CHRG-111hhrg55809--51 Mr. Bernanke," That would make us look very much like the Bank of England and some other central banks that have been brought back to monetary policy-making. I think the experience of the recent crisis is that, and this is the case in the U.K., that the fact that the bank did not have the information it needed about the crisis, about what was happening in the banking system and so on, was a real drawback in terms of the ability of the Central Bank to help stabilize the system. So, of course, you could have a central bank that was focused only on monetary policy, absolutely. But I think that it is very important for the Central Bank to have the information, the expertise, the insight about the banking system in order to both make better monetary policy and to be able to play an appropriate role whenever there is a crisis. " CHRG-111hhrg48873--470 Mr. Bernanke," Many different aspects of the system just proved inadequate under the pressure of the crisis. And I can't identify one specific cause for the crisis. " CHRG-111shrg49488--42 Mr. Clark," I guess what I would say I would not get yourself trapped that if you cannot take a direct link back to the great financial crisis, you should not clean it up. And so I would say the U.S. system obviously has a lot of issues that, even if they did not create the great financial crisis, certainly do not make the system run any better. And so I think whether you have 100 regulators or 50 does not matter. There is clearly regulatory shopping that goes on constantly in the United States, and that cannot be a good thing to have a sound system. " CHRG-111hhrg48873--462 Mr. Bernanke," Well, what we found in this crisis is that through many, many parts of our financial regulatory system and in our financial institutions we simply were not adequately prepared for a crisis of this magnitude. And-- " CHRG-111hhrg55814--97 Secretary Geithner," No. I think you need to separate two different things. One is about prevention, and it's what about what you do in the event of a severe crisis. On the prevention front, what this does is make it clear that regulators would have the responsibility and the authority to limit risk-taking, limit the scale and scope of activities, size if necessary, if that's necessary to protect the system. That's a very important thing. We did not have that in this crisis for a large part of the financial system. That fixes that. " CHRG-111hhrg48873--38 Mr. Bernanke," It is an important issue for avoiding a future systemic crisis. " CHRG-111hhrg48875--94 Secretary Geithner," Well, I think, again, is as this crisis reveals and as the crisis of the thrift and loan crisis, the S&L crisis in the early 1990's revealed, there are circumstances in which it is cheaper for the taxpayer over time and less damaging for the country over time for the government to take some risk in preventing greater cost not just to the deposit insurance fund, but to the rest of the system. That's the balance we have to strike. " fcic_final_report_full--267 COMMISSION CONCLUSIONS ON CHAPTER 13 The Commission concludes that the shadow banking system was permitted to grow to rival the commercial banking system with inadequate supervision and regulation. That system was very fragile due to high leverage, short-term funding, risky assets, inadequate liquidity, and the lack of a federal backstop. When the mortgage market collapsed and financial firms began to abandon the commercial paper and repo lending markets, some institutions depending on them for fund- ing their operations failed or, later in the crisis, had to be rescued. These markets and other interconnections created contagion, as the crisis spread even to mar- kets and firms that had little or no direct exposure to the mortgage market. In addition, regulation and supervision of traditional banking had been weak- ened significantly, allowing commercial banks and thrifts to operate with fewer constraints and to engage in a wider range of financial activities, including activi- ties in the shadow banking system. The financial sector, which grew enormously in the years leading up to the fi- nancial crisis, wielded great political power to weaken institutional supervision and market regulation of both the shadow banking system and the traditional banking system. This deregulation made the financial system especially vulnera- ble to the financial crisis and exacerbated its effects. fcic_final_report_full--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.  fcic_final_report_full--423 CAUSES OF THE FINANCIAL AND ECONOMIC CRISIS CONTENTS Introduction ......................................................................................................  How Our Approach Differs from Others’ .........................................................  Stages of the Crisis .............................................................................................  The Ten Essential Causes of the Financial and Economic Crisis .......................  The Credit Bubble: Global Capital Flows, Underpriced Risk, and Federal Reserve Policy ................................................................................  The Housing Bubble .........................................................................................  Turning Bad Mortgages into Toxic Financial Assets .........................................  Big Bank Bets and Why Banks Failed ...............................................................  Two Types of Systemic Failure ...........................................................................  The Shock and the Panic ...................................................................................  The System Freezing .........................................................................................  INTRODUCTION We have identified ten causes that are essential to explaining the crisis. In this dis- senting view: • We explain how our approach differs from others’; • We briefly describe the stages of the crisis; • We list the ten essential causes of the crisis; and • We walk through each cause in a bit more detail. We find areas of agreement with the majority’s conclusions, but unfortunately the areas of disagreement are significant enough that we dissent and present our views in this report. We wish to compliment the Commission staff for their investigative work. In many ways it helped shape our thinking and conclusions. Due to a length limitation recently imposed upon us by six members of the Com- mission,  this report focuses only on the causes essential to explaining the crisis. We regret that the limitation means that several important topics that deserve a much fuller discussion get only a brief mention here.  CHRG-111hhrg53244--316 Mr. Bernanke," No. Not yet. We have to do I think a very substantial reform of the financial regulatory system to address all the problems that were revealed by the crisis. Ms. Kilroy. Thank you. I yield back. " CHRG-111hhrg52400--155 Mrs. Biggert," Okay. Well, it appears that the insurance sector has fared better than the banking and the securities counterparts in the current economic crisis. What are the reasons for that, and what are some of the elements of the State insurance regulatory system that could be instructive to Federal policymakers in setting up a systemic risk regulatory system? " CHRG-110hhrg46591--86 Mr. Seligman," I would like to suggest that just as in say a national security emergency in the White House, you have one person definitively in charge of command and control under some circumstances. In an economic emergency and to prevent an economic emergency, you need someone who is unequivocally or some institution that is unequivocally in charge. And it could be the Federal Reserve System, it might be the Department of the Treasury. But it is not sufficient for it just to be reactive to a crisis. The question is, how do you provide sufficient information flow, examination, and inspection so we can avoid a crisis. The purpose of regulation is not to clean up messes but to prevent them. And in that sense one of the, I think, pivotal decisions this committee or some committee is going to have to wrestle with is, how do we make permanent a system of risk avoidance or crisis avoidance? The second ordered question, which I touched on briefly in my testimony is however that just begins the analysis. The specialized expert knowledge that some regulatory agencies have specific industries cannot easily be addressed by the crisis manager. " CHRG-111hhrg56766--338 Mr. Bernanke," Yes. That is being considered in international forums and there are examples around the world, like in Spain, where systems like that seem to have been helpful during the crisis. " fcic_final_report_full--475 Indeed, the Commission’s entire investigation seemed to be directed at minimizing the role of NTMs and the role of government housing policy. In this telling, the NTMs were a “trigger” for the financial crisis, but once the collapse of the bubble had occurred the “weaknesses and vulnerabilities” of the financial system— which had been there all along—caused the crisis. These alleged deficiencies included a lack of adequate regulation of the so-called “shadow banking system” and over-the-counter derivatives, the overly generous compensation arrangements on Wall Street, and securitization (characterized as “the originate to distribute model”). Coincidentally, all these purported weaknesses and vulnerabilities then required more government regulation, although their baleful presence hadn’t been noted until the unprecedented number of subprime and Alt-A loans, created largely to comply with government housing policies, defaulted. 6. Conclusion What is surprising about the many views of the causes of the financial crisis that have been published since the Lehman bankruptcy, including the Commission’s own inquiry, is the juxtaposition of two facts: (i) a general agreement that the bubble and the mortgage meltdown that followed its deflation were the precipitating causes—sometimes characterized as the “trigger”—of the financial crisis, and (ii) a seemingly studious effort to avoid examining how it came to be that mortgage underwriting standards declined to the point that the bubble contained so many NTMs that were ready to fail as soon as the bubble began to deflate. Instead of thinking through what would almost certainly happen when these assets virtually disappeared from balance sheets, many observers—including the Commission majority in their report—pivoted immediately to blame the “weaknesses and vulnerabilities” of the free market or the financial or regulatory system, without considering whether any system could have survived such a blow. One of the most striking examples of this approach was presented by Larry Summers, the head of the White House economic council and one of the President’s key advisers. In a private interview with a few of the members of the Commission (I was not informed of the interview), Summers was asked whether the mortgage meltdown was the cause of the financial crisis. His response was that the financial crisis was like a forest fire and the mortgage meltdown like a “cigarette butt” thrown into a very dry forest. Was the cigarette butt, he asked, the cause of the forest fire, or was it the tinder dry condition of the forest? 44 The Commission majority adopted the idea that it was the tinder-dry forest. Their central argument is that the mortgage meltdown as the bubble deflated triggered the financial crisis because of the “vulnerabilities” inherent in the U.S. financial system at the time—the absence 44 FCIC, Summers interview, p.77. of regulation, lax regulation, predatory lending, greed on Wall Street and among participants in the securitization system, ineffective risk management, and excessive leverage, among other factors. One of the majority’s singular notions is that “30 years of deregulation” had “stripped away key safeguards” against a crisis; this ignores completely that in 1991, in the wake of the S&L crisis, Congress adopted the FDIC Improvement Act, which was by far the toughest bank regulatory law since the advent of deposit insurance and was celebrated at the time of its enactment as finally giving the regulators the power to put an end to bank crises. CHRG-111hhrg53245--53 Mr. Wallison," The most important thing that the Systemic Risk Council would do, Mr. Chairman, is to identify areas that were not identified before the current crisis-- " 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-111hhrg48873--466 Mr. Bernanke," So I think an absolutely critical part of the deal here is that, if we are going to put out the fire in the financial system, we also have to promise the American people we are going to take the steps necessary that this will not happen again. And that requires a very extensive rethinking of our financial regulatory system as well as elements of our financial system more broadly. So I absolutely agree with you that we have to fix the system, but it was broken and it did not succeed in the context of this crisis. " FinancialCrisisInquiry--554 BASS: I think, as you entered the crisis, everyone expected everyone could pay. And as the crisis wore on a bit, the inner dealer transactions never posted initial margin, and AIG or triple- A rated counterparties did not post initial margins. So they all trust one another. When trust started to erode from the system and people realized the enormity of the leverage in the system, they started requiring deposits. And when they required deposits, it became pro-cyclical. But they should have required them in the first place, and that’s one of my key points is you need to require initial deposits from the sellers of open-ended risk. WALLISON: January 13, 2010 I don’t have time to finish this. Just let me finish this question, Mr. Chairman. And that is would you just submit in writing a connection between your argument about credit- default swaps and the financial crisis? Why that occurred? CHRG-111hhrg55814--35 Secretary Geithner," That's the central lesson of this crisis, the central imperative of reform. To do that, they have to know who they are. There should not be a fixed list. It may change over time, because the system changes over time. But the central imperative is, if you take on or could risk the stability of the system as a whole-- " CHRG-111hhrg56847--21 Mr. Bernanke," There are multiple dimensions about how to address this, and the financial regulatory reform legislation attempts to look at all the components. First, we need to have a better oversight of the system and more macro prudential or systemic approach to regulation that will allow us to identify gaps and problems before they lead to a crisis. That is part of the philosophy underlying the creation of a Systemic Risk Council and giving the Federal Reserve consolidated supervision over large, systemically critical firms. Secondly, we need to make the system more resilient so that when crises occur it will be more stable. We are doing that through a wide variety of mechanisms, including increased capital requirements, increased liquidity requirements, efforts to make derivatives trading more transparent and the like. And thirdly, if a crisis does occur, we need the tools to manage it. And there, very importantly, Congress has been working on alternative mechanisms for safely winding down, putting in receivership a large systemically critical firm so that it can fail without bringing down the rest of the system. So those are three dimensions of our response I think we are making progress towards. We will never eliminate financial crises, but we need to make sure that they are much less frequent, that they are less virulent and they have less effect on the economy. " CHRG-110hhrg46591--359 Mr. Bartlett," Congressman, we endorsed it because there is a crisis, an economic crisis. And we think that you have to get capital back into the system to restore liquidity. The Secretary of the Treasury and others have proposed a solution. And we constantly advocated to advance that solution on all fronts and, to add to it, to allow for multiple options. It was a colloquy on the Floor, for example right at the end, that then permitted this or at least referred to investing equity in the institutions. " CHRG-111hhrg54867--188 Secretary Geithner," I believe that the system would have--this crisis would have been less damaging, there would have been less damage to the economy as a whole if authority had been stronger, used more effectively, used earlier by a bunch of other authorities. " CHRG-111shrg49488--7 Chairman Lieberman," Thank you. That was most interesting and a good beginning. So at this state, we would say that, in your opinion, which one of these regulatory systems was chosen did not have much of an effect on the economic crisis that occurred. " 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-111hhrg56776--116 Mr. Bernanke," Both to monetary policy, but also to financial stability because we need to see what is happening in the entire banking system, and indeed, small banks can be part of a financial crisis. " FinancialCrisisInquiry--420 BASS: OK. With regard to institutions outside of the system, to reiterate the point I just made, first of all, we have to determine who’s systemically important and who isn’t. And if they systemically important, they need to have a higher risk premium charged to them, and we January 13, 2010 need to regulate them heavily. And if they’re not, they should be able to engage in these non- bank activities or even lending activities and lever however many times they’d like to be levered. But, again, if they fail, they need to be able to fail. In my testimony, I say, you know, capitalism without bankruptcy is like Christianity without hell. Right. There have to be consequences of excessive risk taking. As far as short selling is concerned, I believe that short selling is a vital part of our marketplace. And it’s interesting what, when Mr. Mack was advocating the ban on short selling during the crisis, once the short selling ban was put into place, the financial equities actually dropped more with the ban on than they did prior to the ban being put on. So I think the proof was in the pudding back during the crisis that supposed short sellers didn’t—did not create this crisis; it was simply a lack of confidence in the people that owned these equities. I think it’s actually a very good thing. CHRG-110hhrg44903--20 Mr. Geithner," I think you have to look at everything. You have to be prepared to look at everything. Our system has many strengths. But I think the challenges we have seen in this crisis justify a very broad-based fundamental look. " CHRG-111hhrg49968--168 Mr. Bernanke," Well, first of all let me say that I do think there is a benefit to going toward a more system-wide regulatory approach because so many things that caused problems in the recent crisis sort of slipped under the radar because there was nobody looking at it. So we do need to have a system whereby the large systemically critical firms are being appropriately overseen, where we have a way to address the potential failure of large financial firms, where we make sure that risks that build up in the system are---- Ms. Moore. Should that be you? Before my time expires? " CHRG-111hhrg56776--84 Mr. Bernanke," There were mistakes and problems throughout the system. Regulators, the Federal Reserve, the private sector, and even Congress made mistakes in this crisis. The only thing we can do is go forward and fix the mistakes. We are working at every level. We, of course, are recommending changes to the overall statutory structure to address gaps and other problems in the system, but we are also taking actions ourselves. We are strengthening our capital requirements, for example. Liquidity turned out to be a big issue in this crisis. We have been working internationally to strengthen that substantially. I think execution is very important. Within our own supervisory system, we have been doing a lot of soul searching and a lot of changes and those changes are both at the level of the framework for supervision, which we believe needs to be more systemic, more so-called ``macro-prudential,'' but also in terms of execution. We have found situations just like you described, where we were not fast enough, we were not forceful enough. We need to change our culture, our structure, and our instructions to examiners and so on to make sure we do a better job next time. Everyone has to do a better job. We are working to do a better job. We think there are structural reasons that the central bank needs to be involved in this process. " CHRG-111hhrg63105--73 Mr. Conaway," Speaking of the crisis, I have a short amount of time. I take that that you are fine with these dates. Mr. Chilton, you mentioned that some time frame in the run-up to the bubble in 2008 that there was $200 billion in new money in the system. How much of that money has fled the system? What are the levels today versus then? " CHRG-110hhrg45625--188 Secretary Paulson," But I would just say that we got to the point where we both believed that the only approach became one where we had to deal with it systemically. We couldn't deal with it. We have dealt with it in parts. There are a lot of things we have done. There is a lot of tactical steps, but this is a broad-based systemic approach to deal with the root cause, which is the housing decline having led to illiquid mortgage and mortgage-related securities in the financial system and taking illiquid assets off the balance sheet. I know there are a lot of other ideas out there and we respect those ideas. We have looked at a lot of them, but this was a time we thought for a broad based systemic approach--I am sorry that it has come upon us all so suddenly, but it became very clear that last week we needed to act very quickly. Ms. Brown-Waite. Mr. Chairman, many have said Fannie, Freddie, AIG. What is in your opinion, gentlemen, the next crisis? I am hearing it is credit cards. And I know you have been asked this question before and I never have heard a straight answer. Could we have a straight answer on this? What is the next financial crisis? " 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-111shrg62643--169 Mr. Bernanke," I think the regulators would have had a better chance of identifying some of the problems that arose in this recent crisis with that kind of framework that you have created. But beyond that macroprudential aspect, there is also a number of steps to strengthen the system, make it more resilient, to put more derivatives through central counterparties, to increase capital and so on, so that whatever the source of a future crisis, even if it is not identified and defused, the system will be better able to withstand that effect. And then, finally, if we get unfortunately to the firefighting stage, there are additional tools there. So I think it is a useful approach to have multiple ways of addressing crises, both preventive and resilience and firefighting. So the macroprudential part is very important. It is difficult. It is going to require coordination among different regulators, but it is a direction that regulators around the world and academics and others looking at this really believe is the right direction, and there is quite a bit of thinking already out there about how we could do, for example, stress tests that look at the whole system, which combine the results for individual firms, as you mentioned, but also are able to infer from that how the system as a whole might perform if a certain set of stresses arose. So there is clearly a relationship between the micro- and macroprudential part, but there is a lot of challenging work to be done there. " CHRG-110hhrg46593--181 Mr. Bernanke," Certainly, this situation has sometimes been represented as a failure of capitalism. I don't think that is right. The problem is that our financial system, there have been problems of regulation and problems of execution that have created a crisis in the financial system. We have seen, in many cases, historically and in other countries, that a collapse in the financial system can bring down an otherwise very strong economy. So our efforts have been very focused on stabilizing the financial system. And as that situation is rectified, going forward, we need to really think hard about our supervision and regulation and make sure we get it right. But I don't think that this is an indictment of the broad market system. " CHRG-111shrg50564--168 Chairman Dodd," Right. " Mr. Dodaro,"----but that is done by the financial institutions in the system and not supported by taxpayer funds. I mean, that was something that was modernized during the savings and loan and banking crisis we had in the 1990s. " CHRG-110hhrg44903--27 Mr. Kanjorski," Let me ask you, on our committee right now, we are working on consideration providing legislation to have an optional Federal charter insurance. And of course, we were considerably along that line when the credit crisis occurred. I would like your honest opinion, both of you, actually, is this something that should be delayed on our part because of this tendency to confuse and complicate the existing crisis? Or is it something we should move forward with? Is it a tool that could be utilized to standardize regulatory reform within the system? " CHRG-111hhrg53238--30 Mr. Bartlett," Thank you Mr. Chairman, Ranking Member Bachus, and members of the committee. The focus of this hearing is on the future, as it should be, but I want to begin with an apology about the past--I said this at other times, in other forums, and in other places for perhaps a year; John Dalton, representing the Roundtable and Housing Policy Council, said this the last time he was before the committee--and that is, our sincere--my personal, sincere apologies and those of our organizations for the role that we played and I played in failing to see the crisis in time to help to avert it. So I accept my responsibilities. And we are here to set out some responsibilities to seek reform to avert the next crisis. It is the Roundtable's view and my view that this reform should be comprehensive, should be systemic, and should be quite large in terms of its scope of averting the next crisis. The fact is, there is a lot of blame to go around, a lot of sources of the problem; but the number one problem, it seems to me, that brought us here was the regulatory system that is in chaos in terms of its structure. The current system is characterized much more by silos of regulation than coherent regulation, and that introduces hundreds of different agencies who regulate the same companies with the same activities in totally different ways based on different statutes, different standards, different systems, different goals, with a total lack, or virtually total lack, of common principles and common goals. So I am here today to start with this committee to urge comprehensive reform. The Roundtable supports bold reform, comprehensive reform that will strengthen the ability of our financial systems to serve the needs of consumers and to ensure the stability and integrity and safety and soundness of the financial system. To be clear, the status quo is unacceptable. I am going to comment orally on several components of the legislation or the proposal that has been proposed by the Administration. I have about 15 in total in my written testimony. I will offer four or five. " fcic_final_report_full--537 Further investigation of this issue is necessary, including on the role of the bank regulators, in order to determine what effect, if any, the merger-related commitments to make CRA loans might have had on the number of NTMs in the U.S. financial system before the financial crisis. CHRG-111hhrg56776--15 Mr. Bernanke," Mr. Chairman, I think there were some flaws at each level. There were flaws at the level of the legislative structure. There were flaws at the level of execution. I think we need to look at all of those. I think there are two main lessons from the crisis. One is that every systemically critical large institution needs to have a consolidated supervisor that can look at the whole company and understand the risks that are faced by that company. Many of the worst problems in the investment banks and AIG and in other companies and markets were areas where there was no strong supervisor, where there was just a gap. We need to fix that as we go forward. We also, I think, need to strengthen the concept of consolidated supervision. We currently have a system where each supervisor is assumed to defer to the functional regulator of each subsidiary, and in some cases, that is not appropriate. When a consolidated supervisor sees a problem in a subsidiary, it needs the authority to go in and look at that. The other broad concern, the other thing we learned from the crisis at the very highest level, is the need to look at the system from a systemic perspective, not just look at each individual firm, but to look at broad risks to the whole system. I think that some of the ideas which have been advanced in the House bill and Senator Dodd's proposal, such as creating a systemic risk council, and broadening the responsibilities of some of the regulators, would help address that problem, and together with tougher regulations like higher capital standards, I think that would improve our oversight considerably. " CHRG-111shrg55117--34 Mr. Bernanke," Senator, it is very hard to get credit for something that did not happen, but in September and October, I believe we faced the worst global financial crisis since the 1930s and perhaps including the 1930s. Beyond the crisis of Lehman and AIG and Merrill and Wachovia in September, in mid-October we faced a global banking crisis where not only the United States but many other industrial countries were on the verge of collapse of the banking systems. There was a loosely coordinated effort around the world involving injection of capital, provision of guarantees, purchases of distressed assets, provision of liquidity, which succeeded in stabilizing the global banking system in mid-October, which set the basis for the slow stabilization of the financial system and recovery that we have seen since then. By the way, there has been so much focus here, of course, on AIG and the interventions here, but there have been about a dozen similar interventions around the world. So we are not alone in that respect as other countries have also moved in to protect and avoid the collapse of systemically critical firms. I believe that if those actions had not been taken, if the TARP had not been available to prevent that collapse, if there had not been an aggressive international policy response, I believe we would be in a very, very deep and protracted recession which might be almost like a depression, I think much, much worse than what we are seeing now. The situation--I do not want to understate--the situation now is very poor. The unemployment rate is unacceptably high. Americans are suffering. But I do believe that we have a much better situation than we would have if we had seen a collapse of the global financial system last October. Senator Reed. Mr. Chairman, let me focus on the point that you just made about unemployment. Approximately 540,000 Americans will exhaust their unemployment benefits by the end of September; 1.5 million will run out by the end of the year. We all understand this is a central problem, maybe even a systemic risk. Would you urge us to extend unemployment benefits? " CHRG-111shrg50814--153 Mr. Bernanke," Well, I think the Fed was a very active and conscientious regulator. It did identify a lot of the problems. Along with our other fellow regulators, we identified issues with non-traditional mortgages, with commercial real estate, with leveraged lending and other things. But what nobody did was understand how big and powerful this credit boom and the ensuing credit collapse was going to be, and routine supervision was just insufficient to deal with the size of this crisis. So clearly, going forward, we need to think much more broadly, more macroprudentially, about the whole system and think about what we need to do to make sure that the system as a whole doesn't get subjected to this kind of broad-based crisis in the future. Senator Shelby. Does that include insurance, too, because insurance has been regulated under the McCarran-Ferguson Act by the States, but then you had AIG, which caused systemic stress, to say the least, to our banking system, and they were regulated primarily by the New York State Insurance Commission. " Mr. Bernanke," AIG had a Financial Products Division which was very lightly regulated and was the source of a great deal of systemic trouble. So I think that we do need to have broader-based coverage, more even coverage, more even playing field, to make sure that there aren't--as our system evolves, that there aren't markets and products and approaches that get out of the line of vision of the regulators, and that was a problem we had in the last few years. Senator Shelby. Thank you, Mr. Chairman. " 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-111hhrg48674--100 Mr. Bernanke," Congressman, I have a very open mind about this, and I think it is very important to understand what went wrong, and there are probably many elements that contributed to the crisis. I do not think the evidence supports the view that Federal Reserve monetary policy in the early part of this decade was the principal source of the crisis. I think the principal source of the crisis had to do with the huge capital inflows coming from our trade deficit which overwhelmed our system and made risk management inadequate. That being said, I think we need to review monetary policy and make sure in particular that we don't err in terms of leaving policy too easy too long. Now, whether inflation targets would have helped, I am not sure. One of the key proponents of this view that the Federal Reserve kept rates too low explains the worldwide nature of this crisis by saying all the other central banks did the same thing, and most of them had inflation targets. " CHRG-111shrg54675--94 RESPONSE TO WRITTEN QUESTIONS OF CHAIRMAN JOHNSON FROM ARTHUR C. JOHNSONQ.1. Mr. Hopkins and Mr. Johnson, both of your institutions are members of the Federal Home Loan Bank system. How do you use the Federal Home Loan Bank to support your bank's lending in your market? Has the current economic crisis and the liquidity crisis affected your use of the Federal Home Loan Banks? Last year, HERA expanded the number of community banks that can use collateral to borrow from the FHLBanks. Has your institution's ability to pledge this collateral been helpful?A.1. The FHLBanks have delivered innovation and service to the U.S. housing market for 76 years, and currently have more than 8,100 members in all 50 States and the District of Columbia, American Samoa, Guam, Puerto Rico, and the Northern Mariana and U.S. Virgin Islands. The Federal Home Loan Bank System (FHLBanks) remains viable and strong, despite losses at a number of the Home Loan Banks similar to those incurred by most of the financial services industry due to the economic downturn. Indeed, without the ability by banks and other lenders to borrow from the Federal Home Loan Banks, the credit crisis of the last year would have been significantly worse. From the outset of the credit crisis, the Federal Home Loan Banks have engaged to ensure liquidity to the financial system. Advances to FHLB Member Banks increased from $640,681 billon at year end 2006 to $928,638 billion at year end 2008. This increase of nearly $300 billion in liquidity went, in large part, to community bank members of the Federal Home Loan Banks. Many small banks rely on the System for term advances to meet day to day liquidity demands. Because the System is a cooperative, members have a vested interest in the prudent lending and operations of the Banks. The result is a liquidity source which is transparent and self monitored. Additionally, the recent GSE reform legislation which combined the regulation of Fannie Mae, Freddie Mac, and the Federal Home Loan Banks has led to a more sophisticated, detailed and experienced regulatory regime for the System and its members. ------ CHRG-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-111hhrg52400--33 Mr. Hill," Thank you, Mr. Chairman. Good morning, Chairman Kanjorski, Ranking Member Garrett, and members of the subcommittee. It is an honor to testify before you today on these important issues. My name is John Hill, and I am president and chief operating officer of Magna Carta Companies. Magna Carta was founded in New York in 1925 as a mutual insurance carrier for the taxi cab industry. Although we no longer insure taxis, we employ 240 individuals and write in 22 States. We very much remain a small, Main Street mutual insurer with $170 million in direct-written premium. I am here today on behalf of the National Association of Mutual Insurance Companies, to present our views on systemic risk. NAMIC represents more than 1,400 property and casualty insurance companies, ranging from small farm mutual companies to State and regional insurance carriers to large, national writers. NAMIC members serve the insurance needs of millions of consumers and businesses in every town and city across America. I serve as chairman of NAMIC's financial services task force, which was created specifically to develop NAMIC's policy response to the financial services crisis. Our Nation faces uncertain economic times, and we commend the subcommittee for holding this hearing to explore the role of systemic risk regulation in the insurance industry. The property casualty insurance industry, like millions of Americans and businesses, did not contribute to the current financial crisis. However, we too have felt the negative impact of this crisis. Just like most American citizens and businesses, the property casualty insurance industry has played by the rules. We are solvent, and continue to serve our policyholders the same today as before the economic crisis. If you exclude a very few companies that are linked to financial markets, our analysis concludes that our industry poses no systemic risk. We disagree with the suggestion that we need to completely rethink the regulation of our industry. The property and casualty market place is well-regulated, highly diverse, very competitive, and is open to anyone that is willing to play by the rules. It is important to understand the distinction between the property and casualty insurance industry and others in the financial services sector. The fundamental characteristics of our industry, including conservative and liquid investment portfolios, low leverage ratios, strong solvency regulation, and a highly competitive and diverse market place, make it stand out as unique, and work to insulate the property casualty insurance industry from posing systemic risk. Today, as other financial services companies are failing and seeking government assistance, property and casualty insurers continue to be well capitalized and neither seek nor require Federal funding. Our industry remains one of the well-functioning bedrocks of our financial structure. The record shows that property and casualty insurers played no role in causing the current financial crisis. Moreover, it is exceedingly unlikely that property casualty insurers, either individually or collectively, could cause a financial crisis in the future. For one, the capital structures of property and casualty insurers and the nature of their products make them inherently less vulnerable than the highly leveraged institutions when financial markets collapse. Additionally, the nationwide State-based guaranty funds system also reduces the systemic impact of any failing property casualty insurer. NAMIC believes that any new oversight of systemic risk should focus on products, activities, and market-oriented events and developments, rather than broad corporate categories or industries. It should be carefully designed to address the kind of market-oriented problems that have the ability to cause systemwide access. Only institutions that offer products, or engage in transactions deemed to create systemic risk, including insurers, should be subject to systemic risk oversight. The current crisis demands that Congress act. But Congress must act prudently and responsibly, focusing limited resources on the most critical issues, and avoid the inclination to rush to wholesale reform. NAMIC does believe that Congress can strengthen the regulatory process, improve regulatory coordination, and monitor systemic risk by establishing an office of insurance information to inform Federal decisionmaking on insurance issues, and facilitate international agreements. We would also recommend expanding the President's Financial Working Group to include insurance regulators. We believe such reforms are measured, appropriate, and timely responses to the present crisis. As the process moves forward, we stand ready to work with the committee to address the current problems and regulatory gaps. We urge Congress to keep in mind the dramatic differences between Main Street businesses that have never stopped meeting the needs of local consumers, and those institutions that caused this crisis. Again, thank you for the opportunity to speak here today, and I look forward to answering your questions. [The prepared statement of Mr. Hill can be found on page 81 of the appendix.] " CHRG-111hhrg53238--148 Mr. Bartlett," We think that the new systemic regulator will look at that. So far, we haven't seen the adverse effects, but we may well. We think it is still an open question. That is a real problem. Obviously--and you are not implying this--you don't want to solve that problem by denying Americans the right to invest across markets. So we think it is a problem, but as of this point it hasn't led to a crisis. It hasn't added to the crisis. But we think it ought to be something that ought to be looked at, and we will get you some thoughts on that on the record. " 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.] " FinancialCrisisInquiry--12 Excessive leverage by many U.S. investment banks, foreign banks, commercial banks, and even consumers pervaded the system. This included hedge funds, private equity firms banks and non-banks using off-balance sheet vehicles. There were also several structural risks and imbalances that grew in the lead-up to the crisis. There was an over reliance on short- term financing to support illiquid long-term assets, and over time, certain financing terms became too lax. Another factor in the crisis was clearly a regulatory system. I want to be clear I do not believe the regulators. While they obviously have a critical role to play, the responsibility for companies’ actions rest solely on the companies’ management. But we should also look to see what could have been done better in the regulatory system. We have known that our system is poorly organized with overlapping responsibilities. Many regulators did not have the statutory authority they needed to address the failure of large global financial companies. Much of the mortgage business was not regulated or lacked uniform treatment. Basel II capital standards allowed too much leverage in investment banks and other firms and not incorporate liquidity at all. The extraordinary growth and high leverage of the GSEs also added to the risk. We also learned that our system has many embedded pro-cyclical biases, a number of which proved harmful in times of economic stress. Loan loss reserving methodologies caused reserves to be at their lowest levels at a time when high provisioning might be needed the most. Certain regulatory capital standards are also pro-cyclical, and continuous downgrades by credit agencies also required many financial institutions to raise more capital. When all is said and done, I believe it will be found that macro economic factors will have been some of the fundamental underlying cause of the crisis. Huge trade and financing imbalances caused large distortions in interest rates and consumption. As for J.P. Morgan Chase, the last year and a half was the most challenging period in our company’s history. I’m immensely proud of the way our employees continued to serve our customers through this difficult time. Throughout the financial crisis, we never posted a quarterly loss. We served as a safe haven for depositors. We worked closely with the federal government. And we remained an active lender. FinancialCrisisInquiry--9 One of the largest stresses placed on Goldman Sachs and other firms during the height of the crisis was the possibility that we were managing risk in the same way other institutions, which were severely hampered or later failed, had managed their risks. Getting the market to recognize that our balance sheet was well marked and that our reported capital levels were accurate was one of our most significant challenges. Without question, direct government support was critical in stabilizing the financial system. And we benefitted from it. The system clearly needs to be structured so that in the future private capital rather than government capital is used to stabilize troubled firms promptly before a crisis takes hold. The two mechanisms that seem to hold the most promise for addressing this goal and addressing too-big-to-fail are ongoing stress tests, which are made public, and contingent capital possibly triggered by failing a stress test. These two elements could also be the core of a strong but flexible resolution authority. Certainly, enhanced capital requirements in general will reduce systemic risk. But we should not overlook liquidity. If a significant portion of an institution’s assets are impaired and illiquid and its funding is relying on short-term borrowing, low leverage will not be much comfort. Regulators should lay out standards that emphasize prudence and the need for longer-term maturities depending on the assets being funded. Institutions should also be required to carry a significant amount of cash at all times ensuring against extreme events. Lastly, I wanted to briefly discuss our firm’s experience during 2008 and 2009. While we certainly had to deal with our share of challenges during the financial crisis, Goldman Sachs was profitable in 2008. As I look back to the beginning and throughout the course of the crisis, we couldn’t anticipate its extent. We didn’t know at any moment if asset prices would deteriorate further or had declined too much and would snap back. CHRG-111hhrg48867--26 Mr. Bartlett," Thank you, Mr. Chairman. Beginning about 3 years ago, the Roundtable began to examine the questions of our current regulatory system, many of which are raised today. This dialogue over that time has, over those 3 years, has evolved into a focus on how the current system also undermines the stability and the integrity of the financial services industry. I provided in my written testimony a format that provides at least our answer to many of the questions that were raised today and previously questions and comments. I want to summarize our conclusions as follows: One, the financial services industry is regulated by hundreds of separate independent regulators at various levels. It is a system of fragmentation, inconsistency, and chaos. It is a fragmented system of national and State financial regulation that is based on functional regulation within individual companies, and those companies are also regulated according to their charter type. There is limited coordination and cooperation among different regulators even though firms with different charters often engage in the same, similar, or sometimes exact activities. No Federal agency is responsible for examining and understanding the risk created by the interconnections between firms and between markets. This chaotic system, our conclusion, of financial regulation was a contributing factor to the current crisis. Number two, that is not to say that the fragmented regulation is the only cause. The financial services industry accepts our share of responsibility: badly underwritten mortgages; compensation packages that pay for short-term revenue growth instead of long-term financial soundness; failure to communicate across sectors, even within the same company; and sometimes even downright predatory practices. All of those and more have been part of this crisis. Since early 2007, the industry has formally and aggressively taken actions to correct those practices. Underwriting standards have been upgraded, credit practices have been reviewed and recalibrated, leverage has been reduced, and firms have rebuilt capital, incentives have been realigned, and some management teams have been replaced. We are not seeking credit for that. Clearly the horses are all out of the barn running around in the field. But those are the steps that have been taken in the last 2 years. But the regulatory system that was in place 2 years and 5 years ago is still in place. An absence of coherent comprehensive systemic regulatory structure did fail to identify and prevent the crisis, and we still have the same regulatory system today. Number three, reforming and restructuring the regulatory system in 2009 should be Congress' primary mission moving forward to resolve the crisis and prevent another crisis. Achieving better and more effective regulation does require more than just rearranging regulatory assignments. Better and more effective regulation requires a greater reliance on principle-based regulation, a greater reliance on a system of prudential supervision, a reduction in the pro-cyclical effects of regulatory and accounting principles, and a consistent uniform standard of which similar activities and similar institutions are regulated in similar ways. Number four, we are proposing a comprehensive reform of the regulatory structure that includes clear lines of authority and uniform standards across both State lines and types of business. Within our proposal, we recommend: the consolidation of several existing Federal agencies into single agencies, a single national financial institutions regulator that would be consolidated prudential and consumer protection agency for banking, securities, and insurance; a new capital markets agency through the merger of the SEC and the CFTC to protect depositors and shareholders and investors; and to resolve failing or failed institutions, we propose a creation of the national insurance and resolution authority to resolve institutions that fail in a consistent manner from place to place. Number five, we also advocate a systemic regulator, what we prefer to call a market stability regulator. The market stability regulator would be, as I said in subcommittee testimony, ``NIFO--nose in and fingers out.'' That means a market stability regulator should not replace or add to the primary regulators, but should identify risks and act through and with a firm's primary regulator. We believe that designating the Federal Reserve is the natural complement to the Federal Reserve Board's existing authority as the Nation's central bank and the lender of last resort. The market stability regulator should be authorized to oversee all types of financial markets and financial services firms, whether regulated or unregulated, and we propose an exact definition of at least our proposal of that system of regulation of systemic regulator. And number six, the U.S. regulatory system should be the U.S. system of course, but it should be coordinated and consistent with international standards. Mr. Chairman, the time to act is now. We believe that these reforms should proceed in a comprehensive fashion rather than a piecemeal fashion. The key is to do this correctly, not rapidly, but to do this with the sense of urgency for which the crisis calls. Thank you, Mr. Chairman. [The prepared statement of Mr. Bartlett can be found on page 64 of the appendix.] " 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. " CHRG-111hhrg52397--6 Mr. Ackerman," If we could step into our time machines and go back in time before the near collapse of AIG, I have little doubt that we would have near unanimous support for regulating credit default swaps. But of course we cannot go back in time, we cannot stop AIG from overextending itself, and the next crisis will not stem from AIG's credit default swap portfolio. Our financial regulatory structure is like a tattered quilt made up of dozen of patches, each representing a State and Federal supervisor, agency, some patches overlapping, and we now know some areas completely bare. Preventing the next crisis will require more than simply sewing yet another patch onto the quilt. Regardless of how meritorious the proposals to regulate and clear out these derivatives may be, we need a regulator with the ability to see the complete picture, not just the OTC derivatives market, not just the exchanges, not just the banking system, but all of it. We need a regulator who has the ability to see trends in the OTC derivative markets that independently might not be worrisome but when paired with information pertaining to the reserves of our banks could be cause for concern. And we need the regulator to have the ability to act appropriately and expeditiously to address systemic risk. And so in my view merely granting the SEC or the CFDC the authority to regulate and to clear out these products is near-sighted and inadequate. If we are to learn from this financial crisis, any legislation that seeks to regulate OTC products must be paired with a systemic risk regulator. I thank you and I yield back the balance of my time. " CHRG-111hhrg54869--90 Mr. Volcker," The danger is that the spread of implicitly a moral hazard could make the next crisis bigger. It is not going to be next year. It is not going to be probably 4 or 5 years. But memories are dim. And we want to make a system such that we don't have a still bigger crisis 10 years from now. And if we do nothing and let moral hazard become even more accepted, I am afraid there is a real danger. So you want this resolution system to do such things as creditors taking a haircut if they have to; or convert into stocks, and the stockholder will probably lose and lose completely. In many cases, there will be a forced merger or other actions that will not require the injection of government money that can stabilize the situation. Now, that is more forceful than what happened in the midst of the great crisis a year ago when, by and large, with the exception of Lehman, the bondholders were pretty much protected in the financial world. They weren't protected in General Motors and Chrysler, but they were protected in the financial. And even some of the stockholders were protected. Now, they did not lose as much as you might have thought they should have lost. We want to minimize that kind of result to the extent possible so that the lesson gets through: You creditors are taking a risk and you ought to understand that. And the government isn't going to come to your aid if this institution fails. And this is the game. I hate to call it a game, but this is, I think, the approach that we are trying to instill, and make sure there is what is appropriate uncertainty, or maybe certainty, that if these nonbank institutions are going to fail, the creditors are at risk and the stockholders are at risk. And we do the best we can to do that without destroying the system. Ms. Jenkins. Thank you. I appreciate your input. I yield back the balance of my time. " 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. " 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-111shrg62643--181 Mr. Bernanke," Yes, I think we are. I think there were important gaps in our regulatory system which became painfully evident during the crisis and that substantial progress has been made to closing those gaps. We have increased our capacity to take a macroprudential approach, which I think is an important complement to our current institution-by-institution approach. And the ability to wind down large firms and avoid the bailout problem or avoid the situation where we have to choose between a bailout and a financial crisis, I think that is an important step also. Now, all those things are going to require a lot of work to make them effective and useful tools, but it was very important to address those problems. " CHRG-111hhrg54867--26 Secretary Geithner," No, I would just say we had a test of the proposition that you can solve a crisis by hoping it is going to burn itself out. You saw how deeply damaging it was to the country as a whole. So you can't fix this system, make it more stable in the future, by hoping and promising that you are going to--how should I say it-- " CHRG-111hhrg51698--128 Mr. Kissell," Mr. Damgard, I don't mean to interrupt you, but I do apologize. I understand the home mortgage situation, but we were having these problems with these little train wrecks long before the home mortgage became a crisis. See, I am just curious about the system. How can the system work well when our families are the ones hurting? I can feel tens of thousands of people here and say something went wrong when prices went up that much, and nobody can explain it. That is why I am curious. How should we tweak the system? Mr. Greenberger, you might have a different point of view on this. " CHRG-111hhrg53244--125 Mr. Bernanke," In terms of having the same terms and conditions that they had before the crisis, maybe that will never come back, because credit is sort of permanently tightened up in that respect. I am hopeful that as banks stabilize--and we are seeing some improvements in the banking system--and as the economy stabilizes to give more confidence to lenders, that we will see better credit flows. " CHRG-111shrg53085--23 Mr. Attridge," Mr. Chairman, Ranking Member Shelby, and Members of the Committee, my name is Bill Attridge. I am President and Chief Executive Officer of Connecticut River Community Bank. My bank is located in Wethersfield, Connecticut, a 375-year-old town with about 27,000 people. Our bank opened in 2002 and has offices in Wethersfield, Glastonbury, and West Hartford--all suburbs of Hartford. We have 30 employees and about $185 million in total assets at this time. We are a full-service bank, but the bank's focus is on lending to the business community. I am also a former President of the Connecticut Community Bankers Association. I am here to represent the Independent Community Bankers of America and its 5,000 member banks. ICBA is pleased to have this opportunity to testify today, and ICBA commends your bold action to address the current issues. Mr. Chairman, community bankers are dismayed by the current situation. We have spent the past 25 years warning policymakers of the systemic risk by the unbridled growth of the Nation's largest banks and financial firms. But we were told we did not get it, that we didn't understand the new global economy, that we were protectionist, that we were afraid of competition, and that we needed to get with the ``modern'' times. However, our financial system is now imploding around us. It is important for us to ask: How did this happen? And what must Congress do to fix the problem. For over three generations, the U.S. banking regulatory structure has served this Nation well. Our banking sector was the envy of the world and the strongest and most resilient financial system ever created. But we got off track. Our system has allowed--and even encouraged--the establishment of financial institutions that threaten our entire economy. Nonbank financial regulation has been lax. The crisis illustrates the dangerous overconcentration of financial resources in too few hands. To address this core issue, we recommend the following. Congress should require the financial agencies to identify, regulate, assess, and eventually break up institutions posing a risk to our entire economy. This is the only way to protect taxpayers and maintain a vibrant banking system where small and large institutions are able to fairly compete. Congress should reduce the 10-percent cap on deposit concentration. Congress should direct the systemic risk regulator to block any merger that would result in the creation of a systemic risk institution. An effective systemic risk regulator must have the duty and authority to block activity that threatens systemic risk. Congress should not establish a single, monolithic regulator for the financial system. The current structure provides valuable regulatory checks and balances and promotes best practices among those agencies. The dual banking system should be maintained. Multiple charter options, both Federal and State, are essential preserve an innovative and resilient regulatory system. Mr. Chairman, we do not make these recommendations lightly, but unless you take bold action, you will again be faced with a financial crisis brought on by mistakes made by banks that are too big to fail, too big to regulate, and too big to manage. Breaking up systemic risk institutions while maintaining the current regulatory system for community banks recognizes two key facts: first, our current problems stem from overconcentration; and, second, community banks have performed well and did not cause the crisis. ICBA also believe nonbank providers of financial services, such as mortgage companies and mortgage brokers, should be subject to greater oversight for consumer protection. The incidence of abuse was much less pronounced in the highly regulated banking sector. Many of the proposals in our testimony are controversial, but we feel they are necessary to safeguard America's great financial system and make it stronger coming out of this crisis. Congress should avoid doing damage to the regulatory system for community banks, a system that has been tremendously effective. However, Congress should take a number of steps to regulate, assess, and ultimately break up institutions that pose unacceptable systemic risks to the Nation's financial system. ICBA looks forward to working with you on this very important issue, and we appreciate this opportunity to testify. " CHRG-111hhrg48867--36 Mr. Plunkett," Thank you, Mr. Chairman, Ranking Member Bachus, and members of the committee. I am Travis Plunkett, legislative director of the Consumer Federation of America, and I appreciate the opportunity to testify today about how to better protect the financial system as a whole and the broader economy from systemic risk. I would like to make three key points: First, systemic regulation isn't just a matter of designating and empowering a risk regulator, as important as that may be. It involves a comprehensive plan to reduce systemic risk, including immediate steps both to reinvigorate day-to-day safety and soundness in consumer and investor protection regulation of financial institutions and to address existing systemic risk, in particular by shutting down the shadow banking system once and for all. Second, systemic risk regulation should not rely only on a crisis management approach or focus on flagging a handful of large institutions that are deemed too big to fail. Rather, it must be an ongoing day-to-day obligation of financial regulators focused on reducing the likelihood of a systemic failure triggered by any institution or institutions in the aggregate. Third, CFA has not endorsed a particular systemic regulatory structure, but if Congress chooses to designate the Fed as a systemic regulator, it must take steps to address several problems inherent in this approach, including the Fed's lack of transparency and accountability and the potential for conflicts between the roles of setting monetary policy and regulating for systemic risk. The fact that we could have prevented the current crisis without a systemic regulator provides a cautionary lesson about the limits of an approach that is just focused on creating new regulatory structures. It is clear that regulators could have prevented or greatly reduced the severity of the current crisis using basic consumer protection and safety and soundness authority. Unless we abandon a regulatory philosophy based on a rational faith in the ability of markets to self-correct, whatever we do on systemic risk regulation is likely to have a limited effect. The flip side of this point, the positive side, suggests that simply closing the loopholes in the current regulatory structure, reinvigorating Federal regulators in doing an effective job of the day-to-day task of soundness and investor and consumer protection will go a long way to eliminating the greatest threats to the financial system. Chairman Frank and several members of this committee have been leaders in talking about the importance of a comprehensive approach to systemic risk regulation and have focused on executive compensation as a factor that contributes to systemic risk. We agree about the compensation practices that encourage excessive risk-taking and about the need to bring currently unregulated financial activities under the regulatory umbrella. The experiences of the past year have demonstrated conclusively the ineffectiveness of managing systemic risk only when the Nation finds itself on the brink of a crisis. It is of paramount importance in our view that any new plan provide regulators with ongoing day-to-day authority to curb systemic risk. The goal of regulation should not be focused only or even primarily on the potential bailout of systemically significant institutions. Rather, it should be designed to ensure that all risks that could threaten the broader financial system are quickly identified and addressed to reduce the likelihood that a systemically significant institution will fail and to provide for the orderly failure of nonbank financial institutions. Regardless of which structure Congress chooses to adopt, we urge you to build incentives into the system to discourage institutions from becoming too big or too interconnected to fail. One way to do this is to subject financial institutions to risk-based capital requirements and premium payments designed to deter those practices that magnify risks, such as growing too large, holding risky assets, increasing leverage, or engaging in other activities deemed risky by regulators. To increase the accountability of regulators and reduce the risk of groupthink, we also recommend that you create a high level systemic risk advisory council made up of academics and other independent analysts from a variety of disciplines. Once again, I appreciate the opportunity to appear before you today and look forward to answering questions. [The prepared statement of Mr. Plunkett can be found on page 101 of the appendix.] " Mr. Kanjorski," [presiding] Thank you very much, Mr. Plunkett. Mr. Silvers. STATEMENT OF DAMON A. SILVERS, ASSOCIATE GENERAL COUNSEL, AFL- CHRG-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-110hhrg46593--135 Secretary Paulson," We certainly did not anticipate everything that was going to happen. But, what we did anticipate, we got legislation that was broad enough in the authority, so that what we came out--I think the way you should be looking at it is we gave, we came and we said there is a real crisis; there was a real crisis. We got the authorities we needed, and we went to the heart of the problem. And the heart of the problem was the financial system and capital, and we used a strategy that would work more effectively, and it has worked, number one, in stabilizing the system. Now, you have asked, what were the other things that we were considering or have considered, plan ``B'' or ``C'' or ``D?'' And there are only--to deal with something in the magnitude we are dealing with, there has only been one trade-off we have made. And the trade-off we have made is between capital, which goes farther per dollar of TARP investment, and purchasing illiquid assets, which we would have to do in big size. We are also looking at a variety of other programs but don't involve that big trade-off. I have talked about a program to use a small amount of TARP assets to make it possible for the Fed to provide liquidity to consumer credit. We have talked about the future capital programs. Now, with regard to the automotive industry-- " CHRG-111shrg54533--14 Chairman Dodd," Senator Schumer. Senator Schumer. Thank you, Mr. Chairman, and I want to thank you and congratulate you on the blueprint that you put together, Secretary Geithner, because I do believe it will close many of the most important regulatory gaps in our system. There are a few issues where I think the administration should have pushed a bit farther, but this is an excellent framework and charts a clear course to fix the problems that led us to the crisis. Two places I would like to just give you a pat on the back, I agree with Senator Dodd, a Financial Consumer Product Safety Commission is essential. The Fed failed significantly in this responsibility. So while you have got to be leery of starting over, in this case, you have to start over and a new agency is what is called for. Second, of less noticed but of great importance is the idea that the mortgage issuer and securitizer must hold a piece of the mortgage. That would have stopped Countrywide and others like it in its tracks. It certainly would have greatly lessened the crisis. It might have even avoided it. So that is a great addition, because now they can't issue these junky mortgages and then just not hold them and sell them. On the systemic risk regulator, we need one, there is no question, and the old way is certainly bad. We can criticize any proposal, but keeping the present system is worse. Every agency had a piece of the system to oversee and protect, but nobody had responsibility to mind the whole store rather than just looking after individual aisles. I agree with Senator Shelby, it is really hard to do. But, tackle it we must, or we risk having the same kind of widespread financial crisis that we have just been going through. You cannot let the perfect be the enemy of the good here or we end up with less, and believe me, it is hard to do. Who predicted--you could probably count on your hands and toes the number of people in financial services, the commentators, the press, in government, who predicted 5 years ago that mortgages and this mortgage crisis would bring the whole system down. It is very hard to see around the corner. And my view, I tend to agree--I am not certain, but I tend to agree that the Fed is the best answer. There are no great ones. A council? That is a formula for disaster in something like this. A council, everyone will pass the buck and it will stop nowhere. You must have the buck stop somewhere with systemic risk. So then maybe you should have a new regulator, just someone new. The problem is, you need deep, deep knowledge of how the financial system works and a new council is going to be much slower to start. The Fed has that knowledge. You could argue the reason the Fed failed in the past, and it did, was because of the attitude of some of the people at the top who were for abject deregulation rather than the structure, but to me at least, until shown a better example, I think the Fed, at least tentatively, is the best one. The question I wanted to ask you is about bank responsibility. For years, everybody has said one of the problems of banking regulation is that it is too divided up. The system allowed banks, most recently and notably again Countrywide--that has been a nemesis to me--to game the system for the slightest regulation possible, yet your plan, while consolidating OTS and OCC, leaves significant prudential supervisory authority with the Fed and FDIC. If you count the new consumer watchdog agency, which I am all for, there would be four bodies involved in bank supervision, the same as we started with, no consolidation. A multiplicity of regulators tends to produce less oversight overall. The whole is greater than the sum of its parts when it comes to a symphony orchestra or the New York Giants, but with our patchwork system of banking regulators, the whole is less. So please tell us why you didn't do more consolidation, and particularly with the Fed gaining these powers, why do they have to be the supervisor of State banks, setting up this duplication of systems where you have a Fed regulator, the OCC, for the same exact bank who then shops around to be State chartered? If you want to remove another