to better functioning markets. In this area, Treasury charges the SEC and ``industry'' with these goals. I believe there needs to be consideration of a variety of institutional structures to achieve these goals. Standardization of the market can come from many sources. Possible candidates include the SEC, the American Securitization Forum, the Rating Agencies and the GSEs, Fannie Mae and Freddie Mac. I believe the best institutions to standardize a market are those which have an economic interest in standardization and disclosure. Of all of these entities the GSEs have the best record of standardizing the market; this was especially true before their retained portfolios grew to dominate their income. (As I will discuss below, reform of the GSEs is essential for restoring securitization.) I believe a revived Fannie Mae and Freddie Mac, limited primarily to securitization, structured as member-owned cooperatives, could be an important force for standardization and disclosure. While the other candidates could achieve this goal they each face significant obstacles. The SEC operates primarily through regulation and therefore may not be able to adapt to changing markets. While the ASF has made substantial strides in this direction, the ASF lacks enforcement power for its recommendations and has conflicting constituencies. The rating agencies have not shown the will or the power to force standardization, and such a role may be incompatible with their stated independence. Recommendations 4 and 5 address the role of rating agencies in securitization. 4. The SEC should continue its efforts to strengthen the regulation of credit rating agencies, including measures to require that firms have robust policies and procedures that manage and disclose conflicts of interest, differentiate between structured and other products, and otherwise promote the integrity of the ratings process. 5. Regulators should reduce their use of credit ratings in regulations and supervisory practices, wherever possible. In general I believe that the conflicts of interest facing rating agencies and their rating criteria were well known and easily discovered prior to the financial crisis. Thus I do not believe that greater regulatory authority over rating agencies will offer substantial benefits. In fact, increasing competition in ratings or altering the compensation structure of rating agencies may not serve to increase the accuracy of ratings, since most users of ratings issuers as well as investors are generally motivated to seek higher ratings. (Only if the regulatory reliance on rating agencies is reduced will these structural changes be effective.) To the extent there is reliance on rating agencies in the determination of the capital requirement for financial institutions, a safety and soundness regulators for financial institutions, such the FFIEC or its successor, should have regulatory authority over the rating agencies. Rather than focus on better regulation, I support the second aspect of Treasury's recommendations on rating agencies (recommendation 5) and believe it would be better for safety and soundness regulators to reduce their reliance on ratings and allow the rating agencies to continue their role of providing credit opinions that can be used to supplement credit analysis performed by investors. To reduce reliance on ratings, regulators, and others will need alternative measures of credit and other risks. I believe that the appropriate alternative to ratings is analytical measures of risk. Analytical measures can be adopted, refined, and reviewed by regulators. In addition regulators should insist that regulated entities have sufficient internal capacity to assess the credit and other risks of their investments. In this way regulators would have greater focus on model assumptions and model validation and reduced dependence on the judgment of rating agencies. The use of quantitative risk measures also requires that investors and regulators have access to sufficient information about investments to perform the necessary computations. Opaque investments that depend entirely upon rating agency opinions would be clearly identified. Quantitative measures can also be used to address the concerns raised in the report about concentrations of risk and differentiate structured products and direct corporate obligations. I recently filed a letter with the National Association of Insurance Commissioners on the American Council of Life Insurers' proposal to use an expected loss measure as an alternative to ratings for nonagency MBS in determining risk based capital. Here I would like to present some of the key points in that letter: An analytical measure may be defined as a number, or a value, that is computed based on characteristics of a specific bond, its collateral and a variety of economic factors both historical and prospective. One such analytical measure is the probability of default and another measure is the expected loss of that bond. While an analytical measure is a numeric value that is the result of computations, it should be noted that there may still be some judgmental factors that go into its production. In contrast, a rating is a letter grade, or other scale, assigned to a bond by a rating agency. While ratings have various attributes, generally having both objective and subjective inputs, there is not a particular mathematical definition of a rating. Analytical measures may be useful for use by regulators because they have several characteristics not present in ratings. 1. An analytical measure can be designed for a specific purpose. Specific analytical measures can be designed with particular policy or risk management goals in mind. Ratings may reflect a variety of considerations. For example, there is some uncertainty as to whether ratings represent the first dollar of loss or the expected loss, or how expected loss is reflected in ratings. 2. Analytical measures can be updated at any frequency. Ratings are updated only when the rating agencies believe there has been sufficient change to justify an upgrade, downgrade or watch. Analytical measures can be computed any time new information is available and will show the drift in credit quality even if a bond remains within the same rating range. 3. Analytical measures can take into account price or other investor specific information. Ratings are computed for a bond and generally reflect the risk of nonpayment of contractual cash flows. However, the risk to a particular investor of owning a bond will at least partially depend on the price that the bond is carried in the portfolio or the composition of the portfolio. 4. Regulators may contract directly with vendors to produce analytical results and may choose the timing of the calculations. On the other hand, ratings are generally purchased by the issuer at the time of issuance. Not only may this introduce conflicts of interest, but it also creates a greater focus on initial ratings than on surveillance and updating of ratings. In addition, once a regulator allows the use of a particular rating agency it has no further involvement in the ratings process. 5. Analytical measures based on fundamental data may also be advantageous over purely market-based measures. As market conditions evolve values of bonds may change. These changes reflect economic fundamentals, but may also reflect supply/ demand dynamics, liquidity and risk preferences. Measures fully dependent on market prices may create excessive volatility in regulatory measures, especially for companies with the ability to hold bonds to maturity. Even if regulators use analytical measures of risk, ratings from rating agencies as independent opinions would still be valuable to investors and regulators due to the multifaceted nature of ratings and rating agency analysis can be used to validate the approaches and assumptions used to compute particular analytical measures. Additional measures beyond the credit risk of individual securities such as stress tests, market value sensitivity and measures of illiquidity may also be appropriate in the regulatory structure. The use of analytical measures rather than ratings does not eliminate the potential for mistakes. In general, any rigid system can be gamed as financial innovation can often stay ahead of regulation. To reduce this problem regulation should be based on principles and evolve with the market. Regulators should always seek to build an a margin of safety as there is always a risk that the theory underlying the regulatory regime falls short and that some participants will find mechanisms to take advantage of the regulatory structure. Finally, as discussed by the Administration in the white paper, the future of securitization for mortgages requires the resolution of the status of Fannie/Freddie and role of FHA/GNMA. As stated above, I believe that continuation of Fannie Mae and Freddie Mac as member owned cooperatives would serve to establish standards, and provide a vehicle for the delivery of Government guarantees if so desired. The TBA, or to be announced, market has been an important component in the success of the fixed rate mortgage market in the United States. Careful consideration should be given to the desirability of fixed rate mortgages and the mechanisms for maintaining that market in discussions of the future of the GSEs. ______ CHRG-110hhrg46593--346 Mr. Blinder," I don't rule it out. But I thought at the time and I still think that, being a different direction and given the complexities of starting from scratch, I would rather jump on the train that is leaving the station. However, I don't rule it out. The problem with the insurance plan that was being debated back in September--and, by the way, some insurance aspects come into a lot of these plans--was that it was too much like insuring the house after it had burned down. It is very hard to design an insurance plan for catastrophes that have already happened. But insurance is quite relevant to the ones that haven't happened yet, and probably has merit in that regard. Indeed, a lot of these plans, such as the essence of HOPE for Homeowners, which passed this committee first and then passed the Congress back in July, was to bring in FHA insurance to close the deal. So it was, at its essence, an insurance plan. The government was becoming an insurer. So it really was a first cousin to that idea. Insurance is already in the law. If I was able to wave a magic wand here, which, of course, I cannot, I would make some amendments to HOPE for Homeowners to broaden it and enhance the eligibility. You need money for that. And I would take that away from the TARP. And further to your question, insurance is the essence of that. " CHRG-111hhrg54869--165 Mr. Cochrane," Thank you for giving me the opportunity to talk to you today. This wasn't an isolated event. We are in a cycle of ever-larger risk taking punctuated by ever-larger failures and ever-larger bailouts, and this cycle can't go on. We can't afford it. This crisis strained our government's borrowing ability, there remains the worry of flight from the dollar and government default through inflation. The next and larger crisis will lead to that calamity. Moreover, the bailout cycle is making the financial system much more fragile. Financial market participants expect what they have seen and what they have been told, that no large institution will be allowed to fail. They are reacting predictably. Banks are becoming bigger, more global, more integrated, more systemic, and more opaque. They want regulators to fear bankruptcy as much as possible. We need the exact opposite. We and Wall Street need to reconstruct the financial system so as much of it as possible can fail without government help, with pain to the interested parties but not to the system. There are two competing visions of policy to get to this goal. In the first, large integrated instructions will be allowed to continue and to grow with the implicit or explicit guarantee of government help in the event of trouble, But with the hope that more aggressive supervision will contain the obvious incentive to take more risks. In the second, we think carefully about the minimal set of activities that can't be allowed to fail and must be guaranteed. Then we commit not to bail out the rest. Private parties have to prepare for their failure. We name, we diagnose, and we fix whatever problems with bankruptcy law caused systemic fears. Clearly, I think the second approach is much more likely to work. The financial and legal engineering used to avoid regulation and capital controls last time were child's play. ``Too-big-to-fail'' must become ``too-big-to-exist.'' A resolution authority offers some advantages in this effort. It allows the government to impose some of the economic effects of failure, shareholders and debt holders lose money, without legal bankruptcy. But alas, nothing comes without a price. Regulators fear--their main systemic fear is often exactly the counterparties will lose money, so it is not obvious they will use this most important provision and instead bail out the counterparties. I think the FDIC, as often mentioned, is a useful model. It is useful for its limitations as well as for its rights. These constrain moral hazard and keep it from becoming a huge piggybank for Wall Street losses. The FDIC applies only to banks. Resolution authority must come with a similar statement of who is and who is not subject to its authority. Deposit insurance and FDIC resolution come with a serious restriction of activities. An FDIC-insured bank can't run a hedge fund. Protection, resolution, and government resources must similarly be limited to systemic activities and the minimum that has to accompany them. Deposit insurance in FDIC resolution address a clearly defined systemic problem, bank runs. A resolution authority must also be aimed at a specific defined and understood systemic problem, and the FDIC can only interfere with clear triggers. The Administration's proposal needs improvement, especially in the last two items. It only requires that the Secretary and the President announce their fear of serious adverse effects. That is an invitation to panic, frantic lobbying, and gamesmanship to make one's failure as costly as possible. It is useful to step back and ask, what problem is it we are trying to fix anyway? Regulators say they fear the systemic effects of bankruptcy. But what are these? If you ask exactly what is wrong with bankruptcy, you find fixable, technical problems. The runs on Lehman and Bear Stearns brokerages, collateral stuck in foreign bankruptcy courts, even the run on money market funds, these can all be fixed with changes to legal and accounting rules. And resolution doesn't avoid these questions. Somebody has to decide who gets what. If Citi is too complex for us to figure that out now, how is the poor Secretary of the Treasury going to figure it out at 2 o'clock in the morning on a Sunday night? The most pervasive argument for systemic effective bankruptcy, I think, is not technical; it is psychological. Markets expected the government to bail everybody out. Lehman's failure made them reconsider whether the government was going to bail out Citigroup. But the right answer to that problem is to limit and clearly define the presumption that everyone will be bailed out--not to expand it and leave it vague. Here I have to disagree with Mr. Volcker's testimony. He said we should always leave people guessing, but that means people will always be guessing what the government is going to do, leading to panic when it does something else. And let me applaud Chairman Frank's statement earlier that no one will believe us until we let one happen. I look forward to, not necessarily to that day, but to the clearer statement--clearer understanding by markets and the government of what the rules are going to be the day afterwards. [The prepared statement of Professor Cochrane can be found on page 57 of the appendix.] " CHRG-110hhrg46591--52 Mr. Stiglitz," I agree that one needs to approach this comprehensively. I think that looking at the past and what has caused this problem is only part of what needs to be done, because there are all kinds of crises we could have had and that we will have in the future. We are looking at this in a way parochially as Americans. This has been a global crisis. Countries that didn't have our particular institutions have also had problems. And so I think we really need to think about this looking forward, taking into account the changes in the financial markets that have occurred, what are the risks, and how do we manage those risks. And I guess a final point, I think one of the real difficulties is the very large role of the special interest at play in shaping our current financial structures, regulatory structures, the failures of the current financial regulators are going to make it very difficult to go forward. That is something you just have to take into account, that they are going to try to shape the regulations to allow them to keep doing what they did in the past because it worked for them. " CHRG-110hhrg46594--313 Mrs. Bachmann," Mr. Chairman, thank you. Once again our committee is convened to hear the pleas of yet one more industry to ask the taxpayers for a bailout. This time from our great industry of the automakers, the Big Three, Ford, GM, and Chrysler. My family and I currently own a GM and a Ford, and one of our favorite cars was the Chrysler minivan. So it is with great love for your vehicles that we want to see you succeed. But it is also appropriate that we again total the taxpayers' current bailout tab, $29 billion for Bear Stearns this year, $200 billion for Freddie and Fannie, $300 billion to expand the Federal Housing Administration, $150 billion for AIG. Who knows where that will end? $700 billion for the Paulson plan plus another $110 billion in sweeteners to pass that plan. Then you have to add on the original bailout bill, which would be the stimulus package; that was $168 billion earlier this year. And then we had also the deficit spending of this Congress in the 110th of $455 billion. That is a whopping $2 trillion. And recognize that only 40 percent of Americans even pay taxes. Secretary Paulson and Chairman Bernanke chose to start this bailout mania over 8 months ago. But since then the American people have been told over and over that the woes of our financial markets will subside. They haven't. Yet after bailing out bad decisionmakers time and again to the tune of over $2 trillion, the financial markets seem to remain in even more turmoil than before. What we are asking now is for the American taxpayer who was never part of these initial contracts to solve the spiraling problem that is facing the City of Detroit. We share in the grief that Detroit has had to deal with and in fact the entire State of Michigan. It is not pretty. No one would want the problems that you have to deal with. But we are looking at other problems as well. And the American people suspect that there are long-term management issues at these companies and productivity problems as well. I don't know that we want government bureaucrats, certainly I wonder if we want to have Members of Congress giving you orders for how to run your companies. It has been reported for years that CEOs at Ford, GM, and Chrysler have not made the necessary changes to rein in labor costs and have not downsized facilities to ensure the company's longer-term viability. Again, I don't want to see Congress second guessing your business decisions, but these are concerns that the American people have. In fact the Big Three are paying out an average of $30 more per hour than your competitors. That is what we are told. And you support a large number of retirees under what are now considered outdated contracts. GM, for instance, we are told actually supports more retirees than they support current workers. The auto industry has also been criticized for failing to invest in enough competitive innovative products that American consumers want to buy. And what we are also told is that the Big Three has failed to look into the future and take steps to prepare for the rise in gas prices, although I don't know how anyone could do that. Taxpayers are again being asked to throw their hard earned money behind a short-term unproductive investment which may perhaps only prolong your companies' failures at a cost that could even be higher down the road. I have received no assurances to date that this money will not simply go down a rabbit hole, none of us have in this committee. Plus, much of the urgency that would force the Big Three to make tough restructuring choices would be reduced if the Federal money is made available to you. It is an interesting conundrum. Like AIG, it is easy to predict that you will be back at the taxpayer's trough in no time at the rate that money is being burned in Detroit. Some say the bailout is needed under the premise that consumers just can't get access to car loans due to the broader credit crunch and that this is causing your companies to suffer. But there are automakers that have remained profitable even through these tough times, Toyota, Honda, and Nissan. They are Japanese-owned, but they operate huge manufacturing firms here in the United States, in Kentucky, Tennessee, and Ohio. These companies also employ thousands of American workers who are paying their taxes and struggling to put food on their families' tables. When we take money from this group of taxpayers to save the three ailing companies before us, it is not only unproductive, it is just plain wrong. This Congress has already spent $2 trillion in bailouts this year, and if we move forward with this proposal I don't know where or when this bailout bonanza will end. I think there are other alternatives that we can consider. For instance, if the Big Three would restructure and reorganize under bankruptcy courts, it is possible that you could be saved without a taxpayer bailout and that you could fix your long-term management and labor problems. If you file for Chapter 11 bankruptcy, it doesn't mean that your company has to go belly up and that all jobs will be lost. It would mean that the company actually might have the ability to make structural changes to keep itself afloat without the threat of outside lawsuits, enter a comprehensive payment plan. The taxpayers just want to know. My question that I would have, Mr. Chairman, would be for Mr. Wagoner from GM, and it would be two things. One, I noticed today you wrote an editorial in the Wall Street Journal on why GM deserves support and you said that we know we can't just slash our way to prosperity. And my question for you would be this: Isn't that just a Draconian way of stating the realities of supply and demand in the marketplace, that your company needs to adjust in good times and in bad? If you are smart and looking for the future, shouldn't your companies be treated the same as other separate companies who have to make those vagaries of life decisions? And also in your testimony, sir, you reference that what exposes us to failure now is the global financial crisis. Well, if the global financial crisis is the sole cause of your current troubles, then why aren't we seeing the other car manufacturers in other countries reaching out to their respective governments with similar requests for cash? And similarly, why aren't we seeing Toyota, Honda and Nissan here at the table today? " 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-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-111hhrg52397--34 Mr. Fewer," Chairman Kanjorski, Ranking Member Garrett, and members of the subcommittee, my name is Donald Fewer. I would like to thank the subcommittee for the opportunity to share my views on the regulation of the over-the-counter derivatives market and address the areas of interest outlined by the subcommittee. I have also submitted a larger statement for the record. Analysis of the credit crisis points to the need for enhanced regulation of the OTC market. Results from such analysis point to multiple, and sometimes conflicting, causes of the crisis and the role played by the OTC derivatives market. We suggest creating a cohesive regulatory regime with a systemic risk regulator that has the authority and accountability to regulate financial institutions that are determined to be systemically important. Regulation need not reshape the market or alter its underlying functionality. The U.S. share of global financial markets is rapidly falling and oversight consolidation should not create a regulatory environment that prohibits capital market formation, increases transaction costs, and pushes market innovation and development to foreign markets. The use of CCPs by all market participants, including end users, should be encouraged by providing open and fair access to key infrastructure components, including central clearing facilities, private broker trading venues, and derivative contract repositories. Central clearing will reduce systemic risk by providing multilateral netting and actively managing daily collateral requirements. Mandated clearing of the most standardized and liquid product segments is congruent with efficient global trade flow. Given the size, history and global scope of the OTC derivatives market, migration toward exchange execution has been, and will be, minimal apart from mandatory legislative action. OTC derivative markets will use well-recognized protocols of size, price, payment and maturity dates. Because of these internationally-recognized protocols, OTC dealers globally are able to efficiently customize and best execute at least cost trillions of dollars of customer orders within generally acceptable terms to the market. There is a class of OTC product that is extremely conducive to exchange execution and can warrant exchange listing. The over-the-counter market has a well-established system of price discovery and pre-trade market transparency that includes markets such as U.S. Treasuries, U.S. repo, and EM sovereign debt. OTC markets have been enhanced by higher utilization of electronic platform execution. The unique nature of the OTC markets' price discovery process is essential to the development of orderly trade flow and liquidity, particularly in fixed income credit markets. We are in a period of abundance of mispriced securities where professional market information and execution is required. OTC derivatives and underlying cash markets use an exhaustive price discovery service that can only be realized in the OTC market via execution platforms that integrate cash and derivative markets. Post-trade transparency for all OTC derivative transactions can be properly serviced by CCPs and central trade repositories that aggregate trading volumes and positions, as well as specific counterparty information. These institutions can be structured to maintain books and records and provide access to regulatory authorities on trade-specific data. I would not endorse OTC trade reporting to the level that is currently disclosed by trace. There is ample evidence in the secondary OTC corporate bond market that the trace system has caused dealers to be less inclined to hold inventory and to make capital to support secondary markets. Successful utilization of electronic trade execution platforms is evident in markets such as U.S. Government bonds and U.S. Government repo. I would caution against the mandated electronic execution of OTC cash-in derivative products by regulatory action. Effective implementation of such platforms should be the result of a clear demand made by market makers and a willingness by dealers to provide liquidity electronically. Our experience in North America is that the dealer community has refrained from electronic execution due to the risk of being held to prices during volatile market conditions. I would strongly endorse the hybrid use of electronic platforms where market participants utilize the services of voice brokers in conjunction with screen trading technology. Mr. Chairman, Mr. Ranking Member, and members of the subcommittee, I appreciate the opportunity to provide this testimony. I am available to answer any questions you may have. [The prepared statement of Mr. Fewer can be found on page 156 of the appendix.] " CHRG-110shrg50414--156 Chairman Dodd," Senator Menendez. Senator Menendez. Thank you. Thank you, Mr. Chairman. As I listen here for a while, I get the sense that while you have given this a lot of thought, by the same token I get some sense that we are flying by the seat of our pants and that in that respect, you know, that you want to come in strong and have the cavalry be there, but you are not quite sure what the cavalry does once it arrives. And that is part of my concern here. The trouble is that these assets are so intertwined and complex that no one seems to be able to figure out what they are worth. And, hence, no one has been willing to buy them, which is why, Mr. Chairman, as you described, they have been in a lockdown mode. But you talked about the maturity price, and I just wonder how, in fact, since they are impossible to value as instruments at this point in time, how does one actually achieve that? If the Secretary pays the market rate, presumably if that was enough to be able to achieve the sale, that would be enough to persuade banks to sell already, so they would have sold. For that plan to work, then it would almost seem that you have to pay some type of a premium. And if that is the case--and I have heard the Secretary say many times we are going to look toward market mechanisms. Well, you know, some of us are concerned that market mechanisms have brought us to where we are today. So how do you know--how do any of these institutions even know how to bid, for example, in the reverse auction, if, in fact, they could not in the first place determine what the value is? And, therefore, how do we make the determination of what, in fact, the hold-to-maturity price is so that the taxpayers do not get left holding the bag? " CHRG-111shrg50814--132 Chairman Dodd," Maybe what we ought to do with the Committee sometime is maybe have just an informal dinner one night with interested Members and have a discussion about those days. I think it would be an interesting conversation. Senator Akaka. Senator Akaka. Thank you very much, Mr. Chairman. Welcome, Chairman Bernanke. It is good to see you. I can recall back on September 23, 2008, when we had a Banking meeting with four of you: Treasury Secretary Paulson, Cox, and you, and also with Jim Lockhart. At that time we were trying to learn what the crisis was all about and what we were going to do about it. And as I recall, we came out--really, what came out of it was the $700 billion was to bring confidence to Wall Street. But since then, many things have happened, and well before the current economic crisis, the financial regulatory system was failing to adequately protect working families from predatory practices and exploitation. Families were being pushed into mortgage products with associated risks and costs that they could not afford. Instead of utilizing affordable, low-cost financial services found at regulated banks and credit unions, too many working families have been exploited by high-cost, fringe financial service providers such as payday lenders and check cashers. Additionally, too many Americans lack the financial literacy, knowledge, and skills to make informed financial decisions, and I have two questions for you. What I am asking is what must be done. What must be done as we work toward reforming the regulatory structure for financial services to better protect and educate consumers? " CHRG-111hhrg48867--40 Mr. Yingling," Thank you, Mr. Chairman, Ranking Member Bachus, and members of the committee. The ABA congratulates this committee on the approach it is to taking 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. Last week, Chairman Bernanke gave a speech which focused on three main areas: First, the need for a systemic risk regulator; second, the need for a method of orderly resolution of systemically important financial firms; 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 make sure it does not. The ABA strongly supports the creation of a systemic regulator. In retrospect, it is inexplicable that we have not had such a regulator. To use a simple analogy, think of a systemic regulator as sitting on top of Mount Olympus, looking out over 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 part of the land. Even worse, no one is effectively looking over some areas. 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 Fed. This could be done by giving the authority to the Fed or by creating an oversight committee chaired by the Fed. ABA's one concern in using the Fed relates to what it may mean for the independence of the Federal Reserve in the future. We strongly believe in the importance of Federal Reserve independence in setting monetary policy. ABA believes that systemic regulation cannot be effective if accounting policy is not part of the equation. That is why we support the Perlmutter-Lucas bill, H.R. 1349. To continue my analogy, a 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, a 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. I want to take this opportunity to thank this committee for the bipartisan efforts in the hearing last week on mark-to-market. Your efforts last week will significantly aid in economic recovery. We hope that the FASB and the SEC will take the final action you clearly advocated. ABA strongly supports a mechanism for the orderly resolution of systemically important nonbank firms. Our regulatory body should never again be in a position of making up a solution to a Bear Stearns or an AIG or not being able to resolve a Lehman Brothers. The inability to deal with those situations in a predetermined way greatly exacerbated this 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 in a major fashion determine the parameters of too-big-to-fail. In an ideal world, there would be no such thing as too-big-to-fail; but we know that the concept not only exists, it has grown broader over the last few months. This concept has profound moral hazard and competitive effects that are very important to address. The third area of our focus is where there are gaps in regulation. These gaps have proven to be a major factor in the crisis, particularly the role of largely unregulated mortgage lenders. Credit default swaps and hedge funds should also 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. 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. The ABA pledges to be an active and constructive participant in this critical hour. Thank you. [The prepared statement of Mr. Yingling can be found on page 171 of the appendix.] " CHRG-110shrg50409--82 Mr. Bernanke," Well, of course, fundamentally the market will do it. The free market will do it. But there are things that we can do. The Federal Reserve has already tried to address, some of the regulatory aspects of high-cost mortgage lending. We and our fellow regulators are also looking at the treatment of mortgages by banks and other lenders in terms of their capital and how they manage that. I think the banks and the private sector themselves are rethinking the standards, the underwriting standards, the loan-to-value ratios, those sorts of things as they go forward. So, I anticipate that we will have a healthy recovery in the housing market once we have gone through this necessary process. But it will probably be less exuberant than we saw earlier with somewhat tougher underwriting standards, more investment due diligence, probably less use of securitization or complex securitized products. But I am confident that, with the appropriate background--I probably include here the GSEs and FHA--the housing market will recover, and it will help be part of the economy's return to growth. Senator Carper. One of my colleagues asked you earlier about the drop in the value of the dollar and asked you quantify that. I will not ask you to do that again. But we have seen the dollar drop, whether it is 20 percent or 30 percent or some other number. We have seen exports, conversely, rise, but yet we have seen a continued loss in manufacturing jobs in this country. I think the last month I noticed maybe 30,000 or 40,000 additional manufacturing jobs had been lost. When do we see that turn around? And what do we need to do to turn it around, the loss of manufacturing jobs, that is? " CHRG-111shrg61513--46 Mr. Bernanke," Well, Senator, as you well know, for various reasons, lack of information, cultural reasons, and so on, many minority or immigrant communities don't make much use of the regular banking system. The cost of that is they may find themselves paying much more for check cashing or for short-term borrowing or for other services that they need. In most cases, they would be better off in a mainstream financial institution. We have encouraged banks, credit unions, and other financial institutions to reach out to minority neighborhoods by, for example, having people on staff who speak the language, through advertising and through other activities, through the CRA, the Reinvestment Act. By doing that, you attract people from these communities and give them access to the broader financial network. It helps them not only to get better deals on their financial services, to pay less for check cashing, for example, but it also helps them begin to learn how to save or learn how to borrow for a home and do other things that you need to have access to the broad mainstream financial system in order to achieve. So I think it is very important that mainstream financial institutions continue to reach out to people in their communities, including minorities and immigrants, to attract them to use of mainstream financial services. Senator Akaka. Thank you. Thank you very much, Mr. Chairman. Senator Johnson. Senator Johanns? Senator Johanns. Thank you, Mr. Chairman. Mr. Chairman, good to see you again. Mr. Chairman, let me start out and say that I think we have done some good work as we have tried to move through regulatory reform. I think everybody, quite honestly, has learned from the mistakes of the last years, no doubt about that. But I must admit, I have a concern about something that I think is shared by probably everybody here. It may be a little sensitive, but I want to ask about it, and that is Fannie and Freddie. We have spent a lot of time talking about too big to fail and looking at private companies and how gigantic they had gotten and how that really put us in a box. In the end, the taxpayers got put on the hook for that. Isn't Fannie and Freddie the government version of that too big to fail? And how do you get out of that box? " CHRG-111hhrg55814--268 Mr. Sullivan," Thank you, Mr. Moore, Ranking Member Bachus, and members of the committee for the opportunity to testify at today's hearing. My name is Thomas Sullivan. I am the insurance commissioner for the State of Connecticut. I am also a member of the National Association of Insurance Commissioners, serving as Chair of its Life Insurance and Annuities Committee. Today, I represent the views of my fellow regulators on behalf of the NAIC. With respect to the proposals being considered by Congress to prevent or manage systemic risk, we continue to stress the following principles. First, we believe that any new system must incorporate, but not displace, the State-based system of insurance regulation. State insurance regulators are on the front lines in resolving approximately 3 million consumer inquiries and complaints each year. And that daily attention to the needs of individuals and businesses must remain a cornerstone to any effort of reform. Our national solvency system is resilient and any group capital standards should supplement, but not supplant, the requirements of the functional regulators. Second, Federal legislation should ensure effective coordination, collaboration, and communication among all relevant State and Federal financial regulators in the U.S. financial stability regulation as it relates to insurance can only be stronger with the added expertise of the 13,000 people who currently work in our Nation's State and territorial insurance departments. As such, State insurance regulators must have a meaningful seat at the table of the proposed Financial Services Oversight Council. In order to provide a complete view of the financial system, regulators at the State and Federal level must also have appropriate authority to share information. Third, group supervision of complex holding companies that includes functional regulators is necessary, but preemption of State regulators, if ever necessary, should result only after State efforts have been exhausted. There is a great benefit to having multiple sets of eyes looking at an institution such as what exists today with the current State-based insurance regulatory system. Preemption and putting a single regulator in charge would take away a crucial fail-safe of allowing real and potential oversights by one regulator to be spotted and corrected by another. Additionally, we would also stress that systemic supervision should consider the unique expectations of consumers and that different regulatory structures for different entities within a holding company. The health of a well-regulated subsidiary must not be sacrificed to preserve another unregulated subsidiary. To reiterate, systemic resolution authority must continue to allow State regulators to protect the assets of sound insurance entities from the plundering by unsound, poorly regulated subsidiaries or the broader holding company. State receivership authority prioritizes policyholders as creditors of failed insurers, and we have extensive experience in unwinding insurers. In conclusion, we urge caution in pursuing any proposal that could impact our ability to adequately regulate the insurance market and protect insurance consumers. And we ask that our perspective be considered by this committee in the critical days and weeks ahead. Thank you for the opportunity to testify at today's hearing, and I would be happy to answer any questions. [The prepared statement of Commissioner Sullivan can be found on page 219 of the appendix.] Mr. Moore of Kansas. Thank you, Commissioner Sullivan. The Chair first recognizes himself for 5 minutes of questions. Chairman Bair, I believe we must end ``too-big-to-fail.'' I appreciate the work Chairman Frank and the Treasury Department put into improving the systemic risk and resolution authority title. Taxpayers must be fully protected and creditors, shareholders, and management must be fully accountable before taxpayers step in, in my opinion. The discussion draft takes us in that direction, but the Systemic Risk Council and resolution process must be more accountable, efficient, and transparent. Page 17 of the discussion draft states, ``The Federal Government will not publicly release a list of firms that pose systemic risk.'' I understand the intent for a private list is to eliminate any competitive advantage for being an identified firm but does not the marketplace already know who most of these firms are? And the firms that will be put at a competitive disadvantage will be the ones near the borderline, not the obvious ones, like Goldman Sachs, Citigroup, and Bank of America. Additionally, if the point of putting creditors and shareholders on notice is that they stand to be wiped out if a firm posing systemic risk fails, how will they know the value of their investments legal claims if the list of firms is not public? If the cost and burdens put on these firms are not great enough to offset any perceived advantage, I would prefer to increase those costs instead of trying to hide the list. Why not make the list public? Chairman Bair, do you have any thoughts on that? Or at least require identified firms to notify their shareholders? Ms. Bair. I think that it is probably unrealistic to think that a list like that is going to be kept secret. Everyone will already know the obvious firms. I understand the intent of that provision is to try to not make it look like these institutions are ``too-big-to-fail,'' but I think you take care of that problem with a robust resolution mechanism. So, at the end of the day, I am not really sure it is realistic to try to keep those confidential. In any event, they may very well be required to be disclosed as material under the SEC rules. And we have always asked for institutions to fully comply with securities disclosures. So, my sense is it is perhaps not realistic to require that the list be confidential. Mr. Moore of Kansas. Would anybody else like to address that question? Yes, sir? " CHRG-111shrg51395--275 RESPONSE TO WRITTEN QUESTIONS OF SENATOR DODD FROM THOMAS DOEQ.1. Transparency: Are there additional types of disclosures that Congress should require securities market participants to make for the benefit of investors and the markets? Also, would you recommend more transparency for investors: 1. By publicly held banks and other financial firms of off- balance sheet liabilities or other data? 2. By credit rating agencies of their ratings methodologies or other matters? 3. By municipal issuers of their periodic financial statements or other data? 4. By publicly held banks, securities firms and GSEs of their risk management policies and practices, with specificity and timeliness?A.1. In MMA's written testimony there was extensive discussion regarding the issue of inadequate enforcement of financial disclosure by municipal issuers. The greatest inhibiting aspect of disclosure is the ambiguity regarding rule 15c2-12. The vagueness of the rule has inhibited FINRA from enforcing the regulation and has only ensured that investors are not provided with pertinent financial information, but also that taxpayers do not have access to updated financial information. As the MSRB's EMMA system approaches July 1 hegemony, participants' discussions over the problems with municipal disclosure have become more heated. Last Thursday, Moody's Investors Service withdrew more than a dozen local government ratings based on issuers' failure to provide timely financial or operating information. Although this does not follow a policy change by Moody's, it does reflect increased resources for surveillance and, in our opinion, is a preface to additional rating withdrawals in the coming months. In theory, if investors grow more broadly aware that bond ratings are vulnerable to disclosure lapses, the offending issuers will be forced to pay higher interest rates to borrow in the future. The problem: Disclosure failings undermine liquidity in affected bonds and have led to mistrust of issuers by investors and, likely, modestly higher system-wide interest rates. Disclosure gaps occur because the current regulation is both weak and evasive. Rule 15c2-12 does force primary market participants to require that issuers pledge to disclose future financial and operating information; however, there is little penalty to these same firms if issuers do not honor those pledges. The issuers themselves rarely suffer by letting disclosure languish. Further, firms trading bonds in the secondary market have little effective responsibility to ensure that the bonds being placed in customer accounts (and thus recommended) are actually in compliance with issuers' primary market promises. MMA has elsewhere detailed why we believe issuers fail to disclose as promised, but our assessment that they do fail, and often, is a direct product of our experience analyzing credits in both primary and secondary market trades. Recommendation: Substantive disclosure improvements do not require an end to the Tower Amendment, which bars the Federal Government from regulating State and local issuers. The loss of Tower would needlessly compromise State autonomy and open the door to incremental Federal intervention in State and local affairs. Instead, we advocate a market-based solution: 1. Congress should position a single entity as arbiter to determine whether or not each issuer is in compliance with their stated disclosure requirements. This arbiter would likely need to be physically associated with the MSRB's EMMA system (or its successor). We recommend that a national issuer group control arbiter staffing to reduce potential issuer/investor conflicts in the future. 2. The arbiter would focus on regular, recurring disclosure items; however, regulated market participants should be required to pass along instances of non-recurring disclosure violations when discovered. 3. The arbiter would assign two statistics to each municipal Cusip. First, those issuers not currently in disclosure compliance would be flagged (red, versus green). Second, the arbiter would keep a database to track the number or percent of days the issuer was out of compliance over the last ten years. This historical statistic could be called the ``disclosure compliance score'' (or, ``DCS''). 4. Buyers evaluating primary or secondary market purchases could then evaluate the issuer's current disclosure flag and its historical DCS, increasing or reducing their bid accordingly. Flags could be easily integrated into customer portfolio statements, mutual fund quarterly statements, trading inventory discussions, etc. 5. In addition, all primary market participants (underwriters, bond counsel and other legal staffs, financial and swap advisors, bond insurers, and rating agencies) would be associated with an aggregated DCS for all issuers that they've helped bring to market in the last decade. This firm-by-firm DCS reading could give issuers another means to choose among potential intermediaries, while giving investors some insight into future disclosure compliance of first time issuers. It could also help regulators discover legal or financial firms whose issuer clients' record of disclosure compliance has been poor. 6. All firms trading municipal bonds, regardless of their status, would need to track how many trades, and the volume of par traded, that that firm had made with disclosure-flagged bonds. Registered firms could be prohibited from trading in red-flagged Cusips altogether. Again, this could be very important data for investors evaluating with which firm to invest and for firms' own risk management efforts. 7. New Federal regulations (e.g., the upcoming revisions to 2a-7, any extension of Build America Bond programs, hypothetical SEC rules for financial advisors and dealers, etc.) could leverage disclosure flags and DCS scores in addition to other factors. 8. With respect to the MSRB's EMMA system, we strongly recommend that Congress and/or the SEC ensure that the EMMA database include all historical primary and secondary market disclosure documents now being archived by the four current NRMSRs. This will be a critical factor for investor protection once EMMA becomes the sole NRMSR, as, once that happens, the current providers will lose their incentive (and possibly their financial ability) to adequately maintain the databases that have been painstakingly collected over the last ten years. The failure to add past databases will also allow the MSRB to postpone real disclosure reform on the basis that more time is needed to collect information before the SRO can determine if lapses have actually occurred. We also encourage Congress to require a formal advisory role, with respect to EMMA's organization and delivery of primary and secondary market disclosure items, to the National Federation of Municipal Analysts (NFMA)--which represents the substantial majority of EMMA's users (including, we should note, both buy-side and sell-side firms). 9. Finally, we note that we have included no recommendations with respect to the content of required secondary market disclosures in 15c2-12. While we believe that what is now being disclosed is unsatisfactory in some respects and superfluous in others, changes should be a product of broad industry discussion--as they were when rule 15c2-12 was created. We recommend that the MSRB and SEC be required to revisit this process to make regular adjustments to 15c2-12 in a fully transparent and recurring fashion.Q.2. Conflicts of Interest: Concerns about the impact of conflicts of interest that are not properly managed have been frequently raised in many contexts--regarding accountants, compensation consultants, credit rating agencies, and others. For example, Mr. Turner pointed to the conflict of the board of FINRA including representatives of firms that it regulates. The Millstein Center for Corporate Governance and Performance at the Yale School of Management in New Haven, CT, on March 2 proposed an industry-wide code of professional conduct for proxy services that includes a ban on a vote advisor performing consulting work for a company about which it provides recommendations. In what ways do you see conflicts of interest affecting the integrity of the markets or investor protection? Are there conflicts affecting the securities markets and its participants that Congress should seek to limit or prohibit?A.2. Witness declined to respond to written questions for the record.Q.3. Credit Default Swaps: There seems to be a consensus among the financial industry, government officials, and industry observers that bringing derivative instruments such as credit default swaps under increased regulatory oversight would be beneficial to the nation's economy. Please summarize your recommendations on the best way to oversee these instruments.A.3. Witness declined to respond to written questions for the record.Q.4. Corporate Governance--Majority Vote for Directors, Proxy Access, Say on Pay: The Council of Institutional Investors, which represents public, union and corporate pension funds with combined assets that exceed $3 trillion, has called for ``meaningful investor oversight of management and boards'' and in a letter dated December 2, 2008, identified several corporate governance provisions that ``any financial markets regulatory reform legislation [should] include.'' Please explain your views on the following corporate governance issues: 1. Requiring a majority shareholder vote for directors to be elected in uncontested elections; 2. Allowing shareowners the right to submit amendment to proxy statements; 3. Allowing advisory shareowner votes on executive cash compensation plans;A.4. Witness declined to respond to written questions for the record.Q.5. Credit Rating Agencies: Please identify any legislative or regulatory changes you believe are warranted to improve the oversight of credit rating agencies. In addition, I would like to ask your views on two specific proposals: 1. The Peterson Institute report on ``Reforming Financial Regulation, Supervision, and Oversight'' recommended reducing conflicts of interest in the major rating agencies by not permitting them to perform consulting activities for the firms they rate. 2. The G30 Report ``Financial Reform; A Framework for Financial Stability'' recommended that regulators should permit users of ratings to hold NRSROs accountable for the quality of their work product. Similarly, Professor Coffee recommended creating potential legal liability for recklessness when ``reasonable efforts'' have not been made to verify ``essential facts relied upon by its ratings methodology.''A.5. In the past year, substantial blame has been placed on the rating agencies for: (1) implicit conflicts of interest in the issuer-pays (i.e., banker-pays) system; (2) faulty ratings; and (3) the facilitation of regulators' and the financial industry's over-reliance on ratings generally. We believe all these points are well made; however, the SEC has already taken positive strides by bolstering the regulation of rating agency performance. We do not believe that incremental regulation of the rating agencies themselves, beyond these new rules, will substantially benefit investor protection. Rather, we encourage Congress to focus on changing regulations that deal with how regulators and investors use ratings. 1. The issuer-pays system cannot be abandoned as, in particular in the municipal bond market, there would reasonably be insufficient investor demand to pay for, and consistently maintain, a rating on each and every bond. Were rating agencies no longer able to bill issuers for ratings, the number and quality of ratings available would likely contract, increasing the informational advantage of dealers and large institutional investors versus individuals and small investors. 2. Still, any issuer-pays system has obvious potential conflicts of interest, and our firm has long advised our subscribers to treat rating agency ratings as sales material and consider the rating agencies to be effectively part of bond selling groups. We believe this more adversarial framework should be employed when including ratings or rating requirements in any regulatory documents in the future. 3. To this point, we believe that Congress should create a set of rating definitions (which would speak to investors' expected loss--meaning a combined measure of probability of default and loss if a default were to occur) and require that ratings adhere to these definitions if they are to be used with respect to any Federal regulations (for example, Rule 2a-7). In other words, the rating agencies should be able to promulgate and sell ratings under any scheme of their choosing, but those ratings could only be used by issuers and investors for compliance with Federal regulations if the rating scale's definitions match those explicitly defined by Congress. This addresses what we see as an enormous current problem in that regulations include reference to ratings, but the rating agencies are free to define those ratings to their best judgment. Thus the problem in the municipal industry where municipal ratings reside on a more conservative rating scale than do corporate bonds (AAA corporate bonds have defaulted at 10x the rate of BBB municipals) but Federal regulations, such as money market fund eligibility rules, use identical rating benchmarks for both. Similarly, both commercial mortgage backed securities and the US Treasury can be rated AAA but there are obvious differences in the rating agencies' assumptions about the meaning behind those ratings. The new SEC rules will greatly help that entity monitor the rating agencies' success in plotting individual ratings along specified, expected-loss-based rating scales.Q.6. Hedge Funds: On March 5, 2009, the Managed Funds Association testified before the House Subcommittee on Capital Markets and said: ``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.'' MFA supported the creation or designation of a ``single central systemic risk regulator'' that (1) has ``the authority to request and receive, on a confidential basis, from those entities that it determines . . . 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,'' (2) has a mandate of protection of the financial system, but not investor protection or market integrity and (3) has the authority to ensure that a failing market participant does not pose a risk to the entire financial system. Do you agree with MFA's position? Do you feel there should be regulation of hedge funds along these lines or otherwise?A.6. Witness declined to respond to written questions for the record.Q.7. Self-Regulatory Organizations: How do you feel the self-regulatory securities organizations have performed during the current financial crisis? Are there changes that should be made to the self-regulatory organizations to improve their performance? Do you feel there is still validity in maintaining the self-regulatory structure or that some powers should be moved to the SEC or elsewhere?A.7. The current system of SROs has failed municipal investors during the current financial crisis, noting: 1. The MSRB and FINRA have been almost entirely reactive to developing crises. MSRB did not issue comments on the collapse of the Auction Rate Securities (ARS) market until February 19, more than a month after the failure of most ARS auctions. Instead, the MSRB should have had a more thorough understanding of the ARS product's almost complete dependency on the: (1) ratings of the bond insurers; and (2) balance sheets of dealer banks. MSRB should have begun an aggressive investor education program starting in August 2007 and should have provided clear guidance to dealer firms over their management of failed auctions. 2. The MSRB has chosen to pursue derivatives regulation after substantial pain has already been felt by the industry. Further, the MSRB's plan to regulate swap and financial advisors, while likely to the benefit of the industry, would have done little to arrest many of the problems actually felt by municipal issuers. For example, widespread derivative problems in Tennessee have emanated from derivative sales by Morgan Keegan (a broker/dealer already regulated by MSRB). There are several other similar instances (in Wisconsin and Pennsylvania and Alabama) where it has been regulated firms' derivative sales practices, and not failings of unregulated swap advisors, that ultimately created problems for issuers and ultimately individual investors. 3. Claiming lack of resources, FINRA has been unable to proactively pursue (or, investigate without a specific customer complaint to guide their actions) clear evidence of broad market manipulation. We believe that FINRA's funding for proactive regulation is minimized by design, as their focus on specific, trade-by-trade pricing violations limits their potential influence on systemic market characteristics such as how bonds are valued and how bonds are distributed. 