power from the Fed, which is getting a lot, take it away. Don't have them regulate State banks. Why didn't you consolidate the banking regulators more? " CHRG-111hhrg49968--75 Mr. Bernanke," Well, I think there are some changes that are worth making. And I would mention specifically, I was asked a question a moment ago about AIG, for example. It was with great, great reluctance the Federal Reserve got involved in that kind of situation, there being no good alternative to avoid a collapse of a major financial firm and the consequences that would have for the financial system and for the economy. As I have said a number of times for at least a year, I think a very critical step that the Congress needs to take is to develop a resolution regime that would allow the government--not the Fed, but the government to step in when a major financial firm is near default and the financial system is in crisis. That would be parallel to what we already do now for banks through the fiduciary system. If we could have such a system in place, then the Fed would no longer be in the ``Hobson's choice'' of either standing aside and letting the system collapse or taking these actions using a 13(3) authority, which are very, very uncomfortable for us. So that would be an area where we would be happy to withdraw or pull back on our activity if the government would provide a good system for addressing that issue. " CHRG-110hhrg44900--104 The Chairman," The gentleman from Kansas. Mr. Moore of Kansas. Thank you Mr. Chairman, for having this meeting. My questions are for both Secretary Paulson and Chairman Bernanke. For the past several years, the Treasury and the Federal Reserve have argued that the housing GSE's pose systemic risk to the financial system, and that they were a likely source of the next financial crisis. I agree that we should pass legislation that will give the GSE's a strong, new independent regulator. Do you agree that the GSE's have played a constructive role in trying to stabilize the markets? " CHRG-111shrg54675--89 RESPONSE TO WRITTEN QUESTIONS OF CHAIRMAN JOHNSON FROM JACK HOPKINSQ.1. Mr. Hopkins and Mr. Johnson, both of your institutions are members of the Federal Home Loan Bank system. How do you use the Federal Home Loan Bank to support your bank's lending in your market? Has the current economic crisis and the liquidity crisis affected your use of the Federal Home Loan Banks? Last year, HERA expanded the number of community banks that can use collateral to borrow from the FHLBanks. Has your institution's ability to pledge this collateral been helpful?A.1. Answer not received by time of publication. ------ CHRG-111shrg54533--10 Secretary Geithner," Mr. Chairman, I agree with you. These are some of the most important issues we are going to have to confront together, and I think that you and many others have expressed a number of thoughtful concerns about not just the role of the Fed going forward, but how to think about the right mix of accountability and authority in these areas. So let me just say a few things in response. I think you need to start--we need to start with the recognition that central banks everywhere around the world, in this country and everywhere else, were vested with the dual responsibility at the beginning for both monetary policy and some role in systemic financial stability. That is true here. It is true everywhere. And there is no, I believe, no necessary conflict between those two roles. For example, the Fed has got an exemplary record of keeping inflation low and stable over the last 30 years, even though it had the set of responsibilities you outlined that take it into the areas of financial stability. So I see no conflict. The second point I would make is the following. If you look at the experience of countries in this financial crisis who have taken away from their central bank, from their equivalent of our Federal Reserve, and given those responsibilities for financial stability, for supervision, for looking across the system to other agencies, I think they found themselves in a substantially worse position than we did as a country, with in many ways a worse crisis, with more leverage in their banking systems, with less capacity to act when the crisis unfolded, for a simple basic reason, I think. If you require a committee to act, if the people that have to act in the crisis, if the fire department has no knowledge of the underlying institutions it may have to lend to in crisis, it is likely to make less good judgments in that context. It may be too tentative to act or it may act less with--too indiscriminately in a crisis in that context. So if we look at the experience of many countries in the docu-differ model, it is not encouraging. The model where you take those responsibilities away from the central bank and vest them somewhere is not an encouraging model, in our judgment. I think you see those countries, if you listen carefully, moving in the other direction. Just a few other quick things in response. Our proposals for the additional authority we are giving the Fed are actually quite modest and build on their existing authorities. So, for example, the Fed already is the holding company supervisor of the major firms in the United States that are banks, or built around banks, but it was not given in Gramm-Leach-Bliley clear accountability and authority. It was required to defer to the functional supervisors responsible for overseeing the banks and the broker dealers. That is a bad mix of responsibility without authority, but we are proposing just to tighten that up and clarify it so they feel perfectly accountable for exercising that authority. In the payments area, the Fed has a general responsibility for looking at payment systems, but very limited, weak authority in terms of capital, which is essential to our reform proposals and central to any effort to create a more stable system. The Fed has some role today in helping set capital requirements, but that role is very constrained by the requirements of consensus across a very complicated mix of other regulatory authorities. Those are the key areas where we propose giving the Fed modest additional authority and clarify accountability for responsibility. They are not a dramatic increase in powers. We are proposing to take away from the Fed responsibility for writing rules for consumer protection and enforcing those rules. That is a substantial diminishment of authority and preoccupation and distraction. We are also proposing to qualify their capacity to use their emergency powers to lend to an institution they do not supervise in the future and to require that to exercise that authority, they require the concurrence of the executive branch. So we proposed what we believe is a balanced package over this set of independent regulatory authorities for consumer protection, for market integrity, for resolution authority. We propose establishing a council that will play the necessary coordinating role. That will provide some checks and balances against the risk that those underlying agencies get things wrong. It provides the capacity to deal with gaps, adapt in the future. So those are some of the reasons. I want to just say one more thing to end. I don't think there is any regulator or any supervisor in our country, and I think this is true for all the other major economies, that can look at their record and not find things that they did not do well enough. That is certainly true of the Fed. On the other hand, if you look at where risks were most acute in our country, where underwriting standards were weakest, where consumer protections were least adequate, again, where systemic risk that threatened the system was most acute, those developed largely outside the direct and indirect purview of the Fed and the Fed was left with no responsibility and no ability to contain those basic risks, and that is an important thing for us to change if we are going to build a stronger system. " CHRG-110hhrg46596--197 Mr. Kashkari," Congressman, there is no question that clarity and certainty are very important for developing market confidence. We have had to move and be nimble and react to changes on the ground. I say since the beginning of the credit crisis, the one constant has been its unpredictability. And it has only intensified and deepened more rapidly than we had expected, even in the few weeks that we were working with the Congress on this legislation. So I think we have a choice of being on our back foot and seeing what happens, potentially risking a financial collapse, or being on our front foot and being aggressive to try to stabilize the system, prevent a collapse, and then let the system heal. But I agree with you that more clarity will help with confidence, and will help the system to heal faster. And we think we have the right strategy. " CHRG-111shrg49488--53 Mr. Clark," The system, I think, would be very similar, as I understand from Dr. Carmichael, to the Australian system. There is a group that meets regularly that is chaired by the Deputy Minister of Finance and would have our regulator, OSFI, on it and would have the Bank of Canada on it and the Canada Deposit Insurance Corporation (CDIC), the equivalent to the FDIC, on it. And, in fact, they have now created two committees--one which is called the Financial Institutions Supervisory Committee (FISC), which is designed more to deal with low-level coordination issues, and then a second one that deals with more explicitly strategic issues. And I think it is probably fair to say that as a result of this crisis, the role of that committee in making sure that they are debating what the systemic risk is and who is doing what about it has been elevated as a result of this. Senator Collins. Mr. Green, what about in Great Britain? How is systemic risk handled? " CHRG-111shrg55117--44 Mr. Bernanke," Well, I understand, but I think it is a misconception. The Federal Reserve has worked with the Treasury, both the Republican and the Democratic Treasury, because in a situation of financial crisis, it is very important; I think the American people want to see their financial leadership working together to protect the stability of the system. Senator Bunning. But your job is monetary policy, not fiscal policy. " fcic_final_report_full--4 CONCLUSIONS OF THE FINANCIAL CRISIS INQUIRY COMMISSION The Financial Crisis Inquiry Commission has been called upon to examine the finan- cial and economic crisis that has gripped our country and explain its causes to the American people. We are keenly aware of the significance of our charge, given the economic damage that America has suffered in the wake of the greatest financial cri- sis since the Great Depression. Our task was first to determine what happened and how it happened so that we could understand why it happened. Here we present our conclusions. We encourage the American people to join us in making their own assessments based on the evi- dence gathered in our inquiry. If we do not learn from history, we are unlikely to fully recover from it. Some on Wall Street and in Washington with a stake in the status quo may be tempted to wipe from memory the events of this crisis, or to suggest that no one could have foreseen or prevented them. This report endeavors to expose the facts, identify responsibility, unravel myths, and help us understand how the crisis could have been avoided. It is an attempt to record history, not to rewrite it, nor allow it to be rewritten. To help our fellow citizens better understand this crisis and its causes, we also pres- ent specific conclusions at the end of chapters in Parts III, IV, and V of this report. The subject of this report is of no small consequence to this nation. The profound events of  and  were neither bumps in the road nor an accentuated dip in the financial and business cycles we have come to expect in a free market economic system. This was a fundamental disruption—a financial upheaval, if you will—that wreaked havoc in communities and neighborhoods across this country. As this report goes to print, there are more than  million Americans who are out of work, cannot find full-time work, or have given up looking for work. About four million families have lost their homes to foreclosure and another four and a half million have slipped into the foreclosure process or are seriously behind on their mortgage payments. Nearly  trillion in household wealth has vanished, with re- tirement accounts and life savings swept away. Businesses, large and small, have felt the sting of a deep recession. There is much anger about what has transpired, and jus- tifiably so. Many people who abided by all the rules now find themselves out of work and uncertain about their future prospects. The collateral damage of this crisis has been real people and real communities. The impacts of this crisis are likely to be felt for a generation. And the nation faces no easy path to renewed economic strength. Like so many Americans, we began our exploration with our own views and some preliminary knowledge about how the world’s strongest financial system came to the brink of collapse. Even at the time of our appointment to this independent panel, much had already been written and said about the crisis. Yet all of us have been deeply affected by what we have learned in the course of our inquiry. We have been at various times fascinated, surprised, and even shocked by what we saw, heard, and read. Ours has been a journey of revelation. 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-111hhrg53244--115 Mr. Bernanke," I think you would have had a very good chance of a collapse of the credit system. Even what we did see after the failure of Lehman was, for example, commercial paper rates shot up and availability declined. Many other markets were severely disrupted, including corporate bond markets. So even with the rescue and even with the stabilization that we achieved in October, there was a severe increase in stress in financial markets. My belief is that, if we had not had the money to address the global banking crisis in October, we might very well have had a collapse of the global banking system that would have created a huge problem in financial markets and in the broad economy that might have lasted many years. " CHRG-111shrg56376--161 Mr. Ludwig," Well, I am not honestly sure that is the case. There are certainly claims that that is the case. If it is the case, it is heart-stopping because in the midst of this crisis, one would assume that the information the Fed and the FDIC and other agencies need to do the job would be forthcoming or they would be squawking, I mean big time, to you and others. In addition, we are talking about a systemic regulator. There is the SEC, the CFTC, FINRA. There are all these other agencies, and in terms of giving you the kind of diversity you need to hear other points of view, you will still have the 50 State bank supervisors that can be called up. So you get quite a--even with a simplified Federal regulatory mechanism, you get quite a cacophony of other voices that I think is available. As to your comment on procyclicality, I think that there is the nature of all regulators, and I think that actually if you looked at all the agencies, both at the Federal and State level, you would find that in times of stress they become tougher. You see the calls at the G-20 and others for more capital right now, sort of in a crisis. Senator Corker. Which creates a bigger crisis. " CHRG-111shrg51395--90 Mr. Silvers," Senator Reed, first, I share your concerns about Basel II. I think that is clearly part of the causal fabric here for our crisis. There are three points about the sort of managerial and task challenges associated with systemic risk regulation. First, the Congressional Oversight Panel in its regulatory reform report suggested that the notion of intelligence, of looking over the horizon in relation to financial market systemic risk, should perhaps be delegated not to a regulatory body but to a panel of outside experts--some of my fellow panelists here might make good members of such a panel--whose sole job was to look ahead and that were not intertwined in the politics of the regulatory landscape. Second--and this is a concern that Senator Shelby raised--our view was it would be a very bad idea to name who is systemically significant. In fact, it is not only a bad idea in terms of moral hazard, but it is actually impossible to do; that in a crisis people will--institutions will turn out to be systemically significant that you had no idea were. And Exhibit 1 for that is Bear Stearns. And there are other times, calm times, when very large institutions may be allowed to fail, and probably should be; and that rather than naming institutions, we ought to have the capacity--and this comes to your point--the capacity for the systemic risk regulator to work with other regulators to set ratchets around capital requirements and around insurance costs to discourage people getting essentially too big to fail and to set up the financial basis to rescue them if they do. Finally, there is, I think, some--I am not a Fed expert, but I think there is some confusion about where the money comes from for bailouts and rescues and so forth. The Fed does not have the authority, as far as I know--although you all maybe can educate me. The Fed does not have the authority to simply expend taxpayer dollars. The Fed lends money. It is the lender of last resort. In a true systemic crisis, as we have just learned, we get beyond the ability of liquidity to solve the problem, and in that circumstance we start expending taxpayer dollars. It is hard not to look at the TARP experience and what preceded it and not conclude that the ad hoc quality of those experiences did not build public confidence or political support for what had to be done. Given all of that, I think we need to understand that when we ask a body to take on the role of systemic risk regulator, that also means we are asking them to take on the role of rescuer, and potentially to expend taxpayer dollars. And that I think requires a set of governance mechanisms and capacities, to your question, Senator, that we have yet really to build. And it also requires, I think, a careful balance between genuine public accountability and transparency, on the one hand, and genuine independence from the all too eager desire of everyone around to bail out their friends. Senator Reed. Mr. Turner, do you have comments? " CHRG-111hhrg54868--42 Mr. Dugan," It is similar. We also did not have any rulewriting authority in this area. But we did have considerable examination and enforcement responsibilities with respect to the rules that were on the books, and we think we did a decent job with that. I would make one other very fundamental point, though. A number of the problems that caused the crisis, while consumer protection contributed to it, a big chunk of that was pure and simple underwriting problems. A big chunk of that was outside of the banking system. And we did not have any authority over that in terms of examining and supervising it, and even the rules that were adopted didn't apply to them. And so you had this uneven world where you had two different systems applying to the regulated and the unregulated, and that was a fundamental problem. " CHRG-111hhrg53245--201 Mr. Sherman," Ms. Rivlin, I wonder--you seem to have a comment? Ms. Rivlin. No, I agree with that, and I was glad to get a chance to counteract the absent Mr. Wallison who thinks we only need to worry about banks. I think the lesson of this crisis is we need to worry about the whole financial sector and a lot of the trouble came from outside the banking system. " CHRG-110hhrg46591--320 Mr. Bartlett," Congressman, you have it about right. During the crisis of subprime, 50 percent of all of the subprime mortgages were originated by a totally unregulated mortgage lender. Fifty-eight percent total were sold by mortgage brokers, but it is actually worse than that because then the other 50 percent that were originated by regulated lenders, regardless of the nature of those loans, were mostly then sold to Wall Street, to a different set of regulators, either lightly regulated or not regulated at all, that were then packaged up into another set of unregulated mortgage pools, that were then brought back to mortgage insurance, which was regulated by 50 State regulators, and that were all sort of certified by credit rating agencies that were not regulated at all. So, as to the system as a whole, you are right. Half of it originated was totally unregulated, but the rest of the system that was regulated was virtually unregulated at least with the gaps. So it is the system that needs to be reformed systemically. " CHRG-111shrg55278--113 PREPARED STATEMENT OF ALLAN H. MELTZER Professor of Political Economy, Tepper School of Business, Carnegie Mellon University July 23, 2009Regulatory Reform and the Federal Reserve Thank you for the opportunity to present my appraisal of the Administration's proposal for regulatory changes. I will confine most of my comments to the role of the Federal Reserve as a systemic regulator and will offer an alternative proposal. I share the belief that change is needed and long delayed, but appropriate change must protect the public, not bankers. And I believe that effective regulation should await evidence and conclusions about the causes of the recent crisis. There are many assertions about causes. The Congress should want to avoid a rush to regulate before the relevant facts are established. If we are to avoid repeating this crisis, make sure you know what caused it. During much of the past 15 years, I have written three volumes entitled ``A History of the Federal Reserve.'' Working with two assistants we have read virtually all of the minutes of the Board of Governors, the Federal Open Market Committee, and the Directors of the Federal Reserve Bank of New York. We have also read many of the staff papers and internal memos supporting decisions. I speak from that perspective. I speak also from experience in Japan. During the 1990s, the years of the Japanese banking and financial crisis, I served as Honorary Adviser to the Bank. Their policies included preventing bank failures. This did not restore lending and economic growth. Two findings are very relevant to the role of the Federal Reserve. First, I do not know of any clear examples in which the Federal Reserve acted in advance to head off a crisis or a series of banking or financial failures. We know that the Federal Reserve did nothing about thrift industry failures in the 1980s. Thrift failures cost taxpayers $150 billion. AIG, Fannie, and Freddie will be much more costly. Of course, the Fed did not have responsibility for the thrift industry, but many thrift failures posed a threat to the financial system that the Fed should have tried to mitigate. The disastrous outcome was not a mystery that appeared without warning. Peter Wallison, Alan Greenspan, Bill Poole, Senator Shelby, and others warned about the excessive risks taken by Fannie and Freddie, but Congress failed to legislate. Why should anyone expect a systemic risk regulator to get requisite Congressional action under similar circumstances? Can you expect the Federal Reserve as systemic risk regulator to close Fannie and Freddie after Congress declines to act? Conflicts of this kind, and others, suggest that that the Administration's proposal is incomplete. Defining ``systemic risk'' is an essential, but missing part of the proposal. Trying to define the authority of the regulatory authority when Congress has expressed an interest points up a major conflict. During the Latin American debt crisis, the Federal Reserve acted to hide the failures and losses at money center banks by arranging with the IMF to pay the interest on Latin debt to those banks. This served to increase the debt that the Governments owed, but it kept the banks from reporting portfolio losses and prolonged the debt crisis. The crisis ended after one of the New York banks decided to write off the debt and take the loss. Others followed. Later, the Treasury offered the Brady plans. The Federal Reserve did nothing. In the dot-com crisis of the late 1990s, we know the Federal Reserve was aware of the growing problem, but it did not act until after the crisis occurred. Later, Chairman Greenspan recognized that it was difficult to detect systemic failures in advance. He explained that the Federal Reserve believed it should act after the crisis, not before. Intervention to control soaring asset prices would impose large social costs of unemployment, so the Federal Reserve, as systemic risk regulator would be unwise to act. The dot-com problem brings out that there are crises for which the Federal Reserve cannot be effective. Asset market exuberance and supply shocks, like oil price increases, are nonmonetary so cannot be prevented by even the most astute, far-seeing central bank. We all know that the Federal Reserve did nothing to prevent the current credit crisis. Before the crisis it kept interest rates low during part of the period and did not police the use that financial markets made of the reserves it supplied. The Board has admitted that it did not do enough to prevent the crisis. It has not recognized that its actions promoted moral hazard and encouraged incentives to take risk. Many bankers talked openly about a ``Greenspan put,'' their belief that the Federal Reserve would prevent or absorb major losses. It was the Reconstruction Finance Corporation, not the Fed, that restructured banks in the 1930s. The Fed did not act promptly to prevent market failure during the 1970 Penn Central failure, the Lockheed and Chrysler problems, or on other occasions. In 2008, the Fed assisted in salvaging Bear Stearns. This continued the ``too-big-to-fail'' (TBTF) policy and increased moral hazard. Then without warning, the Fed departed from the course it had followed for at least 30 years and allowed Lehman to fail in the midst of widespread financial uncertainty. This was a major error. It deepened and lengthened the current deep recession. Much of the recent improvement results from the unwinding of this terrible mistake. In 1990-91, the Fed kept the spread between short- and long-term interest rates large enough to assist many banks to rebuild their capital and surplus. This is a rare possible exception, a case in which Federal Reserve action to delay an increase in the short-term rate may have prevented banking failures. Second, in its 96-year history, the Federal Reserve has never announced a lender-of-last-resort policy. It has discussed internally the content of such policy several times, but it rarely announced what it would do. And the appropriate announcements it made, as in 1987, were limited to the circumstances of the time. Announcing and following a policy would alert financial institutions to the Fed's expected actions and might reduce pressures on Congress to aid failing entities. Following the rule in a crisis would change bankers' incentives and reduce moral hazard. A crisis policy rule is long overdue. The Administration proposal recognizes this need. A lender-of-last-resort rule is the right way to implement policy in a crisis. We know from monetary history that in the 19th century the Bank of England followed Bagehot's rule for a half-century or more. The rule committed the Bank to lend on ``good'' collateral at a penalty rate during periods of market disturbance. Prudent bankers borrowed from the Bank of England and held collateral to be used in a panic. Banks that lacked collateral failed. Financial panics occurred. The result of following Bagehot's rule in crises was that the crises did not spread and did not last long. There were bank failures, but no systemic failures. Prudent bankers borrowed and paid depositors cash or gold. Bank deposits were not insured until much later, so bank runs could cause systemic failures. Knowing the Bank's policy rule made most bankers prudent, they held more capital and reserves in relation to their size than banks currently do, and they held more collateral to use in a crisis also. These experiences suggest three main lessons. First, we cannot avoid banking failures but we can keep them from spreading and creating crises. Second, neither the Federal Reserve nor any other agency has succeeded in predicting crises or anticipating systemic failure. It is hard to do, in part because systemic risk is not well-defined. Reasonable people will differ, and since much is often at stake, some will fight hard to deny that there is a systemic risk. One of the main reasons that Congress in 1991 passed FDICIA (Federal Deposit Insurance Corporation Improvement Act) was to prevent the Federal Reserve from delaying closure of failing banks, increasing losses and weakening the FDIC fund. The Federal Reserve and the FDIC have not used FDICIA against large banks in this crisis. That should change. The third lesson is that a successful policy will alter bankers' incentives and avoid moral hazard. Bankers must know that risk taking brings both rewards and costs, including failure, loss of managerial position and equity followed by sale of continuing operations.An Alternative Proposal Several reforms are needed to reduce or eliminate the cost of financial failure to the taxpayers. Members of Congress should ask themselves and each other: Is the banker or the regulator more likely to know about the risks on a bank's balance sheet? Of course it is the banker, and especially so if the banker is taking large risks that he wants to hide. To me that means that reform should start by increasing a banker's responsibility for losses. The Administration's proposal does the opposite by making the Federal Reserve responsible for systemic risk. Systemic risk is a term of art. I doubt that it can be defined in a way that satisfies the many parties involved in regulation. Members of Congress will properly urge that any large failure in their district or State is systemic. Administrations and regulators will have other objectives. Without a clear definition, the proposal will bring frequent controversy. And without a clear definition, the proposal is incomplete and open to abuse. Resolving the conflicting interests is unlikely to protect the general public. More likely, regulators will claim that they protect the public by protecting the banks. That's what they do now. The Administration's proposal sacrifices much of the remaining independence of the Federal Reserve. Congress, the Administration, and failing banks or firms will want to influence decisions about what is to be bailed out. I believe that is a mistake. If we use our capital to avoid failures instead of promoting growth we not only reduce growth in living standards we also sacrifice a socially valuable arrangement--central bank independence. We encourage excessive risk taking and moral hazard. I believe there are better alternatives than the Administration's proposal. First step: End TBTF. Require all financial institutions to increase capital more than in proportion to their increase in size of assets. TBTF gives perverse incentives. It allows banks to profit in good times and shifts the losses to the taxpayers when crises or failures occur. My proposal reduces the profits from giant size, increases incentives for prudent banker behavior by putting losses back to managements and stockholders where they belong. Benefits of size come from economies of scale and scope. These benefits to society are more than offset by the losses society takes in periods of crisis. Congress should find it hard to defend a system that distributes profits and losses as TBTF does. I believe that the public will not choose to maintain that system forever. Permitting losses does not eliminate services; failure means that management loses its position and stockholders take the losses. Profitable operations continue and are sold at the earliest opportunity. Second step: Require the Federal Reserve to announce a rule for lender-of-last-resort. Congress should adopt the rule that they are willing to sustain. The rule should give banks an incentive to hold collateral to be used in a crisis period. Bagehot's rule is a great place to start. Third step: Recognize that regulation is an ineffective way to change behavior. My first rule of regulation states that lawyers regulate but markets circumvent burdensome regulation. The Basel Accord is an example. Banks everywhere had to increase capital when they increased balance sheet risk. The banks responded by creating entities that were not on their balance sheet. Later, banks had to absorb the losses, but that was after the crisis. There are many other examples of circumvention from Federal Reserve history. The reason we have money market funds was that Fed regulation Q restricted the interest that the public could earn. Money market funds bought unregulated, large certificates of deposit. For a small fee they shared the higher interest rate with the public. Much later Congress agreed to end interest rate regulation. The money funds remained. Fourth step: Recognize that regulators do not allow for the incentives induced by their regulations. In the dynamic, financial markets it is difficult, perhaps impossible, to anticipate how clever market participants will circumvent the rules without violating them. The lesson is to focus on incentives, not prohibitions. Shifting losses back to the bankers is the most powerful incentive because it changes the risk-return tradeoff that bankers and stockholders see. Fifth step: Either extend FDICIA to include holding companies or subject financial holding companies to bankruptcy law. Make the holding company subject to early intervention either under FDICIA or under bankruptcy law. That not only reduces or eliminates taxpayer losses, but it also encourages prudential behavior. Other important changes should be made. Congress should close Fannie Mae and Freddie Mac and put any subsidy for low-income housing on the budget. The same should be done to other credit market subsidies. The budget is the proper place for subsidies. Congress, the regulators, and the Administration should encourage financial firms to change their compensation systems to tie compensation to sustained average earnings. Compensation decisions are too complex for regulation and too easy to circumvent. Decisions should be management's responsibility. Part of the change should reward due diligence by traders. We know that rating agencies contributed to failures. The rating problem would be lessened if users practiced diligence of their own. Three principles should be borne in mind. First, banks borrow short and lend long. Unanticipated large changes can and will cause failures. Our problem is to minimize the cost of failures to society. Second, remember that capitalism without failure is like religion without sin. It removes incentives for prudent behavior. Third, those that rely on regulation to reduce risk should recall that this is the age of Madoff and Stanford. The Fed, too, lacks a record of success in managing large risks to the financial system, the economy and the public. Incentives for fraud, evasion, and circumvention of regulation often have been far more powerful than incentives to enforce regulation that protects the public. CHRG-110hhrg46591--106 Mr. Johnson," Well, certainly, I think punishing malfeasance and maintaining the safety and soundness of the market go hand-in-hand with growth and prosperity. So I think that those are one and the same thing. But in my opinion, supervisory failures have been one of the primary factors in this crisis of confidence we have had. And even though our regulatory system is overlapping and somewhat antiquated, the resources are there and the lines of supervision are there to prevent this. We didn't prevent it because we failed to detect systemic risk. That is one of the reasons why I argue that if you try to create a pervasive financial regulatory system, it can't be policed by the public sector because we are already failing now. So we ought to focus our regulatory and supervisory efforts narrowly and pour in all the resources necessary along with strong accountability to make it work. We can't control everything. And it would be a miserable failure if we tried. " CHRG-111hhrg53021Oth--133 Secretary Geithner," I think, again, you need to have capital backing risk where risk is taken and where entities are taking short-term liabilities, borrowing short-term and taking longer-term risk. That requires capital to protect the system. If you don't apply a uniform set of prudential requirements around those entities, then what will happen is the risk will migrate to those parts of the system where there are lower standards, as we have already seen in this financial crisis. So that is important to guard against. Now, that doesn't mean you have to be completely comprehensive, but you have to capture enough of the core participants that you avoid that risk. " CHRG-111hhrg53021--133 Secretary Geithner," I think, again, you need to have capital backing risk where risk is taken and where entities are taking short-term liabilities, borrowing short-term and taking longer-term risk. That requires capital to protect the system. If you don't apply a uniform set of prudential requirements around those entities, then what will happen is the risk will migrate to those parts of the system where there are lower standards, as we have already seen in this financial crisis. So that is important to guard against. Now, that doesn't mean you have to be completely comprehensive, but you have to capture enough of the core participants that you avoid that risk. " fcic_final_report_full--538 This dissenting statement argues that the U.S. government’s housing policies were the major contributor to the financial crisis of 2008. These policies fostered the development of a massive housing bubble between 1997 and 2007 and the creation of 27 million subprime and Alt-A loans, many of which were ready to default as soon as the housing bubble began to deflate. The losses associated with these weak and high risk loans caused either the real or apparent weakness of the major financial institutions around the world that held these mortgages—or PMBS backed by these mortgages—as investments or as sources of liquidity. Deregulation, lack of regulation, predatory lending or the other factors that were cited in the report of the FCIC’s majority were not determinative factors. The policy implications of this conclusion are significant. If the crisis could have been prevented simply by eliminating or changing the government policies and programs that were primarily responsible for the financial crisis, then there was no need for the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, adopted by Congress in July 2010 and often cited as one of the important achievements of the Obama administration and the 111 th Congress. The stringent regulation that the Dodd-Frank Act imposes on the U.S. economy will almost certainly have a major adverse effect on economic growth and job creation in the United States during the balance of this decade. If this was the price that had to be paid for preventing another financial crisis then perhaps it’s one that will have to be borne. But if it was not necessary to prevent another crisis—and it would not have been necessary if the crisis was caused by actions of the government itself—then the Dodd-Frank Act seriously overreached. Finally, if the principal cause of the financial crisis was ultimately the government’s involvement in the housing finance system, housing finance policy in the future should be adjusted accordingly. 533 -----------------------------------------------------Page 562-----------------------------------------------------  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-111hhrg48867--32 Mr. Wallison," Thank you, Mr. Chairman, and Ranking Member Bachus, for this opportunity to testify about a systemic risk regulator. There are two questions here, it seems to me. First, will a systemic regulator perform any useful function? And second, should a government agency be authorized to regulate so-called systemically significant financial institutions? I am going to start with the second question because I believe it is by far the most important. Giving a government agency the power to designate companies as systemically significant and to regulate their capital and activities is a very troubling idea. It has the potential to destroy competition in every market where a systemically significant company is designated. I say this as a person who has spent 10 years warning that Fannie Mae and Freddie Mac would have disastrous effects on the U.S. economy and that ultimately the taxpayers of this country would have to bail them out. Because they were seen as backed by the government, Fannie and Freddie were relieved of market discipline and able to take risks that other companies could not take. For the same reason, they also had access to lower cost financing than any of their competitors. These benefits enabled them to drive out competition and grow to enormous size. Ultimately, however, the risks they took caused their collapse and will cause enormous losses for U.S. taxpayers. When Fannie and Freddie were taken over by the government, they held or guaranteed $1.6 trillion in subprime and Alt-A mortgages. These loans are defaulting at unprecedented rates, and I believe will ultimately cost U.S. taxpayers $400 billion. There is very little difference between a company that has been designated as systemically significant and a GSE like Fannie or Freddie. By definition a systemically significant firm will not be allowed to fail because its failure could have systemic effects. As a result it will be seen as less risky for creditors and counterparties and will be able to raise money at lower rates than its competitors. This advantage, as we saw with Fannie and Freddie, will allow it to dominate its market, which is a nightmare for every smaller company in every industry where a systemically significant company is allowed to operate. Some will contend that in light of the failures among huge financial firms in recent months, we need regulation to prevent such things in the future, but this is obviously wrong. Regulation does not prevent risk-taking or loss. Witness the banking industry, the most heavily regulated sector in our economy. Many banks have become insolvent and many others have been or will be rescued by the taxpayers. It is also argued that since we already have rescued a lot of financial institutions, moral hazard has been created, so now we should regulate all financial institutions as if they will be rescued in the next crisis. But there is a lot of difference between de jure and de facto, especially when we are dealing with an unprecedented situation. Anyone looking at the Fed's cooperation with the Treasury today would say that the Fed de facto is no longer independent. But after the crisis is over, we would expect that the Fed's independence will be reestablished. That is the difference between de jure and de facto. Extending regulation beyond banking by picking certain firms and calling them systemically significant would, in my view, be a monumental mistake. We will simply be creating an unlimited number of Fannies and Freddies that will haunt our economy in the future. Let me now turn to the question of systemic regulation in general. Why choose certain companies as systemically significant? The theory seems to be that the failure of big companies caused this financial crisis or without regulation might cause another in the future. But is the U.S. banking system in trouble today because of the failure of one or more large companies? Of course not. It is in trouble because of pervasive losses on trillions of dollars of bad mortgages. So will regulation of systemically significant companies prevent a recurrence of a financial crisis in the future? Not on the evidence before us. An external shock that causes asset prices to crash or investors to lose confidence in the future will have the same effect whether we regulate systemically significant companies or not. And regulation, as with banks, will not even prevent the failure of systemically significant companies; it will only set them up for bailouts when inevitably they suffer losses in their risk taking. Finally, the Federal Reserve would be by far the worst choice for systemic regulator. As a lender of last resort, it has the power to bail out the companies it is supervising, without the approval of Congress or anyone else. Its regulatory responsibilities will conflict with its central banking role, and its involvement with the politics of regulation will raise doubts about its independence from the political branches. We will achieve nothing by setting up a systemic regulator. If we do it at the cost of destroying faith in the dollar and competition in the financial services market, we will have done serious and unnecessary harm to the American economy. Thank you, Mr. Chairman. [The prepared statement of Mr. Wallison can be found on page 159 of the appendix.] " CHRG-111shrg57709--42 Mr. Volcker," That is very important. " Chairman Dodd,"----see that, as well. Senator Shelby? Senator Shelby. Thank you, Mr. Chairman. Chairman Volcker, commercial banks did engage in activities considered to be investment banking prior to the repeal, including some proprietary trading. But there does not seem to be evidence that I have seen that proprietary trading created the losses that resulted in the rate need and race for bailouts. Some argue it is questionable how curtailment of proprietary trading will protect the financial system from future instabilities, what we are going after. In addition, there are notable examples of failed institutions, such as Bear Stearns, Lehman Brothers, among others, that were at the root of the recent crisis but did not engage in commercial banking and were more dangerous by being interconnected than by being large. And while AIG did have a small thrift--it was a very small thrift--the systemic threat from AIG did not emerge from that thrift. Would you just share with us what you believe are the top three institutions that were engaged in proprietary trading and discuss what it was about these institutions that contributed to the financial crisis that we are confronting now? " CHRG-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-110shrg50417--150 Mr. Palm," Happy to. I think anyone who thinks that the regulatory system in the United States and elsewhere is not in need of reform has not been around for the last 6 months. That would be my first point. We fully support a thoughtful approach to putting together a new regulatory system. Whether that is one super regulator as described, which you mentioned you might be in favor of, or, you know, a tripartite one, one of which consists of investor protection separate from I will call it the soundness of the particular financial institution, et cetera, you know, can be debated. Either system in theory can be made to work. I think the current system--and obviously we are new to being a bank. One of the things that first struck me was the fact that--actually, being a lawyer of sorts, I first got a book out which told me all the different types of organizations you were regulated by if you were in a particular business, and it was mind-numbing, including both regulatory arbitrage as well as--it is not even necessarily arbitrage. It is just people found themselves regulated by different people, having different rules, and so on, and some, from what I can tell, not regulated at all, full stop. So I think it is very important to modernize and move forward. Certainly, the FSA system in London has lots of positives to it. On the other hand, if you step back for a second, even that system obviously did not save their economy from the consequences of what is going on now. So I think you want to have functional based regulation, and as I think Mr. Zubrow alluded to, systemic institutions, i.e., institutions who have global scale, you need to really have people who look after them as an entirety and understand their overall operations. We think that is important. Senator Crapo. Thank you. Dr. Wachter. Ms. Wachter. Yes, it is critically important going forward for the long run to restructure our regulatory system, and there is regulatory arbitrage, and that needs to be part of the issue that is addressed. And I do want to here agree again with Mr. Eakes. The insufficient oversight and lack of reserving for CDS issued by AIG was a critical part of the problem that we are facing today. I want to make two other points. One point, this is a global phenomenon now. We are going to need global cooperation on regulation, and it cannot just be in one nation because, as we see, capital flows are global. Second, again, FSA was not a cure-all. The U.K. had over the same period, not as much as we, but erosion of credit standards, and FSA did not see that happening or could not stop it; and at the same time as erosion of credit standards, a housing asset boom. This U.K. crisis is similar to the Japan crisis, is similar to the Asian financial crisis. So it is not just a better environment for regulation, a better structure, but it is better regulation. Senator Crapo. Thank you. Ms. Finucane. I think I will just reiterate what I think you have heard from the other banks, which is we do believe that there needs to be greater transparency for a regulator. I am not sure that we would support one super regulator. Maybe there is too much risk in that, and there are complications. Consumer regulation versus capital markets might be too big a breadth, so I think we would consider that. The last thing I would just say is clearly from the banks, I think the bank holding company structure has been what seems to be victorious in the long run, so we would start from there as well. Senator Crapo. Thank you. " CHRG-110hhrg46596--114 Mr. Kashkari," We are in the process of working with the regulators to monitor that. As I indicated in my opening statement, there are indicators of the credit crisis softening, some confidence returning. It is going to take time. Think of it this way: Remember the economic stimulus checks that Americans got? If a homeowner or a person was nervous about their economic situation, and they got that check, they would be more likely to put it in the bank than to go out and spend it. And so we need to see confidence return to the system to really see the lending take off, and we need to get all the capital in the system. It is not going to happen as fast as any of us would like, but it is going to happen much faster for us having taken this action than if we hadn't. " CHRG-110hhrg46593--113 Secretary Paulson," Well, okay, to answer that question, there are no banks, when the system is under pressure, unless they are ready to fail, that are going to raise their hand and say, please, I need capital; give me some capital. What happens when an economy turns down and when there is a crisis, they pull in their horns. They say, I don't need help. They don't deal with other banks. They don't lend, and the system gets ready to collapse. So the step that we took was very, very critical, and to be able to go out and go out to the healthy banks and go out before they became unhealthy and to increase confidence in the banks and of the banks so that they lend and that they do business with each other, that was absolutely what we were about. And when we came here to-- " 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. fcic_final_report_full--424 HOW OUR APPROACH DIFFERS FROM OTHERS’ During the course of the Commission’s hearings and investigations, we heard fre- quent arguments that there was a single cause of the crisis. For some it was interna- tional capital flows or monetary policy; for others, housing policy; and for still others, it was insufficient regulation of an ambiguously defined shadow banking sec- tor, or unregulated over-the-counter derivatives, or the greed of those in the financial sector and the political influence they had in Washington. In each case, these arguments, when used as single-cause explanations, are too simplistic because they are incomplete. While some of these factors were essential contributors to the crisis, each is insufficient as a standalone explanation. The majority’s approach to explaining the crisis suffers from the opposite prob- lem–it is too broad. Not everything that went wrong during the financial crisis caused the crisis, and while some causes were essential, others had only a minor im- pact. Not every regulatory change related to housing or the financial system prior to the crisis was a cause. The majority’s almost -page report is more an account of bad events than a focused explanation of what happened and why. When everything is important, nothing is. As an example, non-credit derivatives did not in any meaningful way cause or contribute to the financial crisis. Neither the Community Reinvestment Act nor re- moval of the Glass-Steagall firewall was a significant cause. The crisis can be ex- plained without resorting to these factors. We also reject as too simplistic the hypothesis that too little regulation caused the crisis, as well as its opposite, that too much regulation caused the crisis. We question this metric for determining the effectiveness of regulation. The amount of financial regulation should reflect the need to address particular failures in the financial sys- tem. For example, high-risk, nontraditional mortgage lending by nonbank lenders flourished in the s and did tremendous damage in an ineffectively regulated en- vironment, contributing to the financial crisis. Poorly designed government housing policies distorted market outcomes and contributed to the creation of unsound mortgages as well. Countrywide’s irresponsible lending and AIG’s failure were in part attributable to ineffective regulation and supervision, while Fannie Mae and Freddie Mac’s failures were the result of policymakers using the power of government to blend public purpose with private gains and then socializing the losses. Both the “too little government” and “too much government” approaches are too broad-brush to explain the crisis. The majority says the crisis was avoidable if only the United States had adopted across-the-board more restrictive regulations, in conjunction with more aggressive regulators and supervisors. This conclusion by the majority largely ignores the global nature of the crisis. For example: • A credit bubble appeared in both the United States and Europe. This tells us that our primary explanation for the credit bubble should focus on factors common to both regions. CHRG-111hhrg51591--36 Mr. Webel," I think, to address your last question first, with regard to the impact of possibly driving industries offshore, I think that--I mean, and this can be broader, that essentially the way to deal with too-big-to-fail is don't let anybody get too big. And within the financial services industry, it is true that for non-bank financial services, the United States has historically enjoyed somewhere in the $25- to $30 billion trade surplus range. But I think that when you consider the cost of the last crisis, one can make a very good argument that yes, you might be giving up something in the year-to-year trade balance, but how much do we spend to clean up the crisis that is solved or that has to be solved when too-big-to-fail actually fails? So there are costs and benefits to having that kind of industry, and I think that has to be considered. As a counterpoint to that in the insurance-specific range, the United States has historically enjoyed--has suffered a deficit in the insurance side of the financial services. And I think that does say something interesting about our insurance regulatory system. The regulatory system at the State level is often pointed to as a trade barrier by our European allies. And it is interesting to see this protected industry that still is under a very significant trade deficit. Does this mean that is it--would we have an even worse deficit if you didn't have this ``protection,'' or is it the case that because somehow the State system is not permitting companies to be competitive abroad? So I think that--it brings up interesting questions as to the international competitiveness, and do you really want to be internationally competitive in some of these things. " 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-111hhrg53021Oth--147 Secretary Geithner," I think, Congressman, that is an excellent question. We could debate this for hours. But the lesson of the financial crisis here in the United States, and around the world, is that when you face a loss of confidence and a loss of demand of this magnitude, when you have a financial system on the edge of collapse, the only path to mitigate the damage is for the government to do what this Congress did and this government did, which was to try to make sure you were providing support for investment, for targeted tax cuts, to try to get demand going again. That is necessary but not sufficient. It also requires making sure you stabilize the financial system and help get credit flowing again. And that is the basic strategy that this country, fortunately, has adopted. " CHRG-111hhrg53021--147 Secretary Geithner," I think, Congressman, that is an excellent question. We could debate this for hours. But the lesson of the financial crisis here in the United States, and around the world, is that when you face a loss of confidence and a loss of demand of this magnitude, when you have a financial system on the edge of collapse, the only path to mitigate the damage is for the government to do what this Congress did and this government did, which was to try to make sure you were providing support for investment, for targeted tax cuts, to try to get demand going again. That is necessary but not sufficient. It also requires making sure you stabilize the financial system and help get credit flowing again. And that is the basic strategy that this country, fortunately, has adopted. " FinancialCrisisInquiry--116 I would like to hear the CEOs remind people of this ultimate purpose more often. And I appreciate the commission’s efforts to find out the root cause of this crisis, to bring greater awareness to this mission and to facilitate its execution. I look forward to your questions when they’re done. CHAIRMAN ANGELIDES: Thank you very much for that very good and timely presentation. Thank you very much, Mr. Mayo. Mr. Bass, you are next. And you know what I realize is that even though the commissioners have seen all your bios, you might just identify yourself with your firm and your responsibilities currently. BASS: OK. Thank you. Chairman Angelides, Vice Chairman Thomas and members of the commission, my name is Kyle Bass. I’m the managing partner of Hayman Advisors in Dallas. And I would like to thank you and the members of the committee for the opportunity to share my views with you today as you consider the causes of the recent crisis as well as certain changes that must take place to avoid or minimize future crises. I believe that I have somewhat of a unique perspective with regard to this crisis, as my firm and I were fortunate enough to have seen parts of it coming. Hayman is a global asset management firm that managed several billion dollars of subprime and Alt-A mortgage positions during the crisis. And we remain an active participant in the marketplace today. While I realize the primary objective of the hearing today is to provide baseline information on the current state of the financial crisis and to discuss the roles that four specific banks or investment banks—Goldman, Morgan Stanley, Bank of America and JPMorgan—have played in the crisis, in my opinion, no single bank or group of large institutions single-handedly caused the crisis. While I will address each participant’s structure and problems independently later in my testimony, the problems with the participants and regulatory structure needs to be considered more holistically in order to prevent future systemic breakdowns and taxpayer harm. CHRG-111shrg52619--24 Mr. Tarullo," Thank you, Mr. Chairman, Senator Shelby, and Members of the Committee. We are here this morning because of systemic risk. We have had a systemic crisis. We are still in the middle of it, and I would endorse wholeheartedly Senator Shelby's three-part approach to responding to that crisis. In the weeks that I have been at the Federal Reserve, the discussions that have taken place internally, both among staff and among the members, have focused on the issue of systemic risk and how to prevent it going forward. The important point I would make as a prelude to our recommendations is that the source of systemic risk in our financial system has to some considerable extent migrated from traditional banking activities to markets over the last 20 or 25 years. If you think about the problems that led to the Depression, that were apparent even in the 1970s among some banks, the concern was that there would be a run on a bank, that depositors would be worried about the safety and soundness of that bank and that there would be contagion spreading to other institutions as depositors were uncertain as to the status of those institutions. What has been seen more recently is a systemic problem starting in the interactions among institutions in markets. Now, banks are participants in markets, so this can still be something that affects banks. But we have also seen other kinds of institutions at the source of the systemic problems we are undergoing right now. I think you cannot focus on a single institution or even just look at institutions as a series of silos, as it were, and concentrate solely on trying to assure their safety and soundness. We need to look at the interaction among institutions. Sometimes that means their actual counterparty relationships with one another. Sometimes it means the fora in which they interact with one another, in payment systems and the like. Sometimes it even means the parallel strategies which they may be pursuing--when, for example, they are all relying on the same sources of liquidity if they have to change their investing strategies. So they may not even know that they are co-dependent with other actors in the financial markets. For all of these reasons, our view is that the focus needs to be on an agenda for financial stability, an agenda for systemic risk management. I emphasize that because, although there is rightly talk about a systemic risk regulator, it is important that we understand each component of an agenda which is going to be fulfilled by all the financial regulators over which you have jurisdiction. So what do we mean by this agenda? Well, I tried in my testimony to lay out five areas in which we should pay attention. First, we do need effective consolidated supervision of any systemically important institution. We need consolidated supervision and it needs to be effective. There are institutions that are systemically important, and certainly were systemically important over the last few years, which were not subject to consolidated prudential supervision by any regulator. But that supervision needs to be effective. I think everybody is aware, and ought to be aware, of the ways in which the regulation and supervision of our financial institutions in recent years has fallen short. And unless, as Senator Shelby suggests, we all concentrate on it and reflect on it without defensiveness, we are not going to learn the lessons that need to be learned. Second, there is need for a resolution mechanism. I am happy to talk about that in the back and forth with you, but Comptroller Dugan and Chairman Bair have laid that out very well. Third, there does need to be more oversight of key areas in which market participants interact in important ways. We have focused in particular on payments and settlement systems, because there the Fed's oversight authority derives largely from the coincidence that some of the key actors happen to be member banks. But if they weren't, if they had another corporate form, there is no statutory authority right now for us to exercise prudential supervision over those markets in which problems can arise. Fourth, consumer protection. Now, consumer protection is not and should not be limited to its relationship with potential systemic risk. But, as the current crisis demonstrated, there are times in which good consumer protection is not just good consumer protection, but it is an important component of an agenda for containment of systemic risk. Fifth and finally is the issue of a systemic risk regulator. This is something that does seem to fit into an overall agenda. There are gaps in covering systemically important institutions. There are also gaps in attempting to monitor what is going on across the system. I think in the past there have been times at which there was important information being developed by various regulators and supervisors which, if aggregated, would have suggested developing issues and problems. But without a charge to one or more entities to try to put all that together, one risks looking at things, as I said, in a more siloed fashion. The extent of those authorities for a systemic risk regulator is something that needs to be debated in this Committee and in the entire Congress. But I do think that it is an important complement to the other components of this agenda and the improvements in supervision and regulation under existing authorities, and thus something that ought to be considered. I am happy to answer any questions that you may have. " CHRG-111shrg52619--28 Mr. Polakoff," Good morning, Chairman Dodd. Thank you for inviting me to testify on behalf of OTS on ``Modernizing Bank Supervision and Regulation.'' As you know, our current system of financial supervision is a patchwork with pieces that date back to the Civil War. If we were to start from scratch, no one would advocate establishing a system like the one we have, cobbled together over the last century and a half. The complexity of our financial markets has in some cases reached mind-boggling proportions. To effectively address the risks in today's financial marketplace, we need a modern, sophisticated system of regulation and supervision that applies evenly across the financial services landscape. Our current economic crisis enforces the message that the time is right for an in-depth, careful review and meaningful, fundamental change. Any restructuring should take into account the lessons learned from this crisis. At the same time, the OTS recommendations that I am presenting here today do not represent a realignment of the current regulatory structure. Rather, they represent a fresh start using a clean slate. They represent the OTS vision for the way financial services regulation in this country should be. In short, we are proposing fundamental changes that would affect virtually all of the current financial regulators. It is important to note that these are high-level recommendations. Before adoption and implementation, many details would need to be worked out and many questions would need to be answered. The OTS proposal for modernization has two basic elements. First, a set of guiding principles, and second, recommendations for Federal bank regulation, holding company supervision, and systemic risk regulation. So what I would like to do is offer the five guiding principles. Number one, a dual banking system with Federal and State charters for banks. Number two, a dual insurance system with Federal and State charters for insurance companies. Number three, the institution's operating strategy and business model would determine its charter and identify its responsible regulatory agency. Institutions would not simply pick their regulator. Number four, organizational and ownership options would continue, including mutual ownership, public and private stock entities, and Subchapter S corporations. And number five, ensure that all entities offering financial products are subject to the consistent laws, regulations, and rigor of regulatory oversight. Regarding our recommendations on regulatory structure, the OTS strongly supports the creation of a systemic risk regulator with authority and resources to accomplish the following three functions. Number one, to examine the entire conglomerate. Number two, to provide temporary liquidity in a crisis. And number three, to process a receivership if failure is unavoidable. For Federal bank regulation, the OTS proposes two charters, one for banks predominately focused on consumer and community banking products, including lending, and the other for banks primarily focused on commercial products and services. The business models of the commercial bank and the consumer and community bank are fundamentally different enough to warrant two distinct Federal banking charters. These regulators would each be the primary Federal supervisor for State chartered banks with the relevant business models. A consumer and community bank regulator would close the gaps in regulatory oversight that led to a shadow banking system of uneven regulated mortgage companies, brokers, and consumer lenders that were significant causes of the current crisis. This regulator would also be responsible for developing and implementing all consumer protection requirements and regulations. Regarding holding companies, the functional regulator of the largest entity within a diversified financial company would be the holding company regulator. I realize I have provided a lot of information and I look forward to answering your questions, Mr. Chairman. " fcic_final_report_full--477 PRECIPITATED A FINANCIAL CRISIS Although the Commission never defined the financial crisis it was supposed to investigate, it is necessary to do so in order to know where to start and stop. If, for example, the financial crisis is still continuing, then the effect of government policies such as the Troubled Asset Repurchase Program (TARP) should be evaluated. However, it seems clear that Congress wanted the Commission to concentrate on what caused the unprecedented events that occurred largely in the fall of 2008, and for this purpose Ben Bernanke’s definition of the financial crisis seems most appropriate: The credit boom began to unravel in early 2007 when problems surfaced with subprime mortgages—mortgages offered to less-creditworthy borrowers—and house prices in parts of the country began to fall. Mortgage delinquencies and defaults rose, and the downturn in house prices intensified, trends that continue today. Investors, stunned by losses on assets they had believed to be safe, began to pull back from a wide range of credit markets, and financial institutions—reeling from severe losses on mortgages and other loans—cut back their lending. The crisis deepened [in September 2008], when the failure or near-failure of several major financial firms caused many financial and credit markets to freeze up.” 45 In other words, the financial crisis was the result of the losses suffered by financial institutions around the world when U.S. mortgages began to fail in large numbers; the crisis became more severe in September 2008, when the failure of several major financial firms—which held or were thought to hold large amounts of mortgage-related assets—caused many financial markets to freeze up. This summary encapsulates a large number of interconnected events, but it makes clear that the underlying cause of the financial crisis was a rapid decline in the value of one specific and widely held asset: U.S. residential mortgages. The next question is how, exactly, these delinquencies and losses caused the financial crisis. The following discussion will show that it was not all mortgages and mortgage-backed securities that were the source of the crisis, but primarily NTMs— including PMBS backed by NTMs. Traditional mortgages, which were generally prime mortgages, did not suffer substantial losses at the outset of the mortgage meltdown, although as the financial crisis turned into a recession and housing prices continued to fall, losses among prime mortgages began to approach the level of prime mortgage losses that had occurred in past housing crises. However, those levels were far lower than the losses on NTMs, which reached levels of delinquency and default between 15 and 45 percent (depending on the characteristics of the loans in question) because the loans involved were weaker as a class than in any previous housing crisis. The fact that they were also far larger in number than any 45 Speech at Morehouse College, April 14, 2009. 