4. Indeed, MSRB's history of avoiding the pursuit of better transparency in the municipal market has exaggerated dealer banks' informational advantage versus their customers and individual investors. Specifically we note how better information on issuers' rate and counterparty exposure via derivatives and interest rate swaps could have helped both individual investors and the issuers themselves manage their particular exposure. 5. The MSRB has not aggressively pursued widespread instances of current disclosure failure in the municipal industry. While the MSRB has worked to create and rollout their EMMA system that may bring an ultimate improvement to disclosure, they have avoided taking any opinion or making any immediate corrective actions to ongoing disclosure problems hurting investors today. Further, we believe that the MSRB's plans to rollout EMMA, collect information for a year, and then see if disclosure is really a problem reflects an intent to maintain dealers' informational advantage (gained by limiting investors' access to disclosure documents) for as long as possible. 6. And perhaps most importantly, the MSRB has largely failed to educate and keep informed the macro regulators and US legislature on issues involving municipal bonds. We believe this is a fundamental problem with SROs in that, fearing more formal regulation, they attempt to shield specific details and developments from broad review; thus our phrase, ``municipals are a backwater by design.'' MMA was first contacted by regulators (in the summer of 2007) and since that time we have maintained a highly active dialogue with both Congressional staffs and macro regulators. We have been shocked at the lack of understanding of even the rudiments of our industry, the flows of capital and data, the important players and pressures. In fact, we believe that, had the MSRB more actively attempted to educate Washington policymakers prior to the current crisis, the Federal response could have been more rapid and better informed. Given the events of the past 18 months, I believe that regulation must be integrated and centralized. Because of these failures, it would be prudent to either move the MSRB into the SEC--or, at a minimum certain changes must be made to the MSRB structure. If Congress deems it necessary that a SRO is an inappropriate model for regulation of the municipal industry, the following should take place: 1. Create a Division of Municipal Securities that would report directly to the Chairman of the SEC. Move the current Office of Municipal Securities out of the Division of Trading and Markets into this new Division. Move all MSRB staff and its current funding structure into this new Division. The municipal industry is such a unique market and functions in such a different way from other markets that it should be separate from other markets. In creating a new division, the industry would benefit from specialized staff and researchers as well as having a direct line of communication with the office of the Chairman. 2. The MSRB staff must be bolstered with more seasoned municipal experts and create specific offices within the Municipal division focused on: secondary markets, underwriting, derivatives, accounting, disclosure, ratings, and bond insurance and tax issues. Compensation should and can be competitive to ensure the best staff possible. Under current MSRB funding structure, in 2008 the MSRB received $22.1 million in revenue and in 2007 it relieved $21.4 million in revenue. The Board derives revenue from primary and secondary transactions that market participants pay. Detailed financial statements are available on the Board's Web site. 3. Similar to our conclusions above in the disclosure responses, substantive regularly improvements do not require an end to the Tower Amendment, which bars the Federal Government from regulating State and local issuers. The loss of Tower would needlessly compromise State autonomy and open the door to incremental Federal intervention in State and local affairs. Instead, we advocate a market-based solution. 4. Create a Municipal Securities Rulemaking Advisory Board (MSRAB) that will be made up of 15 ``at large'' current and retired market participants. The MSRAB will produce a report to Congress and the Treasury Dept. annually on new trends in the market and potential regulatory shortcomings. The MSRAB should have continual communication with the Division of Municipals Securities. 5. Create a SEC-FINRA enforcement coalition council whereby information is shared in a fluid basis on future enforcement actions. 6. Create regional SEC municipal offices under the Division to monitor regional activities on closer basis. The municipals market, more than any other market in the U.S., is dominated by local politics and is quite fragmented. Having staff on the ground in every major region is essential to productive regulation and timely enforcement. On the other hand, we do note that there remains strong industry and perhaps even issuer support for the current SRO structure; MMA has received multiple comments to this effect since our Senate testimony. Thus, while we do believe that integrating the MSRB's components into an independent regulator is the better course of action, Congress may instead choose to preserve the current MSRB as an SRO structure. In preserving the SRO, we recommend Congress do the following: 1. Replace the current, dealer-centric MSRB board with representative members who provide independent and objective insight into the various aspects of the purpose of the municipal industry--the efficient and effective raising of capital for municipal entities. 2. Require that there be frequent and regular communication between the municipal regulatory network (MSRB, FINRA, Treasury, SEC, and the Federal Reserve), perhaps in the form of weekly or monthly committee meetings. The SEC should be given full access to minutes of any discussions; these minutes should be made publicly available to the extent possible. A semi-annual report to Congress on the status of the industry should be required. 3. Regulate and collect real-time information on municipal derivatives including interest rate swaps and credit default swaps. All derivatives information should be made publicly available, illustrating, among other points: counterparty exposure, termination and cost exposure under absolute worst case scenarios, and price volatility assumptions. There is no question in my mind that better regulation comes from participants who understand the motivations of the participants and the environment in which market participants work on a daily basis. The theoretical concept or asset of the SRO regulatory concept is based on having knowledgeable people involved in the process--not bureaucrats or those susceptible to political pressures. However, as has been readily apparent, an SRO is inhibited by the time an active market participant can commit to a volunteer position (regardless of how well intended the individual) and the challenge of the participant to act for the industry's best interest (i.e., altruistically) when it may run contrary to the interests of its employer and one's own employment viability. Specific to the municipal industry, the current composition of the Board, with 10 of 15 spots allotted to security dealers, does not provide for a balanced perspective of the industry and participants. The board must be broad, independent and structure/composition must be adaptable and flexible in its construct to anticipate future industry change. A balance of board members from different constituencies of the market and who are predominantly, not necessarily exclusively, retired from active industry involvement would more likely provide independent counsel, industry practical knowledge and a more comprehensive overview being removed from day-to-day industry responsibilities.Q.8. Structure of the SEC: Please share your views as to whether you feel that the current responsibilities and structure of the SEC should be changed. Please comment on the following specific proposals: 1. Giving some of the SEC's duties to a systemic risk regulator or to a financial services consumer protection agency; 2. Combining the SEC into a larger ``prudential'' financial services regulator; 3. Adding another Federal regulators' or self-regulatory organizations' powers or duties to the SEC.A.8. Witness declined to respond to written questions for the record.Q.9. SEC Staffing, Funding, and Management: The SEC has a staff of about 3,500 full-time employees and a budget of $900 million. It has regulatory responsibilities with respect to approximately: 12,000 public companies whose securities are registered with it; 11,300 investment advisers; 950 mutual fund complexes; 5,500 broker-dealers (including 173,000 branch offices and 665,000 registered representatives); 600 transfer agents, 11 exchanges; 5 clearing agencies; 10 nationally recognized statistical rating organizations; SROs such as the Financial Industry Regulatory Authority, the Municipal Securities Rulemaking Board and the Public Company Accounting Oversight Board. To perform its mission effectively, do you feel that the SEC is appropriately staffed? funded? managed? How would you suggest that the Congress could improve the effectiveness of the SEC?A.9. The SEC needs a mechanism to collect market information and input from participants so as to understand the impact both short and long-term regarding policy actions. My limited experience with the municipal division of the SEC is that there is an interest to understand and learn. However, the entrenched mechanisms that have historically inhibited timely action and response to consumer needs or systemic risks has reduced the initiative and innovation among a long standing staff. There would appear to be a need for new structure in order to enliven the current talent pool. The MSRB funding structure is very profitable and moving the MSRB into a new SEC division should pay for itself. MSRB annual financial statements are available on its Web site.Q.10. MSRB's Data System: Please explain in detail why the Congress should consider ``End[ing] the MSRB as an SRO'' and ``Integrat[ing] the MSRB formally and directly into a larger entity, possibly the Securities Exchange Commission, Treasury or Federal Reserve'' as you suggest in your written testimony. Also, what is your evaluation of the impact of the MSRB's new EMMA data system on investors and dealers?A.10. In my oral and written testimony I did advocate for the end of the SRO era with specific reference to the MSRB. My advocacy comes from the direct experience of seeing: 1. Volunteer board members deferring decision-making and becoming over-reliant on staff; 2. Volunteer dealer members slowing down processes to inhibit the creation of regulation that would inhibit current profit-making enterprises; 3. Anti-regulation bias among dealer community inhibited innovative action; 4. That dealer participants, especially in larger firms, were compromised in advocating regulatory changes that might establish regulatory precedent which could potentially reduce their employer's near-term profitability because their own employment could be at risk for taking such action; 5. An absence of representation of the wide range of participants in the municipal industry has historically inhibited the gathering of pertinent information for appropriate regulation that would create better and more informed rules and policies. The current structure of the SRO has resulted in the pockets of regulatory opacity not being addressed. Had the MSRB been integrated into a larger entity in a coordinated manner, the risks being promulgated in the municipal industry might have been recognized sooner--not only to avert the chaos which ensued over the past 18 months but also might have raised awareness that similar excessive risks were occurring in other markets which could have prompted earlier and more prophylactic regulatory action to mitigate the systemic risks which ensued. ------ CHRG-111hhrg51592--2 Chairman Kanjorski," This hearing of the Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprises will come to order. Pursuant to committee rules, each side will have 15 minutes for opening statements. Without objection, all members' opening statements will be made a part of the record. Today we meet to examine the operations of credit rating agencies and approaches for improving the regulation of these entities. Given the amount of scrutiny that these matters have garnered in recent months, I expect that we will have a lively and productive debate. The role of the major credit rating agencies in contributing to the current financial crisis is now well documented. At the very best, their assessments of packages of toxic securitized mortgages and overly complex structured finance deals were outrageously optimistic. At the very worst, these ratings were grossly negligent. In one widely reported internal e-mail exchange between two analysts at Standard and Poor's in April of 2007, one of them concludes that the deals ``could be structured by cows and we would rate it.'' I therefore fear that in many instances the truth lies closer to the latter option, rather than the former possibility. Moreover, if we were to turn the tables today and rate the rating agencies, I expect that most members of the Capital Markets Subcommittee would agree that during the height of the securitization boom, the rating agencies were AA, if not AAA failures. Clearly, they flunked the class on how to act as objective gatekeepers to our capital markets. Along with the expressions of anger, outrage, and blame that we will doubtlessly hear today, I hope that we can also explore serious proposals for reform. Unless we can find a way to improve the accountability, transparency, and accuracy of credit ratings, the participants in our capital markets will discount and downgrade the opinions of these agencies going forward. One could hope that the agencies would do a better job in policing themselves. But if past is prologue, we cannot take that gamble. This time their failures were not in isolated, case-by-case instances. Instead, they were systemic problems across entire classes of financial products and throughout entire industries. Stronger oversight and smarter rules are therefore needed to protect investors and the overall credibility of our markets. As a start, the rating agencies must face tougher disclosure and transparency requirements. For example, investors receive too little information on rating methodologies. The financial crisis has illustrated the danger flawed methodologies pose to the system. If methodologies remain hidden, there exists no check by which to expose their weaknesses. In addition to establishing an office dedicated to the regulation of rating agencies within the Securities and Exchange Commission, oversight must also focus more intently on surveillance of outstanding ratings. The industry has done an inadequate job of downgrading debt before a crisis manifests or a company implodes. Moreover, we must examine how we can further mitigate the inherent conflicts of interest that rating agencies face. In this regard, among our witnesses is a subscriber pay agency. This alternative model is worthy of our consideration. At one time, all rating agencies received their revenues from subscribers, but they evolved into an issuer pay model in response to market developments. I look forward to understanding how a subscriber pay agency succeeds in today's marketplace. Additionally, the question of rating agency liability is of particular interest to me. The First Amendment defense that agencies rely upon to avoid accountability to investors for grossly inaccurate ratings is generally a question for the courts to determine, but Congress can also have its say on these matters. Much like the other gatekeepers in our markets, namely lawyers and auditers, we could choose to impose some degree of public accountability for rating agencies via statute. The view that agencies are mere publishers issuing opinions bears little resemblance to reality, and the threat of civil liability would force the industry to issue more accurate ratings. In sum, the foregoing financial crisis requires us to reevaluate how rating agencies conduct their business, even though we enacted the Credit Rating Agency Reform Act just 3 years ago. As this Congress considers a revised regulatory structure in a broader context, this segment of our markets also needs to be examined and transformed. By considering proposals aimed at better disclosure, real accountability, and perhaps even civil liability, we can advance that debate today and ultimately figure out how to get the regulatory fit just right. Now, I will recognize the gentleman from New Jersey for 5 minutes. " 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-110shrg50414--136 Secretary Paulson," Well, I would say we cannot design these here, but we have been very conscious of this. And when we have dealt with advisors before, we have been very careful about how we do it. But I just cannot emphasize enough to you how important it is that we have experts available to begin working quickly, because this is about market confidence, effectiveness, and so we need to balance. OK? We need to balance the need to go quickly with the protections we build in. And I want strong oversight, strong protections, great transparency. And as this develops, I am sure it will evolve. And it may evolve in various different ways, but right now we need to get up and running and deal with the market as it exists. Senator Carper. Thank you for that response. My time has expired, and I am not going to ask another question. But I do want to make a statement, just to follow up on what others have said, Mr. Chairman, and what I said earlier during my opening statement. I went back in time, and I asked us to recall the Chrysler bailout where the Federal Government did not take an equity position in Chrysler. The Federal Government did not actually make a loan to Chrysler. The Federal Government actually guaranteed loans, and ultimately our guarantee was never exercised. We did not actually have to use the guarantee, although it was out there. But at the end of the day, we made money. The Federal Government and taxpayers made money, recovered money on behalf of our citizens. And the Resolution Trust Corporation, when it was established, my recollection is the Resolution Trust Corporation did not go in there and take an equity position in savings and loans. The Resolution Trust Corporation took off the hands of the S&Ls the nonperforming loans, and a lot of them were actually good investments--shopping centers, apartment complexes, and on and on. And because of the condition of the market, they had fallen in value. They were actually taken off the books of the S&Ls, held for a period of time, and as the economy recovered and as property values recovered, the Resolution Trust Corporation was actually able to recover a fair amount of money for the Treasury. We need that kind of thinking. We need to be entrepreneurial. And I do not know at the end of the day if the Federal Government ought to have an equity position in these companies, but at the end of the day, I do not want to go home unless we can say to the taxpayers in my State, ``We have come as far as we can, as close as we can to recovering every dime we put into these companies.'' And, last, we will be able to look them in the eye and say, ``We have made, to the best we can, every effort to ensure that no bad behavior is being rewarded.'' And the people who should not be rewarded in this financially, they are not going to get rewarded. Thank you very much. " CHRG-111shrg49488--2 Chairman Lieberman," The hearing will come to order. Good afternoon, and a special welcome to our guests, three of whom have come from farther than normal to testify--and without being summoned here by force of law, I might add. So we are particularly grateful that you are here. This is our Committee's third in a series of hearings examining the structure of our financial regulatory system; how that flawed structure contributed to the system's failure to anticipate and prevent the current economic crisis; and, most importantly, looking forward, what kind of structure is needed to strengthen financial oversight. You will note that I used the word ``structure'' at least three times here, and this is because that is the unique function and jurisdiction that our Committee has. We understand that the Banking Committee in particular is leading the effort to review regulations in this field, but we are charged with the responsibility to oversee the organization of government, and we have tried to come at this matter of financial regulatory reform with a focus on that as opposed to the particular regulations. We learned from our previous hearings that our current regulatory system has evolved in a haphazard manner, not just over the 10, 20, or 30 years some of us have been here, but over the last 150 years, largely in response usually to whatever the latest crisis was to hit our Nation and threaten its financial stability. As a result, we have here a financial regulatory system that is both fragmented and outdated. Numerous Federal and State agencies share responsibility for regulating financial institutions and markets, creating both redundancies in some ways and gaps in others--gaps particularly over significant activities and businesses, and redundancies, too, such as consumer protection enforcement, hedge funds, and credit default swaps. Our current crisis has clearly exposed many of these problems. To strengthen our financial regulatory system, an array of interested parties--academics, policymakers, even business people--from across the political spectrum has called for significant structural reorganization. So as we move forward and consider this question, it seemed to Senator Collins and me that it would be very helpful for us to examine the experiences of other nations around the world, and that is the purpose of today's hearing and why we are so grateful to the four of you. Over the past few years, the United Kingdom, Australia, and other countries have dramatically reformed their financial regulatory systems. They have merged agencies, reconsidered their fundamental approaches to regulation, and streamlined their regulatory structures. Many people believe that these reforms have resulted in a more efficient and effective use of regulatory resources and certainly more clearly defined roles for regulators. The American economy is different in size, of course, and in scope from all the others, but there is still much we can learn by studying the examples of these free market partners of ours. We really have an impressive panel of witnesses today, each of whom has not only thought extensively about the different ways in which a country can structure its financial regulatory system, but also played a role in that system. And I would imagine that you all bear some scars from trying to change the regulatory status quo. I would also imagine that you know what we have learned here, that reorganizations are complicated and very difficult. Our Committee learned this firsthand through its role in creating and overseeing the Department of Homeland Security and in reforming our Nation's intelligence community in response to the terrorist attacks of September 11, 2001. But reorganizations can also pay dividends and result in a more effective, responsive, efficient, and transparent government, and of course, that is what we hope for in the area of financial regulation. I am confident in the work that our colleagues on the Senate Banking Committee are doing to address the financial regulations, but as I said at the outset, we are focused here on structure, and the two are clearly tightly interwoven. If we want to minimize the likelihood of severe financial crises in the future, we need to both reform our regulations and improve the architecture of our financial regulators. As Treasury Secretary Geithner and the Obama Administration prepare to announce their own plan for comprehensive reform in the weeks ahead, the testimony presented here today will help ensure that we are cognizant of what has and has not worked abroad, and that surely can help us guide our efforts and the Administration's and clarify for us all which reforms, regulatory and structural, will work best here in the United States of America. Senator Collins. 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. FOMC20050503meeting--137 135,MS. MINEHAN.," I apologize as well. In any event, I’ve probably said enough before on what I’m concerned about. I do think we need to get out of promising to do something about which there is a greater degree of uncertainty at this meeting, and presumably at subsequent meetings, than we felt two or three meetings ago. I don’t think that language is serving us well anymore, but one more meeting is not going to kill anything. I do think the process issue needs further discussion. I communicated with Vincent, probably not adequately, over the weekend. I didn’t bring a copy of my suggested language with me. It was different in some ways from what Bill had. I was more or less a “four from column B” and “two from column C” person, choosing as if ordering from a Chinese menu here. Granted, I take the point that this is not the place to get into a discussion of moving this sentence here and that sentence there and trying to get 19 people to agree on it. Given the complexity of the statement, I just don’t know what process we should use. I’m not sure, even if we spent an entire two-day meeting, that we’d come up with a statement that is adequate, given all the moving parts we now have in it. As I said earlier, going back to something that’s shorter—something that says what we did and why we did it and lets the minutes convey the range of views—is where I think we ought to be headed. But, again, that just may not be in the cards anytime soon." CHRG-111shrg56376--139 Mr. Baily," Well, thank you, Chairman Dodd and Members of the Committee, to give me a chance to talk about this issue. The summary of my testimony is, number one, I think that the best guide to financial reform is the objectives approach, which divides up regulation into microprudential, macroprudential, and conduct of business regulation. So we have to make sure that all parts of the financial sector are adequately supervised, we don't have gaps in regulation. We also want to make sure we don't have duplicative agencies. After all, there were plenty of regulators. There were rooms full of regulators. They didn't prevent this crisis. My second point is that the quality of regulation must be improved regardless of where it is done, and I don't want to denigrate anybody in the regulatory agencies, but I do think there is a problem that they may not always be well enough paid, have enough experience, or have the kind of stature that they need to deal with our very complex financial sector, particularly the large global banks. I don't think we want a situation where people are in Government jobs for a while and then they move over to the financial sector, viewing that as sort of where they are going to make their money. I think we want the regulatory jobs to be desirable and stable jobs and get the best people we can. I agree with the Chairman and very much with Gene Ludwig that we need a single Federal microprudential regulator, combining the supervisory functions currently carried out at the Fed, the OCC, the OTS, the SEC, and the FDIC. I think this regulator should partner closely with State regulators. You mentioned the importance of the community banks, and I agree with you on that. I would say, however, that some of the State chartered nonfinancial institutions were a source of a lot of the bad mortgages that were made, so I think having the right partnership between the Federal regulator and the State chartered enterprises is important. I think there should be a sharing of information there and perhaps of standards and appropriate methods and data. I do think, and this is going a little beyond the immediate discussion of this hearing, but I do think the U.S. does need an effective conduct of business regulator. That is an important part. As Gene said, that has been combined in the U.K., where the FSA was both the prudential regulator and the conduct of business regulator, and cobbling it all, the whole lot that was done there, I think that is a mistake. I think having a separate conduct of business regulator is a good idea. My own view is it would be nice to have that in a single agency, and I think the SEC is probably the place to put it, although the SEC, I must say, did not do a very good job in this crisis. But I think potentially the SEC should be the place that looks after small shareholders and also looks after consumers, so it would have a CFPA division within the SEC. Now, I know there is a case for having a separate consumer agency and I am not diametrically opposed to that. I think there are some advantages to the consolidation of having conduct of business regulation in one place, but a good CFPA on its own would be fine. Now, this structure that we are describing takes away from the Fed an important part of its existing power, which is what has been to supervise the bank holding companies, most of the large banks and a number of the smaller banks. I think that is the right thing to do. I agree with Gene. I don't think this is something that the Fed has done particularly well. They are obviously paying a lot more attention to it now than they used to, but historically, I don't think that is something that they have done very well. I share that view with my colleague, Alice Rivlin, who I think has testified to this Committee, and she was there and saw the point that Gene Ludwig made, which is that the prudential people haven't typically had a lot of say on Open Market Committee meetings. That hasn't been a main thing. I do think it is very important that the Fed, as the lender of last resort to the financial sector, does have to have information about what is going on in the banks. I think that was a significant failure in the U.K., where the FSA and the Bank of England were so separate and were not talking to each other, and I think Mervyn King, the head of the Bank of England, thought it was inappropriate for him to talk too much to the FSA. He wanted the independence of the Bank of England when they were making monetary policy. You know, I see his argument, but I think that was a big mistake and one of the things that got them into trouble. So I think we should have a lot of lines of communication shared between the regulators and the Federal Reserve so that they can set monetary policy with the adequate amount of information and that they are aware of what is going on in the banks, and if they need to be a lender of last resort, that is not suddenly sprung on them. But I think they don't have to be the people that are doing the day-to-day supervision. Another point I would like to make in this regard is that the big bank holding companies, or the big banks, as we know, both investment banks or the traditional commercial banks, are run as single entities. So the idea that you had a bank holding company which was sort of a separate entity from the bank itself really is not the way things operate. These were run from the top and these banks would sort of come up with a new line of business, something that was going to be profitable, and they would discuss it, and then as someone was walking about the door, they would sort of say, well, which legal entity shall we put this in, and the answer to that was typically, well, where would they get the most favorable tax treatment? Where would they get the most favorable regulatory treatment? It is not as if these things were really different entities. So I think another advantage of having a single prudential regulator is that they would regulate these businesses top to bottom as single companies, which is what they are. I have used up my time. The last thing I want to say is to reinforce the point that Gene made. I think we both had the same reaction when we attended the hearing in August. You know, it is natural for regulators to say, well, don't close my agency. Mine is all right. When you came back and some of the other Members of the Committee came back and said, well, shouldn't we consolidate, shouldn't we make this a more rationally organized regulatory structure, the answer came back, well, the U.K. had trouble and they had this single regulator, so we don't see why that should do any good. That prompted, I think, both of us to go take a look--Gene probably knew already, but I actually went to take a look at regulation around the world, not covering every country, but trying to cover several countries, and particularly the English-speaking countries which tend to have some similarity of their institutions, and you are right. Canada, I think, did a much better job. They do actually have quite a few different agencies, so they weren't my ideal. I think Australia, which actually the Paulson Blueprint pointed to, is to be commended. They took quite a while. They decided, what is the best way to regulate. They took their time in doing it. They consolidated in an appropriate way. What happened in the U.K.--and I grew up in the U.K., I am fond of the U.K., but they didn't do this very well--Gordon Brown came in as Chancellor of the Exchequer and he said, it is crazy to have all these agencies. I think he was right about that. That the functions that these different companies are performing are crossing boundaries and we want to have a single agency. But they hadn't made any preparation. They hadn't really laid the groundwork for doing it. They hadn't figured out how to do it well. And, in fact, the FSA remained really quite divided. There were a lot of different subagencies within that, so they weren't communicating well, and as I said earlier, they weren't communicating with the Bank of England. So I think the examples that were given last time to say, oh, other countries--a single agency doesn't work in other countries, I think that is wrong. I think if you look in the right place, you will find that having a single prudential regulator is pretty much what is the right choice to make, based on international experience. Let me stop there. Thank you. " FOMC20080130meeting--338 336,MR. GIBSON.," As noted in the top left panel of exhibit 5, we would like to stress two key points on the rating agency and investor issues. First, credit rating agencies are one of the weak links that helped a relatively small shock in the subprime mortgage market spread so widely, though certainly not the only one. This is not just our staff working group's view--most market participants have also expressed the opinion that rating agencies deserve some of the blame. Second, the way that some investors use ratings for their own risk management has not kept up with financial innovations, such as the growth of structured finance. These financial innovations have made a credit rating less reliable as a sufficient statistic for risk. The top right panel provides a roadmap to our presentation. To start, I'll expand on some of the points that Pat made on the role of rating agencies in the financial crisis. My aim is to show why credit rating agencies were a weak link, which will lead naturally to our recommendations on rating agency practices. As we go, I'll point out several places where the rating agency issues link up with the investor practices issues that you'll hear about next from Bev. We feel strongly that the ratings and investor issues are really just two angles on the same underlying issue. The crisis began in the subprime market, the subject of the next panel. The subprime mess happened--and keeps getting worse--in part because of the issues associated with rating agencies (though as I said earlier, there is plenty of blame to go around). Our staff working group was asked whether the rating agencies got it wrong when they rated subprime RMBS. The answer is ""yes""--they got it wrong. Rating agencies badly underestimated the risk of subprime RMBS. Last year, Moody's downgraded 35 percent of the first-lien subprime RMBS issued in 2006. The average size of these subprime RMBS downgrades was two broad rating categories--for example, a downgrade from A to BB--compared with the historical average downgrade of 1 broad rating categories. As indicated in the exhibit, the rating methodologies for subprime were flawed because the rating agencies relied too much on historical data at several points in their analysis. First, the rating agencies underestimated how severe a housing downturn could become. Second, rating agencies underestimated how poorly subprime loans would perform when house prices fell because they relied on historical data that did not contain any periods of falling house prices. Third, the subprime market had changed over time, making the originator matter more for the performance of subprime loans, but rating agencies did not factor the identity of the originator into their ratings. Fourth, the rating agencies did not consider the risk that refinancing opportunities would probably dry up in whatever stress event seriously threatened the subprime market. Of course, the rating agencies were not alone in this. Many others misjudged these risks as well. Some have suggested that conflicts of interest were a factor in the poor performance of rating agencies. While conflicts of interest at rating agencies certainly do exist, because the rating is paid for by the issuer, we didn't see evidence that conflicts affected ratings. That said, we also cannot say that conflicts were not a factor. The SEC currently has examinations under way at the rating agencies to gather the detailed information that is needed to check whether conflicts had a significant effect. In the next panel, I turn to the ABS CDOs that had invested heavily in subprime. Rating agencies got it wrong for ABS CDOs. The downgrade rate of ABS CDOs in 2007 was worse than the previous historical worst case, just as it was for subprime. AAA tranches of ABS CDOs turned out to be remarkably vulnerable: Last year, twenty-seven AAA tranches were downgraded all the way from AAA to below investment grade. As indicated in the exhibit, the main reason that rating agencies got it wrong for ABS CDOs was that their rating models were very crude. Rating agencies used corporate CDO models to rate ABS CDOs. They had no data to estimate the correlation of defaults across asset-backed securities. Despite the many flaws of credit ratings as a sufficient statistic for credit risk, the rating agencies used ratings as the main measure of the quality of the subprime RMBS that the ABS CDOs invested in. And the rating agencies did only limited, ad hoc analysis of how the timing of cash flows affects the risk of ABS CDO tranches. As a result, the ratings of ABS CDOs should have been viewed as highly uncertain. As one risk manager put it, ABS CDOs were ""model risk squared."" A final point on ABS CDOs is that the market's reaction to the poor performance of ABS CDOs makes it clear that some investors did not understand the differences between corporate and structured-finance ratings. Because structured-finance securities are built on diversified portfolios, they have more systematic risk and less idiosyncratic risk than corporate securities. They will naturally be more sensitive to macroeconomic risk factors like house prices, and by design, downgrades of structured-finance securities will be more correlated and larger than downgrades of corporate bonds. Turning to the bottom panel, as Pat noted, in August of last year the subprime shock hit the ABCP markets, especially markets for ABCP issued by SIVs. Rating agencies also got it wrong for the SIVs. More than two-thirds of the SIVs' commercial paper has been downgraded or has defaulted. The problem with the ratings was that the rating agencies' models for SIVs relied on a rapid liquidation of the SIVs' assets to shield the SIVs' senior debt from losses. While this might have worked if a single SIV got into trouble, the market would not have been able to absorb a rapid liquidation by all SIVs at the same time. Once investors began to understand the rating model for SIVs, even SIVs with no subprime exposure could not roll over their commercial paper. Investors who thought they were taking on credit risk became uncomfortable with the market risk and liquidity risk that are inherent in a SIV's business model. The next exhibit presents the staff subgroup's recommendations for addressing the weaknesses in credit ratings for structured-credit products. A common theme of our recommendations is drawing sharper distinctions between corporate ratings and structured-finance ratings. First, we recommend that rating agencies should differentiate structured-finance ratings from corporate ratings by providing additional measures of the risk or leverage of structured-finance securities to the market along with the rating. We don't make a specific recommendation on exactly what measures of risk or leverage because we believe rating agencies and investors should work out the details together (on this and the recommendations to follow). Second, rating agencies should convey a rating's uncertainty in an understandable way. The ratings of ABS CDOs were highly uncertain because the models were so crude. This is what I call the Barry Bonds solution--put an asterisk on the rating if you have doubts about the quality. [Laughter] Third, we recommend more transparency from rating agencies for structured-finance ratings. What we need is not just a tweak to the existing transparency, but a whole new paradigm that actually helps investors get the information they want and need. For example, why can't the rating agency pass on to investors, along with its rating, all the information it got from the issuer that it used to assign the rating? Fourth, we recommend that rating agencies be conservative when they rate new or evolving asset classes. Fifth, the rating agencies should enhance their rating frameworks for structured products. For example, when they rate RMBS, they should consider the originator as well as the servicer as an important risk factor. Our last recommendation is addressed to regulators, including the Federal Reserve. When we reference a rating, we should differentiate better between corporate and structured-finance ratings. Sometimes we do that already, but we could provide some leadership to the market by doing more. Now Bev will discuss the work on investor practices. " 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-111shrg55278--128 RESPONSE TO WRITTEN QUESTIONS OF SENATOR SHELBY FROM PAUL SCHOTT STEVENSQ.1. Creating a New Systemic Regulator--Mr. Stevens, your testimony pointed out the importance of clearly defining the relationship between any new systemic regulator and existing primary financial regulators. What are the potential consequences of failing to draw clear lines?A.1. Failure to clearly delineate the relationship between any systemic risk regulator and the existing primary financial regulators could have several adverse consequences, particularly if the systemic risk regulator is not constituted as a council of existing primary regulators. It would increase the chances that the systemic risk regulator and one or more primary regulators might find themselves working at cross purposes with respect to a given issue. If each believes that it has responsibility over a particular area, each could adopt regulations that are inconsistent, particularly if the regulators have distinct regulatory philosophies and different types of expertise. If the respective responsibilities of the systemic risk regulator and the primary regulators are not well-defined, there will be no clear avenue for resolving these sorts of conflicts. As a result, there could be delays in addressing the issue at hand. Alternatively, the absence of clear lines could result in the systemic risk regulator and primary regulators duplicating each other's efforts, which would be inefficient and potentially create additional regulatory burdens for financial institutions. Or, the systemic risk regulator and relevant primary regulator may each mistakenly believe that the other is responsible for a particular matter, and the identification and resolution of issues could fall through the cracks. A related point is the need to place explicit limits on the authority granted to the systemic risk regulator and to identify areas in which the systemic risk regulator and the primary regulators should work together. I believe it would be most unfortunate if the systemic risk regulator were to marginalize the primary regulator, thus potentially leading to the loss of specialized expertise that the primary regulator is in the best position to offer.Q.2. Tier 1 Financial Holding Companies--Mr. Stevens, as you noted, the Administration's proposal would vest the Federal Reserve with the ultimate authority to designate a firm as a Tier 1 Financial Holding Company (Tier 1 FHC). A Tier 1 FHC is defined as a firm the failure of which would pose a threat to financial stability due to its size, leverage, and interconnectedness. Some of your larger members could potentially be swept up by that definition. How do you anticipate that could change the way in which large mutual funds are regulated and could the designation of a large fund complex as a Tier 1 FHC create an uneven playing field for smaller firms without that designation?A.2. As a threshold matter, it is useful to note the potential range of financial firms that could be designated as Tier 1 Financial Holding Companies (Tier 1 FHCs). In its white paper on financial services regulatory reform, and in the ``Findings and Purposes'' section of its draft legislation, the Administration describes a Tier 1 FHC as a firm the failure of which would pose a threat to financial stability due to its size, degree of leverage, and interconnectedness. Elsewhere in the draft legislation is a standard that governs Tier 1 FHC designations, and it is much more expansive. In particular, the Federal Reserve need not find all three factors to be present in order to determine that a firm should be designated a Tier 1 FHC--rather, the legislation would require that the Federal Reserve consider these and other enumerated factors, in addition to any other factors that the agency in its discretion deems appropriate. The degree of discretion that the Administration seeks to vest in the Federal Reserve is further illustrated by the Administration's proposal to authorize that agency to require certain financial companies to submit ``such information as [the Federal Reserve] may reasonably require'' for purposes of making Tier 1 FHC designations. Under the draft legislation, this authority would extend to any financial company having (1) $10 billion or more in assets, (2) $100 billion or more in assets under management, or (3) $2 billion or more in gross annual revenue. These thresholds are low enough to capture potentially a wide array of companies in the fund industry. Under such an open-ended framework, it is certainly possible that a large mutual fund (typically organized as a corporation or business trust under state law) or a family of such funds collectively could be designated a Tier 1 FHC. The same might be true for a mutual fund investment adviser and its affiliated companies. Perhaps most likely, a mutual fund adviser that is part of an integrated financial services firm could be swept into the Tier 1 FHC regime. These scenarios are discussed below.Mutual funds Designating a large mutual fund or family of funds as a Tier 1 FHC would not, in my view, be likely to serve the stated purposes of the Administration's proposal. Mutual funds are already subject to comprehensive regulation under the Federal securities laws including, in particular, the Investment Company Act of 1940 (ICA). Perhaps most relevant for this purpose are the ICA's strict limitations on leverage to which mutual funds must adhere. Other core areas of fund regulation, including daily valuation of fund shares, separate custody of fund assets, affiliated transaction prohibitions, diversification requirements, and extensive disclosure and transparency requirements, are part of an extensive regulatory framework that has protected fund investors and proven resilient in difficult market conditions. Importantly, the Federal Reserve has long viewed a mutual fund as being controlled by its independent board and not by its investment adviser or by a company that provides the fund with administrative, brokerage, and other services. Consistent with this longstanding view, the Federal Reserve would presumably need to conclude that the relevant risk characteristics of a mutual fund or fund family themselves warrant designating the fund or fund family as a Tier 1 FHC, and it would not take into account the activities of the fund adviser and/or the adviser's affiliates in making this determination. As discussed above, designating a fund or fund family as a Tier 1 FHC would appear unnecessary given the comprehensive ICA regulatory scheme, including its strict limits on leverage. Under the Administration's proposal, Tier 1 FHC status might be applied to certain kinds of funds such as money market funds, which seek to offer investors stability of principal, liquidity, and a market-based rate of return, all at a reasonable cost. These funds have been comprehensively regulated by the Securities and Exchange Commission (SEC) not only under the ICA provisions outlined above, but also through a specialized and highly prescriptive rule, Rule 2a-7, for 30 years. For the reasons described below, any concerns that a large money market fund or family of such funds could present the potential for systemic risk should be addressed by SEC reforms and other pending initiatives, and not by designating such fund(s) as a Tier 1 FHC. In March, ICI's Money Market Working Group issued a comprehensive report outlining a range of measures to strengthen the liquidity and credit quality of money market funds and ensure that money market funds will be better positioned to sustain prolonged and extreme redemption pressures. \1\ Consistent with the Working Group's recommendations, the Administration, in its white paper, specifically directed the SEC to move forward with plans to strengthen the money market fund regulatory framework to reduce the credit and liquidity risk profile of individual money market funds and to make the money market fund industry as a whole less susceptible to runs. In so doing, the Administration recognized that the SEC, as the primary regulator for money market funds, is uniquely qualified to evaluate and implement potential changes to the existing scheme of money market fund regulation. The SEC already has proposed such amendments, many of which are similar to the Working Group's recommendations, and is currently reviewing the comments it has received from ICI and others on the proposal. \2\ In addition, the President's Working Group on Financial Markets is considering whether any other reforms are needed to further strengthen the resiliency of money market funds to certain short-term market risks.--------------------------------------------------------------------------- \1\ See ``Report of the Money Market Working Group'', Investment Company Institute (March 17, 2009), available at http://www.ici.org/pdf/ppr_09_mmwg.pdf. \2\ See ``Money Market Fund Reform'', SEC Release No. IC-28807 (June 30, 2009), 74 FR 32688 (July 8, 2009), available on the SEC's Web site at http://sec.gov/rules/proposed/2009/ic-28807.pdf.--------------------------------------------------------------------------- Finally, whether the designation of a large fund or fund family as a Tier 1 FHC could create an uneven playing field for smaller funds without that designation is difficult to say. It is conceivable that investors might perceive such a designation as providing some kind of assurance or advantage and, thus, that a Tier 1 designation could have a positive influence on their investment decisions, especially in times of market stress. But it seems more likely that a Tier 1 FHC designation--and its potential effects on how funds are regulated--would put those funds at a competitive disadvantage as compared to their peers that are not so designated.Investment Advisers Bringing a mutual fund investment adviser--most likely, one that is part of an integrated financial services firm--within the proposed supervisory and regulatory scheme for Tier 1 FHCs would impose an additional layer of substantive regulation on the adviser that would be fundamentally different from, and could be at odds with, the regulatory schemes to which fund advisers have long been subject. Generally speaking, a Tier 1 FHC and its subsidiaries--regardless of whether those subsidiaries are already regulated by a ``functional'' regulator such as the SEC--would be subject to supervisory and regulatory authority of the Federal Reserve. Such supervision is intended to be ``macroprudential'' in focus, combining ``enhanced forms'' of the Federal Reserve's normal supervisory tools that are focused on safety and soundness with rigorous assessments of how the firm's overall activities and risk exposures potentially impact other Tier 1 firms, critical markets, and the broader financial system. A firm designated as a Tier 1 FHC would need to meet strict prudential standards, including risk-based capital standards, leverage limits, liquidity requirements, and overall risk management requirements. Following a transition period, the firm also would have to conform to the restrictions on nonfinancial activities in the Bank Holding Company Act, even if the firm did not control an insured depository institution. In a sharp departure from current law, the Federal Reserve would be given authority to impose and enforce prudential requirements on a fund adviser, upon consultation in some cases with the SEC. This would be true regardless of whether the adviser is named a Tier 1 FHC in its own right or is part of an integrated financial services firm that is designated as a Tier 1 FHC. In either case, it is not clear how prudential requirements such as capital standards, which make considerable sense in ensuring the safety and soundness of an insured depository institution and its holding company, would be applied to investment advisers. There would be other ways in which prudential regulation by the Federal Reserve may conflict with the regulatory requirements to which investment advisers already are subject, and it is unclear at this point how such differences in regulatory requirements would be reconciled. Lastly, it is important to recognize that, unlike the SEC, the Federal Reserve does not have an investor protection mandate. Instead, its bottom-line objective is to promote the safety and soundness of financial institutions. In pursuing their respective missions, the two agencies follow distinct regulatory approaches, they have different regulatory tools at their disposal, and each has its particular areas of expertise. The difficulties likely to result from superimposing Federal Reserve supervisory and regulatory authority onto comprehensive SEC regulation of mutual fund advisers should not be underestimated.Q.3. Independent Board Versus Independent Council--Mr. Stevens, you argue that the creation of an independent board, as opposed to a council of existing regulators, could lead to incentives to justify its existence by finding systemic risks even where they do not exist. What aspects of the Council's design would prevent its staff from falling prey to the same pressure to justify the Council's existence?A.3. I believe that several aspects of the design of a Systemic Risk Council (as I have described it in my written testimony) would make it highly unlikely that the Council or its staff would feel pressured to find systemic risks merely to justify the Council's existence. As the leaders of the core financial regulatory agencies, all standing members of the Council would already have critical ``day jobs,'' ones that make them ultimately responsible for the regulation of financial firms, activities, and markets within their spheres of expertise. It is precisely these roles--as Secretary of the Treasury or as Chairman of the SEC, for example--that would well position the Council members to distinguish between regulatory matters best handled by the appropriate primary regulator(s) and those matters that cut across regulatory lines and present the potential for harm that could spread throughout the financial system. In these latter cases, the Council would be required to make a formal determination that the matter is of such nature and import as to require the Council's involvement, both in developing a series of responses to the identified risks and in directing the appropriate primary regulator(s) to implement those responses. I do not believe that the Council members would come to such a conclusion lightly. Moreover, the Council would not just be tasked with the prevention and mitigation of systemic risk--it would also be the body responsible for policy coordination and information sharing across the various federal financial regulators. The time and energies of the Council and its independent staff, and in particular the knowledge gleaned from their continuous monitoring of conditions and developments in the financial markets, would be leveraged for both purposes. This is significant because not all of the issues and risks that they identify will involve threats to overall financial stability. Through the collaborative Council process, these ``lesser'' issues and risks can get the attention that they deserve, presumably by the appropriate primary regulator(s). Finally, as regards the staff, I have proposed that a small but diverse group of highly experienced individuals should be sufficient to support the work of the Council. Many of these individuals should be seconded from the financial regulatory agencies represented on the Council and thus, like the Council members themselves, be well positioned to identify risks that are truly systemic in nature. And the staff, while independent, will follow an agenda that is determined by the Council. All of these factors, in my view, would appropriately focus the staff's efforts. ------ CHRG-111shrg51290--62 PREPARED STATEMENT OF ELLEN SEIDMAN Senior Fellow, New America Foundation and Senior Vice President, ShoreBank Corporation March 3, 2009 Chairman Dodd, Ranking Member Shelby and members of the Committee. I appreciate your inviting me here this morning to discuss consumer protection and oversight in the financial services industry in the context of the current economic crisis, and to provide my thoughts on how the regulatory system should be restructured to enhance consumer protection in the future. In quick summary, I believe that the time has come to create a well-funded single Federal entity with the responsibility and authority to receive and act on consumer complaints about financial services and to adopt consumer protection regulations that would be applicable to all and would be preemptive. However, I believe that prudential supervisors, in particular the Federal and State banking regulatory agencies, should retain primary enforcement jurisdiction over the entities they regulate. My name is Ellen Seidman, and I am a Senior Fellow at the New America Foundation as well as Executive Vice President, National Program and Partnership Development at ShoreBank Corporation, the nation's first and leading community development bank holding company, based in Chicago. My views are informed by my current experience--although they are mine alone, not those of New America or ShoreBank--as well as by my years at the Treasury Department, at Fannie Mae, at the National Economic Council under President Clinton, and as Director of the Office of Thrift Supervision from 1997 to 2001. During my tenure at OTS, we placed significant emphasis on both consumer and compliance issues and on the responsibility of the institutions we regulated to serve the communities in which they were chartered, both because of their obligations under the Community Reinvestment Act and because it was good business. We paid particular attention to compliance, building up our staff and examination capability, establishing a special award (done away with by my successor) to honor the best performer in compliance and community affairs, reaching out to consumers and communities, and enhancing our complaint function. We were by no means perfect, but we worked to put compliance on an equal footing with safety and soundness. Since I left OTS, I have spent much of my time working on issues relating to asset building and banking the underbanked, in which context the importance of consumer protection, for both credit and other products, is plainly apparent. Finally, my years at Fannie Mae and at ShoreBank and the community development work I have been doing have made me both conscious of and extremely sad about what has happened in the mortgage market and the effects it is having on both households and communities. Based on my OTS experience, I believe the bank regulators, given the proper guidance from Congress and the will to act, are fully capable of effectively enforcing consumer protection laws. Moreover, because of the system of prudential supervision, with its onsite examinations, they are also in an extremely good position to do so and to do it in a manner that benefits both consumers and the safety and soundness of the regulated institutions. In three particular cases during my OTS tenure, concern about consumer issues led directly to safety and soundness improvements. Two