471 previous bubble was what caused the catastrophic housing price declines that fueled the financial crisis. 1. How Failures Among NTMs were Transmitted to the Financial System fcic_final_report_full--16 Finally, as to the matter of whether government housing policies were a primary cause of the crisis: for decades, government policy has encouraged homeownership through a set of incentives, assistance programs, and mandates. These policies were put in place and promoted by several administrations and Congresses—indeed, both Presidents Bill Clinton and George W. Bush set aggressive goals to increase home- ownership. In conducting our inquiry, we took a careful look at HUD’s affordable housing goals, as noted above, and the Community Reinvestment Act (CRA). The CRA was enacted in  to combat “redlining” by banks—the practice of denying credit to in- dividuals and businesses in certain neighborhoods without regard to their creditwor- thiness. The CRA requires banks and savings and loans to lend, invest, and provide services to the communities from which they take deposits, consistent with bank safety and soundness. The Commission concludes the CRA was not a significant factor in subprime lend- ing or the crisis. Many subprime lenders were not subject to the CRA. Research indi- cates only  of high-cost loans—a proxy for subprime loans—had any connection to the law. Loans made by CRA-regulated lenders in the neighborhoods in which they were required to lend were half as likely to default as similar loans made in the same neighborhoods by independent mortgage originators not subject to the law. Nonetheless, we make the following observation about government housing poli- cies—they failed in this respect: As a nation, we set aggressive homeownership goals with the desire to extend credit to families previously denied access to the financial markets. Yet the government failed to ensure that the philosophy of opportunity was being matched by the practical realities on the ground. Witness again the failure of the Federal Reserve and other regulators to rein in irresponsible lending. Homeown- ership peaked in the spring of  and then began to decline. From that point on, the talk of opportunity was tragically at odds with the reality of a financial disaster in the making. * * * W HEN THIS C OMMISSION began its work  months ago, some imagined that the events of  and their consequences would be well behind us by the time we issued this report. Yet more than two years after the federal government intervened in an unprecedented manner in our financial markets, our country finds itself still grap- pling with the aftereffects of the calamity. Our financial system is, in many respects, still unchanged from what existed on the eve of the crisis. Indeed, in the wake of the crisis, the U.S. financial sector is now more concentrated than ever in the hands of a few large, systemically significant institutions. While we have not been charged with making policy recommendations, the very purpose of our report has been to take stock of what happened so we can plot a new course. In our inquiry, we found dramatic breakdowns of corporate governance, profound lapses in regulatory oversight, and near fatal flaws in our financial system. We also found that a series of choices and actions led us toward a catastrophe for which we were ill prepared. These are serious matters that must be addressed and resolved to restore faith in our financial markets, to avoid the next crisis, and to re- build a system of capital that provides the foundation for a new era of broadly shared prosperity. CHRG-111hhrg56776--55 Mr. Bernanke," Congressman, I have given a speech on this. I think the bottom line is, nobody really knows for sure, but that the evidence is really quite mixed. I would say even if they were too low for too long, the magnitude of the error was not big enough to account for the huge crisis we had. I think what caused the crisis were the failures of regulation. I would fault the Fed here, too, because some of those failures were ours in the sense that we did not do enough, and I have admitted this and acknowledged this many times, we did not do enough on mortgage regulation. I think it was the weakness of the regulatory system, not monetary policy, that was most important here. Dr. Paul. Of course, I do not agree with that, but if you assume for a minute that it was too low for too long, and you had perfect regulations, what is the harm done by interest rates being too low for too long? Do you see any damage by interest rates being artificially low for a long period of time? Let's sort that away from regulations for a second. " CHRG-111hhrg53245--108 Mrs. Maloney," Thank you, Mr. Chairman. I truly believe that our government was at its best following the 9/11 crisis, when we came together and created a bipartisan professional commission to study exactly what went wrong. They came forward with a professional report that sold more copies than Harry Potter. It pointed out 53 direct areas that they thought needed to be corrected. We then proceeded to react to their recommendations, and this Congress passed 47 of their recommendations. I do not believe that we were aware of what the true problems were until we got that report. I for one would like to see the report coming back from the bipartisan commission on what really caused this crisis, and their ideas of what we need to do to reform our system and to go through that process. We now have a blueprint that in many ways looks like the problems that we confronted. Many people say Fannie and Freddie with their implicit government guarantee caused many of the problems. What are we going to come back with? An implicit guarantee that tier one too-big-to-fail banks are going to be guaranteed. Therefore, everyone is going to want to do business with the guaranteed bank, and every bank is going to want to be a tier one in order to have that implicit guarantee that gives them an advantage in business, lower rates, more prestige. I am not so sure that is the direction we want to go in. Then the other idea is that we have a systemic risk regulator under the Federal Reserve. I would argue we have a systemic risk regulator now under the Federal Reserve. They have tremendous power to look anywhere they want. The prior Administration before Mr. Bernanke was criticized for never having taken a step on the subprime crisis, never coming forward with a directive, never pointing out what needed to be done. I am not so sure a systemic regulator, which is very much dependent on the ability and drive of the person in the position, is the exact answer to our problem. The only thing that we seem to totally agree on is that regulation failed, yet the regulation they are proposing is very similar to the regulation we already have right now. I would build on really a question the chairman brought up earlier, what happens when you disagree? When we have this council of regulators and they disagree, how do you come to the conclusion? Many people say Lehman brought down the stability of our financial sector in many ways. Where was the way to counter the decision of whomever made that decision? How would you agree with these councils? You have to have a specific way that you agree because you know they are going to disagree. I see it every day. There was tremendous disagreement recently over how to respond to other challenges in the private sector with various businesses that was played out in the press. My time has expired. " CHRG-111hhrg53021--252 Secretary Geithner," It is a hard thing to do well. But, again, it is about the balance. The benefits to the system of having more conservative margin requirements than we had coming into this crisis are going to be very, very substantial economically. But you don't want to have them to be so high that you push a bunch of risk offshore or to other places. And that is going to be a hard thing to get right. But I don't think you can look at the last couple years of history and say that we erred on the side of having to be too conservative. " CHRG-111hhrg53021Oth--252 Secretary Geithner," It is a hard thing to do well. But, again, it is about the balance. The benefits to the system of having more conservative margin requirements than we had coming into this crisis are going to be very, very substantial economically. But you don't want to have them to be so high that you push a bunch of risk offshore or to other places. And that is going to be a hard thing to get right. But I don't think you can look at the last couple years of history and say that we erred on the side of having to be too conservative. " CHRG-111hhrg51591--101 Mr. Harrington," My main comment was, one, that if we move towards having an optional Federal system of regulation for insurance, that the whole issue of how we decide to guarantee some insurers' obligations will be critical in determining how much we may lessen market discipline, increase moral hazard, and actually undermine safety and soundness. So if we go that route, that is just a linchpin of weight needs to be done. The other thing I just said, though, is that I am by nature an incrementalist, and I wonder if targeting certain problems with State regulation through less intrusive means that wouldn't require some of the risks that are associated with a Federal regulator couldn't achieve lots of the potential efficiencies that might arise from some sort of change. Now, to be sure, types of things that might be done there have become--they have sort of moved off the front page of the papers today because of the asset crisis and the housing crisis. But I am talking about things that would allow consumers maybe to have more choice in ways in which they buy products and the types of products they buy without having to abide by certain types of regulations at the State level, whether that be a passport system or whether it be some sort of Federal preemption of certain types of regulation that deprive some consumers of, really, the ability to get low-cost products because of the way the price is regulated. " CHRG-111shrg52966--6 Mr. Polakoff," Good afternoon, Chairman Reed, Ranking Member Bunning. Thank you for inviting me to testify on behalf of OTS on the lessons the current economic crisis has taught us about risk management. The topic is timely and important because, as you know, the heart of bank supervision is in monitoring for risks, to help prevent them from endangering the health of regulated financial institutions. Some of the risks I will discuss today not only endangered institutions during this crisis, but played major roles in some failures. The financial crisis has had serious consequences for our economy and for public confidence in the safety of their bank accounts and investments. This confidence and the trust it engenders are necessary for both the smooth operation of our financial system and the larger economy. Restoring confidence is essential to achieving full economic recovery. In my comments today, I will focus on three risks that I think are most significant: concentration risk, liquidity risk, and the risk to the financial system from unevenly regulated companies, individuals, and products. Shortcomings in responding to each of these risks have significant consequences. Let me start with concentration risk, which is basically the risk of a financial institution having too many of its eggs in one basket. If something bad happens to that basket, the institution is in trouble. Although concentration risk is one of the main risks that our examiners traditionally watch closely, the current crisis exposed a new twist to concentration risk, and the OTS has acted to address that risk. The new twist was the risk of a business model heavily reliant on originating mortgage loans for sale into the private label secondary market. The freeze-up in this market for private label mortgage-backed securities in the fall of 2007 exposed this risk for institutions with an originate-to-sell business model. Their warehouse and pipeline loans could no longer be sold and had to be kept on their books, causing severe strain. To prevent this problem in the future, the OTS reviewed all of its institutions for exposure to this risk, updated its examination handbook in September 2008, and distributed a letter to the chief executive officers of OTS-regulated thrifts on best practices for monitoring and managing this type of risk. The financial crisis also taught us lessons about liquidity risk when some of our institutions experienced old-fashioned runs on the bank by panicked customers. In some cases, the size and speed of the deposit withdrawals were staggering. The event showed that the prompt corrective action tool created to prevent a gradual erosion of capital during the financial crisis of the late 1980s and early 1990s is inadequate to address a rapidly accelerating liquidity crisis. Rather than seeking a new type of prompt corrective action for liquidity, Federal banking regulators plan to issue guidance to examiners and financial institutions to incorporate lessons learned on managing liquidity risk. Finally, I would like to discuss the risk to the financial system and the larger economy by companies, individuals, and products that are not regulated at the Federal level or, in some cases, at any level. These gaps in regulation are, in my mind, the root cause of the crisis. If you could distill the cause to a single sentence, I think it would be this: Too much money was loaned to too many people who could not afford to pay it back. The simple lesson is that all financial products and services should be regulated in the same manner, whether they are offered by a mortgage broker, a State-licensed mortgage company, or a federally regulated depository institution. To protect American consumers and safeguard our economy, consistent regulation across the financial services landscape is essential. Thank you again, Mr. Chairman, for having us here today. I look forward to answering your questions. Senator Reed. Thank you, Mr. Polakoff. Dr. Sirri? STATEMENT OF ERIK SIRRI, DIRECTOR, DIVISION OF TRADING AND CHRG-111hhrg48867--84 Mr. Wallison," Thank you, Congressman. Your point about auto manufacturers, I think, suggests how plastic and unclear this whole idea of systemic risk really is. We all talk about it as though it is something that we understand. But it is highly theoretical, and we don't really have an example yet of systemic risk being created by anything other than, as I said in my oral testimony, anything other than some kind of external factor affecting the entire market. The market--the financial system around the world, and especially in the United States--is seriously troubled now, but not because of the failure of any particular company; rather, because of all of the bad mortgages that were spread throughout the world. Regulation did not prevent that from happening. We had a very strong regulatory system in place. The banks were subject to it. FDICIA, which I think you would remember well from your service here at the time, was intended to be the end of all bad banking crises. It is a very strong law, and yet we now have the worst banking crisis of all time. So I think before Congress acts on the question of systemic risk, there ought to be some understanding of what we are really talking about. Because if an agency is empowered to regulate systemic risk--it could apply to auto manufacturers as well as anyone else--Congress is handing over a blank check to a government agency, and that would be a very bad precedent. " 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-111hhrg54873--13 Mr. Carson," Thank you, Mr. Chairman, for holding this important hearing today. We all agree that reform is necessary in the credit rating industry. This has become all too evident in the ongoing financial crisis. However, I believe that as we work to make the industry more independent and objective, we cannot ignore the industry's relation to systemic risk. Credit rating agencies can increase systemic risk through unanticipated and abrupt downgrades. Such rating crises can lead to large market losses, fire sales and liquidity shortages. In this financial crisis, we have seen many recent examples of this. Defaults of subprime loans have led to abrupt and unanticipated rating downgrades of a number of rated securities, insurers, and bond insurers. These downgrades in turn led to larger market losses for investors. Although conflicts of interest and informational issues are key to understanding why such rating crises occur, it is critical to identify the different facets of risks in the ratings market and how it can lead to systemic crises and how to measure and manage them. We need to better assess the nature and extent of the use of credit ratings in financial markets as well as their potential impact on our long-term financial stability. It is clear that such an assessment will require a global approach that includes both micro and macro level analysis and includes all market participants. I look forward to this opportunity to discuss these issues with the distinguished panel, and I yield back my time. " CHRG-111shrg57709--46 Mr. Volcker," That is right. Now, all I am saying is that was a demonstration that proprietary trading can be risky. Now, how can we bring that to heel, so to speak, and what this program suggests is two things. They will have the oversight body, we call it the oversight body, who can intervene with any capital market institution that is both large or very interconnected and presenting a risk to the whole system and limit the leverage, which had not been limited prior to the crisis. And the capital and liquidity had not been overseen. They ran free. And very important, we want to set up a system, and this is the whole philosophy, that those institutions will not again be rescued. Senator Shelby. That is right. " CHRG-111hhrg53021--249 Mr. Moore," Thank you, Mr. Chairman. Mr. Secretary, many Americans probably never heard of derivatives before the financial meltdown, although many companies in the United States used derivatives to manage and hedge their risks. It appears there are two sides of risk from looking at how best to oversee the OTC derivatives market. On the one hand there is the risk to the financial system if they are left unregulated, and on the other hand there is the beneficial tool of risk management that derivatives can provide to many businesses, large and small. Mr. Secretary, I believe we need to regulate this part of the system that was ignored for too long, but we should be careful of unintended consequences. When we consider the United States companies that played no role or part in the financial crisis, how should we weigh systemic stability against higher requirements for firms that are end-users of derivatives? Is there a chance systemic risk could actually grow if companies are forced to stop hedging the risks that they have on their books? " CHRG-111hhrg53021Oth--249 Mr. Moore," Thank you, Mr. Chairman. Mr. Secretary, many Americans probably never heard of derivatives before the financial meltdown, although many companies in the United States used derivatives to manage and hedge their risks. It appears there are two sides of risk from looking at how best to oversee the OTC derivatives market. On the one hand there is the risk to the financial system if they are left unregulated, and on the other hand there is the beneficial tool of risk management that derivatives can provide to many businesses, large and small. Mr. Secretary, I believe we need to regulate this part of the system that was ignored for too long, but we should be careful of unintended consequences. When we consider the United States companies that played no role or part in the financial crisis, how should we weigh systemic stability against higher requirements for firms that are end-users of derivatives? Is there a chance systemic risk could actually grow if companies are forced to stop hedging the risks that they have on their books? " CHRG-110hhrg44900--132 Mr. Bernanke," Well, there have been many financial crises going back to the 1930's, which was of course was probably the worst of the 20th Century. Each one is different-- Involves, in some way or another, with most of these financial crises, either through, as oversight, as moral exhortation, it is convening power, and we have a wide variety of episodes where the Fed has been involved in trying to mitigate a potential financial crisis. The Fed always has to make the choice whether or not it needs to intervene to protect the system or whether the system is strong enough to accept a failure, and in some cases the failure shows in the latter. For example, Drexel was allowed to fail because it was viewed at the time that it would not bring down the whole system and that was the correct assessment. So I think it is a very rare thing to do. This particular confluence of circumstances has not occurred in the past and these were the powers that we had available to try and address this problem. Again, I share your concerns. This is not something I want to do again, it is not something I really wanted to do in the first place, and I hope that the Congress can work with us to develop a set of regulations and rules that will make this unnecessary in the future. " CHRG-111shrg50564--136 Mr. Volcker," I hate to make an advertisement for the Group of 30, but we just issued a big report on that subject. We described, I don't know, what, two dozen countries, different systems. We refrained from saying which is best, but we did pronounce a lot of pros and cons, what looked more promising and the advantages, disadvantages of different systems. There seems to be some intellectual and other movement toward what the Senator was describing of two agencies, one for business practices and one for prudential. I can't claim that that is widespread, but there are two or three countries, or four or five countries that now follow that. For a while, this business of putting everything in one agency seemed to attract a following. That enthusiasm has been a bit dampened by the fact it didn't solve all the problems in the U.K. But those are the two alternatives that need to be looked at. The United States is big enough and complicated enough, we may have a system like nobody else's, but I don't think anybody is very happy with the system we have and it takes this kind of a crisis to change it. Senator Warner. Well, you could, Dr. Volcker, maybe you could share with the Chairman at some point which of those countries you think might be models or might give us some guidelines or lessons we could learn from. " fcic_final_report_full--426 These facts tell us that our explanation for the credit bubble should focus on fac- tors common to both the United States and Europe, that the credit bubble is likely an essential cause of the U.S. housing bubble, and that U.S. housing policy is by itself an insufficient explanation of the crisis. Furthermore, any explanation that relies too heavily on a unique element of the U.S. regulatory or supervisory system is likely to be insufficient to explain why the same thing happened in parts of Europe. This moves inadequate international capital and liquidity standards up our list of causes, and it moves the differences between the regulation of U.S. commercial and invest- ment banks down that list. Applying these international comparisons directly to the majority’s conclusions provokes these questions: • If the political influence of the financial sector in Washington was an essential cause of the crisis, how does that explain similar financial institution failures in the United Kingdom, Germany, Iceland, Belgium, the Netherlands, France, Spain, Switzerland, Ireland, and Denmark? • How can the “runaway mortgage securitization train” detailed in the majority’s report explain housing bubbles in Spain, Australia, and the United Kingdom, countries with mortgage finance systems vastly different than that in the United States? • How can the corporate and regulatory structures of investment banks explain the decisions of many U.S. commercial banks, several large American univer- sity endowments, and some state public employee pension funds, not to men- tion a number of large and midsize German banks, to take on too much U.S. housing risk? • How did former Fed Chairman Alan Greenspan’s “deregulatory ideology” also precipitate bank regulatory failures across Europe? Not all of these factors identified by the majority were irrelevant; they were just not essential. The Commission’s statutory mission is “to examine the causes, domestic and global, of the current financial and economic crisis in the United States.” By fo- cusing too narrowly on U.S. regulatory policy and supervision, ignoring interna- tional parallels, emphasizing only arguments for greater regulation, failing to prioritize the causes, and failing to distinguish sufficiently between causes and ef- fects, the majority’s report is unbalanced and leads to incorrect conclusions about what caused the crisis. We begin our explanation by briefly describing the stages of the crisis. CHRG-111hhrg48674--96 Mr. Bernanke," Congressman, I think the overload issue is a real issue. I take it very seriously. Whoever manages the Federal Reserve would have to worry about allocating resources and so on. As I was saying to Congressman Watt, there are probably a number of different ways to organize in this, and the Fed might be the principal regulator or it might be coordinated with others. It would depend on what is Congress' view as the most effective mechanism. But I do think the Fed already has substantial systemic responsibilities that have gone back to the founding of the Federal Reserve. The Fed was founded principally not to manage prices or output but to manage financial crisis. That is why the Federal Reserve was created, and it has a long tradition of being involved in those issues. So I think that you would probably not have an effective system without the Fed's involvement. But, again, I am very open as to exactly how the governance of that would work and how resources would be allocated and so on. " CHRG-111hhrg49968--164 Mr. Bernanke," It is partly the fact that we had this very sharp decline in the latter part of last year related to the financial crisis that caused a big buildup of inventories. Very importantly, as I discussed earlier, we seem to have achieved a good deal of progress in stabilizing the financial system. That has helped restore confidence. Finally, demand is beginning to stabilize. We still had a very bad first quarter and we may yet have a negative second quarter because of the need to work down those inventories, but because the financial markets are doing better, because there is more confidence in the economy, in the financial system, as those inventories work down, we should begin to see a modest increase in growth. So I would put the internal dynamics of the economy in terms of inventories, and so on, as being part of it, but I also would like to give credit to actions taken by the Treasury, the Fed, the FDIC, and the Congress to help stabilize the financial system. Ms. Tsongas. Thank you, and I yield back. " CHRG-111shrg49488--43 Chairman Lieberman," That is a very important point. We are focused on this now because of the current crisis, and there are some clear linkages, as Mr. Green and Dr. Carmichael said. But there are obviously other reasons beyond that to want to alter our structure, and that is one of them--regulatory shopping. What else? You made a reference in your gracious and diplomatic use of the term ``diversified.'' I presume that underneath that was some sense that it was really pretty hard to work together with the United States because of the way in which the regulatory system was so dispersed? " CHRG-111hhrg55814--153 Secretary Geithner," I believe I agree with you. You cannot allow a system to be created again where institutions exist and operate with the expectation there will be government support if they mismanage themselves to the extent they can't survive with that. That's the central lesson of this crisis, and the central responsibility that we have to make sure that doesn't happen. And that requires us to make sure we have strong constraints on risk-taking and leverage, and we limit dramatically any expectation of government support. " CHRG-111shrg52619--2 Chairman Dodd," The Committee will come to order. Senator Shelby is in his office. He will be along shortly but asked us to commence the hearing. So we will begin this morning. Let me welcome my colleagues, welcome our witnesses as well. We have another long table here this morning of witnesses, and we are trying to move through this series of hearings on the modernization of financial regulation. So I am very grateful to all of you for your testimony. The testimony is lengthy, I might add. Going through last evening the comments--there is Senator Shelby. Very, very helpful, though, and very informative testimony, so we thank you all for your contribution. I will open up with some comments. I will turn to Senator Shelby, and then we will get right to our witnesses. We have got votes this morning as well, I would notify my colleagues, coming up so we are going to have to stagger this a bit so we do not delay the hearing too long, and we will try to, each one of us, go out and vote and come back so we can continue the hearing uninterrupted, if that would work out. So I will ask my colleagues' indulgence in that regard as well. We are gathering here again this morning to discuss the modernization of bank supervision and regulation. This hearing marks yet another in a series of hearings to identify causes of the financial crisis and specific responses that will guide this Committee's formulation of a new architecture for the 21st century financial services regulation. Today, we are going to explore ways to modernize and improve bank regulation and supervision, to protect consumers and investors, and help grow our economy in the decades ahead. A year ago, this Committee heard from witnesses on two separate occasions that the banking system was sound and that the vast majority of banks would be well positioned to weather the storm. A year later, taxpayers are forced to pump billions of dollars into our major banking institutions to keep them afloat. Meanwhile, every day 20,000 people, we are told, are losing their jobs in our country, 10,000 families' homes are in jeopardy from foreclosure, and credit--the lifeblood of our economy--is frozen solid. People are furious right now, and they should be. But history will judge whether we make the right decisions. And as President Obama told the Congress last month, we cannot afford to govern out of anger or yield to the politics of the moment as we prepare to make choices that will shape the future of our country literally for decades and decades to come. We must learn from the mistakes and draw upon those lessons to shape the new framework for financial services regulation, an integrated, transparent, and comprehensive architecture that serves the American people well through the 21st century. Instead of the race to the bottom we saw in the run-up to the crisis, I want to see a race to the top, with clear lines of authority, strong checks and balances that build the confidence in our financial system that is so essential to our economic growth and stability. Certainly there is a case to be made for a so-called systemic risk regulator within that framework, and whether or not those vast powers will reside in the Fed remains an open question, although the news this morning would indicate that maybe a far more open question in light of the balance sheet responsibilities. And, Mr. Tarullo, we will be asking you about that question this morning to some degree as well. This news this morning adds yet additional labors and burdens on the Fed itself, and so the question of whether or not, in addition to that job, we can also take on a systemic risk supervisor capacity is an issue that I think a lot of us will want to explore. As Chairman Bernanke recently said, the role of the systemic risk regulator will entail a great deal of expertise, analytical sophistication, and the capacity to process large amounts of disparate information. I agree with Chairman Bernanke, which is why I wonder whether it would not make more sense to give authority to resolve failing and systemically important institutions to the agency with actual experience in the area--the FDIC. If the events of this week have taught us anything, it is that the unwinding of these institutions can sap both public dollars and public confidence essential to getting our economy back on track. This underscores the importance of establishing a mechanism to resolve these failing institutions. From its failure to protect consumers, to regulate mortgage lending, to effectively oversee bank holding companies, the instances in which the Fed has failed to execute its existing authority are numerous. In a crisis that has taught the American people many hard learned lessons, perhaps the most important is that no institution should ever be too big to fail. And going forward, we should consider how that lesson applies not only to our financial institutions, but also to the Government entities charged with regulating them. Replacing Citibank-size financial institutions with Citibank-size regulators would be a grave mistake. This crisis has illustrated all too well the dangers posed to the consumer and our economy when we consolidate too much power in too few hands with too little transparency and accountability. Further, as former Fed Chairman Volcker has suggested, there may well be an inherent conflict of interest between prudential supervision--that is, the day-to-day regulation of our banks--and monetary policy, the Fed's primary mission--and an essential one, I might add. One idea that has been suggested that could complement and support an entity that oversees systemic risk is a consolidated safety and soundness regulator. The regulatory arbitrage, duplication, and inefficiency that comes with having multiple Federal banking regulators was at least as much of a problem in creating this crisis as the Fed's inability to see the crisis coming and its failure to protect consumers and investors. And so systemic risk is important, but no more so than the risk to consumers and depositors, the engine behind our very banking system. Creating that race to the top starts with building from the bottom up. That is why I am equally interested in what we do to the prudential supervision level to empower regulators, the first line of defense for consumers and depositors, and increase the transparency that is absolutely essential to checks and balances and to a healthy financial system. Each of these issues leads us to a simple conclusion: The need for broad, comprehensive reform is clear. We cannot afford to address the future of our financial system piecemeal or ad hoc without considering the role that every actor at every level must play in creating a stable banking system that helps our economy grow for decades to come. That must be our collective goal. With that, let me turn to Senator Shelby. CHRG-111shrg61651--27 Mr. Zubrow," Thank you very much, Chairman Dodd, Ranking Member Shelby, Members of the Committee. Thank you for giving us the opportunity to appear this morning. While the history of the financial crisis has yet to be written conclusively, we know enough about the causes to recognize that we need substantial regulatory reform. Our current framework was patched together over many decades. When it was tested, we saw its flaws all too clearly. Mr. Chairman, I want to assure you and the other Members of the Committee that we strongly support your efforts to craft and pass meaningful regulatory legislation. In our view, the markets and the economy reflect continued uncertainty about the regulatory environment. However, the details matter a great deal, and a bill that creates further uncertainty or undermines the competitiveness of the U.S. financial sector will not serve our goal of a strong, stable economy. At a minimum, we need a systemic regulator to monitor risk across our financial system. In addition, as we at JPMorgan Chase have stated repeatedly, no firm, including our own, should be too big to fail. Regulators need enhanced resolution authority to wind down failing firms, in a controlled way that does not put taxpayers' dollars at risk or the broader economy at risk. Other aspects of the regulatory system also need to be strengthened, including consumer protection, capital standards and the oversight of OTC derivatives. But I emphasize systemic risk regulation and resolution authority because they provide a useful framework for consideration of the most recent proposals from the Administration. Two weeks ago, the Administration proposed new restrictions on certain activities related to proprietary trading, hedge funds and private equity. The new proposals are a divergence from the hard work being done by legislators, central banks and regulators around the world to address the root causes of the financial crisis and to establish robust mechanisms to properly regulate systemically important financial institutions. While there may be valid reasons to examine these activities, there should be no misunderstanding. The activities the Administration proposes to restrict did not cause the financial crisis. Further, regulators currently have the authority to ensure that these risks are adequately managed in the areas that the Administration proposes to restrict. We need to take the next logical step of extending these authorities to all systemically important firms regardless of their legal structure. If the last 2 years have taught us anything, it is that threats to our financial system can and do originate in nondepository institutions. Thus, any new regulatory framework should reach all systemically important entities, including investment banks whether or not they have insured deposits. All systemically important institutions should be regulated to the same rigorous standards. If we leave some firms outside the scope of this regulation framework, we will be right back where we were before the crisis started. We cannot have two tiers of regulation for these systemically important, interconnected firms. As I noted at the outset, it is also very important that we get the details right. Thus far, the Administration has offered few details on what is meant about proprietary trading. Any individual trade taken in isolation might appear to be proprietary trading, but in fact is part of a mosaic of serving clients and properly managing the firm's risks. If defined improperly, this proposal could reduce the safety and soundness of our banking institutions, raise the cost of capital formation and restrict the availability of credit for businesses, large and small, all with no commensurate benefit to reducing systemic risk. Similarly, the Administration has yet to define what ownership or sponsorship of hedge funds and private equity activities means. Asset managers, including JPMorgan, serve a broad range of clients including individuals, universities and pensions, and need to offer these investors a broad range of investment opportunities across all types of asset classes. In each case, investments are designed to meet the needs of our clients. While we agree that the United States must show leadership in regulating financial firms, if we take an approach that is out of sync with other major countries, without any demonstrable risk reduction benefit, we will dramatically weaken our firms' ability to serve our clients in this Country. The Administration also proposed certain limits on the size of financial firms. If you consider the institutions that failed during the crisis, some of the largest and most consequential failures were standalone investment banks, mortgage companies, thrifts and insurance companies, not the diversified financial firms that appear to be the target of the Administration's proposals. It is not AIG's or Bear Stearns's size that led to their problems, but rather the interconnection of those firms that required the Government to step in. In fact, our capabilities, size and diversity were essential to both withstanding the impacts of the crisis and emerging as a stronger firm, but equally importantly putting us in a position to acquire Bear Stearns and Washington Mutual when the Government asked us to help. An artificial cap on liabilities will likely have significant negative consequences. Banks' liabilities and capital support the asset growth of their lending activities. By artificially capping liabilities, banks may be incented to reduce the growth of assets or the size of their existing balance sheets, which in turn would restrict our ability to make loans to consumers, to businesses, as well as to invest in Government securities. While numerical limits and strict rules may sound simple. There is great potential that they would undermine the goals of economic stability, growth and job creation. The better solution is modernization of our financial regulatory regime that gives regulators the authority and the resources needed to do the rigorous oversight involved in examining firms' balance sheets and lending practices. Let me conclude by just noting that it is vital that you as policymakers and those like us, with a stake in our financial system, work together to overhaul regulation thoughtfully and well. While the specific changes may seem arcane and technical, they are critical to the future of our economy. We look forward to working with the Committee to enact reforms that will position our financial industry and economy for sustained growth for decades to come. Thank you and I look forward to your questions. " CHRG-111shrg54533--15 Secretary Geithner," Senator, we thought a lot about that, and I think nobody would argue if we were starting from scratch today that we would replicate the current structure that we have of 50 State-level supervisors of banks, one at the Federal level--we are proposing one at the Federal level--and it is a complicated structure and I don't think anybody would advocate starting from that if we were starting from scratch. But I think it is fair to say, and the basic principle that guided our proposals was we wanted to make sure we are focusing on those problems that were central causes of this crisis, and we do not want to put you in the position of having to spend a lot of time on changes that may be desirable, may leave us with a neater system, maybe a more efficient system, but were not central to the cause of the problem. And in our judgment, the central source of arbitrage opportunity, the central problems we had were banks were able to evade stronger standards applied by one supervisor--in this case, it was the Fed's stronger standards that left Countrywide and others to flip their charter to a thrift. The basic problem we faced was in the thrift charter. Now, there are thousands of thrifts across the country that are well managed, were very conservative, demonstrated admirable capacity to meet the needs of their community, but in the case of too many of the celebrated failures that helped magnify this crisis, that arbitrage opportunity was central to the problem. So if you just look at AIG, Countrywide, you have described many of them, you can see examples of that basic problem. So we thought it was necessary to fix that problem, but while it was not essential to take on that more complicated challenge of fundamentally transforming the rest of the system where there is a balance now between State and Federal supervision of State-chartered banks. Now--and again, if you look at the opportunities that exist now, problems created by the potential to shift from a State charter to a national charter, I think because there are stronger, more uniform standards in place now across those banks, those problems--they are material in some cases, but they are much, much less significant. So we are making a pragmatic choice to focus on things that were a central cause of the crisis, leaving aside for the moment changes that many would support but we don't think are necessary to do just now. Senator Schumer. Thank you. " CHRG-111hhrg56776--120 Mr. Bernanke," We operate the way all the bank regulators do, which is we want to make sure the banks are safe and sound, so to the extent they are taking derivative positions or hedging their risk, we want to make sure they are doing so in a way that is safe, that takes into account counterparty risk, takes into account the full range of risks they face. Clearly, safety and soundness is a big part of our mission. We want to make sure those banks are safe. At the same time, the stability of the entire system depends on the operation of derivatives markets, for example. We saw in the crisis how problems with credit default swaps and other types of derivatives caused broader issues in the economy. As a regulator of the banking system, we will be able to see what is happening and be able to make better decisions about how to address any potential risks to the broad system that those kinds of products might pose. " FinancialCrisisInquiry--168 Well, in any transaction of the kind that people do with Lehman, they have an interest in making sure that they’re protected. So if I enter a credit-default swap with Lehman and ask for their insurance, I want to be sure that they are covering me. Why would I not ask for collateral? BASS: Because you’re a triple-A rated counterparty. WALLISON: No. I want Lehman’s protection. Why would I not be asking for collateral from Lehman? BASS: OK. I’m not following you. As far as... WALLISON: The collateral is posted by the person who has the obligation in order to back the obligation. And so I’m just wondering why a collateral is not required at the beginning of these credit- default swap transactions if the counter party is expecting to have the risk covered by the person who is offering the coverage. BASS: I think, as you entered the crisis, everyone expected everyone could pay. And as the crisis wore on a bit, the inner dealer transactions never posted initial margin, and AIG or triple- A rated counterparties did not post initial margins. So they all trust one another. When trust started to erode from the system and people realized the enormity of the leverage in the system, they started requiring deposits. And when they required deposits, it became pro-cyclical. But they should have required them in the first place, and that’s one of my key points is you need to require initial deposits from the sellers of open-ended risk. WALLISON: CHRG-111shrg50564--115 Mr. Volcker," I think you should at least explore the idea of two regulators, which was raised by Secretary Paulson's report a year or so ago, that you have one on so-called business practices and consumer protection and investor protection and one on prudential safety and soundness concerns. They overlap. They are not entirely separate, but there is substantial difference between those two approaches. In fact, there is enough difference in approaches you will get a clash between those agencies. But maybe that is healthy---- Senator Crapo. Right. " Mr. Volcker,"----instead of just having one. Now, you take the English pattern, they went all one way and away from the Central Bank. Now, that didn't work so well in terms of crisis. So how do you get----what we did say very clearly is whatever system you have, you had better get the Central Bank involved enough so they can respond effectively to a crisis. Senator Crapo. And that is consistent also with Secretary Paulson's blueprint---- " fcic_final_report_full--450 INTRODUCTION Why a Dissent? The question I have been most frequently asked about the Financial Crisis Inquiry Commission (the “FCIC” or the “Commission”) is why Congress bothered to authorize it at all. Without waiting for the Commission’s insights into the causes of the financial crisis, Congress passed and the President signed the Dodd-Frank Act (DFA), far reaching and highly consequential regulatory legislation. Congress and the President acted without seeking to understand the true causes of the wrenching events of 2008, perhaps following the precept of the President’s chief of staff—“Never let a good crisis go to waste.” Although the FCIC’s work was not the full investigation to which the American people were entitled, it has served a useful purpose by focusing attention again on the financial crisis and whether—with some distance from it—we can draw a more accurate assessment than the media did with what is often called the “first draft of history.” To avoid the next financial crisis, we must understand what caused the one from which we are now slowly emerging, and take action to avoid the same mistakes in the future. If there is doubt that these lessons are important, consider the ongoing efforts to amend the Community Reinvestment Act of 1977 (CRA). Late in the last session of the 111 th Congress, a group of Democratic congressmembers introduced HR 6334. This bill, which was lauded by House Financial Services Committee Chairman Barney Frank as his “top priority” in the lame duck session of that Congress, would have extended the CRA to all “U.S. nonbank financial companies,” and thus would apply, to even more of the national economy, the same government social policy mandates responsible for the mortgage meltdown and the financial crisis. Fortunately, the bill was not acted upon. Because of the recent election, it is unlikely that supporters of H.R. 6334 will have the power to adopt similar legislation in the next Congress, but in the future other lawmakers with views similar to Barney Frank’s may seek to mandate similar requirements. At that time, the only real bulwark against the government’s use of private entities for social policy purposes will be a full understanding of how these policies were connected to the financial crisis of 2008. Like Congress and the Administration, the Commission’s majority erred in assuming that it knew the causes of the financial crisis. Instead of pursuing a thorough study, the Commission’s majority used its extensive statutory investigative authority to seek only the facts that supported its initial assumptions—that the crisis was caused by “deregulation” or lax regulation, greed and recklessness on Wall Street, predatory lending in the mortgage market, unregulated derivatives and a financial system addicted to excessive risk-taking. The Commission did not seriously investigate any other cause, and did not effectively connect the factors 443 it investigated to the financial crisis. The majority’s report covers in detail many elements of the economy before the financial crisis that the authors did not like, but generally failed to show how practices that had gone on for many years suddenly caused a world-wide financial crisis. In the end, the majority’s report turned out to be a just so story about the financial crisis, rather than a report on what caused the financial crisis. 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-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-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-111shrg56376--43 Mr. Dugan," I think there are ways that you have to limit it. I think there are presumptions so that you make it more difficult to exercise. I think there are measures that you have to take up front so you don't get yourself in that position. My only point, though, is this: when you are in a crisis and you need to take action and you need to do it to protect the financial stability of the system, I don't think we should tie the hands of the Government from being able to do it in a moment's notice if we have to. I don't ever want to be in some of the weekend situations that I was in last fall, and we did have mechanisms that ensured a wide variety of the Government was involved in the decisions. People can second-guess some of those judgments, but I really do not think it is a good idea to completely forbid the ability to address systemic situations and crises if we have to. Senator Corker. Thank you. " fcic_final_report_full--631 Chapter 21 1. Brian Moynihan, written testimony for the FCIC, First Public Hearing of the Financial Crisis In- quiry Commission, day 1, session 1: Financial Institution Representatives, January 13, 2010, p. 1. 2. Clarence Williams, written testimony for the FCIC, Hearing on the Impact of the Financial Crisis— Sacramento, session 4: Impact of the Financial Crisis on Sacramento Neighborhoods and Families, Sep- tember 23, 2010, p. 8; and testimony before the FCIC, transcript, pp. 259–60. 3. Ed Lazear, interview by FCIC, November 10, 2010. 4. Jeannie McDermott, testimony before the FCIC, Hearing on the Impact of the Financial Crisis— Greater Bakersfield, session 6: Forum for Public Comment, September 7, 2010, transcript, pp. 211–13. 5. Marie Vasile, testimony before the FCIC, in ibid., transcript, pp. 244–51. 6. “National Delinquency Survey,” Mortgage Bankers Association, Fourth Quarter 2007, March 2008, p. 4; Third Quarter 2010, November 2010, p. 4. 7. CoreLogic, “U.S. Housing and Mortgage Trends: August 2010,” November 2010, p. 5. 8. Jeremy Aguero, principal analyst, Applied Analysis, written testimony for the FCIC, Hearing on the Impact of the Financial Crisis—State of Nevada, session 1: Economic Analysis of the Impact of the Fi- nancial Crisis on Nevada, September 8, 2010, p. 3. 9. Mauricio Soto, “How Is the Financial Crisis Affecting Retirement Savings?” Urban Institute, De- cember 10, 2008, available at www.urban.org/url.cfm?ID=901206. 10. Steven K. Paulson, “Auditors Say Colorado Pension Plan Recovering,” Associated Press, August 16, 2010. 11. Charles S. Johnson, “Montana Pension Funds Growing but Haven’t Made Up Losses,” The Billings Gazette, May 18, 2009. 12. The Conference Board news release, May 27, 2008. 13. The Conference Board news release, December 28, 2010. 14. Gregory D. Bynum, testimony before the FCIC, Hearing on the Impact of the Financial Crisis— Greater Bakersfield, session 3: Residential and Community Real Estate, September 7, 2010, transcript, p. 102. 15. Board of Governors of the Federal Reserve System, October 2010 Senior Loan Officer Opinion Survey on Bank Lending Practices, Net Percentage of Domestic Respondents Tightening Standards on Consumer Loans, Credit Cards, November 8, 2010. 16. American Bankruptcy Institute, “Annual Business and Non-business Filings by Year (1980–2009).” 17. Jeff Agosta, conference call with FCIC, February 25, 2010. 18. American Bankruptcy Institute, “Annual Business and Non-Business Filings by Year (1980– 2009).” 19. Board of Governors of the Federal Reserve System, July 2007 Senior Loan Officer Opinion Survey on Bank Lending Practices, August 13, 2007, p. 13. 20. Liz Moyer, “Revolver at the Heads,” Forbes, October 7, 2008. Gannett Corporation withdrew $1.2 billion, FairPoint Communications withdrew $200 million, and Duke Energy withdrew $1 billion. 21. Murillo Campello, John R. Graham, and Campbell R. Harvey, “The Real Effects of Financial Con- straints: Evidence from a Financial Crisis,” Journal of Financial Economics 97 (2010): 476. 629 22. Board of Governors of the Federal Reserve System, January 2009 Senior Loan Officer Opinion fcic_final_report_full--453 The shadow banking business . The large investment banks—Bear, Lehman, Merrill, Goldman Sachs and Morgan Stanley—all encountered diffi culty in the financial crisis, and the Commission majority’s report lays much of the blame for this at the door of the Securities and Exchange Commission (SEC) for failing adequately to supervise them. It is true that the SEC’s supervisory process was weak, but many banks and S&Ls—stringently regulated under FDICIA—also failed. This casts doubt on the claim that if investment banks had been regulated like commercial banks— or had been able to offer insured deposits like commercial banks—they would not have encountered financial diffi culties. The reality is that the business model of the investment banks was quite different from banking; it was to finance a short-term trading business with short-term liabilities such as repurchase agreements (often called repos). This made them especially vulnerable in the panic that occurred in 2008, but it is not evidence that the existence of investment banks, or the quality of their regulation, was a cause of the financial crisis. Failures of risk management . Claims that there was a general failure of risk management in financial institutions or excessive leverage or risk-taking are part of what might be called a “hindsight narrative.” With hindsight, it is easy to condemn managers for failing to see the dangers of the housing bubble or the underpricing of risk that now looks so clear. However, the FCIC interviewed hundreds of financial experts, including senior offi cials of major banks, bank regulators and investors. It is not clear that any of them—including the redoubtable Warren Buffett—were suffi ciently confident about an impending crisis that they put real money behind their judgment. Human beings have a tendency to believe that things will continue to go in the direction they are going, and are good at explaining why this must be so. Blaming the crisis on the failure to foresee it is facile and of little value for policymakers, who cannot legislate prescience. The fact that virtually all participants in the financial system failed to foresee this crisis—as they failed to foresee every other crisis—does not tell us anything about why this crisis occurred or what we should do to prevent the next one. 1 See, e.g., Peter J. Wallison, “Deregulation and the Financial Crisis: Another Urban Myth,” Financial Services Outlook , American Enterprise Institute, October 2009. 447 FinancialCrisisInquiry--216 I think that’s probably right. And I’d say 4 million people who became homeowners probably shouldn’t have become homeowners. We put them in a situation which wasn’t really tenable. HOLTZ-EAKIN: And in the fallout from that, we had a large financial crisis. And, Mark, I know you’ve thought a lot about this. From the fall of 2008 going forward, we’ve had a series of interventions—the Capital Purchase Programs, we did stress tests, we had suspension of mark-to-market rules—and, I guess, I want your opinion, out of the array of the financial market interventions, which do you think are deservedly credited with the turnaround we’ve seen to date—I don’t want to overstate it—and which do you put on a lower rung? ZANDI: I think the Capital Purchase Program was a necessary condition for stabilizing the financial system. I don’t think the system would have stabilized without that injection of capital at that point in time, so I think that was absolutely vital. I think the thing that really ended the—the panic once and for all were the stress tests. I think they were incredibly therapeutic, to my surprise. I—I did not expect them to go as well as they did. And, in fact, I think that is a very therapeutic process to be adopted going forward. We do a lot of risk modeling. We try to incorporate economic information into the risk processes, the financial institutions, something we’ve done in the—in the wake of the crisis. And it is to my great surprise that these institutions did not have any systematic way of stressing their portfolios. And actually some of the larger institutions—interestingly enough, they are quite sophisticated, but they’re very siloed. So the credit card folks would do it one way; the mortgage guys would do it another way; the corporate bond— the corporate lending folks another. There was no sort of across the entire balance sheet. And this stress test process for the 19 bank-holding companies was, in fact, that, and it was, I thought, very well done and ultimately restored confidence in the system and is where we are today. Now, the one part of the system that’s not working and the system will not work well without it is the process of securitization. Ironically, that’s what got us—the flawed securitization process goes to your point. That’s how we got that homeownership rate up. That’s how we got all those bad loans being made. And $2 trillion in private bond issuance in 2006 at the height of the... CHRG-110hhrg46591--98 Mr. Seligman," The system has to be comprehensive. That means it has to address some gaping holes such as right now like credit default swaps. Second, there has to be some sort of risk avoidance or crisis manager at the top. This could be the same agency that would address things like financial holding companies. Third, you have to have sufficient expert knowledge to address a series of specialized industries including securities and investment banks, insurance, and commodities. " CHRG-111shrg61513--62 Mr. Bernanke," In short, yes, I would support that--13(3) has been used two ways. It has been used in what you would call bailouts, and it has been used in developing these broad-based lending facilities to help individual markets, like the ones we just closed down on February 1st. I think the latter is a valuable thing to have in case of a future crisis, but we would be happy to give up any involvement in the wind-down of failing, systemically critical firms. Senator Vitter. And just to make clear, I am talking about the former not the latter, so I think we are on the same page. " CHRG-111shrg52619--89 Mr. Tarullo," Senator, I may have misunderstood. I understood you to be asking not about regulatory actions in the midst of the crisis, but in the period preceding it, when supervision is supposed to be ongoing. And I think there is a lot to the question that you asked, not so much because, I would say, of the conflict of interests as such between different roles, but because everybody tends to fall into a notion of what operating principles are for whatever period we may be in. And so people come to accept things. Bankers do, supervisors do, maybe even Members of Congress do--something that is ongoing, is precisely because it has been ongoing, thought to be an acceptable situation. So I think from both our perspective and your perspective the challenge here is to figure out what kinds of mechanisms we put in place within agencies, between the Hill and agencies in legislation which force consideration of the kinds of emerging issues that we can't predict now because we don't know what the next crisis might look like, but which are going to be noticed by somebody along the way. And while I really don't want to overstate the potential utility of a systemic risk regulator for the reasons I said earlier, I would say that in an environment in which an overall assessment of the system is an explicit part of the mandate of one or more entities in the U.S. Government, you at least increase the chances that that kind of disparate information gets pulled together and somebody has to focus on it. Now, what you do with it, that is another set of questions, but I think that gets you at least a little bit down the road. Senator Reed. Mr. Polakoff, and my time is expiring, so your brevity is appreciated. " CHRG-111shrg55739--62 Mr. Barr," The conversation that we had with them, the Secretary made clear the regulators are free to defend their own agency prerogatives. They are independent agencies. He expected that they would. He asked that they keep in mind, as they did that, the fundamental goals that we all share to protect consumers, to address systemic risk in our system, to make sure the Government had the tools they need to resolve financial firms in a crisis, and as they expressed their differences that we work together in the areas where we do have agreement. We had a long conversation about the important roles of the council versus the independent regulators. We had a long discussion about micro prudential versus macro prudential regulation. It was the kind of conversation that we have had with them on many occasions. Senator Bunning. The same type of discussion from Secretary Geithner and you with the regulators that you have had in the past. " CHRG-110hhrg46596--254 Mr. Kashkari," Congressman, I feel confident that the financial system is stronger than it was when the Congress acted so quickly. But this crisis has been unpredictable. And there have been times in the past when market participants breathed a sigh of relief and said, okay, we are through it. I don't want to make predictions, but I do say that it is important that we all stay on our front foot, and continue to move aggressively to take action to adjust to situations on the ground until we are sure we are through it. That is about as good an answer as I can give you, Congressman. " CHRG-111hhrg53248--39 Secretary Geithner," And if you look at the value of the investment the government made in Goldman Sachs after the warrants, the government did realize a 23 percent annual return on investment. And that is a measure of the effectiveness of the policies that Congress helped put in place to try to bring more stability to our financial system. With the effect of those actions, the ultimate cost of this crisis could prove to be very modest relevant to the scale of the risk we confronted, but we won't know that until-- " fcic_final_report_full--488 Government Actions Create a Panic More than any other phenomenon, the financial crisis of 2008 resembles an old-fashioned investor and creditor panic. In the classic study, Manias, Panics and Crashes: A History of Financial Crises , Charles Kindleberger and Robert Aliber make a distinction between a remote cause and a proximate cause of a panic: “ Causa remota of any crisis is the expansion of credit and speculation, while causa proxima is some incident that saps the confidence of the system and induces investors to sell commodities, stocks, real estate, bills of exchange, or promissory notes and increase their money holdings.” 58 In the great financial panic of 2008, it is reasonably clear that the remote cause was the build-up of NTMs in the financial system, primarily— as I have shown in this analysis—as a result of government housing policy. This unprecedented increase in weak and risky assets set the financial system up for a crisis of some kind. The event that turned a potential crisis into a full-fledged panic—the proximate cause of the panic—was also the government’s action: the rescue of Bear Stearns in March 2008 and the subsequent failure to rescue Lehman Brothers six months later. In terms of its ultimate cost to the public, this was one of the great policy errors of all time, and the reasons for the misjudgments that led to it have not yet been fully explored. The lesson taught by the rescue of Bear was that all large financial institutions—and especially those larger than Bear—would be rescued. The moral hazard introduced by this one act irreparably changed the position of Lehman Brothers and every other large firm in the world’s financial system. From that time forward, (i) the critical need for more capital became less critical; the likelihood of a government bailout would reassure creditors, so there was no need to dilute the shareholders any further by raising additional capital; (ii) firms such as Lehman, that might have been saved through an acquisition by a larger firm or an infusion of fresh capital by a strategic investor, drove harder bargains with potential acquirers; (iii) the potential acquirers themselves waited for the U.S. government to pick up some of the cost, as it had with Bear—an offer that never came in Lehman’s case; and (iv) the Reserve Fund, a money market mutual fund, apparently assuming that Lehman would be rescued, decided not to sell the heavily discounted Lehman commercial paper it held; instead, with devastating results for the money market fund industry, it waited to be bailed out on the assumption that Lehman would be saved. But Lehman was not saved, and its creditors were not bailed out. At a time when large mark-to-market losses among U.S. financial firms raised questions about which large financial institutions were insolvent or unstable, the demise of Lehman was a major shock. It overturned all the rational expectations about government 58 Charles P. Kindleberger and Robert Aliber, Manias, Panics, and Crashes: A History of Financial Crises , 5th edition, John Wiley & Sons, Inc., 2005, p.104. 483 policies that market participants had developed after the Bear rescue. With no certainty about who was strong or who was weak, there was a headlong rush to U.S. government securities. Banks—afraid that their counterparties would want a return of their investments or their corporate customers would draw on lines of credit—began to hoard cash. Banks wouldn’t lend to other banks, even overnight. As Chairman Bair suggested, that was the financial crisis. Everything after that was simply cleaning up the mess. CHRG-110hhrg46591--223 Mr. Bartlett," Thank you, Mr. Chairman, and Ranking Member Bachus. I provided in my written testimony a description of the size and scope and some examples of the problem of the regulatory system as it now stands. Suffice it to say that in summary it is a lack of coordination, a lack of uniformity, huge gaps in the system in which literally hundreds of agencies are not even authorized to talk with one another about their regulatory structure or regulatory conclusions, much less to engage in a consistent regulatory coordination. As you noted, Mr. Chairman, that will be entered into the record. The current crisis has erupted. And when the current crisis erupted, literally no coordinating body was clearly responsible, and so it was an ad hoc response that required all the agencies, and including Congress. So today we bring ourselves--and Mr. Chairman, I commend you and the members of the committee. This is an extraordinary hearing, with an extraordinary turnout. It may be the first that I can recall during this time, this season, in which this many members of the committee would come on a legislative effort such as this. The hearing is timely. It is urgent. And I think it requires some relatively rapid action. I propose today, Mr. Chairman, I would share with you five near-term regulations the Financial Services Roundtable have. These are--I call them ``no regret moves'' in that they won't stand in the way of long-term solutions. And I believe that the committee and the Congress will consider and adopt long-term solutions in short order. But on the near-term, and these near-term solutions should lead to those longer term restructuring, I would cite five. First, is market stabilization. Reduce the potential for systemic risk by giving the Federal Reserve Board overarching supervisory authority over systemically significant financial services firms that seek access to the discount window. And provide that statutory authority in advance of the crisis, not after the crisis. Second, interagency coordination. Our proposal in the short term is to expand the membership and mission of the President's Working Group by statute to make it more forward looking. The fact is the President's Working Group is the only authority at all with any coordinating authority. They have no statutory authority. And on that group is not the OCC, the OTS, the PCAOB, or any insurance regulatory agency. Third, adopt principle-based regulation. The principles should be adopted by statute by Congress. Enact those principles to serve as a common point of reference for all regulatory agencies as encompassed. Fourth, is prudential supervision. Encourage the early identification of potential risk by the application of prudential supervision by all financial regulators for all financial services forms. And fifth, is adopt financial insurance supervision. The fact is that the State-by-State system of insurance regulation is the last vestige of 19th Century regulation. It is time to move into the 20th Century. We would have you implement those recommendations--we would not--I would not contend that the implementation of those regulations would have prevented this current crisis entirely. But I do believe they would have helped regulators and the financial services industry to better and much earlier appreciate the market developments, and would have significantly reduced the scope and the severity of the crisis. We do recommend, Mr. Chairman, three additional actions to take in the near term. First, is fair value accounting. We advocate the use of a clear-minded system to determine the true value of assets in distressed and illiquid markets. The current application of fair value accounting is neither clear-minded nor fair. It is causing significant damage to individual institutions, but way more importantly, to the economy as a whole. The SEC and the Public Company Accounting Oversight Board has the authority to act. We urge them to provide auditors the flexibility in the application to apply fair value accounting. Second, credit default swaps. We think that the first step is to--the first step will lead to regulation. We think the first step is to establish a clearinghouse for credit default swaps. We do think it requires a Federal regulator. We recommend either the CFTC or the Federal Reserve. And then, third, is mortgage interest rates, Mr. Chairman. We believe that at this point this sort of mystical thing in London called the LIBOR has declined 6 days in a row--that is some kind of a record--to lead us out of the crisis, but it has not led to a reduction of mortgage interest rates. And until that happens, the economy will continue to be in jeopardy and getting worse. So if mortgage rates do not fall, then we urge Congress, the Treasury, and the Federal regulatory agencies to consider additional appropriate actions. Lastly, Mr. Chairman, we do believe that sitting here on October the 21st, it is not clear at this point whether an additional fiscal stimulus should be adopted. But Congress should consider that if in the next few weeks the measures that have already been taken do not result in the beginning of a recovery, then we think the Congress should consider a stimulus package. That stimulus package, in our view, should have 3 points: Housing; job creation; and capital investment. Mr. Chairman, we urge neither more regulation nor less regulation, but better, more effective regulation. Thank you. [The prepared statement of Mr. Bartlett can be found on page 106 of the appendix] " Mr. Watt," [presiding] I thank the gentleman for his testimony. " Mr. Yingling," STATEMENT OF EDWARD YINGLING, PRESIDENT AND CHIEF EXECUTIVE OFFICER, AMERICAN BANKERS ASSOCIATION (ABA) " CHRG-110hhrg46593--10 Secretary Paulson," Thank you very much, Mr. Chairman. Mr. Chairman, Congressman Bachus, and members of the committee, thank you for the opportunity to testify this morning. Six weeks ago, Congress took the critically important step of providing important authorities and resources to stabilize our financial system. Until that time, we faced a financial crisis without the proper tools. With these tools in hand, we took decisive action to prevent the collapse of our financial system. We have not in our lifetimes dealt with a financial crisis of this severity and unpredictability. We have seen the failures or the equivalent of failures of Bear Stearns, IndyMac, Lehman Brothers, Washington Mutual, Wachovia, Fannie Mae, Freddie Mac, and AIG, institutions with a collective $4.7 trillion in assets when this year began. By September, the financial system had seized up, presenting a system-wide crisis. Our objectives in asking Congress for a financial rescue package were to, first, stabilize a financial system on the verge of collapse and then to get lending going again to support American consumers and businesses. Over the next few weeks, conditions worsened significantly. Confidence in the banking system continued to diminish. Industrial company access to all aspects of the bond market was dramatically curtailed. Small- and middle-sized companies with no direct connection to the financial sector were losing access to the normal credit needed to meet payrolls, pay suppliers, and buy inventory. During that same period, the FDIC acted to mitigate the failure of Washington Mutual and made clear that it would intervene to prevent Wachovia's failure. Turmoil had developed in the European markets. In a 2-day period at the end of September, the governments of Ireland, the U.K., Germany, Belgium, France, and Iceland intervened to prevent the failure of one or more financial institutions in their countries. By the time legislation had cleared Congress, the global market crisis was so broad and severe that powerful steps were necessary to quickly stabilize our financial system. Our response, in coordination with the Federal Reserve, the FDIC, and other banking regulators was a program to purchase equity in banks across the country. We have committed $250 billion to this effort. This action, in combination with the FDIC's guarantee of certain debt issued by financial institutions and the Fed's commercial paper program helped us to immediately stabilize the financial system. The Capital Purchase Program for banks and thrifts has already dispersed $148 billion, and we are processing many more applications. Yesterday, Treasury announced the terms for participation for nonpublicly traded banks, another important source of credit in our economy. We have designed these terms to help provide community development financial institutions and minority depository institutions with capital for lending to low-income and minority populations. These institutions have committed to use this capital for businesses and projects that serve their communities. In addition, we are developing a matching program for possible future use by banks or nonbank financial institutions. Capital strength enables banks to take losses as they write down or sell troubled assets. Stronger capitalization is also essential to increasing lending, which although difficult to achieve during times like this, is essential to economic recovery. We expect banks to increase their lending over time as a result of these efforts and as confidence is restored. This lending won't materialize as fast as any of us would like. But it will happen much, much faster having used the TARP to stabilize our system. As we continue significant work on our mortgage asset purchase plan, it became clear just how much damage the crisis had done to our economy. Third quarter GDP growth showed negative three-tenths of a percent. The unemployment rate rose to a level not seen in 15 years. Home price status showed that home prices in 10 major cities had fallen 18 percent over the previous year, demonstrating that the housing correction had not abated. The slowing of European economies has been even more dramatic. We assessed the potential use of remaining TARP funding against the backdrop of current economic and market conditions. It is clear that an effective mortgage asset purchase program would require a massive commitment of TARP funds. In September, before economic conditions worsened, $700 billion in troubled asset purchases would have had a significant impact. But half of that sum in a worse economy simply isn't enough firepower. We have therefore determined that the prudent course at this time is to conserve the remaining funds available from the TARP, providing flexibility for this and the next Administration. Other priorities that need to be addressed include actions to restore consumer credit. Treasury has been working on a program with the Federal Reserve to improve securitization in the credit marketplace. While this would involve investing only a relatively modest share of TARP funds in the Federal Reserve liquidity facility, it could have substantial positive benefits for consumer lending. Finally, Mr. Chairman, Treasury remains committed to continuing to work to reduce avoidable foreclosures. Congress and the Administration have made substantial progress on that front through HUD programs, the FDIC's IndyMac approach, our support and leadership of the HOPE NOW Alliance, and our work with the GSEs, including an important announcement they made last week establishing new servicer guidelines that will set a new standard for the entire industry. Our actions to stabilize and strengthen Fannie Mae and Freddie Mac have also helped mitigate the housing correction by increasing access to lower-cost mortgage lending. As some on the committee know, I have reservations about spending TARP resources to directly subsidize foreclosure mitigation because this is different than the original investment intent. We continue to look at good proposals and are dedicated to implementing those that protect the taxpayer and work well. Mr. Chairman, the actions of the Treasury, the Fed, and the FDIC have stabilized our financial system. The authorities in the TARP have been used to strengthen our financial system and to prevent the harm to our economy and financial system from the failure of a systemically important institution. As facts and conditions in the market and economy have changed, we have adjusted our strategy to most effectively address the urgent crisis and to preserve the flexibility of the President-elect and the new Secretary of the Treasury to address future challenges in the economy and capital markets. Thank you again for your efforts and for the opportunity to appear today. I would like to just make one last comment in response to a question that Congressman Bachus asked because it is one I hear a lot, the distinction between the financial markets and the economy. So when we have talked about the crisis and the financial markets and being unprecedented and having to go back to the Great Depression to see anything of this magnitude and be presented with this amount of difficulty, we are talking about the financial markets. Now, when the financial markets have problems, they hurt the economy. So the reason that it was very important to get in quickly and stabilize it was to mitigate damage to the economy. When we were here before you, we saw what was happening to the economy. We talked about it. We took the steps. The economy has continued to get worse. The American people look at the worsening economy. And as your chairman said to me yesterday, in politics, you don't get much credit for what might have happened and didn't happen. What the American people see is what is happening to the economy. But again, our purpose in coming to you was to take-- " CHRG-110shrg50414--243 Mr. Bernanke," I don't think so, but I don't know how that rating agency does its analysis. Senator Tester. Good enough. The ``too big to fail'' issues have been brought up here several times today, and this is for Chairman Bernanke. Both you and your predecessor have warned about the threat of systemic risk to financial markets when some companies are too big to fail, or we are talking about the whole system. Chairman Greenspan spoke most frequently about the systemic risk Fannie Mae and Freddie Mac posed. In response to the recent crisis, Secretary Paulson, if I can quote you, you said, ``as we have worked through this period of market turmoil, we have acted on a case-by-case basis,'' which is accurate. In that work, we have forced some marriages of some of Wall Street's biggest titans, Bear Stearns, AIG, Bank of America and Merrill Lynch, Morgan Chase, all those. So the question is, are we posing additional risks by this consolidation in the marketplace and how do we spread risk as long as this consolidation is going on, because it appears we are forcing some of this consolidation. " CHRG-111shrg56376--16 Chairman Dodd," Let me just ask you and the other panelists to comment on this. Clearly, we are looking back in the rearview mirror as to what happened, and that is certainly a motivation here. But it is not the sole motivation. It is not just a question of addressing the problems that occurred, but going forward, in the 21st century, in a very different time, in a global economy today--we saw the implications of what happened not only here in this country but around the world. The idea that we would maintain the same architecture we have for decades is not only a question about what has occurred and whether or not the system responded well enough to it, but looking forward as to whether or not this architecture and structure is going to be sufficient to protect the safety and soundness in a very different economic environment than existed at the time these agencies emerged through the process of growth over the years. It seems to me that is just as important question as looking back. Ms. Bair. I think it is a very important question, and I am very glad you are having these hearings. But I do not think that this is going to solve the problems that led to this crisis. Looking at the performance of other models in European countries that have a single regulator, the performance is not particularly good. I do think there is a profound risk of regulatory capture by very large institutions if you collapse regulatory oversight into one single entity. I think having multiple voices is beautiful. We testified before this Committee on the Advanced Approaches under Basel II. We resisted that, and we slowed it down. And because of that, our banks--commercial banks, FDIC-insured banks--had not transitioned into that new system, which would have significantly lowered the amount of capital they would have had going into this crisis, unlike what happened in Europe and with investment banks. So we think having multiple voices can actually strengthen regulation and guard against regulatory capture. If you have a single monopoly regulator, there is not going to be another regulator out there saying, ``We are going to have a higher standard,'' ``We are going to be stronger,'' or ``We are going to question that.'' I think you lose that with a single regulator. So you should look carefully at the European models and how they functioned during the crisis. " 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 .. fcic_final_report_full--437 The dangerous imprecision of the term “shadow banking” Part II of the majority’s report begins with an extensive discussion of the failures of the “shadow banking system,” which it defines as a “financial institutions and activi- ties that in some respects parallel banking activities but are subject to less regulation than commercial banks.” The majority’s report suggests that the shadow banking sys- tem was a cause of the financial crisis. “Shadow banking” is a term used to represent a collection of different financial in- stitutions, instruments, and issues within the financial system. Indeed, “shadow banking” can refer to any financial activity that transforms short-term borrowing into long-term lending without a government backstop. This term can therefore in- clude financial instruments and institutions as diverse as: • The tri-party repo market; • Structured Investment Vehicles and other off-balance-sheet entities used to in- crease leverage; • Fannie Mae and Freddie Mac; • Credit default swaps; and • Hedge funds, monoline insurers, commercial paper, money market mutual funds, and investment banks. As discussed in other parts of this paper, some of these items were important causes of the crisis. No matter what their individual roles in causing or contributing to the crisis, however, they are undoubtedly different. It is a mistake to group these is- sues and problems together. Each should be considered on its merits, rather than painting a poorly defined swath of the financial sector with a common brush of “too little regulation.” BIG BANK BETS AND WHY BANKS FAILED The story so far involves significant lost housing wealth and diminished values of se- curities financing those homes. Yet even larger past wealth losses did not bring the global financial system to its knees. The key differences in this case were leverage and risk concentration. Highly correlated housing risk was concentrated in large and highly leveraged financial institutions in the United States and much of Europe. This leverage magnified the effect of a housing loss on a financial institution’s capital re- serve, and the concentration meant these losses occurred in parallel. CHRG-111hhrg48674--72 Mr. Bernanke," Well, I think at this point the reason the banks and the credit markets are frozen is no longer the legacy subprime mortgages and those things. It is more concern about where the economy is going. So I think we need strong action to stabilize the economy and the financial system. If we can do that, we will get a virtuous circle rather than a vicious circle that will get the economy back to a more normal state. But I have to say that this has been an extraordinary episode. This is the most severe financial crisis since the 1930's, and in all honesty, I have to tell you, we can't expect immediate results. We have to be patient and keep working with it. " CHRG-111shrg51395--54 Mr. Pickel," I think the requirement for greater coordination among the regulators is very important. I think that one of the things we are looking at here in the financial crisis is the ability to connect the dots across different products and across different markets, both nationally and globally. I think that is the root of some of the suggestions for the systemic risk regulator. But I think it could also be achieved, as I think Mr. Silvers and Mr. Turner suggested, through greater coordination or some collection of supervisor who would look at these issues and connect those dots. " CHRG-111hhrg55809--122 Mr. Meeks," Let me just get this question in really quick because of the big issue that is starting to happen in New York, and that is dealing with commercial real estate. Could you give us a quick update on the state of the commercial real estate market and whether it would be a drag on the recovery going forward, or is it another potential systemic risk crisis brewing? And which parts of the market do you expect would be the most affected by any pending crises in the commercial real estate area? " 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-111shrg52619--140 Chairman Dodd," Thanks, Senator Bunning, for the question, I am not going to ask you to respond to this because I have taken a lot of your time already today, not to mention there was a little confusion with the votes we have had. But we want to define what we mean when we talk about a systemic risk regulator. Do you mean regulating institutions that are inherently systemically risky or important? Or are you talking about regulating systemically risky practices that institutions can engage in? Or are you talking about regulating or setting up a resolution structure so that when you have institutions like AIG and Lehman Brothers, you have got an alternative other than just pumping capital into them, as we did in the case of AIG? I get uneasy about the fact that the Fed is the lender of last resort. Simultaneously the Fed now also falls into the capacity of being particularly in the last function, the resolution operation. It seems to me you get, like in the thrift crisis years ago, the regulator becomes also the one that also deals with these resolutions. I think that is an inherently dangerous path to go down. That is my instinct. " fcic_final_report_full--557 Unless otherwise specified, data come from the sources listed below. Board of Governors of the Federal Reserve System, Flow of Funds Reports: Debt, international capital flows, and the size and activity of various financial sectors Bureau of Economic Analysis: Economic output (GDP), spending, wages, and sector profit Bureau of Labor Statistics: Labor market statistics BlackBox Logic and Standard & Poor’s: Data on loans underlying CMLTI 2006-NC2 CoreLogic: Home prices Inside Mortgage Finance, 2009 Mortgage Market Statistical Annual: Data on origination of mortgages, issuance of mortgage-backed securities and values outstanding Markit Group: ABX-HE index Mortgage Bankers Association National Delinquency Survey: Mortgage delinquency and fore- closure rates 10-Ks, 10-Qs, and proxy statements filed with the Securities and Exchange Commission: Com- pany-specific information Many of the documents cited on the following pages, along with other materials, are available on www.fcic.gov. Chapter 1 1. Charles Prince, testimony before the FCIC, Hearing on Subprime Lending and Securitization and Government-Sponsored Enterprises (GSEs), day 2, session 1: Citigroup Senior Management, April 8, 2010, transcript, p. 10. 2. Warren Buffett, testimony before the FCIC, Hearing on the Credibility of Credit Ratings, the In- vestment Decisions Made Based on Those Ratings, and the Financial Crisis, session 2: Credit Ratings and the Financial Crisis, June 2, 2010, transcript, p. 208; Warren Buffett, interview by FCIC, May 26, 2010. 3. Lloyd Blankfein, testimony before the First Public Hearing of the FCIC, day 1, panel 1: Financial Institution Representatives, January 13, 2010, transcript, p. 36. 4. Ben S. Bernanke, closed-door session with FCIC, November 17, 2009; Ben S. Bernanke, testimony before the FCIC, Hearing on Too Big to Fail: Expectations and Impact of Extraordinary Government In- tervention and the Role of Systemic Risk in the Financial Crisis, day 2, session 1: The Federal Reserve, September 2, 2010, transcript, p. 27. 5. Alan Greenspan, written testimony for the FCIC, Subprime Lending and Securitization and Gov- ernment-Sponsored Enterprises (GSEs), day 1, session 1: The Federal Reserve, April 7, 2010, p. 9. 553 6. Richard C. Breeden, interview by FCIC, October 14, 2010. 7. Paul A. McCulley, testimony before the FCIC, Hearing on the Shadow Banking System, day 2, ses- sion 3: Institutions Participating in the Shadow Banking System, May 6, 2010, transcript, p. 249. 8. Arnold Cattani, testimony before the FCIC, Hearing on the Impact of the Financial Crisis—Greater CHRG-111hhrg51698--126 Mr. Kissell," Thank you, Mr. Chairman. Thank you, panel. I am going to approach this a little bit differently than Mr. Damgard and Mr. Gooch. Mr. Gooch, you said you had thought the system functioned very well, and maybe I am interpreting it wrong, but it seemed to me it functioned well because there was no major train wreck like we saw in the financial end; the banks weren't collapsing and so forth. But from the perspective of the individuals, the families in my district and across this nation, there were millions of train wrecks. I am interested in your idea that the system functioned well when the speculation that took place caused so much hardship for our families, and created such an economic crisis of energy and food and other hardships on our families. So how could the system maybe be tweaked so that it continues to function well in some regards, but it offers protections to our families where those small train wrecks are taking place? " CHRG-110hhrg44901--8 The Chairman," The Federal Reserve doesn't get to object. Dr. Paul. I think everybody recognizes today that our financial markets are in a big mess, and I have complained for many years about the Federal Reserve System. But I would have to say that Chairman Bernanke himself is not responsible for this mess. Not that I think he has the answers in this deeply flawed monetary system, but obviously the seeds of this mess have been planted over a long period of time. It is more a reflection of the system rather than that of one individual. It is amazing how panicky people have been getting, and how everybody is wringing their hands, and yet our government tells us, well, there is no recession, so things must be all right. A lot of people are very angry. Yet we know there is something seriously wrong, with all the mess that we have in the financial markets. And now we see this morning that inflation is roaring back, yet it is still way below what the private economists are saying about what inflation is really doing. But the consumer knows all about it. It seems like around here, whether it is from Treasury or the Federal Reserve or even in the Congress, all we need now is to have a world-class regulator that is going to solve all our problems, and I think that is so simplistic. From my viewpoint, what we need is a world-class dollar, a dollar that is sound, not a dollar that continues to depreciate, and not a system where we perpetually just resort to inflation and deficit financing to bail out everybody. This is what we have been doing. It hasn't been just with this crisis, but an ongoing crisis. We have been able to pull ourselves out of these nosedives quite frequently. One of the worst with the dollar was in 1979. We patched it together. I think the handwriting on the wall is there is a limit to how many times we can bail the dollar out, because conditions are so much worse today than they have ever been. We talk a lot about predatory lending, but I see the predatory lending coming from the Federal Reserve. Interest at 1 percent, overnight rates, loaning to banks, encouraging the banks and investors to do the wrong things causes all the malinvestment. These conditions were predictable. They were predicted by the Austrian free market economists. It should surprise nobody, yet nobody resorts to looking to those individuals who are absolutely right about what was coming and what we should have done. Even as early as 7 years ago, I introduced legislation that would have removed the line of credit to the Treasury, which was encouraging the moral hazard and the malinvestment. Here, it looks like now we are going to need $300 billion of new appropriations. So we need to look at the monetary system and its basic fundamental flaws that exist there, and then we might get to the bottom of these problems we are facing today. " fcic_final_report_full--454 Securitization and structured products . Securitization—often pejoratively described as the “originate to distribute process”—has also been blamed for the financial crisis. But securitization is only a means of financing. If securitization was a cause of the financial crisis, so was lending. Are we then to condemn lending? For decades, without serious incident, securitization has been used to finance car loans, credit card loans and jumbo mortgages that were not eligible for acquisition by Fannie Mae and Freddie Mac. The problem was not securitization itself, it was the weak and high risk loans that securitization financed. Under the category of securitization, it is necessary to mention the role of collateralized debt obligations, known as CDOs. These instruments were “toxic assets” because they were ultimately backed by the subprime mortgages that began to default in huge numbers when the bubble deflated, and it was diffi cult to determine where those losses would ultimately settle. CDOs, accordingly, for all their dramatic content, were just another example of the way in which subprime and other high risk loans were distributed throughout the world’s financial system. The question still remains why so many weak loans were created, not why a system that securitized good assets could also securitize bad ones. Credit default swaps and other derivatives . Despite a diligent search, the FCIC never uncovered evidence that unregulated derivatives, and particularly credit default swaps (CDS), was a significant contributor to the financial crisis through “interconnections”. The only company known to have failed because of its CDS obligations was AIG, and that firm appears to have been an outlier. Blaming CDS for the financial crisis because one company did not manage its risks properly is like blaming lending generally when a bank fails. Like everything else, derivatives can be misused, but there is no evidence that the “interconnections” among financial institutions alleged to have caused the crisis were significantly enhanced by CDS or derivatives generally. For example, Lehman Brothers was a major player in the derivatives market, but the Commission found no indication that Lehman’s failure to meet its CDS and other derivatives obligations caused significant losses to any other firm, including those that had written CDS on Lehman itself. Predatory lending . The Commission’s report also blames predatory lending for the large build-up of subprime and other high risk mortgages in the financial system. This might be a plausible explanation if there were evidence that predatory lending was so widespread as to have produced the volume of high risk loans that were actually originated. In predatory lending, unscrupulous lenders take advantage of unwitting borrowers. This undoubtedly occurred, but it also appears that many people who received high risk loans were predatory borrowers, or engaged in mortgage fraud, because they took advantage of low mortgage underwriting standards to benefit from mortgages they knew they could not pay unless rising housing prices enabled them to sell or refinance. The Commission was never able to shed any light on the extent to which predatory lending occurred. Substantial portions of the Commission majority’s report describe abusive activities by some lenders and mortgage brokers, but without giving any indication of how many such loans were originated. Further, the majority’s report fails to acknowledge that most of the buyers for subprime loans were government agencies or private companies complying with government affordable housing requirements. fcic_final_report_full--429 VII. Risk of contagion. The risk of contagion was an essential cause of the crisis. In some cases, the financial system was vulnerable because policymakers were afraid of a large firm’s sudden and disorderly failure triggering balance- sheet losses in its counterparties. These institutions were deemed too big and interconnected to other firms through counterparty credit risk for policy- makers to be willing to allow them to fail suddenly. VIII. Common shock. In other cases, unrelated financial institutions failed be- cause of a common shock: they made similar failed bets on housing. Uncon- nected financial firms failed for the same reason and at roughly the same time because they had the same problem: large housing losses. This common shock meant that the problem was broader than a single failed bank–key large financial institutions were undercapitalized because of this common shock. IX. Financial shock and panic. In quick succession in September , the fail- ures, near-failures, and restructurings of ten firms triggered a global financial panic. Confidence and trust in the financial system began to evaporate as the health of almost every large and midsize financial institution in the United States and Europe was questioned. X. Financial crisis causes economic crisis. The financial shock and panic caused a severe contraction in the real economy. The shock and panic ended in early . Harm to the real economy continues through today. We now describe these ten essential causes of the crisis in more detail. THE CREDIT BUBBLE: GLOBAL CAPITAL FLOWS, UNDERPRICED RISK, AND FEDERAL RESERVE POLICY The financial and economic crisis began with a credit bubble in the United States and Europe. Credit spreads narrowed significantly, meaning that the cost of borrowing to finance risky investments declined relative to safe assets such as U.S. Treasury securi- ties. The most notable of these risky investments were high-risk mortgages. The U.S. housing bubble was the most visible effect of the credit bubble but not the only one. Commercial real estate, high-yield debt, and leveraged loans were all boosted by the surplus of inexpensive credit. There are three major possible explanations for the credit bubble: global capital flows, the repricing of risk, and monetary policy. Global capital flows Starting in the late s, China, other large developing countries, and the big oil- producing nations consumed and invested domestically less than they earned. As CHRG-111shrg56376--18 Mr. Dugan," I cannot really defend the current system of so many regulators. As one of my predecessors used to say, it does not work in theory, but we have worked hard to make it work in practice. And having said that, I think there is more you could do if you were so inclined, and you have gone from four regulators to three prudential regulators in the proposal. You could go the next step to have a single regulator for State-chartered institutions, which would bring you down to two. You could go to one regulator for the banks, and you could even bring in the holding company regulation to the prudential supervisor. As I mentioned in my testimony, there are advantages and disadvantages in each of those steps. I think at the end of the day, if you put everything all in one place, it would be probably too much. And so I think that is probably a bridge too far, but there are things that you could do that would simplify things for the future. I do not believe, and agree with Sheila, that this was a principal contributing cause of this crisis. But I think going forward we do have to think hard about what is the best system for the future, and giving those matters real thought is a good thing. " 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-111shrg54533--49 Secretary Geithner," Excellent question and a core concern that shaped our recommendations. Just to go back to where you started on the GSEs, remember, these institutions were allowed to operate with this implicit guarantee. As you said, lower borrowing costs take on a huge amount of leverage. They were not subjected to remotely conservative--sufficiently conservative capital requirements and there was no mechanism established in the law for dealing with their potential failure. Congress created, at least laid a foundation for fixing both those problems in the legislation it passed last year. That is a beginning, but it is only a beginning. As I said to one of your colleagues earlier, we are going to have to come--we are going to make recommendations once we get through this proposing what we do with those institutions in the future. What we are proposing for the rest of the system is based on that lesson, in many ways, which is stronger, more conservative capital requirements where there is the risk of moral hazard in the system and a resolution authority that gives us the capacity for managing failure. Those are the two critical things to do and our core responsibility, I think, is to do those key things and that will help mitigate the risk that you referred to which we, of course, are deeply concerned by, that the actions that we have created and that we have taken in this crisis to contain the damage will sow the seeds of future crisis by leading people to believe they will be insulated from the cost of future mistakes. Again, the best protection against that is to make the system safe for failure in the future, reduce the risk of large pockets of excess leverage with conservative capital requirements, and better tools for managing failure, orchestrating an orderly unwinding of a large, complex institution in the future. Senator Martinez. I still don't know how we will avoid the--and I agree with you completely that the GSEs were well undercapitalized, underregulated, and there was no plan for their dissolution. However, how do not a group of companies become then those that are too big to fail, which in turn allows them to borrow cheaper money? I mean, once the risk of failure is diminished by government backing, implicit that becomes explicit, aren't they in a position to borrow cheaper and therefore squeeze out competition from those who are not considered systemically important? " fcic_final_report_full--9 And the leverage was often hidden—in derivatives positions, in off-balance-sheet entities, and through “window dressing” of financial reports available to the investing public. The kings of leverage were Fannie Mae and Freddie Mac, the two behemoth gov- ernment-sponsored enterprises (GSEs). For example, by the end of , Fannie’s and Freddie’s combined leverage ratio, including loans they owned and guaranteed, stood at  to . But financial firms were not alone in the borrowing spree: from  to , na- tional mortgage debt almost doubled, and the amount of mortgage debt per house- hold rose more than  from , to ,, even while wages were essentially stagnant. When the housing downturn hit, heavily indebted financial firms and families alike were walloped. The heavy debt taken on by some financial institutions was exacerbated by the risky assets they were acquiring with that debt. As the mortgage and real estate mar- kets churned out riskier and riskier loans and securities, many financial institutions loaded up on them. By the end of , Lehman had amassed  billion in com- mercial and residential real estate holdings and securities, which was almost twice what it held just two years before, and more than four times its total equity. And again, the risk wasn’t being taken on just by the big financial firms, but by families, too. Nearly one in  mortgage borrowers in  and  took out “option ARM” loans, which meant they could choose to make payments so low that their mortgage balances rose every month. Within the financial system, the dangers of this debt were magnified because transparency was not required or desired. Massive, short-term borrowing, combined with obligations unseen by others in the market, heightened the chances the system could rapidly unravel. In the early part of the th century, we erected a series of pro- tections—the Federal Reserve as a lender of last resort, federal deposit insurance, am- ple regulations—to provide a bulwark against the panics that had regularly plagued America’s banking system in the th century. Yet, over the past -plus years, we permitted the growth of a shadow banking system—opaque and laden with short- term debt—that rivaled the size of the traditional banking system. Key components of the market—for example, the multitrillion-dollar repo lending market, off-bal- ance-sheet entities, and the use of over-the-counter derivatives—were hidden from view, without the protections we had constructed to prevent financial meltdowns. We had a st-century financial system with th-century safeguards. When the housing and mortgage markets cratered, the lack of transparency, the extraordinary debt loads, the short-term loans, and the risky assets all came home to roost. What resulted was panic. We had reaped what we had sown. • We conclude the government was ill prepared for the crisis, and its inconsistent response added to the uncertainty and panic in the financial markets. As part of our charge, it was appropriate to review government actions taken in response to the developing crisis, not just those policies or actions that preceded it, to determine if any of those responses contributed to or exacerbated the crisis. FOMC20080625meeting--300 298,MR. KOHN.," Thank you, Mr. Chairman. I think I would just like to dig into some of the comments that President Lockhart and President Evans just made, just for a second, take a step back, and ask why we are here having this conversation. I know the timing is because we have this PDCF, but what happened was that the financial markets evolved in such a way that simply having a liquidity backstop for commercial banks was not sufficient to protect the economy from systemic risk. I myself have been very surprised--I will be very open about this--at the persistence, the extent, the depth, and the spread of this crisis and how long it went and what it covered. Every couple of months, I thought it was about to be over, and then another wave would come. I think that we have learned something about the financial system in the process, and we have learned that the regulatory structure and the liquidity provision structure were not sufficient to give the economy the protection it needed from the new style of financial system. That is really the background of why we are here, not just because we made the loan or we set up the facilities because we thought we needed to do so to protect the system under the circumstances. I completely support, Mr. Chairman, your suggested path forward for the near-tointermediate term. I think that is the right way to go. I would say, relative to the two senators that I testified in front of last week, that they were very supportive of the memorandum of understanding between the Fed and the SEC and particularly supportive of the efforts that the Federal Reserve Bank of New York and the other regulators are leading to strengthen the infrastructure of the OTC derivatives markets. We didn't get into tri-party repos, fortunately. But I'm sure they would have been supportive of that, too. I think everybody has raised very good questions about where, in this new financial system, you draw the boundaries. What do you need to do? There are no easy answers here, and I look forward to coming back to this. My going-in position is that our liquidity facilities outside of commercial banks ought to be available in systemic circumstances, not in just any circumstances, and they ought to be available at this point to just broker-dealers or investment banks. I would hesitate to get outside that realm. Those guys are already regulated, and so what we're talking about is strengthening the regulation. I think that we can strengthen the core of the system to make it resilient to things happening outside, but I am not totally dug in on that. So I look forward to more discussion. It is going to be very hard to draw the line and make it credible. I agree, partly this will be defining what we mean by ""systemic,"" but I don't think we will ever really get to the point of having a bright line around that. It will always need a great amount of judgment, combined with--as you said, Mr. Chairman--a process by which you make that decision, to help limit the moral hazard. Crises are always difficult. You get into a crisis, and the near-term costs are much more palpable than the long-term costs that might be there. So it is always hard to say ""no."" We have said ""no"" in the past on certain circumstances. Drexel is the obvious example. Markets were a little stressed. There was a little disorder. It was fine, but it was a very different circumstance. I think that completes my remarks. Thank you, Mr. Chairman. " 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-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-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-111hhrg54869--38 Mr. Volcker," Two relevant questions. On the first question, I am not recommending anything particularly different so far as banks are concerned that already have lender of last resort, they already have deposit insurance, and we have some history of intervening with Federal Reserve money or government money in the case of failure of very large banking institutions. So that I take is a given. And that is common around the world. There isn't a developed country that doesn't have a similar system to protect banks because banks are, I think, the backbone of the system. Now it is also true in the United States the relevant importance of banks has declined in terms of giving credit because more of the credit creation has been going into securities, which is the province of the capital market. What is different is the situation has changed where some of the benefits anyway, the safety net, has been extended outside the banking system. That is what I want to change. But you can't change it just by saying it is not going to happen because you are going to have problems. You have to develop some other possibilities and arrangements to minimize the chances of a crisis. So that is what we are proposing. " FOMC20080130meeting--421 419,VICE CHAIRMAN GEITHNER.," Just very quickly, you did a terrific job. I think it's important, though, to recognize that this isn't done yet, and we're not going to know fundamentally how we feel about the relative strengths and weaknesses in the system until we see how this plays out. Don't let these initial presumptions--either the diagnosis or the prescription, particularly your list of prescriptions--harden too much because there are some judgments that we're just not going to be able to make until the dust settles and we have a little time for reflection in that context. I think a lot of damage has been done to the credibility of our financial system. It's not clear how much damage because we don't know how this is going to play out. But damage has been done, and we are going to bear a lot of the burden of figuring out how to craft a compelling policy response, recognizing of course that regulation may be part of the problem and won't necessarily be part of the solution. Anyway, mostly I just meant to compliment you. You did a great job, and I think it's helpful really to have this much work done early on in getting us to the point where we know what we're going to do to the system to make it less vulnerable to this in the future. Even as we manage the crisis, I think it's good to have made that investment and a good tribute to the strength of the system that we were able to devote these quality resources even though we've all been busy managing the storm. " CHRG-111hhrg54868--61 Mr. Smith," I will try. First of all, sir, if I might say so, we have just had a financial meltdown under subprime. The States were all over subprime for years. No one has ever said, to my knowledge, that the State regulation caused the subprime crisis. In fact, if anything, the State regulation was on top of the subprime crisis before anybody else. It is astonishing to me to hear the regulators of enterprises that have lost billions of dollars somehow related to subprime say they weren't involved then. This is an astonishing proposition. It seems to me in cases where there are appropriate Federal standards or where Federal standards are enforced, the States have other things to do right now than fry these fish. We will work with the Federal Government. We have worked with the Federal Government on the SAFE Act. We thank you for adopting that. Forty-nine States have adopted similar legislation to license mortgage originators so that we can get our arms around this issue, and we have been doing this stuff for years. So I think it is really quite unfair to say that allowing States to have higher standards to protect consumers somehow damages the financial system. " CHRG-111hhrg53234--149 Mr. Mishkin," It is a great pleasure to be here to discuss what is a very important issue, which is what role the Federal Reserve should have as a systemic risk regulator. I want to boil this down to three questions, even though we were asked four, but I think three that are quite relevant to these issues. And the first question is the essential one, which is, should the Fed be the systemic risk regulator? And I am going to answer yes to that question, and there are four reasons that I take that view. The first is that the Federal Reserve is involved in daily interaction with the market, and in terms of being a systemic risk regulator, that kind of information or that contact is extremely useful. The second is that there is a synergy between thinking about macroeconomic stability and financial stability, and that is, I think, extremely important in terms of performing the appropriate analysis to do systemic risk regulation in the best way possible. The third is that there is a synergy between the actions that are required in terms of promoting macroeconomic stability and financial stability. And so we have seen this, of course, in very major ways during this recent crisis. This involves the role of the Federal Reserve as a so-called lender of last resort, providing liquidity to the financial system to, in fact, make sure that macroeconomic stability is preserved. And, finally, the Federal Reserve is one of the most independent of government agencies. In order to be an effective systemic risk regulator, the kind of independence the Fed has had in the past and has used in the past would be also very helpful in this regard. So when I look at this issue of the Fed being a systemic risk regulator, I think that, from my viewpoint, it really is the appropriate logical choice when we think about the nature of this role. The second issue is should the Fed relinquish some of its other roles if it became the systemic risk regulator? And I think the answer here is yes. In particular, the Treasury plan has suggested that the Federal Reserve no longer be a consumer protection regulator, and I concur with this view. There are three reasons why I think that the Fed should no longer be involved in this activity if, in fact, it is handed these additional responsibilities. The first is that being a consumer protection regulator is not at the core mission of what the Federal Reserve does, where I actually do see macroeconomic stability and financial stability is part of that core mission. The second is that it uses a very different skill set. And so in the context of thinking about the synergies, I do not see them to be nearly as relevant. And the third, I think, is really the most important, which is that consumer protection regulation is very political. Everybody cares about it. In the past I testified on credit cards. Everybody has issues in terms of their dealing with the credit card companies. In that context, the possibility of there being more pressure, political pressure, put on the Federal Reserve system is, in fact, greater. And so again I think that this is another reason why having something that is not in your core mission which is, in fact, something that tends to get more political could be harmful to the independence of the Fed, something that I am going to turn to later. The third question is, are there dangers from the Federal Reserve taking on this role of systemic risk regulator? And I think the answer is yes. There are three dangers that do particularly concern me. I will argue, however, that even though these dangers exist, that the Federal Reserve still should be the risk regulator, systemic risk regulator, and there are steps that the Congress can take to, in fact, ensure that the Federal Reserve can do its job adequately both in terms of monetary policy and in terms of promoting financial stability. So the first danger is that the Federal Reserve might lose its focus on price stability. Clearly there are concerns in the marketplace about this issue about the credibility of the Fed as an inflation fighter and steps that it needs to take in terms of making sure that inflation is not too high. And in this context I have argued elsewhere, both when I was a Governor at the Federal Reserve and also afterwards in op eds, that one way of dealing with this would be to have the Federal Reserve to have an explicit numerical objective in terms of inflation, something that it does not have at the current time. The second issue is, could systemic risk regulation interfere with the independence of the Fed? And I think there is some danger here. The danger, of course, is that systemic risk regulation, particularly in the context of having to deal with an institution which has to be reined in, could actually mean that there is some pressure put on the Federal Reserve in that context. And so I think that there is some danger here. But, again, I think that the issue here is that the Congress has to be aware that the independence of the Federal Reserve is very much in the national interest. Indeed, this is a very major concern that I have right now, given concerns about the Federal Reserve's independence and people who have been saying the Federal Reserve needs to be reined in, I think it actually is something that can damage the Federal Reserve's ability to maintain price stability and also macroeconomic stability. But, furthermore, I think that there is also an issue that--in that context that we could actually have even problems currently with concerns about Fed's credibility, which is actually something that can raise interest rates, something that I think has indeed happened. The third issue is something that is not really discussed as much as I would like to see discussed, which is the Federal Reserve's resources have been stretched to the limit by this crisis. And this is particularly true of the Board of Governors. I saw this as a member of the Board of Governors where the staff was working extremely long hours and was exhausted. And I left in September of 2008, before the crisis really got bad. So there are issues in terms of the Fed having enough resources and the support of the Congress for the Fed to acquire the resources that it needs. And I think, again, that is something that is quite important. So the bottom line here for me is that one of the important lessons from this crisis is that we absolutely desperately need a systemic risk regulator. And then I look at the issue about who can do that the best, and my view is that the Federal Reserve is, in fact, best positioned to do so. On the other hand, there are some dangers here, but this is why I think the Congress needs to, in fact, support the Federal Reserve in its independence in terms of the resources that it needs to do this job. And as a result, I think that we would be better served having the Fed pursue this role. Thank you very much. [The prepared statement of Dr. Mishkin can be found on page 83 of the appendix.] " CHRG-111hhrg48868--70 Mr. Polakoff," Well, thank you, sir. Congressman, I want to go on record as saying OTS should have, in 2004, stopped this book of business with an understanding, with an anticipation, with an analysis that suggested that the real estate market might get as bad as it has gotten in the last 2 years. At the 2004 assessment, we should have done it; we didn't do it. There are a lot of people walking around who failed to understand how bad the real estate market was going to get. I, in no way, want to suggest that there is a pointing game going on here or we are looking at others. We do believe that this kind of company deserves the oversight of what we will call a systemic risk regulator and that systemic risk regulator would have three parts to it: The ability to examine; the ability to provide liquidity if there is a liquidity crisis; and the ability to place an institution into receivership if that is a necessary outcome. " 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. " 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-110hhrg44903--29 Mr. Geithner," On the question of whether you need to do it now, I think that, in general, across the set of issues, I think it is going to be hard to get the ideal balance and mix until we are through this crisis. And so I think most of the big questions need to be thought of in an overall context once we get to the other side of this downturn. But I think, right now, there needs to be a spirit, and I think there is, a spirit of pragmatism at the State level among those insurance supervisors so that if capital can come into the parts of the system now where capital is necessary, that is able to happen with the necessary speed. " FinancialCrisisInquiry--134 As far as short selling is concerned, I believe that short selling is a vital part of our marketplace. And it’s interesting what, when Mr. Mack was advocating the ban on short selling during the crisis, once the short selling ban was put into place, the financial equities actually dropped more with the ban on than they did prior to the ban being put on. So I think the proof was in the pudding back during the crisis that supposed short sellers didn’t—did not create this crisis; it was simply a lack of confidence in the people that owned these equities. I think it’s actually a very good thing. SOLOMON : Well, I’m not an expert in this, but I will note that the SEC change in short selling, eliminating the uptick rule, was viewed by an awful lot of my friends who are in the trading business as a bizarre event. They couldn’t understand why the SEC in sort of the middle of the summer or wherever it was eliminated the uptick rule. And I’m not talking about the period you’re talking about, which is it was the ban on short selling of financial institutions. That was really very, very late. But it was one of the more curious things that occurred in the regulatory environment was this change in the uptick rule. And you really should look into how that happened and who influenced it. And one of the things that the folks have covered, one really has to look on the influence of the financial institutions in terms of campaign contributions on the regulatory and legislative process in this country. MAYO: I think we’re talking about systemically important. I think there’s four different factors we can think about as we talk about this topic. CHRG-111shrg50564--20 Chairman Dodd," Well, I would welcome that as you give it more thought. Last, let me address the issue of systemic risk regulation again. And I realize I am not specifically referring to the report in some cases. I am drawing upon your knowledge and expertise in these areas. The G-30 report describes one of the lessons from the current crisis as follows, and let me quote it. It says: Unanticipated and unsustainably large losses in proprietary trading, heavy exposure to structured credit products and credit default swaps, and sponsorship of hedge funds have placed at risk the viability of the entire enterprise and its ability to meet its responsibilities to its clients, counterparties, and investors. Three questions: Should we allow financial institutions to become large and systemically significant? Should there be a single systemic risk regulator or should that substantial be shared among different agencies? Should the systemic risk responsibility be given to the Federal Reserve, in your view? And are you concerned that it would also be a burden on the Federal Reserve with numerous divergent tasks which you and I have discussed? And I will not elaborate here. You know the point I am trying to make. And, third, are you concerned that extensive involvement by the Fed in so many aspects of day-to-day operations of the economy and the financial system might jeopardize its independence? " CHRG-111shrg50564--111 Chairman Dodd," So there is a value in maybe talking about that model, as well. Senator Crapo has been, of all the members of this Committee, probably has worked as hard on Government regulation, reform regulation as any member, so we welcome your continuing participation in the Committee, Mike. Thank you. Senator Crapo. Thank you, Mr. Chairman. Chairman Volcker, I want to go back to the Group of 30 report just to kind of try to understand maybe in a little more detail with you what was intended by it. I am going to first focus on one of the concepts that Senator Schumer mentioned--I apologize for my voice, I might lose it during the questions--and that is the principle of unifying our regulatory system. For some time even before we ran into this crisis, I have been arguing that we need to unify our regulatory system and really make sure that we had the right regulatory system for our financial system and for our capital markets. In that context, as I look at what we have today, it seems to me we have a lot of overlap that is unnecessary. We have gaps where there is no regulation where there should be. And we have weaknesses in some parts of our system. And what we need to do, as I think you said earlier, we need to get good regulation, not necessarily a lot of it. We have got to be thorough. We have got to cover everything, and in my opinion, eliminate overlaps. As I look at the first principle of the Group of 30's report, it talks about dealing with gaps and weaknesses and so forth in the system. But one of your first points is that the activities of banks should be subject to prudential regulation and supervision by a single consolidated regulator. Do I understand you or the report at that point to be talking about something like merging the functions of the OCC and the OTS and perhaps other regulators? " CHRG-111hhrg54872--305 Mr. Yingling," I am not sure I have the total answer. I think the hearing today brought out a lot of options that we can look at. I think part of it is making it more explicit in the statute that you should do this. I think part of it may be the structure of whatever we end up doing here, whether it be within something that looks like the existing framework or something new that builds in an explicit focus. Part of it could be in staff requirements. Frankly, a lot of it is in who is appointed. If you think through who was sitting on the Federal Reserve Board at this critical time or who has been in some of these seats, perhaps there could have been somebody on the Federal Reserve Board with more of a focus on it. But I don't think you can rely totally on people, that is a major part, but I think we have to in some way institutionalize in whatever we end up doing here, something that says there will be focus. One way to do it also that we have suggested is you have the regular Humphrey-Hawkins type hearings before this committee, that you have regular hearings on the consumer issues. The other thing is, this doesn't get down into the trees, but as you consider the creation of a systemic regulator, the systemic regulator should also have built in a consumer focus, because systemic problems are not just a huge institution, they are not just credit default swaps. The mortgage crisis was a systemic problem. " FinancialCrisisInquiry--21 We have seen, in our view, four crises unfold: a mortgage crisis, a capital markets crisis, a global credit crisis, and a severe global recession. The mortgage crisis originated with the dramatic expansion in the availability of mortgage credit through subprime lending and aggressive mortgage terms even in prime products. This led to a greater debt burden for consumers. Lenders, prompted by lower interest rates, rapidly rising home prices, and large amounts of capital available, made credit available to borrowers who could not previously qualify for a mortgage or extended more credit to a borrower who could or perhaps should—would not be able to handle. The national policy to expand American homeownership was also popular and created tailwinds. No one involved in the housing system—lenders, rating agencies, investors, insurers, consumers, regulators, and policy makers, foresaw a dramatic and rapid depreciation of home prices. When the nation did experience this rapid depreciation in home prices, the first that had been experienced since the Great Depression, many of these loans became very unfavorable and the option of refinancing disappeared leading to defaults. The second crisis came in investment banks in the capital markets area. Investment banks not only had underwritten mortgages, but they had retained significant amounts of the risk by holding interest and providing backup liquidity for mortgage-related securities they had sold. Investment banks created products based on these mortgage assets. The risk of these assets spread. This happened when a monoline insurer guaranteed the mortgages or a structured investment vehicle brought the mortgage securities and having the money- market funds to purchase that commercial paper from those vehicles. Third, the stress of the financial crisis began to spread beyond the investment banks and mortgages to other fixed income products and to more market participants. This destabilized the financial institutions and non-financial institutions that had little to do with the U.S. or the mortgage market. This contagion was, in fact, global. Without government intervention to restore liquidity to capital markets, the risk of global economic collapse was very real. FinancialCrisisInquiry--14 Even so, we remained relatively strong throughout the crisis so much so that we were called upon to take actions to help stabilize the system. Over the weekend of March 15, 2008, the federal government asked us to assist in preventing Bear Stearns from going bankrupt before the opening of the Asian markets on Monday morning. On September 25 th , we acquired the deposits, assets and certain liabilities of Washington Mutual from the FDIC. Later we learned that we were the only bank that was prepared to act immediately following the largest bank failure in U.S. history. In addition we continued to lend and support our clients’ financing and liquidity needs throughout the crisis. Over the course of the last year, we’ve provided more than $800 billion in direct lending and capital raising for investor and corporate clients. For example, we helped provide state and local government financing to cover cash flow shortfalls. We are the only institution that agreed to lend California $1.5 billion in its time of need. And even though small business loan demand has been down, we have maintained our lending levels to small business. In November of last year, we announced plans to increase lending to small businesses by $4 billion, to a total of $10 billion this year. For the millions of Americans feeling with the effects of this crisis, we are doing everything we can to help them meet their mortgage obligations. In 2009 we offered approximately 600,000 new trial loan modifications to struggling homeowners through our own program as well as through participation in government programs like the U.S. Making Home Affordable initiative. Our capabilities, size and diversity of business have been essential to our withstanding the crisis and emerging as a stronger firm. It is these trains that have put us in a position to acquire Bear Stearns and Washington Mutual. Some have suggested that size alone or the combination of investment banking and commercial banking caused the crisis. We disagree. If you consider the institutions that failed during the crisis, some of the largest and most consequential failures were stand-alone investment banks, mortgage companies, thrifts and insurance companies. 