involved guidance that got thrifts out of sub-prime monoline credit card lending (just months before that industry got into serious trouble) and payday lending. In another case involving a specific institution, through our compliance examiners' concern about bad credit card practices, we uncovered serious fair lending and safety and soundness issues. Consumer protection can be the canary that gives early warning of safety and soundness issues--but only if someone is paying attention to dying birds. We also sounded the alarm on predatory lending. Sub-prime guidance issued in 1998 by all the bank regulators warned of both safety and soundness and consumer protection issues. In speeches and testimony I gave in 2000, concerns about predatory lending and discussion about what we were doing to respond were a consistent theme. Nevertheless, as I will discuss below, I think it is time to consider whether consolidation of both the function of writing regulations and the receipt of complaints would make the system more effective for consumers, for financial institutions and for the economy.The Current Crisis The current crisis has many causes, including an over-reliance on finance to ``solve'' many of the needs of our citizens. When real incomes stagnate while the cost of housing, health care and education skyrocket, there are really only two possible results: people do without or they become more and more overleveraged. Financial engineering and cheap investor funding, largely from abroad, enabled the overleveraging, but a lack of adequate attention to the manner in which the financial services system interacted with consumers certainly kept the process going and caused consumers and the economy to fall harder when it ended. There were really two parallel problems: the proliferation of bad products and practices and the sale of hard-to-understand credit and investment products to consumers for whom they were not suitable; and the lack of high quality products that meet consumer needs, well priced and effectively marketed, especially in lower income communities. I believe that there where three basic regulatory problems. First, there was a lack of attention, and sometimes unwillingness, to effectively regulate products and practices even where regulatory authority existed. The clearest example of this is the Federal Reserve's unwillingness to regulate mortgage lending under HOEPA. However, as the recent actions by the Federal Reserve, OTS and NCUA have demonstrated, there was also authority under the FTC Act that went unused. It is important to understand that this is not only an issue of not issuing regulations or guidance; it is perhaps even more importantly a lack of effective enforcement. Compliance has always had a hard time competing with safety and soundness for the attention of regulators--which is one reason I spent a good deal of my tenure at OTS emphasizing its importance--but there was a deliberate downgrading of the compliance function at the Federal level at the start of the Bush Administration. Moreover, neither the Federal Reserve nor the OTS--at least until fairly recently--has seriously probed the consumer practices of non-depository subsidiaries of the holding companies they regulate. This is not just an issue at the Federal level. While there are certain states--North Carolina, Maryland and Massachusetts prominent among them--that have consistently engaged in effective enforcement of consumer protection laws with respect to the entities under their regulation, others, including California, the home of many of the most aggressive mortgage lenders, were even less aggressive than the Federal regulators. Moreover, ineffective enforcement is not just an issue of consumer protection regulation per se; the ability to move badly underwritten products completely off the balance sheet, earning fees for originating them, but holding no responsibility for them and no capital against them, only encouraged the proliferation of such activities. Second, we need to acknowledge that there were, and are, holes in the regulatory system, both in terms of unregulated entities and products, and in terms of insufficient statutory authority. The clearest case relates to mortgage brokers, where there was no Federal regulation at all, no regulation beyond simple registration in many states, and ineffective regulation even in most of the states that actually asserted some regulatory authority. But there are other examples--payday lending is prohibited in some states, regulated more or less effectively in others, and pretty much allowed without restriction in still others. And then of course there is the question of what kind of responsibility sellers of non-investment financial products have to customers. We know we have not imposed a fiduciary duty on them, but does that mean there is no responsibility to match customer with product? Finally, there is and was confusion, for both the regulated entities and consumers and those who work with them. Consumer protection comes in many forms, from substantive prohibitions like usury ceilings and payday lending prohibitions, through required terms and practices, to disclosures and marketing rules. I would assert it also includes the affirmative mandate of the Community Reinvestment Act; recent experience has demonstrated that where well-regulated entities do not provide quality services that meet needs and are well marketed, expensive and sometimes predatory substitutes will move in. Multiple regulators and enforcement channels exacerbate the confusion. At the Federal level, there are multiple bank regulators, not to mention the NCUA, the FTC and HUD, and their jurisdiction is frequently overlapping. States and even localities also regulate consumer protection, again often through multiple agencies. And of course, sometimes the Federal and State laws overlap. The enforcement mechanisms are just as confusing, involving examinations, complaints, collateral consequences such as limitations on municipal deposits or procurement, and both public and private lawsuits. The system clearly could be improved. But as we do so, we should not be lulled into thing the solutions are obvious or easy. In general they're not, and I would assert that they are harder and more subtle than is the case with manufactured consumer products. The products, even the good ones, can be extremely complex. Just try describing the lifetime interest rate on a Savings Bond or how a capped ARM works. Or for that matter whether a payday loan or a bounced check is more expensive. Many products, especially loans and investments, involve both uncertainty and difficult math over a long period of time, which is hard for even the most educated consumer. And the differences between a good product and a bad one can be subtle, especially if the consumer doesn't know where to look. An experienced homeowner knows the importance of escrowing insurance and taxes, but the dire consequences of the lack of an escrow are easy for a first-time homebuyer to miss. And a relatively safe ARM can turn into a risky one when caps are removed or a prepayment penalty added. Finally, different consumers legitimately have different needs. To take the example economists love, when there is a normal, upward sloping yield curve, most homebuyers are better off with a 5-year ARM than with a 30-year fixed rate mortgage, because with the long-term loan they are paying a higher interest rate for an option they are unlikely ever to use, since they will likely move, prepay or refinance long before 30 years are up. But for a consumer whose income is unlikely to increase, who has few other resources, or who has difficulty budgeting--or who is just plain risk-averse--the certainty of the fixed rate mortgage may well be worth the additional cost.Looking Forward Before turning to regulatory issues, I suggest there is a broader social context of change that we need to consider. To what extent can we turn some of the complex, long-term financial obligations that we have foisted on individual consumers--most clearly retirement and health care--back to more collective management? We also should recognize that there is some level of interest and some level of financial engineering at which ``availability of credit'' is an excuse for both not having sufficient income and collateral supports (such as health care) and an insufficient level of financial understanding--it's not a way of life. We need to educate our children from day one about what money means, how interest rates work, and who to get help from, and we need to create systems of helpers, which can include the internet and things like overdraft alarms, but which also requires low-cost access to people who are competent to give advice and have a fiduciary duty to the consumer. In this period when consumers are being forced to deleverage and cut back, and are actually beginning to save more on their own accord, we should once again make saving easy and an expected part of life. Having an account at a bank or credit union helps encourage saving, although the account needs to be designed so consumers have the liquidity they need without paying for it through excessive overdraft fees. Tying savings to credit, such as by requiring part of a mortgage payment to go into a savings account for emergencies like repairs or temporary inability to make a payment, can also help. And so would moving toward more savings opt-outs, like payroll deductions for non-restricted savings accounts that can be used in an emergency (as well as for retirement accounts), a concept we are testing at the New America Foundation as AutoSave.Principles for Regulation The regulatory framework, of course, involves both how to regulate and who does it. With respect to how, I suggest three guiding principles. First, to the maximum extent possible, products that perform similar functions should be regulated similarly, no matter what they are called or what kind of entity sells them. For example, we know that many people regarded money market mutual funds and federally insured deposit accounts as interchangeable. Either they are, and both the products and--to the extent the regulation has to do with making sure the money is there when the customer wants it--the regulation should be similar, or they are not and they should not be treated as such, including by regulators who are assessing capital requirements. To take another example, payday loans and bounced check protection have a good deal in common, and probably should be regulated in a similar manner. This also means that a mortgage sold directly through a bank should be subject to the same regulatory scheme and requirements as one sold through a broker. Second, we should stop relying on consumer disclosure as the primary method of protecting consumers. While such disclosures can be helpful, they are least helpful where they are needed the most, when products and features are complex. The Federal Reserve's recognition of this with respect to double cycle credit card billing was a critical breakthrough: by working with consumers, they came to understand that no amount of disclosure was going to enable consumers to understand the practice. The same is true of very complex mortgage products. The ``one page disclosure'' is great for simple mortgage products, but where there are multiple difficult-to-understand concepts in a single mortgage--indexes and margins, caps on rate increases and on payments, per adjustment and over the loan's lifetime, escrows or not, prepayment penalties that change over time, option payments and negative amortization, and many different fees--the likelihood is low that any disclosure will enable those for whom these issues really make a difference to understand them. In the last few years, several academics have suggested some potential substitutes for disclosure that go beyond the traditional type of prohibitory consumer protection rules. For example, Professor Ronald Mann has suggested that credit card contracts be standardized, with competition allowed on only a few easily understood terms, such as annual fees and interest rates.\1\ In some ways, this is what the situation was with mortgages well into the 1990s. Professors Michael Barr, Eldar Shafir and Sendil Mullainathan have suggested the development of high quality, easily understood ``default'' products such as mortgages, credit cards and bank accounts, allowing other products to be sold, but with more negative consequences for sellers if the products go bad, such as requiring the seller to prove that the disclosures were reasonable as a condition to enforcing the contract, including in a mortgage foreclosure action.\2\--------------------------------------------------------------------------- \1\ Ronald Mann, `` `Contracting' for Credit,'' 104 Mich LR 899 (2006) at 927-28. \2\ Michael Barr, Sendhil Mullainathan, and Eldar Shafir, ``A One-Size-Fits-All Solution,'' New York Times, December 26, 2007, available at http://www.nytimes.com/2007/12/26/opinion/26barr.html?scp=1&sq=michael percent20barr percent20mortgage&st=cse. See also Michael Barr, Sendhil Mullainathan, and Eldar Shafir, ``Behaviorally Informed Financial Services Regulation'' (Washington, DC: New America Foundation, October 2008), available at http://www.newamerica.net/files/naf_behavioral_v5.pdf. --------------------------------------------------------------------------- Third, enforcement is at least as important as writing the rules. Rules that are not enforced, or not enforced equally across providers, generate both false comfort and confusion, and tend to drive, through market forces, all providers to the practices of the least well regulated. This is in many ways what we have seen with respect to mortgages; it is not just that some entities were not subject to the same rules as others, but also that the rules were not enforced consistently across entities.Who Should Regulate As discussed above, that there are currently a myriad of regulators both making the rules and enforcing them. This situation makes accomplishment of the substantive principles discussed above very difficult. To a substantial extent, both the Federal Reserve and the FTC have broad jurisdiction already; whether they take action to write rules depends to some extent on capacity, will and priorities. But even where they have such authority and take it, significant problems remain concerning both enforcement and to what extent their rules trump State rules. The bank regulators, both together when they can agree and separately when they can't, also write rules and guidance that is often as effective as rules, but those apply only to entities under their jurisdiction, and generate very substantial controversy concerning the extent to which regulations of the OCC and OTS preempt State laws and regulations. As I mentioned at the start, I believe the bank regulators, given the guidance from Congress to elevate consumer protection to the same level of concern as safety and soundness, can be highly effective in enforcing consumer protection laws. Nevertheless, I think it is time to give consideration to unifying the writing of regulations as to major consumer financial products--starting with credit products--and also to establish a single national repository for the receipt of consumer complaints. The mortgage situation has shown that a single set of regulations that governs all parties is a precondition to keeping the market at the level of those engaged in best practices--or at least the practices condoned by the regulators--not the worst. The situation with payday lending, especially in multi-State metropolitan areas, is similar. And among regulators with similar jurisdictions, whether the Federal bank regulators or State regulators, having major consumer products governed by a single set of regulations will reduce the opportunity for regulatory arbitrage. A single entity dedicated to the development of consumer protection regulations, if properly funded and staffed--unfortunately the experience of both the FTC and CPSC over the last 8 years, but in fact for many more years suggests that's a big ``if''--will be more likely to focus on problems that are developing and to propose, and potentially, take action before they get out of hand. In addition, centralizing the complaint function in such an entity will give consumers and those who work with them a single point of contact and the regulatory body the early warning of trouble that consumer complaints provide. Such a body will also have the opportunity to become expert in consumer understanding and behavior. This will enable it to use the theories and practices being developed about consumer understanding and how to maximize positive consumer behavior--the learnings of behavioral economics--to regulate effectively without necessarily having a heavy hand. The regulator could also become the focus for the myriad of scattered and inefficient Federal efforts surrounding financial education. The single regulator concept is not, however, a panacea. Three major issues that could stymie such a regulator's effectiveness are funding, preemption, and the extent of its enforcement authority. How will the new regulator be funded, and at what level? It is tempting to think that annual appropriations will be sufficient, but is that really the case? Political winds and priorities change, and experience suggests that consumer regulatory agencies are at risk of reduced funding. Is this a place for user fees--a prospect more palatable if there is a single regulator covering all those in the business rather than multiple regulatory bodies for whom lower fees can become a marketing tool? In any event, it is essential that this entity be well funded; if it is not, it will do more harm than good, as those relying on it will not be able to count on its being effective. What will be the regulator's enforcement authority? Will it have primary authority over any group of entities? Will the authority be secondary to other regulatory bodies that license or charter those providing financial services? My opinion is that regulators who engage in prudential supervision (Federal and State), with onsite examinations, should have primary regulatory authority, with the new entity empowered to bring an enforcement action if it believes the regulations are not being effectively enforced. Coupled with Congressional direction to the prudential supervisors to place additional emphasis on consumer protection, the supplemental authority of the consumer protection regulator to act should limit the number of situations in which the new regulator is forced to take action. And finally, will the regulations written by the new entity preempt both regulations and guidance of other Federal regulators and State regulation? My opinion is that where the new entity acts, their regulations should be preemptive. We have a single national marketplace for most consumer financial products. Whereas in the past the argument that providers can't be expected to respond to a myriad of rules held sway, as technology has advanced this argument has lost its potency. But consumers are entitled to a consistent level of protection no matter where they live and with whom they deal. Yes, there may be times when the agency does not work as fast or as broadly as some advocates would like. But the point of having a single agency with responsibility in this area is to create a single focal point for action that will benefit all Americans. Where the agency does take action, it should fill the field. But preemption may well be the most difficult issue of all, not only because preemption is ideologically difficult, but also because the uniformity that a single regulator can provide will always be in tension with the attempts of some actors to get around the regulations and of regulators and other parties to move in to respond.Conclusion While the current crisis has many causes, the triggering event was almost certainly the collapse of the sub-prime mortgage market. That is an event that need never have happened if both our regulatory system and regulators had been more completely and effectively focused on protecting consumers. For many years, many of us have been pointing out that bad consumer practices are also bad economic practices. Not only because of the damage it does to consumers, but also because when the music stops, we all get hurt. The current state of affairs provides a golden opportunity to make significant improvements in the regulatory system. If not now, when? ______ CHRG-111hhrg51698--18 Mr. Gooch," Thank you. I am Michael Gooch, Chairman and CEO of GFI Group Inc. Thank you, Chairman Peterson and Ranking Member Lucas, for inviting us here to testify today. I began my career in financial brokerage in London in 1978, emigrated to the U.S. in 1979, and eventually became a naturalized U.S. citizen. I founded GFI Group in 1987 with $300,000 of capital. The firm is now one of five major global inter-dealer brokers, or IDBs, with approximately 1,700 employees on six continents and with $500 million in shareholder equity. GFI Group is a U.S. public company listed on NASDAQ under the symbol GFIG. GFI Group and other inter-dealer brokers operate neutral marketplaces in a broad spectrum of credit, financial, equity, and commodity markets, both in cash instruments and derivatives. We are transaction agents to the markets we serve and do not trade for our own accounts. GFI is also a leading provider of electronic trading platforms to many global exchanges and competing IDBs. GFI has been ranked as the number one broker of credit derivatives since the market began over 11 years ago, which provides us with far more experience with the product than any exchange. The leading IDBs offer sophisticated electronic trading technology that has been widely adopted in Europe and Asia. These European markets have functioned well in the wake of the credit crisis. The electronic ATS trading environment for inter-dealer OTC-CDS that is operating successfully in Europe and Asia could be replicated in the U.S. immediately. Most, if not all, of GFI's individual brokers of credit derivatives in the U.S. are licensed, registered representatives, regulated by FINRA. GFI supports this Committee's initiatives for greater transparency, central counterparty clearing, and effective regulatory oversight. However, the matter of central counterparty clearing is not a simple one. Any clearing mechanism is only as good as its members in the event that its initial clearing funds are exhausted. It is my opinion, and I believe it is shared by many in the financial community, that in the event major global investment banks had failed last September, then the clearinghouses of the various futures exchanges would have failed, too. Sixty percent of the inter-bank volume in credit derivatives is transacted outside of the United States. To successfully achieve OTC clearing, large inter-bank dealer and global cooperation will be required. Notwithstanding the complexities of central clearing a global OTC credit derivatives market, it is my view that the listed exchanges can play an important role in introducing simple vanilla futures contracts on the most liquid indexes and single names. Both cleared and uncleared OTC and listed futures can co-exist as they do in most other financial markets. I would like to specifically address two sections of the proposed legislation: section 14 and section 16. We support the extension of CFTC regulation to the market for carbon offset credits and emissions allowances under section 14 of the bill. As a major broker of European emissions credits, we are very familiar with the importance of an orderly, efficient, and well-regulated marketplace. Therefore, we do not see a reason why the proposed legislation requires all trades to be done on a designated contract market and not also allowed on a CFTC-regulated DTEF. We believe that the limitation of transactions to DCMs needlessly stifles competition, leading to greater costs that are ultimately passed along to the consumer. With regard to section 16, we are very concerned that the elimination of naked interest will kill the CDS market and significantly inhibit the liquidity of credit markets, including the market for corporate bonds and bank loans. Just as third-party liquidity providers and risk takers are willing to buy and sell futures and options in agricultural products, providing much-needed liquidity for businesses in agriculture to hedge and offset risk, so do such risk takers enhance liquidity in credit markets. There is plenty of capital on the sidelines today willing to take risk in credit without becoming direct lenders. This source of credit will not be available if the buying of credit derivatives is limited to those with a direct interest in the underlying instruments. That is because risk takers need to take risk on both sides of the market in order for there to be a liquid market. New issuance of corporate debt cannot happen without a liquid, functioning bond market; and since credit derivatives are often more liquid than the market for the underlying bonds, it is clear that a functioning credit derivatives market is paramount for the unfreezing of credit markets. Killing the CDS market will contribute to an extended period of tight lending markets, where credit will only be available to the most secure borrowers, which will extend and deepen the current recession we are experiencing. Thank you for this opportunity to address you today. I will be happy to answer any questions you may have. [The prepared statement of Mr. Gooch follows:]Prepared Statement of Michael A. Gooch, Chairman of the Board and CEO, GFI Group, Inc., New York, NY I am Michael Gooch, Chairman and CEO of GFI Group, Inc. Thank you Chairman Peterson and Ranking Member Lucas for inviting us to testify today. About GFI Group: I began my career in financial brokerage in London in 1978, emigrated to the U.S. in 1979 and became a naturalized U.S. citizen. I founded GFI Group in 1987 with $300,000 of capital. The firm is now one of five major global ``inter-dealer brokers'' with approximately 1,700 employees on six continents and with 500 million dollars in shareholder equity. GFI Group is a U.S. public company listed on the NASDAQ under the symbol ``GFIG''. GFI Group and the other inter-dealer brokers operate neutral market places in a broad spectrum of credit, financial, equity and commodity markets both in cash instruments and derivatives. GFI group has a strong presence in many over-the-counter (or ``OTC'') and listed derivative markets and has a reputation as being the leader globally in Credit Derivatives. We function as an intermediary on behalf of our brokerage clients by matching their trading needs with counterparties having reciprocal interests. We are transaction agents to the markets we serve and do not trade for our own account. We offer our clients a hybrid brokerage approach, combining a range of telephonic and electronic trade execution services, depending on the needs of the individual markets. We complement our hybrid brokerage capabilities with decision-support service, such as value-added data and analytics products and post-transaction services including straight-through processing (or ``STP'') and transaction confirmations. We earn revenues for our brokerage services and charge fees for certain of our data and analytics products. We are also a leading provider of electronic trading software through our Trayport subsidiary, which licenses critical transaction technology in numerous product markets from energy to equities that is used by institutional market participants, such as futures exchanges and competing IDBs. GFI is a global leader in numerous OTC derivatives markets. We have ranked as the number one broker for credit derivative since the market began over 11 years ago. In that time, GFI Group has brokered billions of dollars of credit derivative transactions that provides us with far more experience with the product than any exchange. In 2008, GFI was ranked as both the Number One Credit Derivative Broker and the Number One Commodity Broker.About Inter-Dealer Brokerage: I would like to take a moment to describe the market role played by inter-dealer brokers such as GFI. Inter-dealer Brokers (or ``IDBS'' as they are known) are an established part of the global, financial landscape. GFI and its competitors, aggregate liquidity and facilitate transactions in both OTC and exchange transactions between major financial and non-financial institutions around the world. IDBs cross transactions over-the-counter in listed futures in equities, energy and financial markets and post them to recognized exchanges within stringent regulator-mandated reporting time frames. The leading IDBs offer sophisticated electronic trading technology that has been widely adopted in Europe and Asia. These European markets have functioned well in the wake of the credit crisis. In the credit derivatives market, for example, millions of electronic messages are recorded and processed by IDBs in real time every business day. With the most sophisticated IDBs that handle the bulk of the inter-dealer business in Europe, Asia and the U.S., the technology is connected via API to the Depository Trust Clearing Corporation (DTCC) the main central warehouse for CDS trades with Straight through Processing (STP) to all the major credit derivatives dealers. The electronic ATS trading environment for inter-dealer OTC-CDS that is operating successfully in Europe and Asia could be replicated in the U.S. immediately. At least four global regulated inter-dealer brokers have the ATS technology in place to achieve this now. Most, if not all, of GFI's individual brokers of credit derivatives in the U.S. are licensed, registered representatives regulated by the Financial Industry Regulatory Authority (FINRA). Such IDBs with FINRA registered representatives keep electronic copies of all communications supporting each credit derivatives transaction they cross and the bids and offers leading up to those trades. Trading data, in some cases, goes back as far as 1996.About the Proposed Legislation: As a major aggregator of liquidity in OTC derivatives, GFI supports this Committee's initiatives for greater transparency, central counterparty clearing and effective regulatory oversight. We believe that enhancing transparency and eliminating counterparty risk will be a major improvement in the CDS market structure that will ensure its role as a credit transfer tool for investors. We commend the Committee for its efforts to achieve these goals. We also support its efforts to provide the CFTC with greater regulatory oversight. We have a deep appreciation for the work of the CFTC. Our experience is that they are dedicated, competent, and hard working and have done an excellent job. Nevertheless, the matter of central counterparty clearing is not a simple one. A central clearing mechanism requires a degree of standardization and price transparency not available for all instruments and all credits. Any clearing mechanism is only as good as its members in the event its initial clearing funds are exhausted. It is my opinion and I believe it is shared by many in the financial community that in the event certain major, global investment banks had failed last September, then the clearing houses of the various futures exchanges would have failed too. The large banks and prime brokers represent the bulk of the open interest on the various futures exchanges and the gapping of markets that would have occurred overnight in such an outcome would have led to a call on the capital of the very firms that may have failed. To have illiquid credits in such clearing mechanisms would only have exacerbated the problem. Since the large banks and prime brokers represent the bulk of the clearing capital at risk, it makes sense that a clearing solution provided by those banks with a high degree of transparency on pricing and mark to market makes the most sense. We believe that the credit derivatives market could certainly benefit from a central counterparty. It would be a mistake, however, to presuppose that the entire market for credit derivatives operates only in the U.S. and that a single vertical clearing and execution venue can be designated for the entire global market. Sixty (60%) percent of the inter-bank volume in credit derivatives is transacted outside of the United States. Central counterparty clearing in CDS is a complex issue that is under-estimated by those that propose or believe it can be achieved almost overnight. To successfully achieve OTC clearing, large inter-bank dealer and global co-operation will be required. Notwithstanding the complexities of centrally clearing a global OTC credit derivative market, it is my view that the listed exchanges can play an important role in introducing simple vanilla futures contracts on the most liquid indexes and single names. Both cleared and un-cleared OTC and listed futures can co-exist as they do in most other financial markets.Issues Raised by the Proposed Legislation I would like to specifically address two sections of the proposed legislation: section 14 and section 16. We support the extension of CFTC regulation to the market for carbon offset credits and emission allowances under section 14 of the bill. As a major broker of European emissions credits, we are very familiar with the importance of an orderly, efficient and well regulated marketplace. Therefore, we do not see a reason why the proposed legislation requires all trades to be done on a Designated Contract Market (or ``DCM'') and not also on a CFTC-regulated ``Derivatives Transaction Execution Facility'' (or ``DTEF''). We believe that the limitation of transactions to DCMs needlessly stifles competition leading to greater costs that are ultimately passed along to the consumer. With regard to section 16, we are very concerned that limiting participation in the Credit Derivatives market to entities with a direct interest in the credit being protected, i.e., elimination of naked interest, will kill the CDS market and significantly inhibit the liquidity of the credit markets, including the market for debt instruments such as corporate fixed income and bank loans. Just as third party liquidity providers and risk takers are willing to buy and sell futures and options in agricultural products providing much needed liquidity for businesses in agriculture to hedge and offset risk, so do such risk takers enhance liquidity in credit markets. There is plenty of capital on the side lines today willing to take risk in credit without becoming direct lenders. This source of credit will not be available if the buying of credit derivatives is limited to those with a direct interest in the underlying instruments. That is because risk takers need to take risk on both sides of the market in order for there to be a liquid market. Without question, new issuance of corporate debt cannot happen without a liquid, functioning bond market and, since credit derivatives are often more liquid than the market for the underlying bonds, it is clear that a functioning credit derivatives market is paramount for the unfreezing of credit markets. Killing the CDS market will contribute to an extended period of tight lending markets where credit will only be available to the most secure borrowers. CDS has become so integral to the functioning of credit markets that killing it will extend and deepen the current recession we are experiencing. In conclusion, let me just say that the global market for credit derivatives is not murky or unregulated as some would have us believe. Rather, it is highly liquid and, potentially, quite transparent. It is today functioning well and will play an important role in the unfreezing of the credit markets and the recovery of the global economy. That critical role could be jeopardized if we do not sort out the half-truths and misperceptions surrounding credit derivatives and their market structure. It is only then that the discussion of improving the credit derivatives market through central clearing and electronic trading can be put in proper context. Thank you for this opportunity to address you today. I will be happy to answer any questions you may have. " CHRG-109shrg30354--110 Chairman Bernanke," I would like to comment briefly, Senator. I think you and I or a group need to talk about this in much more detail. I would just make a few comments. One is that the notice for proposed rulemaking which is going out is a joint product of all four Federal banking agencies. So it is an agreed upon notice. And it is one where, of course, we are going to invite all kinds of comments from all parties who are interested. I discussed the QIS-4 in previous testimony. I will not take time to do that. But we certainly agree that we would not tolerate, would not want to see capital levels decline anywhere like what was seen in the QIS-4. We do think that safety and soundness of the banking system, given how complex and sophisticated it is becoming, does require some significant updates of the Basel II approach. And the banking agencies have essentially agreed that this is the right framework. But we are very open both to suggestions about details and also about methods of making sure the capital does not fall unduly. If I may finally say, on the three methods, I believe it is the case that other countries will be asking their largest and most sophisticated banks to use the advanced method because that is really the only one of the three that is appropriate for the kind of international banks that we are talking about. Senator Sarbanes. We understand that the Conference of State Bank Supervisors has recently written, encouraging consideration of the standardized approach in the implementation of Basel II. And this also apparently is the request that these major U.S. banks have now made to the regulatory agencies. It is an approach apparently being allowed by other countries. What is the problem in considering the standardized approach? " CHRG-111hhrg51698--2 The Chairman," The Committee will come to order. We have Members coming in. We don't have votes until 6:30, so I appreciate the Members making an effort to come back. I think we will have more Members joining us. Good afternoon to everybody, and welcome to today's hearing on derivatives legislation. For those on the Committee who were here in the 110th Congress, today's hearing will cover many of the issues and topics considered during the nine hearings held last year on this subject. The effort to strengthen oversight and improve transparency in derivatives markets, whether regulated or unregulated, whether they are physically based commodities or financial commodities has been a top priority of this Committee. For those of you who are new to the Committee, welcome to the fire. Members and staff have been working hard on this issue since the last Congress adjourned, and it is my intent to move expeditiously this month; because every day we delay is another day where markets operate without the oversight or transparency they desperately need. Last year, we began our journey with extensive public hearings on the issue of speculation, lack of convergence, lack of effective oversight, and increased transparency of derivative markets. The result of those hearings was a strong bipartisan bill that had more than \2/3\ majority when it passed the House last September. We will continue this effort in the 111th Congress, but this time with new provisions resulting from the hearings we held late last year on the role of credit derivatives in the economy after the collapse of large financial institutions that were heavily engaged in the over-the-counter derivatives transactions and market. The language that I circulated last week, and that this Committee will be discussing, contains provisions similar to last year's bipartisan bill. It will strengthen confidence and trader position limits on all futures markets as a way to prevent potential price distortions caused by extensive speculative trading. It would close the so-called London loophole by requiring foreign boards of trade to share trading data and adopt position limits on contracts that trade U.S. commodities linked to U.S.-regulated exchanges. It would direct the CFTC to get a clearer picture of the over-the-counter markets, and it calls for a new full-time CFTC staff to improve enforcement, prevent manipulation, and prosecute fraud. This proposal would bring a sense of order to the over-the-counter market by requiring transparent central clearing for all OTC derivatives. The legislation contemplates multiple entities, whether regulated by the CFTC, the SEC, or the Federal Reserve, offering clearing services for the market. In that sense, it is modeled after the current law. However, the bill requires these clearing entities to follow the same set of core principles in their operations as a means of avoiding regulatory arbitrage. The failures of AIG, Lehman, Bear Stearns, and other institutions have shown us that it is time for some transparency in the market for credit derivatives. The way for us to identify and reduce the risk out there is to facilitate clearing it. The draft bill provides the CFTC with authority to exempt some derivatives from clearing in recognition of the fact that not every OTC trade is suitable for clearing. However, those seeking to remain in the derivatives business without clearing will have to report their actions and demonstrate their financial soundness. In the debate over credit derivatives, there has been much discussion about choosing the proper regulator, whether it is the CFTC, the SEC, or the Fed. I have made it clear that I believe the CFTC is the agency that has the knowledge and the expertise in these markets. I am flat-out opposed to the Fed having a role in clearing or overseeing these products. If I could have my way, the Fed would not be involved. However, that is probably not a political reality of today, and the draft legislation reflects that. The Federal Reserve is an independent banking system, not a police officer of derivatives transactions. I share the concerns of those who think the Fed controls too much already. They are an unelected body that sets monetary policy, oversees its state member banks, oversees holding companies, and now they are printing money for the bailout. I am not surprised that the large banks are clamoring for the Fed to regulate derivative activity, given their cozy relationship with Fed members. Plus, they probably think it is a good idea to have a regulator with resources to bail them out if things go wrong. I am also strongly opposed to allowing the SEC to have primary authority over these contracts. The SEC uses a rules-based system that is behind the curve of today's modern, complex financial products and in my opinion is just not workable. They are not just trying to solve yesterday's problems or last week's problems; they are still trying to solve the last decade's problems. As a result, they have done a poor job. How much confidence can we have in an agency that repeatedly ignored calls even from within its own agency to examine the investment advisory business of Bernard Madoff, which turned out to be the biggest Ponzi scheme in history? They gave them a road map as to what was going on; and they missed it. They even missed the red flags in their oversight of Bear Stearns, as was detailed in a report by the SEC Inspector General. Other people are trying to use the problems of credit default swaps as an argument to create a super financial regulator. However, in my opinion, taking something that is working, like the CFTC oversight of the futures market, and moving it to another place where things are not working is, frankly, crazy. To name a financial czar or a single super-regulator over the whole thing is an even worse idea and has the potential to create financial markets' version of the Department of Homeland Security, which a lot of us don't want to see happen. So I don't want to even imagine the problems that we would create if we would go down that avenue. So as this Committee moves forward on this matter, we will continue to work on a bipartisan basis on this bill. We will do our work out in the open, and we will listen to any and all who want to comment. That is what we did with the farm bill, with the reauthorization of the Commodity Exchange Act and with our examination of speculation. The result of that approach was passage of strong bipartisan legislation last Congress that had the support of the Ranking Member at the time, Mr. Goodlatte, and it received \2/3\ of the vote in the House. This is must-pass legislation, in my view, which is why we need to move quickly; and that is why I have circulated this language, and why we are holding these hearings today and over the next couple of weeks. So I welcome all of today's witnesses and the Members to the hearing. I look forward to their testimony. [The prepared statement of Mr. Peterson follows:] Prepared Statement of Hon. Collin C. Peterson, a Representative in Congress From Minnesota Good afternoon and welcome to today's hearing on derivatives legislation. For those on the Committee who were here in the 110th Congress, today's hearing will cover many of the issues and topics considered during the nine hearings held last year on this subject. The effort to strengthen oversight and improve transparency in derivative markets, whether regulated or unregulated; whether they are physically based commodities or financial commodities has been a top priority of this Committee. For those of you who are new to the Committee, welcome to the fire. Members and staff have been working hard on this issue since the last Congress adjourned and it is my intent to move expeditiously this month because every day we delay is another day where markets operate without the oversight or transparency they desperately need. Last year, we began our journey with extensive public hearings on the issue of speculation, lack of convergence, lack of effective oversight, and increased transparency of derivatives markets. The result of those hearings was a strong, bipartisan bill that had more than a \2/3\ majority when it passed the House last September. We will continue this effort in the 111th Congress, but this time with new provisions resulting from the hearings we held late last year on the role of credit derivatives in the economy after the collapse of large financial institutions that were heavily engaged in OTC derivative transactions. The language that I circulated last week and that this Committee will be discussing contains provisions similar to last year's bipartisan bill. It would strengthen confidence in trader position limits on all futures markets as a way to prevent potential price distortions caused by excessive speculative trading. It would close the so-called London Loophole by requiring foreign boards of trade to share trading data and adopt position limits on contracts that trade U.S. commodities linked to U.S.-regulated exchanges. It would direct the CFTC to get a clearer picture of the over-the-counter markets, and it calls for new full-time CFTC staff to improve enforcement, prevent manipulation, and prosecute fraud. This proposal would bring a sense of order to the over-the-counter market by requiring transparent, central clearing for all OTC derivatives. The legislation contemplates multiple entities, whether regulated by the CFTC, the SEC, or the Federal Reserve, offering clearing services for market. In that sense, it is modeled after current law. However, the bill requires these clearing entities to follow the same set of core principles in their operations, as a means to avoid regulatory arbitrage. The failures of AIG, Lehman, Bear Stearns, and other institutions have shown us that it is time for some transparency in the market for credit derivatives. The way for us to identify and reduce the risk out there is to facilitate clearing it. The draft bill provides the CFTC with authority to exempt some derivatives from clearing, in recognition of the fact that not every OTC trade is suitable for clearing. However, those seeking to remain in the derivatives business without clearing will have to report their actions and demonstrate their financial soundness. In the debate over credit derivatives, there has been much discussion about choosing the proper regulator; whether it is the CFTC, the SEC, or the Fed. I have made it clear that the CFTC is the agency that has the knowledge and expertise in these markets. I am flat opposed to the Fed having a role in clearing or overseeing these products. If I could have my way, the Fed would not be involved; however that is not the political reality of today, and the draft legislation reflects that. The Federal Reserve is an independent banking system, not a police officer of derivatives transactions. I share the concerns of those who think the Fed controls too much already. They are an unelected body that sets monetary policy, oversees its state member banks, oversees holding companies, and now they are printing money for the bailout. I am not surprised that the large banks are clamoring for the Fed to regulate derivative activity, given their cozy relationship with Fed members. Plus, they probably think it is a good idea to have a regulator with the resources to bail them out when things go south. I am also strongly opposed to allowing the SEC to have primary authority over these contracts. The SEC uses a rules-based system that is behind the curve of today's modern, complex financial products and is just not workable. They are not just trying to solve yesterday's problem or last week's problem; they are still trying to solve last decade's problem. As a result, they have done a poor job. How much confidence can we have in an agency that repeatedly ignored calls, even from within its own agency, to examine the investment advisory business of Bernard Madoff, which turned out to be the biggest Ponzi scheme in history, having cheated an untold number of investors, charities, and foundations out of billions; or that missed the red flags in its oversight of Bear Stearns, as was detailed by a report from the SEC Inspector General? Other people are trying to use the problems with credit default swaps as an argument for creating a super financial regulator. However, in my opinion, taking something that is working, like CFTC oversight of the futures markets, and moving it to another place where things are not working is just crazy. To name a financial czar or single super regulator over the whole thing is an even worse idea that has the potential to create a financial markets version of the Department of Homeland Security. I don't want to even imagine the kind of mess that would create. As this Committee moves forward on this matter, we will continue to work on a bipartisan basis on this bill, and we will do our work out in the open and listen to any and all who want to comment. That is what we did with the farm bill, with reauthorization of the Commodity Exchange Act, and with our examination of speculation. The result of that approach was passage of strong bipartisan legislation last Congress that had the support of the Ranking Member at the time, Mr. Goodlatte, and achieved \2/3\ votes in the House. This is must-pass legislation, in my view, which is why we need to move quickly. That is why I have circulated this language and why we will be holding hearings over the next 2 weeks. I welcome today's witnesses and I look forward to their testimony. At this time I would like to yield to Ranking Member Lucas for an opening statement. " FOMC20050202meeting--164 162,MS. BIES.," Thank you, Mr. Chairman. To me, the forecasts presented in the Greenbook and the consensus forecast of those from the private sector paint a sound economic picture for 2005— February 1-2, 2005 118 of 177 I’m comfortable that the removal of policy accommodation at a measured pace that we’ve announced and have been implementing is supportive of this growth going forward. As some of you have mentioned, given such a good forecast, the question that arises is: What should we be worrying about in this picture? I’d like to mention two concerns that I’ve been focusing on lately. The first is the risk around inflation. This is not a huge risk, but when I look at the Greenbook projection compared to various private-sector forecasts, the Greenbook’s inflation forecast is at the lower end of the range of the Blue Chip forecasts. Hopefully, the Greenbook will be the right forecast on this, but the inflation numbers have shown a lot of volatility in the last two years. So in light of the recent volatility, even in the core measures of inflation, I think it’s important that we look carefully at incoming data every month and keep on top of what is happening to try to get a better understanding. The second concern has also been mentioned by a couple of you around the table, and that is the mystery of why long-term interest rates aren’t any higher than they are. My personal forecast a year ago would never have had long-term interest rates at the levels at which they’ve been sitting. If I look at various aspects of this, in trying to understand it, I can explain some things. For example, we know that corporations have been seeing record profit margins and, as a result, have been generating tremendous cash flow. That means that corporations have been able to fund a large part of their investment in inventory buildup through internal funds, as opposed to going to banks or to the markets. We also have seen fewer accounting scandals, which generated a lot of the uncertainty that widened credit spreads in 2002. Those spreads have really come back down again as we’ve had relatively fewer shocks to market confidence. We’ve also seen rating agencies worldwide reduce the number of downgrades relative to upgrades; so that has turned around, which is another good sign. And as Governor Olson mentioned, the bankers are very positive about current credit quality. But I would say again that we should recognize that we are probably at the sweet spot in that credit February 1-2, 2005 119 of 177 On the other hand, consumers have been borrowing like crazy, and they’ve been borrowing at the long end of the curve. In large part, this is a reflection of the fact that interest rates are historically low, and people are being very rational by locking in at long-term rates and borrowing all that they can. On net, though, we’ve seen that there’s been plenty of liquidity in the long market. So what could happen here if long rates do move up as we go forward? I guess I worry primarily about what that could do in terms of business investment. We know that there may be a narrowing in profit margins. And cash flow has changed to some degree, in that companies are beginning to look more to the outside for credit, especially as merger activity picks up, and that could affect the relative demand for credit from corporations. On the household side, we’re seeing that consumers have used these low rates to support consumption. They’ve done it through equity extractions as they refinance. They’ve also had the benefit of tremendously innovative mortgage products being offered by bankers and other lenders. For tax reasons, people want to borrow as much of their debt against their houses as they can, and lenders have accommodated them by innovations in ARMs [adjustable-rate mortgages] where borrowers can lock in a low rate for a period on the short end of the curve. But lenders have also offered interest-only loans and mortgages with very high loan-to-value ratios to provide more credit that is eligible for tax deductions. If interest rates rise, will consumers begin to slow their use of credit and, if so, what does that mean for consumption in the forecast? This is the issue I really want to focus on because, to me, consumers have been the mainstay of this whole economic cycle. To the extent that there is a wealth effect of housing, this could be a concern if people begin to purchase houses at a slower pace or even if housing construction stays at a high level but doesn’t grow. We’ve seen several private-sector forecasts of flat house prices next year. If suddenly the equity buildup and the net worth of households were to slow, that could have an impact for consumers. When we look at why the saving rate is so low today, we also have to look at the fact that the ratio of net worth to income is at record levels. Consumers have not had to save out of current February 1-2, 2005 120 of 177 income almost entirely to current consumption. But if net worth begins to stabilize and consumers are not able to increase cash flow through refinancings or home equity lines, that could slow the pace of consumer spending and result in less GDP growth than in the Greenbook forecast. Thank you." CHRG-111shrg55278--127 RESPONSES TO WRITTEN QUESTIONS OF SENATOR BUNNING FROM VINCENT R. REINHARTQ.1. I doubt we can create a regulator that will be able to see and stop systemic risk. It seems to me a more practical and effective way to limit the damage firms can do is to limit their size and exposure to other firms. That also has the benefit of allowing the free markets to operate, but within reasonable limits. Do you agree with that?A.1. Financial firms have gotten too complicated and too interconnected. This is related to, but not completely explained by, the size of a firm. In March 2008, for instance and much to my regret, financial authorities were unwilling to let market forces determine the fate of the mid-sized investment bank, Bear Stearns, because of concerns about its interconnectedness. My preferred solution is to combat complexity directly by enforcing strict consolidation of balance sheets and requiring different activities within a holding company to be chartered and capitalized separately. If a firm's balance sheet is transparent, then the market can exert meaningful discipline.Q.2. 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 we make sure the rules were being enforced the same across the board?A.2. Management by committee never works well. Introducing layers of supervision invites turf wars among the regulators, the search for regulatory gaps among the regulated, and mutual finger-pointing after the fact of failure.Q.3. 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.3. Systemic risk refers to the possibility that there will be a widespread withdrawal from risk taking that does not discriminate across borrowers.Q.4. 