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.] " fcic_final_report_full--1  PREFACE The Financial Crisis Inquiry Commission was created to “examine the causes of the current financial and economic crisis in the United States.” In this report, the Com- mission presents to the President, the Congress, and the American people the results of its examination and its conclusions as to the causes of the crisis. More than two years after the worst of the financial crisis, our economy, as well as communities and families across the country, continues to experience the after- shocks. Millions of Americans have lost their jobs and their homes, and the economy is still struggling to rebound. This report is intended to provide a historical account- ing of what brought our financial system and economy to a precipice and to help pol- icy makers and the public better understand how this calamity came to be. The Commission was established as part of the Fraud Enforcement and Recovery Act (Public Law -) passed by Congress and signed by the President in May . This independent, -member panel was composed of private citizens with ex- perience in areas such as housing, economics, finance, market regulation, banking, and consumer protection. Six members of the Commission were appointed by the Democratic leadership of Congress and four members by the Republican leadership. The Commission’s statutory instructions set out  specific topics for inquiry and called for the examination of the collapse of major financial institutions that failed or would have failed if not for exceptional assistance from the government. This report fulfills these mandates. In addition, the Commission was instructed to refer to the at- torney general of the United States and any appropriate state attorney general any person that the Commission found may have violated the laws of the United States in relation to the crisis. Where the Commission found such potential violations, it re- ferred those matters to the appropriate authorities. The Commission used the au- thority it was given to issue subpoenas to compel testimony and the production of documents, but in the vast majority of instances, companies and individuals volun- tarily cooperated with this inquiry. In the course of its research and investigation, the Commission reviewed millions of pages of documents, interviewed more than  witnesses, and held  days of public hearings in New York, Washington, D.C., and communities across the country that were hard hit by the crisis. The Commission also drew from a large body of ex- isting work about the crisis developed by congressional committees, government agencies, academics, journalists, legal investigators, and many others. FinancialCrisisInquiry--191 We stand ready to assist the commission over the coming year and we look forward to your findings on these matters of utmost importance to America’s families. Thank you very much. CHAIRMAN ANGELIDES: Thanks, Ms. Gordon. Mr. Cloutier? CLOUTIER: Thank you very much. Chairman Angelides, Vice Chairman Thomas and members of the commission, my name is Rusty Cloutier, and I am pleased to testify today on the current state of the financial crisis and in particular the effect it has had on the small- business lending community. I am president and chief executive officer of MidSouth Bank, a $980 million community bank headquartered in Lafayette, Louisiana, with locations throughout south Louisiana and southeast Texas. I am also the author of the book “Big Bad Banks,” which details how a few megabanks and powerful individuals fueled the current financial and economic crisis. I’m proud to testify today on behalf of the Independent Community Bankers of America and its 5,000 community bank members nationwide. Mr. Chairman, it is difficult to talk about the effects of the financial crisis without speaking to the root cause. Too-big-to-fail institutions and the systemic risks that they pose were the heart of our financial and economic meltdown. Equally responsible were those institutions making up the unregulated shadow banking industry operating just not outside of legal parameters, of the regulatory framework, which made most of the subprime exotic loans and brought the housing markets to its knees. For far too long, these institutions have enjoyed privileges of favorable government treatment, easier access to cheaper funding sources, lower or no compliance cost, and little if any oversight. A little more than a few years ago, a key element of the financial system nearly collapsed due to the failure of these institutions to manage their highly risky activities. CHRG-111shrg55117--25 Mr. Bernanke," If you are referring, Senator, to the fund or the cost of resolving failing financially systemically critical firms, my understanding of the proposal is that assessments would be based on noninsured liabilities. So in principle, any bank holding company or almost any financial company might be subject to assessments to help pay for an intervention when a large systemically critical firm is failing. However, small banks, small community banks, most of their liabilities are insured, their deposits, for example. And so the portion of their liabilities which would be subject to an assessment would be relatively small. So I would imagine that the bulk of the costs would be borne by larger banks, and indeed, you could make the costs progressive and put a heavier weight on the assets or liabilities of larger firms. So I do think that is an important issue and I do think it would be appropriate for larger more systemically critical firms to bear their fair share, obviously, of the costs of resolving any systemically critical firm. Senator Johnson. There has been speculation in recent weeks about the effectiveness of the economic stimulus package that was enacted in February and if enough has been done at the Federal level to bolster our economy. In your judgment, is the stimulus package mitigating some of the effects of the economic crisis, and are there additional fiscal policy responses that Congress can take to help the current economic situation? " CHRG-111hhrg55809--195 Mr. Bernanke," In principle, it would be great. But there are two practical problems that we have to try to confront. One is actually identifying the bubble. And when the policies in question were taking place in 2003, 2004, there really was substantial disagreement among experts about whether this was a bubble and how big it was. The other problem is that by using monetary policy, which is a very blunt tool, to try to pop bubbles, you may have a side effect of having bad effects on the rest of the economy, because you can't just target one sector. That is why, even though, as I say, I am open-minded about the role of monetary policy in bubbles, in affecting bubbles, I do think that the first line of defense needs to be a stronger regulatory system that would, on the one hand, prevent excessive build-ups of risk in the first place; and if they do pop and if there is a problem like that, would make the system strong enough that it wouldn't create such an enormous crisis as we have seen recently. " CHRG-109hhrg22160--91 Mr. Greenspan," I am telling you that I have always supported PAYGO. I think it has been a mistake to allow PAYGO to lapse. I support PAYGO for both the tax side and the spending side. And I trust that the Congress will reinstitute it---- Ms. Waters. Okay. " Mr. Greenspan,"--as expeditiously as possible. Ms. Waters. Well, good. And let me just go to my Social Security question. This administration is redefining Social Security as we know it. They say it is a crisis, and they have got young people all riled up in this country about the fact that it won't be there for them. And the President has rolled out with the personal accounts aspect of this Social Security redefinition. What does personal accounts have to do with the solvency of the Social Security system? Could you please explain that to us in very simple, factual language, excluding any speculation, and help us to understand how privatization is going to make the system solvent? " CHRG-111shrg50564--3 STATEMENT OF SENATOR SHELBY Senator Shelby. Thank you, Mr. Chairman. Today, the Committee will hear from one of this Nation's most respected economists and veteran policymakers. Dr. Volcker is no stranger to this Committee. Senator Dodd and I remember many years ago when he would come here as Chairman of the Federal Reserve Board. During the financial crisis in the late 1970s, it was Paul Volcker who helped put our economic house back in order, and, Dr. Volcker, I welcome you back to the Committee again. While I am very interested in the views of our witnesses on regulatory modernization, I think the hearing could be a little bit premature. Let me explain. As I have said many times and will continue to say, I believe that before we discuss how to modernize our regulatory structure, or even before we consider how to address the current financial crisis, we need to first understand its underlying causes. If we do not have a comprehensive understanding of what went wrong, we will not be able to determine with any degree of certainty whether our regulatory structure was sufficient and failed or was insufficient and must change. I understand that next week Chairman Dodd plans to hold a hearing on the origins of the financial crisis, for which I commend him. I welcome that hearing, but I believe that one hearing, or even a handful of hearings, falls well short of what these exceptional times will demand. Instead, this Committee should, I believe, and must conduct a full and thorough investigation of the market practices, regulatory actions, and economic conditions that led to this crisis. The Committee should hear testimony from all relevant parties and produce a written report of its findings. This work is crucial, I believe, if we are to develop policies that will help end this crisis and prevent it from occurring again. While I understand many people have their own views of what happened, this Committee has yet to make that determination in a comprehensive and organized manner. As a result, nearly a year and a half later, we still have not documented what started the crisis and why it became so severe. The uncertainty about its origins has not only exacerbated our economic downturn by undermining confidence in our entire financial system, but it has left us without a clear understanding of what needs to be done. We need to remedy that. Thus far, the efforts of the Treasury Department and the Congress have been ad hoc at best. When this all began, I strongly opposed the TARP bailout legislation because I believed Congress jumped right to a legislative solution without first identifying the problem it was trying to solve. Since we never developed a consensus about what caused this crisis, neither Congress nor the Treasury Department can devise a targeted solution. And as a result, TARP has drifted rudderless since it was passed 4 months ago, wasting taxpayer dollars while the crisis rages on without an end in sight. It is well past time that we investigate the origins of the financial crisis so that we can begin to lay the groundwork for a bipartisan, effective, and durable solution. In the absence of such effort, there is now talk of creating a commission to examine the origin of the financial crisis and to make recommendations for further action. At this time, I would oppose the creation of such a commission because a thorough investigation is something that this Committee can do and must do. The American people rightly expect their elects representatives, the Senators here, not unaccountable commissions to do the work necessary to solve the problems facing the country. This Committee is uniquely positioned to conduct a transparent investigation that could build the necessary political consensus around the appropriate legislative remedy that we must seek. This particular Committee has a long history of conducting such investigations. The best precedent, I believe, for this type of investigation that our current economic situation demands is the year-long investigation of stock market abuses the Committee conducted during the Great Depression. The so-called Pecora hearings produced a detailed report exposing a wide range of abuses on Wall Street. The Committee heard testimony from hundreds of witnesses, producing nearly 12,000 pages of transcripts from over 100 hearings. The investigative staff was made up of dozens of individuals and included attorneys, accountants, and statisticians. They conducted scores of interviews and sworn depositions. The Committee subpoenaed corporate records and heard testimony from the heads of Wall Street and industry, including 3 days of testimony, I have been told, from Mr. Morgan himself. The Committee's investigative record comprises 171 boxes in the National Archives. The record that the Pecora hearings established ultimately laid the groundwork for the passage of the Securities Act and the creation of the Securities and Exchange Commission. Recently, renowned economic historian Ron Chernow wrote an editorial in the New York Times calling for Congress to initiate an investigation in the tradition of the Pecora hearings. He stated the importance of such an investigation to resolving the current crisis by pointing out, and I will quote him: If history is any guide, legislators can perform a signal service by moving beyond the myriad details of the rescue plans to provide a coherent account of the origins of the current crisis. The moment calls for nothing less than a sweeping inquest into the twin housing and stock market crashes to create both the intellectual context and the political constituency for change.I believe that he is correct. The hearings this Committee has held to date on the credit crisis have been helpful, but I think they have lacked the focus and purpose displayed during the Pecora hearings, partly due to the Committee's lack of resources up to this time. To remedy this problem, Senator Dodd and I have already submitted an initial request for additional funding and office space for the Committee. We were recently informed that the Committee is going to receive additional funding, although not what is necessary, I believe, to conduct a thorough and fair investigation. I am hoping that our colleagues on the Rules Committee would agree that this type of effort here in the Banking Committee right now is not only necessary but deserving of their support. I believe the investigation should start by calling before the Committee all of the regulators from the past decade or more who were appointed to make sure this crisis did not happen, but it did. The Committee has heard from regulators on their views on how to solve the crisis, but it has yet to hear from present and former regulators on what caused the crisis and whether steps could have been taken to prevent it. The Committee, I believe, should supplement this testimony with an exhaustive review of the records of the regulators from that period. Once again, there will be a time to discuss what needs to be done, but before we entrust any new or existing regulator with additional responsibilities or authorities, I believe we need to know if and how our present regulatory structure failed us. After we complete a thorough review of the role of the regulators, we should then call the CEOs of the largest banks, insurance companies, brokerage firms, home builders, realtors, and other financial services companies of the past 10 years to testify. This, of course, would be preceded by an extensive staff effort to examine the activities of each institution or industry. Since the crisis began, the Committee has not yet heard from Wall Street CEOs on their role in creating the toxic assets that have spread through our financial system like a cancer. Nor have they publicly explained why their risk management systems failed or why they operated with such dangerous levels of leverage. Because many of these firms have either failed, received public money, or sought some type of Federal assistance, I believe they owe it to the American people to explain how this crisis started and what role they played in it. Last year, I called for a hearing to examine the role of underwriters in spawning the crisis. The Committee announced that it would hold a hearing to examine underwriting practices, but it was postponed and is yet to be scheduled. That hearing could now be part of this effort. Mr. Chairman, I am willing to work with you, as I have, and I believe this Committee is uniquely positioned, as you do, to perform this important service at this time for the American people. I pledge my full support should you choose to undertake your own version of the Pecora hearings, as long as they are comprehensive. " CHRG-111shrg53822--64 Mr. Rajan," Thank you. Mr. Chairman, Senators, there is, in my view, a more important concern arising from this financial crisis than when private institutions are deemed ``too big to fail.'' Other than the reasons that have already been laid out, let me add one more. When systemically important institutions are bailed out, it is very hard for the authorities to refute allegations of crony capitalism, for the outcomes are observationally equivalent; after all, the difference is only one of intent. In this kind of system, the authorities do not want to bail out the systemically important institutions but are forced to, while in crony capitalism they do so willingly. The collateral damage in this system to public faith and free enterprise is enormous, especially when the public senses two sets of rules, one for the systemically important and another one for the rest of us. I have avoided saying ``too big to fail.'' That is because size, in my view, is neither necessary nor sufficient for an institution to be deemed too systemic to fail. Given my limited time, let me focus on how we can overcome the problems of too systemic to fail institutions in some measure. The three obvious possibilities: one, prevent institutions from becoming too systemic in the first place; second, create additional private sector buffers that keep them from failing; and, third, make it easier for the authorities to fail them when they do become truly distressed. Let me explain each in turn. I personally believe, like Mr. Baily does, that proposals to prevent institutions from expanding beyond a certain size or to significantly limit the activities of some institutions may be very costly without achieving their intent. Consider some economic costs. Some institutions get large not through unwise acquisitions but through organic growth based on superior efficiency. A crude size limit applied across the board will prevent the economy from benefiting from such institutions. Furthermore, size can imply greater diversification, which can reduce risk. Moreover, the threshold size can vary across activities and across time. A trillion dollar mutual fund family may not be a concern, while a $25 billion mortgage guarantor might well be. Finally, size itself is hard to define. Do we mean assets, gross derivative positions, net derivative positions, transactions or profitability? Given these difficulties, any legislation on size limits will have to give regulators substantial discretion. That creates its own problems. Similar issues arise with activity limits. What activities will be prohibited? Some suggest banning banks from proprietary trading, that is trading for their own account. But how would the law distinguish between illegitimate proprietary trading and legitimate risk-reducing hedging? Many of the activities that were prohibited to commercial banks under Glass-Steagall were peripheral to this crisis, and activities that did get banks into trouble, such as holding sub-prime mortgage-backed securities, would have been permissible under Glass-Steagall. Finally, regulating size or activity limits would be a nightmare because the regulator would be strongly tempted to arbitrage the regulations. I would suggest rather than focusing on these limits, we focus on creating stronger private-sector buffers in making institutions easier to fail. Now, the traditional buffer is capital, and I do agree that raising capital might be a good thing, but one should not put too much weight for reasons that have already been stated; in particular, that banks will tend to take more risks when they are asked to hold more capital. In some ways, I would rather advocate a more contingent buffer where systemically important institutions arrange for capital to be infused when the institution or the system is in trouble. And the difference between the two is quite important. As an analogy, additional capital is like keeping buckets full of water ready to douse a potential fire. As the years go by and the fire does not appear, the temptation is to use up the water. My contrast, contingent capital is like installing sprinklers. There is no water to use up, and when the fire threatens, the sprinklers actually turn on. One version of contingent capital, proposed by the nonpartisan Squam Lake Group, is for a portion of a bank's debt to be automatically converted to equity when two conditions are met: one, the system is deemed in crisis either based on regulatory assessments or based on objective indicators like the size of losses of the system; and, second, the bank's capital ratio falls below a certain value. There are other versions of contingent capital, such as requiring banks to purchase fail-safe insurance policies from unlevered institutions that will provide them an insurance payment when they are in trouble, and there are ways of structuring this that I would be happy to go into. Let me turn to the other possible remedy, making them easier to fail. And here I think that there are a number of issues that have been talked about, which makes banks hard to fail. I would suggest we also want to recruit banks in the process of making themselves easier to fail. And this is why I would suggest that banks also be subject to a requirement where they focus on creating a shelf bankruptcy plan, which would focus on how they themselves could be made easier to fail. For example, over time, the amount of time it will take to fail a bank could be reduced to such time as we could actually fail some of these large institutions, over a weekend. By putting this requirement and stress testing it at regular intervals, I think you would give banks an incentive to become less complicated, not to add layers of complexity in the capital structure or in the organization structure, and we could well get easier resolution. Senator Warner. Thank you, sir. The vote has started, I think, about 10:56. I will try to ask two to three minutes worth, and then if Senator Bennett or Senator Merkley want to try to get it in before the vote. If not, we will go into recess. And I am not sure how many votes there are going to be, so we will have to have a little flexibility. Very quickly, without lots of extra commentary, Peter, I would love to hear your comment about not having the need in terms of a non-bank financial systemic risk regulator, where we deal with the AIGs of the world. For all of the panel, perhaps very briefly, Mr. Baily, Mr. Wallison, you both said we do not want to make a line in the sand about ``too big to fail,'' but, in effect, what we want to do is we want to try and stop more institutions from becoming ``too big to fail.'' At some point, if we are going to have additional capital requirements, or if we are going to have added insurance fees or other kinds of resolution fees, we are going to have make some definition. We are still going to be backed into a definition, are we not? Third, questions where we are saying we ought to allow these to grow organically. But some of the actions of, for example, the combination of Merrill and Bank of America, and some of the other things that have taken place in the last six months, I am not sure these would have all have been in the normal course of organic growth. And does that mean because of the crisis, we have to then live with these institutions that were, in effect, created out of the crisis? I know that is a lot. If you could keep your comments or answers fairly short, so, again, my colleagues may get a word in before we go to vote. " CHRG-111shrg54533--27 Secretary Geithner," Can I just--I think this is a very important issue and you are asking a very good question. It is a very different challenge. Our challenge with Fannie and Freddie now, and this is true about the government's role in the housing market more generally, is more a challenge for exit, what the future should be. We have to fundamentally rethink what the appropriate role of the government is in the future. We did not get that right. It was not a tenable balance we struck in that situation. But it is a different challenge now that we face in putting in place the foundations of a more stable system, a clearer set of rules of the game, stronger consumer protections. It is more about a range of questions we face about how the government gets out of and dials back and reverses these extraordinary interventions we have been forced to undertake to help protect the system from this crisis. Senator Vitter. Mr. Secretary, the creation of this Tier 1 of institutions, tell me why that isn't a big flashing neon sign, ``too-big-to-fail''? " CHRG-111shrg382--2 Mr. Sobel," It has been pushed for me. OK. Thank you. Thank you for this opportunity to testify on international efforts to promote regulatory reform, especially following the Pittsburgh Summit. Immediately after the start of the crisis, policymakers and regulators worldwide redoubled efforts to repair financial systems and put in place a stronger regulatory and supervisory framework so that a crisis of the magnitude we have witnessed does not occur again. Good progress is being made, and much was achieved already through the Washington and London G-20 Summits. We strengthened prudential oversight, reached agreement to extend the scope of regulation, strengthened international cooperation, and have taken action to deal with jurisdictions that failed to commit to high-quality standards. A fundamental objective of the Pittsburgh Summit was to build on these accomplishments. Leaders agreed on four priorities: Capital. They agreed to develop rules to improve the quantity and quality of capital and to discourage excessive leverage by end 2010. This agreement tracks closely with Secretary Geithner's principles issued earlier this month. On compensation, leaders endorsed the implementation of standards to help financial institutions and regulators better align compensation with long-term value and risk management. National supervisors will impose corrective measures on firms with unsound practices. On OTC derivatives, they agreed that all standardized OTC derivative contracts should be traded on exchanges or electronic trading platforms and cleared through central counterparties by end 2012. Non-centrally cleared contracts will be subject to higher capital requirements. On cross-border resolution, they agreed to strengthen domestic resolution frameworks and that prudential standards for the largest, most interconnected firms should be commensurate with the costs of their failure. Leaders also called on international accounting bodies to redouble efforts to achieve a single set of high-quality, global accounting standards. Firms are now global in scope, as you noted, Mr. Chairman, and we derive benefits from open, interconnected markets. But the crisis highlighted that financial duress can spread quickly across national boundaries. And while the responsibility for sound regulation begins at home, different national standards open the possibility for regulatory arbitrage, gaps in oversight, and a race to the bottom. International cooperation is essential to avoid these pitfalls. Throughout the crisis, standard setters and other bodies, in addition to the G-20, have helped in this effort. But one body, the Financial Stability Board, has played a critical role in promoting international financial stability. Founded as the Financial Stability Forum in the aftermath of the Asia crisis with strong U.S. support, it brought G-7 officials together with key standard-setting bodies. At the outset of the crisis, the G-7 asked the forum to analyze the causes of the crisis and provide recommendations to increase the resilience of markets and institutions. Those recommendations have been at the center of the international consensus on how to overhaul the world's financial regulatory system. In April, with strong U.S. backing, the Financial Stability Forum was reconstituted as the Financial Stability Board, with an enhanced mandate and membership now encompassing all G-20 countries. The FSB has been a key venue to prepare for G-20 leaders summits. I have provided greater detail in my written testimony on the FSB's purposes and functioning. In the United States, we have set out a proposal for comprehensive regulatory reform, but to promote a global race to the top, we need our G-20 partners to be equally ambitious. The three institutions we represent have worked closely together in preparing for FSB meetings. In addition, U.S. regulatory officials are heavily involved in setting the agenda for international standard setters. This strong cooperation between U.S. and international officials is reflected in the closely aligned agendas pursued by the FSB in the United States and has allowed us to forge more consistent global standards in line with the U.S. agenda. As part of our work to help ensure a cohesive national vision at the international level, U.S. officials also coordinate through the President's Working Group on Financial Markets and at a working level conference calls hosted by Treasury with U.S. regulators to discuss implementation of the G-20 leaders and FSB work. Looking forward, consistent national implementation throughout the G-20 will increasingly be our focus. The FSB will be an important forum to assess progress. Despite our achievements, much more remains to be done. Some of the flaws in the U.S. financial system and regulatory framework that allowed this crisis to occur are still in place. In conclusion, the United States has led the effort to create the FSB, shape its agenda, expand its membership, and involve it closely in the G-20's work. In turn, the Financial Stability Board has been a key instrument for policy development. We can be confident knowing that the machinery to strengthen the international financial system is in place and has set forth principles for reform that are consistent with the administration's own plan. Again, thank you for having me here today. Senator Bayh. Thank you, Mr. Sobel. Ms. Casey. STATEMENT OF KATHLEEN L. CASEY, COMMISSIONER, SECURITIES AND CHRG-111shrg53822--51 Mr. Stern," Well, shareholders, of course, in some of these cases have lost a lot of money, and that has been appropriate, but it is not sufficient to address moral hazard. It is the creditors, the uninsured creditors, that need to take some losses going forward--not in the middle of a crisis like this, I will hasten to add, but going forward. And so we want to put ourselves in a position to do that. The legislation is not up to me, but, obviously, if it is going to contain, as it may well appropriately contain, a systemic risk exception so that, you know, if there really is the threat of systemic difficulties that would threaten not only the functioning of the financial system but maybe parts of the economy as well, clearly policymakers ought to be able to deal with those. What you want to put yourself in the position to do is to invoke that systemic risk exception as infrequently with as low a probability as possible. So it seems to me that legislation can help, but it is not going to get you the entire way, assuming it has that systemic risk exception--and, indeed, it seems appropriate to have such a thing. Senator Merkley. Sheila, do you wish to add at all to that? Ms. Bair. No. I would agree with that. With the bank resolution process we have now, Congress has laid out a very clear claims priority for us. One of the benefits of having a resolution authority for holding companies and perhaps non-bank financial institutions is that Congress would lay out what the rules of the game are so market participants could understand in advance what their losses will be if an institution gets into trouble. I think that increases the market discipline, which is what we are all trying to get back into the system. Senator Merkley. Well, thank you very much to both of you for your testimony and for helping us wrestle with this pretty sizable issue. " CHRG-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. ______ fcic_final_report_full--6 From  to , the amount of debt held by the financial sector soared from  trillion to  trillion, more than doubling as a share of gross domestic product. The very nature of many Wall Street firms changed—from relatively staid private partnerships to publicly traded corporations taking greater and more diverse kinds of risks. By , the  largest U.S. commercial banks held  of the industry’s assets, more than double the level held in . On the eve of the crisis in , financial sector profits constituted  of all corporate profits in the United States, up from  in . Understanding this transformation has been critical to the Commis- sion’s analysis. Now to our major findings and conclusions, which are based on the facts con- tained in this report: they are offered with the hope that lessons may be learned to help avoid future catastrophe. • We conclude this financial crisis was avoidable. The crisis was the result of human action and inaction, not of Mother Nature or computer models gone haywire. The captains of finance and the public stewards of our financial system ignored warnings and failed to question, understand, and manage evolving risks within a system essen- tial to the well-being of the American public. Theirs was a big miss, not a stumble. While the business cycle cannot be repealed, a crisis of this magnitude need not have occurred. To paraphrase Shakespeare, the fault lies not in the stars, but in us. Despite the expressed view of many on Wall Street and in Washington that the crisis could not have been foreseen or avoided, there were warning signs. The tragedy was that they were ignored or discounted. There was an explosion in risky subprime lending and securitization, an unsustainable rise in housing prices, widespread re- ports of egregious and predatory lending practices, dramatic increases in household mortgage debt, and exponential growth in financial firms’ trading activities, unregu- lated derivatives, and short-term “repo” lending markets, among many other red flags. Yet there was pervasive permissiveness; little meaningful action was taken to quell the threats in a timely manner. The prime example is the Federal Reserve’s pivotal failure to stem the flow of toxic mortgages, which it could have done by setting prudent mortgage-lending standards. The Federal Reserve was the one entity empowered to do so and it did not. The record of our examination is replete with evidence of other failures: financial institu- tions made, bought, and sold mortgage securities they never examined, did not care to examine, or knew to be defective; firms depended on tens of billions of dollars of borrowing that had to be renewed each and every night, secured by subprime mort- gage securities; and major firms and investors blindly relied on credit rating agencies as their arbiters of risk. What else could one expect on a highway where there were neither speed limits nor neatly painted lines? CHRG-111shrg49488--48 Mr. Nason," Sure. The clearest and easiest example--sorry to beat it to death--is insurance. There are two things that are clear. One, the international community does not understand and appreciate the State regulatory system for insurance, so that American industry is not well represented around the globe. And, second, in periods of crisis like this, we learned all too well at the Treasury that we would be benefited significantly by having a Federal expert in insurance that you can draw upon for expertise. One of the big problems associated with dealing with the AIG failure is there is no Federal person responsible for that industry, so you cannot draw on Federal expertise. And that was a very significant consequence of having this fractured system. Another example we mentioned is the Office of Thrift Supervision, which has oversight responsibilities for the holding companies of a lot of these institutions, but does not have the appropriate stature to represent the thrifts around the world. So it is an inequality that hurts the institutions that have thrifts in this structure. " CHRG-110hhrg44900--28 Mr. Bernanke," There were a number of recommendations in those reports I referred to. There are many steps that could be taken at the regulatory and supervisory level to strengthen the oversight of banks and other financial institutions. For example, I mentioned the Basel Accords which are strengthening liquidity requirements, changing capital charges for different kinds of activities, making recommendations to the regulators about how to go about strengthening the risk management systems of these firms. We are paying very close attention to the system as a whole. We are looking at the payment systems and other parts. The Federal Reserve has after all acted as a de facto--along with the Treasury--crisis manager for many decades. So there are a number of things we can do to strengthen the oversight under existing statutes and to make sure that the infrastructure is working as well as possible. For example, I mentioned also the private-public cooperation that we are now having to strengthen the OTC derivatives infrastructure and the like. So there's a lot that we can do, but we are doing--I just want to make very, very clear that what we are doing is, you know, working within the current statutory framework. The broader reforms that I believe are necessary are obviously the purview of Congress. And, you know, we hope that you'll be addressing those issues in a timely way. " 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-110hhrg44903--143 Mr. Geithner," Those are deep existential fundamental theological questions for people involved in the central bank and supervision. And I personally don't know how we get a better balance between the accounting regimes that now apply, particularly to those institutions that exist to quota the system. But I would just say one basic point is that what you want to assist is have a system where you have a level of cushion in terms of capital reserves, liquidity, etc., in the good times that you can allow so that when things change, confidence erodes, risk goes up, that those cushions are stabilizing rather than destabilizing. If you run a system where people hold cushions that are too thin against plausible states of the world because they expect to be able to catch up and raise those in extremis, then you risk amplifying the crisis. And what you need to do is make sure you look at the interaction between the incentives we create for capital and those created through accounting regimes to make sure that they reinforce that basic objective. But this basic issue of procyclicality, very complicated, and you have very thoughtful people spend a lifetime advocating the benefits of both those regimes, and we live now in a somewhat uncomfortable middle. " CHRG-111hhrg53238--10 The Chairman," The gentleman from Kansas is recognized for 2 minutes. Mr. Moore of Kansas. Thank you, Mr. Chairman, and I thank you for your work to introduce H.R. 3126 to create the Consumer Financial Protection Agency. I look forward to working with you and members of this committee to ensure that we have oversight of any new agency and the regulatory structures. I will be working to add an independent Office of Inspector General to the CFPA, as well as increasing the coordination between all financial IGs to ensure regulatory gaps are identified and addressed. The financial meltdown last year made it very clear that our financial regulatory structure has problems that need to be fixed. We need to make sure that we have a system that protects consumers, investors, and taxpayers. I thank the witnesses for their views on the Administration's proposal. We need to act thoughtfully and carefully, but quickly, to repair the gaps identified in our regulatory system. We also need to make sure that community banks that did not create this crisis are fairly treated under the new system. Thank you, Mr. Chairman, and I yield back. " CHRG-111shrg53822--67 Mr. Rajan," Very quickly, I think it is a mistake to identify systemically important institutions. Then you make the market actually treat them as systemically important and act accordingly. That is a problem. I think you can talk about systemically important. You can sort of have a broad definition. But, in general, regulations should not identify them and create a difference between systemically important and others. Perhaps you can have increasing capital requirements based on size, but it would not have to be capital requirements which suddenly change when you move from being an ordinary bank to becoming a systemically important bank. I think that will be the challenge that Congress has in devising regulations, how to deal with systemically important without actually identifying the specific institutions that are systemically important. Senator Warner. If I heard correctly, I think you have all said, you know, this is very challenging, do not leave it to the regulator, and you better not mess up, Congress. Thank you. I think the Committee will stand in recess until we are finished voting. [Recess.] Senator Akaka. [Presiding.] This hearing, Martin Baily, Raghuram Rajan and Peter Wallison, I will begin with you on questions to all of you. It is pretty clear that our current regulatory system failed to address the risks taken by many large financial organizations that resulted in the current economic crisis. It is equally clear that these companies grossly failed to manage their risks. And with all of this, we have been making every effort to deal with the problems they face and to try to stabilize the problems that we have. So, the second panel, I would like to ask you, should Congress impose a new regime that would simply not allow financial organizations to become too large or too complex, perhaps, by imposing strict size or activity restrictions? So let me first all on Mr. Wallison for your response. " CHRG-111hhrg48873--149 Secretary Geithner," I think it is absolutely right that we are not going to get through this financial crisis unless this system is willing to take risks, unless banks and private investors are able and willing to take risks again. That does require some confidence and clarity about the rules of the game going forward, and I think it is an important obligation we share with the Congress to try to make sure we are providing Congress with that level of competence and clarity. Also important, though, is to make sure that we reassure the American people that the taxpayers' money is not going to go to reward failure and to encourage excessive risk-taking in the future. " CHRG-111hhrg53240--70 Mr. Meeks," Thank you, Mr. Chairman. And thank you, Ms. Duke. Let me ask you, we had a panel here earlier before the full committee, and what I was trying to figure out and what a number of individuals are talking about is the fact that some are questioning whether the systemic risk regulator should be the Fed. The Fed has been--they have talked about giving the Fed a lot more jurisdiction, a lot more responsibility. And some are concerned about--and I think that based upon the White Paper that the President has put out, that there is going to be tremendous responsibility that is going to cause a lot more work. Now we want to make sure, because we are looking forward to put some legislation that we think is going to take place and survive for 70, 80, 100 years. What is wrong with letting the Fed focus as a systemic risk regulator and doing what it has to do in maintaining this whole spectrum of responsibilities, and then having another agency whose primary focus is on consumer protection? It seems to me to make sense so that we are not overburdening the Fed. What is wrong with that? Ms. Duke. If the question is the overburdening of the Fed, the first thing I would say about the systemic risk responsibility that is in the proposal from the Administration is actually not an incrementally large increase in the activities we have today. The systemically important institutions, the vast majority of them were not necessarily bank holding companies last Fall, but through the crisis became bank holding companies. And I am not aware of very many institutions that would be considered systemically important that we don't supervise today. I think the difference would be probably in the focus of that supervision which would look not just to the individual institutions themselves, but also to the impact of their activities across the financial system. " CHRG-111hhrg54872--48 Mr. Castle," I am not going to have time for another question, but I will throw out a couple of thoughts in the remaining seconds I have. I am concerned that the legislation as currently drafted is not focused enough on the products and services that contributed to the financial crisis and perhaps in terms of its reach. I am not an expert in all the details of it, but that does concern me. I have heard some of you mention preemption in what you are--I am also concerned about the confusion that eliminating preemption could bring into a system in terms of getting products out and is that going to end up being positive or negative. So these are things that I intend to continue to keep my eye on. I yield back the balance of my time. " FinancialCrisisInquiry--693 ZANDI: I think the Capital Purchase Program was a necessary condition for stabilizing the financial system. I don’t think the system would have stabilized without that injection of capital at that point in time, so I think that was absolutely vital. I think the thing that really ended the—the panic once and for all were the stress tests. I think they were incredibly therapeutic, to my surprise. I—I did not expect them to go as well as they did. And, in fact, I think that is a very therapeutic process to be adopted going forward. We do a lot of risk modeling. We try to incorporate economic information into the risk processes, the financial institutions, something we’ve done in the—in the wake of the crisis. And it is to my great surprise that these institutions did not have any systematic way of stressing their portfolios. And actually some of the larger institutions—interestingly enough, they are quite sophisticated, but they’re very siloed. So the credit card folks would do it one way; the mortgage guys would do it another way; the corporate bond— the corporate lending folks another. There was no sort of across the entire balance sheet. And this stress test process for the 19 bank-holding companies was, in fact, that, and it was, I thought, very well done and ultimately restored confidence in the system and is January 13, 2010 where we are today. Now, the one part of the system that’s not working and the system will not work well without it is the process of securitization. Ironically, that’s what got us—the flawed securitization process goes to your point. That’s how we got that homeownership rate up. That’s how we got all those bad loans being made. And $2 trillion in private bond issuance in 2006 at the height of the... CHRG-111shrg51303--125 Mr. Kohn," I wasn't worried so much about the counterparties. I am worried more about other U.S. institutions operating in the financial market. So we are in the middle of a very severe crisis with confidence in a lot of important U.S. institutions eroded significantly, as reflected in the equity markets and elsewhere. And our concern was that if we imposed losses on the counterparts for AIG, not so much worried about those particular counterparties. I actually don't know what the list is, but my guess is many of them can handle it themselves. I am worried about the knock-on effects in the financial markets. So now would other people be willing to do business with other U.S. financial institutions? Forget AIG. Forget the counterparties. Think about the systemic risk here if they thought that in a crisis like this, they might have to take some losses. There is a huge moral hazard here. We have made those credit counterparties whole in ways that will reduce their incentive to be careful in the future---- Senator Warner. So we have, sir, if I can just--what I think you are saying is we, the American taxpayer, have taken a high-flying company that was doing what most of us would believe in a normal market circumstance was high risk--- " 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.] " fcic_final_report_full--398 Over the next several months Bank of America worked with its regulators to iden- tify the assets that would be included in the asset pool. Then, on May , Bank of America asked to exit the ring fence deal, explaining that the company had deter- mined that losses would not exceed the  billion that Bank of America was required to cover in its first-loss position. Although the company was eventually allowed to ter- minate the deal, it was compelled to compensate the government for the benefits it had received from the market’s perception that the government would insure its as- sets. On September , Bank of America agreed to pay a  million termination fee:  million to Treasury,  million to the Fed, and  million to the FDIC. COMMISSION CONCLUSIONS ON CHAPTER 20 The Commission concludes that, as massive losses spread throughout the finan- cial system in the fall of , many institutions failed, or would have failed but for government bailouts. As panic gripped the market, credit markets seized up, trading ground to a halt, and the stock market plunged. Lack of transparency contributed greatly to the crisis: the exposures of financial institutions to risky mortgage assets and other potential losses were unknown to market participants, and indeed many firms did not know their own exposures. The scale and nature of the over-the-counter (OTC) derivatives market cre- ated significant systemic risk throughout the financial system and helped fuel the panic in the fall of : millions of contracts in this opaque and deregulated market created interconnections among a vast web of financial institutions through counterparty credit risk, thus exposing the system to a contagion of spreading losses and defaults. Enormous positions concentrated in the hands of systemically significant institutions that were major OTC derivatives dealers added to uncertainty in the market. The “bank runs” on these institutions in- cluded runs on their derivatives operations through novations, collateral de- mands, and refusals to act as counterparties. A series of actions, inactions, and misjudgments left the country with stark and painful alternatives—either risk the total collapse of our financial system or spend trillions of taxpayer dollars to stabilize the system and prevent catastrophic damage to the economy. In the process, the government rescued a number of fi- nancial institutions deemed “too big to fail”—so large and interconnected with other financial institutions or so important in one or more financial markets that their failure would have caused losses and failures to spread to other institutions. The government also provided substantial financial assistance to nonfinancial corporations. As a result of the rescues and consolidation of financial institutions through failures and mergers during the crisis, the U.S. financial sector is now more concentrated than ever in the hands of a few very large, systemically signifi- cant institutions. This concentration places greater responsibility on regulators for effective oversight of these institutions. CHRG-111shrg61651--75 Mr. Reed," There was a tremendous amount of leverage. Senator Merkley. ----101 or something like that. Senator Reed. Yes, it was tremendous leverage, and what we should have learned was that there wasn't enough capital to absorb the risks that were in the system, and therefore, when the risks manifest themselves, the human reaction is, let us gang together and we will see if we can take this together. Well, we had a situation there that was a one-institution version of what later happened to all of us and where basically the taxpayer had to step in because there wasn't enough capital in the private sector to cover the risks that were manifesting themselves in this crisis we have gone through. And so my question about Long-Term Capital was there was the anatomy of the problem that we are today wrestling with. It was alone that sat there. It was tremendously interconnected. As you say, it had counterparty lines. It had all sorts of assets which conceivably would have been liquidated at very distressed prices and so forth, which would have impacted the market. And yet as a system, we sort of ganged together, papered it over, and went on having learned nothing. " CHRG-110hhrg46593--73 Mr. Bernanke," Yes, Congressman. I don't think the dollar system is dead. I think the dollar remains the premier international currency. We have seen a good bit of appreciation in the dollar recently during the crisis precisely because there has been a lot of interest in the safe haven and the liquidity of dollar markets. And the Federal Reserve has been engaged in swap agreements to make sure there is enough dollar liquidity in other countries because the need for dollars is so strong. So I think the dollar system remains quite strong. I do agree with you very much on one point, which is about the current accounts. The current account imbalances have proven to be a very serious problem. It was, in fact, the large capital inflows from those current accounts which created a lot of the financial imbalances we saw and have led to some of the problems we are seeing. And one of the silver linings in this huge great cloud is that we are seeing some improvement in greater balance in our current account deficits. Dr. Paul. But does the subject of a new regime ever come up? " CHRG-111hhrg48867--97 Mr. Wallison," I think that structure is largely responsible for the financial crisis that this country is experiencing. And that is because Fannie and Freddie essentially were a distortion of the credit system. Congress had a good idea, it seems to me, in intending to support homeownership in the United States. There are a lot of benefits that come from homeownership and it is a good idea to support it. But Congress chose to support it through Fannie and Freddie and CRA by distorting the credit system and asking private organizations--private profit-making organizations--to bear the cost and hide the cost in their balance sheets and in their income statements. And so we never really understood the risks that they were required to take in order to support this congressional objective. If Congress wants to accomplish something, it should accomplish it by appropriating funds so the taxpayers can understand what the objectives of this government are and what it is spending on those things, and not push all of those costs on to private sector balance sheets and income statements. " FinancialCrisisInquiry--3 The meeting of the Financial Crisis Inquiry Commission will come to order. There is a quorum present, and so we will now proceed with this first of our public hearings. Good morning to everyone and thank you for being here. I’m honored to welcome you, as we start this series of public hearings, into the causes of the financial and economic crisis that’s gripped this entire country. I thank Vice Chairman Thomas for his extraordinary cooperation and partnership. I applaud the dedication of my fellow commissioners, and I’m grateful to all of our witnesses for giving us their testimony and sharing their wisdom. We’ve been given a critical mission, one that goes far beyond any party or even policy agenda to conduct a full and fair inquiry into what brought America’s financial system to its knees. We’re after the truth, the hard facts, because it’s our job to provide an unbiased accounting of the actions that led to devastating economic consequences for so many American families. We’ll follow the evidence wherever it leads. We’ll use our subpoena power as needed. And if we find wrongdoing, we will refer it to the proper authorities. That’s what the American people want, that’s what they deserve, and that’s what this commission is going to give them. Some already speak of the financial crisis in the past tense, as some kind of historical event. The truth is it is still here and still very real. Twenty-six million Americans are unemployed or can’t find full-time work or have given up even looking for jobs. CHRG-111shrg62643--39 Mr. Bernanke," Well, speaking for myself and the Federal Reserve, we think that the framework in this bill is very constructive. It addresses many of the gaps and problems that we saw in the crisis, and for our part, we intend to write rules that will implement the intent of Congress and that will be sufficiently tough to ensure that the risk of another crisis is very low. A lot of the effectiveness of this bill, of course, depends on the implementation, not just the rule writing, but also the actual supervision and execution of those rules, and we are taking this very seriously. We are restructuring our entire supervisory framework, both intellectually and in management terms, to make sure that we are able to address risks to the broader financial system as this bill envisions and that we are able to support the FDIC in its wind-down function and the CFTC and SEC in their oversight of central counterparties, et cetera. So we are very committed to making this work and we think it gives us the tools that will allow us to do that. Senator Reed. Just to follow up, I think you understand that there is a very--the high degree of skepticism. And you go into this, I presume, acknowledging that in the public, so that your efforts have to be transparent and not only for the substance, but also the appearance of the deliberation is not influenced by anyone, is that a fair---- " fcic_final_report_full--554 Richard S. “Dick” Fuld Jr., Former Chairman and Chief Executive Officer, Lehman Brothers Harvey R. Miller, Business Finance & Restructuring Partner, Weil, Gotshal & Manges, LLP Barry L. Zubrow, Chief Risk Officer, JPMorgan Chase & Co. 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 : The Federal Reserve Ben S. Bernanke, Chairman, Board of Governors of the Federal Reserve System Session : The Federal Deposit Insurance Corporation Sheila C. Bair, Chairman, U.S. Federal Deposit Insurance Corporation Public Hearing on the Impact of the Financial Crisis—Greater Bakersfield, Kern County Board of Supervisors Chambers,  Truxtun Avenue, Bakersfield, CA, September ,  Session : Welcome Congressman Kevin McCarthy, California’s nd District Ray Watson, Kern County Supervisor, District  Irma Carson, Bakersfield City Councilwoman, Ward  Session : Local Banking Arnold Cattani, Chairman, Mission Bank Steve Renock, President and CEO, Kern Schools Federal Credit Union D. Linn Wiley, Vice Chairman, CVB Financial Corporation and Citizens Business Bank Session : Residential and Community Real Estate Gregory D. Bynum, President, Gregory D. Bynum and Associates, Inc. Warren Peterson, Warren Peterson Construction, Inc. Session : Local Housing Market Gary Crabtree, Principal Owner, Affiliated Appraisers Lloyd Plank, Lloyd E. Plank Real Estate Consultants Session : Foreclosures and Loan Modifications Brenda Amble, Escrow Manager, Ticor Title Laurie McCarty, Coldwell Banker Preferred Jeannie McDermott, Small Business Owner Session : Forum for Public Comment James Stephen Urner Marvin Dean Marie Vasile Public Hearing on the Impact of the Financial Crisis—State of Nevada, University of Nevada, Las Vegas, Student Union Building, Las Vegas, NV, September ,  Session : Economic Analysis of the Impact of the Financial Crisis on Nevada Jeremy Aguero, Principal, Applied Analysis Session : The Impact of the Financial Crisis on Businesses of Nevada Steve Hill, Founder, Silver State Materials Corporation; Immediate Past Chairman, Las Vegas Chamber of Commerce William E. Martin, Vice Chairman and Chief Executive Officer, Service st Bank of Nevada 551 CHRG-111hhrg48867--249 Mr. Silvers," The way Fannie and Freddie were managed, particularly since 2003--and that date is very important--is a substantial contributing factor. However, the narrative that has been put forward by, essentially, people who have a, sort of, principled disagreement with regulation, that Fannie and Freddie are the primary cause of this problem, is completely and utterly wrong. And specifically, it is completely and utterly wrong because Fannie and Freddie functioned, for example, for 10 years, almost, following the strengthening of the Community Reinvestment Act without bringing on systemic crisis. They began to do what my friend Peter was talking about when deregulated mortgage markets began to encroach on their market share and in a context in which credit was available broadly without regard to risk because of policies of the Fed and the Bush Administration. And that began in 2003, and that is when you saw the explosion of subprime. Fannie and Freddie were participants in that conduct starting in 2003. But their existence and the existence of GSEs, the existence of the Community Reinvestment Act are not primarily responsible for this crisis, and to assert so is to fundamentally distort the record. " 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. ______ CHRG-110hhrg46596--160 Mr. Kashkari," The mark-to-market is a very important issue. We are focused on stabilizing the financial system so that they can recognize their losses and also raise additional capital and get lending going in our community again. We believe that both by helping the consumers directly; for example, through our facility with the Federal Reserve that I have spoken about, and putting more capital in the banks, it puts them in a better position so that we can weather this downturn and get these assets moving again. So there is no one tool. All of the regulators are bringing the various tools to bear in a complementary manner to try to get through the financial crisis. The TARP is very important, but it complements the other tools that we have. " CHRG-111shrg52619--3 STATEMENT OF SENATOR RICHARD C. SHELBY Senator Shelby. Thank you, Chairman Dodd. We are in the midst of an unprecedented financial crisis. I believe the challenge before us involves three tasks: First, we must work to stabilize the system. Second, we must understand the origins of the current crisis. And, third, we must work to restructure our regulatory regime to meet the demands of a 21st century financial system. Today, the Committee will focus primarily on the third task, rebuilding the regulatory structure. I believe the success of our effort will depend a great deal on our ability to determine what led us to this point. Without that knowledge, we will not know whether we are regulating the right things in the right way. We need to determine whether the regulators had sufficient authority and whether they used the authority they had to the fullest extent. We need to consider here whether market developments outpace current regulatory capabilities. We also need to better understand the impact regulation has on the private sector's due diligence and risk management practices. After understanding the nature of the regulatory structure, I believe we need to come to an understanding as to the specific cause or causes of the regulatory failure. We then need to address those failures in such a manner where we create a durable, flexible, and robust regime that can grow with markets while still protecting consumers and market stability. This is a very tall order. It will take an intensive and extended effort on our behalf, but in the end, getting this thing done right is more important than getting it done quickly. Thank you, Mr. Chairman. " CHRG-111shrg54533--74 Secretary Geithner," Well, on balance, we are not increasing the number of agencies. We are reducing the one important source of arbitrage and inefficiency, which is between a national bank and a national thrift charter. But you are right, we are proposing to separate the consumer function from the existing safety and soundness function and the other authorities that have that and put it in once place with accountability for the reasons I said, which is the current model with a long record in it, and it did fail in important respects. I believe that this basic concern about the competitiveness of our system remains a very important concern that has to guide everything we do. But I do believe our system will be stronger, more effective, more competitive, greater confidence--enjoy greater confidence around the world if we have better safeguards and protections, not just around disclosure, which is very important, where I think we still lead the world, but in terms of basic protections against stability. Our system will not be competitive, our institutions will not be competitive if we have a system in the future that has been as vulnerable as ours had to period crises like this every 2 to 3 to 4 years. Now, this is the first crisis we have had in a long time of this severity, but we have had a record over the last three decades where every 3 to 5 years we have had a shock of significant magnitude, and I think that does not make our system or our institutions competitive, and a better foundation to stability would be supportive of trying to make sure that our system remains in many ways the envy of the world in doing this core job of taking the savings of American investors and channeling them to where they can be best used in support of innovation, new ideas, growing companies. Senator Crapo. Thank you. My time is up. I would like to pursue this further with you, though. Senator Johnson. Senator Bayh. Senator Bayh. Thank you, Mr. Secretary. I would like to start off with a comment and then two questions. First, my comment is I would like to thank you for your openness and the dialogue you have established with Members of this Committee. There was a comment made previously about the timing of briefings and that sort of thing. I was at the breakfast that you had a few weeks ago. It was bipartisan. You elicited comments from all of us. So I want to just go on the record as thanking you for that. Second, I want to commend you on the work product you have produced here. Very difficult dilemmas to wrestle with. It seems to me you have struck the right balance here focusing on the core mission, putting off until later some things that are desirable, but perhaps can be left to another day. That takes me to my question, the first of my two questions. I am concerned--and you alluded to this--that there were a number of causes of the crisis that we face right now, some macroeconomic in nature. I am concerned that your excellent work product will go for naught and that we will be overwhelmed once again in 5 years, 6 years, 7 years, in a ways we cannot anticipate if those are not dealt with. And I refer specifically to the imbalance of savings and consumption in the world. As the crisis, God willing, appears to be abating, I simply do not see the willingness on the part of some countries to rethink their basic economic models. And so I would be interested in your comment about--I am deeply concerned that we are going to see a recurrence of this if that is not dealt with, so I am interested in your comment about that. In particular, you know, on the savings side, I see Americans are beginning to save a little bit more. That harms consumption in the short run, but in the long run it is probably a prudent thing. But isn't it also true that one of the best ways to increase national savings is to get our deficit down? And I am concerned that if you look at the size of the deficit, this year and next year is understandable, but in the out-years it looks like it may be larger than GDP growth, that is a concerning thing. So what about these macroeconomic factors and their ability to overwhelm this architecture if they are not addressed? That is number one. " CHRG-111hhrg56776--17 Mr. Bernanke," Mr. Chairman, we are quite concerned by proposals to make the Fed a regulator only of the biggest banks. It makes us essentially the ``too-big-to-fail'' regulator. We do not want that responsibility. We want to have a connection to Main Street as well as to Wall Street. We need to have insights into what is happening in the entire banking system to understand how regulation affects banks, to understand the status of the assets and credit problems of banks at all levels, all sizes, and smaller and medium-sized banks are very valuable to us and they provide irreplaceable information, both in terms of making monetary policy and in terms of us understanding the economy, but also in terms of financial stability. Let's not forget that small institutions have been part of financial crises in the past, including in the 1930's, in the thrift crisis, and other examples. We think it is very important for the Federal Reserve not to be just the big institution regulator. We need to have exposure to the entire economy and to the broad financial system. " CHRG-111hhrg52400--196 Mr. Baird," I will try to keep this in the context of the purpose of the hearing, which is systemic risk. If the chairman will indulge me for 30 seconds, I have been coming up here for 7 or 8 years, long before AIG became the household name, and long before there was a financial crisis. And we were up here, advocating for an optional Federal charter, because we thought we could serve our customers--those of us who do business on a national basis, which is much of the life insurance business--better. As Congresswoman Bean suggested--and you had a bigger number than I would have in my pocket, but there are billions of dollars of annual operating expenses that would be saved if we had a single regulator, rather than the 51 regulators that ultimately gets passed on to the customers. Now, in the context of systemic risk, what we have been talking about today is, whether it's Federal or whether it's State in the past, there have been failures of regulators on both sides. And I think the purpose of this hearing is to try to make it better, it is to try to improve, and it's trying to bring all of the risks from the entire financial services industry together to keep this from happening again, which, given the amount of sleep that I have lost in the last 8 months, I am all about. So, if we are indeed here to talk about a Federal systemic overseer or regulator, we don't think that you can regulate just systemic risk of the life insurance industry without having the expertise, collaboration, and cooperation of a Federal functional regulator. And that, to me, is how we bring all this together. " CHRG-110hhrg46596--66 Mr. Kashkari," Congressman, thank you for the question. Let me answer it in two parts. First, in terms of the remaining use of the TARP funds, right now we are executing the programs that we have announced. So we have announced the Capital Purchase Program. We are deep in execution; the execution is going quite well. We can discuss that, and I am sure members have views. Second, we have announced, the Federal Reserve has announced a program for asset-backed securitization facility, which is going to get consumer credit going--auto lending, consumer loans, student loans, etc. That program in the process of being developed and stood up. That also will use $20 billion from the TARP. In terms of future programs, we have a lot of policy development work going on. That policy development work, in many cases, is we are consulting with the transition team to keep them informed of what we are developing. At this point, there has been no determination made by the Secretary on whether or when to request further funds from the Congress, the $350 billion. If that determination were to be made, he would do it, consult with the transition team, also notify Congress and provide details of exactly what our plans would be for those remaining funds, number one. Number two, in terms of a master industrial policy, candidly, Congressman, that is not something that I have spent much time thinking about. My focus, and I think the Treasury Department's focus right now, is just to ensure the stability of the financial system so that credit can flow to our communities and our consumers and our businesses. I think that, as a Nation, my personal perspective is, once we get through the immediate crisis, we need to take a step back and thoughtfully review our regulatory system to make sure we don't get back here again in the future. Sometimes it is hard to make those judgments in the middle of a crisis. " CHRG-111shrg56376--53 Mr. Tarullo," Senator, as you know, I agree, personally--it is not a Board position--with you that the Fed took too long to use its existing authority to enact consumer protection associated with mortgages. I was referring a few moments ago--and I will elaborate on it now--to the authority to provide consolidated supervision for any systemically important institution. As you know, a year-and-a-half ago, that statement would have, in practical terms, meant that a whole set of institutions--at that point, the five free-standing investment banks--would likely have been brought in by law to the consolidate supervision program. Because of the financial crisis, and the fact that a couple of those institutions are no longer with us and others have become bank holding companies, the immediate practical importance of the authority would not be as great as it would have been a year-and-a-half or 2 years ago. However, there is first the possibility that an institution which has become a bank holding company in the middle of the crisis, in an effort to get the imprimatur of having consolidated supervision, would, when things calm down, decide it does not so much like being a supervised entity, so it would dis-elect being a holding company. Senator Bunning. We could prevent that. " CHRG-111shrg61651--69 Mr. Johnson," If I could just add to that, Goldman Sachs in 1997 was about a $200 billion bank in terms of assets. It was about $270 billion in today's money. It peaked at about $1.1 trillion. Now, I completely agree with Mr. Reed that having risk takers and risk-taking institutions in our economy is useful. I am a professor of entrepreneurship at MIT. I am completely supporting that. But if you let these risky enterprises become big relative to the system, when a crisis comes, even if you have a relatively stable core--and I do fully endorse what Mr. Reed is calling for here--you have this rather stable core and you have got very big other parts of the financial system that fail or are in danger of failing, then you let them into the discount window, which is what we did in September of 2008. So the size of these risk-taking parts matters, even if we are able to achieve a stable base, which is what Mr. Reed is rightly arguing for. " CHRG-111shrg55278--95 PREPARED STATEMENT OF SENATOR RICHARD C. SHELBY Thank you Mr. Chairman. At the core of the Administration's financial regulatory reform proposal is the concept of systemic risk. The President believes that it can be regulated and that the Fed should be the regulator. As we begin to consider how to address systemic risk, my main concern is that while there appears to be a growing consensus on the need for a systemic risk regulator, there is no agreement on how to define systemic risk, let alone how to manage it. I believe that it would be legislative malfeasance to simply tell a particular regulator to manage all financial risks without having reached some consensus on what systemic risk is and whether it can be regulated at all. Should we reach such a consensus, we then must be very careful not to give our markets a false sense of security that could actually exacerbate our ``too-big-to-fail'' problem. If market participants believe that they no longer have to closely monitor risks presented by financial institutions, the stage will be set for our next economic crisis. If we can decide what systemic risk is and that it is something that should and can be regulated, our next question should be: Who should regulate it? Unfortunately, the Administration's proposal largely places the Federal Reserve in charge of regulating systemic risk. It would grant the Fed authority to regulate any bank, securities firm, insurer, investment fund or any other type of financial institution that the Fed deems a systemic risk. The Fed would be able to regulate any aspect of these firms, even over the objections of other regulators. In effect, the Fed would become a regulatory leviathan of unprecedented size and scope. I believe that expanding the Fed's powers in this manner could be very dangerous. The mixing of monetary policy and bank regulation has proven to be a formula for taxpayer-funded bailouts and poor monetary policy decisions. Giving the Fed ultimate responsibility for the regulation of systemically important firms will provide further incentive for the Fed to hide its regulatory failures by bailing out troubled firms. Rather than undertaking the politically painful task of resolving failed institutions, the Fed could take the easy way out and rescue them by using its lender-of-last-resort facilities or open market operations. Even worse, it could undertake these bailouts without having to obtain the approval of Congress. In our system of Government, elected-officials should make decisions about fiscal policy and the use of taxpayer dollars, not unelected central bankers. Handing over the public purse to an enhanced Fed is simply inconsistent with the principles of democratic Government. Augmenting the Federal Reserve's authority also risks burdening it with more responsibility than one institution can reasonably be expected to handle. In fact, the Federal Reserve is already overburdened with its responsibility for monetary policy, the payment system, consumer protection, and bank supervision. I believe anointing the Fed as the systemic risk regulator will make what has proven to be a bad bank regulator even worse. Let us not forget that it was the Fed that pushed for the adoption of the flawed Basel II capital accords, which would have drained our banking system of capital. It was the Fed that failed to adequately supervise Citigroup and Bank of America, setting the stage for bailouts in excess of $400 billion. It was the Fed that failed to adopt mortgage underwriting guidelines until well after this crisis was underway. It was the Fed that said there was no need to regulate derivatives. It was also the Fed that lobbied to become the regulator of financial holding companies as part of Gramm-Leach-Bliley. The Fed won that fight and got the additional authority it sought. Ten years later, however, it is clear that the Fed has proven that it is incapable of handling that responsibility. Ultimately, if we are able to reach some sort of agreement on systemic risk and whether it can be managed, I strongly believe that we should consider every possible alternative to the Fed as the systemic risk regulator. Thank you Mr. Chairman. ______ CHRG-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-111shrg56376--200 Mr. Baily," Well, I think--I am an admirer of Ben Bernanke. I am not a close friend of his, but I have known him for a long time and I admire the way he handled this crisis. As I said in my testimony, I don't think the Fed--I am also an admirer of Alan Greenspan, who is a friend of mine, and I don't think--leading up to this crisis, I think they made some very substantial mistakes when they didn't give enough consumer protection and they didn't react to some of the bad lending that was going on. So I think there were certainly a lot of mistakes that were made prior to this crisis that would have mitigated it. So, you know, I understand why, obviously, the Fed wants to hold on to the authorities it has, but I think what we are suggesting is that you take away the prudential regulation part, because that may be in conflict. You make sure that it still has access to the information it needs, but it is no longer the prudential regulator. I think the thing that the Federal Reserve has done well is monetary policy, not that they haven't made any mistakes, but if you look over the last, oh, 20, 30 years, I think they have done a good job, and typically when you pick people to serve on the Fed, you tend to pick economists or people with expertise in monetary policy, and that is the thing they should do, and I think they should also, since monetary policy is key to the stability of the economy, I think they should also be concerned with systemic stability. But I don't see why--they certainly haven't done a great job on prudential regulation and I don't see--what is the point of the Chairman of the Federal Reserve sitting around worrying about details of credit card regulation? That is what he is doing right now, and I think that is a mistake and not a good use of his time. Senator Merkley. Does anyone else want to comment? " 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. ______ CHRG-111shrg54533--91 PREPARED STATEMENT OF TIMOTHY GEITHNER Secretary, Department of the Treasury June 18, 2009 Financial Regulatory Reform: A New FoundationIntroduction Over the past 2 years we have faced the most severe financial crisis since the Great Depression. Americans across the Nation are struggling with unemployment, failing businesses, falling home prices, and declining savings. These challenges have forced the government to take extraordinary measures to revive our financial system so that people can access loans to buy a car or home, pay for a child's education, or finance a business. The roots of this crisis go back decades. Years without a serious economic recession bred complacency among financial intermediaries and investors. Financial challenges such as the near-failure of Long-Term Capital Management and the Asian Financial Crisis had minimal impact on economic growth in the U.S., which bred exaggerated expectations about the resilience of our financial markets and firms. Rising asset prices, particularly in housing, hid weak credit underwriting standards and masked the growing leverage throughout the system. At some of our most sophisticated financial firms, risk management systems did not keep pace with the complexity of new financial products. The lack of transparency and standards in markets for securitized loans helped to weaken underwriting standards. Market discipline broke down as investors relied excessively on credit rating agencies. Compensation practices throughout the financial services industry rewarded short-term profits at the expense of long-term value. Households saw significant increases in access to credit, but those gains were overshadowed by pervasive failures in consumer protection, leaving many Americans with obligations that they did not understand and could not afford. While this crisis had many causes, it is clear now that the government could have done more to prevent many of these problems from growing out of control and threatening the stability of our financial system. Gaps and weaknesses in the supervision and regulation of financial firms presented challenges to our government's ability to monitor, prevent, or address risks as they built up in the system. No regulator saw its job as protecting the economy and financial system as a whole. Existing approaches to bank holding company regulation focused on protecting the subsidiary bank, not on comprehensive regulation of the whole firm. Investment banks were permitted to opt for a different regime under a different regulator, and in doing so, escaped adequate constraints on leverage. Other firms, such as AIG, owned insured depositories, but escaped the strictures of serious holding company regulation because the depositories that they owned were technically not ``banks'' under relevant law. We must act now to restore confidence in the integrity of our financial system. The lasting economic damage to ordinary families and businesses is a constant reminder of the urgent need to act to reform our financial regulatory system and put our economy on track to a sustainable recovery. We must build a new foundation for financial regulation and supervision that is simpler and more effectively enforced, that protects consumers and investors, that rewards innovation, and that is able to adapt and evolve with changes in the financial market. In the following pages, we propose reforms to meet five key objectives: 1. Promote robust supervision and regulation of financial firms. Financial institutions that are critical to market functioning should be subject to strong oversight. No financial firm that poses a significant risk to the financial system should be unregulated or weakly regulated. We need clear accountability in financial oversight and supervision. We propose: A new Financial Services Oversight Council of financial regulators to identify emerging systemic risks and improve interagency cooperation. New authority for the Federal Reserve to supervise all firms that could pose a threat to financial stability, even those that do not own banks. Stronger capital and other prudential standards for all financial firms, and even higher standards for large, interconnected firms. A new National Bank Supervisor to supervise all federally chartered banks. Elimination of the Federal thrift charter and other loopholes that allowed some depository institutions to avoid bank holding company regulation by the Federal Reserve. The registration of advisers of hedge funds and other private pools of capital with the SEC. 2. Establish comprehensive supervision of financial markets. Our major financial markets must be strong enough to withstand both systemwide stress and the failure of one or more large institutions. We propose: Enhanced regulation of securitization markets, including new requirements for market transparency, stronger regulation of credit rating agencies, and a requirement that issuers and originators retain a financial interest in securitized loans. Comprehensive regulation of all over-the-counter derivatives. New authority for the Federal Reserve to oversee payment, clearing, and settlement systems. 3. Protect consumers and investors from financial abuse. To rebuild trust in our markets, we need strong and consistent regulation and supervision of consumer financial services and investment markets. We should base this oversight not on speculation or abstract models, but on actual data about how people make financial decisions. We must promote transparency, simplicity, fairness, accountability, and access. We propose: A new Consumer Financial Protection Agency to protect consumers across the financial sector from unfair, deceptive, and abusive practices. Stronger regulations to improve the transparency, fairness, and appropriateness of consumer and investor products and services. A level playing field and higher standards for providers of consumer financial products and services, whether or not they are part of a bank. 4. Provide the government with the tools it needs to manage financial crises. We need to be sure that the government has the tools it needs to manage crises, if and when they arise, so that we are not left with untenable choices between bailouts and financial collapse. We propose: A new regime to resolve nonbank financial institutions whose failure could have serious systemic effects. Revisions to the Federal Reserve's emergency lending authority to improve accountability. 5. Raise international regulatory standards and improve international cooperation. The challenges we face are not just American challenges, they are global challenges. So, as we work to set high regulatory standards here in the United States, we must ask the world to do the same. We propose: International reforms to support our efforts at home, including strengthening the capital framework; improving oversight of global financial markets; coordinating supervision of internationally active firms; and enhancing crisis management tools. In addition to substantive reforms of the authorities and practices of regulation and supervision, the proposals contained in this report entail a significant restructuring of our regulatory system. We propose the creation of a Financial Services Oversight Council, chaired by Treasury and including the heads of the principal Federal financial regulators as members. We also propose the creation of two new agencies. We propose the creation of the Consumer Financial Protection Agency, which will be an independent entity dedicated to consumer protection in credit, savings, and payments markets. We also propose the creation of the National Bank Supervisor, which will be a single agency with separate status in Treasury with responsibility for federally chartered depository institutions. To promote national coordination in the insurance sector, we propose the creation of an Office of National Insurance within Treasury. Under our proposal, the Federal Reserve and the Federal Deposit Insurance Corporation (FDIC) would maintain their respective roles in the supervision and regulation of State-chartered banks, and the National Credit Union Administration (NCUA) would maintain its authorities with regard to credit unions. The Securities and Exchange Commission (SEC) and Commodity Futures Trading Commission (CFTC) would maintain their current responsibilities and authorities as market regulators, though we propose to harmonize the statutory and regulatory frameworks for futures and securities. The proposals contained in this report do not represent the complete set of potentially desirable reforms in financial regulation. More can and should be done in the future. We focus here on what is essential: to address the causes of the current crisis, to create a more stable financial system that is fair for consumers, and to help prevent and contain potential crises in the future. (For a detailed list of recommendations, please see Summary of Recommendations following the Introduction.) These proposals are the product of broad-ranging individual consultations with members of the President's Working Group on Financial Markets, Members of Congress, academics, consumer and investor advocates, community-based organizations, the business community, and industry and market participants.I. Promote Robust Supervision and Regulation of Financial Firms In the years leading up to the current financial crisis, risks built up dangerously in our financial system. Rising asset prices, particularly in housing, concealed a sharp deterioration of underwriting standards for loans. The Nation's largest financial firms, already highly leveraged, became increasingly dependent on unstable sources of short-term funding. In many cases, weaknesses in firms' risk-management systems left them unaware of the aggregate risk exposures on and off their balance sheets. A credit boom accompanied a housing bubble. Taking access to short-term credit for granted, firms did not plan for the potential demands on their liquidity during a crisis. When asset prices started to fall and market liquidity froze, firms were forced to pull back from lending, limiting credit for households and businesses. Our supervisory framework was not equipped to handle a crisis of this magnitude. To be sure, most of the largest, most interconnected, and most highly leveraged financial firms in the country were subject to some form of supervision and regulation by a Federal Government agency. But those forms of supervision and regulation proved inadequate and inconsistent. First, capital and liquidity requirements were simply too low. Regulators did not require firms to hold sufficient capital to cover trading assets, high-risk loans, and off-balance sheet commitments, or to hold increased capital during good times to prepare for bad times. Regulators did not require firms to plan for a scenario in which the availability of liquidity was sharply curtailed. Second, on a systemic basis, regulators did not take into account the harm that large, interconnected, and highly leveraged institutions could inflict on the financial system and on the economy if they failed. Third, the responsibility for supervising the consolidated operations of large financial firms was split among various Federal agencies. Fragmentation of supervisory responsibility and loopholes in the legal definition of a ``bank'' allowed owners of banks and other insured depository institutions to shop for the regulator of their choice. Fourth, investment banks operated with insufficient government oversight. Money market mutual funds were vulnerable to runs. Hedge funds and other private pools of capital operated completely outside of the supervisory framework. To create a new foundation for the regulation of financial institutions, we will promote more robust and consistent regulatory standards for all financial institutions. Similar financial institutions should face the same supervisory and regulatory standards, with no gaps, loopholes, or opportunities for arbitrage. We propose the creation of a Financial Services Oversight Council, chaired by Treasury, to help fill gaps in supervision, facilitate coordination of policy and resolution of disputes, and identify emerging risks in firms and market activities. This Council would include the heads of the principal Federal financial regulators and would maintain a permanent staff at Treasury. We propose an evolution in the Federal Reserve's current supervisory authority for BHCs to create a single point of accountability for the consolidated supervision of all companies that own a bank. All large, interconnected firms whose failure could threaten the stability of the system should be subject to consolidated supervision by the Federal Reserve, regardless of whether they own an insured depository institution. These firms should not be able to escape oversight of their risky activities by manipulating their legal structure. Under our proposals, the largest, most interconnected, and highly leveraged institutions would face stricter prudential regulation than other regulated firms, including higher capital requirements and more robust consolidated supervision. In effect, our proposals would compel these firms to internalize the costs they could impose on society in the event of failure.II. Establish Comprehensive Regulation of Financial Markets The current financial crisis occurred after a long and remarkable period of growth and innovation in our financial markets. New financial instruments allowed credit risks to be spread widely, enabling investors to diversify their portfolios in new ways and enabling banks to shed exposures that had once stayed on their balance sheets. Through securitization, mortgages and other loans could be aggregated with similar loans and sold in tranches to a large and diverse pool of new investors with different risk preferences. Through credit derivatives, banks could transfer much of their credit exposure to third parties without selling the underlying loans. This distribution of risk was widely perceived to reduce systemic risk, to promote efficiency, and to contribute to a better allocation of resources. However, instead of appropriately distributing risks, this process often concentrated risk in opaque and complex ways. Innovations occurred too rapidly for many financial institutions' risk management systems; for the market infrastructure, which consists of payment, clearing, and settlement systems; and for the Nation's financial supervisors. Securitization, by breaking down the traditional relationship between borrowers and lenders, created conflicts of interest that market discipline failed to correct. Loan originators failed to require sufficient documentation of income and ability to pay. Securitizers failed to set high standards for the loans they were willing to buy, encouraging underwriting standards to decline. Investors were overly reliant on credit rating agencies. Credit ratings often failed to accurately describe the risk of rated products. In each case, lack of transparency prevented market participants from understanding the full nature of the risks they were taking. The build-up of risk in the over-the-counter (OTC) derivatives markets, which were thought to disperse risk to those most able to bear it, became a major source of contagion through the financial sector during the crisis. We propose to bring the markets for all OTC derivatives and asset-backed securities into a coherent and coordinated regulatory framework that requires transparency and improves market discipline. Our proposal would impose record-keeping and reporting requirements on all OTC derivatives. We also propose to strengthen the prudential regulation of all dealers in the OTC derivative markets and to reduce systemic risk in these markets by requiring all standardized OTC derivative transactions to be executed in regulated and transparent venues and cleared through regulated central counterparties. We propose to enhance the Federal Reserve's authority over market infrastructure to reduce the potential for contagion among financial firms and markets. Finally, we propose to harmonize the statutory and regulatory regimes for futures and securities. While differences exist between securities and futures markets, many differences in regulation between the markets may no longer be justified. In particular, the growth of derivatives markets and the introduction of new derivative instruments have highlighted the need for addressing gaps and inconsistencies in the regulation of these products by the CFTC and SEC.III. Protect Consumers and Investors From Financial Abuse Prior to the current financial crisis, a number of Federal and State regulations were in place to protect consumers against fraud and to promote understanding of financial products like credit cards and mortgages. But as abusive practices spread, particularly in the market for subprime and nontraditional mortgages, our regulatory framework proved inadequate in important ways. Multiple agencies have authority over consumer protection in financial products, but for historical reasons, the supervisory framework for enforcing those regulations had significant gaps and weaknesses. Banking regulators at the State and Federal level had a potentially conflicting mission to promote safe and sound banking practices, while other agencies had a clear mission but limited tools and jurisdiction. Most critically in the run-up to the financial crisis, mortgage companies and other firms outside of the purview of bank regulation exploited that lack of clear accountability by selling mortgages and other products that were overly complicated and unsuited to borrowers' financial situation. Banks and thrifts followed suit, with disastrous results for consumers and the financial system. This year, Congress, the Administration, and financial regulators have taken significant measures to address some of the most obvious inadequacies in our consumer protection framework. But these steps have focused on just two, albeit very important, product markets--credit cards and mortgages. We need comprehensive reform. For that reason, we propose the creation of a single regulatory agency, a Consumer Financial Protection Agency (CFPA), with the authority and accountability to make sure that consumer protection regulations are written fairly and enforced vigorously. The CFPA should reduce gaps in Federal supervision and enforcement; improve coordination with the States; set higher standards for financial intermediaries; and promote consistent regulation of similar products. Consumer protection is a critical foundation for our financial system. It gives the public confidence that financial markets are fair and enables policy makers and regulators to maintain stability in regulation. Stable regulation, in turn, promotes growth, efficiency, and innovation over the long term. We propose legislative, regulatory, and administrative reforms to promote transparency, simplicity, fairness, accountability, and access in the market for consumer financial products and services. We also propose new authorities and resources for the Federal Trade Commission to protect consumers in a wide range of areas. Finally, we propose new authorities for the Securities and Exchange Commission to protect investors, improve disclosure, raise standards, and increase enforcement.IV. Provide the Government With the Tools It Needs To Manage Financial Crises Over the past 2 years, the financial system has been threatened by the failure or near failure of some of the largest and most interconnected financial firms. Our current system already has strong procedures and expertise for handling the failure of banks, but when a bank holding company or other nonbank financial firm is in severe distress, there are currently only two options: obtain outside capital or file for bankruptcy. During most economic climates, these are suitable options that will not impact greater financial stability. However, in stressed conditions it may prove difficult for distressed institutions to raise sufficient private capital. Thus, if a large, interconnected bank holding company or other nonbank financial firm nears failure during a financial crisis, there are only two untenable options: obtain emergency funding from the U.S. Government as in the case of AIG, or file for bankruptcy as in the case of Lehman Brothers. Neither of these options is acceptable for managing the resolution of the firm efficiently and effectively in a manner that limits the systemic risk with the least cost to the taxpayer. We propose a new authority, modeled on the existing authority of the FDIC, that should allow the government to address the potential failure of a bank holding company or other nonbank financial firm when the stability of the financial system is at risk. In order to improve accountability in the use of other crisis tools, we also propose that the Federal Reserve Board receive prior written approval from the Secretary of the Treasury for emergency lending under its ``unusual and exigent circumstances'' authority.V. Raise International Regulatory Standards and Improve International Cooperation As we have witnessed during this crisis, financial stress can spread easily and quickly across national boundaries. Yet, regulation is still set largely in a national context. Without consistent supervision and regulation, financial institutions will tend to move their activities to jurisdictions with looser standards, creating a race to the bottom and intensifying systemic risk for the entire global financial system. The United States is playing a strong leadership role in efforts to coordinate international financial policy through the G20, the Financial Stability Board, and the Basel Committee on Banking Supervision. We will use our leadership position in the international community to promote initiatives compatible with the domestic regulatory reforms described in this report. We will focus on reaching international consensus on four core issues: regulatory capital standards; oversight of global financial markets; supervision of internationally active financial firms; and crisis prevention and management. At the April 2009 London Summit, the G20 leaders issued an eight-part declaration outlining a comprehensive plan for financial regulatory reform. The domestic regulatory reform initiatives outlined in this report are consistent with the international commitments the United States has undertaken as part of the G20 process, and we propose stronger regulatory standards in a number of areas. CHRG-111shrg61513--35 Mr. Bernanke," So again, to address AIG issues, you need a strong consolidated supervisor that can identify those kinds of risks to the company and you also need some methodology, and I think you would agree that we don't want to have too-big-to-fail firms. We don't want the Fed involved in these bailouts. So you need an alternative legal structure. We have supported a resolution regime. I know this Committee is considering alternatives that would allow the government, excluding the Fed, to wind down a firm like this in a crisis in a way that would not bring down the overall financial system. I think that is a very important direction. Senator Bunning. Does any other Fed Governor have their own staff? " CHRG-111shrg56376--11 Mr. Tarullo," Thank you, Mr. Chairman, Ranking Member Shelby, and other Members of the Committee. Before the final history of the financial crisis is written, I am certain that supervisory shortcomings in all kinds and sizes of financial institutions, will have been revealed. The crisis has also shown that the framework for prudential supervision and regulation has not kept pace changes in the structure, activities, and interrelationships of the financial sector. In my prepared testimony, I have suggested and tried to elaborate the elements of an effective framework for prudential supervision, including a number of recommendations for legislative actions. Knowing of your time constraints this morning, let me confine these introductory remarks to three quick points. First, prudential supervision must be required for all systemically important institutions. It is noteworthy that a number of the firms at the heart of the crisis had not been subject to mandatory prudential supervision of any sort. Improving the quality of supervision will fall short of realizing the maximum potential gains for financial stability if important institutions can escape the rules and requirements associated with the supervisory process. Second, there must be effective supervision of the companies that own insured depository institutions, a task that is distinct from the supervision of the banks themselves. Large organizations increasingly manage their businesses on an integrated basis, with little regard for the corporate boundaries that typically define the jurisdiction of individual functional supervisors. There is need for close scrutiny of the linkages between the banks and other affiliates within a holding company--not just straightforward financial or contractual ties, but also managerial, operational, and reputational linkages. The premise of so-called ``functional regulation''--that risks within a diversified organization can be successfully evaluated and controlled through supervision within each individual firm--has been belied by the experience of the financial crisis. Third, it is important to emphasize that much of what needs to be done to improve and adapt our system of prudential supervision lies within the existing authorities of the agencies represented at this table. Together, we have acted to shut down the practice of converting charters in order to escape enforcement actions or adverse supervisory ratings. We are working together in international fora to assure that all internationally active financial institutions are subject to effective regulation. The Federal Reserve is adjusting its approach to prudential supervision, particularly of the largest banking organizations. Building on the experience of the unprecedented Supervisory Capital Assessment Program, or SCAP, we are expanding our use of horizontal examinations to assess key operations, risks, and risk management of large institutions. We are creating an enhanced quantitative surveillance mechanism that will draw on a multidisciplinary group of economists and other experts to create and evaluate scenarios that cross large firms. These top-down analyses will provide an independent supervisory perspective on the bottom-up work of supervisory teams. The two perspectives will be joined in a well-coordinated process involving both the supervisory teams and Washington staff. Thank you all for your attention. I look forward to discussing both agency and congressional initiatives to strengthen further our prudential supervisory system. " FinancialCrisisInquiry--16 The past two years have been unlike anything I’ve seen in my 40 years in financial service. Unprecedented illiquidity and turmoil on Wall Street saw the fall of two leading franchises and the consolidation of others. We saw credit markets seize, the competitive landscape remade, and vast governmental intervention in the financial sector. And the consequences have obviously spread far beyond Wall Street. Millions in America today are struggling to find work. They’ve lost homes. They watched their retirements evaporate their savings. I believe the financial crisis exposed fundamental flaws in our financial system. There is no doubt that we as an industry made mistakes. In retrospect it’s clear that many firms were too highly leveraged. They took on too much risk, and they didn’t have sufficient resources to manage those risks effectively in a rapidly changing environment. The financial crisis also made clear that regulators simply didn’t have the visibility, tools or authority to protect the stability of the financial system as a whole. Let me briefly walk you through what happened from Morgan Stanley’s viewpoint and our response to the crisis. As the commission knows, the entire financial service history was hit by a series of macro shocks that began with the steep decline in U.S. real estate prices in 2007. Morgan Stanley, like many of its peers, experienced significant losses related to the decline in the value of securities and collateralized debt obligations backed by residential mortgage loans. This was a powerful wake-up call for this firm, and we moved quickly and aggressively to adapt our business to the rapidly changing environment. We cut leverage. We strengthened risk management. We raised private capital and dramatically reduced our balance sheet. We increased total average liquidity by 46 percent, and we entered the fall of ‘08 with $170 billion in cash on our balance sheet. Thanks to these prudent steps, we were in a better position than some of our peers to weather the worst financial storm, but we did not do everything right. When Lehman Brothers collapsed in early September of ‘08, it sparked a severe crisis of confidence across global financial markets. Like many of our peers, we experienced a classic run on the bank as the entire investment banking business model came under siege. Morgan Stanley and other financial institutions experienced huge swings and spreads on the credit-default swaps tied to our debt and sharp drops in our share price. This led clearing banks to request that firms post additional collateral causing further depletion of cash resources. fcic_final_report_full--442 Conclusion: The risk of contagion was an essential cause of the crisis. In some cases the financial system was vulnerable because policymakers were afraid of a large firm’s sudden and disorderly failure triggering balance-sheet losses in its counterparties. These institu- tions were too big and interconnected to other firms, through counterparty credit risk, for policymakers to be willing to allow them to fail suddenly. Systemic failure type two: a common shock If contagion is like the flu, then a common shock is like food poisoning. A common factor affects a number of firms in the same way, and they all get sick at the same time. In a common shock, the failure of one firm may inform us about the breadth or depth of the problem, but the failure of one firm does not cause the failure of another. The common factor in this case was concentrated losses on housing-related assets in large and midsize financial firms in the United States and some in Europe. CHRG-111shrg57923--25 Mr. Liechty," I would be happy to. I will echo what Allan has said, what Dr. Mendelowitz has said, about in the importance in terms of political pressures that the institute is able to act in a way that it feels is in the best interest for the country. I have five reasons for being here: Joseph, Jacob, Sam, Matt, and Tom, my five boys. I want them to have a safe, secure financial system that gives them the same opportunity as I had when they grow up and get into the real world and start providing for a family. I think you need to have somebody who has the ability to speak the truth in the middle of a crisis or in the buildup to a crisis and can have the protection. There are really two roles that you think about in terms of systemic regulation. One is advisory, seeing and understanding the risks, and then speaking about them. The second one is the actual regulatory implementation, the different actions you might take in terms of how capital requirements--or how the institutions themselves are regulated. And I think it is very important to separate those two, and making the National Institute of Finance independent would do that. A second point that you want to consider in terms of why you want to keep the National Institute of Finance independent and why you want to also have somebody of high stature involved who is a Presidential appointee, who is going to be able to serve not at the will of the President but for a fixed term, is that if there is a crisis, again, that does happen and the National Institute of Finance is in place, all eyes will turn to the National Institute of Finance. And it needs to have absolute credibility. It needs in some sense to be like the National Oceanic and Atmospheric Administration. When it speaks, it is not speaking because it has some political agenda or because it has to worry about whether its budget is going to be cut or not cut. It is speaking because it is trying to serve the best interests of the Nation. Senator Reed. I want to invite the other panelists to comment also, but one other factor that I think strikes me is that it goes to your point about surprise, and I thought the analogy with the hurricane of 1938 was--I will borrow it. It seems very compelling. But part of this was this was never seriously discussed at a national level--``this'' meaning the growing housing bubble, the national characteristics of it, the growing derivatives trade from a notional value of X to 200X. And as a result, it sort of got lost in the shuffle, and I think one of the purposes of having an agency like this is to get critical topics on the agenda of Congress and the regulators. Then it is our responsibility. But if you do not have an authoritative institution supported by data doing that, then the problem I think you will have is that the next time it will be something different. It will not be a housing bubble and subprime mortgages. It will be something we are not even thinking about, and it will come up. Regulators will talk about it. I am sure the Fed debated internally about the housing bubble. I am sure that the OCC and everybody did. But it never broke through because there was no one tasked with saying this is a serious systemic risk or should be considered at least at this juncture as such. So that is my two bits on the point. Dr. Engle, please, and then Mr. Horne. " FinancialCrisisInquiry--82 Many people got preferred stocks, and other things you’d see the same. The yields reached, in some cases, I know, at least as high as 30 percent. So I think the investors, actually, are pricing in a deep discount. What they individually did, you’d have to ask— you could get panels of investors to say, but during those tough times, I don’t think any of us in the industry didn’t think about the ramifications of what could happen if we could—if the liquidity and stuff was not at least restored in the system in some regard. MACK: I think after Lehman was allowed to fail, that no investor—at least in Morgan Stanley— was thinking we were too big to fail or the government would come in and help us. As a result, the stock traded at one point down to $6.71. If they had a view that that was not the case, the stock would have never gotten that low. So I think Lehman sent a wake-up call to any investor out there that the government was here to help you and would get you through this crisis. At the board level, it was never discussed. It was never discussed if we get into where the Japanese are not going to put the money that they invested in with us, would we be bailed out by the United States government. It was never discussed, never thought about. DIMON: You raise a very interesting question, and because at no point before the crisis did the market price these firms like they’re too big to fail. And all you have to do is look at what they paid... HENNESSEY: CHRG-111shrg53085--2 Chairman Dodd," The Committee will come to order. Good morning, everyone, and welcome to the Senate Banking Committee. Let me welcome my colleagues and our witnesses and the guests who are here in the audience. We appreciate your presence here this morning. This morning we will hold what amounts to our eighth full Committee hearing on the subject matter of modernization of Federal regulations. Today, we are talking about the modernization of bank supervision and regulation. This morning I want to welcome our witnesses. We have got a very distinguished panel of witnesses who are here to share some thoughts with us. We are going to again explore ways in which we will try to modernize and improve bank regulation and supervision to better protect consumers and restore confidence in our banking system. We do so at a time when our country's massive challenges loom very large indeed. All of us in the Congress of the United States, Democrats and Republicans alike, are trying to work together to meet these challenges and restore public confidence in our financial institutions. In the coming weeks, we will be working on critical legislation to lay out a long-term budget blueprint to address our continuing financial crisis and to address the issue of executive compensation. As we continue to address the economic crisis going forward, I think it is important we recognize that not all banks are responsible for this crisis. Quite the contrary. And as Chairman Bernanke has said only recently, small bank lending might very well help lead the way out of this crisis in many places. None of this is to suggest that small banks do not face economic troubles of their own, of course. Some do, and on an almost weekly basis, we hear stories about how the FDIC takes over banks and works to reassure depositors that their money will be safe. But it would be a mistake to paint every financial institution with the same broad brush, and as I have heard from community banks around my State of Connecticut, many of our community banks are in far better shape right now than the financial system is as a whole. Why? Well, in part because when the financial institutions align their practices and incentives with their long-term health, they are far less prone to engage in riskier behavior. They are far less likely to put their companies and the economic security of the American consumer at risk. Former Fed Chairman Greenspan believes companies would not take such extraordinary risks, because their own survival could be in jeopardy. Clearly, he was wrong, and that assumption cost the American people dearly. Some of that failure can be attributed to the prevailing ideology of the moment, ranging from the abusive terms mortgage lenders offered to the practices credit card companies still engage in. Many of us believe that if we had failed to protect the consumer, we failed to protect our economy. Others felt, of course, just the opposite. Many of us believed that if we had skin in the game, we would all take the consequences of our actions more seriously. Others were confident risk could be managed. Today, it is clear that consistent regulation across our financial architecture is paramount, and that with strong cops on the beat in every neighborhood, institutions would be far less likely to push risk onto the consumer. Regulators are the first line of defense for consumers and depositors, which is why we need to end the practice of shopping for the most lenient regulator and consider creating a single coordinated prudential regulator. In a crisis created first and foremost by our failure to protect consumers, we cannot afford to consider a so-called systemic risk regulator without also considering how we can better protect the consumers. All too often in this crisis, we saw that the relationship between the consumer and their financial institutions was, in effect, severed because of a lack of incentives to ensure loans are paid off down the road. That was not true of smaller institutions like those in my State and those of my colleagues' here. Like so many credit unions and community banks, they recognized something very simple: that your company reaps the benefits when you treat your customers fairly. With this hearing, I hope we can take a close look at how these values can be the building blocks for a modernized 21st century financial architecture in our country. That must be our goal, not only today but in the coming weeks, as we are charged with the responsibility of modernizing the Federal financial regulations. With that, let me turn to Senator Shelby, and then I will quickly turn to my colleagues for any comments they want, and then we will go to our witnesses. CHRG-111hhrg53238--115 The Chairman," The gentlewoman from California, Ms. Waters. And we will break after this. I must say, it is not entirely clear if we will be able to reconvene this panel. We have five votes, I am informed, leading with a 15-minute vote. I am told that Members are advised that additional Republican procedural votes are possible during this next series of votes. So if we have not been able to conclude by about 1:30--if we are not back by 1:30, goodbye. Ms. Waters. Mr. Chairman and members, I almost hesitate to ask you any questions. I am just dumbfounded that we have before us representatives of the overall industry here today who do not appear to understand we have a crisis. We have rising foreclosures. There is no end. And the tale keeps going on and on and on. And you come here today and say, don't try to stop us from having any kind of product we can come up with that we can put on the market, no matter what you say about some kind of standard product. We have products for any and everybody, whatever you can think of. Someone just said to me, maybe I should design my own product for you. Well, let me just say that, in addition to no support, no real support for a consumer finance agency to protect consumers from these exotic products that worry us so much, we are confronted with our constituents who are trying to get loan modifications. You can't even do that right. You can't set up systems where you can train enough people, that you can have telephone responses, that you can work out modifications and we can do something about keeping people in their homes. You don't come here with any real instructions, advice, or plans that you can share with us to deal with the crisis that we are having. All you can do is come here and talk about preemption, knowing full well that you will work your magic with your influence in the Congress of the United States to keep any real strong legislation from coming out of here; and you want to prevent the States from coming up with anything that would cause you any kind of concerns at all. What do I have to ask you? I don't know what I have to ask you. Would somebody answer me whether or not you think there is a crisis? Anybody? Is there a crisis? " CHRG-111hhrg49968--104 Mr. Bernanke," Sir, in dealing with a situation like this, there is the immediate emergency response and then there is the longer-term actions you want to take. On the emergency response, the two lessons I learned from studying the Great Depression are, first, that monetary policy has to respond aggressively. The Fed did not respond in the early thirties, and we, of course, have done that. The second is that maintaining financial stability is absolutely critical. And as you know, we have taken a number of measures--some of them quite extraordinary--working with the Treasury to prevent a meltdown in the financial system. And I believe that we have averted a much worse outcome by taking those steps. Going forward, we certainly want to avoid this kind of crisis happening in the future. We have learned a lot of lessons from the recent experience. I think we will have to have stronger oversight of the large firms, maybe higher capital. We need to have resolution regimes, as I mentioned earlier, to help resolve failing firms. And I believe we need to strengthen the financial infrastructure. But I would also say that I think we do need to take a more system-wide approach to regulation. Instead of looking only at individual firms where agency A is responsible for firm one and agency B is responsible for firm two, that there needs to be a more collaborative approach that looks at the whole system and make sure they aren't building risks in one area that are being ignored because they don't bear on a particular firm. So I think a more macro-prudential or system-wide approach would be helpful. " 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. CHRG-111hhrg48873--439 Secretary Geithner," Well, you are right to express that concern, and we are going to have to make sure that we design these conditions carefully to help mitigate that risk. And we are going to have to come to a better balance with the Congress as again we try to figure out how to respond to the reasonably perfectly understandable public outrage. We are not using public assistance to reward failure, but still get our system working again, and that is going to require people taking risk, be willing to take risk so the government doesn't have to assume all the losses in solving this financial crisis. And we are going have to get to a better place, both the Congress and the Executive Branch, on this very complicated question. " CHRG-111shrg55278--3 STATEMENT OF SENATOR RICHARD C. SHELBY Senator Shelby. Thank you, Mr. Chairman. At the core of the Administration's financial regulatory reform proposal is the concept of systemic risk. The President believes that it can be regulated and that the Fed should be the regulator. But as we begin to consider how to address systemic risk, my main concern is that while there appears to be a growing consensus on the need for a systemic risk regulator, there is no agreement on how to define systemic risk, let alone how to manage it. I believe that it would be legislative malfeasance to simply tell a particular regulator to manage all financial risk without having reached some consensus on what systemic risk is and whether it can be regulated at all. Should we reach such a consensus, I believe we then must be very careful not to give our markets a false sense of security that could actually exacerbate our ``too-big-to-fail'' problem. If market participants believe that they no longer have to closely monitor risk presented by financial institutions, the stage will be set for our next economic crisis. If we can decide what systemic risk is and that it is something that should and can be regulated, I believe our next question should be: Who should regulate it? Unfortunately, I believe the Administration's proposal largely places the Federal Reserve in charge of regulating systemic risk. It would grant the Fed, as I understand the white paper, authority to regulate any bank, securities firm, insurer, investment fund, or any other type of financial institution that the Fed deems a systemic risk. The Fed would be able to regulate any aspect of these firms, even over the objections of other regulators. In effect, the Fed would become a regulator giant of unprecedented size and scope. I believe that expanding the Fed's power in this manner could be very dangerous. The mixing of monetary policy and bank regulation has proven to be a formula for taxpayer-funded bailouts and poor monetary policy decisions. Giving the Fed ultimate responsibility for the regulation of systemically important firms will provide further incentives for the Fed to hide its regulatory failures by bailing out troubled firms. Rather than undertaking the politically painful task of resolving failed institutions, the Fed could take the easy way out and rescue them by using its lender-of-last-resort facilities or open market operations. Even worse, it could undertake these bailouts without having to obtain the approval of the Congress. In our system of Government, elected officials should make decisions about fiscal policy and the use of taxpayers' dollars, not unelected central bankers. Handing over the public purse to an enhanced Fed is simply inconsistent with the principles of democratic Government. Augmenting the Federal Reserve's authority also risks burdening it with more responsibility than one institution can reasonably be expected to handle. In fact, the Federal Reserve is already overburdened with its responsibility for monetary policy, the payment system, consumer protection, and bank supervision. I believe anointing the Fed as the systemic risk regulator will make what has proven to be a bad bank regulator even worse. Let us not forget that it was the Fed that pushed for the adoption of the flawed Basel II Capital Accords right here in this Committee which would have drained our banking system of capital. It was the Fed that failed to adequately supervise Citigroup and Bank of America, setting the stage for bailouts in excess of $400 billion there. It was the Fed that failed to adopt mortgage underwriting guidelines until well after this crisis was underway. Yes, it was the Fed that said there was no need to regulate derivatives right here in this Committee. It was also the Fed that lobbied to become the regulator of financial holding companies as part of Gramm-Leach-Bliley. The Fed won that fight and got the additional authority it sought. Ten years later, however, it is clear that the Fed has proven that it is incapable of handling that responsibility. Ultimately, I believe if we are able to reach some sort of agreement on systemic risk and whether it can be managed, I strongly believe that we should consider every possible alternative to the Fed as a systemic risk regulator. Thank you, Mr. Chairman. " fcic_final_report_full--447 The role of Fannie Mae and Freddie Mac in causing the crisis The government-sponsored enterprises Fannie Mae and Freddie Mac were elements of the crisis in several ways: • They were part of the securitization process that lowered mortgage credit quality standards. • As large financial institutions whose failures risked contagion, they were massive and multidimensional cases of the too big to fail problem. Policymakers were un- willing to let them fail because: – Financial institutions around the world bore significant counterparty risk to them through holdings of GSE debt; – Certain funding markets depended on the value of their debt; and – Ongoing mortgage market operation depended on their continued existence. • They were by far the most expensive institutional failures to the taxpayer and are an ongoing cost. There is vigorous debate about how big a role these two firms played in securitiza- tion relative to “private label” securitizers. There is also vigorous debate about why these two firms got involved in this problem. We think both questions are less impor- tant than the multiple points of contact Fannie Mae and Freddie Mac had with the fi- nancial system. These two firms were guarantors and securitizers, financial institutions holding enormous portfolios of housing-related assets, and the issuers of debt that was treated like government debt by the financial system. Fannie Mae and Freddie Mac did not by themselves cause the crisis, but they contributed significantly in a number of ways. THE SYSTEM FREEZING Following the shock and panic, financial intermediation operated with escalating frictions. Some funding markets collapsed entirely. Others experienced a rapid blowout in spreads following the shock and stabilized slowly as the panic subsided and the government stepped in to backstop markets and firms. We highlight three funding markets here: • Interbank lending. Lending dynamics changed quickly in the federal funds market where banks loan excess reserves to one another overnight. Even large banks were unable to get overnight loans, compounding an increasingly re- stricted ability to raise short-term funds elsewhere. • Repo. By September , repo rates increased substantially, and haircuts bal- looned. Nontraditional mortgages were no longer acceptable collateral. • Commercial paper. The failure of Lehman and the Reserve Primary Fund breaking the buck sparked a run on prime money market mutual funds. Money market mutual funds withdrew from investing in the commercial paper mar- ket, leading to a rapid increase in funding costs for financial and nonfinancial firms that relied on commercial paper. CHRG-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-110hhrg44900--36 Mr. Kanjorski," Thank you, Mr. Chairman. Secretary Paulson, Chairman Bernanke, listening to your response to the chairman about timing, since last August of course all of us have examined and watched market failure occurring in various and sundry areas growing from subprime failure in August to what we call now a credit crisis. And the information that I am receiving from some entities is that the end is not here; there are other shoes to fall. And what occurs to me is that this gap we are talking about between now and when the new Congress convenes it could pass the emergency powers or extraordinary powers or change powers that are necessary to meet this crisis. It is probably for all intents and purposes 9 months at least. In the meantime, between now and March or April of next year, what type of anticipated problems could we be dealing with or could you be dealing with and the American economy be dealing with that we should take cognizance of now? And is there perhaps a need for extraordinary emergency legislation to empower either the Federal Reserve or Treasury to take certain actions to prevent systemic risk if over the next 9-month period the Congress is not able to act and you discern that the powers you have are not adequate to meet the challenges? That hiatus seems to me to be one that we have to address now. Mr. Secretary? " 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-111hhrg48875--167 Secretary Geithner," There is a third question about who should be responsible for what we are calling here the systemic, core responsibilities in the system. And as I said in my opening statement, there are a range of issues we are going to have to look at to deliver a more streamlined consolidated financial oversight framework. And we want to make sure that we have the right division of labor. There is clarity about responsibility. The responsibility is matched with authority. And the guys who are responsible are competent to execute that. We are open to looking at a range of suggestions for how that authority should be framed and where that should be lodged in the system. But let me just give you a few basic principles. And this is, again, the authority we are calling the Systemic Risk Authority. It should not be the Treasury. It needs to be vested in an independent supervisory authority. I do not believe it should be pulled together in one independent agency. I think too much concentrated power for all that regulatory authority would be not a sensible thing for the country. I think it is probably best to build on the existing authorities that we have for holding companies under the current statute. And I want to end with just one basic example, which is that, you know, in a fire, the fire station needs to understand the neighborhood. It needs to know the neighborhood it is operating in. And you don't want to have to convene a committee before it can get the engines out of the station. So it has to be able to move very, very quickly in extremis with the knowledge so it can make sensible judgments. And there is a good pragmatic case, I believe, looking at the lessons of crises in our country and around the world, to try to have that authority for crisis management matched with the authority for mitigating systemic risk. Not too much concentration. Not vested within the Treasury. Appropriate checks and balances. But there is a range of those three different areas we have to make some judgments about responsibility. " CHRG-111hhrg53234--164 Mr. Meltzer," Thank you, Chairman Watt. And greetings to my old friend, Congressman Ron Paul, and to the members. Thank you for the opportunity to present my appraisal of the Administration's proposal for regulatory changes. I will confine most of my comments to the role of the Federal Reserve as a systemic regulator, and will offer an alternative proposal much closer to the Republican proposal. I share the belief that change is needed and long delayed, but appropriate change must protect the public, not the bankers. During much of the past 15 years, I have written three volumes entitled, ``A History of the Federal Reserve.'' Working with two assistants, we have read virtually all of the of the minutes of the Board of Governors, the Federal Open Market Committee, and the Directors of the New York Federal Reserve Bank. We have also read many of the staff papers and the internal memos supporting decisions. I speak from that perspective. Two findings are very relevant for the role of the Federal Reserve. First, I do not know of any single clear example in which the Federal Reserve acted in advance to head off a crisis or a series of banking and financial failures. We all know of several where it failed to act in advance. Members of Congress should ask themselves this question: Can you expect the Federal Reserve or anyone else as systemic regulators to close Fannie Mae and Freddie Mac after Congress has decided that it declined to act? What kind of a conflict is that going to pose? And how is it going to be resolved? Second, in its 96-year history, the Federal Reserve has never announced a lender of last resort policy. It has discussed internally the content of such a policy several times, but it rarely announced what it would do. And the announcements that it made, as in 1987, were limited to the circumstances of that time. Announcing and following a policy would alert financial institutions to the Fed's expected actions and might reduce pressures on Congress to aid failing entities. Following the rule in a crisis, the lender-of-last-resort rule in a crisis would change bankers' incentives and reduce moral hazard. A crisis policy rule is long overdue. The Administration proposal recognizes the need, but doesn't propose the rule. Experiences in the past from the history suggest three main lessons: First, we cannot avoid banking failures, but we can keep them from spreading and creating crises; Second, neither the Federal Reserve nor any other Agency has succeeded in predicting crises or anticipating systemic failure. It is hard to do, in part because systemic risk is not well defined. Reasonable people will differ, and since much is often at stake, some will fight hard to deny that there is a systemic risk. One of the main reasons that Congress in 1991 passed FDICIA, the Federal Deposit Insurance Corporation Improvement Act, was to prevent the Federal Reserve from delaying closure of failing banks, increasing losses, and weakening the FDIC fund. The Federal Reserve and the FDIC have not used FDICIA against large banks in this crisis. That should change. The third lesson is that a successful policy will alter bankers' incentives and avoid moral hazard. Bankers must know that risk-taking brings both rewards and costs, including failure, loss of managerial position and equity, followed by sale of continuing operations. Several reforms are needed to reduce or eliminate the cost of financial failure to the taxpayers. Members of Congress should ask themselves and each other, is the banker or the regulator more likely to know about the risks on the bank's balance sheet? Of course, it is the banker, and especially so if the banker is taking large risks that he wants to hide. To me, that means the reform should start by increasing the banker's responsibility for losses. The Administration proposal does the opposite, by making the Federal Reserve responsible for systemic risk. Systemic risk is a term of art; I doubt that it can be defined in a way that satisfies the many parties involved in regulation. Members of Congress will properly urge that any large failure in their district is systemic. Administrations and regulators will have other objectives. Without a clear definition, the proposal will bring frequent controversy, and without a clear definition, the proposal is incomplete. Resolving the conflicting interests is unlikely to protect the general public. More likely, regulators will claim that they protect the public by protecting the banks. I think that is wrong. I believe there are better alternatives than the Administration's proposal. First step, end ``too big to fail.'' Require all financial institutions to increase capital more than in proportion to the increase in the size of their assets. ``Too big to fail'' is perverse; it allows banks to profit in good times and shifts the losses to the taxpayers when crises or failures occur. Second step, require the Federal Reserve to announce a rule for ``lender of last resort.'' Congress should adopt a rule that they are willing to sustain. The rule should give banks an incentive to hold collateral to be used in a crisis period. Bagehot's Rule from the 19th Century Bank of England is a great place to start. Third step, recognize that regulation is an ineffective way to change behavior. My first rule of regulation states that lawyers regulate, but markets circumvent burdensome regulation. The Basel Accord is a current example. It told banks to hold more reserves if they held more risky assets. So they put the assets off their balance sheets. Later, after the fact, they had to take them back, but that was after the fact. Fourth step, recognize that regulators do not allow for the incentives induced by their regulations. In the dynamic financial markets, it is difficult, perhaps impossible, to anticipate how clever market participants will circumvent the rules without violating them. The fifth step, either extend FDICIA to include holding companies or subject financial holding companies to bankruptcy law. Make the holding company subject to early intervention either under FDICIA or under bankruptcy law. That not only reduces or eliminates taxpayer losses, but it also encourages prudential behavior. Other important changes should be made. Congress should close Fannie Mae and Freddie Mac and put any subsidy for low-income housing on the budget. The same should be done to other credit market subsidies. The budget is the proper place for subsidies. Three principles should be borne in mind: First, banks borrow short and lend long. Unanticipated large changes can and will cause failures. Our problem is to minimize the costs of failures to society. Second, remember that capitalism without failure is like religion without sin. It removes incentives for prudent behavior. Third, those that rely on regulation to reduce risks should recall that this is the age of Madoff. The Fed, too, lacks a record of success in managing large risks to the financial system, the economy, and the public. Incentives for fraud, evasion, and circumvention of regulation often have been more powerful than incentives to enforce regulation that protects the public. Thank you, sir. [The prepared statement of Dr. Meltzer can be found on page 71 of the appendix.] " CHRG-111hhrg56776--251 Mr. Meltzer," Thank you, Mr. Chairman. Happy St. Patrick's Day. It's a pleasure to be here again. Both Houses of Congress have worked hard to develop means of reducing greatly the risk of future financial crises. I believe they have neglected to remove completely the two most important causes of the recent crisis. First, in my opinion, the disastrous mortgage and housing problem, especially the rules as followed by Fannie Mae and Freddie Mac and all recent Administrations. If they had not existed, the crisis would not have happened. Second, without advance warning, the Treasury and the Federal Reserve ended a 30-year policy of ``too-big-to-fail'' in the midst of a recession by letting Lehman fail. The first reform, the one that is ignored most is, I believe you need to put Fannie Mae and Freddie Mac on the budget the way--with a subsidy on the budget. It's not a question of whether there should be a housing and mortgage policy; it's where it should be located. It should not be located as a subsidy through the financial markets, subsidies in a well-run democratic country are on the budget. After the failure, after the mistake of allowing Lehman to fail, the Fed acted forcefully, directly, aggressively, and intelligently to prevent the failure from spreading. What we want to consider is what might be done to avoid a repeat of government policy failure. ``Too-big-to-fail'' encouraged some large bankers, to use the word of the then-chairman of Citigroup, ``to get up to dance when the music was playing.'' That was a mistake. That mistake, I believe, would not have happened if there were not--if he didn't believe that he could take the risks and allow the taxpayers to pay the losses. The taxpayers, indeed, paid for the losses. So did he. We need a system that protects the public. The current system leans toward protecting the banks. It's important, most important, to end ``too-big-to-fail'' in a way that will work in crises. Regulation often fails. We have the examples of Madoff, Stanford, the structured--the SIVs that circumvented the Basel Accord Basel regulated risks. The markets circumvented it. Ask yourselves what happened to FDICIA. This committee, in 1991, passed a rule that said we're going to try to do early intervention before companies fail, before banks fail. It didn't happen. FDICIA has been missing. Is that unusual? No. It's the common effect of regulation. The first law of regulation, my first law of regulation is that bureaucrats, lawyers make regulations. Markets learn to circumvent the costly ones. The second law of regulation is regulation is static; markets are dynamic. If they don't figure out how to circumvent them at first, they will after a while. That's what has happened very often in the case of regulation. So you need to do something. You must regulate, but you have to regulate in ways that rely on incentives that affect the way the bankers behave. And my proposal is, you want to tie the capital standards to the size of the bank. Let the banks choose their size. Beyond some minimum size, say $10 billion, for every 1 percent they increase their assets, they have to increase their capital by 1.2 percent. That way, the capital ratio will go up and up and up with the size of the bank and that will limit the size of the bank and it will put the stockholders and the management at risk. That's the way to prevent failures. One other step: If failures occur, markets require something to be done about the counterparties. In the 96 years of its history, the Fed has never announced or followed a consistent lender of last resort policy. Never. They have never announced it. They have discussed it internally many times. They have never had a consistent policy. Congress should insist on a lender of last resort policy and it has to be one that the Congress will honor in a crisis. So it should negotiate with the management of the Fed to choose a lender of last resort strategy that the Congress is willing to honor. Let me say a few other things in my remaining 10 seconds. First, the regulators talk about systemic risk, and there's a systemic risk council. No one can define systemic risk in an operational way. You and your colleagues will properly say there is a large failure in your district. It's a responsibility to do something about it. That's a systemic risk as far as you're concerned. Who will decide on systemic risk? The Secretary of the Treasury. Who has been the person most active in bailouts? The Secretary of the Treasury. Therefore, moving to a systemic risk council with the Secretary of the Treasury as its chairman is an invitation to continue to do the things we have been doing: bailing them out. " CHRG-111shrg51290--60 STATEMENT OF STEVE BARTLETT President and Chief Executive Officer, Financial Services Roundtable March 3, 2009 Chairman Dodd, Ranking Member Shelby and Members of the Senate Banking Committee. I am Steve Bartlett, President and Chief Executive Officer of the Financial Services Roundtable. The Roundtable is a national trade association composed of the nation's largest banking, securities, and insurance companies. Our members provide a full range of financial products and services to consumers and businesses. Roundtable member companies provide fuel for America's economic engine, accounting directly for $85.5 trillion in managed assets, $965 billion in revenue, and 2.3 million jobs. On behalf of the members of the Roundtable, I wish to thank you for the opportunity to participate in this hearing on the role of consumer protection regulation in the on-going financial crisis. Many consumers have been harmed by this crisis, especially mortgage borrowers and investors. Yet, the scope and depth of this crisis is not simply a failure of consumer protection regulation. As I will explain in a moment, the root causes of this crisis are found in basic failures in many, but not all financial services firms, and the failure of our fragmented financial regulatory system. I also believe that this crisis illustrates the nexus between consumer protection regulation and safety and soundness regulation. Consumer protection and safety and soundness are intertwined. Prudential regulation and supervision of financial institutions is the first line of defense for protecting the interests of all consumers of financial products and services. For example, mortgage underwriting standards not only help to ensure that loans are made to qualified borrowers, but they also help to ensure that the lender gets repaid and can remain solvent. Given the nexus between the goals of consumer protection and safety and soundness, we do not support proposals to separate consumer protection regulation and safety and soundness regulation. Instead, we believe that the appropriate response to this crisis is the establishment of a better balance between these two goals within a reformed and more modern financial regulatory structure. Moreover, I would like to take this opportunity to express the Roundtable's concerns with the provision in the Omnibus Appropriations bill that would give State attorneys generals the authority to enforce compliance with the Truth-in-Lending Act (TILA) and would direct the Federal Trade Commission to write regulations related to mortgage lending. As I will explain further, we believe that one of the fundamental problems with our existing financial regulatory system is its fragmented structure. This provision goes in the opposite direction. It creates overlap and the potential for conflict between the Federal banking agencies, which already enforce compliance with TILA, and State