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.4. Systemic risk is a contagion. The most effective response is to isolate the source. Before the fact, regulated entities should be required to keep a simple balance-sheet structure that limits interconnections. This reduces the risk of contagion. In the event, weak firms should be allowed to fail. If there are activities of the firm that pose system risk, they should be isolated and protected--after sufficient haircuts--and the rest of the firm left to fail.Q.5. How would we identify firms that pose systemic risks?A.5. A systemic threat is posed by any firm with large gross exposures, relative to its capital, to many different firms with no effective netting regime.Q.6. All of the largest financial institutions have international ties, and money can flow across borders easily. AIG is probably the best known example of how problems can cross borders. How do we deal with the risks created in our country by actions somewhere else, as well as the impact of actions in the U.S. on foreign firms?A.6. We can best protect our national interest by requiring that any firm operating in the United States have a transparent balance sheet and sufficient capital for each of its independent lines of business.Q.7. As you probably have heard, many are calling for an audit of the Fed. Chairman Bernanke and others are opposed to that idea because they fear it will lead to Congressional interference with monetary policy. What can be done to improve transparency at the Fed? What should not be done? Is there any information on Fed discussions and the data that goes into them that would compromise the Fed's independence or ability to do its job if made public?A.7. There are limits to transparency. A requirement that the Fed disclose more information sooner would probably push decision making more outside organized meetings, to the detriment of openness. There are two areas where the Fed could volunteer improvement. First, it could make a numeric summary of its staff forecast public with its minutes. The forecast is influential among FOMC participants. If they find it useful, would not the public? Second, the transcripts could be released sooner than the current 5-year lag, and probably substantially so.Q.8. Do you have any suggestions for ways to improve the Fed's ability to carry out its core mission of monetary policy? Do you have any other comments about the Fed generally?A.8. The Fed would be far better off if it focused on its core responsibility of monetary policy and hardened the wall of independence around it. Shed bank supervision, which it did not do well. Collect and share more data to compensate for the lack of supervision. Articulate a long-run inflation goal to anchor the public's understanding. The Fed's unwillingness to engage the Congress in a meaningful dialogue about the appropriate role of the central bank is a mistake. ------ CHRG-110shrg50416--137 Chairman Dodd," I appreciate that. Senator Corker. Senator Corker. Mr. Chairman, thank you. I appreciate the opportunity to ask a few additional questions. Ms. Duke, on the AIG issue, I know there has been a lot of consternation about the fact that AIG is paying--look, by the way, I agree with all the concerns that have been raised about their behavior and think it is reprehensible based on where they are. But then on the flip side of that, as far as moving them away from Government, I know there has been a lot of speculation about actually this is a pretty usurious arrangement in some ways and that they might be better off, if you will, either in bankruptcy or seeking other ways out of this. Any sense of where we are? They are a public company. You are a public entity. I am sure you can talk about those pretty freely with us. Where are we as it relates to anexit strategy and moving them away from where they are today? Ms. Duke. AIG has a plan and had from the very beginning a plan to sell assets to repay the loans from the Federal Reserve---- Senator Corker. And let me just ask you, I mean, I understand about selling assets so, in essence, you end up with sort of nothing left. There is a growing concern there. I would love any editorial comments as to whether that is even the best result or whether seeking equity in other ways at this point, now that people can ascertain what the real risk is and have had time to do that, I would love editorial comments as to whether their plan is even the right plan. Ms. Duke. Let me try to answer your question without getting into any non-public information about the company. We have been working with them ever since the loan was made. First of all, the reason the loan was made originally was a concern about systemic risk and risk to the financial markets. And we did not at that time fully know or understand exactly where all of those risks might be and what the magnitude of them might be. And so we are spending a lot of time trying to understand exactly what the risk is. If we are going to hold up the tent, if you will, we want to find out exactly what the risk is that we are protecting against. And then what steps it will take to get us to the other side. How quickly are those risks unwinding? And also what steps will it take to bring this to a conclusion to have AIG take the steps that it needs to take to repay the---- Senator Corker. And is the best step for them to sell off all the parts? Or is the best step for them, now that people have a better sense of what the real risk is, a different type of equity injection? Ms. Duke. I think our best effort is to make sure that the overall outcome to the public is the best outcome to the financial markets generally, not necessarily for the single institution. Senator Corker. And I understand that, and that is why we are all up here. So I guess what you are saying is your are semi-agnostic in that regard, and if selling assets pays the $85 billion back plus the additional injection you just made, or the other, either way, that we get away from the immediate taxpayer risk, but then on top of that, maybe even more importantly, or equally important--I should not say ``more''--is the system risk. Ms. Duke. The systemic risk is the key to it, and while we are certainly mindful of having our loan repaid, it is not just a pure credit decision. This is also one of trying to monitor the---- Senator Corker. And since you can't give publicly some of the discussions that you are having, is there a sense that there is something working right now that will move them away from your institution and into a different scenario that does alleviate that systemic risk? Ms. Duke. The sense is that there are an awful lot of people working toward that end, and the company is so large and there are so many subsidiary companies, and the markets in which they operate are so complex that I think it is going to take quite a bit of working through to that conclusion. Senator Corker. Thank you. Mr. Lockhart, I just could not resist with you being here. How much time is left in your term? " CHRG-111shrg61513--21 Mr. Bernanke," We would do it as part of our overall risk management assessment. We would look at the range of activities that the company engages in. There might be some activities that would be explicitly prohibited by legislation, say perhaps owning a hedge fund, for example. But if there are other activities, such as purchasing of, say, credit default swaps, I think it would be appropriate for the supervisor to, first of all, ascertain that the use of credit default swaps is primarily intended to hedge other positions and therefore is overall a net reduction in risk for the company as opposed to an increase or a speculative increase in risk. Second, even if the purposes of the program are in some sense legitimate, there is still the question of whether the company has adequate managerial risk management resources to properly manage those risks, and what we saw in the previous crisis, and I think this is one of the things we really learned, is that many large, complex companies didn't really understand the full range of risks that they were facing and as a result they found themselves exposed in ways they didn't anticipate. So if a company didn't have strong risk management controls and a strong culture of system--enterprise-wide risk management, I think that would be also grounds for the supervisor requesting either substantial strengthening in those controls or eliminating those activities. Senator Reed. Just an observation. Those controls are much more rigorous today, but they tend to erode over time, particularly as these unpleasant crises fade. And also, the capacity of the regulators, the Federal Reserve and other regulators, to make very nuanced judgments about management, et cetera, there is really a question of regulatory capacity as well as managerial capacity that at least the last several months suggests that it won't be handled by simply sort of letting you do what you inherently can do now. " CHRG-111hhrg55811--112 Mr. Gensler," Liquidity is fundamental to markets and fundamental to all the users of these products. Capital is that the financial institutions that hold themselves out to the public as dealers have sufficient shock absorbers, so to speak, in their business. One of the key assumptions to regulation is that we were regulating the large financial institutions, and I truly believe the financial regulatory system failed the American public. So that is why we are recommending that it has to be more explicit in writing rules about the capital. These large financial institutions already were supposed to have capital for their derivatives business; not AIG, but the others, so to speak. We think that is just more transparent, go through the usual Administrative Procedures Act and have real explicit rules on the capital on these products. " CHRG-110shrg50416--20 Mr. Kashkari," Chairman Dodd, Senator Shelby, and members of the Committee, good morning and thank you for the opportunity to appear before you today. I would like to provide you with an update on the Treasury Department's progress implementing our authorities under the Emergency Economic Stabilization Act of 2008. My written testimony includes a much more detailed description of where we are, but I am going to give a summary right now. Every American depends on the flow of money through our financial system. They depend on it for car loans, for home loans, for student loans, and to meet their basic family needs. Employers rely on credit to pay their employees. In recent months, as you know, our credit markets froze up and lending became extremely impaired. Congress, led by this Committee and others, recognized the threat the frozen credit markets posed to Americans and to our economy as a whole. Secretary Paulson is implementing the Department's new authorities with one simple goal: to restore capital flows to the consumers and businesses that form the core of our economy. The Treasury has moved quickly since enactment of the bill to implement programs that will provide stability to our markets, protect the taxpayers to the maximum extent possible, and help our financial institutions to support our consumers and businesses across the country. Since the announcement of our capital purchase program, we have seen numerous signs of improvement in our markets and in the confidence of our financial institutions. While there have been recent positive developments, our markets remain fragile. I would like to spend just a quick few moments outlining steps we have taken to implement the TARP. We have seven policy teams driving forward and they are making rapid progress. First, our mortgage-backed securities purchase program. We selected the Bank of New York Mellon to serve as a custodian and expect to hire asset managers in the coming days. A Treasury team has been working around the clock to design the auction, identify which mortgage-backed securities to purchase, and to determine how best to reach the thousands of financial institutions who may be bidding. Two, whole loan purchase program. This team is working with bank regulators to identify which types of loans to purchase first, how to value them, and which purchase mechanism will best meet our policy objectives. They also expect to hire asset managers very soon. Third, insurance program. We are establishing a program to insure trouble mortgage-related assets. We have submitted a request for comment to the Federal Register and are seeking the best ideas on structuring options for that program. Four, equity purchase program. Treasury worked very closely with the four banking regulatory agencies to design and announce a voluntary capital purchase program to encourage U.S. financial institutions to raise capital to increase the flow of financing to U.S. businesses and consumers and to support the U.S. economy. Treasury will purchase up to $250 billion of senior preferred shares on standardized terms. This is an investment. The Government will not only own shares that we expect will result in a reasonable return, but will also receive warrants for common stock in participating institutions. The program is available to qualifying U.S. depository institutions. We are working very hard to publish the legal documentation required so that private banks can participate on the same terms as public institutions. We have allocated sufficient capital so that all qualifying banks can fully participate. Treasury and the banking regulatory agencies have announced a streamlined and systematic process to apply for the capital program. Financial institutions should first consult with their primary Federal regulator and then use the single standardized application form that's available on their regulator's website. Once the regulator has reviewed the application, they will send the application to the Treasury Department. Treasury will give considerable weight to the recommendations of the regulators and decide ultimately whether or not to make the capital purchase. All completed transactions will be announced to the public within 48 hours, but we will not announce any applications that are withdrawn or denied. No. 5, homeownership preservation. We have begun working with the Department of Housing and Urban Development and HOPE NOW to maximize the opportunities to help as many homeowners as possible while also protecting the taxpayers. We have hired Donna Gambrell, who is the Director of the Community Development Financial Institution Fund and former Deputy Director of Consumer Protection and Community Affairs at the FDIC to oversee this effort and serve as our interim Chief of Homeownership Preservation. When we purchase mortgages or mortgage-backed securities, we will look for every opportunity possible to help homeowners. No. 6, executive compensation. Companies participating in Treasury's programs must adopt the Treasury Department standards for executive compensation and corporate governance. And No. 7, compliance. Treasury is committed to transparency and oversight in all aspects of this program. We have been meeting regularly with the Government Accountability Office to monitor the program and GAO is establishing an office onsite at Treasury. The Financial Stability Oversight Board has already met several times and they selected Chairman Bernanke to serve as Chairman of the Oversight Board. The Administration is also working to identify potential candidates to serve as Special Inspector General. In the interim, Treasury is working with our own Inspector General to monitor our progress. Now let me spend just a moment on procurement. Our approach to procurement is based on the following strategy: first, in order to protect the taxpayers, we will seek the very best private sector expertise to help us execute this program. Second, to the extent possible, opportunities to compete for contracts and to provide services should be available to small businesses, veteran-owned businesses, minority, and women-owned businesses. And third, we are taking appropriate steps to mitigate and manage potential conflicts of interest. Firms competing to provide services must disclose their potential conflicts of interest and recommend specific steps to manage those conflicts. Treasury will only hire firms when we are confident in our ability and their ability to successfully manage those conflicts. Our Chief Compliance Officer will be responsible for making certain that firms comply with the agreed upon mitigation steps. Chairman, as you can see, we have accomplished a great deal in a short period of time, but our work is only beginning. A program as large and complex as this would normally take months or even years to establish. But we do not have months or years. Hence, we are moving to implement the TARP as quickly as possible while working to ensure high quality execution. Thank you. " CHRG-111hhrg54868--84 Mr. Scott," Thank you, Mr. Chairman. Let me ask, it is a great pleasure to have the three of you here, who are our primary regulators in our system. But I would like to take the gist of my questions on the state of the economy now. Because in the final analysis, a major reason why we are putting these financial reforms in place is to, quite honestly, save our economy and our financial system. But if I am the American people out watching us and trying to glean something from what is a very complex, complicated issue, our report card for the American people would get an ``F'' right now. And I want to ask you, Ms. Bair, Comptroller Dugan, Mr. Bowman, and also you, Mr. Smith, why are we at the state that we are after spending $700 billion in TARP money, $700 billion in bailout money, $700 billion in economic recovery? We are looking at almost $2 trillion that we directly put out within the last 7 or 8 months, and yet, as you and I have discussed, Ms. Bair, and I would like for you to lead off, because the indicators are not very good for us. Home foreclosures are still ratcheting through the roof. Bank closings are at a record rate, especially in my home State of Georgia. Unemployment is at 10 percent, and in some areas at Depression levels. Banks that we are supervising and you are regulators of are not lending, particularly to small businesses, therefore bringing out bankruptcies there. So to me, the American people are probably saying, what good does it do for us to be sitting up dealing with these regulatory reforms when, in fact, where is the report on what we have been doing? Why is it that we can't see the jobless numbers go down? Why is it that banks are not moving to mitigate loans? Why is it that banks are not restructuring? And at the same time that this is happening, many of them are going back to their same old ways of bonuses and salaries. The American people have a right to be very angry. So could you please respond to why we are in the state we are in? And what are we doing to get these banks to unleash this money and make loans and mitigate loans so that people can--we can really stimulate the economy and keep people in their homes? I think if we do that, that is the way in which we are going to stop all of these bank foreclosures and small businesses going into bankruptcy. And Ms. Bair, I would particularly like for you, because we moved to give the FDIC the authority and funding to move within the foreclosure area particularly to deal with this area, could you really tell us how we are progressing there, and why we are not doing more? Ms. Bair. Well, a couple of things. Regarding loan modifications, that is something certainly we advocated. And some of the work we did with the IndyMac loan modification program was used by Treasury and HUD to launch their own HAMP program. This is not something we are doing, though we support it and have tried to provide technical assistance. They estimate they can get about 500,000 loans modified in the near future. It is making a dent, but it was never meant to be the complete cure. It is not, but it can help a significant number of folks stay in their homes. To get banks to lend, we have taken a number of steps. We are asking our examiners to do a lot. There was some bad lending going on. There was some lending based on rising collateral values that shouldn't have happened. So, because there was too much credit out there, there needed to be some type of pull back. But the challenge is to make sure it doesn't pull back so far that the credit-worthy loans, the prudent loans, are not being made. We have tried to strike this balance with our examiners. We want our banks to lend. We want prudent lending. But, we don't want them to overreact. There are a lot of cross-currents. There are a lot of people saying that regulation wasn't tough enough; we need to be tougher. And there are other people saying, you are being too tough. It is a hard balance to strike. We have tried to provide clarity in a number of key areas. We have said very specifically that we want commercial loans restructured also. We want small business loans restructured, too. Loss mitigation is a good business practice, whether it is for residential mortgages or commercial mortgages. That needs to be disclosed and done properly. We want the appropriate loans restructured. We don't want good loans written down just because the collateral value has fallen. We don't want that to happen. We have made that very clear. " CHRG-111hhrg53242--28 Mr. Kanjorski," Thank you again, Mr. Lowenstein. And our next witness will be Ms. Diahann Lassus, president of Lassus Wherley, on behalf of the Financial Planning Coalition. STATEMENT OF DIAHANN W. LASSUS, PRESIDENT, LASSUS WHERLEY & ASSOCIATES, ON BEHALF OF THE FINANCIAL PLANNING COALITION Ms. Lassus. Thank you, Mr. Chairman, and members of the committee. Thank you for the opportunity to speak on this critically important topic. My name is Diahann Lassus, and I come before you today as a representative of the Financial Planning Coalition, a group of three leading financial planning organizations dedicated to improving consumer access to competent, ethical, and professional financial planning advice. I also serve as chairman of the board of the National Association of Personal Financial Advisers, the leading professional association dedicated to the advancement of fee-only financial planning. Most significantly, however, I am the co-founder and president of Lassus Wherley & Associates, a woman-owned wealth management firm focused on helping families secure their financial future every day. Consumer protection and the need for accountability and transparency are not abstract concepts or academic debates. They are the reality my clients and I face every day. Every time I meet with new clients, I hear stories about their experience with other financial planners. These clients often explain that they trusted and followed the planner's advice because the planner said he was putting the client's best interests first. Based on the recommended products, it is abundantly clear that the planner was looking to profit from commissions, and may not have even considered the client's best interests. Sadly, though, these stories are not unusual. Since the Great Depression, financial services regulation has developed essentially along dual tracks: laws governing the sale of financial products; and laws governing investment advice. When the delivery of financial services involves a combination of product sales and financial advice, the dual regulatory structure has led to consumer confusion, conflicts of interest, and gaps in oversight. No single law governs the delivery of financial planning advice to the public. There is a patchwork regulatory scheme where financial planners currently maintain as many as three different licenses--insurance, brokerage, and investment adviser--with different standards of care and accountability to consumers. This has led to consumer confusion, misrepresentation, and fraud, all things that the Administration seeks to correct in their reform package. We were very happy to see the President propose that broker-dealers who provide investment advice be held to the same fiduciary standard as investment advisers. We are pleased that this committee is considering that proposal, and hope it results in an unambiguous fiduciary duty for all financial professionals who provide investment advice, and does not undermine the fiduciary duty that already exists under the Investment Advisers Act of 1940. We are working with a group of organizations that represent diverse interests and constituencies to support this concept. We all share the view that the highest legal standard, the fiduciary duty, should apply to all who give financial advice to consumers. Taking a step beyond extending the fiduciary duty, and in an effort to close the regulatory gap I mentioned, the Financial Planning Coalition supports the creation of a professional oversight board for financial planners and advisers, much like professional or medical legal boards, that would establish baseline competency standards for financial planners and require adherence to a stringent fiduciary standard of care. We seek to apply a principles-based regulation to individuals providing comprehensive financial planning services or holding themselves out as financial planners, not to the firms that employ them. This leaves intact other regulatory coverage for institutions, and operates consistently with existing Federal regulation for broker-dealers and investment advisers, as well as State regulation of insurance producers, accountants, and lawyers. As a small business owner, I am very sensitive to charges of increased administrative and cost burdens, especially in this economy. However, the ability of Americans to identify and place their trust in competent, ethical, and professional financial planners outweighs these burdens. We fully support the Administration's five key principles for strengthening consumer protection: transparency; simplicity; fairness; accountability; and access. And we are pleased to see the chairman carry these principles forward as he works to fill the regulatory gaps to protect consumers. Thank you. [The prepared statement of Ms. Lassus can be found on page 72 of the appendix.] " CHRG-110shrg50418--324 PREPARED STATEMENT OF ROBERT A. FICANO Wayne County Executive, Detroit, Michigan November 18, 2008 My name is Robert Ficano, and I serve as County Executive for the tenth largest county in the United States, Wayne County, Michigan. Southeast Michigan is home to the ``Big Three'' domestic automotive companies. I appreciate the opportunity to submit testimony for the Committee's consideration. As the Committee begins to examine the state of the automotive industry, I would like to bring to mind a quote from automotive pioneer, Henry Ford, to help set the stage for a Congressional response to the automobile industry's need for increased financial assistance: ``Coming together is a beginning. Keeping together is progress. Working together is success.'' Thank you and congratulations to Members of Congress for working together to pass the most recent economic stimulus package. The legislation allows the automotive industry to secure low-interest loans for retooling plants and moving forward with research and development. This is one step forward in stabilizing the industry. However, more direct assistance is necessary--the automobile industry remains in a perilous economic position, which has a significant, negative impact on the State of Michigan and, in particular, Wayne County. More direct financial support and intervention are needed as the auto industry continues to suffer and millions of jobs are in jeopardy. Congress correctly perceives this as a national problem with severe consequences. The automotive industry is the largest sector of our manufacturing industry in the United States. According to the National Center for Manufacturing Sciences, government assistance to the automotive industry for research and development will enable innovation of infrastructure into all sectors of manufacturing. New products and technology, frequently cultivated in the automotive sector, have spun off to other industries such as green technology, alternative energy, medicine, and aerospace, to name just a few. The assistance from the Federal government should be viewed as an opportunity to infuse new growth. Building new infrastructure can also lead to better safety and security of intellectual property. Wayne County is home to nearly 2 million residents, as well as Ford, General Motors, and 17 automotive plants. According to the Southeast Michigan Council of Governments (SEMCOG), Michigan lost more than 87,000 automotive manufacturing jobs between 2000 and 2008. The total job loss, including suppliers and spin off businesses, for the region was 13 percent or 254,000. As widely reported, unemployment rates in the region are significantly higher than the national average since 2001, 8.5 percent compared to 6.1 percent nationally. Over the past 7 years, nearly 160,000 people have moved out of Southeast Michigan. The loss of automotive jobs triggers tremendous ripple effects on business, housing market, and Michigan has experienced a severe decline in its tax base. SEMCOG has forecasted that the loss of another 50,000 jobs in the automotive manufacturing sector will have an immediate and severe impact totaling in an additional loss of 7 percent or 190,000 jobs. According to the Center for Automotive Research (CAR), immediate collapse of the industry would result in nearly 3 million lost jobs. An estimated 239,341 jobs would be lost at the ``Detroit Three'' and another 973,696 indirect or supplier jobs and 1.7 million related jobs also would be lost. Federal assistance is much needed and should be viewed as an opportunity to stabilize the industry and prevent the economy from faltering further. According to General Motors, the cost to local, state, and Federal governments could reach $156.4 billion over three years in lost taxes, unemployment, and health care assistance. Some define this Federal assistance as a bail-out, while it is really a loan to be paid back. I also urge Congress to view this as I do--and see it as opportunity to re-structure and grow the industry. The Federal government previously intervened, with great success, on behalf of Chrysler in 1980 and, more recently, the airline industry. The government's investment prevented these companies from going bankrupt, which would have negatively affected employee pensions, vehicle sales, suppliers, dealerships, and related industries. On a final note, I want to mention one underlying problem that perhaps escaped much scrutiny. I urge Congress to commit once again to tackling the health care cost and access problems facing our Nation. Our public leaders across the board must commit to making health care more affordable. Skyrocketing health care costs are affecting business and government equally. It is time to reevaluate our national health care policies before all businesses are forced to seek government assistance. We in Wayne County strongly advocate bipartisan Congressional Leadership and intervention to assist the automobile industry. Attached to this statement is a letter I sent last week to the President and President-Elect as well as House and Senate Congressional Leadership. The collapse of one or more of the ``Big Three'' auto makers could put millions of jobs across our country at stake. As a Nation, we cannot allow such a vital systemic part of the American economy to collapse under the current financial crisis. To successfully survive the global credit crunch, it is imperative that auto makers receive financial assistance to remain viable and competitive. Henry Ford stated that ``most people spend more time and energy going around problems than in trying to solve them.'' On behalf of our people, thank you for your timely consideration on such an important issue for the citizens of our Nation, Michigan, and Wayne County. CHRG-110hhrg46591--82 Mrs. Biggert," Thank you, Mr. Chairman. I thank you all for your testimony. And like some of you, I want to see a Federal entity that supervises and ensures the safety and soundness of larger hybrid financial institutions like AIG. Second, that we need the FEC to regulate the credit default swaps market, revise mark to market accounting, enhance the credibility of credit rating agencies, reign in hedge funds, as well as market manipulations like the short selling. And third, it is essential, I think, that we work towards modernizing mortgage and credit product regulations like RESPA, TILA, UDAP and determining the fate of Fannie and Freddie. And I will assume that you all have read Paulson's Blueprint for a modernized financial regulatory structure. The model proposes that instead of the functional regulations that we create the three primary financial services regulations to focus on market stability across the entire financial system and then safety and soundness of financial institutions with government guarantee; and then third is the business conduct regulations that investors and consumers--that gives the investors and consumers protection. So I would like to know, in your opinion, is this a silver bullet structure that you can paint a picture for us as to what the ideal financial services regulatory structure would look like? Maybe Mr. Seligman. You talked a lot about the-- " CHRG-111hhrg54872--24 Mr. Ellison," Thank you, Mr. Chairman. One of the most important causes of the financial crisis was the complete and utter failure of our system of consumer financial protection. The most abusive and predatory lenders were not federally regulated, while regulation was overly lax for banks and other institutions that were covered. To address this problem, we need a new agency dedicated to consumer financial protection, a Consumer Financial Protection Agency. Of course there are some who would like to keep the same regulators on the job and thereby duct-tape together the shards of a broken system. Anyone who wants to take this bankrupt approach should read the Washington Post article from this last Sunday, which I will submit for the record, that discussed the Fed's failures to act on consumer protection. Those failures were so great that even former Fed Chairman Alan Greenspan has backtracked and said the Administration's proposal is probably the ``right decision'' regarding a Consumer Financial Protection Agency. Of course, that initial proposal was not perfect, but we will continue to work on it over the weeks ahead. I yield back. Thank you. " CHRG-111hhrg58044--2 Chairman Gutierrez," This hearing of the Subcommittee on Financial Institutions and Consumer Credit will come to order. Good morning and thanks to all of the witnesses for agreeing to appear before the subcommittee today. Today's hearing will examine the impact that the use of credit reports and information has on consumers outside of the traditional use for lending and credit purposes. We will examine the use of credit-based insurance scores, where the medical debt is predictive of a person's chances of defaulting, and finally, whether or not a consumer's credit information should be used to determine their employability. We will be limiting opening statements to 10 minutes per side, but without objection, all members' opening statements will be made a part of the record. We may have members who wish to attend but do not sit on the subcommittee. As they join us, I will offer an unanimous consent motion for each to sit with the subcommittee and for them to ask questions when time allows. I yield myself 5 minutes for my opening statement. This morning's hearing is about the use of credit information in areas such as insurance underwriting and employment purposes. We will hear about important yet complex and often opaque processes concerning credit board insurance and insurance scores in the first panel. In the second panel, we will hear about issues that are equally important to a vast number of consumers--the little known or understood use of credit information for hiring and even firing decisions, and the effect medical debt has on one's consumer report, even after you paid the medical debt off. When legislators or regulators attempt to fully grasp an issue such as credit-based insurance scores, they see a complex system laden with ever-changing computer applications and models, but it is precisely this complexity that should make us here in Congress delve further into an issue that affects every single American who owns or rents a house, a car, has insurance, has a job or is looking for a job, or is likely to incur medical debt. Do most consumers know that their car or homeowner's insurance rates may go up due to their credit score? Do they know that if one of their medical bills goes to a collection agency and they pay it in full and settle it, it will still affect their credit report for up to 7 years? Do people realize that even in these tough economic times, pre-employment consumer credit checks are increasingly widespread, trapping many people in the cycle of debt that makes it harder for them to pay off their debts and harder for them to get the job that would allow them to pay off the debt? I wonder--when you go to State Farm or Allstate or GEICO to get your insurance and they have a credit score, and that credit score was negative, so they are going to charge you more for your insurance, do they send you a note in the mail telling you that you are going to pay more for that insurance? I think these are all very important questions that the American public should know. Indeed, the current system facilitates the denial of employment to those who have bad debt, even though bad debt oftentimes results from the denial of employment, a vicious cycle. You cannot get a job, so you get a bad credit score. You have a bad credit score, so you cannot get a job. I wonder who is most likely to be affected, especially in these economic times. What? Extend unemployment compensation? What about the national debt? I have a way maybe we could settle unemployment compensation, how about letting somebody get a job and prove who they are without some mysterious number coming out of a black box somewhere where nobody knows about it. That is why the subcommittee is holding this hearing, the second so far this year on the issue of credit reports, credit scores, and their impact on consumers. We will look at reports and studies about the predictive nature of insurance scores and traditional scores among other things. As we do so, we also need to look at the basic guiding principles of equity, fairness and transparency. Some have contended that there is no disparate treatment of minorities in credit-based insurance scores. Some will say that even if there is a disparate impact on some groups, the system still does not need to be changed. The question of how predictive a credit-based insurance score is on an insured's likelihood to file a claim is important, as it is the predictive value of traditional credit scores used for credit granting. As long as there continue to be disparities in the outcomes of the current system for racial and ethnic groups and along class and geographical lines, I believe the system needs strenuous oversight and may need fundamental change. How to correct the disparities in the system with this disproportionately negative impact on minorities and low-income groups while maintaining the core framework of credit information as a risk management tool is a challenge we should take on. For example, on issues like the use of credit information for developing insurance pricing and the inclusion of medical debt collection in determining a consumer's risk of default, I have doubts as to whether there are biased uses of data. The Equal Employment Opportunity Commission, the Federal Reserve, the Brookings Institution, the Federal Trade Commission, and the Texas Department of Insurance have all found that racial disparities between African Americans, Latinos and Whites in credit scores exist, and we will see this has wide ranging implications beyond simply obtaining consumer credit. Defending a system where decisions such as determining car insurance rates or even something as vital as to whether or not to hire someone is based on something that has shown to possess a degree of bias is difficult, to say the least. I welcome the testimony this morning of those who believe the system works, and of those who believe the system needs to be changed to work in a more equitable, fair, and transparent fashion. In the same spirit of transparency, I am making it clear at the outset that I side with the latter group. I do not think you need any sort of score to predict that, from my point of view. In order to persuade this committee not to move forward on legislation that would strongly limit what we believe to be unfair practices, the industry witnesses before us must prove to me that not only are the practices we call into question scientifically predictive, but more importantly, they are fair and equitable to all Americans. The ranking member, Mr. Hensarling, is recognized. " CHRG-111hhrg54869--163 Mr. Zandi," Thank you to the members of the committee for the opportunity to testify today. My remarks are my personal views and not those of the Moody's Corporation, my employer. The Obama Administration's proposed financial regulatory reforms will, if largely enacted, result in a more stable and well-functioning financial system. I will list five of the most important elements of the reform, and I will make a few suggestions on how to make them more effective. First, reform must establish a more orderly resolution process for large, systemically important financial firms. Regulators' uncertainty and delay in addressing the problems at Lehman Brothers and AIG, in my view, contributed significantly to the panic that hit the financial system last September. Financial institutions need a single, well-articulated, and transparent resolution mechanism outside the bankruptcy process. The new resolution mechanism should preserve the system of stability while encouraging market discipline by imposing losses on shareholders and other creditors and replacing senior management. Charging the FDIC with this responsibility is appropriate given the efficient job it does handling failed depository institutions. I think it would also be important to require that financial firms maintain an acceptable resolution plan to guide regulators in the event of their failure. As part of this plan, institutions should be required to conduct annual stress tests based on different economic scenarios similar to the tests that large banks engaged in this last spring. Such an exercise, I think, would be very therapeutic and would reveal how well institutions have prepared themselves for a badly-performing economy. Second, reform must address the ``too-big-to-fail'' problem, which has become even bigger in the financial crisis. The desire to break up large institutions is understandable, but I don't think there is any going back to the era of Glass-Steagall. Taxpayers are providing a substantial benefit to the shareholders and creditors of institutions considered ``too-big-to-fail,'' and these institutions should meet higher standards for safety and soundness. As financial firms grow larger, they should be subject to greater disclosure requirements, required to hold more capital, satisfy stiffer liquidity standards, and pay deposit and other insurance premiums commensurate with their size and the risks they pose. Capital buffers and insurance premiums should increase in the good times and decline in the bad times. Third, reform should make financial markets more transparent. Opaque structured-finance markets facilitated the origination of trillions of dollars in badly underwritten loans which ignited the panic when those loans and the securities they supported started to go bad. The key to better functioning financial markets is increased transparency. Requiring over-the-counter derivative trading takes place on central clearing platforms make sense; so does requiring that issuers of structured financed securities provide markets with the information necessary to evaluate the creditworthiness of the loans underlying the securities. Issuers of corporate equity and debt must provide extensive information to investors, but this is not the case for mortgage and asset-backed securities. Having an independent party also vet the data to ensure its accuracy and timeliness would also go a long way to ensure better lending and reestablishing confidence in these markets. Fourth, reform should establish the Federal Reserve as a systemic risk regulator. The Fed is uniquely suited for this task given its position in the global financial system, its significant financial and intellectual resources, and its history of political independence. The principal worry in making the Fed the systemic risk regulator is that its conduct of monetary policy may come under onerous oversight. Arguably one of the most important strengths of the financial system is the Fed's independence in setting monetary policy. It would be very counterproductive if regulatory reform were to diminish even the appearance of that independence. To this end it would be helpful if oversight of the Fed's regulatory functions were separated from the oversight of its monetary policy responsibilities. One suggestion would be to establish semi-annual reporting to the Congress on its regulatory activities much like its current reporting to Congress on monetary policy. Fifth, and finally, reform should establish a new Consumer Financial Protection Agency to protect consumers of financial products. The CFPA should have rulemaking, supervision, and enforcement authority. As is clear from the recent financial crisis, households have limited understanding of their obligations as borrowers or the risks they take as investors. It is also clear that the current fractured regulatory framework overseeing consumer financial protection is wholly inadequate. Much of the most egregious mortgage lending during the housing bubble earlier in the decade was done by financial firms whose corporate structures were designed specifically to fall between the regulatory cracks. There is no way to end the regulatory arbitrage in the regulatory framework. The framework itself must be fundamentally changed. The idea of a new agency has come under substantial criticism from financial institutions that fear it will stifle their ability to create new products and raise the cost of existing ones. This is not an unreasonable concern but it can be adequately addressed. The suggestion that the CFPA should require institutions to offer so-called plain vanilla financial products to households should be dropped. Such a requirement would create substantial disincentives for institutions to add useful features in existing products. Finally, let me just say I think the Administration's proposed regulatory reform is much-needed and reasonably well-designed. Reform will provide a framework that would not have prevented the last crisis, but it would have made it measurably less severe and it certainly will reduce the odds and severity of future calamities. [The prepared statement of Dr. Zandi can be found on page 112 of the appendix.] " CHRG-111shrg56376--127 RESPONSES TO WRITTEN QUESTIONS OF SENATOR BUNNING FROM JOHN C. DUGANQ.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. The financial crisis has highlighted the importance of inter-linkages between the performance of systemically important banks, financial stability, and the real economy. It has also highlighted the risks of firms that are deemed ``too big to fail.'' There are a range of policy options that are under active consideration by U.S. and global supervisors to address these issues. Given the multifaceted nature of this problem, we believe that a combination of policy responses may be most appropriate. A crucial first step, we believe, is strengthening and raising the current capital standards for large banking organizations to ensure that these organizations maintain sufficient capital for the risks they take and pose to the financial system. Part of this effort is well underway through initiatives being taken by the Basel Committee on Bank Supervision (the ``Committee''). As announced in July, the Committee has adopted a final package of measures that will strengthen and increase the capital required for trading book and certain securitization structures. The results of a recent quantitative analysis conducted by the Committee to assess the impact of the trading book rule changes suggest that these changes will increase average trading book capital requirements by two to three times their current levels, although the Committee noted significant dispersion around this average. The Committee has underway several other key initiatives that we believe are also critical to reduce the risks posed by large, internationally active banks. These include: Strengthening the quality, international consistency, and transparency of a bank's capital base; Developing a uniform Pillar -1 based leverage ratio, which, among other requirements, would apply a 100 percent credit conversion factor to certain off- balance sheet credit exposures; Introducing a minimum global standard for funding liquidity that includes a stressed liquidity coverage ratio requirement, underpinned by a longer-term structural liquidity ratio; and Developing a framework for countercyclical capital buffers above the minimum requirement. The framework will include capital conservation measures such as constraints on capital distributions. The Basel Committee will review an appropriate set of indicators, such as earnings and credit-based variables, as a way to condition the build up and release of capital buffers. In addition, the Committee will promote more forward-looking provisions based on expected losses.The OCC has been actively involved in, and strongly supports, these initiatives. In addition to these actions, there are other policy initiatives under consideration, including the development of incremental capital surcharges that would increase with the size and/or risk of the institution, and measures to reduce the systemic impact of failure, such as reduced interconnectedness and resolution planning. As noted in my testimony, the OCC also endorses domestic proposals to establish a Financial Stability Oversight Council that would identify and monitor systemic risk, gather and share systemically significant information, and make recommendations to individual regulators. 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. We also endorse enhanced authority to resolve systemically significant financial firms. We believe that a multipronged approach, as outlined above; is far more appropriate than relying on a single measure, such as asset size, to address the risks posed by large institutions. We also believe that to ensure the competitiveness of U.S. financial institutions in today's global economy, many of these policy initiatives need to be coordinated with, and implemented by, supervisors across the globe. Finally, we strongly disagree with any suggestion that Federal preemption was a root cause of the financial crisis or that rolling back preemption would be a solution. In this regard, we would highlight that the systemic risk posed by companies such as AIG, Lehman Brothers, and Bear Stearns were outside of the OCC's regulatory authority and thus not affected by the OCC's application of Federal preemption decisions.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. It is critical that the new agency be independent from the Treasury Department and the Administration to the same extent that the OCC and OTS are currently independent. 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. It is crucial that these firewalls be maintained in a form that is at least as robust as current law provides with respect to the OCC and the OTS, to enable the new regulator to maintain comparable independence from political influence. In addition, consideration should be given to providing the new regulator the same independence from OMB review and clearance of its regulations as is currently provided for the FDIC and the Federal Reserve Board. This would further protect the new agency's rulemaking process from political interference.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. In the ongoing debate about reforming the structure of financial services regulation to address the problems highlighted by the financial crisis, relatively little attention has been paid to the initial problem that sparked the crisis: the exceptionally weak, and ultimately disastrous, mortgage underwriting practices accepted by lenders and investors. The worst of these practices included: The failure to verify borrower representations about income and financial assets (the low documentation loans mentioned in this question); The failure to require meaningful borrower equity in the form of real down payments; The acceptance of very high debt-to-income ratios; The qualification of borrowers based on their ability to afford artificially low initial monthly payments rather than the much higher monthly payments that would come later; and The reliance on future house price appreciation as the primary source of repayment, either through refinancing or sale.The consequences of these practices were disastrous not just for borrowers and financial institutions in the United States, but also for investors all over the world due to the transmission mechanism of securitization. To prevent this from happening again, while still providing adequate mortgage credit to borrowers, regulators need to establish, with additional legislative authorization as necessary, at least three minimum underwriting standards for all home mortgages: First, underwriters should verify income and assets. Second, borrowers should be required to make meaningful down payments. Third, a borrower should not be eligible for a mortgage where monthly payments increase over time unless the borrower can afford the later, high payments.It is critical that these requirements, and any new mortgage regulation that is adopted, apply to all credit providers to prevent the kind of competitive inequity and pressure on regulated lenders that eroded safe and sound lending practices in the past. Prudential bank supervisors, including the OCC, are best positioned to develop such new underwriting standards and would enforce them vigorously with respect to the banks they supervise. A separate regulatory mechanism would be required to ensure that such standards are implemented by nonbanks. While the proposed new Consumer Financial Protection Agency would have consumer protection regulatory authority with respect to nonbanks, they would not have--and they should not have--safety and soundness regulatory authority over underwriting standards.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. When there are systemwide problems with residential mortgages, institutions that concentrate their activities in those instruments will sustain more losses and pose more risk to the deposit insurance fund than more diversified institutions. On the other hand, there are many thrifts that maintained conservative underwriting standards and have weathered the current crisis. The Treasury proposal would eliminate the Federal thrift charter--but not the State thrift charter--with all Federal thrifts required to convert to a national bank, State bank, or State thrift, over the course of a reasonable transition period. (State thrifts would then be treated as State ``banks'' under Federal law.) An alternative approach would be to 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, and a narrower charter (a national bank has all the powers of a Federal thrift plus many others), it is unclear whether institutions will choose to retain their thrift charters over the long term.Q.5. Should banking regulators continue to be funded by fees on the regulated firms, or is there a better way?A.5. Funding bank regulation and supervision through fees imposed on the regulated firms is preferable to the alternative of providing funding through the appropriations process because it ensures the independence from political control that is essential to bank supervision. For this reason, fee-based funding is the norm in banking regulation. 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. Since enactment of the National Bank Act in 1864, the OCC has been funded by various types of fees imposed on national banks, and over the more than 145 years that the OCC has regulated national banks, this funding mechanism has never caused the OCC to weaken or change its regulation or supervision of national banks, including with respect to national banks' compliance with consumer protection laws. Neither the Federal Reserve Board nor the FDIC receives appropriations. State banking regulators typically also are funded by assessments on the entities they charter and supervise.Q.6. Why should we have a different regulator for holding companies than for the banks themselves?A.6. Combining the responsibilities for prudential bank supervision and holding company supervision in the same regulator would be a workable approach in the case of those holding companies whose business is comprised solely or overwhelmingly of one or more subsidiary banks. Elimination of a separate holding company regulator in these situations would remove duplication, promote simplicity and accountability, and reduce unnecessary compliance burden for institutions as well. Such a consolidated approach would be more challenging where the holding company has substantial nonbanking activities in other subsidiaries, such as complex capital markets activities, securities, and insurance. The focus of a dedicated, strong prudential banking supervisor could be significantly diluted by extending its focus to substantial nonbanking activities. The Federal Reserve has unique resources and expertise to bring to bear on supervision of these sorts of activities conducted by bank affiliates in a large, complex holding company. Therefore, a preferable approach would be to preserve such a role for the Federal Reserve Board, but to clearly delineate the respective roles of the Board and the prudential bank supervisors with respect to the holding company's activities.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. Yes. Thrift holding companies, unlike bank holding companies, currently 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. The Treasury Proposal would make these types of firms subject to the Bank Holding Company Act and supervision by the Federal Reserve Board. We support this approach, including a reasonable approach to grandfathering the activities of some thrift holding companies that may not conform to the activities limitations of the Bank Holding Company Act.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 the 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 Treasury proposal establishes the Financial Services Oversight Council to identify potential threats to the stability of the U.S. financial system; to make recommendations to enhance the stability of the U.S. financial markets; and to provide a forum for discussion and analysis of emerging issues. Based on its monitoring of the U.S. financial services marketplace, the Council would also play an advisory role, making recommendations to, and consulting with, the Board of Governors of the Federal Reserve System. As I understand the Treasury proposal, however, the Council's role is only advisory; it will not be setting any rules. Therefore, we do not anticipate any conflicting enforcement issues to arise from the Council's role.Q.9. Mr. Dugan, in Mr. Bowman's statement he says Countrywide converted to a thrift from a national bank after it had written most of the worst loans during the housing bubble. That means Countrywide's problems were created under your watch, not his. How do you defend that charge and why should we believe your agency will be able to spot bad lending practices in the future?A.9. In evaluating the Countrywide situation, it is important to know all the facts. Both Countrywide Bank, N.A., and its finance company affiliate, Countrywide Home Loans, engaged in mortgage lending activities. While the national bank was subject to the supervision of the OCC, Countrywide Home Loans, as a bank holding company subsidiary, was subject to regulation by the Federal Reserve and the States in which it did business. Mortgage banking loan production occurred predominately at Countrywide Home Loans, \1\ the holding company's finance subsidiary, which was not subject to OCC oversight. Indeed, all subprime lending, as defined by the borrower's FICO score, was conducted at Countrywide Home Loans and not subject to OCC oversight. The OCC simply did not allow Countrywide Bank, N.A., to engage in such subprime lending.--------------------------------------------------------------------------- \1\ Countrywide Financial Corporation 10-Q (Mar. 31, 2008).--------------------------------------------------------------------------- When Countrywide Financial Corporation, the holding company, began to transition more of the mortgage lending business from Countrywide Home Loans to the national bank, the OCC started to raise a variety of supervisory concerns about the bank's lending risk and control practices. Shortly thereafter, on December 6, 2006, Countrywide Bank applied to convert to a Federal savings bank charter. Countrywide Bank became a Federal savings bank on March 12, 2007. Going forward, Countrywide Bank, FSB, was regulated by OTS, and Countrywide Home Loans was regulated by the OTS and the States in which it did business. Countrywide Financial Corporation continued to transition its mortgage loan production to the Countrywide Bank, FSB. By the end of the first quarter of 2008, over 96 percent of mortgage loan production of Countrywide Financial Corporation occurred at Countrywide Bank, FSB. \2\--------------------------------------------------------------------------- \2\ Countrywide Financial Corporation 10-Q (Mar. 31, 2008).