AGs. It also creates overlap and the potential conflict between the Federal banking agencies, which are responsible for mortgage lending activities, and the Federal Trade Commission. While it may be argued that more ``cops on the beat'' can enhance compliance, more ``cops'' that are not required to act in any coordinated fashion will simply exacerbate the regulatory structural problems that contributed to the current crisis. My testimony is divided into three parts. First, I address ``What Went Wrong.'' Second, I address ``How to Fix the Problem.'' Finally, I take this opportunity to comment on the lending activities of TARP-assisted firms, and the Roundtable's continuing concerns over the impact of fair value accounting.What Went Wrong The proximate cause of the current financial crisis was the nation-wide collapse of housing values, and the impact of that collapse on individual homeowners and the holders of mortgage-backed securities. The crisis has since been exacerbated by a serious recession. The root causes of the crisis are twofold. The first was a clear breakdown in policies, practices, and processes at many, but not all, financial services firms. Poor loan underwriting standards and credit practices, excessive leverage, misaligned incentives, less than robust risk management and corporate governance are now well known and fully documented. Corrective actions are well underway in the private sector as underwriting standards are upgraded, credit practices reviewed and recalibrated, leverage is reduced as firms rebuild capital, incentives are being realigned, and some management teams have been replaced, while whole institutions have been intervened by supervisors or merged into other institutions. So needed corrective actions are being taken by the firms themselves. More immediately, we need to correct the failures that the crisis exposed in our complex and fragmented financial regulatory structure. Crises have a way of revealing structural flaws in regulation, supervision, and our regulatory architecture that have long-existed, but were little noticed until the crisis exposed the underlying weaknesses and fatal gaps in regulation and supervision. This one is no different. It has revealed significant gaps in the financial regulatory system. It also revealed that the system does not provide for sufficient coordination and cooperation among regulators, and that it does not adequately monitor the potential for market failures, high-risk activities, or vulnerable interconnections between firms and markets that can create systemic risk and result in panics like we saw last year and the crisis that lingers today. The regulation of mortgage finance illustrates these structural flaws in both regulation and supervision. Many of the firms and individuals involved in the origination of mortgage were not subject to supervision or regulation by any prudential regulator. No single regulator was held accountable for identifying and recommending corrective actions across the activity known as mortgage lending to consumers. Many mortgage brokers are organized under State law, and operated outside of the regulated banking industry. They had no contractual or fiduciary obligations to brokers who referred loans to them. Likewise, many brokers were not subject to any licensing qualifications and had no continuing obligations to individual borrowers. Most were not supervised in a prudential manner like depository institutions engaged in the same business line. The Federal banking regulators recognized many of these problems and took actions--belatedly--to address the institutions within their jurisdiction, but they lacked to power to reach all lenders. Eventually, the Federal Reserve Board's HOEPA regulations did extend some consumer protections to a broader range of lenders, but the Board does not have the authority to ensure that those lenders are engaged in safe and sound underwriting practices or risk management. The process of securitization suffered from a similar lack of systemic oversight and prudential regulation. No one was responsible for addressing the over-reliance investors placed upon the credit rating agencies to rate mortgage-backed securities, or the risks posed to the entire financial system by the development of instruments to transfer that risk worldwide.How to Fix the Problem How do we fix this problem? Like others in the financial services industry, the members of the Financial Services Roundtable have been engaged in a lively debate over how to better protect consumers by addressing the structural flaws in our current financial regulatory system. While our internal deliberations continue, we have developed a set of guiding principles and a ``Draft Financial Regulatory Architecture'' that is intended to close the gaps in our existing financial regulatory system. We are pleased that the set of regulatory reform principles that President Obama announced last week are broadly consistent and compatible with the Roundtable's principles for much needed reforms. Our first principle in our 2007 Blueprint for U.S. Financial Modernization was to ``treat consumers fairly.'' Our current principles for regulatory reform this year build on that guiding principle and call for: 1) a new regulatory architecture; 2) common prudential and consumer and investor protection standards; 3) balanced and effective regulation; 4) international cooperation and national treatment; 5) failure resolution; and 6) accounting standards. Our plan also seeks to encourage greater coordination and cooperation among financial regulators, and to identify systemic risks before they materialize. We also seek to rationalize and simplify the existing regulatory architecture in ways that make more sense in our modern, global economy. The key features of our proposed regulatory architecture are as follows. Financial Markets Coordinating Council To enhance coordination and cooperation among the many and various financial regulatory agencies, we propose to expand membership of the President's Working Group on Financial Markets (PWG) and rename it as the Financial Markets Coordinating Council (FMCC). We believe that this Council should be established by law, in contrast to the existing PWG, which has operated under a Presidential Executive Order since 1988. This would permit Congress to oversee the Council's activities on a regular and ongoing basis. We also believe that the Council should include representatives from all major Federal financial agencies, as well as individuals who can represent State banking, insurance, and securities regulation. This Council could serve as a forum for national and State financial regulators to meet and discuss regulatory and supervisory policies, share information, and develop early warning detections. In other words, it could help to better coordinate policies within our still fragmented regulatory system. We do not believe that the Council should have independent regulatory or supervisory powers. However, it might be appropriate for the Council to have some ability to review the goals and objectives of the regulations and policies of Federal and State financial agencies, and thereby ensure that they are consistent.Federal Reserve Board To address systemic risk, we believe the Federal Reserve Board (Board) should be authorized to act as a market stability regulator. As a market stability regulator, the Board should be responsible for looking across the entire financial services sector to identify interconnections that could pose a risk to our financial system. To perform this function, the Board should be empowered to collect information on financial markets and financial services firms, to participate in joint examinations with other regulators, and to recommend actions to other regulators that address practices that pose a significant risk to the stability and integrity of the U.S. financial services system. The Board's authority to collection information should apply not only to depository institutions, but also to all types of financial services firms, including broker/dealers, insurance companies, hedge funds, private equity firms, industrial loan companies, credit unions, and any other financial services firms that facilitate financial flows (e.g., transactions, savings, investments, credit, and financial protection) in our economy. Also, this authority should not be based upon the size of an institution. It is possible that a number of smaller institutions could be engaged in activities that collectively pose a systemic risk.National Financial Institutions Regulator To reduce gaps in regulation, we propose the consolidation of several existing Federal agencies into a single, National Financial Institutions Regulator (NFIR). This new agency would be a consolidated prudential and consumer protection agency for banking, securities and insurance. More specifically, it would charter, regulate and supervise (i) banks, thrifts, and credit unions, currently supervised by the Office of the Thrift Supervision, the Office of the Comptroller of the Currency, and the National Credit Union Administration; (ii) licensed broker/dealers, investment advisors, investment companies, futures commission merchants, commodity pool operators, and other similar intermediaries currently supervised by the Securities and Exchange Commission or the Commodities Futures Trading Commission; and (iii) insurance companies and insurance producers that select a Federal charter. The AIG case illustrates the need for the Federal Government to have the capacity to supervise insurance companies. Also, with the exception of holding companies for banks, the NFIR would be the regulator for all companies that control broker/dealers or national chartered insurance companies. The NFIR would reduce regulatory gaps by establishing comparable prudential standards for all of these of nationally chartered or licensed entities. For example, national banks, Federal thrifts and federally licensed brokers/dealers that are engaged in comparable activities should be subject to comparable capital and liquidity standards. Similarly, all federally chartered insurers would be subject to the same prudential and market conduct standards. In the area of mortgage origination, we believe that the NFIR's prudential and consumer protection standards should apply to both national and State lenders. Mortgage lenders, regardless of how they are organized, should be required to retain some of the risk for the loans they originate (keep some ``skin-in-the-game''). Likewise, mortgage borrowers, regardless of where they live or who their lender is, should be protected by the same safety and soundness and consumer standards. As noted above, we believe that is it important for this agency to combine both safety and soundness (prudential) regulation and consumer protection regulation. Both functions can be informed, and enhanced, by the other. Prudential regulation can identify practices that could harm consumers, and can ensure that a firm can continue to provide products and services to consumers. The key is not to separate the two, but to find an appropriate balance between the two.National Capital Markets Agency To focus greater attention on the stability and integrity of financial markets, we propose the creation of a National Capital Markets Agency through the merger of the Securities and Exchange Commission (SEC) and the Commodities Futures Trading Commission (CFTC), preserving the best features of each agency. The NCMA would regulate and supervise capital markets and exchanges. As noted above, the existing regulatory and supervisory authority of the SEC and CFTC over firms and individuals that serve as intermediaries between markets and customers, such as broker/dealers, investment companies, investment advisors, and futures commission merchants, and other intermediaries would be transferred to the NFIR. The NCMA also should be responsible for establishing standards for accounting, corporate finance, and corporate governance for all public companies.National Insurance Resolution Authority To protect depositors, policyholders, and investors, we propose that the Federal Deposit Insurance Corporation (FDIC) would be renamed the National Insurance and Resolution Authority (NIRA), and that this agency act not only as an insurer of bank deposits, but also as the guarantor of retail insurance policies written by nationally chartered insurance companies, and a financial backstop for investors who have claims against broker/dealers. These three insurance systems would be legally and functionally separated. Additionally, this agency should be authorized to act as the receiver for large non-bank financial services firms. The failure of Lehman Brothers illustrated the need for such a better system to address the failure of large non-banking firms.Federal Housing Finance Agency Finally, to supervise the Federal Home Loan Banks and to oversee the emergence and future restructuring of Fannie Mae and Freddie Mac from conservatorship we propose that the Federal Housing Finance Agency remain in place, pending a thorough review of the role and structure of the housing GSEs in our economy.TARP Lending and Fair Value Accounting Before I close I would like to address two other issues of importance to policymakers and our financial services industry: lending by institutions that have received TARP funds, and the impact of fair value accounting in illiquid markets. Lending by institutions that have received TARP funds has become a concern, especially given the recessionary pressures facing the economy. I have attached to this statement a series of tables that the Roundtable has compiled on this issue. Those tables show the continued commitment of the nation's largest financial services firms to lending. Fair value accounting also is a major concern for the members of the Roundtable. We continue to believe that the pro-cyclical effects of existing policies are unnecessarily exacerbating this crisis. We urge this Committee to direct financial regulators to adjust current accounting standards to reduce the pro-cyclical effects of fair value accounting in illiquid markets. We also urge the U.S. and international financial regulators coordinate and harmonize regulatory policies to development accounting standards that achieve the goals of transparency, understandability, and comparability.Conclusion Thank you again for the opportunity to appear today to address the connection between consumer protection regulation and this on-going financial crisis. The Roundtable believes that the reforms to our financial regulatory system we have developed would substantially improve the protection of consumers by reducing existing gaps in regulation, enhancing coordination and cooperation among regulators, and identifying systemic risks. We also call on Congress to address the continuing pro-cyclical effects of fair value accounting. Broader regulatory reform is important not only to ensure that financial institutions continue to meet the needs of all consumers but to restart economic growth and much needed job creation. Financial reform and ending the recession soon are inextricably linked--we need both. We need a financial system that provides market stability and integrity, yet encourages innovation and competition to serve consumers and meet the needs of a vibrant and growing economy. We need better, more effective regulation and a modern financial regulatory system that is unrivaled anywhere in the world. We deserve no less. At the Roundtable, we are poised and ready to work with you on these initiatives. As John F. Kennedy once cited French Marshall Lyautey, who asked his gardener to plant a tree. The gardener objected that the tree was slow growing and would not reach maturity for 100 years. The Marshall replied, ``In that case, there is no time to lose; plant it this afternoon!'' The same is true with regard to the future of the United States in global financial services--there is no time to lose; let's all start this afternoon. ______ CHRG-111hhrg54868--19 Mr. Bowman," Good afternoon, Chairman Frank, Ranking Member Bachus, and members of the committee. Thank you for the opportunity to testify today. When I testified here 2 months ago, my remarks concentrated on addressing real problems underlying the financial crisis. In my written testimony today, I debunk the myth of regulatory arbitrage by the industry. In my brief remarks here this afternoon, I would also like to emphasize that we will not solve the potential problems of tomorrow by merging regulatory agencies. There are five reasons why consolidation would neither solve those problems, nor promote efficiency, especially if the thrift charter is preserved. First, as you know, the OTS conducts consolidated supervision of thrifts and their holding companies. Although I do not believe the OTS is the proper regulator for systemically important conglomerates, I think it makes perfect sense for the agency to continue to supervise thrift holding companies, particularly for the many local consumer and community lenders across America who should not be asked to bear the cost and the inefficiency of a separate holding company regulatory scheme. Although larger thrifts tend to get the headlines, the overwhelming majority of thrifts are small, conservative lenders that offer home mortgages, car loans, and other day-to-day financial services to people in towns and cities, suburban and rural, across the country. Quite a few are community-based mutual institutions--much like the Bailey Building and Loan in the movie, ``It's a Wonderful Life''--that had been integral parts of their communities for decades. They did not contribute to the financial crisis, and they should not have to pay for it. The health of the financial services industry is improving, but it is by no means robust. The transition cost of thrifts converting to a different supervisor and a separate holding company regulator would be an unnecessary burden at a difficult time. My second point also relates to the fact there is no efficiency to be gained by merging regulatory agencies that do not fit together. Currently, thrifts report their financial status to the OTS through quarterly thrift financial reports, while banks file call reports under consolidation proposals. Either thrifts would need to spend money to overhaul their financial reporting systems, or the consolidated agency would need to operate and maintain two different reporting systems. Either approach would undercut efficiency. The third point is that trillion-dollar megabanks have almost nothing in common with small community thrifts. If these different types of businesses were supervised by a single regulator, the needs of the community-oriented majority could be too often overlooked by a bureaucracy forced to focus on the institutions that pose the greatest risks to the financial system. A fourth point is that multiple viewpoints among regulators foster better decisionmaking. OTS's leadership of banning unfair credit card practices is just one example. Remember that countries with a single monolithic bank regulator fared no better than the United States during this financial crisis we are currently undergoing. My fifth and final point dovetails with the first two. Consolidating agencies would take years, cost the industry millions of dollars, and generate upheaval in the day-to-day supervision of the financial institutions. All of this would be done to achieve a forced fit of fundamentally different agencies that regulate the fundamentally different charters and institutions; in effect, trying to pound a square peg into a round hole with no efficiencies or other benefits for taxpayers, consumers or the industry. To reiterate my remarks to this committee 2 months ago, the proposed consolidation could not address the problems that caused the financial crisis or could cause the next one. Thank you again, Mr. Chairman. I am happy to respond to your questions. [The prepared statement of Mr. Bowman can be found on page 65 of the appendix.] " CHRG-111shrg56376--167 Mr. Carnell," First, that the agency, Senator Corker, would incorporate a diversity of views because under what I am proposing it would have the Fed and the FDIC on its board. They would share in making policy. But even so, they are likely to have some disagreement with what comes out, and they will let you know about the disagreement. You would have more diversity within such a board than you would at most any independent agency and the rest of the Government. Second, it is key in preventing crisis to look ahead and fix the roof while the sky is still blue, not to wait until the thunderstorm is brewing up. Now, as for being procyclical--and I am building on that point--the Federal Reserve has actually tried to get rid of one of the existing two capital standards: the leverage limit. It has tried at least twice in the past 15 years. The existing capital standards were set in 1986 and 1992. We had years of enormous, unprecedented prosperity, record profits, and nothing was done to raise capital standards that had been set as the second best during a crisis. So I think the existing system, including the Fed's role in it, does not look good at all there. Senator Corker. Chairman Dodd, Senator Warner and I had a summit last night down at Johnny's Half Shell, and---- " 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-111shrg61651--138 PREPARED STATEMENT OF BARRY L. ZUBROWChief Risk Officer and Executive Vice President, JPMorgan Chase and Co. February 4, 2010 Good morning Chairman Dodd, Ranking Member Shelby, Members of the Committee. My name is Barry Zubrow, and I am the Chief Risk Officer and Executive Vice President of JPMorgan Chase and Co. Thank you for the opportunity to appear before the Committee today to discuss the Administration's recent proposals to limit the size and scope of activities of financial firms. While the history of the financial crisis has yet to be written conclusively, we know enough about the causes--poor underwriting, too much leverage, weak risk management, excessive reliance on short-term funding, and regulatory gaps--to recognize that we need substantial reform and modernization of the regulatory structure for financial firms. Our current framework was patched together over many decades; when it was tested, we saw its flaws all too clearly. We at JPMorgan Chase strongly support your efforts to craft and pass meaningful regulatory reform legislation that will provide clear, consistent rules for our industry. It is our view that the markets and the economy reflect continued uncertainty about the regulatory environment. I believe that economic recovery would be fostered by passage of a bill that charts a course for strong, responsible economic leadership from U.S. financial institutions. However, the details matter a great deal, and a bill that creates uncertainty or undermines the competitiveness of the U.S. financial sector will not serve our shared goal of a strong, stable economy. At a minimum, reform should establish a systemic regulator responsible for monitoring risk across our financial system. Let me be clear that responsibility for a company's actions rests solely with the company's management. However, had a systemic regulator been in place and closely watching the mortgage industry, it might have identified the unregulated pieces of the mortgage industry as a critical point of failure. It might also have been in a position to recognize the one-sided credit derivative exposures of AIG and the monoline insurers. While it may be unrealistic to believe that a systemic regulator could prevent future problems entirely, such a regulator may be able to mitigate the consequences of some failures and prevent them from collectively becoming catastrophic. As we at JPMorgan Chase have stated repeatedly, no firm--including our own--should be too big to fail. The goal is to regulate financial firms so they don't fail; but when they run into trouble, all firms should be allowed to fail, regardless of their size or interconnections to other firms. To ensure that this can happen--especially in times of crisis--regulators need enhanced resolution authority to wind down failing firms in a controlled way that does not put taxpayers or the broader economy at risk. Such authority can be an effective mechanism that makes it absolutely clear that there is no financial safety net for managements or shareholders. Under such a system, a failed bank's shareholders should lose their investments; unsecured creditors should be at risk and, if necessary, wiped out. A regulator should be able to terminate management and boards and liquidate assets. Those who benefited from mismanaging risks or taking on inappropriate risk should feel the pain. Other aspects of the regulatory system also need to be strengthened--including consumer protection, capital standards and the oversight of the OTC derivatives market--but I emphasize systemic risk regulation and resolution authority specifically because they provide a useful framework for consideration of the most recent proposals from the Administration.Restrictions on Proprietary Trading and Bank Ownership of Private Equity and Hedge Funds Two weeks ago, the Administration proposed new restrictions on financial firms. The first would prohibit banks from ``owning, investing in or sponsoring a hedge fund or a private equity fund, or proprietary trading operations'' that are not related to serving customers. The new proposals are a divergence from the hard work being done by legislators, central banks and regulators around the world to address the root causes of the financial crisis and establish robust mechanisms to properly regulate systemically important financial institutions. While there may be valid reasons to examine these activities, there should be no misunderstanding: the activities the Administration proposes to restrict did not cause the financial crisis. In no case were bank-held deposits threatened by any of these activities. Indeed, in many cases, those activities diversified financial institutions' revenue streams and served as a source of stability. The firms that failed did so largely as a result of traditional lending and real estate-related activities. The failures of Wachovia, Washington Mutual, Countrywide, and IndyMac were due to defaulting subprime mortgages. Bear Stearns, Lehman, and Merrill Lynch were all damaged by their excessive exposure to real estate credit risk. Further, regulators currently have the authority to ensure that risks are adequately managed in the areas the Administration proposes to restrict. Regulators and capital standards-setting bodies are empowered, and must utilize those powers, to ensure that financial companies of all types are appropriately capitalized at the holding company level (as we are at JPMorgan Chase). While bank holding companies may engage in proprietary trading and own hedge funds or private equity firms, comprehensive rules are in place that severely restrict the extent to which insured deposits may finance these activities. And regulators have the authority to examine all of these activities. Indeed, existing U.S. rules require that firms increase the amount of capital they hold as their private equity investments increase as a percentage of capital, effectively restraining their private equity portfolios. While regulators have the tools they need to address these activities in bank holding companies, we need to take the next logical step of extending these authorities to all systemically important firms regardless of their legal structure. If the last 2 years have taught us anything, it is that threats to our financial system can and do originate in nondepository institutions. Thus, any new regulatory framework should reach all systemically important entities--including investment banks--whether or not they have insured deposit-based business; all systemically important institutions should be regulated to the same rigorous standard. If we leave outside the scope of rigorous regulation those institutions that are interconnected and integral to the provision of credit, capital and liquidity in our system, we will be right back where we were before this crisis began. We will return to the same regime in which Bear Stearns and Lehman Brothers both failed and other systemically important institutions nearly brought the system to its knees. We cannot have two tiers of regulation for systemically important firms. As I noted at the outset, it is also very important that we get the details right. Thus far, the Administration has offered few details on what is meant by ``proprietary trading.'' Some traditional bank holding company activities, including real estate and corporate lending, expose these companies to risks that have to be managed by trading desks. Any individual trade, taken in isolation, might appear to be ``proprietary trading,'' but in fact is part of the mosaic of serving clients and properly managing the firm's risks. Restricting activities that could loosely be defined as proprietary trading would reduce the safety and soundness of our banking institutions, raise the cost of capital formation, and restrict the availability of credit for businesses, large and small--with no commensurate benefit in reduced systemic risk. Similarly, the Administration has yet to define ``ownership or sponsorship'' of hedge fund and private equity activities. Asset managers, including JPMorgan Chase, serve a broad range of clients, including individuals, universities, and pensions, and need to offer these investors a broad range of investment opportunities in all types of asset classes. In each case, investments are designed to meet the specific needs of the client. Our capital markets rely upon diversified financial firms equipped to meet a wide range of financing needs for companies of all sizes and at all stages of maturity, and the manner in which these firms are provided financing is continually evolving in response to market demand. Codifying strict statutory rules about which firms can participate will distort the market for these services--and result in more and more activities taking place outside the scope of regulatory scrutiny. Rather, Congress should mandate strong capital and liquidity standards, give regulators the authority they need to supervise these firms and activities, and conduct rigorous oversight to ensure accountability. While we agree that the United States must show leadership in regulating financial firms, if we take an approach that is out of sync with other major countries around the world without demonstrable risk-reduction benefits, we will dramatically weaken our financial institutions' ability to be competitive and serve the needs of our clients. Asset management firms (including hedge funds and private investment firms) play a very important role in today's capital markets, helping to allocate capital between providers and users. The concept of arbitrarily separating different elements of the capital formation process appears to be under consideration only in the U.S. Forcing our most competitive financial firms to divest themselves of these business lines will make them less competitive globally, allowing foreign firms to step in to attract the capital and talent now involved in these activities. Foreign banks will gain when U.S. banks cede the field.Concentration Limits The second of the recent Administration proposals would limit the size of financial firms by ``growth in market share of liabilities.'' Again, while the Administration has not provided much detail, the proposal appears to be based on the assumption that the size of financial firms or concentration within the financial sector contributed to the crisis. If you consider the institutions that failed during the crisis, some of the largest and most consequential failures were stand-alone investment banks, mortgage companies, thrifts, and insurance companies--not the diversified financial firms that presumably are the target of this proposal. It was not AIG's and Bear Stearns' size but their interconnection to other firms that prompted the Government to step in. In fact, JPMC's capabilities, size, and diversity were essential to our withstanding the crisis and emerging as a stronger firm--and put us in a position to acquire Bear Stearns and Washington Mutual when the Government asked us to. Had we not been able to purchase these companies, the crisis would have been far worse. With regard to concentration specifically, it is important to note that the U.S. financial system is much less concentrated than the systems of most other developed nations. Our system is the 2nd least concentrated among OECD countries, just behind Luxembourg; the top 3 banks in the U.S. held 34 percent of banking assets in 2007 vs. an average for the rest of the OECD of 69 percent. An artificial cap on liabilities will likely have significant negative consequences. For the most part, banks' liabilities and capital support the asset growth of its loan and lending activities. By artificially capping liabilities, banks may be incented to reduce the growth of assets or the size of their existing balance sheet, which in turn would restrict their ability to make loans to consumers and businesses, as well as to invest in Government debt. Capping the scale and scope of healthy financial firms cedes competitive ground to foreign firms and to less regulated, nonbank financial firms--which will make it more difficult for regulators to monitor systemic risk. It would likely come at the expense of economic growth at home. No other country in the world has a Glass-Steagall regime or the constraints recently proposed by the Administration, nor does any country appear interested in adopting one. International bodies have long declined to embrace such constraints as an approach to regulatory reform.Conclusion We have consistently endorsed the need for meaningful regulatory reform and have worked hard to provide the Committee and others with information and data to advance such reform. We agree that it is critically important to eliminate any implicit financial ``safety net'' by assuring appropriate capital standards, risk management and regulatory oversight on a consistent and cohesive basis for all financial firms, and, ultimately, having a robust regime that allows any firm to fail if it is mismanaged. While numerical limits and strict rules may sound simple, there is great potential that they would undermine the goals of economic stability, growth, and job creation that policymakers are trying to promote. The better solution is modernization of our financial regulatory regime that gives regulators the authority and resources they need to do the rigorous oversight involved in examining a firm's balance sheet and lending practices. Effective examination allows regulators to understand the risks institutions are taking and how those risks are likely to change under different economic scenarios. It is vital that policymakers and those with a stake in our financial system work together to overhaul our regulatory structure thoughtfully and well. Clearly such work needs to be done in harmony with other countries around the world. While the specific changes required by reform may seem arcane and technical, they are critical to the future of our whole economy. We look forward to working with the Committee to enact the reforms that will position our financial industry and economy as a whole for sustained growth for decades to come. Thank you." 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-111shrg62643--87 Mr. Bernanke," Well, the excess reserves in particular, which are created by Federal Reserve purchases of securities in the open market, are a strength of the system in the sense that they ensure that banks have easy access to large amounts of liquidity. But it is a separate issue from capital. Senator Gregg. Well, I guess my point is: Isn't our financial structure in pretty good shape right now compared to where it was a year and a half ago? And isn't it moving in the right direction? And so when you say ``unusual uncertainties,'' isn't at least one certainty that at least that element of the crisis which we confronted a year and a half ago has been settled out and is moving in the right direction? " 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-111hhrg52261--23 Mr. Robinson," Chairwoman Velazquez, Ranking Member Graves, and members of the committee, thank you for the opportunity to testify. I am J. Douglas Robinson, Chairman and Chief Executive Officer of the Utica National Insurance Group, a group led by two mutual insurers headquartered near Utica, New York. Utica National provides coverages primarily for individual and commercial risks with an emphasis on specialized markets, including public and private schools, religious institutions, small contractors, and printers. My company markets its products through approximately 1,200 independent agents and brokers. Our 2008 direct written premiums were more than $632 million. I am testifying today on behalf of the Property Casualty Insurers Association of America, which represents more than 1,000 U.S. insurers. We commend President Obama and Congress for working to ensure that the financial crisis we experienced last fall is never repeated. Achieving this goal requires a focus on fixing what went wrong with Wall Street without imposing substantial new one-size-fits-all regulatory burdens on Main Street, small businesses, and activities that are not highly leveraged nor systemically risky. My company insures small businesses like bakeries, child care centers, auto service centers, and funeral homes. These Main Street businesses should not bear the burden of an economic crisis they did not create. Home, auto, and commercial insurers did not cause the financial crisis, are not systemically risky and have strong and effective solvency and consumer protection regulation at the State level. We are predominantly a Main Street, not a Wall Street, industry with less concentration and more small business competition than other sectors. Property casualty insurers have not asked for government handouts. Our industry is stable and continues to provide critical services to local economies and communities. However, small insurers are concerned about being subject to administration proposals intended to address risky Wall Street banks and securities firms, but that apply broadly to the entire financial industry. Specifically, we are concerned about the following: The proposed Consumer Financial Protection Agency does not adequately exclude insurance from its scope. An exclusion should be added for credit, title, and mortgage insurance, which are generally provided by and to relatively small businesses. Protection should be added for insurance payment plans which are already well regulated by State insurance departments. The proposed new Office of National Insurance is given too much subpoena and preemption power without adequate due process or limits on its scope and its ability to enter into international insurance agreements. It also needs a definition of ""small insurer"" to prevent excessive reporting requirements. Systemic risk regulation needs to be modified to reduce government backing of large firms at the competitive expense of small financial providers. Leveraged Wall Street behemoths must not be made bigger through government bailouts and consolidation. Government shouldn't forget or harm Main Street in addressing systemic risk regulation. Resolution costs of systemically risky firms should be paid for by firms with the greatest systemic risk. Bank regulators should not be allowed to resolve systemic risk failures by reaching into the assets of small insurance affiliates whose losses would then be charged to other innocent small competitors through State guaranty funds. Finally, congressionally proposed repeal of the McCarran-Ferguson Act would significantly reduce insurance competition, primarily harming smaller insurers that would not otherwise have access to loss data and uniform policy forms necessary to compete effectively, and that would ultimately harm consumers. The cost of new regulations almost always disproportionately affects small business who can least afford the necessary legal and compliance requirements. The property casualty industry is healthy and competitive and the current system of regulating the industry at the State level is working well. Should the Congress fail to address the issues we have identified, the consequences on consumers and the economy could be quite harsh, imposing an especially large burden on small insurers and small businesses. Thank you. " CHRG-111hhrg56847--203 Mr. Bernanke," Okay. Ms. Kaptur. Thank you. Number three, how can you use your power--and this goes to the housing issue--how can you use your power as the Fed to get these megabanks and the servicers that they have hired to the table to do housing workouts to avoid the ghost towns and ghost neighborhoods that we are getting across this country? There is a real stop-up in the system, a real blockage. Even though, for example, home values have lost 30 percent of value, that isn't booked on the books of the banks. And you can't get a negotiation at the local level because there is nothing requiring the servicers to come to the stable. And there is a contractual relationship due to the subprime bonded nature of the instrument. We need the Fed to take a look at this since you deal in the bond markets, and you deal with these companies anyway. We need to get people to the table. And with the number of underwater loans, this isn't going to get any better. Across the country--I was talking to Dennis Cardoza yesterday, from California. He and I are in the same boat, and his boat is actually sinking faster than ours. And we really need somebody to hold these servicers accountable. Is there some way you can use your power to do that? That is question one. And then, question two, since the crisis began, the megabanks actually have a larger share of assets in the market than they did at the beginning, and the big investment banks that are very important to the Fed and the way you operate particularly up there in New York. And they had about a third of the assets of the country prior to the crisis. They now have nearly two-thirds. In the meanwhile, institutions in places like I represent are paying huge FDIC fees, up from maybe $20,000 5 years ago up to $70,000 last year, this year $700,000. The reason that lending is constricted at the local level is because these large institutions are really holding so much of the power, and we don't have a really balanced financial system. So they are not making the small business loans. So my question is, what role can you play as the Fed in restoring prudent lending and broad competition across our financial system? So question one relates to getting the servicers to the table, working with the megabanks. And number two, what can you do to help restore lending across this country through a competitive financial marketplace? " CHRG-111shrg50564--9 Chairman Dodd," Well, thank you very much, Mr. Chairman as well. And what I am going to do is ask the clerk here to put the clock on at 8 minutes, and we will try to adhere to that so we can get around to everybody, since we have not had opening statements be made. And I will begin, then turn to Senator Shelby. Let me, if I can, begin with a couple of--sort of a broad question, if I can. The GAO report states--and I am quoting it here. It says, ``Mechanisms should be included for identifying, monitoring, and managing risks to the financial system, regardless of the source of the risk.'' What was the source of the risk in the current crisis, in your view? " CHRG-111hhrg53245--88 Mr. Bachus," Mr. Kanjorski and I were at a meeting with one of the leading hedge fund managers. I will not name his name. The Financial Times said he was the smartest billionaire in the world. He said the same thing you said about Lehman in your testimony. The problem was the markets were shocked. They thought they were going to bail them out because they had bailed out Lehman, which is exactly what you said. I am not sure if you were aware. This gentleman is a very private individual. You all came to the same conclusion. Mr. Johnson goes on to say, and I believe this is absolutely true, some of our largest financial firms have actually become bigger relative to the system and stronger politically as a result of the crisis. The competition has been eliminated. Do you agree with that, Mr. Johnson? " CHRG-111shrg53085--201 PREPARED STATEMENT OF SENATOR RICHARD C. SHELBY Thank you, Mr. Chairman. I think the events of the last few days have made it clear that our efforts must remain directed at dealing with the problems in the financial system. As we have seen from the huge swings in the markets with each announcement coming from Washington, the situation remains extremely volatile. Until we effectively deal with our financial system our efforts may, at best, be misguided and, at worst, damaging. After we deal with the financial crisis, we will then have to focus on correcting the weaknesses in the existing regulatory framework. I look forward to continuing the examination we began last week at our hearing with the banking regulators. Among the other issues that emerged from our hearing, I think it is clear that we need to have a better understanding about the nature and causes of systemic risk. With greater knowledge regarding this very difficult problem, we will have a better chance at fashioning the necessary measures to deal with it in the future. As I stated last week, it should be our goal to create a durable, flexible and robust regime that can grow with markets while still protecting consumers and market stability. This can only be done through a serious and considered effort on the part of the Committee. Once more, getting this done right is more important than getting it done quickly. Thank you Mr. Chairman. ______ CHRG-111hhrg53240--115 Chairman Watt," The gentleman's time has expired. The gentleman from Texas is recognized for 5 minutes. Dr. Paul. I thank you, Mr. Chairman. I have a question for Mr. Carr on how optimistic he might be about what we are trying to do. I tend toward pessimism at times; and I think the problem is almost bigger than what we are dealing with here, and we are just dealing on the edge of the basic problem. So the system that we have had has been around a long time. We have had a system--some people refer to it as capitalism that was unregulated. I happen to think that it doesn't have much to do with capitalism; it has to do with corporatism, where corporations seem to get the benefits of some of the programs that are designed to help the poor. We have multiple programs that have been going on for a long time designed to help the poor, and yet sometimes I think that is so superficial. The poor seem to become more numerous and the poor--especially since the crisis has hit; but it is always on a pretense to help the poor, and yet the corporations stand to make the money. So they make the money and they have the power and they have the insight with some of our financial institutions, including the Federal Reserve; and when the bubble forms, they benefit, and nobody complains too much if it seems to satisfy a lot of people. But when the bust comes, then we have a bailout. Who does the bailout serve? Do we immediately go out and bail out the people that we tried to get houses for? No. We immediately go out and bail out the system. So--the system is so deeply flawed, so they make the money when the bubble is being formed and they get bailed out when the bubble bursts. We come along with a new system that we hope will work. But for housing programs, for instance, you know, we want houses for the poor people, but developers make a lot of money, builders make a lot of money, mortgage companies make a lot of money, the banks make a lot of money. And all of a sudden the system doesn't work very well and the poor get wiped out and they lose their houses. So if we don't address that major problem, the structure of the system, this corporatism which has invaded us, how can this idea that, well, we will regulate a little bit in order to protect the consumer--I guess I am rather cynical, and I want you to tell me whether you share any of that concern, whether my cynicism sometimes is justified or not. " 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-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. " CHRG-111shrg53822--89 PREPARED STATEMENT OF MARTIN NEIL BAILY Senior Fellow, Economic Studies Program, the Brookings Institution, and former Chairman of the Council of Economic Advisers Under President Clinton, and Robert E. Litan \1\ May 6, 2009 Thank you Mr. Chairman and members of the Committee for asking us to discuss with you the appropriate policy response to what has come to be widely known as the ``too big to fail'' (TBTF) problem. We will first outline some threshold thoughts on this question and then answer the questions that you posed in requesting this testimony.--------------------------------------------------------------------------- \1\ Robert E. Litan is Vice President, Research and Policy, The Kauffman Foundation and Senior Fellow, Economic Studies and Global Economy Programs, The Brookings Institution. This testimony draws on several of the authors' recent essays on the financial crisis on the Brookings website, www.brookings.edu, the work of Douglas Elliott of Brookings and the papers of the Squam Lake Working Group on Financial Regulation http://squamlakeworkinggroup.org/.---------------------------------------------------------------------------The Key PointsToo Big to Fail and the Current Financial Crisis The U.S. economy has been in free fall. Hopefully the pace of decline is now easing, but the transition to sustained growth will not be possible without a restoration of the financial sector to health. The largest U.S. financial institutions hold most of the financial assets and liabilities of the sector as a whole and, despite encouraging signs, many of them remain very fragile. Many banks in the UK, Ireland, Switzerland, Austria, Germany, Spain and Greece are troubled and there is no European counterpart to the U.S. Treasury to stand behind them. The global financial sector is in a very precarious state. In this situation policymakers must deal with ``too big to fail'' institutions because we cannot afford to see the disorderly failure of another major financial institution, which would exacerbate systemic risk and threaten economic recovery. The stress tests are being completed and some banks will be told to raise or take additional capital. There is a lot more to be done after this, however, as large volumes of troubled or toxic assets remain on the books and more such assets are being created as the recession continues. It is possible that one or two of the very large banks will become irretrievably insolvent and must be taken over by the authorities and, if so, they will have to deal with that problem even though the cost to taxpayers will be high. But pre-emptive nationalization of the large banks is a terrible idea on policy grounds and is clouded by thicket of legal problems.\2\--------------------------------------------------------------------------- \2\ See the papers by Doug Elliott on the Brookings website. Getting the U.S. financial sector up and running again is essential, but will be very expensive and is deeply unpopular. If Americans want a growing economy next year with an improving labor market, Congress will have to bite the bullet and provide more Treasury TARP funds, maybe on a large scale. The costs to taxpayers and the country will be lower than nationalizing the --------------------------------------------------------------------------- banks. Congress recently removed from the President's budget the funds to expand the TARP, a move that can only deepen the recession and delay the recovery.\3\--------------------------------------------------------------------------- \3\ If it is any consolation, between 72 and 80 percent of Federal income taxes are paid by the top 10 percent of taxpayers. Average working families will not be paying much for the bailout.---------------------------------------------------------------------------Too Big to Fail: Answering the Four Key Questions (Plus One More) Should regulation prevent financial institutions from becoming ``too big to fail''? We need very large financial institutions given the scale of the global capital markets and, of necessity, some of these may be ``too big to fail'' (TBTF) because of systemic risks. For U.S. institutions to operate in global capital markets, they will need to be large. Congress should not punish or prevent organic growth that may result in an institution having TBTF status. At the same time, however, TBTF institutions can be regulated in a way that at least partially offsets the risks they pose to the rest of the financial system by virtue of their potential TBTF status. Capital standards for large banks should be raised progressively as they increase in size, for example. In addition, financial regulators should have the ability to prevent a financial merger on the grounds that it would unduly increase systemic risk (this judgment would be separate from the traditional competition analysis that is conducted by the Department of Justice's Antitrust Division). Should Existing Institutions be Broken Up? Organic growth should not be discouraged since it is a vital part of improving efficiency. If, however, the FDIC (or another resolution authority) assumes control of a weakened TBTF financial institution and later returns it to the private sector, the agency should operate under a presumption that it break the institution into pieces that are not considered TBTF. And it should also avoid selling any one of the pieces to an acquirer that will create a new TBTF institution. The presumption could be overcome, however, if the agency determines that the costs of breakup would be large or the immediate need to avoid systemic consequences requires an immediate sale to another large institution. What Requirements Should be Imposed on Too Big to Fail Institutions? TBTF or systemically important financial institutions (SIFIs) can and should be specially regulated, ideally by a single systemic risk regulator. This is a challenging task, as we discuss further below, but we believe it is both one that can be met and is clearly necessary in light of recent events. Too big to fail institutions have an advantage in that their cost of capital is lower than that of small institutions. At a recent Brookings meeting, Alan Greenspan estimated informally that TBTF banks can borrow at lower cost than other banks, a cost advantage of 50 basis points. This means that some degree of additional regulatory costs (in the form of higher capital requirements, for example) can be imposed on large financial institutions without rendering them uncompetitive.\4\--------------------------------------------------------------------------- \4\ However it is important that international negotiation be used to keep a level playing field globally. Improved Resolution Procedures for Systemically Important Banks. This is an important issue that should be addressed soon. When large financial firms become distressed, it is difficult to restructure them as ongoing institutions and governments end up spending large amounts to support the financial sector, just as is happening now. The Squam Lake Working group has proposed one solution to this problem: that systemically important banks (and other financial institutions) be required to issue a long-term debt instrument that converts to equity under specific conditions. Institutions would issue these bonds before a crisis and, if triggered, the automatic conversion of debt into equity would transform an undercapitalized or insolvent institution, at least in principle, into a well capitalized one at no cost to taxpayers.\5\--------------------------------------------------------------------------- \5\ http://squamlakeworkinggroup.org/. Where the losses are so severe that they deplete even the newly converted capital, there should be a bank-like process for orderly resolving the institution by placing it in receivership. Treasury Secretary Geithner has outlined a process for doing this, which we generally support. There are other important resolution-related issues that must be --------------------------------------------------------------------------- addressed and we discuss them below. The Origin of the Crisis and the Structure of the Solution. The financial crisis was the result of market failure and regulatory failure. Market failure occurred because wealth- holders in many cases failed to take the most rudimentary precautions to protect their own interests. Compensation structures were established in companies that rewarded excessive risk taking. Banks bought mortgages knowing that lending standards had become lax.\6\--------------------------------------------------------------------------- \6\ See ``The Origins of the Financial Crisis'' and ``Fixing Finance'' available on the Brookings website. At the same time, there were thousands of regulators who were supposed to be watching the store, literally rooms full of regulators policing the large institutions. Warnings were given to regulators of impending crisis but they chose to ignore --------------------------------------------------------------------------- them, believing instead that the market could regulate itself. In the future we must seek a system that takes advantage of market incentives and makes use of well-paid highly qualified regulators. Creating such a system will take time and commitment, but it is clearly necessary.Expanding on the Issues As the Committee is well aware, TBTF actually is somewhat of a misnomer, since no company is actually ``too big to fail.'' More accurately, as we have seen in the various bailouts during this crisis, even when the government comes to the rescue, it does not prevent shareholders from being wiped out or having the value of their shares significantly diminished. The beneficiaries of the rescues instead are typically short-term creditors, and in some cases, longer term creditors. The rescues are mounted to prevent systemic risk, which can arise in two ways: if creditors at one institution suffer loss or have to wait for their money, their losses will cascade throughout the financial system and threaten the failure of other firms and/or creditors in similar institutions will ``run'' and thereby trigger a wider crisis. In what follows we refer to financial institutions whose failure poses systemic risk as ``systemically important financial institutions'' or ``SIFIs'' for short. Clearly, large banks can be SIFIs because they are funded largely by deposits that can be withdrawn on demand. But, as has been painfully learned during this crisis, policymakers have feared that certain non-banks--the formerly independent investment banks and AIG--can be SIFIs because they, too, are or were funded largely by short-term creditors. By similar reasoning, other financial institutions--if sufficiently large, leveraged, or interconnected with the rest of the financial system--also can be systemically important, especially during a time of general economic stress: --Our entire financial system, for example, depends on the ability of the major stock and futures exchanges to price financial instruments, and on the major financial clearinghouses to pay those who are owed funds at the end of each day. --The harrowing experience with the near failure of LTCM in 1998 demonstrates that large, leveraged hedge funds can expose the financial system to real dangers if counter-parties are not paid on a timely basis. --Large troubled life insurers can also generate systemic risks if policyholders run to cash out their life insurance policies, or if the millions of retirees who rely on annuities suddenly learn that their contracts may not be honored sharply curtail their spending as a result. --It is an open question whether the large monoline bond insurers, which have been hit hard by losses on subprime securities they have guaranteed, are systemically important. On the one hand, these losses for a time appeared to threaten the ability of these insurers to continue underwriting municipal bond issues (their core business), which could have had major negative ripple effects throughout the economy. On the other hand, as the recent entry of Berkshire Hathaway into this business has demonstrated, other entrants eventually can take up the slack in the market if one or more of the existing bond insurers were to fail. Nonetheless, because the entry process takes time, it is possible that one or more of the existing bond insurers could be deemed too big (or important) to fail in a time of broad economic distress, such as the present time. --One or more large property-casualty insurers could be deemed to be systemically important if they each were hit suddenly by a massive volume of claims--for example, following one or a series of catastrophic hurricanes--which, among other things, could trigger a large amount of securities sales in a short period of time. A large volume of CAT claims could also imperil the solvency of one or more large insurers (and/or possibly state backup insurance pools, like the one in Florida) and leave millions of policy holders without coverage, an outcome that Federal policymakers may deem unacceptable. One question we are certain you have been asked by your constituents and the media is why the auto companies have been treated differently, at least so far, from large financial firms. To be sure, in each case, it now appears that the Federal Government will end up owning some or, in the case of GM, most of the equity. But the creditors of the auto companies are not being protected, unlike those of the large financial firms that have been labeled ``too big to fail.'' Why the difference? There is an economic answer to this question which admittedly may be politically less than persuasive to some. Essentially by definition, systemically important financial institutions are funded largely if not primarily by short-term borrowings--deposits, repurchase agreements, commercial paper--which if not fully repaid when due or ``rolled over'' will cause not only the firm to fail, but threaten the failure of many other firms throughout the economy in one or both of the ways we have already described. In contrast, non-financial firms are typically not funded primarily by short-term borrowing, but instead by a combination of longer-term debt and equity. To be sure, their failure can lead to the failure of other firms, such as suppliers, and also trigger a wider loss of confidence among consumers, but most economists believe the damage to the entire economy is not likely to be as substantial as it would be if depositors at one or more of the largest banks or the short-term counter-parties of a large hedge fund or insurance company are not paid on time. We are nonetheless confident that the various financial firm bailouts do not please you or your constituents, which presumably is why you've convened this hearing. We are all highly uncomfortable with having the government bail out some or all possibly all of the creditors of large systemically important financial institutions. In particular, there are three reasons for this discomfort. First, if creditors of some institutions know that they will be fully protected regardless of how the managers of those firms act, the creditors will have no incentive to monitor the firms' risks and to discourage the taking of excessive risk. Economists call this the ``moral hazard'' effect, and over time, if left unchecked it will lead to too much risk-taking by too many institutions, putting the economy at risk of future bubbles and the potentially huge costs when they pop. Second, bailouts of creditors of failed firms are fundamentally inconsistent with capitalism, which rewards and thus provides incentives for success, but punishes failure. Socializing the risks of failure is not how the game is played, and not only introduces too much risk-taking into the economy, but is also rightfully perceived as unfair by those firms whose creditors who are not given this protection. Third, we are learning that bailouts undermine the public's trust in government, which can make it harder for elected officials to do the public's business. Thus, for example, the unpopularity of the bailouts thus far may slow down the much needed cleanup of the financial system, which will slow the recovery. Likewise, if the public gets the impression that much of what Washington does is bail out mistakes, voters may be much more reluctant to support and fund worthy, cost-effective endeavors by government to ensure more universal health care, fix education, and address climate change, among other important objectives. For all these reasons, policymakers must take reasonable steps now to prevent institutions from becoming TBTF, or if that is the outcome of market forces, then to prevent these institutions from taking excessive risks that expose taxpayers to paying for their mistakes. These are essentially the options on which you have requested comment, and to which we now turn.Desirability and Feasibility of Preventing Institutions from Becoming CHRG-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-111hhrg53245--17 Mr. Wallison," Thank you very much, Mr. Chairman. Leaving aside Fannie Mae and Freddie Mac, which I think are a very special case, if there is such a thing as a firm that is too big to fail, it is only a large commercial bank. And we now have several of them that are enormous. When we say that a firm is too big to fail, we mean that its failure could have a major, adverse effect on the entire economy. This is not simply a mere disruption of the economy. It would have to be a systemic breakdown. We can't define that very well, but it would have to be something greater than simply the kind of disruption that would occur from the failure of a firm. In my view, only a large commercial bank can create this kind of systemic breakdown. When a large bank fails, its depositors are immediately deprived of the funds they expected to have to meet payrolls and to pay their bills. Smaller banks are depositors in the larger banks, so the failure of a large bank can send a cascade of losses through the economy. If there is such a thing as a systemic breakdown, this would be it. For the same reasons, it is difficult to see how a large non-bank financial institution, that is, a bank holding company, a securities firm, a finance company, or a hedge fund can cause systemic risk. And thus it is difficult to see why a non-bank can ever be, in terms we are talking about today, too big to fail. Non-banks do not take deposits. They borrow for the short-, medium-, and long-term, but if they fail, their creditors don't suffer any immediate cash losses that would make it difficult for them to pay their bills. No one deposits his payroll or the money he expects to use for doing business with a securities firm or a finance company. In addition, their creditors are likely to be diversified lenders, so all their eggs are not in the same basket. However, the freeze-up in lending that followed the collapse of Lehman Brothers has led some people to believe, and I think incorrectly, that Lehman caused that event. This is not accurate. They conclude that a non-bank financial firm can cause a systemic breakdown that it can thus be too big to fail. But Lehman's failure caused what is called a common shock, where a market freezes up because new information has come to light. The new information that came to light with Lehman's failure was that the government was not going to rescue every firm larger than Bear Stearns, which had been rescued 6 months before. In this new light, every market participant had to reevaluate the risks of lending to everyone else. No wonder lending ground to a halt. Common shocks don't always cause a financial crisis. This one did, because virtually all large banks were thought at that time to be weak and unstable. They held large amounts of mortgage backed securities, later called toxic assets, that were of dubious value. If the banks had not been weakened by these assets, they would have continued to lend to each other. There would not have been a freeze-up in lending and the investor panic that followed. So if we want to avoid another crisis like that, we should focus solely on ensuring that the banks--we're talking about commercial banks--are healthy. Other financial firms, no matter how large, are risk takers and should be allowed to fail. Accordingly, if we want to deal with the problem of too big to fail and systemic risk bank regulation should be significantly reformed. Capital requirements for large banks should be increased as those banks get larger, especially if their assets grow faster than asset values generally. Higher capital requirements for larger banks would cause them to reconsider whether growth for its own sense really makes sense. Bank regulators should develop metrics or indicators of risk taking that banks should be required to publish regularly. This will enhance market discipline, which is fundamentally the way we control risk taking in the financial field. Most important of all, Congress should create a systemic risk council on the foundation of the Presidents Working Group, which would include all the bank supervisors and other financial regulators. The council should have its own staff and should be charged with spotting the development of conditions in the banking industry, like the acquisition by virtually all banks of large amounts of toxic assets, that might make all major banks weak or unstable and leave them vulnerable to a common shock. If we keep our banks stable, we'll keep our financial system stable. Finally, as a member of the Financial Crisis Inquiry Commission, I urge this committee to await our report before adopting any legislation. Thank you. [The prepared statement of Mr. Wallison can be found on page 79 of the appendix.]STATEMENT OF SIMON JOHNSON, PROFESSOR, MASSACHUSETTS INSTITUTE CHRG-111shrg57322--1101 Mr. Blankfein," Yes. I think the industry is substantially less leveraged. I will tell you, we thought we weren't leveraged going into the crisis as much--and we weren't as much as other investment banks like ourselves. With the benefit of hindsight, we were too leveraged even at what we thought at the time was fine and we are substantially--we are less than half as leveraged as we were then. The recency of this crisis is going to reverberate with me for the rest of my career and my life. So I will be--the image of it and the fear and the anxiety that we all had. And so I agree, I think the firm--all firms will be run much more conservatively and I hope for a long time, and I tell you that society will not rely on the good will and the memory of financial firms. I think Congress and regulators will impose tighter-higher capital requirements and liquidity requirements, and I think that is appropriate, because as we also found out in the crisis, we all have interrelated obligations to each other and it wouldn't suit me to have Goldman Sachs be conservative if everybody else is going to take too much risk and put the system at risk, which is why, again, I echo making the world safer and ending too big to fail, I think, is something that is a substantial interest of society at large and also of the industry and Goldman Sachs. Senator Pryor. Thank you. Mr. Chairman, thank you for your diligence on this matter. Like I said, this didn't start with you 2 weeks ago. This has been going on for a year and a half and you have just done yeoman's work on this. Thank you. Senator Levin. Thank you so much, Senator Pryor. Senator Tester. Senator Tester. Yes. Thank you, Mr. Chairman. I want to echo Senator Pryor's remarks, and Mr. Blankfein, I appreciate you being here. I am going to get into some questions here that I have prepared, but is Goldman too big to fail? " fcic_final_report_full--400 THE ECONOMIC FALLOUT CONTENTS Households : “I’m not eating. I’m not sleeping” ..................................................  