--------------------------------------------------------------------------- Bank of America completed its acquisition of Countrywide Financial Corporation on June 30, 2008. Countrywide Bank, N.A., was not the source of toxic subprime loans. The OCC raised concerns when Countrywide began transitioning more of its mortgage lending operations to its national bank charter. It was at that point that Countrywide flipped its national bank charter to a Federal thrift charter. The facts do not imply lax supervision by the OCC, but rather quite the opposite. The OCC continues to identify and warn about potentially risky lending practices. On other occasions, the OCC has taken enforcement actions and issued guidance to curtail abuses with subprime credit cards and payday loans. Likewise, the Federal banking agencies issued guidance to address emerging compliance risks with nontraditional mortgages, such as payment option ARMs, and the OCC took strong measures to ensure that that guidance was effectively implemented by national banks throughout the country.Q.10. All of the largest financial institutions have international ties, and money can flow across borders easily. AIG is probably the best known example of how problems can cross borders. How do we deal with the risks created in our country by actions somewhere else, as well as the impact of actions in the U.S. on foreign firms?A.10. As noted in our response to Question 1, the global nature of today's financial institutions increasingly requires that supervisory policies and actions be coordinated and implemented on a global basis. The OCC is an active participant in various international supervisory groups whose goal is to coordinate supervisory policy responses, to share information, and to coordinate supervisory activities at individual institutions whose activities span national borders. These groups include the Basel Committee on Bank Supervision (BCBS), the Joint Forum, the Senior Supervisors Group (SSG), and the Financial Stability Board. In addition to coordinating capital and other supervisory standards, these groups promote information sharing across regulators. For example, the SSG recently released a report that evaluates how weaknesses in risk management and internal controls contributed to industry distress during the financial crisis. The observations and conclusions in the report reflect the results of two initiatives undertaken by the SSG. These initiatives involved a series of interviews with firms about funding and liquidity challenges and a self-assessment exercise in which firms were asked to benchmark their risk management practices against recommendations and observations taken from industry and supervisory studies published in 2008. One of the challenges that arise in resolving a cross-border bank crisis is that crisis resolution frameworks are largely designed to deal with domestic failures and to minimize the losses incurred by domestic stakeholders. As such, the current frameworks are not well suited to dealing with serious cross-border problems. In addition to the fact that legal systems and the fiscal responsibility are national matters, a basic reason for the predominance of the territorial approach in resolving banking crises and insolvencies is the absence of a multinational framework for sharing the fiscal burdens for such crises or insolvencies. To help address these issues, the BCBS has established a Cross-border Bank Resolution Group to compare the national policies, legal frameworks and the allocation of responsibilities for the resolution of banks with significant cross-border operations. On September 17, 2009, the BCBS issued for comment a report prepared by this work group that sets out 10 recommendations that reflect the lessons from the recent financial crisis and are designed to improve the resolution of a failing financial institution that has cross-border activities. The report's recommendations fall into three categories including: The strengthening of national resolution powers and their cross-border implementation; Ex ante action and institution-specific contingency planning, which involves the institutions themselves as well as critical home and host jurisdictions; and, Reducing contagion and limiting the impact on the market of the failure of a financial firm by actions such as further strengthening of netting arrangements.We believe adoption of these recommendations will enhance supervisors' ability to deal with many of the issues posed by resolving a cross-border bank. ------ CHRG-111shrg54533--85 PREPARED STATEMENT OF SENATOR TIM JOHNSON Thank you, Mr. Chairman, for holding today's hearing with Secretary Geithner to discuss the Administration's new proposal to restructure our Nation's financial services regulatory structure. As we all know, Federal regulators were forced to make unpopular decisions last year based on the belief that weakened financial firms were so big and so interconnected that their failure would devastate the world economy. Our economy began to nosedive as we faced the worst recession since the Great Depression. When the TARP bill came through Congress last year, I felt it did not go far enough to improve regulation. Instead, we sent companies the message that if they are bad actors, the government will step in and buy the assets that are dragging their companies down. Many of these troubled firms were deemed ``too-big-to-fail,'' and thus we bailed them out with tens of billions of dollars in taxpayer funds. Yesterday, President Obama and his economic team announced some of the biggest regulatory changes to our financial system since the 1930s. Overall, this is a very complicated task to reform and modernize the financial services regulatory structure. All reforms Congress considers must help prevent a repeat of the events of the past 9 months and must shift the burden away from the American taxpayer and to the financial institutions that were reckless. While the devil is in the details, it appears that the President's plan will give regulators the teeth they need to do the job, but also the flexibility to make sure our economy grows. Over the coming months, the Banking Committee will work closely with the Administration to develop legislation that should make the needed changes to our regulatory structure and clear the way for a stronger, brighter and more stable economic future. I look forward to your testimony, Secretary Geithner, as we learn more details about the Administration's proposal. ______ FOMC20070807meeting--143 141,VICE CHAIRMAN GEITHNER.," Thank you, Mr. Chairman. Just quickly, I think we are actually all in a fairly similar place, not far apart in our basic diagnosis, and that’s good, given the complexity of our decisions going forward in some sense. We want to soften slightly the asymmetry in our current statement to give us a bit more flexibility and to show some awareness of the change in the reality out there. Quickly on the statement, first, I agree that, on the question of how we characterize and how we display some recognition of financial market developments, the reference to volatility itself may not capture it. Somebody suggested that we say something instead about going to “risk premium” or something more generally, and I think that might be slightly better—a small point. The second question is whether we should revert to June on the inflation readings in response, I think, to the right observation by President Plosser that this does convey more comfort with a level than the previous wording did. So I would be fine going back to June, but I could also live with this because it conveys a sense that the readings have been and continue to be reasonably favorable. So I would be fine with the way it is, but I could go back to the June language. On the question about whether we refer explicitly to downside risks to growth, which we’ll be doing for the first time—a sort of consequential act—and, if so, how we do it. I would have been fine leaving it implicit rather than introducing it explicitly. I think Don is right: If we’re going to do it, unless we’re going to change the structure of the statement significantly and put some risk assessment on growth in paragraph 2 and some risk assessment around inflation in paragraph 3, then we need to leave it in paragraph 4. So, again, on the risks to growth, I’m okay with putting that language in. I think it’s consistent with the broad objectives. I guess my preference would have been to leave it implicit. Finally, on “predominant,” my own view is that we should not repeat “predominant” and that we would be better off simply stating that the Committee remains concerned about the risks or concerned that inflation will fail to moderate as expected. I don’t think the arguments for sticking with “predominant” are that compelling. I don’t think that taking it out constrains our options going forward. It is true that it’s a shift in some broad sense, but I don’t think we need to say so starkly now that we’ve looked at this set of risks—very different types of risk, some very fast moving, very uncertain, and some slower moving, probably manageable over time—and say that we weighed that balance and we think the latter risks continue to predominate. I think that’s the substance of the argument we face. I think it would be better to slightly soften that further. Having said all of that, I can live with alternative B as drafted. [Laughter]" CHRG-111hhrg56766--65 Mr. Neugebauer," I also heard you say you are now going back internally and looking within your organization as to what are the things we missed, what should we have been looking at, and moving forward. I think one of the questions--I hear almost all of your former colleagues keep using the word ``capital,'' and I truly believe if you want to regulate the financial entities, capital is the primary way to do that. Looking forward, what is going to be the appropriate leverage level that we should allow our large financial institutions to have so they will have a shock absorber moving forward? Some of these entities were leveraged, 30, 40, big numbers. As the Federal Reserve Chairman, primary regulator for many of these entities, what is the appropriate leverage? " CHRG-111hhrg54872--19 Mr. Hensarling," Thank you, Mr. Chairman. As I read the bill summary of the new CFPA law, it reminds me of a title of one of my favorite Led Zeppelin works, ``The Song Remains the Same.'' If in doubt, read the bill. Section 131(b)(1), 136(a)(1) shows that we still have an agency that can outlaw products and practices that are determined to be ``unfair,'' ``abusive,'' or do not substitute ``fair dealing'' totally in their subjective opinion. Are subprime loans inherently abusive? Tell that to the millions of Americans who have homeownership only because of a subprime loan. Are payday loans inherently unfair? Tell that to the millions of Americans who use them to avoid an eviction notice or prevent the utilities from being shut off. What is different? Now a single unelected bureaucrat, as opposed to five unelected bureaucrats, will have the power to decide whether the Rodriguez family in Mesquite, Texas, can obtain a mortgage; whether the King family of Athens, Texas, can get a car loan; or whether the Shane family of Kaufman, Texas, can even get a credit card to buy their groceries. For those who persist in wanting to, by government fiat, restrict credit opportunities in the midst of a national credit crunch, when that particularly impacts low- and middle-income families, the bill is well-designed to achieve those goals. What else remains the same? Product approval can still trump safety and soundness. Clearly, taxpayers are left out of the equation. Preemption remains--multiple standards that add cost and uncertainty. Taxing the agency--it still retains the power to essentially tax the industry, taxes that are passed on to consumers in the form of higher fees and less credit. Plain vanilla goes from mandatory to highly, highly suggested. The bill supposedly is about consumer protection. The best way that we can protect consumers is with competitive markets that encourage product innovations, give customers choices, and prevent fraud and deception. Thank you, Mr. Chairman. " CHRG-111hhrg56766--51 The Chairman," The gentleman from Texas, Mr. Paul. Dr. Paul. I thank you, Mr. Chairman. The Federal Reserve Transparency Act, which has passed the House already, is something that the Federal Reserve obviously has been opposed to, and one of the reasons they are opposed to it, as I understand it, is it would politicize monetary policy, which is not what the bill actually does. The other reason they give is that if Congress had any subtle influence, they would inflate more than the Federal Reserve might want to. It is sort of ironic, the Federal Reserve kept interest rates too low for too long and the consensus now in the financial community is that is true, interest rates are still down at 1 percent, hardly could the Congress influence the Federal Reserve in a negative way by causing them to inflate even more. There has been a cozy political relationship between Congress and the Federal Reserve, although the Congress has been derelict in their responsibilities to perform oversight. When it comes to debt, the Fed is there. They can monetize the debt and keep interest rates low. The Congress can keep spending and get re-elected. They do not have to raise taxes so the Fed can act as a taxing authority. You print the money, dilute the value of the money. Prices go up and price inflation is a tax. When people pay a lot more for their medical care than they used to, they ought to think about the inflationary tax. Also, the Fed accommodates the Congress by liquidating debt, by debasement of the currency, the real value of the money goes down, the real debt actually goes down. In many ways, the Congress and the Fed do have a pretty cozy political relationship. I would like to get to more specifics on the transparency bill because it has been reported in the past that during the 1980's, the Fed actually facilitated a $5.5 billion loan to Saddam Hussein, who then bought weapons from our military industrial complex, and also that is when he invested in a nuclear reactor. A lot of cash was passed through and a lot of people supposed it was passed through the Federal Reserve when there was a provisional government after the 2003 invasion. That money was not appropriated by the Congress, as the Constitution said. Also, there have been reports that the cash used in the Watergate scandal came through the Federal Reserve. When investigators back in those years tried to find out, they were always stonewalled, and we could not get the information. My question is, you object to this idea that I would say give us 6 months, after 6 months, we could find out what we are doing, but what about giving you 10 years? Would you grant that the American people deserve to know whether the Federal Reserve has been involved in this, and what kind of shenanigans they are involved in with foreign countries and foreign central banks, and find out possibly you are working now to bail out Greece, for all we know. Would you grant that after 10 or 15 years, the American people deserve to know? It seems if the Fed was not involved with this at all, it would be to your advantage to say no, we do not do stuff like that. Why could we not open the books up 10 years back and find out the truth of these matters? " FOMC20071211meeting--109 107,VICE CHAIRMAN GEITHNER.," Thank you. The outlook for real activity has deteriorated somewhat since our last meeting. In our modal forecast we now expect several quarters of growth below potential with real GDP for ’08 a bit above 2 percent. The sources of the deterioration in the outlook for us are pretty much as outlined in the Greenbook. What separates us from the Greenbook still is about 40 or 50 basis points of different views on what potential growth is. Our view of the likely path of the output gap is similar. So as in the Greenbook, we expect a deeper contraction in housing activity and prices. We expect nominal and real income growth to slow more than we expected and consumer spending also to moderate more than we had anticipated. Part of that lower path of real spending is, of course, due to energy prices. We also expect the rate of growth in business fixed investment to slow a bit more than we had previously thought, and these changes are in part, but not solely, due to the expected effects of tighter financial conditions. For a given path of the nominal fed funds rate, they are tighter now than they otherwise would have been because of the fall in the estimated neutral rate. In our view, growth in the rest of the world will slow a bit, but along with the effects of the decline in the dollar, it will still provide enough pull for net exports to contribute positively to growth, offsetting part of, but just part of, the deceleration in domestic demand growth. Our forecast for core inflation is little changed. We expect the core PCE deflator to rise at a rate just under 2 percent over the forecast period. Like many of you, we see considerable downside risks to the forecast for growth, and they have intensified since our last meeting. The Greenbook alternative scenarios on housing and the credit crunch seem plausible, perhaps more likely to happen together than to happen independently, and I think reality is likely to fall somewhere between the baseline Greenbook scenario and these two darker alternatives. The risk to the inflation forecast still seems closer to balance in the forecast period. The higher forward curve of energy prices and the lower path of the dollar will raise headline inflation a bit and, in the near term, the core inflation path. But these pressures should be offset by the fall in anticipated pressure on resource utilization, not just here but also globally where the economies that have been growing above potential are likely to slow as monetary policy tightens. I think it’s important to recognize that breakevens in inflation at longer horizons have stayed relatively stable in the context of the fairly substantial move in the dollar, the fairly substantial move in actual and expected energy and commodity prices, and the very dramatic change in expectations of how the Fed is likely to respond to the change in the balance of risks to growth. In light of these changes to the outlook and the risks to the outlook, we’ve lowered our expected path for the fed funds rate. We now think it’s likely that the Committee will reduce the target rate to 3.75 percent over the next few quarters, and this puts our real and our nominal fed funds rate assumption for ’08 a bit under the new path in the Greenbook. We’d raise it back in ’09. But our fed funds rate path is significantly above the market’s estimate. As you’ve all recognized, conditions in markets have deteriorated substantially since our last meeting, but the basic dynamic is still the same. Actual and anticipated losses to financial institutions have risen as the prices of a large range of assets have fallen. Uncertainty over the path of housing prices in the real economy and complexity in valuing assets and structured financial instruments that are most exposed to those risks make it very hard for markets to know with confidence the likely dimension of total losses and who is most exposed to them. Financial institutions have seen a sharp increase in their cost of funds, a substantial shortening in maturities at which they borrow, and a significant reduction in their ability to liquidate or borrow against their assets. Most banks have seen a very large and unanticipated expansion of their balance sheets as they’ve been forced or have chosen to provide funding in various forms. As banks and other financial institutions have moved to position themselves to deal with a more adverse economic and financial environment, they have become much more selective in how they use their liquidity and capital. The consequence of those actions is evident in the sharp increase in the cost of unsecured borrowing and the spreads on secured financing. Now, it’s important to recognize that, although a source of this pressure is concern about macroeconomic risk and its consequence for credit loss and asset values, the consequences of the adjustment by institutions to this new reality are very severe liquidity pressures in markets. These are particularly acute in Europe, and they are—at least in the market’s expectations—likely to persist well beyond year-end. These pressures are the symptom of the underlying problem, as fever is the sign of the immune system’s response to an infection. But just as high fevers can cause organ failure before the infection kills the body, illiquidity itself can threaten market functioning and the economy. The longer we live with these conditions—large spikes in demand for liquid risk-free assets, a general shortening of funding maturities, a limited amount of available financing even against high-quality collateral, the risk of substantial liquidation of financial assets, and the chances of runs on individual institutions’ funds—the more we are vulnerable to a self-reinforcing adverse spiral that leads to a greater retrenchment in credit supply than fundamentals might otherwise suggest and with a greater effect on growth. I don’t think the past four to six months have been kind to those who have argued that this was just a mild and transitory bump. As in August, I think we have to be willing to treat both the fever and the infection and, if you step back a second, the appropriate policy response to this set of challenges will entail a mix of measures. Monetary policy will probably have to be eased further to contain the risk of a more substantial and prolonged contraction in demand growth. I think we will probably need to continue to adjust our various liquidity instruments. We may need to encourage some institutions to raise more equity sooner than they otherwise might choose to do. We need to be very careful to avoid making both types of the classic errors in supervision in financial crises. These are, on the one hand, actions that would amplify the credit crunch by forcing banks to protect their ratios by selling more assets à la New England or, on the other hand, the commission of what you might call irresponsible forbearance à la Japan in the hopes of masking weakness and stretching out the pain. We also need to be careful to keep thinking through more adverse scenarios for the economy and the financial system and the policy responses that may be appropriate if they materialize. The United States is, I think, a remarkably resilient economy still. Outside of housing, we don’t have the same imbalance in inventories with the same degree of overinvestment in other parts of the economy that we have had going into past downturns. Corporate balance sheets still seem relatively healthy. The world economy is no doubt stronger. Current account imbalance is coming down. Our core institutions entered this adjustment period with a fair amount of capital. It is very encouraging to see so many of them start to raise capital so early. The financial infrastructure is more robust. Inflation expectations imply a fair degree of confidence in our ability to keep inflation low over time. The speed and the extent of the adjustment that we’ve seen in housing and by financial institutions to this new reality are really signs of health, of how well our system works. But we need to be cognizant that the market is torn between two quite plausible scenarios. In one, we just grow below potential for a given period of time as credit conditions adjust to this new equilibrium; in the other, we have a deep and protracted recession driven as much by financial headwinds as by other fundamentals. There are good arguments for the former, the more benign scenario, but we need to set policy in a way that reduces the probability of the latter, the more adverse scenario. Thank you." CHRG-111hhrg48867--266 Mr. Silvers," Well, you know, one of my observations from being on the Oversight Panel for TARP, which I think is, sort of, what you are getting at, is that what is a healthy institution can be a puzzling thing. Every recipient, with the exception of AIG, of TARP money has in some respect been designated a healthy institution by the United States Government. So perhaps your question is, well, we are just giving money to healthy institutions already. I am not sure that is a very plausible statement, but it is, more or less, what the record shows. The question of increasing lending, I think, is complex. There is no question that there is a need for more credit in our economy right now. On the other hand, the levels of leverage we had in our economy during the last bubble are not ones we ought to aspire to returning to or sustaining. Getting that balance right is extremely important. And, furthermore, it is also the case, I believe, that allowing very, very large institutions to come apart in a chaotic fashion would be very harmful to our economy. The punch line is I think that we have not learned enough about to what extent TARP's expenditures have produced the increased supply of credit that your question indicates and to what extent that is because of, I think as you put it, the fact that a majority of that money has gone to a group of very large institutions. Those are questions that I know the Oversight Panel is interested in and questions that I am very interested in. I can't tell you what I believe the answer to them to be today. " 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-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. " FinancialCrisisReport--20 By 2003, many lenders began using higher risk lending strategies involving the origination and sale of complex mortgages that differed substantially from the traditional 30-year fixed rate home loan. The following describes some of the securitization practices and higher risk mortgage products that came to dominate the mortgage market in the years leading up to the financial crisis. Securitization. To make home loans sales more efficient and profitable, banks began making increasing use of a mechanism now called “securitization.” In a securitization, a financial institution bundles a large number of home loans into a loan pool, and calculates the amount of mortgage payments that will be paid into that pool by the borrowers. The securitizer then forms a shell corporation or trust, often offshore, to hold the loan pool and use the mortgage revenue stream to support the creation of bonds that make payments to investors over time. Those bonds, which are registered with the SEC, are called residential mortgage backed securities (RMBS) and are typically sold in a public offering to investors. Investors typically make a payment up front, and then hold onto the RMBS securities which repay the principal plus interest over time. The amount of money paid periodically to the RMBS holders is often referred to as the RMBS “coupon rate.” For years, securitization worked well. Borrowers paid their 30-year, fixed rate mortgages with few defaults, and mortgage backed securities built up a reputation as a safe investment. Lenders earned fees for bundling the home loans into pools and either selling the pools or securitizing them into mortgage backed securities. Investment banks also earned fees from working with the lenders to assemble the pools, design the mortgage backed securities, obtain credit ratings for them, and sell the resulting securities to investors. Investors like pension funds, insurance companies, municipalities, university endowments, and hedge funds earned a reasonable rate of return on the RMBS securities they purchased. Due to the 2002 Treasury rule that reduced capital reserves for securitized mortgages, RMBS holdings also became increasingly attractive to banks, which could determine how much capital they needed to hold based on the credit ratings their RMBS securities received from the credit ratings agencies. According to economist Arnold Kling, among other problems, the 2002 rule “created opportunities for banks to lower their ratio of capital to assets through structured financing” and “created the incentive for rating agencies to provide overly optimistic assessment of the risk in mortgage pools.” 15 High Risk Mortgages. The resulting increased demand for mortgage backed securities, joined with Wall Street’s growing appetite for securitization fees, prompted lenders to issue mortgages not only to well qualified borrowers, but also higher risk borrowers. Higher risk borrowers were often referred to as “subprime” borrowers to distinguish them from the more creditworthy “prime” borrowers who traditionally qualified for home loans. Some lenders began 15 “Not What They Had In Mind: A History of Policies that Produced the Financial Crisis of 2008,” September 2009, Mercatus Center, http://mercatus.org/sites/default/files/publication/NotWhatTheyHadInMind(1).pdf. to specialize in issuing loans to subprime borrowers and became known as subprime lenders. 16 FinancialCrisisReport--13 Gemstone 7, even securities which Mr. Lippmann was calling “crap” or “pigs.” Despite the poor quality of the underlying assets, Gemstone’s top three tranches received AAA ratings. Deutsche Bank ultimately sold about $700 million in Gemstone securities, without disclosing to potential investors that its global head trader of CDOs had extremely negative views 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 their purchase. Within months of being issued, the Gemstone 7 securities lost value; by November 2007, they began undergoing credit rating downgrades; and by July 2008, they became nearly worthless. Both Goldman Sachs and Deutsche Bank underwrote securities using loans from subprime lenders known for issuing high risk, poor quality mortgages, and sold risky securities to investors across the United States and around the world. They also enabled the lenders to acquire new funds to originate still more high risk, poor quality loans. Both sold CDO securities without full disclosure of the negative views of some of their employees regarding the underlying assets and, in the case of Goldman, without full disclosure that it was shorting the very CDO securities it was marketing, raising questions about whether Goldman complied with its obligations to issue suitable investment recommendations and disclose material adverse interests. The case studies also illustrate how these two investment banks continued to market new CDOs in 2007, even as U.S. mortgage delinquencies intensified, RMBS securities lost value, the U.S. mortgage market as a whole deteriorated, and investors lost confidence. Both kept producing and selling high risk, poor quality structured finance products in a negative market, in part because stopping the “CDO machine” would have meant less income for structured finance units, smaller executive bonuses, and even the disappearance of CDO desks and personnel, which is what finally happened. The two case studies also illustrate how certain complex structured finance products, such as synthetic CDOs and naked credit default swaps, amplified market risk by allowing investors with no ownership interest in the reference obligations to place unlimited side bets on their performance. Finally, the two case studies demonstrate how proprietary trading led to dramatic losses in the case of Deutsche Bank and undisclosed conflicts of interest in the case of Goldman Sachs. Investment banks were the driving force behind the structured finance products that provided a steady stream of funding for lenders originating high risk, poor quality loans and that magnified risk throughout the U.S. financial system. The investment banks that engineered, sold, traded, and profited from mortgage related structured finance products were a major cause of the financial crisis. CHRG-111hhrg52406--124 The Chairman," Well, if you can do it quickly. We do have a second panel. Mr. Miller of California. Thank you very much. Professor Warren, I really enjoyed your comments on the transparency and disclosure and simplified forms. Is somebody other than an attorney going to draft these? Ms. Warren. I am sorry, is someone other than an attorney-- Mr. Miller of California. Well, I really enjoyed, you talk about transparency and disclosure and simplified forms. But a fair question is, is somebody other than an attorney going to draft these? Ms. Warren. Well, I think, at least what I hope, is this will be done in consultation with the industry and with consumers. Mr. Miller of California. So we are going to put attorneys on it, so we can understand what they are saying. Ms. Warren. So part of the point here is so that we understand that we have products that consumers can understand. If consumers can't understand them, then they don't meet regulatory muster. Mr. Miller of California. If you look at GSEs, they have various programs, and then they constantly evolve different products in that program. They might evolve products daily to meet the consumer demands. And I am concerned about how what you are going to do might impact that. And I guess the most important question I have, have you ever read legislation that comes out of Congress? Ms. Warren. I am sorry. Mr. Miller of California. Have you read the legislation that comes out of Congress and how we mandate and regulate the financial services industry in banks? Ms. Warren. Yes, sir, I teach it. Mr. Miller of California. How do you apply that to a simplified form? Ms. Warren. Well, I think the point is-- Mr. Miller of California. Now, give consideration to RESPA, mortgage closings, and then you have State law to deal with. I am not trying to argue. Just having been a Realtor and a builder and a State legislator, you are going to have the States involved here, too; how is all this going to work in a simplified form? Ms. Warren. Congressman, as I see it, what this agency does is it picks up all of those regulatory burdens that are there now. It puts them into one agency, and it comes up with a slimmer, more effective set of regulations that apply across-the-board wherever the product is issued, regardless of who issues it. Mr. Miller of California. How does a lender deal with the reality of their having to draft some form of a contractual loan document agreement that covers them as a lender and covers the consumer who is getting a loan? And I am looking at all the mandates and all the laws and all the requirements that we place on them where they have to safeguard themselves and safeguard the consumer. Ms. Warren. That is the point, Congressman. We are really trying to change the legal mandates. We are trying to say that more legal mandates of ineffective disclosure is not helping the consumer, is driving up costs for the financial institutions, and is a bad idea. So what we want is a new agency that has the power to say, we are going to slim these down. We are going to make the disclosures work for consumers and frankly be far cheaper for the financial institutions. Where that difference will be felt of course will be for the financial institutions who cannot afford to hire a team of lawyers in order to figure out the current regulatory compliance. Mr. Miller of California. And you are establishing a floor, am correct? Ms. Warren. I'm sorry? Mr. Miller of California. You establish a floor for Federal regulations. Ms. Warren. That is right, that is what is proposed. Mr. Miller of California. How do you deal with the ceiling when you have to deal with the States? I know California, and we regulate the heck out of anything that walks, talks, breaths or ever moved. So what are you going to do with the States when, all of a sudden, these State legislators who think they are more brilliant than you and a committee that you might form, how do you deal with them? I am not being sarcastic. Ms. Warren. Congressman, I know you are not. This creates a floor, and it creates a floor--we really have to be clear here. In response to the fact that the OCC in particular has used its Federal power to protect the financial institutions from any effective regulation, including preventing the States from enforcing their own laws on fraud-- Mr. Miller of California. So we have an override over State regulation for the first time in this type of a form. So RESPA and the way Realtors have to form closing statements and those type of things that the States actually mandate, we are going to supersede that. Ms. Warren. So this is going to bring all of the Federal rulemaking, all of the Federal disclosure responsibilities into one place. And I want to make one important point about preemption. It is my own view. If we get this right, if we get the plain vanilla forms right and they work for the community banks and they work for the customers, if we get that right, the need for the States to write additional regulations, in my view, becomes much less. Mr. Miller of California. But it won't happen in reality. One last question. This is very, very important, and this raises a huge red flag. You said good products will be rewarded, and bad products will be driven out. Who is to determine what the good product is and--I mean, it is a matter of apples and oranges. I like apples; he likes oranges. Ms. Warren. No. It is the customer who will make that decision. That is the whole point behind this. When I can take a 2-page credit card agreement and I can look at four of them and tell instantly what the costs are, what the risks are, and how I get my free gifts, then I can make the decision as a customer. This is about making markets work. That is the point behind it. Mr. Miller of California. I guess I am going to have to buy you lunch to discuss this because I am out of time. This such a complex industry driven by government regulations and mandates and requirements; I don't know how you just forego everything we have done in the past, and we mandate on lenders, and just make it simple without firing all the attorneys. Thank you. I yield back. " Mr. Gutierrez," [presiding] I am not in that big of a hurry. You could continue going. Let me just make a statement about what is kind of going on, what my perspective on what is going on here. So I was here, I think it was in 1994, when we passed legislation to deal with mortgages to make it clearer to people, and then it took the Federal Reserve until this year to pass the rules and the regulations. So, you know, there have been people saying no regulations, no regulations, no regulations, and guess what happened, a lot of people got caught up. And now they passed some nice rules, obviously. Mr. Miller of California. Would the gentleman yield for one second? " 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. ______ 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-111hhrg74090--68 Mr. Leibowitz," Thank you so much, Mr. Chairman. Chairman Rush, Ranking Member Radanovich, Vice Chair Schakowsky, members of the subcommittee, I appreciate the opportunity to be here to discuss consumer protection regulatory reform including President Obama's far-reaching proposal to enhance consumer protection through the creation of a new Consumer Financial Protection Agency, the CFPA. As all of us in this room know and as many of you on the panel articulated and as Mr. Barr also effectively articulated, the need for reform has become as painfully clear as the distress the consumers are now experiencing in these difficult economic times from a failure of regulation. All of us on the Commission support the President's goal of elevating consumer protection, although some of us have different views as to the best means to that end. For my part, this initiative, which enhances the resources and authority for the FTC and which creates the CFPA, is clearly preferable to the status quo. In any case, the Commission will continue to vigorously protect consumers of financial services while this proposal is under discussion and while the CFPA if it is enacted is ramping up. Beyond that, we look forward to working collaboratively with the new agency. In the last 5 years, we have brought more than 100 financial consumer protection cases and have recovered nearly half a billion dollars in the last decade for consumers. Since I last testified before this subcommittee in late March, we have continued aggressively pursuing financial predators, bringing 14 new cases in this area. In fact, today we are announcing distribution of an additional $8 million in consumer redress checks to Americans who were deceived by deceptive mortgage origination fees, and on June 1st, using the new APA rulemaking authority that you gave us in the omnibus appropriations bill, we began a rulemaking addressing mortgage modification and foreclosure rescue scams which have become, as all of you know, all too common recently, and also addressing the entire mortgage lifecycle, advertising, origination, appraisals and servicing. Simply put, this work will help ensure that consumers aren't ripped off by bogus mortgages or false advertising. Mr. Chairman, President Obama emphasized the importance of giving the FTC tools and increased resources, the ones that we need to stop practices that harm consumers and violate the law. First, the proposal grows our agency, giving us the staff that we need to do the job that you all want us to do. Currently we have just over 1,100 FTEs. That is down from about the 1,800 FTEs we had in the late 1970s and early 1980s, despite a considerable growth in the U.S. population, and in our own responsibilities including enforcing canned spam, Do Not Call, COPPA, the Children's Online Privacy Protection Act, Gramm-Leach-Bliley and other statutes. Second, the proposal provides the FTC with APA notice and comment rulemaking which is used by virtually every other agency in the federal government. It would strengthen the Commission's ability to address widespread problems more quickly. Third, the proposal authorizes the FTC to obtain civil penalties for violations of section 5 of the FTC Act. This new power we believe would help deter would-be violations and help protect consumers more effectively. I think something like 47 State attorneys general have fining authority. And by the way, fining authority was originally proposed by Casper Weinberger when he was chairman of the Federal Trade Commission under President Nixon in the early 1970s. Finally, the proposal authorizes the FTC to go after those who aid and abet others who violate the law. We would also urge Congress as you consider this legislation to give both the FTC and the CFPA the ability to bring civil penalty actions on our own, which would put both of us on equal footing with other consumer protection agencies like the SEC and the CFTC and not make us as we do currently have to wait for the Justice Department to clear our going forward. Now, we expect that as with any bold and complex new initiative clarifications will be worked out as the legislative process moves forward, but from my perspective, the President's goal of streamlining the overall system for protecting consumers from financial abuse is more than commendable, and eliminating the balkanization of consumer protection oversight over non-banks and banks, as Mr. Barr has alluded to, is laudable and very, very critical. We do have some concerns, however, about the draft legislation or the legislation as it was initially drafted, although I am optimistic that we can work these out as the legislative process moves forward. So for example, the proposal states that the FTC would have backstop authority but the draft legislation imposes a review period that could require us to wait 120 days before filing certain cases. We also believe it would be helpful to make definitions of the proposal's terms such as credit and financial activity clearer, and let me tell you why with an example. So suppose the FTC finds a telemarketer making illegal robo calls to millions of consumers on the Do Not Call Registry urging them to purchase something like advanced fee credit cards which are, I wouldn't say per se illegal but almost always, let us say often illegal, and suppose that a payment processor participated in the fraud. It is critical that we be able to bring action against all of the malefactors expeditiously but it is unclear under this draft whether we would have the jurisdiction over the telemarketer offering the financial products or the payment processor, and if so, whether the 120-day waiting period would come into play. Now, we have made much progress with Treasury on several of these boundary issues and we are continuing to make progress but getting this right and allowing us to put an immediate halt to harmful practices is crucially important. Having said that, with this committee involving in writing any legislation, I am confident that this very, very important initiative will be considered, discussed, clarified and refined with all open issues resolved in favor of American consumers. We understand, of course, that under this proposal rulemaking authority and primary enforcement responsibility for financial products and services would go to the new agency but we will continue to aggressively enforce these laws as a cop on the beat where necessary as well as each and every other consumer protection law within our jurisdiction. We look forward to working with the Administration and Congress to reach a plan that best protects American consumers, and I thank you for your time. [The prepared statement of Mr. Leibowitz follows:] " FinancialCrisisInquiry--598 ROSEN: I’m Ken Rosen. I want to thank Chairman Angelides and Vice Chairman Thomas, and the commission for having me here. I want to not read my testimony since you have it. But I’m going to talk a little bit about what I think is the epicenter of the crisis—where this started, how it got there, and where we are today, which is the housing market—the housing and residential mortgage market. Excessively easy credit, extremely low interest rates created a house price bubble. And the house price bubble when it burst has really caused a significant part of the problems that we had—at least the—initially. And of course it caused—helped cause the great recession where we have lost over eight million jobs. I think the most important thing to say is how did we get here. And I would say that low interest rates is part of the blame, but really it’s the poorly structured products that came about in this environment. Innovative products are important, and a good thing. And I’ve written papers on—on this in the 1970s and 80s while we needed innovative mortgage products. And they’re good for some people—some households. Subprime— there is a need for having that. But not to the market share it got. Low down payment loans – Alt-A loans, option arms. All those made some sense for a portion of the population. What happened is we layered all these risks. We went from a conservatively written subprime loan to a subprime loan that had no down payment, and didn’t document someone’s income or employment. So we made a mistake from what was a good idea by financial institutions became a bad idea for the entire overall market. And then we combine that with a second component which was I thought bad underwriting. We lowered underwriting standards dramatically. We started this in California, and it spread everywhere. We—we do this sometimes. Liars loans which are stated income loans, and there was rampant fraud at the consumer level. We’ve heard discussion of this at the institutional level, but I think the consumer basically really did this so they could qualify for the loan. There was some complicity on January 13, 2010 the part of brokers and originators. I think—I do not think this was at the high level institutions, but it’s at the individual originator level. And then we had wide-spread speculation. And I submitted an article to you as a commission, which I wrote in 2006 that was published in 2007. Nearly 30 percent of all home sales in the hot markets were just speculators. And this is not a bad thing, but the speculators put down almost no money. They were flipping houses. And our mortgage system was not able to distinguish between a homeowner and a speculator. And I think we really need to do a much better job of that in the future. We already are trying to. We’re— nothing wrong with speculating, but you’ve got to put down hard money -- 30 percent down. Some big number so they’re not destroying the market for the people who want to own and live in houses. There was a regulatory failure, and everybody knew this was happening. Everybody in the country knew this was happening by the middle of 2006 -- late 2006. One of the unregulated institutions—New Century—a mortgage broker—went bankrupt in early 2007. Everybody knew this, but it kept on going on. I tried very hard and others as well to talk to regulators about this—inform them of this—and within institutions—the Fed in particular. There was a big debate going on. Should they do something about it? And it was decided not to. They didn’t think they had the power. They didn’t really believe it was as bad as it was. But there was a big debate with board members about doing something about this. I think really the whole system of a non-recourse loan in both commercial and residential while desirable by the people borrowing has really created this problem. That there is a belief that it’s a—a put option. Things go well, great. If not, I can give it back. And this misalignment of interest at this level—the consumer level, the borrower level—and the misalignment of—of interest throughout the entire system where risk and rewards are disconnected is really how we’re going to fix this. So if I were to summarize I would say too much leverage, poor underwriting and lax regulation. But I want to take you through some of the charts I have. I know I’ve got January 13, 2010 about five more minutes, but tell you where we are today. And I think you have these at the end of the testimony. They’re figures. And let’s take the first one, which is the housing bubble. It says, “Figure One—U.S. Housing, Single Family Starts.” You can see here that we had—hopefully you have it, but if not I’ll describe the numbers. We were producing in single-family starts about 1.1 million a year on average. That’s roughly the average level of single-family starts. And that’s the demographic demand. During the peak moments here, we produced 1.7 million. So we were producing about -- we produced during this whole bubble about a million more new starts then demographic demand would have you produced. And one of the reasons for that was that these—basically people were able to put down $1,000 or $2,000 or $3,000 to control a $100,000 to $200,000 house. It was a—basically a call option. And homebuilders sold them this house. They took an order, and of course they didn’t have to fulfill that order. If prices went up, they take the order and flip the house. So we built about a million too many. We are now building about 500,000 houses, and as you know in many markets this has led to lots of layoffs. I think roughly 15 percent of the decline in employment is in the construction industry. So this is a—a very big negative. But we’ve begun to come back a little bit, and my guess is we’ll slowly recover. I would agree with Mark. It’s going to take three to four years to get recovery here. Maybe a little bit longer. If we skip to this figure three—there was some reference to this earlier—is the house price bubble, which is on the second page there. And the house price bubble I think is really why we’ve had all this fallout. House prices went up in nominal terms dramatically. And in real terms also very dramatically. We’ve had big house price inflations before. In the late 70s we had that happen. But that was accompanied by overall inflation. This time house prices went up, and we did not have overall inflation. So real house prices went up dramatically. And only one other period of time have we ever seen a—a January 13, 2010 drop in house prices that was in a big way, and that was in the 1930s. It really didn’t happen in the post-war period. But we’ve seen a cumulative price decline based on realtor data of about 21 percent based on another index Kay short about 30 percent. So this bubble bursting is what’s caused I think the bad loan issues in the financial sector with mortgages being a big part of it. The chart below that though is what was referred to by Mr. Bass earlier—key thing—housing became unaffordable during 2003, 4 and 5. The affordability—that is the income relative to the payments you had to make wasn’t there. And so that is why we had these new mortgage instruments come about. Because people could not afford to buy the house. And so they had to find an instrument that allowed them to make a lower initial payment. This would not have been a bad thing if they had fully verified the person’s income, they’d have laid down 20 percent, did all the things that made sense. Unfortunately we layered these risks, and that did not happen. So it was the affordability problem that really and partly caused the bubble. But because the bubble itself made people go to these instruments that were at least much more risky. From the investment community side, of course as you said earlier, that people wanted to get higher yields. They weren’t getting them cause the interest rates were so low. So they—investor also wanted these instruments. The fall out is figure five, which is unfortunately not over. In a way you’re investigating what caused this, but we’re still in the middle of this crisis from the point of view of the consumer, and—and Main Street. Wall Street feels great, but Main Street does not feel great. And this just shows you that the delinquency and foreclosure the total non-performing loans continue to mount for all of the—both the risky loans, and also for non-risky loans. Remember, there’s $11 trillion of mortgages. There are about $3 trillion of the risky category. There’s $7 trillion of what is called prime mortgages. And those are going bad January 13, 2010 because house prices have dropped so much, people have lost their jobs, and there’s no end in sight of this. I think 2010 is going to be a bigger year than 2009. And then of course our friends at Fannie Mae and Freddie Mac. Again you can see delinquency rates are rising there dramatically. They are much lower than the—the risky mortgage types even though after some time these numbers are going to continue to rise as far as we can see. The next figure on figure seven shows you the same thing is happening with FHA. Big rises in delinquencies in the FHA mortgage program. So to summarize, we’re not done by any means. The cost to the government so far has been large with the bailouts. But I think that we—we see continual further losses over the next year, year and a half, in the residential mortgage market. So we’re not at all done. I do have some other data which we’ll be able to take in questions. But I— I’m hoping that I will be able to give you some advice in how this happened, and how it—we can make it not happen again. Thank you very much. CHRG-111hhrg53238--12 Mrs. Biggert," Thank you, Mr. Chairman. It is no secret that one of the reasons our country got into this financial mess in the first place is because there simply were too many regulators who weren't doing their job and not talking to one another. Thus, I am very skeptical that for consumers the answer is making government bigger by creating a new Federal agency that is paid for by taxpayers, that tells consumers what financial products they can and cannot have, and tells financial institutions what products they can and cannot offer. There is no question that our financial services regulatory structure is broken; and for both consumers and the health of our financial services industry and the economy, we need to clean it up. However, I fear that we are moving in the wrong direction when we strip from the banking regulators their mission to protect consumers. Instead, we place that responsibility with a new government bureaucracy, an agency that I think should really be called the Credit Rationing and Pricing Agency. Why do I say this? Well, because this new agency, charged with deciding what is an affordable and appropriate product for each consumer, can only result in one or more of three things: First, many consumers who enjoy access to credit today will be denied credit in the future; Second, riskier consumers will have access to affordable products, but who will pay for that risk? It is the less risky consumer whose cost of credit will increase; and Third, financial institutions will be told to offer certain products at a low cost to risky consumers, which will jeopardize the safety and soundness of that financial institution. Secretary Geithner last week couldn't really answer the question, would the safety and soundness banking regulator trump a new consumer regulator if the consumer regulator's policy would put the bank in unsafe territory? We must first do no harm. We must find a balanced approach to financial regulation. I think our Republican plan that puts all the banking regulators and consumer protection functions under one roof is a better answer for the consumer and really gets to the heart of preventing another financial meltdown. I look forward to today's hearing and I yield back. " FOMC20070918meeting--101 99,MS. YELLEN.," Thank you, Mr. Chairman. Readings on core inflation during the intermeeting period have continued to be encouraging, and the downward trend has persisted long enough that I’ve lowered my inflation forecast slightly. With the weaker outlook for growth, I also see less upside inflation risk emanating from cyclical pressures. With respect to economic activity, I’ve downgraded my forecast for growth in the fourth quarter by about the same amount as Greenbook and lowered it only marginally, a bit less than Greenbook, in 2008. The downside risks to this forecast are substantial and worrisome. The downward revision to my forecast reflects three factors: first, incoming data bearing on the outlook; second, my assessment of the likely impact of the financial shock that’s been unfolding since mid-July; third, the offsetting effect of the policy changes I consider appropriate in response to the first two forces. My forecast assumes that the fed funds rate will fall to about 4½ percent in the fourth quarter. In other words, my forecast is premised on timely actions by the Committee to mitigate much of the potential damage. Let me begin by commenting on the economic data that we have received since early August. Some has certainly been positive. Growth in the second quarter was revised upward, suggesting more momentum heading into the current quarter, and most indicators of consumer spending and business fixed investment were also robust. Like most observers, I’ve concluded that these data taken together support a small upward revision in my estimate of third-quarter growth. However, recent data on housing and forward-looking indicators relating to this sector suggest even greater weakness in residential investment than we previously anticipated. Manufacturing activity recently turned down, and importantly to me, the August employment report showed a marked deceleration in payroll employment growth over the past three months, suggesting that the financial shock hit an economy possessing quite a bit less momentum than I had factored into my previous forecast. Moreover, survey measures of consumer confidence are down, and these results probably do incorporate early effects from the recent financial shock. Of course, the most important factor shaping the forecast for the fourth quarter and beyond is the earthquake that began roiling financial markets in mid-July. Our contacts located at the epicenter—those, for example, in the private equity and mortgage markets—report utter devastation. Anecdotal reports from those nearby—for example, our contacts in banking, housing construction, and housing-related businesses—suggest significant damage from the temblor. For example, a large furniture retailer with stores in Utah and Nevada has seen sales fall off, and he has tightened credit terms for his customers and has already frozen his hiring and investment plans. In contrast, our business contacts operating further from the epicenter appear remarkably unfazed. Luckily for them and for us, the financial quake has thus far produced at most minor tremors in their businesses. This is not surprising. It is still too early to expect the ripple effects to be noticed by our contacts or to show up in the spending data. We could take a wait-and-see approach to the financial shock, incorporating its impact on our growth forecasts only after we observe its imprint in the spending data. But such an approach would be misguided and fraught with hazard because it would deprive us of the opportunity to act in time to forestall the likely damage. This means we must do our best to assess the likely effect of the shock. The simplest approach is to rely on our usual forecasting models. However, as David emphasized in his remarks, the shock has not affected to any great extent the financial variables that are typically included in our macro models. Since we last met, there have been only small net changes in broad equity indexes and the dollar. Of course, risk spreads in credit markets are up across a broad range of instruments and for most borrowers, both corporate and households. But there has been an offsetting drop in Treasury rates so that key rates appearing in our models—the interest rate on conforming mortgages and the interest rate facing prime corporate borrowers—are little changed or even slightly lower. It is riskier corporate borrowers and households seeking nonconforming mortgage loans, including jumbos, that have seen their borrowing rates rise over the past few months. But importantly, it is the drop in Treasury yields, about 50 to 100 basis points since early July, that has thus far shielded so many borrowers from higher interest rates, and of course, this drop reflects the market’s expectations that the Committee will ease the stance of monetary policy rather substantially. As I noted, my forecast assumes that we will plan to ease by around 75 basis points by year-end in line with market expectations. Even under this assumption, I see movements in interest rates alone as adding to a modest tightening of financial conditions. But, of course, an evaluation of the likely economic impact from the financial shock must also take into account changes in credit availability and lending terms even though these variables rarely appear explicitly in forecasting models. It is apparent that the availability of lending of some types, including subprime and alt-A mortgages, has diminished substantially or disappeared entirely. Moreover, banks and other financial institutions are imposing tighter terms and conditions across a broad range of corporate and household lending programs. For example, FICO cutoffs have been raised and maximum loan-to-value ratios lowered in many mortgage programs according to our contacts. In part, these changes reflect the pressures that banks and other financial intermediaries are experiencing in the context of severe illiquidity in secondary markets for nonconforming mortgages and other asset-backed securities, asset-backed commercial paper, and term loans in the interbank market. Many of the liquidity problems now afflicting banks and other financial market participants will presumably be resolved at least eventually, but it’s hard to believe that markets will return to business as usual as defined by conditions in the first half of this year even after that occurs. For one thing, many of the structured credit products that became so widely used may prove to be too complex to be viable going forward, and this would more or less permanently reduce the quantity of credit available to many risky borrowers. Moreover, if the financial intermediation that was routinely conducted via asset securitization and off-balance-sheet financing vehicles ultimately migrates back onto the books of the banks, borrowing spreads and lending terms are likely to remain tighter given current limitations on bank capital and the higher costs of conducting intermediation through the banking sector. Most important, the recent widening of spreads appears to reflect a return to more-realistic pricing of risk throughout the economy; this development may be positive for the long run, but it will be contractionary in the short run. Similar to the Greenbook, we’ve incorporated these financial developments into our projection by revising down our forecast for residential construction and home prices. But as we all know, housing is a small sector, so a major question is to what extent the financial shock will spread to other parts of the economy. We see a large drop in house prices as quite likely to adversely affect consumption spending over time through a number of different channels, including wealth effects, collateral effects, and negative effects on spending through the interest rate resets. A big worry is that a significant drop in house prices might occur in the context of job losses, and this could lead to a vicious spiral of foreclosures, further weakness in housing markets, and further reductions in consumer spending. Several alternative simulations in the Greenbook illustrate some of the unpleasant scenarios that could develop. A final concern is that the uncertainty associated with turbulent financial markets could make households and businesses more cautious about spending, causing some investment plans to be put on hold and some planned purchases of houses and consumer durables to be deferred. So at this point I am concerned that the potential effects of the developing credit crunch could be substantial. I recognize that there’s a tremendous amount of uncertainty around any estimate. But I see the skew in the distribution to be primarily to the downside, reflecting possible adverse spillovers from housing to consumption and business investment." CHRG-111shrg52966--75 PREPARED STATEMENT OF SCOTT M. POLAKOFF Acting Director, Office of Thrift Supervision March 18, 2009I. Introduction Good afternoon Chairman Reed, Ranking Member Bunning and members of the Subcommittee. Thank you for inviting me to testify on behalf of the Office of Thrift Supervision (OTS) on how the Federal financial regulators conduct oversight of risk management. I appreciate the opportunity to familiarize the Subcommittee with several critical risk management areas and how OTS has revised its supervisory oversight based on lessons learned. I also appreciate the opportunity to comment on the state of risk management in the financial services industry and OTS's recommendations for improving regulatory oversight and cooperation. In my testimony, I will discuss critical risk management areas that led to the failure or near-failure of an array of financial institutions. I will provide examples of the lessons learned and the actions that OTS has taken to revise industry and examiner guidance to ensure effective and efficient regulation. I will also describe risk management areas that warrant close supervision and provide OTS's perspective on how to proceed. My discussion will focus on five primary risk areas that played roles in the economic crisis: concentration risk, liquidity risk, capital adequacy, loan loss provisioning and fair value accounting.II. Overview of OTS-regulated Entities I would like to begin with an overview of the thrift industry. At the end of 2008, OTS supervised 810 savings associations with total assets of $1.2 trillion and 463 holding company enterprises with approximately $6.1 trillion in U.S. domiciled consolidated assets. The majority of savings associations (97.2 percent) exceed well capitalized regulatory standards with combined assets that represent 95.3 percent of industry aggregate assets. Recent increases in problem assets have resulted primarily from the housing market downturn and rising unemployment. In December 2008, troubled assets (noncurrent loans and repossessed assets) rose to 2.52 percent of assets, up from 1.66 percent a year ago. The current level of troubled assets is the highest since the early 1990s, when it reached 3.74 percent; however, the composition is quite different. While one- to four-family mortgage loans are traditionally lower-risk, they currently account for about 72 percent of the thrift industry's troubled assets. Economic problems are spreading to commercial real estate (nonresidential mortgage, multifamily and construction loans), which now account for 20 percent of the troubled assets. In contrast, 68 percent of troubled assets in 1990 were commercial real estate loans. One- to four-family mortgages accounted for 23 percent of troubled assets. The prominence of residential mortgage loans among troubled assets requires a strong commitment to effective loan modification programs. OTS is collaborating with the Office of the Comptroller of the Currency to produce a quarterly Mortgage Metrics Report that analyzes performance data of first-lien residential mortgage loans serviced by federally regulated savings associations and national banks. The agencies are finalizing the report for the fourth quarter of 2008. The goal is to provide a comprehensive picture of mortgage servicing activities of the industry's largest mortgage servicers. This report includes data on mortgage delinquency rates, home retention actions and foreclosures. The fourth quarter report will include granular information to measure the effectiveness of loan modifications and new data on the affordability and sustainability of loan modifications. Preliminary analysis from the fourth quarter Mortgage Metrics Report indicates that credit quality continues to deteriorate, resulting in increased delinquencies and early payment defaults. However, home retention efforts, including loan modifications and payment plans, continue to increase. The fourth quarter report analyzes modifications based on four categories of payment modification. The two categories that lower the borrower's monthly payment are the most successful in improving affordability and sustainability. Servicers have increased use of these types of loan modifications, which is leading to fewer foreclosures. The number of problem thrifts has risen over the past year. OTS defines problem institutions as those with the two lowest composite safety-and-soundness exam ratings of ``4'' or ``5.'' There were 26 problem thrifts representing 3.2 percent of all thrifts at the end of the year. This is more than double from year-end 2007, when OTS reported 11 problem institutions. One common measurement of capital strength in an unstable economic period is the ratio of tangible common equity capital to tangible assets. The ratio is stable for savings associations, measuring 7.61 percent at the end of 2008. This measurement remains close to the 9-year average of 7.70 percent. Focusing attention on core earnings is another method to assess the strength of insured depository institutions while eliminating volatile items. Core earnings measures exclude one-time events such as branch sale gains or acquisition charges. They also exclude charges for provisions for loan losses, which is a major reason for the losses by savings associations. The thrift industry's operating earnings remained stable and measured 1.39 percent of average assets in 2008. This is consistent with operating earnings of 1.37 percent and 1.34 percent for 2007 and 2006, respectively. Although a focus remains on problem banks and the deteriorating mortgage market, the vast majority of insured financial institutions maintain solid capital, sufficient loan loss reserves, stable operating earnings and effective risk management.III. Critical Risk Areas OTS has learned multiple lessons during this economic cycle and has used this knowledge to refine and improve its regulatory program. The agency conducts independent internal failed bank reviews for savings associations placed in receivership and generates a series of recommended actions to supplement and improve its regulatory oversight. Upon finalizing each review, senior managers distribute internal guidance identifying lessons learned to improve examiners' focus on critical risk management areas. OTS also committed to implementing the recommendations derived from the Material Loss Review reports from the Office of the Inspector General. The agency has made substantial progress in implementing recommended actions to improve regulatory oversight. The OTS closely monitors--in some cases participates in--and responds to risk management recommendations by the Senior Supervisors Group report on Risk Management Practices, the Financial Stability Forum's report on enhancing market and institutional resilience, the Basel Joint Forum's report on the identification and management of risk concentrations, and the Government Accountability Office report on regulatory oversight of risk management systems. The agency reviews these reports and integrates their findings when revising regulatory guidance and examination programs. OTS participated on the Joint Forum working group that produced the report on risk concentrations. Several of the report's recommendations derive from OTS's expertise in supervising or regulating financial institutions ranging from community banks to international conglomerates. All of the Federal banking agencies are members of the international Basel Committee on Banking Supervision, which comprises banking supervisors worldwide. The Basel Committee on Banking Supervision provides an international forum to collaborate and improve the quality of bank supervision. Managing compliance with consumer protection laws is also a critical element of effective enterprise risk management and is a focus of OTS's supervisory oversight of risk management. OTS requires sound compliance risk management programs in all savings associations. Excessive compliance risk can harm consumers, diminish a savings association's reputation, reduce its franchise value and limit its business opportunities. It can also expose a financial institution to supervisory enforcement action and litigation. OTS expects the sophistication of a savings association's risk management program to be appropriate for the size and complexity of the financial institution. OTS places responsibility on a financial institution's Board of Directors for understanding, prescribing limits on and monitoring all risk areas. Traditionally, financial institutions have managed their operations by organizational unit or legal entity rather than from a holistic, enterprise-wide risk management perspective. However, financial institutions are shifting their focus toward enterprise-wide risk management structures. This transition from a silo-based risk management function to horizontal risk management across business lines is an appropriate evolution. One of the lessons of the current crisis and a key recommendation of each of the risk management reports mentioned above is that financial institutions must be aware of how risk concentrations and business activities interrelate throughout the organization. Regulators, in turn, must identify weaknesses in enterprise risk management and ensure that boards of directors take prompt action to correct the deficiencies. OTS communicates refinements in its supervisory program to examiners, Chief Executive Officers, Board members and industry groups through examination handbooks, official correspondence, outreach meetings, and other internal and external issuances. Based on the knowledge we have gained through horizontal reviews of OTS-regulated financial institutions, cooperation with domestic and international financial regulators, routine examination and supervision of savings associations and their holding companies, and failed bank reviews, the agency has identified several key risk management areas for discussion.Concentration Risk Poorly managed concentration risk contributed significantly to the deterioration in performance of several OTS-regulated problem banks. Concentrations are groups of assets or liabilities that have similar characteristics and expose a financial institution to one or more closely related risks. OTS defines a concentration as an asset, liability, or off-balance sheet exposure that exceeds 25 percent of the association's core capital, plus allowances for loan and lease losses. The agency encourages its examiners to use discretion in identifying higher-risk assets or liabilities that may not meet this threshold, but still pose a concentration risk. OTS also encourages financial institutions' Boards of Directors to approve limits and monitor concentrations based on their exposure relative to Tier 1 capital and allowances for loan and lease losses. Concentrations pose risk because the same economic, political, geographic, or other factors can negatively affect the entire group of assets or liabilities. The financial industry and the regulatory community have learned a valuable lesson about the risk exposure of asset, liability and off-balance sheet concentrations. Institutions with concentrations need to manage the risk of individual assets or liabilities, as well as the risk of the whole group. For example, an institution may have a portfolio of prudently underwritten loans located in a single geographic location. The geographic concentration exposes otherwise prudent loans to the risk of loss because a single regional economic event can expose the entire portfolio to losses. If the institution does not appropriately manage its geographic lending activity through size, sector and counterparty limits, then it has heightened risk exposure. Management should regularly evaluate the degree of correlation between related assets or liabilities, and establish internal guidelines and concentration limits that control the institution's risk exposure. The Basel Committee on Banking Supervision Joint Forum's paper on concentration risk surveyed and summarized concentration risk management among financial conglomerates. While its focus was on financial conglomerates, the principles of concentration risk it identified are applicable to all financial institutions. It suggests that concentration risk has three elements. The first element of concentration risk is materiality. Financial institutions must identify whether the risk concentration can produce losses that threaten their health or ability to maintain their core operations. They must also determine whether an interruption in the concentrated business activity would lead to a material change in their risk profile. The second element is the identification of single, or closely related, drivers of risk that may affect each part of the institution differently. Effective risk management requires that the impact of these drivers be integrated into any analysis to assess the overall risk exposure of the institution. The third element is that risk concentrations arise not just in assets, but also in liabilities, off-balance sheet items, or through the execution or processing of transactions. OTS captures each of these elements in its supervisory program and requires examiners to document concentrations of assets, liabilities and off-balance sheet activity in each comprehensive examination report. The agency is acutely aware of the risk that a concentration can pose to an institution, whether the concentration arises from a business strategy, a product type, or a funding program. OTS guidelines recommend establishing limits based on a ratio of the asset, liability, or off-balance sheet item to core capital and allowances for loan and lease losses. In many cases, OTS places limitations on the amount of assets, liabilities, or other activities that expose the institution to concentration risk. Firms should also have additional capital as a buffer against the larger loss potential that a concentration can present. The agency also has expectations that savings associations with high concentration risk establish robust risk management practices to identify, measure, monitor and control the risk. A key concentration risk that OTS identified in the current crisis is the risk exposure of warehouse and pipeline loans in financial institutions that engage in an originate-to-sell business model during stressful market events. In response, OTS updated its one- to four-family real estate lending examination handbook in September 2008. The agency also distributed a letter to Chief Executive Officers outlining revised recommendations for monitoring and managing the level of pipeline, warehouse and credit-enhancing repurchase exposure for mortgage loans originated for sale to nongovernment sponsored purchasers. In the letter, OTS states that any concentration that exceeds 100 percent of Tier 1 capital will receive closer supervisory review. This revised guidance was in response to the lessons learned from recent bank failures and a horizontal review of all OTS institutions to assess the examination and supervision of mortgage banking activity. Another example of the regulatory expectations for concentration risk management is the 2006 guidance on managing commercial real estate concentration risk. The guidance applied to savings associations actively engaged in commercial real estate (CRE) lending, especially those that are entering or rapidly expanding CRE lending. The guidance states that institutions should perform a self-assessment of exposure to concentration risk. They should continually monitor potential risk exposure and report identified concentration risk to senior management and the board of directors. The guidance also recommends implementing risk management policies and procedures to monitor and manage concentration risk based on the size of the portfolio and the level and nature of concentrations. The OTS expects savings associations to continually assess and manage concentration risk. OTS conducts quarterly monitoring of savings associations' investments to determine compliance with portfolio limitations and to assess each association's exposure to concentration risk. An institution should hold capital commensurate with the level and nature of its risk exposure. Accordingly, savings associations with mortgage banking or commercial real estate concentration exposure should assess the credit risk, operational risk and concentration risk of those business activities. In assessing the adequacy of an institution's capital, OTS also considers management expertise, historical performance, underwriting standards, risk management practices and market conditions. By the nature of the thrift charter, savings associations are required to hold a concentration in real estate mortgage or consumer lending-related assets. OTS-regulated savings associations are subject to two distinct statutory restrictions on their assets, which contribute to this inherent concentration in mortgage lending. The first is a requirement that thrifts hold 65 percent of their assets in qualified thrift investments. This ensures that thrifts maintain a focus on mortgage and retail consumer lending activities. The second set of restrictions includes limitations on the ability of savings associations to engage in specific lending activities, including consumer, commercial and small business lending. Although there is merit for maintaining restrictions to ensure that savings associations focus on mortgage and retail consumer and community lending activities consistent with the purpose of the thrift charter, certain asset restrictions contradict the purpose of the charter and compromise safety and soundness. For example, savings associations have no limits on credit card lending, an unsecured lending activity, but are limited to 35 percent of their assets in secured consumer lending activities. This has the clearly unintended effect of promoting unsecured consumer lending activities over secured consumer lending. Similarly, the existing 20 percent of assets limit on small business lending discourages thrifts from pursuing business activities that could diversify their lending operations and credit risk. The OTS has offered several legislative proposals to address these shortcomings, while maintaining the thrift charter's focus on consumer and community lending. These increases would strengthen OTS-regulated institutions by further diversifying their business lines and would increase the availability of credit in local communities. Small business lending is a key to economic growth and recovery, particularly in low- and moderate-income areas.Liquidity Risk Another risk management area that requires additional focus is liquidity risk. OTS and the other U.S. banking agencies published interagency guidance that required institutions to develop a comprehensive liquidity risk management program. As articulated in this interagency guidance, a sound liquidity risk management program includes clearly written policies, well-defined responsibilities, strong management information systems, sound forecasting and analysis, thoughtful contingency planning, scenario analyses, and diversification and management of funding sources. Recent events illustrate that liquidity risk management at many insured depository institutions needs improvement to comply with this guidance. Deficiencies include insufficient holdings of liquid assets, funding risky or illiquid asset portfolios with potentially volatile short-term liabilities, insufficient cash-flow projections and a lack of viable contingency funding plans. The current crisis also identified areas where it is necessary to strengthen supervisory guidance and oversight. In mid 2007, the secondary mortgage markets began showing signs of stress as investor appetite for non-conforming mortgages greatly diminished. Many large institutions that relied on the originate-to-distribute model were trapped by the speed and magnitude of market liquidity evaporation. As the size of their mortgage warehouse ballooned, lenders and depositors became increasingly concerned about the financial health and long-term viability of these organizations. Those institutions that had a strong contingency funding strategy were able to find temporary relief until they could develop longer-term solutions. OTS is working with the other U.S. banking agencies to issue updated interagency guidance on funding liquidity risk management. The revised guidance will incorporate the recent lessons learned and the liquidity guidance issued by the Basel Committee on Banking Supervision. As part of this guidance, the agencies will reiterate the need for diversified funding sources, stress testing and an unencumbered cushion of highly liquid assets that are readily available and are not pledged to payment systems or clearing houses. This increased emphasis on high-quality liquid assets is important because many firms had a misconception about the extent to which decreases in market and funding liquidity are mutually reinforcing. As market liquidity erodes, so does the availability of funding. The regulatory agencies plan to release the revised guidance with a notice for public comment the first half of 2009. OTS is also strengthening its examination and supervision of savings associations with high-risk business models or reliance on volatile funding sources. In some cases, OTS is obtaining daily liquidity monitoring reports from financial institutions to identify cash in-flows and out-flows and the availability of unpledged collateral. We are also stressing the need for institutions to test the actual availability of lines of credit and to work actively with their respective Federal Home Loan Banks to ensure sufficient borrowing capacity. OTS is also conducting a review of liquidity risk management to identify best practices and issue guidance to savings associations. The agency is using the review to develop additional liquidity metrics as a tool for examiners to use to identify institutions with developing liquidity problems.Capital Adequacy OTS and the other Federal banking agencies agree that capital adequacy is a central component of safe and sound banking. Capital absorbs losses, promotes public confidence and provides protection to the deposit insurance fund. It provides a financial cushion for a financial institution to continue operating during adverse events. OTS has learned important lessons about how the capital adequacy rules work in a broad economic downturn and when financial systems are stressed primarily because of systemic events, including the deterioration in values of entire asset classes. This crisis underscores the critical importance of prudent underwriting for every loan. The risk of home loans varies depending upon factors, such as the loan-to-value, borrower creditworthiness, loan terms and other underwriting factors. Yet the risk-based capital requirements do not adequately address the varying levels of risk in different types of home loans. The existing risk-based capital rules treat almost all home loans as having similar risk and assign most of them a 50 percent risk weight, which effectively requires $4 of capital for every $100 dollars of asset value. A more sensitive risk-based capital framework with meaningful risk drivers should encourage Federal depositories to make fewer higher-risk mortgage loans, or to support higher-risk lending activity with a more realistic capital cushion. Among the capital tools available to a supervisor in an environment of financial stress is the early intervention authority under Section 38 of the Federal Deposit Insurance Act, known as Prompt Corrective Action (PCA). The purpose of PCA statutory authority was to require and enable supervisory intervention before an institution becomes critically undercapitalized. PCA is triggered by an institution's capital category, as defined in 12 USC Sec. 1831o and 12 CFR Part 565. Depending on an institution's PCA capital category, the statute automatically imposes certain restrictions and actions. The restrictions begin once an institution falls below the well-capitalized category. In addition to the automatic restrictions, there are other discretionary PCA actions. The expectation is that banking agencies must apply progressively significant restrictions on operations as an institution's capital category declines. To be effective, supervisory intervention must be timely when an institution is experiencing a rapid and severe deterioration in its financial condition. However, because PCA is linked to declining capital categories, we have learned that its utility is limited in a liquidity crisis, particularly when the crisis is widespread. We have witnessed severe and rapid declines in the financial condition of well or adequately capitalized institutions that were precipitated by an inability to meet rapid, sustained deposit outflows or other cash and collateral demands. In the current crisis, PCA has not been an effective supervisory tool because its triggers for supervisory action are capital-driven. Extraordinary liquidity demands typically do not produce the gradual erosion of capital envisioned by PCA. It is possible to modernize the PCA framework to link the PCA system to other risk areas. Liquidity and funding problems can stem from a lack of investor confidence in an institution's financial condition. In the current environment, this may also stem from a lack of confidence in balance sheets of financial institutions and a belief that there is insufficient transparency. While institutions report well-capitalized ratios, investors are questioning the value of those ratios under extreme financial stress when it is difficult to value assets. Some have also questioned the quantity and quality of capital and the validity of capital buffers in stressful periods. The economic crisis demonstrates the interrelationship of portfolio risk, liquidity, risk-based capital rules and PCA. The Agencies will continue to review our rules in light of these lessons learned. OTS and the other Federal banking agencies finalized the Basel II advanced capital adequacy rules, which establish a capital requirement that increases proportionally with loan risk. The advanced rules are mandatory only for the largest financial institutions in the United States, in part due to the complexity of measuring risk and assigning commensurate capital requirements, often requiring a models-based approach. Due to this complexity, implementation of the advanced Basel II rules will take several years. The Agencies have also developed a proposal for a standardized risk-based capital adequacy framework that is simpler than the advanced rule, yet more risk sensitive than the existing framework for home mortgages. If this voluntary framework is finalized in its current form, no one knows how many institutions would adopt it, but most of the banking industry would likely not choose it. The Agencies proposed these new standardized rules in 2008, but based on recent lessons learned, the proposal needs further improvement. OTS supports expanding the risk-based capital refinements in the proposed rule and extending capital modernization to all Federal depositories. In designing the Basel II capital adequacy framework, the Basel Committee intended for Basel II to be a ``living framework.'' As part of its strategic response to address weaknesses revealed by the financial market crisis, the Basel Committee has reviewed the Basel II capital adequacy framework and has developed and published for comment a series of proposed enhancements to strengthen the framework. The Basel Committee has also just announced it is developing a combination of measures to strengthen the level of capital in the banking system to increase resilience to future episodes of economic stress. It plans to introduce standards to increase capital buffers for stress events and to strengthen the quality of bank capital. The Committee also announced that it would review the regulatory minimum level of capital to arrive at a higher level than the current Basel II framework. OTS and the other Agencies continue our work with other Basel Committee members to evaluate the financial crisis and refine our rules.Loan Loss Provision Another area that deserves attention because of the rapid deterioration in credit quality is the adequacy of allowances for loan and lease losses (ALLL). Economic weakness and uncertainty of the timing of the economic recovery require elevated levels of loan loss reserves. Savings associations responded to this environment and outlook by significantly bolstering their ALLL. In the fourth quarter, savings associations added $8.7 billion to loan loss provisions, bringing the total additions to a record $38.7 billion for the year. These substantial loan loss provisions increased the ratio of loss reserves to total loans and leases 63 percent, from 1.10 percent 1 year ago to 1.79 percent at the end of 2008. Because financial institutions build loan loss reserves through charges to earnings, these substantial loss provision expenses are driving industry net losses. The large provision for losses in the fourth quarter resulted in a net loss of $3 billion, or an annualized return on average assets (ROA) of negative 1.02 percent. The record annual provision drove the industry's loss to a record for all of 2008 of $13.4 billion, or an ROA of negative 1.00 percent. Loss provisioning will continue to dampen industry earnings until home prices stabilize, job market losses slow and the employment outlook improves. On September 30, 2008, OTS issued guidance to its examiners and other supervision staff members about the allowance for loan losses. The purpose of the guidance was to highlight best practices for savings associations. This guidance discussed inflection points, or periods of increasing or decreasing losses, the use of lagging data when loss rates change quickly, and validation methods that rely on leading data rather than historical loss experience. Institutions rely on the 2006 interagency guidance, ``Interagency Policy Statement on the Allowance for Loan and Lease Losses and supplemental Questions and Answers on Accounting for Loan and Lease Losses,'' to manage loan loss provisions. This guidance uses the Generally Accepted Accounting Principles' incurred loss model for assessing losses and establishing reserves. When there is a significant economic downturn following an extended period of positive economic performance, the incurred loss model may result in insufficient loan loss allowances and the need for substantial increases. OTS supports refining the current accounting model to one based on expected credit losses for the life of the loan. An expected loss model will result in more robust allowances throughout the credit cycle to absorb all expected charge-offs as they occur over the life of the loan, without regard to the economic environment. The expected loss model would not eliminate pro-cyclicality, but it would allow for earlier recognition of loan losses.Fair Value Accounting Many have blamed the current economic crisis on the use of ``mark-to-market'' accounting. Some assert that this accounting model contributes to pro-cyclicality or 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. In order to increase regulatory capital ratios, those institutions de-leverage by selling assets into stressed, illiquid markets. This triggers a cycle of additional sales at depressed prices and results in further write-downs by institutions holding similar assets. The term ``mark-to-market'' can be misleading. Thrifts carry less than 5 percent of their assets at market value, with gains and losses recognized in earnings and regulatory capital. These include trading assets, derivatives and financial instruments for which the thrift has voluntarily elected the fair-value option. We believe it is appropriate to report these assets at fair value because financial institutions manage them, or should manage them, on a fair-value basis. Fair value accounting requires the recognition in earnings and regulatory capital of significant declines in the fair value of investment securities, including mortgage backed securities. Fair value determinations are more challenging when the markets are illiquid. Financial institutions find it difficult to determine fair value because there is a lack of trades of identical or similar securities. The result is that institutions must rely on models and assumptions to estimate fair value. The OTS supports disclosure of the assumptions used to estimate fair value. Increased transparency would improve confidence in the fair value adjustment. The Securities and Exchange Commission (SEC), in its Report and Recommendations Pursuant to Section 133 of the Emergency Economic Stabilization Act of 2008: Study on Mark-To-Market Accounting, stated that fair value accounting did not play a meaningful role in bank failures in 2008. The SEC staff concluded that U.S. bank failures resulted from growing probable credit losses, concerns about asset quality and, in certain cases, eroding lender and investor confidence. The report also concluded that for the failed banks that did recognize sizable fair-value losses, the reporting of these losses was not the reason the bank failed. OTS believes that refining fair value accounting is a better approach than suspending it. It is possible to improve the accounting standards to respond to both those who insist fair value accounting should continue and those that call for its suspension. The most significant fair value issue facing savings associations relates to nontrading investment securities. Non-trading investment securities are those the institution designates as available-for-sale or held-to-maturity. The concept of ``other-than-temporary impairment'' (or OTTI) is the primary area of concern. Accounting standards call for different impairment (loss) recognition models, based on whether an asset is a loan or a security. Loan impairment reflects only credit losses. The measure of impairment of debt securities is fair value. In the current market, fair value can include recognition of significant additional losses because of illiquidity and other non-credit losses that may be temporary. This discrepancy, although largely overlooked in the past, is at the center of the debate about fair value accounting because the non-credit components of fair value losses in some cases represent the majority of the loss amount. OTS supports an alternative to the current mark-to-market accounting model that is gaining recognition through recent roundtable discussions on accounting standards. The Center for Audit Quality recommended this alternative approach to the SEC in its November 13, 2008 letter responding to the SEC's study of mark-to-market accounting. The proposed alternative would identify and clarify the components of fair value and improve the application and practice of the fair value accounting standards. Fair value estimates incorporate numerous observable data, such as the credit worthiness and paying capacity of the debtor, changes in interest rates and the volume of market liquidity. Under the proposed alternative accounting treatment, financial institutions would continue to report impaired investment securities at fair value. They would separate impairment losses into two components: credit and non-credit. They would continue to report the credit component as a reduction of earnings, but they would report the noncredit component as a direct reduction of equity. The significant result of this alternative accounting treatment is that only the credit loss portion would immediately reduce regulatory capital. It would also mitigate the effects of temporary market volatility on earnings. The non-credit component would result in a direct reduction in equity, but would not reduce earnings or regulatory capital unless the institution sells the security and realizes the loss. The credit component consists of probable declines in expected cash-flows. These declines represent a loss of contractual or estimated cash-flows anticipated by an investor, and should reduce earnings and regulatory capital immediately. OTS believes that this recommendation to recognize the credit loss component of the OTTI impairment through earnings improves the application of the fair value accounting standards. This improvement in the accounting standards will align the recognition of impairment for loans and securities more closely. Financial institutions already record an allowance for loan loss based only on the credit impairment. Because many investment securities held by financial institutions are mortgage- or asset-backed securities, it is reasonable to use a similar model to recognize losses on debt securities. Investor panic to sell certain investments immediately rather than take a longer-term view of their underlying value has exacerbated current market conditions. The desire to stop the decline in fair value fuels these sales because of the current OTTI accounting requirements. Bifurcation of the fair value components will permit investors to take a longer-term view of investments, by only recognizing declines in expected cash-flows in earnings. Other components of fair value adjustments will be reported in a separate section of equity. When markets return to normalized activity, financial institutions can recover these components.IV. Regulatory Restructuring Lessons learned on risk management are helping to guide OTS's position on regulatory restructuring. The events of the past several years have reinforced the need for a review of the framework for the regulatory oversight of financial services firms of all types. The importance of ensuring consistent regulation for similar products regardless of the issuer or originator has become evident, whether the product is a mortgage loan or a complex commercial instrument. One of the goals of creating a new framework should be to ensure scrutiny of all bank products, services and activities. There should be consistent regulation and supervision of every entity that provides bank-like products, services and activities, whether or not it is an insured depository institution. The ``shadow bank system,'' where bank or bank-like products are offered by nonbanks, should be subject to the same rigorous standards as banks. As one element of regulatory modernization, OTS recommends subjecting unevenly regulated or under-regulated mortgage brokers and independent mortgage companies to the same regulatory, supervisory and enforcement regime as insured institutions offering the same products. Another important element in regulatory modernization is establishing a systemic risk regulator. OTS endorses establishing a systemic risk regulator with broad regulatory and monitoring authority of companies whose failure or activities could pose a risk to financial stability. 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.V. Conclusion Effective enterprise risk management, commensurate with the size and complexity of a financial institution's operations, is paramount. The lessons learned from this economic cycle support this conclusion. A holistic approach to identifying, assessing and managing risk is relevant not only for financial institutions, but also for the regulatory environment. The interdependency of each risk area warrants a comprehensive solution from financial institutions and the agencies that regulate them. Thank you, Mr. Chairman, Ranking Member Bunning and members of the Subcommittee for the opportunity to testify on risk management and the steps that OTS is taking to adjust its examinations based on the lessons learned during the economic crisis. Concentration risk, liquidity risk, capital adequacy, allowances for loan and lease losses and fair value accounting are critical areas where risk management deficiencies contributed to the recent turmoil. OTS is committed to refining and improving its oversight to ensure that financial institutions adopt stronger risk management programs. ______ 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. ------ CHRG-111shrg54789--73 Mr. Barr," Senator Warner, this only applies to consumer financial protections. So in our proposal, consumer financial protection issues would be at this one agency and the consumer issues would be able to be examined across the financial services sector. But there is no proposal to have broad Federal prudential---- Senator Warner. No prudential regulation on the whole nonbank sector of the---- " CHRG-111hhrg52261--58 Mrs. Dahlkemper," Thank you, Chairwoman Velazquez and Ranking Member Graves for convening this critical hearing on the impact of financial and regulatory restructuring on small businesses and community lenders. And thank you to the panel of witnesses for joining us today. While it is clear from the recent economic crisis that we must impose greater oversight, transparency and accountability in the financial sector, we must also ensure that our financial regulatory restructuring does not negatively impact the ability of financial institutions to continue to provide the American people, our small businesses and our communities with access to capital. Ensuring liquidity in the market will continue to promote economic recovery. In my district in Pennsylvania, local businesses are reeling as a result of banks not lending. So we have to enact balanced reform, but still allow for a healthy flow of capital. However, we must also ensure that consumers are protected and adequately informed in their financial choices and that they are ensured a variety of financial products that carry better disclosed and understood risk. Mr. Anderson, I do have a couple questions for you. In your testimony, you mentioned a host of Federal regulations that mortgage brokers must comply with. Which Federal agencies are charged with enforcing these regulations? " CHRG-111hhrg56767--60 The Chairman," Thank you. So what we have is--because it has been appointed by several Administrations. So, the Board of Governors has imposed restrictions on all financial institutions that minimizes this as between--if the compensation restrictions are the same, you don't get that. But also I gather--and I was gratified, frankly, that you expressed your support for those elements of H.R. 4173--I know the Federal Reserve is not for all elements of H.R. 4173, our financial regulatory bill--but that you do like the notion that we apply those across-the-board so that you would not have the theoretical competitive disadvantage, if there was one in retention, between the institutions that you regulate and other financial institutions. Is that accurate? " CHRG-111shrg382--3 EXCHANGE COMMISSION Ms. Casey. Chairman Bayh, Ranking Member Corker, and members of the Committee, thank you for inviting me to testify about the international cooperation to modernize financial regulation. I am very pleased to have the opportunity to testify on behalf of the Securities and Exchange Commission on this very important topic. International cooperation is critical to the effectiveness of financial regulatory reform efforts. In reaffirming their commitment to strengthening the global financial system, the G-20 Finance Ministers and Bank Governors recently set forth a number of actions to ``maintain momentum [and] make the system more resilient.'' The G-20 banking statement correctly recognizes that, due to the mobility of capital in today's world of interconnected financial markets, activity can easily shift from one market to another. Only collective regulatory action can be effective in fully addressing cross-border activity in our global financial system. As an SEC Commissioner and Chairman of the Technical Committee of the International Organization of Securities Commissions, I bring the perspective of both a national securities market regulator and a member of the international organization charged with developing a global response to the challenges posed to securities markets by the financial crisis. I also represent the SEC and IOSCO in the Financial Stability Board, where the U.S. representation is led by the Department of Treasury, with the Securities and Exchange Commission and the Federal Reserve Board both serving as members. The financial crisis has made it clear that there are regulatory gaps that we must address. The Commission has recently proposed action to this end in a number of different areas, recognizing, however, that some regulatory gaps and market issues cannot be fully addressed without legislative action. The SEC already is working to achieve consistency on the domestic and international levels, including through IOSCO and the FSB, with banking, insurance, futures, and other financial market regulators. The Commission also is working to ensure respect for the integrity of independent accounting and auditing standard-setting processes in the global regulatory environment. This is essential for the benefit and protection of investors. The Commission has worked actively to achieve consistency in regulatory policy and implementation on an international basis through multilateral, regional, and bilateral mechanisms for many years. The SEC was a founding member of IOSCO and has maintained a leading role in the organization. The Commission's commitment to international cooperation has become increasingly important to its mission in recent years in response to the increasingly global nature of financial markets. In addition to my chairmanship of IOSCO's Technical Committee, Commission staff leads or is very active in IOSCO's standing committees and task forces, as well as many other multilateral organizations. While IOSCO represents the primary vehicle for development of common international approaches to securities market regulation, the Financial Stability Board is another key mechanism for the Commission to engage internationally on broader financial market issues. The Financial Stability Board has a broader scope, with membership comprised of national regulatory and supervisory authorities, standard-setting bodies, and international financial institutions, central bankers, and Finance Ministers. Its mission is to address vulnerabilities and to encourage the development of strong regulatory, supervisory, and other policies in the interest of financial stability. In addition to multilateral global engagement, the Commission participates in regional and bilateral mechanisms for discussion and promotion of common approaches to regulation, such as our engagement in a number of Treasury-led regulatory dialogues, including with the European Commission, Japan, China, and India, as well as with Australia and our North American partners, Canada and Mexico. Securities-regulatory-focused dialogues between the Commission and our counterpart securities regulators in these and other jurisdictions also complement these broader financial sector dialogues. Recently, the Commission and a number of other securities regulators have also entered into bilateral ``supervisory'' memoranda of understanding that go well beyond sharing information on enforcement investigations. These supervisory MOUs represent ground-breaking efforts by national securities regulators to work together to cooperate in the oversight of financial firms that increasingly operate across borders. As these efforts suggest, the infrastructure for international cooperation on securities regulatory policy is well developed, and the Commission plays a key role in promoting rising levels of cooperation and building on our successes in raising standards of cross-border enforcement cooperation. Today the SEC has broad authority to share supervisory information as well as to assist foreign securities authorities in their investigations through various tools, including exercising the SEC's compulsory powers to obtain documents and testimony. In order to facilitate international cooperation, the SEC supports legislation providing authority to the Public Company Accounting Oversight Board, which the SEC oversees, to share confidential supervisory information with foreign counterparts. The Commission believes that granting this authority to the PCAOB would enhance auditor oversight, audit quality, and, ultimately, investor protection. In closing, the Commission looks forward to continuing the ongoing constructive dialogue with our colleagues at the Fed, Treasury, and other agencies, in developing common U.S. position on international cooperation in the future. While the Commission's particular focus--and that of IOSCO on investor protection and efficient and fair markets has remained constant and somewhat distinct from that of banking supervisors and regulators of other market segments, our recent collaborative work, both at home and internationally, continues to enhance our ability to identify and address systemic risks across the world's financial markets and will be central to efforts to strengthen the global financial regulatory system. Thank you again for the opportunity to testify, and I look forward to taking your questions. Senator Bayh. Thank you, Ms. Casey. " Mr. Tarullo," STATEMENT OF DANIEL K. TARULLO, MEMBER, BOARD OF GOVERNORS OF 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? FinancialCrisisReport--315 CDOs.” 1231 The examinations reviewed CRA practices from January 2004 to December 2007. In 2008, the SEC issued a report summarizing its findings. The report found that “there was a substantial increase in the number and in the complexity of RMBS and CDO deals,” “significant aspects of the ratings process were not always disclosed,” the ratings policies and procedures were not fully documented, “the surveillance processes used by the rating agencies appear to have been less robust than the processes used for initial ratings,” and the “rating agencies’ internal audit processes varied significantly.” 1232 In addition, the report raised a number of conflict of interest issues that influenced the ratings process, noted that the rating agencies failed to verify the accuracy or quality of the loan data used to derive their ratings, and raised questions about the factors that were or were not used to derive the credit ratings. 1233 (2) New Developments Although the Credit Rating Agency Reform Act of 2006 strengthened oversight of the credit rating agencies, Congress passed further reforms in response to the financial crisis to address weaknesses in regulatory oversight of the credit rating industry. The Dodd-Frank Act dedicated an entire subtitle to those credit rating reforms which substantially broadened the powers of the SEC to oversee and regulate the credit rating industry and explicitly allowed investors, for the first time, to file civil suits against credit rating agencies. 1234 The major reforms include the following: a. establishment of a new SEC Office of Credit Ratings charged with overseeing the credit rating industry, including by conducting at least annual NRSRO examinations whose reports must be made public; b. SEC authority to discipline, fine, and deregister a credit rating agency and associated personnel for violating the law; c. SEC authority to deregister a credit rating agency for issuing poor ratings; d. authority for investors to file private causes of action against credit rating agencies that knowingly or recklessly fail to conduct a reasonable investigation of a rated product; e. requirements for credit rating agencies to establish internal controls to ensure high quality ratings and disclose information about their rating methodologies and about each issued rating; 1231 7/2008 “Summary Report of Issues Identified in the Commission Staff’s Examinations of Select Credit Rating Agencies,” prepared by the SEC, at 1. The CRAs examined by the SEC were not formally subject to the Credit Rating Agency Reform Act of 2006 or its implementing SEC regulations until September 2007. 1232 Id. at 1-2. 1233 Id. at 14, 17-18, 23-29, 31-37. 1234 See Title IX, Subtitle C – Improvements to the Regulation of Credit Rating Agencies of the Dodd-Frank Act. f. amendments to federal statutes removing references to credit ratings and credit rating agencies in order to reduce reliance on ratings; g. a GAO study to evaluate alternative compensation models for ratings that would create financial incentives to issue more accurate ratings; and h. an SEC study of the conflicts of interest affecting ratings of structured finance products, followed by the mandatory development of a plan to reduce ratings shopping. 1235 FinancialCrisisReport--305 Moody’s staff, however, had raised concerns about personnel shortages impacting their work quality as early as 2002. A 2002 survey of the Structured Finance Group staff reported, for example: “[T]here is some concern about workload and its impact on operating effectiveness. … Most acknowledge that Moody’s intends to run lean, but there is some question of whether effectiveness is compromised by the current deployment of staff.” 1182 Similar concerns were expressed three years later in a 2005 employee survey: “We are over worked. Too many demands are placed on us for admin[istrative] tasks ... and are detracting from primary workflow .... We need better technology to meet the demand of running increasingly sophisticated models.” 1183 In 2006, Moody’s analyst Richard Michalek worried that investment bankers were taking advantage of the fact that analysts did not have the time to understand complex deals. He wrote: “I am worried that we are not able to give these complicated deals the attention they really deserve, and that they (CS) [Credit Suisse] are taking advantage of the ‘light’ review and the growing sense of ‘precedent’.” 1184 Moody’s managers and analysts interviewed by the Subcommittee stated that staff shortages impacted how much time could be spent analyzing a transaction. One analyst responsible for rating CDOs told the Subcommittee that, during the height of the boom, Moody’s analysts didn’t have time to understand the complex deals being rated and had to set priorities on what issues would be examined: “When I joined the [CDO] Group in 1999 there were seven lawyers and the Group rated something on the order of 40 – 60 transactions annually. In 2006, the Group rated over 600 transactions, using the resources of approximately 12 lawyers. The hyper-growth years from the second half of 2004 through 2006 represented a steady and constant adjustment to the amount of time that could be allotted to any particular deal’s analysis, and with that adjustment, a constant re-ordering of the priority assigned to the issues to be raised at rating Committees.” 1185 1181 Id. at 97. 1182 5/2/2002 “Moody’s SFG 2002 Associate Survey: Highlights of Focus Groups and Interviews,” Hearing Exhibit 4/23-92a at 6. 1183 4/7/2006 “Moody’s Investor Service, BES-2005: Presentation to Derivatives Team,” Hearing Exhibit 4/23-92b. 1184 5/1/2006 email from Richard Michalek to Yuri Yoshizawa, Hearing Exhibit 4/23-19. 1185 Prepared statement of Richard Michalek at 20, April 23, 2010 Subcommittee hearing. CHRG-111hhrg52397--39 Chairman Kanjorski," Thank you very much, Mr. Murphy. And next we will hear from Mr. Don Thompson, managing director and associate general counsel of JPMorgan Chase & Co. Mr. Thompson? STATEMENT OF DON THOMPSON, MANAGING DIRECTOR AND ASSOCIATE GENERAL COUNSEL, JPMORGAN CHASE & CO. Mr. Don Thompson. Mr. Chairman, Ranking Member Garrett, and members of the committee, my name is Don Thompson, and I am a managing director and associate general counsel at JPMorgan Chase & Co. Thank you for inviting me to testify at today's hearing. For the past 30 years, American companies have used OTC derivatives to manage interest rate currency and commodity risk. Increasingly, many companies incur risks outside their core operations that if left unmanaged would negatively affect their financial performance and possibly even their viability. In response to marketplace demand, risk management products, such as futures contracts and OTC derivatives, were developed to enable companies to manage risks. OTC derivatives have become a vital part of our economy. According to the most recent data, over 90 percent of the largest American companies and over 50 percent of mid-size companies use OTC products to hedge risk. JPMorgan's role in the OTC derivatives market is to act as a financial intermediary. In much the same way that financial institutions act as a go-between with investors seeking return and borrowers seeking capital, we work with companies looking to manage their risks and entities looking to take on those risks. A number of mainstream American companies have expressed great concern about the unintended consequences of recent policy proposals, particularly at a time when our economy remains fragile. In our view, the effect of forcing such companies to face an exchange or a clearinghouse will limit their ability to manage the risk they incur in operating their businesses and have negative financial consequences for them because of increased collateral posting. These unintended consequences have the potential to harm economic recovery. Let me first touch on some of the benefits of OTC derivatives. Companies today demand customized solutions for risk management and the OTC market provides them. Keep in mind that customization does not necessarily mean complexity. Rather, it means the ability to hand tailor every aspect of a risk management product to the company's needs to ensure that the company is able to offset its risks exactly. For example, a typical OTC derivative transaction might involve a company that is borrowing at a floating interest rate. To protect itself against the risk that interest rates will rise, the company would enter into an interest rate swap. These transactions generally enable the company to pay an amount tied to a fixed interest rate and the dealer counterparty will pay an amount tied to the floating rate of the loan. This protects the company against rising interest rates and allows them to focus on their core operations. In addition, the company is often able to qualify for hedge accounting and thus avoid seeing volatility in its financial reporting that would obscure the true value of its business. OTC derivatives are used in a similar manner by a wide variety of companies seeking to manage volatile commodity prices, foreign exchange rates, and other market exposures. In addition to customization, the other main benefit of OTC derivatives is flexibility with respect to the collateral that supports a derivative transaction. In the interest rate swap example I went through before, the dealer counterparty may ask the company to provide credit support to mitigate the credit risk that it faces in entering into the transaction. Most often, that credit support comes in the same form as the collateral provided for in the extensions of credits by that dealer counterparty to the customer. Thus, if the loan is agreement is secured by property, equipment or accounts receivable, that same high-quality collateral would be used to secure the interest rate swap. As a result, the company does not have to incur additional costs in obtaining and administering collateral for the interest rate swap. It is important to note that although derivatives are currently offered on U.S. exchanges, few companies use these exchange traded contracts for two main reasons: First, exchange-traded products are by necessity highly standardized and not customized. As a result, companies are unable to match the products that are offered on exchanges to their unique portfolio of risks. Second, clearinghouse collateral requirements are by design onerous and inflexible. Clearinghouses require that participants pledge only highly liquid collateral, such as cash or short-term government securities to support their positions. However, companies need their most liquid assets for their working capital and investment purposes. Thus, in the example I gave, if the company had actually hit its hedge on an exchange, it would have had to post cash or readily marketable collateral up front and twice daily thereafter. By transacting in the OTC market, the company is able to use the same collateral that it has already pledged to secure its loan with no additional liquidity demands or administrative burdens. This collateral is high quality, given that it is the basis for the extension of credit in the loan but posting it does not affect the company's operations or liquidity. The flexibility to use various forms of credit support significantly benefits companies because without it, many companies will choose not to hedge risks because they cannot afford to do so. While we believe that exchanges play a valuable role in risk management, not all companies can or want to trade on exchange. Currently, companies have the choice of entering into hedging transactions on exchange or in the OTC markets, and we believe that companies should be allowed to have the choice to continue to use those competing products. The discussion of the benefits of OTC derivatives is not to deny that there have been problems with their use and it is essential that policymakers carefully examine the causes of the financial crisis to ensure that it does not repeat it. We have noted recent press reports indicating that banks are engaged in the concerted effort to avoid regulation. This is absolutely not true. For the past 4 years, major derivatives dealers, working in conjunction with regulators, have been engaged in an extensive effort to improve practices and controls in the OTC derivatives market. The letter referred to is just the latest quarterly submission outlining our efforts to enhance market practices, and we are committed to reforming the regulatory system and increasing confidence in the markets. To that end, we propose the following, which is consistent with the Administration's position, and CFDC Chairman Gensler's recent remarks on the issue: First, financial regulation should be considered on the basis of function, not form; second, a systemic risk regulator should oversee all systemically significant financial institutions and their activities; third, standardized OTC derivative transactions between major market participants should be cleared through regulated clearinghouses; and, finally, enhanced reporting requirements should apply to all OTC derivatives transactions, whether cleared or not. JPMorgan is committed to working with Congress, regulators, and other industry participants to ensure that an appropriate regulatory framework for OTC derivatives is implemented. I appreciate the opportunity to testify and look forward to taking your questions. [The prepared statement of Mr. Don Thompson can be found on page 189 of the appendix.] " CHRG-111hhrg53021Oth--15 Mr. Bachus," Thank you, Mr. Chairman. As the Chairman and the Ranking Member of the Agricultural Committee have said, derivatives serve an important function in the market, they allow--they allow thousands of companies--I am going to start over. Thank you. Does that work? All right. As the three gentlemen before me said, derivatives serve an important function in the market. They allow companies to hedge against risk, to deploy capital more effectively, to lower their costs and to offer protection against fluctuating prices. Derivatives are about shifting risk, and my greatest concern is that we do not want a system, and I fear that the Administration is going down the path of shifting that risk, not to the investors or to the dealers, but ultimately to the taxpayers. The companies, the four companies that will deal in these derivatives--over-the-counter derivatives--the most will be four or five of the largest companies, financial companies in America. All of them will be deemed to be systemically significant. Part of the Administration's proposal is for when these companies get in trouble, and one reason they could get in trouble is trading in these over-the-counter derivatives, because they can protect against risk, they can lower costs. But as we saw with, I guess, Enron as a great example, they can take both dealers and investors down. And when that happens I would like some assurance that the taxpayers are not going to ultimately be the ones who assume that risk, that is not what we ought to be about. Now, leading up to last September, a lot of people made investments, they wrote over-the-counter derivatives, they made billions of dollars, profits on the way up, but when things turned down who was asked to come in and backstop them? Who was asked to take the risk, to suffer the loss? It was the taxpayer. Now I personally believe that we ought to allow corporations to continue to write customized derivatives and that yes, the government can look at them. But another thing that we ought to consider is whether the government is the best party to judge risk? And I say, no. I think the government has a very poor track record of regulators in identifying risk. Are we going to leave--when we start having standardized trading of over-the-counter derivatives, particularly the more complex ones and the regulators bless those trades, or say that they are safe, are we going to attract a whole new generation of investors who think that they are investing in a safe security or future. We found out with Fannie and Freddie that people began to think it was an implied government guarantee and they invested in those stocks. We need to totally avoid any implication that just because the government is going to regulate these markets they are going to insure these markets or backstop these markets. And I would like some assurance from the Secretary of the Treasury that however we ultimately decide the level of regulation--I look forward to the Memorandum of Understanding between the Fed, the CFTC and the SEC--that ultimately the taxpayers do not come in and take the burden, the risk, and the cost of over-the-counter derivatives gone bad. Thank you, Mr. Secretary. " CHRG-111hhrg53021--15 Mr. Bachus," Thank you, Mr. Chairman. As the Chairman and the Ranking Member of the Agricultural Committee have said, derivatives serve an important function in the market, they allow--they allow thousands of companies--I am going to start over. Thank you. Does that work? All right. As the three gentlemen before me said, derivatives serve an important function in the market. They allow companies to hedge against risk, to deploy capital more effectively, to lower their costs and to offer protection against fluctuating prices. Derivatives are about shifting risk, and my greatest concern is that we do not want a system, and I fear that the Administration is going down the path of shifting that risk, not to the investors or to the dealers, but ultimately to the taxpayers. The companies, the four companies that will deal in these derivatives--over-the-counter derivatives--the most will be four or five of the largest companies, financial companies in America. All of them will be deemed to be systemically significant. Part of the Administration's proposal is for when these companies get in trouble, and one reason they could get in trouble is trading in these over-the-counter derivatives, because they can protect against risk, they can lower costs. But as we saw with, I guess, Enron as a great example, they can take both dealers and investors down. And when that happens I would like some assurance that the taxpayers are not going to ultimately be the ones who assume that risk, that is not what we ought to be about. Now, leading up to last September, a lot of people made investments, they wrote over-the-counter derivatives, they made billions of dollars, profits on the way up, but when things turned down who was asked to come in and backstop them? Who was asked to take the risk, to suffer the loss? It was the taxpayer. Now I personally believe that we ought to allow corporations to continue to write customized derivatives and that yes, the government can look at them. But another thing that we ought to consider is whether the government is the best party to judge risk? And I say, no. I think the government has a very poor track record of regulators in identifying risk. Are we going to leave--when we start having standardized trading of over-the-counter derivatives, particularly the more complex ones and the regulators bless those trades, or say that they are safe, are we going to attract a whole new generation of investors who think that they are investing in a safe security or future. We found out with Fannie and Freddie that people began to think it was an implied government guarantee and they invested in those stocks. We need to totally avoid any implication that just because the government is going to regulate these markets they are going to insure these markets or backstop these markets. And I would like some assurance from the Secretary of the Treasury that however we ultimately decide the level of regulation--I look forward to the Memorandum of Understanding between the Fed, the CFTC and the SEC--that ultimately the taxpayers do not come in and take the burden, the risk, and the cost of over-the-counter derivatives gone bad. Thank you, Mr. Secretary. " CHRG-111hhrg56776--200 Mr. Volcker," This is one area where the discussion came up earlier as to whether you have one regulator, or there is some value in having a variety of regulators. There are a lot of small banks. And we now have divided direct supervisor authority over them. I think this is one area where it is possible to argue that having more than one supervisor is not a bad thing. It doesn't pose the same kind of systemic risk that the big institutions do, but there is value to the Federal Reserve, and maybe some value in having more than one agency concern there. Because the FDIC has a legitimate interest in knowing what's going on among a lot of institutions that it may have to--does provide insurance for. Mr. Moore of Kansas. Thank you. Another issue I'm interested in is in looking at how we become dependent on debt across the board: corporations; consumers; governments; and especially financial firms. In a letter to Senators, Tom Hoenig, the president of the Kansas City Fed, wrote last month, ``This financial crisis has shown the levels to which risk-taking and leveraging can go when our largest institutions are protected from failure by public authorities. A stable and robust financial industry will be more, not less, competitive in the global economy. Equitable treatment of financial institutions will end the enormous taxpayer-funded competitive advantage that the largest banks enjoy over the regional and community banks all over the country.'' As we think of how overleveraged the largest financial firms became leading up to the crisis that we have experienced, if the Fed is disconnected from smaller financial institutions who were not overleveraged, and leaving the Fed with nothing to compare to, would that hinder the Fed's supervision of the largest institutions? Any thoughts there, Chairman Bernanke? " CHRG-111hhrg74855--20 Mr. Doyle," Mr. Chairman, thank you for holding this hearing and inviting all of the important stakeholders to provide their testimony today. In particular, I am happy to see Vincent Duane from PJM here today. As you know, PJM is the regional transmission organization that keeps the lights on in my district and I think it is important to get their input on how this bill will affect them. I am glad we are holding this hearing today to bring attention to some potential unintended consequences of reforming our financial regulatory system. It was only a year ago that our financial system was on the edge of grinding to a halt. Though there were many contributing factors, lack of regulations in our commodities market undoubtedly added to the problem. I applaud my colleagues, the chairman of the House Financial Services and Agriculture Committee, for their work on this legislation to remedy the poor regulation of over-the-counter derivatives and force irresponsible speculators out of the market. However, in their attempt to be thorough, I am concerned that my colleagues have overlooked a duplicative effect that this bill could have on energy markets at the end of the day, rate payers, also. Since the creation of regional transmission organizations, FERC has had a responsibility to monitor energy markets in each RTO and review and report on any hint of manipulation or abuse. In fact, with the passage of EPACT 2005, we gave FERC even greater authority to protect against fraud and abuse in electricity and natural gas markets. Let me be clear, we need to clean up our financial derivatives markets and I think this bill does a good job of getting us there. The CFTC needs to increase oversight and control of these financial products and bring more transparency to the swaps market. We just need to be sure that it doesn't inadvertently require our RTOs to endure another layer of regulation that would keep them from providing electricity to consumers at competitive rates. I look forward to the testimony from all our distinguished witnesses and hope that we can produce an excellent bill to bring to the floor. With that, Mr. Chairman, I will yield back my time. " CHRG-111shrg62643--81 Mr. Bernanke," Well, Senator, you have been a leader in this area for a very long time, and, of course, you are well aware that many people, particularly in many cases immigrants or minorities, are utilizing nonmainstream financial institutions, like payday lenders or check cashers, and that frequently that is very costly for them and may involve getting trapped in a cycle of debt where they have to continue taking out more loans at high interest rates in order to pay back their previous loans. So I think it is very important--and you and I have had this discussion on a number of occasions--to bring the broader public into the mainstream financial system, not only for deposits but for credit, for saving, for all the important functions of the financial system for families. I agree that there are some useful things in the bill that will address that, including financial literacy provisions as well. I believe the Consumer Protection Bureau will have some education and literacy components. That is very complementary. The Consumer Bureau will certainly be active in trying to eliminate deceptive, misleading advertising or products, but that alone is really not sufficient for people to make the best use of financial markets and financial products. They have to be educated as well. And, you know, I think that is very positive that we are going to increase the commitment to that training. Senator Akaka. Thank you. Chairman Bernanke, as you mentioned financial literacy, the recently enacted law includes a provision to establish the Office of Financial Education within the newly created Bureau of Consumer Financial Protection. The office will craft a strategy to develop and implement initiatives to improve financial literacy among consumers. What do you think must be done to ensure that consumers are able to make informed financial decisions? " 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-111shrg53176--38 Mr. Joseph," Senator, I am here for you. Senator Bennett. We are grateful for people who serve who are not on the Federal payroll. Madam Chairman, you talked about balance, and as I listened to all of this, I think balance is a word we need to keep very much in front of us--the balance to get the good people and at the same time try to keep our eye on potential conflict of interest. In times of crisis, the impulse is always to go absolutely in the direction of protection against everything else, and the ultimate protection of investors to make sure that they do not lose any money would be to shut down the market, because as long as there is no market, nobody is going to lose anything. And, obviously, we do not want to do that because it is the power of the American market that has allowed entrepreneurs to make America not only very profitable but truly unique. I have done business around the world. I have owned businesses in other countries and done business with companies from other countries. And the American entrepreneurial spirit is indeed unique and the driving force, I think, behind our long-term prosperity. So striking the balance between regulation that will find the Bernie Madoffs and get rid of them, which the public clearly needs to do, and allowing the markets to work is, I think, philosophically your biggest challenge. Ms. Schapiro. I could not agree more. Senator Bennett. Do you want to respond to that? Have you had any late-night thoughts in a quiet room about that? Or have you been so overwhelmed with the details you have not gotten around to thinking about it? Ms. Schapiro. It is a question we confront really every single day, in small issues and large. How do we keep the balance right? How do we do exactly as you say, assure the protection of investors, the integrity of the marketplace, but not regulate everything within an inch of its life so that we do not have any more innovation and we do not have any more opportunity for people with great ideas to bring them to the marketplace? I do not have any wisdom, certainly no more wisdom than you have on this. I just think it is something we have to think about as we approach every single issue. And it is one reason I like very much to have a broad and diverse group of people within the agency and on my personal staff to consult with me on issues, because they bring those different perspectives and they will tell me to slow down, not to get caught up in the moment, and think about the implications of each and every thing we are doing. And I hope we will bring that very deliberative process to all of the issues--which is not to say we will not have lots of disagreements with different constituencies, but we will always try to get the balance right. Senator Bennett. That is my concern, one of my concerns with respect to the proposals that we have before us to restructure our whole regulatory system. Systemic risk, let us give that to the Fed; safety and soundness, let us give that to FDIC; and then transparency and business practices, let us give that to the SEC, and you will all see to it that there is no problem of any kind anywhere else. I was a new Member of this Committee right after the RTC circumstance, and there was an overreaction to the question of making sure every institution is safe and sound. I remember sitting in this room as Members of this Committee were beating up bankers about you are not making enough loans, you are not making any money available to people. And the reaction of the bankers was: Are you kidding? What we have just been through where we were beaten up for being too open in making money available to people who went out and lost it? You are darn right we are not making any loans because the regulators will kill us if we do. We are threatening safety and soundness if we make loans. You are now in an atmosphere very similar to that atmosphere where the populist reaction to things is shut everybody down, and my only concern is that if we overreact and do shut everybody down, we make the recession longer, we hurt the country, and all of the rest of it. One last quick comment. I understand before I came in you did speak about the uptick rule and looking at the locator. You and I have had these conversations. I am very grateful to you that you have now gone public with our private conversations because I still believe the issue of naked short selling is a genuine issue that too many people have said for too long does not really exist, and if it does, it does not really matter because it is really very small. And to those investors who have seen their companies destroyed as a result of it, it is a big deal. Mr. Joseph, did you want to comment on the short-selling thing? You looked expectant there, and I did not want to cut you off. " CHRG-109shrg30354--128 RESPONSE TO WRITTEN QUESTIONS OF SENATOR SHELBY FROM BEN S. BERNANKEQ.1. China's foreign exchange reserves stand at $941.1 billion, creating excess liquidity in their banking system. In addition, various estimates of China's first and second quarter growth rates suggest that the Chinese economy has grown by upward of 10 percent this year. Do you see any danger that the Chinese economy is overheating? Are the Chinese now willing to take all necessary steps, like a revaluation of their currency, which could rein in problems before they pose systemic risk?A.1. The ratio of investment to GDP was over 40 percent in 2005, which is likely too high a rate for an economy to absorb efficiently. This is leading to overcapacity in some industries and is likely to add to the already large stock of bad loans in the future. However, there is less evidence of widespread overheating. Inflation is still quite low, at about 1\1/2\ percent for consumer prices on a 12-month basis, despite the fact that the money supply has been growing at a rate of almost 19 percent. Chinese authorities have indicated that they would like investment to slow and that they would also like growth to be better balanced between external and domestic demand. They have taken some steps to try to encourage consumption. However, they still have not allowed a substantial appreciation of the reminbi, a step that many analysts argue would be the most effective way to address the imbalances in the economy.Q.2. Has the Federal Reserve been asked or offered to provide guidance to the Chinese Central Bank and are you concerned about any spillover effects that a Chinese economic crisis could have in U.S. markets?A.2. The Federal Reserve has provided technical assistance to the People's Bank of China for a number of years on various aspects of central banking. The Federal Reserve has also been supportive of the U.S. Treasury's initiative to provide technical assistance to China in the economic and financial areas. We believe that the chance of a Chinese economic crisis is very low for the foreseeable future. Although the banking sector is burdened with an enormous and probably growing stock of problematic loans, the government possesses sizable resources and is unlikely to allow the banking system to fail. The large stock of foreign exchange reserves also makes a potential currency crisis a very low probability event. However, we do not entirely discount the possibility of a ``hard landing,'' in the form of significantly slower growth, as the authorities attempt to reduce investment growth from its current rapid pace. We do not think this is the most likely outcome, but it is a possibility. Such an outcome would have significant repercussions for other Asian economies, including Japan, and would also be detrimental for some of the other emerging market economies, notably in Latin America and the Middle East, that have been supplying the enormous Chinese demand for oil and other commodities. The impact on the United States would be less direct, given that China is not a major buyer of our exports, but the overall impact on world GDP would certainly have some negative effect on the United States.Q.3. In recent weeks, several banks have suggested that the current Basel II framework should be revised to provide any bank the option to use either the advanced approach or the standardized approach set forth in the original Basel II framework. Apparently, there is concern that Basel II as set forth in the draft NPR released last March would not be cost effective for banks to implement. Does the Federal Reserve support allowing banks such an option? If not, please explain your rationale. Does the Federal Reserve believe that concerns about the cost effectiveness of Basel II as presently set forth in the draft NPR are valid? Would you please update the Committee on the Federal Reserve's timetable for the implementing Basel II and Basel IA? Please provide specific dates, if possible, by which the Federal Reserve expects to have completed each of steps for implementing Basel II and Basel IA.A.3. The Federal Reserve and the other banking agencies have received several comment letters asking that we provide optionality in the United States. Basel II framework similar to that provided in the Basel Mid-Year text. As with other comments we have received on the draft Basel II NPR, and consistent with out duties under the Administrative Procedure Act, we will seriously consider the merits of the suggestion. As I tried to indicate in my response to a similar question posed by Senator Sarbanes, I am concerned that the Basel II standardized approach would not accommodate the risks that the large, complex, internationally active banks take, both on and off their balance sheets. In my judgment, elements of the Basel II standardized approach, particularly those related to the measurement of credit risk, would be more appropriately applied to smaller, less complex, and primarily domestic U.S. banking organizations. That is how it was designed and that is how it appears it will be implemented in other countries. For example, there is no evidence that any of the largest 50 non-U.S. G-10 banks plans to adopt the standardized approach, even though they have the option to do so. Evaluating the cost effectiveness of Basel II NPR requires measurement of both costs and benefits, both of which are difficult. With respect to the costs of compliance, it should be noted that many of the risk measurement and risk management policies and practices required by the draft Basel II NPR are policies and practices that banking organizations adopted or would have adopted even in the absence of Basel II in order to (i) improve their own understanding of their risk profile; (ii) meet supervisory expectations for good risk measurement and management; or (iii) satisfy Basel II regulatory capital requirements in other jurisdictions. On the benefits side, we expect that Basel II will improve the risk sensitivity of our bank regulatory capital framework, remove opportunities for regulatory capital arbitrage, improve our supervisory ability to evaluate a bank's capital adequacy, improve market discipline of banks, and, ultimately enhance the safety and soundness of our banking system. Given the inherent complexities in measuring costs and benefits, it is difficult to evaluate the question of cost effectiveness in any simple terms. We have sought, and will continue to seek, comment from banks and others to gain a better understanding of the costs of compliance with our Basel II proposals. The timetable for implementation of Basel II and Basel IA is set by the four Federal banking agencies acting in concert. That timetable currently contemplates adoption of final rules for Basel II and Basel IA by mid-2007 so that the parallel run for Basel II can begin in January 2008. Transitional capital floors and other safeguards will be in place at least through January 2012 and perhaps longer for some banks depending on when they complete their parallel run. CHRG-111shrg50814--42 Mr. Bernanke," Two points, Senator. First, we did not choose to let Lehman fail. We had no option because we had no authority to stop it. But second, I do believe that the failure of Lehman Brothers and its impact on the world financial market confirms that we made the right judgment with Bear Stearns, that the failure of a large international financial institution has enormously destructive effects on the financial system and consequently on---- Senator Bunning. In other words, there are too many--there are some banks that are too big to fail? " FOMC20070321meeting--207 205,MR. KROSZNER.," As I said in my discussion, obviously I’m very concerned about a reference to financial conditions, especially “still-favorable financial conditions.” But as I also said, I think that it hangs out there a bit naked without some color around it. I would be fine with keeping personal income gains and the gradually waning correction to the housing market. My preference would be just something like “income gains, among other factors” to put something there. But that may be so weak that it may be better to cut off. I’m sympathetic to having some color, but I think the wrong color is the financial market condition." CHRG-110shrg50415--18 Mr. Ludwig," Mr. Chairman and Members of the Committee, I commend you for your leadership in holding these really important hearings on the origins and impact of the crisis developing--evolving in the financial services world. Understanding the root causes of our predicament will allow us to restore our economy and install a regulatory framework that can withstand the challenges of the technology-driven 21st century. I am honored to testify before your Committee, Mr. Chairman, and to contribute my thoughts and answer any questions you have. The increasingly painful and heart-stopping developments in the United States and global financial systems are not the result of mere happenstance. We are in the midst of a historic sea change, particularly in the American financial system, indeed in the direction of the American economy itself. The paradigm of the last decade has been the conviction that un- or underregulated financial services sectors would produce more wealth, net-net. If the system got sick, the thinking went, it could be made well through massive injections of liquidity. This paradigm has not merely shifted--it has imploded. This paradigm implosion is rooted in fundamental imbalances in our economy and financial system, as well as regulatory structures and crisis response mechanisms that are outdated, including importantly: Consumerism run riot, made worse by domestic fiscal laxity and modern financing techniques; A deterioration in market conduct, brought on by a short-term profitability horizon, aided and abetted by technology and globalization; A regulatory hodgepodge involving absent or inadequate regulation of the predominant portion of our financial system and procyclical policies that have not been well conceived; And, finally, a misguided belief that in financial storms we should let bare-knuckled, free-market capitalism as opposed to compassion and balance rule the day. By understanding these root causes of our predicament, we can rebuild from the ashes of the current burnout. For decades we have looked to the consumer as the key driver of our economy. Taken in proportion this is a good thing. However, consumerism has been taken to an extreme, propelled by policies that have resulted in a negative savings rate of historic proportion. Policymakers' excuses that negative savings were not a problem because home prices were rising only caused the consumer to dig a bigger hole for himself. Home and hearth became the consumers' ATM machine as home equity and other consumer loans leveraged the American consumer to the hilt. Such excess would inevitably lead, as it did, to a financial wildfire. The actual sparks that ignited the fire began to fly in the early months of 2006. It was at this moment when house prices begin to level off and fall while at the same time there was an explosion in the use and availability of novel, low-quality mortgage instruments designed to ``help''--and I put ``help'' in quotes--consumers pump every dollar possible out of their homes. Our grandparents' generation would have recognized the ``help'' consumers were getting from financiers and from Government for what it was. Consumers were not being helped. They were being enticed to mortgage not just their homes but their futures and the future of their children on national and personal deficits based on thin promises. The notion that home prices would climb forever and that we could spend our way to financial and national success was accepted unblinkingly. Interest rates held too low for too long, excess liquidity, and structural fiscal and trade deficits based on an imbalanced tax regime benefited the sellers at the expense of those who really could not afford what they were buying. And this excess, this lack of sound standards, was turbo-charged by the plentiful oxygen of model-driven, structured financial products. Importantly and unfortunately, these highly leveraged products, based on misunderstood and often inaccurate ratings, were distributed throughout the world. Derivatives with even thinner capital bases were in turn piled on top of this mountain of structured products. Acronyms for plain old excessive, underregulated leverage--SIVs, CDOs, CDOs squared, swaps, swaptions--lulled us into a false sense of high-tech financial complacency. A second major area of failure that brought on the current conflagration has been a marked deterioration over the last several years in market conduct by too many financial services players--mostly, but not only, the un- and underregulated financial intermediaries. So mortgage brokers sold consumers mortgages that were too often inappropriate for their circumstances in exchange for outsized fees. More heavily regulated financial institutions sliced, diced, and bundled the inappropriate mortgages, selling them off to other intermediaries or end purchasers, feeling no compunction because they held no principal risk. This turn away from traditional relationship finance based on customer care and high integrity standards has been facilitated in part by the increasing financial use of technology and by globalization. Through increasing speed and scale, the face-to-face linkage to the consumer has been attenuated. This has made rules fashioned for a bygone era harder to apply. Finance is in many ways an information business, and the technological revolution we have been living through has been essentially an information technology revolution. The computer has allowed global connectivity, mathematical/financial modeling, and savings to scale that have created entirely new financial products, and allowed, if not driven, rapid and extraordinary consolidations and concentrations on a global scale unthinkable a decade ago. It has also placed financial firms further away from the end-use consumer. In a sense, technology, plus globalization, plus finance has created something quite new, often called ``financial technology.'' Its emergence is a bit like the discovery of fire--productive and transforming when used with care, but enormously destructive when mishandled. Like anything new and dangerous, we should have handled this financial technological fire with great care, with appropriately cautious regulation, with concerns about those--particularly low- and moderate-income Americans--who were touched by it in numerous ways but by no means understood it. But instead of more cautious regulations in this new more dangerous era, we took the regulatory lid off. Over approximately the last decade, the country has been in the thrall of a deregulatory viewpoint which has left us with too few financial regulatory firefighters too far away from where the fire started and where it has burned the hottest. We have allowed a huge portion of our financial system--perhaps as much as 80 percent--to go un- or underregulated. Indeed, going into this crisis, official Washington not only did not know where all the pockets of mortgage-related risk were; they did not know the magnitude of the risk itself. At the same time, the regulated portion of the system has been unevenly regulated. Some aspects of bank regulation--for example, in the anti-money-laundering area--have been very heavily regulated with tens of millions of dollars of fines and enforcement actions being piled on enforcement action. Other aspects of finance--for example, credit standards, securitizations, suitability of products for customer usage--have been markedly less strictly regulated. To add insult to injury, as a result of history and not logic, we have a bank and securities regulatory system that has been unflatteringly referred to as the ``alphabet soup'' of regulators. This alphabet soup of regulators has exacerbated the problem of overregulation in some areas and created gaping holes in other areas. For example, the ``special investment vehicles,'' the SIVs, which were a great portion of the bank subprime mortgage risk, were off-balance-sheet bank holding company constructs that were essentially completely unregulated. As if this were not enough, over the past decade we have allowed a number of procyclical and largely untested policies to grow up that are wholly inappropriate and way too rigid. What I mean by procyclical is that regulatory, accounting, and policy standards and practices tend to move in the same direction as the broader economy. The result is a sort of amplifier effect, in which both good times and the bad times are reinforced as their effects are rapidly transmitted through the economy. And one way to think about it is that the failure of our regulatory, accounting, and policy standards and practices to exert a moderating influence at all times is what makes the highs so high and the lows so low; that is to say, this procyclicality that we have built in now to our accounting and other regulatory systems actually exacerbates these swings in the cycle which we are living through right now. Now, while procyclicality bias sounds rather abstract, it is a real weakness of our financial system with which policymakers must grapple. Some countries already have, as a matter of fact. Now, how does procyclical bias present itself in clinical terms? We see it in our accounting rules. The concepts around mark-to-market accounting and the relatively recent reliance upon accounting formulas instead of judgments in establishing loan loss reserves clearly added to the financial catastrophe. Mark-to-market accounting by definition cannot work when markets cease to operate correctly. Likewise, we have relied on rigid new accounting rules and models to set loan loss reserves with a mark-to-market methodology that has left the reserves too thin to do their job in difficult times. More subtle, but of even greater importance, is the accounting governance mechanism that disconnects accounting rulemaking from business and economic reality, as well as from the public policymaking framework. This has resulted in some rules that run contrary to the time-honored principle that accounting should reflect, not drive, economic reality. Now, every bit as important, perhaps more important even than our off-kilter accounting rules and rulemaking, is that our regulators have allowed short-term pressures to rule our financial institutions. Compensation schemes, too, have rewarded executives for short-term results. All of this has forced our financial institutions, their senior executives, and their boards to ``keep dancing'' when times were good even though they knew in their hearts that the music would stop with a thud. Further, Basel II capital standards, though less of an obvious cause, are certainly not a help in these troubled times. Basel II Pillar 1 is itself too new, too procyclical, too complicated and model-driven. There is no evidence that it in any way has helped in the crisis, and there is evidence that it was overly procyclical. To summarize, gobs of liquidity, consumers on a binge, new highly combustible financial tools, and little effective and overly procyclical regulation has resulted in a financial firestorm. It is as if the modern tools of finance were used to create their magical new fire of finance in the center of our living rooms, filled with highly combustible furniture, and not in a properly regulated fireplace. Too little, too late. To add insult to injury, the response to the rising heat of the fire was a series of too little, too late steps based on an ideology that the market could take care of itself. Bureaucracies proved less flexible than was necessary. Our responses to the conflagration were typically taken after the next fire broke out, not before. The capstone of this initial phase of the effort was the decision to allow Lehman Brothers to fail. To my mind this is what started the financial panic, egged on by the failure to support the preferred stockholders in the Fannie and Freddie nationalizations and the decision to treat AIG so differently from Lehman Brothers. And the panic got out of control because we have allowed short sellers and rumor mongers to roil instead of calm the markets on the one hand and have not had sufficiently flexible circuit breakers to give the markets a bit of a time out on the other. The TARP, the liquidity facilities being created by the Federal Reserve, and the nationalization of parts of the financial system will ultimately get the economy under control. Ultimately. The key is for the Fed and the Treasury to act vigorously and liberally now with the use of these facilities to remove the much discussed stigma of seeking Government support and move these facilities forward. And I still worry that there is a disconnect between policy and bureaucracy, one that can and should be bridged with great haste at this time. It is clear that the deregulatory mantra of the last decade is dead. The real question is how far do we go in terms of regulating the financial system. Do we in essence nationalize it, making banking all but a public utility? I fervently hope not. But we have to massively change how we have been regulating and supervising. We have to take better control of the revolutions in technology and globalization. We have to get the fire back in the fireplace. In order for America to enjoy the benefits of a modern financial system that can allow it to move readily to help rebuild our factories, hospitals, schools, and homes, we need a new regulatory framework, one suited to a technology-driven financial system of the 21st century. Let me quickly go through what I think are the nine key points we need. One, sound finance must start with fair treatment of the consumer and much higher standards of market conduct. I think this is the No. 1 heart of the problem. We must have a financial system that starts with the consumer and with higher standards of market conduct. We cannot allow any American to be knowingly sold inappropriate financial products as has just taken place too often in respect of subprime and Alt-A mortgage products. For all the good we are doing to bolster the financial system, we will have won the battle and lost the war if we fail to redouble our commitment to keeping homeowners now in their homes. No. 2, all financial enterprises should be regulated within a unified framework. In other words, financial enterprises engaged in roughly the same activities that provide roughly the same products should be regulated in roughly the same way. The same logic must apply to institutions of roughly the same size. They should be under roughly the same regulatory regime. Just because an institution chooses one charter or one name does not mean it should be able to manipulate the system and find a lower standard of regulation. Three--and I appreciate your patience--the U.S. must abandon our alphabet soup of regulators and create a more coherent regulatory service. We have a system that is rooted in a proud history, that includes exceptionally fine and dedicated public servants, and that in many ways has served us well in the past. But it is now beyond debate that a banking regulatory framework with its roots in agrarian 18th century America is in urgent need of a radical 21st century change in our global economy. However, the secret to effective regulation is not how we move around the boxes. Mashing the alphabet noodles into one incoherent glob will not make the concoction taste any better. What we need is a much more effective regulatory mechanism. We have to take the whole effort up a notch. We have to put the time and energy into determining both what regulations are effective and what regulations place pure counterproductive and bureaucratic burdens on institutions. We need to professionalize financial services regulations. We have college degrees for everything from carpentry to desktop publishing to commercial fishing, yet we do not have full courses of studies, degrees, or chairs at major universities in supervision and regulation. America is, in fact, blessed with many talented and dedicated examiners and supervisors, almost despite our system, not because of it. We need to deleverage the financial system--this is a very important point--deleverage the financial system and country as a whole and restrain excess liquidity buildup. In this regard, we have to encourage savings, eliminate the structural Federal budget deficit, and contain asset price bubbles before they get so large that pricking them brings down the economy. We must reverse the tendency of the last decade to have procyclical regulatory and accounting policies. Mark-to-market accounting is clearly flawed and must be materially reworked. Finally, we need to align financial rewards for executives with the well-being of their companies and the stakeholders they serve. Clearly, financial institution governance is off kilter. And to give a king's ransom to traders and other financial executives who have in essence beggared their companies and then walked away from a shipwreck to a comfortable retirement is pernicious. At the same time, executives who take the wheel, stay with the vessel, and steer it through stormy seas deserve to be fairly compensated. These are but a few elements of what must be a greatly changed financial services system. I have also submitted for the record a lecture I was asked to deliver on this topic recently before the International Conference of Banking Supervisors, which provides a more detailed description of my thoughts on this matter. For America to continue to be a leader in the world and for finance to serve the needs of our people, we cannot wait. We must start now to learn from our mistakes and move forward and rebuild. Thank you very much. " 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-111hhrg53245--5 Mr. Sherman," Thank you, Mr. Chairman. Some say too big to fail, some say too interconnected to fail. Some of my constituents just think it's too well-connected to fail. We need to design a system for the future that is bailout free. I was disappointed when the Secretary of the Treasury testifying about derivatives said in effect by not answering my question that we should continue to allow derivatives to be written today, that he reserves the right to seek to bail out tomorrow. We need to return to an economic system where bailout is not a possibility. We need to make sure that the resolution authority is extremely clear that it is not bailout authority. And we were still faced with this issue of what is too big to fail. Too big to fail means too big to exist. We cannot put the taxpayer in a position where entities are allowed to grow in their complexity or their size to the point where they can hold the American taxpayer hostage, and say, we're going to take risks. And if these risks turn out badly, you have to bail us out or the entire economy will suffer. The solution is obvious: Prevent risks from being taken that endanger the entire economy. Now, we will be told that taking all these risks is somehow wonderful for the overall Wall Street system. I don't think the American people want to hear it. They want no bailouts in the future; no possibility of bailouts in the future; and they want a system designed where everyone on Wall Street and everyone in Washington can say no bailouts ever. And if that means that our banks have to be smaller than their foreign competition, that is something I think the American people are ready to accept. So let us talk about breaking up those that are too big to fail before we talk about bailing them out, and hopefully we can, through better capital reserves and better regulation, eliminate both possibilities. Thank you. " CHRG-111hhrg49968--11 Mr. Bernanke," No, sir, I am quite sure we would not be. I recognize that many people have raised concerns about various aspects of policies, financial risks that have been incurred, for example. And those are real and serious concerns. But I do think we need to keep in front of us the fact that without the concerted effort of the Federal Reserve, the Treasury, and other agencies like the FDIC, supported by the Congress and the administration, that last fall we very likely would have had a serious and perhaps global financial meltdown, with extraordinarily adverse implications for the U.S. and global economies. I think having averted that and that we now seem to be on a process of slow and gradual repair, both of the financial system and of the economy, is a major accomplishment. And though, again, there are many issues that remain, we must keep in front us the fact that we averted, I think, a very, very serious calamity. " CHRG-110hhrg44900--12 Secretary Paulson," Mr. Chairman, Ranking Member Bachus, thank you very much for holding this hearing and for your leadership on these very important issues. As you know, our financial markets have been experiencing turmoil since last August. It will take additional time to work through these challenges. Progress has not come in a straight line, but much has been accomplished. Our financial institutions are repricing risk, de-leveraging, recognizing losses, raising capital, and improving their financial position. Their ability to raise capital even during times of stress is a testament to our financial institutions and to our financial system. Fannie Mae and Freddie Mac are also working through this challenging period. They play an important and vital role in our economy and housing markets today, and they need to continue to play an important role in the future. Their regulator has made clear that they are adequately capitalized. Market practices and discipline on the part of financial institutions and investors are also improving. Our regulators are shining a light on our challenges. Through the President's Working Group on Financial Markets, we have issued a report analyzing the causes of the turmoil and recommending a comprehensive policy response, implementation of which is well underway. Regulators are enhancing guidance, issuing new rules, and communicating more effectively across agencies domestically and internationally. Although our regulatory architecture and authorities are outdated and less than optimal, we have been working together; while respecting our different authorities or responsibilities, we have been working together to ensure the stability of the financial system, because it is in the interest of the American people that we do so. Today this is by far our most important priority. And our seamless cooperation to achieve it is made possible by the leadership and support provided by this committee and by other leaders in Congress. I have confidence in our regulators and markets. We need to remain focused and continue to address challenges with your support and with your help. But we will ultimately emerge with strong capital markets, which will in turn enable our economy to continue to grow. Now looking beyond this period of market stress, which will eventually pass as these situations always do, I have presented my ideas for improving our regulatory structure and expanding our emergency powers. I look forward to discussing these ideas with you today, even as we continue our primary focus on confronting current challenges and maintaining stable, orderly financial markets. In March, I laid out a Blueprint for a Modernized Financial Regulatory Structure in which we recommended a U.S. regulatory model based on objectives that more closely link the regulatory structure to the reasons why we regulate. Our model proposes three primary regulators: One focused on market stability across the entire financial sector; another focused on safety and soundness at institutions supported by a Federal guarantee; and the third focused on protecting consumers and investors. A major advantage of this structure is its timelessness and its flexibility, and that because it is organized by a regulatory objective rather than by financial institution category, it can more easily respond and adapt to the ever-changing marketplace. If implemented, these recommendations eliminate regulatory competition that creates inefficiencies and can engender a race to the bottom. The Blueprint also recommends a number of near-term steps. These include formalizing the current informal coordination among U.S. financial regulators by amending and enhancing the Executive Order which created the President's Working Group on Financial Markets, and while retaining State level regulation of mortgage origination practices, creating a new Federal level commission, the Mortgage Origination Commission, to establish minimum standards for among other things personal conduct and disciplinary history, minimum educational requirements, testing criteria and procedures, and appropriate licensing revocation standards. The Blueprint includes recommendations on a number of intermediate steps as well, focusing on payment and settlement systems in areas such as futures and securities, where our regulatory structure severely inhibits our competitiveness. We recommended the creation of an optional Federal charter for insurance companies similar to the current dual charter system for banking, and that the thrift charter has run its course and should be phased out. We also recommend the creation of a Federal charter for systemically important payment and settlement systems, and that these systems should be overseen by the Federal Reserve in order to guarantee the integrity of this vital-- " CHRG-111shrg52619--169 PREPARED STATEMENT OF MICHAEL E. FRYZEL Chairman, National Credit Union Administration March 19, 2009Introduction As Chairman of the National Credit Union Administration (NCUA), I appreciate this opportunity to provide my position on ``Modernizing Bank Supervision and Regulation.'' Federally insured credit unions comprise a small but important part of the financial institution community, and NCUA's perspective on this matter will add to the overall understanding of the needs of the credit union industry and the members they serve. \1\--------------------------------------------------------------------------- \1\ 12 U.S.C. 1759. Unlike other financial institutions, credit unions may only serve individuals within a restricted field of membership. Other financial institutions serve customers that generally have no membership interest.--------------------------------------------------------------------------- As NCUA Chairman, I agree with the need for establishing a regulatory oversight entity (systemic risk regulator) whose responsibilities would include monitoring the financial institution regulators and issuing principles-based regulations and guidance. I envision this entity would be responsible for establishing general safety and soundness guidance for federal financial regulators under its control while the individual federal financial regulators would implement and enforce the established guidelines in the institutions they regulate. This entity would also monitor systemic risk across institution types. For this structure to be effective for federally insured credit unions, the National Credit Union Share Insurance Fund (NCUSIF) must remain independent of the Deposit Insurance Fund to maintain the dual regulatory and insurance roles for the NCUA that have been tested and proven to work in the credit union industry for almost 40 years. The NCUA's primary mission is to ensure the safety and soundness of federally insured credit unions. It performs this important public function by examining all federal credit unions, participating in the examination and supervision of federally insured state chartered credit unions in coordination with state regulators, and insuring federally insured credit union members' accounts. In its statutory role as the administrator of the NCUSIF, the NCUA insures and supervises 7,806 federally insured credit unions, representing 98 percent of all credit unions and approximately 88 million members. \2\--------------------------------------------------------------------------- \2\ Approximately 162 state-chartered credit unions are privately insured and are not subject to NCUA oversight. Based on December 31, 2008, Call Report (NCUA Form 5300) data.--------------------------------------------------------------------------- Overall, federally insured, natural person credit unions maintained reasonable financial performance in 2008. As of December 31, 2008, federally insured credit unions maintained a strong level of capital with an aggregate net worth ratio of 10.92 percent. \3\ While earnings decreased from prior levels due to the economic downturn, federally insured credit unions were able to post a 0.30 percent return on average assets in 2008. \4\ Delinquency was reported at 1.37 percent, while net charge-offs was 0.84 percent. \5\ Shares in federally insured credit unions grew at 7.71 percent with membership growing at 2.01 percent, and loans growing at 7.08 percent. \6\--------------------------------------------------------------------------- \3\ Based on December 31, 2008, Call Report (NCUA Form 5300) data. \4\ Ibid. \5\ Ibid. \6\ Ibid.---------------------------------------------------------------------------Federally Insured Credit Unions Require Separate Oversight Federally insured credit unions' unique cooperative, not-for-profit structure and statutory mandate of serving people of modest means necessitate a customized approach to their regulation and supervision. The NCUA should remain an independent agency to preserve the credit union model and protect credit union members as mandated by Congress. An agency responsible for all financial institutions might focus on the larger financial institutions where the systemic risk predominates, potentially to the detriment of smaller federally insured credit unions. As federally insured credit unions are generally the smaller, less complex institutions in a consolidated financial regulator arrangement, the unique character of credit unions would quickly be lost, absorbed by the for-profit model and culture of the banking system. Federally insured credit unions fulfill a specialized role in the domestic marketplace; one that Congress acknowledged is important in assuring consumers have access to basic financial services such as savings and affordable credit products. Loss of federally insured credit unions as a type of financial institution would limit access to these affordable financial services for persons of modest means. Federally insured credit unions serve an important competitive check on for-profit institutions by providing low-cost products and services. Some researchers estimate the competitive presence of credit unions save bank customers $4.3 billion annually. \7\ Research also shows that in many markets, credit unions provide a lower cost alternative to abusive and predatory lenders. The research describes the fees, rates, and terms of the largest United States credit card providers in comparison to credit cards issued by credit unions with similar purchase interest rates but with fewer fees, lower fees, lower default rates, and clearer disclosures. The details of credit union credit card programs show credit card lending is sustainable without exorbitant penalties and misleading terms and conditions. \8\--------------------------------------------------------------------------- \7\ An Estimate of the Influence of Credit Unions on Bank CD and Money Market Deposits in the U.S.--Idaho State University, January 2005. Also, An Analysis of the Benefits of Credit Unions to Bank Loan Customers--American University, January 2005. \8\ Blindfolded Into Debt: A Comparison of Credit Card Costs and Conditions at Banks and Credit Unions. The Woodstock Institute, July 2005.--------------------------------------------------------------------------- Federally insured credit unions provide products geared to the modest consumer at a reasonable price, such as very small loans and low-minimum balance savings products that many banks do not offer. Credit unions enter markets that other financial institutions have not entered or abandoned because these markets were not profitable or there were more lucrative markets to pursue. \9\ Loss of credit unions would reduce service to underserved consumers and hinder outreach and financial literacy efforts.--------------------------------------------------------------------------- \9\ Increase in Bank Branches Shortchanges Lower-Income and Minority Communities: An Analysis of Recent Growth in Chicago Area Bank Branching. The Woodstock Institute, February 2005, Number 27.--------------------------------------------------------------------------- When comparing the size and complexity of federally insured credit unions to banks, even the largest federally insured credit unions are small in comparison. As shown in the graph below, small federally insured credit unions make up the majority of the institutions the NCUA insures. Eighty-four percent of federally insured credit unions have less than $100 million in assets as opposed to 38 percent of the institutions that the Federal Deposit Insurance Corporation (FDIC) insures with the same asset size. \10\ Total assets in the entire federally insured credit union industry are less than the individual total assets of some of the nation's largest banks. \11\--------------------------------------------------------------------------- \10\ FDIC Quarterly Banking Profile--Fourth Quarter 2008. \11\ December 31, 2008, total assets for federally insured credit unions equaled $813.44 billion, while total assets for federally insured banks equaled $13.85 trillion. Based on December 31, 2008, Call Report (NCUA Form 5300) data and FDIC Quarterly Banking Profile--Fourth Quarter 2008.---------------------------------------------------------------------------Specialized Supervision In recognition of the importance of small federally insured credit unions to their memberships, the NCUA established an Office of Small Credit Union Initiatives to foster credit union development, particularly in the expansion of services provided by small federally insured credit unions to all eligible members. Special purpose programs have helped preserve the viability of several institutions by providing access to training, grant assistance, and mentoring. \12\--------------------------------------------------------------------------- \12\ NCUA 2007 Annual Report.--------------------------------------------------------------------------- The NCUA has developed expertise to effectively supervise federally insured credit unions. The agency has a highly trained examination force that understands the intricacies and nuances of federally insured credit unions and their operations. The NCUA's mission includes serving and maintaining a safe, secure credit union community. In order to accomplish this, the NCUA has put in place specialized programs such as the National Examination Team to supervise federally insured credit unions showing a higher risk to the NCUSIF, Subject Matter Examiners to address specific areas of risk, and Economic Development Specialists to provide hands-on assistance to small federally insured credit unions.NCUA's Tailored Guidance Approach The systemic risk regulator would set the general safety and soundness guidelines, while the NCUA would monitor and enforce the specific rules for the federally insured credit union industry. For example, the NCUA has long recognized the safety and soundness issues regarding real estate lending. Real estate lending makes up fifty-four percent of federally insured credit unions' lending portfolio. As a result, the NCUA has provided federally insured credit unions detailed guidance regarding this matter. The below chart outlines the regulatory approach taken with real estate lending. As demonstrated by the guidance issued, the NCUA proactively addresses issues with the industry as they evolve and as they specifically apply to federally insured credit unions. Due to federally insured credit unions' unique characteristics, the NCUA should be maintained as a separate regulator under an overseeing entity to ensure the vital sector of federally insured credit unions is not ``lost in the shuffle'' of the financial institution industry as a whole.Maintain Separate Insurance Fund Funds from federally insured credit unions have established the NCUSIF. The required deposit is calculated at least annually at one percent of each federally insured credit union's insured shares. The fund is commensurate with federally insured credit unions' equity interests and the risk level in the industry. The small institutions that make up the vast majority of federally insured credit unions should not be required to pay for the risk taken on by the large conglomerates. The NCUA has a successful record of regulating federal credit union charters and also serving as insurer for all federally insured credit unions. This structure has stood the test of time, encompassing various adverse economic cycles. The NCUA is the only regulator with this 100 percent dual regulator/insurer role. The overall reporting to a single regulatory body creates a level of efficiency for federally chartered credit unions in managing the regulatory relationship. This unique role has allowed the NCUA to develop economies of scale as a federal agency. The July 1991 Government Accountability Office (GAO) report to Congress considered whether NCUA's insurance function should be separated from the other functions of chartering, regulating, and supervising credit unions. The GAO concluded ``[s]eparation of NCUSIF from NCUA's chartering, regulation, and supervision responsibilities would not, on the basis of their analyses, by itself guarantee either strong supervision or insurance fund health. And such a move could result in additional and duplicative oversight costs. In addition, it could be argued that a regulator/supervisor without insurance responsibility has less incentive to concern itself with the insurance costs, should an institution fail.'' \16\--------------------------------------------------------------------------- \16\ GAO, July 1991 Study.--------------------------------------------------------------------------- The 1997 Treasury study reached conclusions similar to the GAO report. The Treasury study discussed the unique capitalization structure of the NCUSIF and how it fits the cooperative nature of federally insured credit unions and offered the following: \17\--------------------------------------------------------------------------- \17\ Treasury, December 1997 Study of Credit Unions. We found no compelling case for removing the Share Insurance Fund from the NCUA's oversight and transferring it to another federal agency such as the FDIC. The NCUA maintains some level of separation between its insurance activities and its other responsibilities by separating the operating costs of the Fund from its noninsurance expenses. \18\--------------------------------------------------------------------------- \18\ Treasury, December 1997 Study of Credit Unions, page 52. Under the current structure, the NCUA can use supervision to control risks taken by credit unions--providing an additional measure of protection for the Fund. We also believe that separating the Fund from the NCUA could: (1) reduce the regulator's incentives to concern itself with insurance costs, should an institution fail; (2) create possible confusion over the roles and responsibilities of the insurer and of the regulator; and (3) place the insurer in the situation of safeguarding the insurance fund without having control over the risks taken by the insured entities. \19\--------------------------------------------------------------------------- \19\ Ibid, page 52. The financing structure of the Share Insurance Fund fits the cooperative character of credit unions. Because credit unions must expense any losses to the Share Insurance Fund, they have an incentive to monitor each other and the Fund. This financing structure makes transparent the financial support that healthier credit unions give to the members of failing credit unions. Credit unions understand this aspect of the Fund and embrace it as a reflection of their cooperative character. \20\--------------------------------------------------------------------------- \20\ Ibid, page 58. The unique dual regulatory role in which the NCUA operates has proven successful in the credit union industry. At no time under this structure has the credit union system cost the American taxpayers any money.Federally Insured Credit Unions Demonstrate Unique Characteristics Federally insured credit unions are unique financial institutions that exist to serve the needs of their members. The statutory and regulatory frameworks in which federally insured credit unions operate reflect their uniqueness and are significantly different from that of other financial institutions. Comments that follow in this section provide specific examples for federal credit unions. However, most of the examples also apply to federally insured state chartered credit unions because of their similar organization as institutions designed to promote thrift. \21\--------------------------------------------------------------------------- \21\ 12 U.S.C. 1781(c)(1)(E).---------------------------------------------------------------------------One Member One Vote The federal credit union charter is the only federal financial charter in the United States that gives every member an equal voice in how their institution is operated regardless of the amount of shares on deposit with its ``one member, one vote'' cooperative structure. \22\ This option allows federal credit unions to be democratically governed. The federal credit union charter provides an important pro-consumer alternative in the financial services industry.--------------------------------------------------------------------------- \22\ 12 U.S.C. 1760.---------------------------------------------------------------------------Field of Membership Federal credit unions are not-for-profit, member-owned cooperatives that exist to provide their members with the best possible rates and service. A federal credit union is chartered to serve a field of membership that shares a common bond such as the employees of a company, members of an association, or a local community. Therefore, federal credit unions may not serve the general public like other financial institutions and the federal credit unions' activities are largely limited to domestic activities, which has minimized the impact of globalization in the federal credit union industry. Due to this defined and limited field of membership, federal credit unions have less ability to grow into large institutions as demonstrated by 84 percent of federally insured credit unions having less than $100 million in assets. \23\--------------------------------------------------------------------------- \23\ Based on December 31, 2008, Call Report (NCUA Form 5300) data.---------------------------------------------------------------------------Volunteer Board of Directors Federal credit unions are managed largely on a volunteer basis. The board of directors for each federal credit union consists of a volunteer board of directors elected by, and from the membership. \24\ By statute, no member of the board may be compensated as such; however, a federal credit union may compensate one individual who serves as an officer of the board. \25\--------------------------------------------------------------------------- \24\ 12 U.S.C. 1761(a). \25\ 12 U.S.C. 1761(c).---------------------------------------------------------------------------Consumer Protection The Federal Credit Union Act requires federal credit union boards of directors to appoint not less than three members or more than five members to serve as members of the supervisory committee. \26\ The purpose of the supervisory committee is to ensure independent oversight of the board of directors and management and to advocate the best interests of the members. The supervisory committee either performs or contracts with a third-party to perform an annual audit of the federal credit union's books and records. \27\ The supervisory committee also plays an important role as the member advocate.--------------------------------------------------------------------------- \26\ 12 U.S.C. 1761b. \27\ 12 U.S.C. 1761d.--------------------------------------------------------------------------- As the member advocate, the supervisory committee is charged with reviewing member complaints. \28\ Complaints cover a broad spectrum of areas, including annual meeting procedures, dividend rates and terms, and credit union services. Regardless of the nature of the complaint, NCUA requires supervisory committees to conduct a full and complete investigation. When addressing member complaints, supervisory committees will determine the appropriate course of action after thoroughly reviewing the unique circumstances surrounding each complaint. \29\--------------------------------------------------------------------------- \28\ As noted in the preamble of final rule incorporating the standard federal credit union bylaws into NCUA Rules and Regulations Part 701. \29\ Supervisory Committee Guide, Chapter 4, Publication 4017/8023 Revised December 1999.--------------------------------------------------------------------------- This committee and function of member advocacy are unique to federal credit unions. No member of the supervisory committee can be compensated. \30\--------------------------------------------------------------------------- \30\ 12 U.S.C. 1761.---------------------------------------------------------------------------Regulatory Limitations While there have been significant changes in the financial services environment since 1934 when the Federal Credit Union Act was implemented, federal credit unions have only had modest gains in the breadth of services offered relative to the broad authorities and services of other financial institutions. By virtue of their enabling legislation along with regulations established by the NCUA, federal credit unions are more restricted in their operation than other financial institutions. A discussion of some of these limitations follows.Investment Limitations Federal credit unions have relatively few permissible investment options. Investments are largely limited to United States debt obligations, federal government agency instruments, and insured deposits. \31\ Federal credit unions cannot invest in a diverse range of higher yielding products, including commercial paper and corporate debt securities. Also, federal credit unions have limited authority for broker-dealer relationships. \32\ These limitations have helped credit unions weather the current economic downturn.--------------------------------------------------------------------------- \31\ NCUA Rules and Regulations Part 703. \32\ NCUA Rules and Regulations Part 703.---------------------------------------------------------------------------Affiliation Limitations Federal credit unions are much more limited than other financial institutions in the types of businesses in which they engage and in the kinds of affiliates with which they deal. Federal credit unions cannot invest in the shares of an insurance company or control another financial depository institution. Also, they cannot be part of a financial services holding company and become affiliates of other depository institutions or insurance companies. Federal credit unions are limited to only the powers established in the Federal Credit Union Act. \33\--------------------------------------------------------------------------- \33\ 12 U.S.C. 1757.---------------------------------------------------------------------------Capital Limitations Unlike other financial institutions, federal credit unions cannot issue stock to raise additional capital. \34\ Also, federal credit unions have borrowing authority limited to 50 percent of paid-in and unimpaired capital and surplus. \35\--------------------------------------------------------------------------- \34\ 12 U.S.C. 1790d(b)(1)(B)(i). \35\ 12 U.S.C. 1757(9).--------------------------------------------------------------------------- A federal credit union can only build net worth through its retained earnings, unless it is a low-income designated credit union that can accept secondary capital contributions. \36\ Federally insured credit unions must also hold 200 basis points more in capital than other federally insured financial institutions in order to be considered ``well-capitalized'' under federal ``Prompt Corrective Action'' laws. \37\ In addition, federal credit unions must transfer their earnings to net worth and loss reserve accounts or distribute it to their membership through dividends, relatively lower loan rates, or relatively lower fees.--------------------------------------------------------------------------- \36\ 12 U.S.C. 1790d(o)(2)(B). \37\ 12 U.S.C. 1790d.---------------------------------------------------------------------------Lending Limitations Federal credit unions are not permitted to charge a prepayment penalty in any type of loan whether consumer or business. \38\ With the exception of certain consumer mortgage loans, federal credit unions cannot make loans with a maturity greater than 15 years. \39\ Also, federal credit unions are subject to a federal statutory usury, currently set at 18 percent, which is unique among federally chartered financial institutions and far more restrictive than state usury laws. \40\--------------------------------------------------------------------------- \38\ 12 U.S.C. 1757(5)(viii). \39\ 12 U.S.C. 1757(5). \40\ 12 U.S.C. 1757(5)(A)(vi).--------------------------------------------------------------------------- While federal credit unions have freedom in making consumer and mortgage loans to members, except with regard to limits to one borrower and loan-to-value restrictions, they are severely restricted in the kind and amount of member business loans they can underwrite. Some member business lending limits include restrictions on the total amount of loans, loan to value requirements, construction loan limits, and maturity limits. \41\--------------------------------------------------------------------------- \41\ 12 U.S.C. 1757a and NCUA Rules and Regulations Part 723.---------------------------------------------------------------------------Access to Credit Despite regulatory constraints, federally insured credit unions continue to follow their mission of providing credit to persons of modest means. Amid the tightening credit situation facing the nation, federally insured credit unions have continued to fulfill their members' borrowing needs. While other types of lenders severely curtailed credit, federally insured credit unions experienced a 7.08 percent loan growth in 2008. Credit unions remain fundamentally different from other forms of financial institutions based on their member-owned, democratically operated, not-for-profit cooperative structure. Loss of credit unions as a type of financial institution would severely limit the access to financial services for many Americans.Regulatory Framework Recommendation I agree with the need for establishing a regulatory oversight entity to help mitigate risk to our nation's financial system. It is my recommendation that Congress maintain multiple financial regulators and charter options to enable the continued checks and balances such a structure produces. The oversight entity's main functions should be to establish broad safety and soundness principles and then monitor the individual financial regulators to ensure the established principles are implemented. This structure also allows the oversight entity to set objective-based standards in a more proactive manner, and would help alleviate competitive conflict detracting from the resolution of economic downturns. This type of structure would also promote uniformity in the supervision of financial institutions while affording the preservation of the different segments of the financial industry, including the credit union industry.Conclusions Federally insured credit union service remains focused on providing basic and affordable financial services to members. Credit unions are an important, but relatively small, segment of the financial institution industry serving a unique niche. \42\ As a logical extension to this, the NCUSIF, which is funded by the required insurance contributions of federally insured credit unions, should be kept separate from any bank insurance fund. This would maintain an appropriate level of diversification in the financial system.--------------------------------------------------------------------------- \42\ As of December 31, 2008, approximately $14.67 trillion in assets were held in federally insured depository institutions. Banks and other savings institutions insured by the FDIC held $13.85 trillion, or 94.44 percent of these assets. Credit unions insured by the NCUSIF held $813.44 billion, or 5.56 percent of all federally insured assets.--------------------------------------------------------------------------- While the NCUA could be supportive of a regulatory oversight entity, the agency should maintain its dual regulatory functions of regulator and insurer in order to ensure the federally insured credit union segment of the financial industry is preserved. ______ CHRG-111hhrg51698--550 Mr. Fewer," Thank you, Mr. Chairman. Chairman Peterson, Ranking Member Lucas and Members of the Committee, my name is Donald Fewer, Senior Managing Director of the Standard Credit Group, LLC in New York. As the first inter-dealer broker in the over-the-counter CDS market, I consummated the first trades between dealers at the market's inception in 1996, and have participated in the market's growth and development since then, including single named CDS, credit index and index tranches. I have submitted my full statement for the record and will comment on four areas in the proposed legislation. The first is regarding central counterparty clearing. My first point is an affirmation of the sentiments expressed by virtually all of the panelists that central clearing facilities of organized exchanges will work to eliminate counterparty credit issues in over-the-counter bilateral derivative contracts, and will undergird and strengthen the over-the-counter derivatives market infrastructure. Providing access to all market participants, sell-side and buy-side, to an open platform centered in CCP, will stimulate credit market liquidity by reconnecting more channels of capital to the credit intermediation and distribution function. The use of exchange CCP facilities will have a significant impact on credit markets by enabling participants to free up posted collateral and recycled trading capital back into market liquidity. Legislation that expands the role of organized exchanges beyond CCP to include exchange execution of OTC credit derivative products will be disruptive, and lacks the clear recognition of the already well-established and economically viable over-the-counter market principles. My second point is exchange execution of over-the-counter credit derivative products. Given the size and established structure of the OTC derivatives market, migration toward exchange execution has been, and will be, minimal apart from mandatory legislative action. It has been argued that the lack of standard product specifications of OTC derivatives is a market flaw and should be remedied by mandated exchange listing and execution. This argument lacks support. CDS contracts utilize standard payments and maturity dates. Credit derivative participants have adopted a higher degree of standardization because credit risk is different from the other types of underlying risks. Unlike interest rate swaps in which the various risks of a customized transaction can be isolated and offset in underlying money and currency markets, credit default swaps involve lumpy credit risks that do not lend themselves to decomposition. Standardization, the most significant attribute of exchange-traded products, is therefore a substitute for decomposition. Recent improvements in CDS market standards have resulted in up-front payments, and the establishment of annual payments that resemble fixed coupons similar to bonds. These changes will simplify trading and reduce large gaps between cash flows that can amplify losses. Most importantly, enhancing these standards will build a higher degree of integration between CDS and the underlying over-the-counter cash debt markets that simply cannot be replicated on an exchange. This aggregation and dispersion of credit risk between the over-the-counter cash and derivative markets is critical to the development of overall debt market liquidity, going forward. Other mechanisms implemented by the OTC market include post-default recovery rate auction and trade settlement protocols, innovation and portfolio compression methodologies. All of these functions performed exceptionally well during the market turbulence of last year. A regulation that would force exchange execution of CDS products would be harmful and disruptive to the credit risk transfer market. The third point I would like to address is underlying bond ownership requirements as proposed by the legislation. The draft legislation fails to recognize the underlying risk transfer facility of the plain vanilla credit default swap by requiring bond ownership. Limiting CDS trading to underlying asset ownership will cripple credit markets by stripping from the instrument the risk management and credit risk transfer efficiencies inherent in its design. The basic use of a credit default swap enables a credit intermediary, such as a commercial bank, to trade and transfer credit risk concentrations while being protected from a default at the senior unsecured level of the reference entity's capital structure. For example, financial institutions servicing large corporate clients must offer commercial lending, corporate bond underwriting, working capital facilities and interest rate risk management. In addition, the financial institution provides a market-making facility in all of the secondary markets for which it underwrites a client's credit. All of these financial services expose the financial institution to client counterparty risk. The credit risk transfer market optimizes the use of capital by enabling financial intermediaries to efficiently hedge and manage on- and off-balance-sheet credit risk. Credit derivatives therefore play a vital role to credit intermediation and market liquidity. Requiring bond ownership will counteract and work directly against the credit stimulation initiatives in the economic stimulus legislation currently under consideration. My fourth and final point is the unintended consequences of inappropriate regulatory action. As I detailed in my full statement, the value of cash bond trading has declined dramatically since the implementation of FINRA's Trade Reporting and Compliance Engine known as TRACE. TRACE led directly to the deterioration of the over-the-counter inter-dealer, investment-grade, and high-yield bond trading volume. While TRACE was anticipated to facilitate transparency, its implementation revealed the failure to fully understand over-the-counter corporate bond market structure, and created an inadvertent level of disclosure that frankly devastated the economic basis for dealer market-making. The lack of a liquid secondary market for corporate debt throughout the term structure of credit spreads dramatically increased the risk in underwriting new debt. The underwriters and dealers facility to trade out of and manage bond risk was so restricted that the unintended consequence was to damage the secondary bond market. It is not coincidental that the U.S. high-yield bond market reported zero new-deal issuance for the month of November in 2008. Almost half of the U.S. companies fell below investment-grade credit ratings, making the $750 billion high-yield bond market a critical source of financing. Mr. Chairman, Mr. Ranking Member and Members, I appreciate the opportunity to provide the testimony today and would urge you to continue to reach out to the inter-dealer market for its input. [The prepared statement of Mr. Fewer follows:] Prepared Statement of Donald P. Fewer, Senior Managing Director, Standard Credit Group, LLC, New York, NY Mr. Chairman Peterson, Ranking Member Lucas and Members of the Committee: Good morning. My name is Donald P. Fewer, Senior Managing Director of Standard Credit Group, LLC. a registered broker/dealer and leading provider of execution and analytical services to the global over-the-counter inter-dealer market for credit cash and derivative products. I was fortunate enough to have consummated the first trades between dealers at the markets inception in 1996 and have participated in the market's precipitous growth and development as well as its challenges. I would like to thank this Committee for the opportunity to share my thoughts on the draft legislation on Derivatives Markets Transparency and Accountability Act 2009, as it applies to the over-the-counter market generally and the credit derivatives market specifically. The Committee's draft legislation comes at a pivotal time. The consequences of the crisis paralyzing global credit markets will have significant and long term effects on credit creation, intermediation and risk transfer. I believe that legislation that attempts to address derivative market accountability and transparency should reflect a clear understanding of credit market dynamics, particularly credit risk transfer. With this in mind, I would like to address five areas of the draft legislation that does not meet this pre-requisite: Central Counterparty Clearing and the Role of Organized Exchanges. Exchange Execution of OTC Credit Derivative Products. Transparency and Price Discovery. Underlying Bond Ownership Requirements of CDS. Unintended Consequences of Inappropriate Regulatory Action.Central Counterparty Clearing, Credit Risk Transfer Derivatives and the Role of Organized Exchanges There has been significant criticism of the over-the-counter derivative products market, particularly credit derivatives, as the root cause of our global crisis. While much disparagement is based upon misinformation and misunderstanding, effective regulation directed at supporting the proper functioning of the credit risk transfer market is critical. Use of central clearing facilities of organized exchanges will not only work to eliminate counterparty credit issues in OTC bilateral derivative contracts, it will undergird and strengthen the OTC derivatives market infrastructure. The role of organized exchanges, in providing CCP services, can be the mechanism by which new capital and liquidity providers participate in the credit risk transfer market. The use of CCPs by all market participants, including ``end-users'' (i.e., hedge funds, asset managers, private equity groups, insurance companies, etc.) should be encouraged by providing open and fair access to key infrastructure components including but not limited to exchange clearing facilities, private broker trading venues and contract repositories. OTC trading venues will provide voice and electronic pre-trade transparency, trade execution and post-trade automation. This view of providing access to all market participants, sell side and buy side, to an open platform centered in CCP, will stimulate credit market liquidity by re-connecting more channels of capital to the credit intermediation and distribution function. The use of exchange CCP facilities will have a significant effect by enabling participants to free up posted collateral and recycle trading capital back into market liquidity. However, the proposed legislation, which expands the role of organized exchanges beyond CCP to include exchange execution of OTC credit derivative products, will be disruptive and lacks a clear recognition of the already well established and economically viable OTC market principles.Exchange Execution of OTC Credit Derivative Products: Disruptive and Unnecessary Given the size and establishment of the OTC derivatives market, migration toward exchange execution has been and will be minimal apart from mandatory legislative action. With regard to CDS, the failure to migrate to exchange execution is because the credit derivatives market is characterized with a higher degree of standardization than other forms of OTC derivatives. It has been argued that the lack of standard product specifications of OTC derivatives is a market flaw and should be remedied by mandated exchange listing and execution. This argument is inaccurate. CDS contracts utilize standard payments and maturity dates. Credit derivatives participants have adopted a higher degree of standardization because credit risk is different from other types of underlying risks. Unlike interest rate swaps, in which the various risks of a customized transaction can be isolated and offset in underlying money and currency markets, credit default swaps involve ``lumpy'' credit risks that do not lend themselves to decomposition. Standardization, the most significant attribute of exchange traded products, is therefore a substitute for decomposition. Recent work on reinforcing CDS market standards will result in upfront payments and the establishment of annual payments that will resemble fixed coupons. These changes will simplify trading and reduce large gaps between cash flows that can amplify losses. Most importantly, enhancing these standards will build a higher degree of integration between CDS and underlying OTC ``cash'' debt markets that cannot be replicated on an exchange. This aggregation and dispersion of credit risk between OTC cash and derivative markets will be critical to the development of overall debt market liquidity going forward. Other mechanisms implemented by the OTC market include post-default recovery rate auction and trade settlement protocols, novation and portfolio compression methodologies. All of these functions performed exceptionally well during the market turbulence of last year. A regulation that would force exchange execution of CDS products would be harmful and disruptive to the credit risk transfer market. It has also been argued that the ``opaqueness'' of the OTC derivatives market is a detriment to market transparency and price discovery and exchange listing and execution is required to increase the integrity and fairness of the market place. With respect, this position does not reflect current market realities.Transparency, Execution and Post-Trade Automation: The Work of OTC Markets The over-the-counter market has a well established system of price discovery and pre-trade market transparency that includes markets such as U.S. Treasuries, U.S. Repo, EM sovereign debt, etc. OTC markets have been enhanced by higher utilization of electronic platform execution. Private broker platforms will interface directly to CCPs and provide automated post-trade services. This was clearly demonstrated in the wake of Enron's collapse and the utilization of CCP facilities by the leading over-the-counter energy derivatives brokers to facilitate trading and liquidity. It is clear to all market participants that financial dislocation and illiquidity will persist across many asset classes and geographies for some time. As alluded to earlier, the unique nature of the OTC market's price discovery process is absolutely essential to the development of orderly trade flow and liquidity in fixed income credit markets. We are entering a period with an abundance of mispriced securities where professional market information and execution is required. OTC price discovery throughout the term structure of credit spreads will require a more focused and integrated execution capability between OTC CDS and cash, utilizing key component inputs from equity markets and the various constituents of the capital structure (i.e., senior and subordinated corporate bonds, loans, etc.). This type of exhaustive price discovery service can only be realized in the over-the-counter market via execution platforms that integrate derivatives and cash markets across asset classes (i.e., debt, equities, emerging markets, etc.). This will be critical to the repair of credit market liquidity globally. The implementation of a central trade repository, (i.e., DTCC), that is publicly disseminating detailed information of the size, reference entity and product break-down of the credit derivatives market on a weekly basis will serve to strengthen public confidence in disclosure and transparency of the CDS market.Underlying Bond Ownership Requirements: The Virtual Elimination of the Inherent Value of CDS The draft legislation fails to recognize the underlying risk transfer facility of the ``plain vanilla'' credit default swap by requiring bond ownership for credit default swap purchases. Limiting CDS trading to underlying asset ownership will cripple credit markets by stripping from the instrument the risk management and credit risk transfer efficiencies inherent in its design. The basic use of a credit default swap enables a credit intermediary (i.e., commercial bank) to trade and transfer credit risk concentrations while being protected from an event of default at the senior unsecured level of the reference entities capital structure. For example, a financial institution servicing a large corporate client is required to offer commercial lending, corporate bond underwriting, working capital facilities, interest rate management services, etc. In addition, the financial institution provides a market-making facility in all of the secondary markets for which it underwrites a client's credit (i.e., senior, junior and convertible bonds, loans, etc.) All of these above services expose the financial institution to counterparty risk to the corporate customer. The credit risk transfer market optimizes the use of capital by enabling financial intermediaries to efficiently hedge and manage on and off balance sheet (i.e., unexpected credit line draw-downs, ``pipeline'' risk, etc.) credit risk. Credit derivatives therefore play a critical and vital role to credit intermediation and market liquidity. The implementation of the use of CDS in requiring bond ownership will counteract and work directly against the credit stimulation initiatives currently under consideration by Congress in the Economic Stimulus Bill H.R. 1.Unintended Consequences of Inappropriate Regulatory ActionTRACE--an example of disruptive regulatory action Goldman Sachs recently reported that the value of cash bond trading has fallen each year over year for the past 5 years. The value of cash bond trading stood at $12,151bn in 2003 and declined to $8,097bn in 2008. The CDS market achieved CAGR exceeding 100% since 2004 and stood at $62tn year end 2007. The inter-dealer market experienced firsthand the decline in secondary market bond turnover and that decline can be correlated directly to the implementation of FINRA's Trade Reporting and Compliance Engine (TRACE) reporting system. TRACE led directly, as an unintended consequence, to the deterioration of OTC inter-dealer investment grade and high yield bond trading volume. While TRACE was anticipated to facilitate the demand for ``transparency'' its implementation revealed the lack of depth in understanding the OTC corporate bond market structure and created an inadvertent level of disclosure that devastated the economic basis for dealer ``market-making''. The lack of a liquid secondary market for corporate debt throughout the term structure of credit spreads dramatically reduces the risk tolerance to underwrite new debt. The underwriters and dealers' facility to trade out of and manage bond risk was so restricted that the unintended consequence was to damage the secondary bond market. This is most notable in the U.S. High Yield bond market. It is not coincidental that the U.S. High Yield bond market reported zero new deal issuance for the month of November 2008. Almost half of U.S. companies have below-investment grade credit ratings, making the $750 billion junk-bond market a critical, if not sole source of financing for an increasing number of corporations large and small all across America.Loss of Money and Capital Markets to Off-Shore Financial Centers The United States is at significant risk to lose the flow of money and capital market trading activities to off-shore financial centers more conducive to over-the-counter market development. While American financial institutions have been the originators of financial innovation that enabled the free flow of capital across international markets, the United States is declining as a recognized financial capital globally. Legislation that creates a regulatory environment that prohibits capital market formation will push market innovation and development to foreign markets, which would be welcoming. Mr. Chairman, Mr. Ranking Member and Members of the Committee, I appreciate the opportunity to provide this testimony today and would urge that you continue to reach out to the dealer market for its input. I am pleased to respond to any questions you may have. Thank you. " CHRG-111shrg53085--27 Mr. Patterson," Thank you, Chairman Dodd, Ranking Member Shelby, and Members of the Committee. My name is Aubrey Patterson, Chairman and CEO of BancorpSouth, Inc. Our company operates over 300 commercial banking, mortgage, insurance, trust and broker-dealer locations throughout six Southern States. I am pleased to testify on ABA's recommendations for a modernized regulatory framework. I might add that ABA does represent over 95 percent of the assets of the industry. Recently, Chairman Bernanke gave a speech which focused on three main areas: first, the need for a systemic risk regulator; second, the need for a method for orderly resolution of a systemically important financial firm; and, third, the need to address gaps in our regulatory system. We agree that those three issues should be the priorities. This terrible crisis should not have been allowed to happen again, and addressing these three areas is critical to ensure that it does not. ABA strongly supports the creation of a systemic regulator. In retrospect, it is inexplicable that we have not had such a regulator. If I could use a simple analogy, think of the systemic regulator as sitting on top of Mount Olympus looking out over all of our land. From that highest point, the regulator is charged with surveying the land looking for fires. Instead, we currently have had a number of regulators each of which sits on top of a smaller mountain and only sees its relative part of the land. Even worse, no one is looking over some areas, creating gaps in the process. While there are various proposals as to who should be the systemic regulator, much of the focus has been on giving the authority to the Federal Reserve. There are good arguments for looking to the Fed. This could be done by giving the authority to the Fed or by creating an oversight committee chaired by the Fed. ABA's one concern in using the Fed relates to what it may mean for the independence of that organization. We strongly believe in the importance of Federal Reserve independence in its role in setting and managing monetary policy. ABA believes that systemic regulation cannot be effective if accounting policy is not in some fashion part of the equation. To continue my analogy, the systemic regulator on Mount Olympus cannot function well if part of the land is strictly off limits and under the rule of some other body, a body that can act in a way that contradicts the systemic regulator's policies. That is, in fact, exactly what has happened with mark-to-market accounting. 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 an impromptu solution to a Bear Stearns or an AIG or not being able to resolve a Lehman Brothers. The inability to deal with these situations in a predetermined way greatly exacerbated the crisis. A critical issue in this regard is ``too big to fail.'' The decision about the systemic regulator and a failure resolution system will help determine the parameters of ``too big to fail.'' In an ideal world, there would be no such thing as too big to fail, but we all know that the concept not only exists it has, in fact, broadened over the last few months. This concept has profound moral hazard and competitive effects that are very important to address. The third area for focus is where there are gaps in regulation. Those gaps have proven to be major factors in this crisis, particularly the role of 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, more effective regulatory structure. ABA pledges to be an active and constructive participant in this critical effort. I would be happy to answer any questions, Mr. Chairman. " CHRG-111hhrg53241--6 Mrs. Biggert," Thank you, Mr. Chairman. Our financial regulatory system is broken, and our job is to clean it up, making it more efficient and effective. However, as I expressed during yesterday's hearing, I fear that we are moving in the wrong direction when we strip from the banking regulators their mission to protect consumers. Our country got into this financial mess because there were simply too many regulators who weren't doing their job and were not talking to one another. So the logical answer to this problem of too many regulators not doing their job should be to consolidate and require more efficient, frequent, and effective regulators. Instead, H.R. 3126 in the Administration's proposal goes 180 degrees in the opposite direction by placing the responsibility to protect consumers with a new government bureaucracy, an agency that I think should be called the Credit Rationing and Pricing Agency. And why do I say this? Because this new agency that tells consumers what they can and cannot do and businesses large and small what they can and cannot offer to consumers can only result in one or more of three things: First, many consumers who enjoy access to credit today will be denied credit in the future. Second, riskier consumers will have access to affordable products or plain vanilla products, but who will pay for that risk? That is the less risky consumer whose cost of credit will certainly increase. And, third, financial institutions will be told to offer certain products at a low cost to risky consumers, which will jeopardize the safety and soundness of the financial institution. Secretary Geithner last week couldn't really answer the question: Would the safety and soundness banking regulator trump a new consumer if the consumer's regulatory policy would put the bank in an unsafe territory? Maybe some of our witnesses today can explain what would happen in that situation. In addition, maybe some of our witnesses today can better explain why we should keep CRA with a prudential regulator but not the consumer protection regulation. I am very skeptical that, for consumers, the answer is making government bigger and eliminating Federal preemption. I think it weakens the system and could very well be detrimental to consumers, businesses, and the U.S. economy at a time when we can least afford it. We must first do no harm, and we must find a balanced approach to financial regulation. I think our Republican plan that puts all of the banking regulators and consumer protection functions under one roof is a better answer for the consumer and really gets to the heart of preventing another financial meltdown. With that, I yield back the balance of my time. " CHRG-111hhrg53238--124 Mr. Lucas," That is very true, Mr. Chairman. I recently met with a group of bankers from small community banks and financial institutions in my district, and they have serious concerns, as do I, about the impact of the proposed Consumer Financial Protection Agency and what it will do to them. Our community banks are small financial institutions that have had little to do with the cause of the current financial crisis and continue to serve their communities as safe and reliable sources of credit. Their very success depends on the success of their communities. However, under this new regulatory agency, they could, I fear, be disproportionately burdened with additional regulations and fees. In addition, there has been a lot of discussion here today in regard to the threat that too-big-to-fail institutions pose to the stability of our financial institutions as a whole, and how best to address this threat. When considering how best to approach reform, we must not sacrifice the health of our small institutions that did not cause this situation. Now, I address my question in particular to Mr. Yingling and Mr. Menzies. I do not represent a capital-intensive district. I do not have any money market facilities, institutions in my district. I have consumers of products, and I have small businesses. Your two organizations represent the backbone of the financial institutions in my district. Expand for a moment what the effect of this piece of legislation, as now drafted, will be on those institutions. Because, after all, we all know rules have many effects. And they can limit opportunities and they can kill, too. That is the nature of the Federal process. Explain to me what this bill will do to your folks in my district. " CHRG-111shrg53176--32 Mr. Joseph," Thank you, Senator. I agree with the Chairman. Her comments are right on. And you are correct, the whole system--the entire financial system--is built on trust and confidence. And at the moment I think that is a little bit shaky. If people do not believe they are on a level playing field, and if that does not happen, obviously they are not going to invest. I agree that we need to focus on investor protection. I believe we need to be certain that the people who are licensed to sell securities are adequately prepared and qualified to do so. The securities that they are selling, for example, the Reg. D Rule 506 offerings, need more regulatory scrutiny; otherwise, in some cases it is just pure gambling. Senator Dodd also pointed out that in some cases it is speculation. Senator Dodd, I would say it is speculation at best and gambling at worst in some cases. Last, we need to enforce, and enforce strongly. And I believe the SEC and the States must continue on in that role, and we take our roles very seriously. Senator Tester. Thank you. One quick comment before I get to my next question. Chairwoman Schapiro, I appreciate your consideration of the uptick rule. There is a bill that Senator Isakson, Senator Kaufman, and myself are on to reintroduce it, and I think it could help, reinstituting that rule that was taken away after 8 years. I appreciate you taking that up. I want to talk just very briefly, because I have only got a minute left, about the power of a monolithic regulatory scheme versus a patchwork scheme that we have now of regulation that, quite frankly--and I think it was your predecessor who said that there was no regulation in some of these financial instruments, and it is one of the reasons we are at this point, at least from my perspective. There seemed to be a lack of consistency with the patchwork scheme because of gaps that inherently open up. Then on the other side of the coin--and I do not want to put words in your mouth--you talked about one agency could get too powerful, and I agree with that, too. So how do we solve the problem? How do we solve the problem of gaps and people saying, well, I really do not have authority to regulate this, it is somebody else's authority, and they are saying the same thing and things fall through the cracks? Ms. Schapiro. I think it is critically important that we fill the gaps, first and foremost. We will have overlap, and I think that does create some tension among regulators. But as compared to gaps, that is a pretty manageable process, and sometimes the creative tension that evolves between banking and securities regulators actually results in a positive. But as we identify those areas of the financial system that have not been subject to regulation--hedge funds, credit default swaps, other kinds of pooled investment vehicles--it is important that we decide that if they are important to investor protection, if they are important to the financial system, that they be brought under the Federal regulatory umbrella with the support, obviously, in multiple areas of State regulators as well, and that those gaps basically be filled by a functional regulator. I think there is also a role for a systemic risk regulator, again, whether it is done by an individual institution that has responsibility for monitoring exposures and working on prudential regulatory standards and working with a resolution regime or with a college of regulators, there has to be heightened sensitivity to these components of the financial system that have not been regulated. Senator Tester. In an ideal system, you are right. But what happens when you have a lack of resources? How anxious are you to jump on some other regulatory financial mechanism out there if you can say, well, gosh, this really is not my job anyway, and I am limited in financial resources, we will let somebody else take care of it? Ms. Schapiro. It is really our responsibility, and we should not be in these roles if we are not willing to come to Congress and say this is a problem, we need your help, we need legislation, we need resources. Senator Tester. Thank you. Thank you, Mr. Chairman. " CHRG-111hhrg52261--3 Mr. Graves," Thank you, Madam Chair, and I would like to thank you for holding this important hearing on the debate that is going to occur about restructuring the regulatory oversight of America's financial sector. Given the fact that the financial services sector contributed more than a third of corporate profits in this country during the last decade, it is a significant debate. No one can question that the events affecting Wall Street last year had consequences on the overall American economy. Once credit becomes unavailable, the modern economy comes to a grinding halt. Consumers and businesses do not buy, manufacturers do not sell, and unemployment skyrockets. Any reform to the financial regulatory process must meet two key objectives. First, it must provide for an efficient operation of the financial markets; and second, small businesses, the prime generator of new jobs in the economy, must have access to capital. Competitive markets need full information to operate properly. To the extent that regulatory reform improves the information available to all parties that use the financial markets, it will be beneficial. That benefit must be weighed against the cost of providing information. Much of the focus on financial regulatory reform proposals address either protecting consumers or preventing one or a group of institutions from creating systemic risk leading to the collapse of capital and the credit markets. However, little has been said on the impact that such regulatory oversight might have on the access to capital for small businesses. If the regulatory reform inhibits the ability of small businesses to obtain credit or access needed capital, the regulation will have an adverse long-term consequence on the ability of the economy to grow. A famous philosopher once said that ""Those who cannot remember the past are condemned to repeat it."" Whatever the outcome of the debate on restructuring the regulation of the financial sector, we cannot repeat the mistakes of the past. Given the fact that financial panics have periodically occurred in this country going back to 1837, achieving a regulatory restructuring that ensures Congress does not repeat the mistakes of the past will be one of our most difficult tasks. I again would like to thank the Chairwoman for holding this important hearing, and I yield back. [The statement of Mr. Graves is included in the appendix.] " CHRG-111hhrg53245--24 Mr. Mahoney," Thank you, Mr. Chairman, Ranking Member Bachus, and members of the committee. I appreciate the opportunity to present my views here today. I will discuss those portions of the Administration's regulatory reform proposals that deal with the largest financial institutions, the so-called Tier 1 financial holding companies. The Administration proposes a special resolution regime for financial holding companies outside the normal bankruptcy process, that would be triggered when the stability of the financial system is at risk. And when the Treasury triggers the special resolution regime, it will have the authority to lend the institution money, purchase its assets, guarantee its liabilities, or provide equity capital with funds to be recaptured in the future from healthy institutions. I think it is fair to use the term, ``bailout'' to describe that system. There are two general schools of thought on how best to avoid future financial crises leading to widespread bailouts. The first holds that it was an error in the recent crisis to help creditors of failed institutions avoid losses that they would have realized in a normal bankruptcy proceeding, and that the focus of policy going forward should be to make it clear that the mistake will not be repeated. The alternative is to concede that the government will ordinarily bail out large and systemically important financial institutions. Under this approach, Congress should focus on limiting the risks that those institutions can take, in order to minimize the likelihood that they will become financially distressed. Buy if those efforts fail, and a systemically important institution becomes financially distressed, a bailout will follow as a matter of course. The Administration's financial reform blueprint takes this approach. I think the first approach will produce a healthier financial services industry that will make fewer claims on taxpayer dollars going forward. It is based on a sounder premise--that the best way to reduce moral hazard is to ensure that economic agents bear the costs of their own mistakes. The Administration's plan is premised on the view that regulatory oversight will compensate for misaligned incentives. The central argument for trying to avoid bailouts through regulatory oversight rather than insisting that financial institutions bear the cost of their mistakes is that some institutions are too big to fail. Putting those institutions through bankruptcy could spread contagion, meaning that other banks or financial institutions may also fail as a consequence. Widespread bank failures in turn may reduce the availability of credit to the real economy, causing or exacerbating a recession. There is debate over that analysis. But in any event, it is not clear that the magnitude of the problem is sufficient to justify the scale of government intervention that we have seen in the past year. It is important to note that the loss of capital in the banking system in the recent crisis was not just the result of a temporary liquidity problem. It was the consequence of sharp declines in real estate and other asset values. A bailout can redistribute those losses to taxpayers, but it cannot avoid them. The bankruptcy process is itself a means of recapitalizing an insolvent institution. Bankruptcy does not imply or require that the firm's assets, employees, and know-how disappear. Instead, it rearranges the external claims on the firm's assets and cash flows. The holders of the firm's equity may be wiped out entirely while unsecured creditors may have to substitute part or all of their debt claims for equity claims, thereby reestablishing a sound capital structure. If the insolvent institution still has the skill and experience to facilitate credit formation, it will continue to do so under new ownership, management, and capital structure. Of course, the bankruptcy process is subject to inefficiencies and delays, and those should be addressed. A more streamlined process may be appropriate for financial institutions, because they do have short-term creditors. But this does not require an alternative regime of institutionalized bailouts. A bailout regime, unlike a bankruptcy regime, creates moral hazard problems that impose costs on the banking sector continuously and not just during crises. Because creditors of too-big-to-fail financial institutions anticipate that they will be able to shift some or all of their losses to taxpayers, they do not charge enough for the capital they provide. The financial institution in turn does not pay a sufficient price for taking risk. The result is a dangerous feedback loop. Large banks have access to cheap capital, which causes them to grow even larger and more systemically important, while taking excessive risks--all of which increase the probability of a crisis. Thus, a bailout regime leads to more frequent crises, even as it attempts to insulate creditors from them. The Administration believes its proposal will alleviate moral hazard and decrease the concentration of risk in too-big-to-fail institutions. The idea is that these Tier 1 financial holding companies will be subject to more stringent capital rules that will reduce the amount of risk they can take and create a disincentive to become a Tier 1 financial holding company in the first place. I think these disincentives are insufficient and implementation of the plan would increase and not decrease the concentration of risk. Once a firm has been designated a Tier 1 FHC, other financial institutions will view it as having an implicit government guarantee. The theory behind the proposal is that this advantage will be offset by stricter capital requirements and other regulatory costs, which will on balance make the cost of capital higher for Tier 1 FHCs. That analysis strikes me as wildly optimistic. Having an implicit government guarantee, Tier 1 financial holding companies will be extremely attractive counterparties, because risk transferred to them will in effect be transferred to the Federal Government. Tier 1 financial holding companies will have a valuable asset in the form of the implicit guarantee that they will be able to sell in quantities limited only by the Fed's oversight. They will have powerful incentives to find mechanisms--new financial products, or creative off-balance sheet devices--to evade any limits on the risks they can purchase from the rest of the financial sector. And banks that are not already Tier 1 financial holding companies will have strong incentives to grow to the point that they become Tier FHCs in order to guarantee access to bailout money. The fastest way to grow larger is to take bigger risks. An institution that can keep its gains while transferring losses to the government will engage in excessive risk-taking and excessive expansion, and the financial system as a whole will suffer more frequent crises. Thank you, and I look forward to your questions. [The prepared statement of Mr. Mahoney can be found on page 61 of the appendix.] " 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-111hhrg52407--54 Mr. Salisbury," I would say it is not as much totally independent as making sure that consumers are included. That is, if there is a board of five, a majority of that board is made up of people who view themselves principally as financial consumers, as opposed to, for example, members of the regional Federal Reserve banks. Six of the nine board members are appointed by the banks, who own the Fed. The Federal Reserve Board banks are basically self-regulatory organizations, the banks regulating the banks. If that was what this agency was, I would argue a consumer agency that is run by the financial services organizations definitionally can't be a consumer protection agency. So it would be that, if there is a board of five, making sure a majority of that board are actually financial consumers, not those who basically have come out of the financial services industry and, if history is a guide, would go back to work for the financial services industry after service on the board. "