Businesses: “Squirrels storing nuts” ...................................................................  Commercial real estate: “Nothing’s moving” ......................................................  Government: “States struggled to close shortfalls” .............................................  The financial sector: “Almost triple the level of three years earlier” ....................  Panic and uncertainty in the financial system plunged the nation into the longest and deepest recession in generations. The credit squeeze in financial markets cascaded throughout the economy. In testifying to the Commission, Bank of America CEO Brian Moynihan described the impact of the financial crisis on the economy: “Over the course of the crisis, we, as an industry, caused a lot of damage. Never has it been clearer how poor business judgments we have made have affected Main Street.”  In- deed, Main Street felt the tremors as the upheaval in the financial system rumbled through the U.S. economy. Seventeen trillion dollars in household wealth evaporated within  months, and reported unemployment hit . at its peak in October . As the housing bubble deflated, families that had counted on rising housing val- ues for cash and retirement security became anchored to mortgages that exceeded the declining value of their homes. They ratcheted back on spending, cumulatively putting the brakes on economic growth—the classic “paradox of thrift,” described al- most a century ago by John Maynard Keynes. In the aftermath of the panic, when credit was severely tightened, if not frozen, for financial institutions, companies found that cheap and easy credit was gone for them, too. It was tougher to borrow to meet payrolls and to expand inventories; businesses that had neither credit nor customers trimmed costs and laid off employees. Still to- day, credit availability is tighter than it was before the crisis. Without jobs, people could no longer afford their house payments. Yet even if moving could improve their job prospects, they were stuck with houses they could not sell. Millions of families entered foreclosure and millions more fell behind on their mortgage payments. Others simply walked away from their devalued proper- ties, returning the keys to the banks—an action that would destroy families’ credit for  years. The surge in foreclosed and abandoned properties dragged home prices down still more, depressing the value of surrounding real estate in neighborhoods across the country. Even those who stayed current on their mortgages found themselves whirled into the storm. 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-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-110hhrg44901--57 Mr. Bernanke," Well, first of all, IndyMac did fail, and the Fed did not do anything about that. I would add to your constituents, as I mentioned earlier, that all insured deposits were available immediately and no insured depositor is going to take any loss from that. We have in this episode just been confronted with weaknesses and problems in the financial system that we didn't fully--we collectively, the regulators, the Congress, the economists did not fully anticipate. And in the interest of the broader financial system and particularly as always, always the ultimate objective is the strength of the economy and the conditions for--economic conditions for all Americans. We found weaknesses and we had to respond in crisis situations. I think that--while I certainly would defend the actions we have taken, I would much prefer in the future not to have to take such ad hoc actions and, as I described, I think to Ranking Member Bachus, the best solution is to have a set of rules that govern when a bank can be or other institution can be, you know, put through a special process. In particular, we already have such a process for depository institutions, which is a fiduciary process where the requirement is that the government resolve that bank at the least cost to the taxpayer unless a determination by a broad range of financial officials that a systemic risk exists, in which case other measures could be taken. So I think it wouldn't be appropriate for me to try to give you any guidelines right now. I think what we are doing right now is trying to do the best we can to make sure the financial markets continue to improve, and that they begin to function at a level which would be supportive of the economy. I think what is critical is as we go forward, we take stock from the lessons we have learned from this experience and try to set up a system that will be less prone to these kinds of difficult decisions that we have had to make. " fcic_final_report_full--14 Finally, when the housing bubble popped and crisis followed, derivatives were in the center of the storm. AIG, which had not been required to put aside capital re- serves as a cushion for the protection it was selling, was bailed out when it could not meet its obligations. The government ultimately committed more than  billion because of concerns that AIG’s collapse would trigger cascading losses throughout the global financial system. In addition, the existence of millions of derivatives con- tracts of all types between systemically important financial institutions—unseen and unknown in this unregulated market—added to uncertainty and escalated panic, helping to precipitate government assistance to those institutions. • We conclude the failures of credit rating agencies were essential cogs in the wheel of financial destruction. The three credit rating agencies were key enablers of the financial meltdown. The mortgage-related securities at the heart of the crisis could not have been marketed and sold without their seal of approval. Investors re- lied on them, often blindly. In some cases, they were obligated to use them, or regula- tory capital standards were hinged on them. This crisis could not have happened without the rating agencies. Their ratings helped the market soar and their down- grades through 2007 and 2008 wreaked havoc across markets and firms. In our report, you will read about the breakdowns at Moody’s, examined by the Commission as a case study. From  to , Moody’s rated nearly , mortgage-related securities as triple-A. This compares with six private-sector com- panies in the United States that carried this coveted rating in early . In  alone, Moody’s put its triple-A stamp of approval on  mortgage-related securities every working day. The results were disastrous:  of the mortgage securities rated triple-A that year ultimately were downgraded. You will also read about the forces at work behind the breakdowns at Moody’s, in- cluding the flawed computer models, the pressure from financial firms that paid for the ratings, the relentless drive for market share, the lack of resources to do the job despite record profits, and the absence of meaningful public oversight. And you will see that without the active participation of the rating agencies, the market for mort- gage-related securities could not have been what it became. * * * T HERE ARE MANY COMPETING VIEWS as to the causes of this crisis. In this regard, the Commission has endeavored to address key questions posed to us. Here we discuss three: capital availability and excess liquidity, the role of Fannie Mae and Freddie Mac (the GSEs), and government housing policy. First, as to the matter of excess liquidity: in our report, we outline monetary poli- cies and capital flows during the years leading up to the crisis. Low interest rates, widely available capital, and international investors seeking to put their money in real estate assets in the United States were prerequisites for the creation of a credit bubble. Those conditions created increased risks, which should have been recognized by market participants, policy makers, and regulators. However, it is the Commission’s conclusion that excess liquidity did not need to cause a crisis. It was the failures out- lined above—including the failure to effectively rein in excesses in the mortgage and financial markets—that were the principal causes of this crisis. Indeed, the availabil- ity of well-priced capital—both foreign and domestic—is an opportunity for eco- nomic expansion and growth if encouraged to flow in productive directions. Second, we examined the role of the GSEs, with Fannie Mae serving as the Com- mission’s case study in this area. These government-sponsored enterprises had a deeply flawed business model as publicly traded corporations with the implicit back- ing of and subsidies from the federal government and with a public mission. Their  trillion mortgage exposure and market position were significant. In  and , they decided to ramp up their purchase and guarantee of risky mortgages, just as the housing market was peaking. They used their political power for decades to ward off effective regulation and oversight—spending  million on lobbying from  to . They suffered from many of the same failures of corporate governance and risk management as the Commission discovered in other financial firms. Through the third quarter of , the Treasury Department had provided  bil- lion in financial support to keep them afloat. 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-110hhrg45625--100 Mr. Bernanke," This plan is an emergency plan to put out a fire, to resolve a serious crisis which has real Main Street implications. The Congresswoman really made the point for us, it has direct bearing on small businesses, job creation, auto loans, and production; all aspects of the real economy out there. And that is the real connection. I think what we have learned here though, as part of this process, is if we are going to put out the fire, we have to take a look at the fire code. We have to come back and see why it happened. Are there regulatory issues and gaps, overlaps, deficiencies; are there problems in the way our markets are structured that can be improved? So I think what we want to do is come out of this with a much stronger, more resilient, market-based financial system. That is really critical to do. But of course I don't think it is really possible to do in a few days. " CHRG-110shrg50414--141 Mr. Bernanke," Senator Dole, this is an instrument that has grown extraordinarily rapidly, as you point out, more quickly than the infrastructure that supports it. And the Federal Reserve, particularly the New York Federal Reserve Bank, have been extremely active in working with market participants to improve the transparency, the clarity of those trades, to develop protocols in case there is a failure, how to deal with that, and to move toward a central counterparty that will help make this a safer market. So we are working on that and making a lot of progress. It is part of a broader plan to try to make the system more resilient, more transparent, so that when we have crisis conditions that, you know, those problems will be much less severe. So we understand your concern, and we have been working very hard to try to make that market better. Senator Dole. Yes. " CHRG-111shrg51395--26 Mr. Bullard," Thank you, Chairman Dodd, Ranking Member Shelby, and Members of the Committee for the opportunity to appear here today. I congratulate the Committee for its thorough and deliberate investigation into the causes of the current financial crisis. Recent events have provided useful lessons on the management of systemic risk, prudential regulation, and investor protection in the investment management industry. The performance of stock and bond mutual funds, for example, has demonstrated the remarkable resiliency of the investment company structure in times of stress. As equity values have plummeted, most shareholders and stock funds have stood their ground, notwithstanding that they have the right to redeem their shares at short notice at their NAVs. There is no scientific explanation for the stability of mutual funds during this crisis, but I believe it is related to this redemption right, as Paul was describing a moment ago. Mutual fund investors are confident that they will receive the net asset value of their holdings upon redemption and they appear to believe that the net asset value of those shares--the net asset value will be fair and accurate. This confidence in the valuation and redeemability of mutual fund shares reduces the likelihood of the kind of panic selling that creates systemic risk and may provide a useful lesson for the regulation of other financial intermediaries. The current crisis has exposed certain investor protection issues, however. Many investors in target date and short-term bond funds have experienced investment returns that are not consistent with returns typical of that asset class. If a fund uses the name Target Date 2010, for example, its equity allocation should fall within the generally expected range for someone on the brink of retirement. Similarly, a 529 plan option that is touted as appropriate for a 16-year-old should not lose 40 percent of its value 2 years before the money will be needed for college. Investors should be free to choose more aggressive asset allocations than those normally considered most appropriate for this situation. But funds that use a name that most investors will assume reflects a particular strategy should be required to invest consistent with that strategy. In contrast with other types of mutual funds, the performance of money market funds has raised systemic and prudential regulation concerns. Money market funds constitute a major linchpin in our payment system and therefore a run on these funds poses significant systemic risk. The management of this risk has been inadequate, as demonstrated by the recent run on money market funds following the failure of the reserve primary fund. There are important lessons to be learned from this experience, but not the lessons that some commentators have found. The Group of 30, for example, has recommended that the money market franchise be eliminated. Former Fed Chairman Volcker explained that if money market funds are going to talk like a bank and squawk like a bank, they ought to be regulated like a bank. The problem with this argument is that money market funds don't fail like banks. Since 1980, more than 3,000 U.S. banks have failed, costing taxpayers hundreds of billions of dollars. During the same period, two money market funds have failed, costing taxpayers zero dollars. I agree that a regulatory rearrangement is in order, but it is banks that should be regulated more like money market funds. Banks routinely fail because they invest in risky, long-term assets while money market funds invest in safe, short-term assets. Insuring bank accounts may be necessary to protect against the systemic risk that a run on banks poses to the payment system, but there is no good reason why banks should be permitted to invest insured deposits in anything other than the safest assets. And there is no good reason why money market funds that pose the same systemic risk to our payment system should be left uninsured. I note, Chairman Dodd, you may have picked up this morning on Chairman Bernanke's comments that some kind of interim insurance program may be an appropriate response to the crisis, and I have to disagree with Paul that the program will necessarily end in September. I posted an article on SSRN that deals with one thesis of how to approach money market fund insurance and I hope the Committee and staff will take a look at that. The current crisis has also exposed significant weaknesses in hedge fund and investment advisor regulation. For example, hedge funds are permitted to sell investments to any person with a net worth of at least $1 million, a minimum that has not been adjusted since 1982. This means that a hedge fund is free to sell interest to a recently retired couple that owns a $250,000 house and has $750,000 in investments, notwithstanding that their retirement income is likely to be around $35,000 a year before Social Security. Finally, the Madoff scandal has again reminded us of the risks of the SEC's expansive interpretation of the broker exclusion from the definition of investment advisor. It appears that Madoff did not register as an investment advisor in reliance on the SEC's position that managing discretionary accounts could somehow be viewed as solely incidental to related brokerage services. This over-broad exclusion left Madoff subject only to broker regulation, which failed to uncover this fraud. The SEC has since rescinded its ill-advised position on discretionary accounts, but it continues to read the ``solely incidental'' exception so broadly as to leave thousands of brokers who provide individualized investment advice subject only to a broker's suitability obligation. These brokers should be subject to the same fiduciary duties that other investment advisors are subject to, including the duty to disclose revenue sharing payments and other compensation that create a potential conflict with their clients' interests. And finally, I would just add to the comments on the question of systemic or prudential regulator. I agree with Professor Coffee's comments that there is something simply fundamentally inconsistent with the SEC's investor protection role and the prudential role that it has not served particularly well in recent times and that those roles should be separated. I agree that there should be a Federal Prudential Regulator, which is what I would call it, that oversees all of those similar characteristics, such as net capital rules, money market fund rules, banking regulations that share those prudential or systemic risk concerns. It is not clear to me, however, that the particular types of liabilities that insurance companies hold would be suitable for one common prudential regulator, but that is something we don't necessarily need to consider unless the Federalizing of insurance regulation begins to make additional progress. And I would also add that we need to keep in mind that there is a significant difference between customer protection and investor protection. I think when Paul was talking about a Capital Markets Regulator, the way I would think of capital markets as being a way of talking about a regulator as investor protection regulator, which would serve fundamentally different functions, especially in that it embraces risk and looks to the full disclosure of that risk as its principal objective as opposed to what might be viewed as customer protection, which is really to ensure that promised services are what are delivered in a fully disclosed and honest way. These and other issues are addressed in greater detail in my written submission. Thank you very much. " CHRG-111shrg52619--44 Mr. Tarullo," Thank you, Mr. Chairman. I agree with my colleagues that we should not undermine the dual banking system in the United States, and so you are going to have at least two kinds of charters. It does seem to me, though, that the question is not so much one of can an institution choose, but what constraints are placed upon that choice. So, for example, under current law, with the improvements that were made to the Federal Deposit Insurance Act following the savings and loan crisis, there are now requirements on every federally insured institution that apply whether you are a State or a Federal bank. I think that Chairman Bair was alluding to some areas in which she might like to see more constraints within the capacity to choose, so that a bank cannot escape certain kinds of rules and regulations by moving from one charter to another. " CHRG-111hhrg54869--177 Mr. Sherman," Mr. Levitt, you say we shouldn't adopt the standard of no more bailouts. The Executive Branch believes not only that there should be a capacity for future bailouts but that it ought to be orderly. And by orderly, what they mean is no further congressional involvement, that if the Executive Branch wants to tie up $1 trillion, $2 trillion, and they think it is necessary, God, they are good people, they should be able to make that decision without the disorderliness that we saw last fall where Congress added a bunch of provisions, oversight, and even voted it down the first time. Do you believe that we ought to give the Executive Branch the authority to commit over $1 trillion to bail out systemically important firms in a time of crisis without further congressional approval? " 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. ______ fcic_final_report_full--455 Why Couldn’t We Reach Agreement? After the majority’s report is published, many people will lament that it was not possible to achieve a bipartisan agreement on the facts. It may be a surprise that I am asking the same question. If the Commission’s investigation had been an objective and thorough investigation, many of the points I raise in this dissent would have been known to the other commissioners before reading this dissent, and perhaps would have been influential with them. Similarly, I might have found facts that changed my own view. But the Commission’s investigation was not structured or carried out in a way that could ever have garnered my support or, I believe, the support of the other Republican members. One glaring example will illustrate the Commission’s lack of objectivity. In March 2010, Edward Pinto, a resident fellow at the American Enterprise Institute (AEI) who had served as chief credit offi cer at Fannie Mae, provided to the Commission staff a 70-page, fully sourced memorandum on the number of subprime and other high risk mortgages in the financial system immediately before the financial crisis. In that memorandum, Pinto recorded that he had found over 25 million such mortgages (his later work showed that there were approximately 27 million). 2 Since there are about 55 million mortgages in the U.S., Pinto’s research indicated that, as the financial crisis began, half of all U.S. mortgages were of inferior quality and liable to default when housing prices were no longer rising. In August, Pinto supplemented his initial research with a paper documenting the efforts of the Department of Housing and Urban Development (HUD), over two decades and through two administrations, to increase home ownership by reducing mortgage underwriting standards. 3 This research raised important questions about the role of government housing policy in promoting the high risk mortgages that played such a key role in both the mortgage meltdown and the financial panic that followed. Any objective investigation of the causes of the financial crisis would have looked carefully at this research, exposed it to the members of the Commission, taken Pinto’s testimony, and tested the accuracy of Pinto’s research. But the Commission took none of these steps. Pinto’s research was never made available to the other members of the FCIC, or even to the commissioners who were members of the subcommittee charged with considering the role of housing policy in the financial crisis. Accordingly, the Commission majority’s report ignores hypotheses about the causes of the financial crisis that any objective investigation would have considered, while focusing solely on theories that have political currency but far less plausibility. This is not the way a serious and objective inquiry should have been carried out, but that is how the Commission used its resources and its mandate. There were many other deficiencies. The scope of the Commission’s work was determined by a list of public hearings that was handed to us in early December 2009. At that point the Commission members had never discussed the possible causes of the crisis, and we were never told why those particular subjects were important or were chosen as the key issues for a set of hearings that would form the backbone 2 3 Edward Pinto, “Triggers of the Financial Crisis” (Triggers memo), http://www.aei.org/paper/100174. Edward Pinto, “ Government Housing Policies in the Lead-up to the Financial Crisis: A Forensic Study,” http//ww.aei.org/docLib/Government-Housing-Policies-Financial-Crisis-Pinto-102110.pdf. 449 of all the Commission’s work. The Commission members did not get together to discuss or decide on the causes of the financial crisis until July, 2010, well after it was too late to direct the activities of the staff. The Commission interviewed hundreds of witnesses, and the majority’s report is full of statements such as “Smith told the FCIC that….” However, unless the meeting was public, the commissioners were not told that an interview would occur, did not know who was being interviewed, were not encouraged to attend, and of course did not have an opportunity to question these sources or understand the contexts in which the quoted statements were made. The Commission majority’s report uses these opinions as substitutes for data, which is notably lacking in their report; opinions in general are not worth much, especially in hindsight and when given without opportunity for challenge. CHRG-110shrg50417--147 Mr. Campbell," I have to admit that this is beyond my capability, but we would be happy to have the people who are aware report back to your staff, if that is what you would like. Senator Crapo. All right. Thank you very much. The last issue that I want to get into, as I mentioned in my initial comments, is regulatory reform. I have for a long time, even before we got into the thick of this crisis right now, believed that we need significant regulatory reform for our financial system in the United States. And I will not go into all the details for why I believe that, but, you know, our capital markets I think have needed to be served by a much better regulatory system for some time. Just yesterday, I believe it was, Walt Lukken, the Chairman of the CFTC, made a proposal that we reform and modernize our regulatory system. His approach, which I think is very similar to the one that Secretary Paulson made last March in his framework that he put forward, suggests that we have three regulators: one on systemic risk--by the way, my understanding is that depending on what kind of business you are in in the financial world today in the United States, you could have as many as seven different regulators, and that does not count all the State regulators and States and other potential impacts. And so this proposal is that we streamline it to a system in which we have three regulators, I assume some of them with increased regulatory strength: one for systemic risk, one for market integrity, and one for investment protection. I for quite some time have been interested in the one-regulator approach that we have seen over in Britain with the FSA, and my question is really a broad, open-ended question, and it has sort of got three parts, but it is all sort of the same question, and that is--and I open this to anyone on the panel who would like to respond. First of all, do you agree that we seriously need a new, modernized regulatory structure? Or is the regulatory structure that we have today one that we can just fine-tune a little bit and keep moving with? And, No. 2, if you do believe that we need to have a significant look at regulatory reform, what do you think of these proposals, the three different regulators or the one regulator based on principles rather than what I call the ``gotcha'' approach? I think you are all understanding where I am headed with this, but what are your thoughts as to where we should head in terms of the regulatory system we should have in place for the future for the United States financial system? And you do not have to answer if you do not want to, if you are not engaged on this issue, but I will start here on the left, and we can just move down. Mr. Eakes. " 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-111shrg54533--16 Chairman Dodd," Senator Bennett. Senator Bennett. Thank you very much, Mr. Chairman. Mr. Secretary, good to see you and you continue to have interesting days in the Chinese sense of that term. I don't want to be overly parochial about this, but there is one section of this thing that does affect my State pretty directly, and since I only have 5 minutes, that is what I will focus on. Right now, one of the problems we have in the economy is that there is not enough credit. We keep hearing, well, I can't get a loan. I have got a good deal, but I can't get a loan. I can't get any help. And in this proposal, you are killing one very major source of credit where there has been no difficulty with respect to the crisis. You said, we are trying to deal with those that were essential to the crisis. I am talking about ILCs. There is not a single ILC that contributed to the crisis. There is not a single ILC that went down. And interestingly, when Lehman Brothers went down, one of the crown jewels of the bankruptcy was, well, at least they have got an ILC that is functioning and that is financially sound. And you talk about adding a modest amount of increased power to the Fed. In this case, it is not a modest amount of increased power, it is actually a destruction of the industry. We are going to cancel the ILC charter. We are going to cancel the industry as a whole. So my basic question to you is, why does the elimination of ILC, thrifts, and commercial ownership of banks make the system stronger and safer when you have a track record, at least with the ILCs, that says that they, in fact, by virtue of their ownership have been stronger than the banks? So you are going to wipe them out as a source of credit, take them out of the marketplace where they are providing niche credit for people that don't otherwise get it, and I would like to compare that track record with the track record of bank holding companies if you are going to say, where do you have a source of strength. " 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-111hhrg48873--211 Mr. Watt," Thank you, Mr. Chairman. Mr. Dudley, it seems to me the other two gentlemen keep punting the questions on AIG up to you, so I want to ask you to provide, because I think the committee would benefit from having an analysis of what the upside potential of the 79 percent ownership in AIG and the various other ownership interests that we are taking in various other entities associated with AIG. I assume at some point we will divest that, but it would be helpful to have a written analysis, I think, for the committee of what that upside potential is; I know it is to some degree speculative. Mr. Geithner, Secretary Geithner, all of these questions that I am asking are really forward-looking. I want to go to your proposal for resolution authority. We found out in the midst of this crisis that there was emergency exigent circumstances authority given to the Fed to do a lot of things that have been very important and productive, but have also created a substantial degree of discomfort going forward, with one entity having such substantial authority to do what Chairman Bernanke has done, we think, admirably, but creates some angst. The effect of the resolution authority that you proposed in your opening statement seems to me to suggest that basically the Secretary of the Treasury would be the de jure interim systemic regulator for things outside the banking system. Am I misreading that? " CHRG-111shrg55278--129 RESPONSE TO WRITTEN QUESTIONS OF SENATOR SHELBY FROM ALICE M. RIVLINQ.1. Super Regulators--Ms. Rivlin, you state in your testimony that it would be ``a mistake to give the Federal Reserve responsibility for consolidated prudential regulation'' of systemically important institutions as the Obama administration has proposed. You note that if the Fed acquires this additional responsibility it will need leaders with regulatory skills--lawyers, not economists like Volcker, Greenspan, and Bernanke. Is it realistic to expect that any one person can be an expert in all of the areas falling under the Fed's jurisdiction? As a former Vice-Chair of the Fed, do you think that the Fed was an effective bank regulator in the run up to this crisis?A.1. Answer not received by time of publication. ------ CHRG-111shrg50564--2 Chairman Dodd," The Committee will come to order. Let me thank all of my colleagues, and I think you all understood we intended, obviously, at some time earlier to have this hearing a little earlier. But as I think all of you may know, we had an interesting session on our side of the aisle, gathering today to listen to some of our new economic team under President Obama, as well as the President himself and others, talk about many of the issues that are confronting the country, not the least of which was the issue of the subject matter of this hearing, the modernization of the U.S. financial regulatory system. I am particularly honored and delighted to have Paul Volcker here with us, who has been a friend for many years, someone I have admired immensely for his contribution to our country. How we will proceed is, because we are getting underway much later than normal for the conducting of Senate hearings, with the indulgence of my colleagues, I will make some opening comments myself, turn to Senator Shelby, and then we will go right to you, if we could, Chairman Volcker. Then I will invite my colleagues and tell them that any opening comments that they do not make for themselves, we will include them in the record as if given. And since there are not many of us here, we can move along pretty quickly, I hope, as well. So, with that understanding, we will get underway and, again, I thank all of you for joining us here today. Today, we continue the Senate Banking Committee's examination of how to modernize our outdated financial regulatory system. We undertake this examination in the midst of a deepening recession and the worst financial crisis since the Great Depression in the 20th century. We must chart a course forward to restore confidence in our Nation's financial system upon which our economy relies. Our mission is to craft a framework for 21st century financial regulation, informed by the lessons we have learned from the current crisis and designed to prevent the excesses that have wreaked havoc with homeowners and consumers, felled financial giants, and plunged our economy into a recession. This will not be easy, as we all know. We must act deliberately and thoughtfully to get it right. We may have to act in phases given the current crisis. But inaction is not an option at all, and time is not neutral. We must move forcefully and aggressively to protect consumers, investors, and others within a revamped regulatory system. Last Congress, this Banking Committee built a solid foundation upon which we will base our work today, and I want to once again thank Dick Shelby, former Chairman of this Committee, and my colleagues, both Democrats and Republicans, who played a very, very constructive role in the conduct of this Committee that allowed us to proceed as we did. Subcommittees and Committees held 30 hearings to identify the causes and consequences of this crisis, from predatory lending and foreclosures, to the collapse of Bear Stearns, the role of the credit rating agencies, the risks of derivatives, the regulation of investment banks and the insurance industry, and the role and condition of banks and thrifts. The lessons we have learned thus far have been rather clear, and let me share some of them with you. Lesson number one: consumer protection matters. The current crisis started with brokers and lenders making subprime and exotic loans to borrowers unable to meet their terms. As a former bank regulator recently remarked to me, ``Quite simply, consumers were cheated.'' Some lenders were so quick to make a buck and so certain they could pass the risk on to the next guy, they ignored all standards of prudent underwriting. The consumer was the canary in the coal mine, but no one seemed to notice. Lesson number two: regulation is fundamental. Many of the predatory lenders were not regulated. No one was charged with minding the store. But soon the actions of these unregulated companies infected regulated institutions. Banks and their affiliates purchased loans made by mortgage brokers or the securities or derivatives backed by these loans, relying on credit ratings that turned out to be wildly optimistic. So we find that far from being the enemy of well-functioning markets, reasonable regulation is fundamental to sound and efficient markets, and necessary to restore the shaken confidence in our system at home and around the globe. Lesson number three: regulators must be focused, aggressive, and energetic cops on the beat. Although banks and thrifts made fewer subprime and exotic loans than their unregulated competitors, they did so with impunity. Their regulators were so focused on banks' profitability, they failed to recognize that loans so clearly unsafe for consumers were also a threat to the banks' bottom line. If any single regulator recognized the abusiveness of these loans, no one was willing to stand up and say so. And with the Fed choosing not to use its authority to ban abusive home mortgages, which some of us have been calling for, for years, the regulators were asleep at the switch. Lesson number four: risks must be understood in order to be managed. Complex instruments, collateralized debt obligations, credit default swaps designed to manage the risks of the fault loans that backed them turned out to magnify that risk. The proliferation of these products spread the risk of subprime and Alt-A loans like an aggressive cancer through the financial system. Institutions and regulators alike failed to appreciate the hidden threat of these opaque instruments, and the current system of regulators acting in discrete silos did not equip any single regulator with the tools to identify or address enterprise or systemwide risks. On top of that, CEOs had little incentive to ferret out risks to the long-term health of their companies because too often they were compensated for short-term profits. I believe these lessons should form the foundation of our effort to shape a new, modernized, and, above all, transparent structure that recognizes consumer protection and the health of our financial system are inextricably linked. And so in our hearing today and those to come--and there will be many--I will be looking for answers to these questions. What structure best protects the consumer? What additional regulations are needed to protect consumers from abusive practices? We will explore whether to enhance the consumer protection mission of the prudential regulators or create a regulator whose sole job is protecting the American consumer. How do we identify and supervise the institutions and products on which the health of our financial system depends? Financial products must be more transparent for consumers and institutional investors alike. But heightened supervision must not stifle innovation of financial actors and markets. Third, how do we ensure that financial institution regulators are independent and effective? We cannot afford a system where regulators withhold bold and necessary action for fear that institutions will switch charters to avoid stricter supervision. We should consider whether a single prudential regulator is preferable to the alphabet soup of regulators that we have today. Fourth, how should we regulate companies that pose a risk to our system as a whole? Here we must consider whether to empower a single agency to be the systemic risk regulator. If that agency is the Federal Reserve Board, we must be mindful of ensuring the independence and integrity of the Fed's monetary policy function. Some have expressed a concern--which I share, by the way--about overextending the Fed when they have not properly managed their existing authority, particularly in the area of protecting consumers. Fifth, how should we ensure that corporate governance fosters more responsible risk taking by employees? We will seek to ensure that executives' incentives are better aligned with the long-term health of their companies, not simply short-term profits. Of course, my colleagues and our witnesses today may suggest other areas. I do not mean to suggest this is the beginning and end-all of the questions that need to be asked, and I welcome today's witnesses' as well as our colleagues' contributions to this discussion and the questions that ought to be addressed. I look forward to moving forward collaboratively in this historic endeavor to create an enduring regulatory framework that builds on the lessons of the past, restores confidence in our financial system, and recognizes that our markets and our economy will only be as strong as those who regulate them and the laws by which they abide. That is the responsibility of this Committee. It is the Republican of this Congress. It is the responsibility of the administration. I will recognize Senator Shelby for an opening comment and ask my colleagues if they might withhold statements, at least at the outset, so we can get to our witnesses. With that, I turn to Senator Shelby. CHRG-111hhrg53234--155 Mr. Galbraith," Thank you very much, Mr. Chairman. And as a member or an alumnus of this committee staff, it is again a pleasure and privilege to be here. I want to begin with a comment on this question of independence which has been touched on repeatedly. Vice Chairman Kohn said, and I think with very carefully chosen words, that the Congress granted a substantial degree of independence to the Federal Reserve. That independence is, of course, independence from the Executive Branch. It is not and cannot be independence from the Congress itself. The Federal Reserve may be delegated certain functions by the Congress, but the Congress can always choose to hold it accountable, and this committee, of course, has the responsibility of oversight precisely for that reason. So I think we should be very clear that, when speaking of the independence of the Federal Reserve, it is a legal independence of a kind that other regulatory institutions have had over the course of our history. It is not an independence which is specific to monetary policy per se. The question before us is whether the Federal Reserve is the best agency to take on the responsibility for regulating systemic risk, and I have some reservations about that, and I would classify them in three broad categories. The first one we might call constitutional, and I would pick up the point that was already made this afternoon by Congressman Sherman, concerning the fact that the Federal Reserve is constituted in part of regional Federal Reserve, of Federal Reserve district banks, who have boards of directors who are formed from the member banks themselves. And it is, of course, true that the district banks are represented on the Federal Open Market Committee with a voting power whose constitutionality, incidentally, was challenged in court by the chairman of this committee back in the 1970's when I was serving here on the staff. The issue was never resolved on the legal merits. It is also the case, as I understand it, that the examiners under a systemic risk supervision regime would actually reside in the district banks rather than at the Federal Reserve Board, and it seems to me this does raise a question at least of perception; that is to say, whether it is appropriate to have systemic risk regulators who are part of institutions that report in part and are accountable in part to boards of directors consisting in part of the member banks of those institutions for two reasons. One, there may be a systematic conflict between the interests of the member banks and the interests of system stability. And, secondly, there may be conflicts between the interests of member banks and the interests of other Tier I financial holding companies who are not member banks. So it seems to me that is at least a question which is worth considering as you think about the architecture of this particular system. The second concern that I would have is institutional. It is whether, in an agency whose primary functions are macroeconomic, one would ever have a commitment to the systemic risk regulation, to the supervisory responsibilities that are commensurate with the importance of that particular function. It seems to me worth pointing out that there is in the Treasury proposal basically a two-stage process, one of which is analytical, and the other one has more of an enforcement character. The analytical question is to determine what is a systemically dangerous institution to be classified as a Tier I financial holding company. That, it seems to me, would be an appropriate function to vest in the Federal Reserve Board, where an office that is incremental in the sense that Vice Chairman Kohn stipulated could decide amongst the relatively small number of large institutions who is and who is not in that category. The enforcement, the supervision, and the regulation of the behavior of the institutions, it seems to me, naturally would be more appropriately placed in an agency for whom that is the primary priority, an agency such as the FDIC. The third concern that I have is a question of really the leadership of the Federal Reserve. Historically this is--the chairmanship of the Board of Governors of the Federal Reserve is an extremely high-profile appointment. It is an individual who tends to be close to and to need the confidence of the financial markets, and there is a real question as to whether there is any record in the history of the Federal Reserve of effective response to systemic risk in advance of crisis. This was not the case of Benjamin Strong of the 1920's, who was the leading figure at the time, although not the Chairman of the Board. It was not the case of Alan Greenspan in the run-up to the latest crisis. We had a doctrine which, in effect, denied that systemic risk could, in fact, bring down the system. That doctrine was articulated at the peak of the Federal Reserve, and it seems to me that we had a test of that proposition, and it came up wanting. So it does seem to me that there are reasons to be worried about investing the authority for systemic risk in the Federal Reserve. Thank you very much. [The prepared statement of Dr. Galbraith can be found on page 50 of the appendix.] " CHRG-111hhrg53238--211 Mr. Menzies," I guess your question presumes that we have some knowledge on whether this is all behind us or not; and that depends upon whether you are from Florida, California, Arizona, Nevada, Ohio, Michigan, or Atlanta, or when you are from the Eastern Shore of Maryland. You can bet I don't know the answer to that question. It also presumes that there is a need to create some regulation to deal with the problem, to deal with the collapse, if you will. And again I would repeat that it is so important to focus on what caused the problem. What caused the $7 trillion of economic loss to the American consumer? We can have all the product legislation in the world and do everything possible to protect the consumer, but the greatest damage to the consumer was the failure of a system because of concentrations and excesses across the board, of a Wall Street vehicle that gathered together substandard, subprime, weird mortgages that community banks didn't make, created a warehouse to slice and dice those entities, make huge profits selling off those items, and have very little skin in the game, very little capital at risk, and to be leveraged, leveraged in some cases, according to the Harvard Business Review this week, 70 to 1. That deserves attention. The too-big-to-fail, systemic-risk, too-big-to-manage, too-big-to-regulate issue must be dealt with. And from the perspective of the community banks, that is the crisis of the day. That is what has destroyed the free market system. " fcic_final_report_full--39 Before the summer was over, Fannie Mae and Freddie Mac would be put into conser- vatorship. Then, in September, Lehman Brothers failed and the remaining invest- ment banks, Merrill Lynch, Goldman Sachs, and Morgan Stanley, struggled as they lost the market’s confidence. AIG, with its massive credit default swap portfolio and exposure to the subprime mortgage market, was rescued by the government. Finally, many commercial banks and thrifts, which had their own exposures to declining mortgage assets and their own exposures to short-term credit markets, teetered. In- dyMac had already failed over the summer; in September, Washington Mutual be- came the largest bank failure in U.S. history. In October, Wachovia struck a deal to be acquired by Wells Fargo. Citigroup and Bank of America fought to stay afloat. Before it was over, taxpayers had committed trillions of dollars through more than two dozen extraordinary programs to stabilize the financial system and to prop up the na- tion’s largest financial institutions. The crisis that befell the country in  had been years in the making. In testi- mony to the Commission, former Fed chairman Greenspan defended his record and said most of his judgments had been correct. “I was right  of the time but I was wrong  of the time,” he told the Commission.  Yet the consequences of what went wrong in the run-up to the crisis would be enormous. The economic impact of the crisis has been devastating. And the human devasta- tion is continuing. The officially reported unemployment rate hovered at almost  in November , but the underemployment rate, which includes those who have given up looking for work and part-time workers who would prefer to be working full-time, was above . And the share of unemployed workers who have been out of work for more than six months was just above . Of large metropolitan areas, Las Vegas, Nevada, and Riverside–San Bernardino, California, had the highest un- employment—their rates were above . The loans were as lethal as many had predicted, and it has been estimated that ul- timately as many as  million households in the United States may lose their homes to foreclosure. As of , foreclosure rates were highest in Florida and Nevada; in Florida, nearly  of loans were in foreclosure, and Nevada was not very far behind.  Nearly one-quarter of American mortgage borrowers owed more on their mortgages than their home was worth. In Nevada, the percentage was nearly .  Households have lost  trillion in wealth since . As Mark Zandi, the chief economist of Moody’s Economy.com, testified to the Commission, “The financial crisis has dealt a very serious blow to the U.S. economy. The immediate impact was the Great Recession: the longest, broadest and most se- vere downturn since the Great Depression of the s. . . . The longer-term fallout from the economic crisis is also very substantial. . . . It will take years for employment to regain its pre-crisis level.”  Looking back on the years before the crisis, the economist Dean Baker said: “So much of this was absolute public knowledge in the sense that we knew the number of loans that were being issued with zero down. Now, do we suddenly think we have that many more people—who are capable of taking on a loan with zero down who we think are going to be able to pay that off—than was true , ,  years ago? I mean, what’s changed in the world? There were a lot of things that didn’t require any inves- tigation at all; these were totally available in the data.”  CHRG-111shrg57322--1098 Mr. Blankfein," That we are working on. There will be gives and takes in it, and I am not sure myself where it would--nobody is--where it would come out, so the need for reform. I mentioned earlier the need for higher capital standards, systemic risk regulation. That is general. And obviously every firm needs to manage its risks very well and better than they have been doing in most cases. And I think in our case, particularly, you have to look also through every aspect of your business practices to make sure, and to not be defensive, which there is a tendency to be, but to learn from prior situations, including the one we are in now, and make sure that you do a better job. Senator Pryor. Well, that was one of my questions that I was going to follow up with, is what are the lessons learned from this most recent financial crisis and what is Goldman doing differently internally now that you have had to go through the bailout and all the other strains and difficulties that we have all gone through the last year and a half? " CHRG-111hhrg55814--530 Mr. Baker," Certainly, we feel that a council-like structure would be more appropriate in providing balance and perspective. I understand the concerns Members have with regard to the Federal Reserve unilaterally engaging. There are certain questions with regard to monetary policy obligations and resolution of particular systemically significant entities, which could create issues. Go back to Mr. Volcker during the Mexican currency crisis, when it was advocated that banks extend credit, notwithstanding concerns about creditworthiness, which created considerable concerns about the integrity of monetary policy formulation and bank lending activity. This is a very carefully constructed question that I think we should take time to examine. But certainly having a Presidential appointee unilaterally make the decision or have the Federal Reserve make the decision, both are fraught with inappropriate resolution ability. " CHRG-111shrg55278--120 RESPONSES TO WRITTEN QUESTIONS OF SENATOR SHELBY FROM MARY L. SCHAPIROQ.1. Identify Systemic Risk in Advance?--I believe we can all agree that very few if anyone was able to effectively identify where the systemic risk resided in our economy prior to our current financial difficulties. While we had regulatory efforts in effect to combat these risks in commercial bank and thrift institutions, the real risk was shown to be outside of this area. Chairman Schapiro, what about the structure proposed by the Obama administration gives you confidence that this new regulatory body will succeed where so many others failed?A.1. While there is no guarantee, the one proposed by the Administration represents a number of improvements over the current regulatory landscape in terms addressing gaps in regulatory oversight and minimizing incentives for regulatory arbitrage. For example, the Administration's proposal seeks to address the importance of and strengthen consolidated supervision of large financial conglomerates, including supervision of previously unregulated subsidiaries. Critical elements of a successful systemic risk regulation program also include strong support of functional regulators. The Council and SRR should complement and augment the role of functional regulators by leveraging their specialized knowledge and expertise and should take action in contravention of functional regulators' standards if necessary when those standards are less stringent than those advocated by the Council or SRR. Indeed, functional regulators' standards are the first line of defense, as functional regulators understand the markets, products and activities of their regulated entities. The effective implementation of a systemic risk regulation program is critical to its success. Because the process of identifying emerging risks heavily relies on the analysis of significant amounts of information and reporting gathered from firms and regulators, a successful program must be appropriately resourced, employing an adequate number of staff with appropriate skill sets. It is important that the competencies of monitoring and inspection staff are equal to those of the firm's personnel regarding the relevant topic. Having a staff that is multidisciplinary and equipped with the proper skill sets to review and analyze the information obtained is critical. Generalists with substantial experience across the breadth of issues and firm relationships should complement their skills with those of experts in relevant quantitative specialties.Q.2. SEC as Systemic Risk Regulator--Chairman Schapiro, the SEC's Consolidated Supervised Entity program, a program that existed without the benefit of statutory authorization, collapsed as its firms failed, were taken over, or shifted to regulation as bank holding companies. How does the SEC's experience with the CSE program inform the model for regulation of systemic risk that you are advocating today?A.2. Between 2004 and 2008, the SEC was recognized as the consolidated supervisor for the five large independent investment banks under its Consolidated Supervised Entity or ``CSE'' program. The CSE program was created as a way for U.S. global investment banks that lacked a consolidated holding company supervisor to voluntarily submit to consolidated regulation by the SEC. In connection with the establishment of the CSE program, the largest U.S. broker-dealer subsidiaries of these entities were permitted to utilize an alternate net capital computation (ANC). \1\ Other large broker-dealers, whose holding companies are subject to consolidated supervision by banking authorities, were also permitted to use this ANC approach. \2\--------------------------------------------------------------------------- \1\ In 2004, the SEC amended its net capital rule to permit certain broker-dealers subject to consolidated supervision to use their internal mathematical models to calculate net capital requirements for the market risks of certain positions and the credit risk for OTC derivatives-related positions rather than the prescribed charges in the net capital rule, subject to specified conditions. These models were thought to more accurately reflect the risks posed by these activities, but were expected to reduce the capital charges and therefore permit greater leverage by the broker-dealer subsidiaries. Accordingly, the SEC required that these broker-dealers have, at the time of their ANC approval, at least $5 billion in tentative net capital (i.e., ``net liquid assets''), and thereafter to provide an early warning notice to the SEC if that capital fell below $5 billion. This level was considered an effective minimum capital requirement. \2\ Currently six broker-dealers utilize the ANC regime and all are subject to consolidated supervision by banking authorities.--------------------------------------------------------------------------- Under the CSE regime, the holding company had to provide the Commission with information concerning its activities and exposures on a consolidated basis; submit its nonregulated affiliates to SEC examinations; compute on a monthly basis, risk-based consolidated holding company capital in general accordance with the Basel Capital Accord, an internationally recognized method for computing regulatory capital at the holding company level; and provide the Commission with additional information regarding its capital and risk exposures, including market, credit and liquidity risks. It is important to note that prior to the CSE regime, the SEC had no jurisdiction to regulate these holding companies. \3\ Accordingly, these holding companies previously had not been subject to any consolidated capital requirements. This program was viewed as an effort to fill a significant gap in the U.S. regulatory structure. \4\--------------------------------------------------------------------------- \3\ The Gramm-Leach-Bliley Act had created a voluntary program for the oversight of certain investment bank holding companies (i.e., those that did not have a U.S. insured depository institution affiliate). The firms participating in the CSE program did not qualify for that program or did not opt into that program. Only one firm (Lazard) has ever opted for this program. \4\ See, e.g., Testimony by Erik Sirri, Director of the Division of Trading and Markets, Before the Senate Subcommittee on Securities, Insurance and Investment, Senate Banking Committee, March 18, 2009. http://www.sec.gov/news/testimony/2009/ts031809es.htm.--------------------------------------------------------------------------- During the financial crisis many of these institutions lacked sufficient liquidity to operate effectively. During 2008, these CSE institutions failed, were acquired, or converted to bank holding companies which enabled them to access Government support. The CSE program was discontinued in September 2008. Some of the lessons learned are as follows: Capital Adequacy Rules Were Flawed and Assumptions Regarding Liquidity Risk Proved Overly Optimistic. The applicable Basel capital adequacy standards depended heavily on the models developed by the financial institutions themselves. All models depend on assumptions. Assumptions about such matters as correlations, volatility, and market behavior developed during the years before the financial crisis were not necessarily applicable for the market conditions leading up to the crisis, nor during the crisis itself. The capital adequacy rules did not sufficiently consider the possibility or impact of modeling failures or the limits of such models. Indeed, regulators worldwide are reconsidering how to address such issues in the context of strengthening the Basel regime. Going forward, risk managers and regulators must recognize the inherent limitations of these (and any) models and assumptions--and regularly challenge models and their underlying assumptions to consider more fully low probability, extreme events. While capital adequacy is important, it was the related, but distinct, matter of liquidity that proved especially troublesome with respect to CSE holding companies. Prior to the crisis, the SEC recognized that liquidity and liquidity risk management were critically important for investment banks because of their reliance on private sources of short-term funding. To address these liquidity concerns, the SEC imposed two requirements: First, a CSE holding company was expected to maintain funding procedures designed to ensure that it had sufficient liquidity to withstand the complete loss of all short term sources of unsecured funding for at least 1 year. In addition, with respect to secured funding, these procedures incorporated a stress test that estimated what a prudent lender would lend on an asset under stressed market conditions (a ``haircut''). Second, each CSE holding company was expected to maintain a substantial ``liquidity pool'' that was composed of unencumbered highly liquid and creditworthy assets that could be used by the holding company or moved to any subsidiary experiencing financial stress. The SEC assumed that these institutions, even in stressed environments, would continue to be able to finance their high-quality assets in the secured funding markets (albeit perhaps on less favorable terms than normal). In times of stress, if the business were sound, there might be a number of possible outcomes: For example, the firm might simply suffer a loss in capital or profitability, receive new investment injections, or be acquired by another firm. If not, the sale of high quality assets would at least slow the path to bankruptcy or allow for self-liquidation. As we now know, these assumptions proved much too optimistic. Some assets that were considered liquid prior to the crisis proved not to be so under duress, hampering their ability to be financed in the repo markets. Moreover, during the height of the crisis, it was very difficult for some firms to obtain secured funding even when using assets that had been considered highly liquid. Thus, the financial institutions, the Basel regime, and the CSE regulatory approach did not sufficiently recognize the willingness of counterparties to simply stop doing business with well-capitalized institutions or to refuse to lend to CSE holding companies even against high-quality collateral. Runs could sometimes be stopped only with significant Government intervention, such as through institutions agreeing to become bank holding companies and obtaining access to Government liquidity facilities or through other forms of support. Consolidated Supervision Is Necessary but Not a Panacea. Although large interconnected institutions should be supervised on a consolidated basis, policy makers should remain aware of the limits of such oversight and regulation. This is particularly the case for institutions with many subsidiaries engaging in different, often unregulated, businesses in multiple countries. Before the crisis, there were many different types of large interconnected institutions subject to consolidated supervision by different regulators. During the crisis, many consolidated supervisors, including the SEC, saw large interconnected, supervised entities seek Government liquidity or direct assistance. Systemic Risk Management Requires Meaningful Functional Regulation, Active Enforcement, and Transparent Markets. While a consolidated regulator of large interconnected firms is an essential component to identifying and addressing systemic risk, a number of other tools must also be employed. These include more effective capital requirements, strong enforcement, functional regulation, and transparent markets that enable investors and other counterparties to better understand the risks associated with particular investment decisions. Given the complexity of modern financial institutions, it is essential to have strong, consistent functional regulation of individual types of institutions, along with a broader view of the risks building within the financial system.Q.3. SEC's Endorsement of Treasury's Approach--Chairman Schapiro, you chose to testify today on your own behalf. I suspect that if you had submitted your testimony for a Commission vote, you might have met some resistance since you endorse an approach that envisions the creation of a systemic risk regulator that will have authority over firms within the SEC's jurisdiction. Although cast as a second set of eyes to back up the front line financial regulators, the systemic risk regulator could complicate the SEC's job. Are you concerned that the addition of a new regulatory body will water down your regulatory authority over firms that you oversee?A.3. While a SRR should play a critical role in assessing emerging systemic risks by setting standards for liquidity, capital and risk management practices, in my view it is vital that its role be complemented by the creation of a strong and robust Council. I believe the Council should have authority to identify institutions, practices, and markets that create potential systemic risks, and also should be authorized to set policies for liquidity, capital and other risk management practices at firms whose failure could pose a threat to financial stability due to their combination of size, leverage, and interconnectedness. The Council also would provide a forum for analyzing and recommending harmonization of certain standards at other significant financial institutions. In most times, I would expect the Council and SRR to work with and through primary regulators of systemically important institutions. The primary regulators understand the markets, products and activities of their regulated entities. The SRR, however, can provide a second layer of review from a macroprudential perspective. If differences arise between the SRR/Council and the primary regulator regarding the capital or risk management standards of systemically important institutions, I strongly believe that the higher (more conservative) standard should govern. The systemic risk regulatory structure should serve as a ``brake'' on a systemically important institution's riskiness; it should never be an ``accelerator.'' In emergency situations, the SRR/Council may need to overrule a primary regulator (for example, to impose higher standards or to stop or limit potentially risky activities). However, to ensure that authority is checked and decisions are not arbitrary, the Council should be where general policy is set, and only then to implement a more rigorous policy than that of a primary regulator. This should reduce the ability of any single regulator to ``compete'' with other regulators by lowering standards, driving a race to the bottom.Q.4. SEC as Systemic Risk Regulator--Chairman Schapiro, under the plan the Administration set forth, a so-called ``Tier 1 Financial Holding Company'' (Tier 1 FHC) and its subsidiaries would be subject to examination by the Federal Reserve. Thus, a broker-dealer subsidiary of a Tier 1 FHC would be subject to examination by the Fed and the SEC. Should we be concerned that, rather than clarifying regulatory responsibility, this arrangement could blur lines of regulatory responsibility?A.4. A similar arrangement exists today for broker-dealers subsidiaries within a Bank Holding Company. At its core, the mission of the SEC is to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation. Accordingly, rigorous financial responsibility requirements apply to all U.S. broker-dealers, which are designed to ensure that broker-dealers operate in a manner that permits them to meet all obligations to customers and counterparties. The first of these requirements is the net capital rule, which, among other things, requires the broker-dealer to maintain a level of liquid assets in excess of all unsubordinated liabilities to enable the firm to absorb business losses and, if necessary, finance an orderly self-liquidation. The second is the customer protection rule, which requires the firm to safeguard customer cash and securities by segregating these assets from its proprietary business activities. The third prong is comprised of recordkeeping and financial reporting requirements that require the broker-dealer to make and maintain records and file reports that detail its net capital positions and document the segregation of customer assets. To ensure an equal playing field among the large and small, all broker-dealers should be subject to the same regulation, but additional review and holding company supervision can also take place. The SRR/Council could serve as a second set of eyes upon those larger institutions whose failure might put the system at risk, with the mandate of monitoring the entire financial system for systemwide risks and forestalling emergencies.Q.5. Too-Big-To-Fail--Chairman Schapiro, your testimony correctly recognizes that one type of systemic risk is that we create a system that favors large institutions over their ``smaller, more nimble competitors.'' Your testimony also suggests that a Financial Stability Oversight Council could prevent the formation of institutions that are too-big-to-fail. How would this work in practice?A.5. The Council, SRR, and primary regulators all should have a role in addressing the risks posed by large interconnected financial institutions. One of most important regulatory arbitrage risks is the potential perception that large interconnected financial institutions are too-big-to-fail and will therefore benefit from Government intervention in times of crisis. This perception can lead market participants to favor large interconnected firms over smaller firms of equivalent creditworthiness, fueling greater risk. To address these issues, policy makers should consider the following: Strengthen Regulation and Market Transparency. Given the financial crisis and the Government's unprecedented response, it is clear that large, interconnected firms present unique and additional risks to the system. To minimize the systemic risks posed by these institutions, policy makers should consider using all regulatory tools available--including supplemental capital, transparency and activities restrictions--to reduce risks and ensure a level playing field for large and small institutions. A strong Council could provide a forum for examining regulatory standards across markets, ensuring that capital and liquidity standards are in place and being enforced and that those standards are adequate and appropriate for systemically important institutions and the activities they conduct. The Council and SRR would be primarily responsible for setting standards at the holding company level. Establish a Resolution Regime. In times of crisis when a systemically important institution may be teetering on the brink of failure, policy makers have to immediately choose between two highly unappealing options: (1) providing Government assistance to a failing institution (or an acquirer of a failing institution), thereby allowing markets to continue functioning but creating moral hazard; or (2) not providing Government assistance but running the risk of market collapses and greater costs in the future. Markets recognize this dilemma and can fuel more systemic risk by ``pricing in'' the possibility of a Government backstop of large interconnected institutions. This can give such institutions an advantage over their smaller competitors and make them even larger and more interconnected. A credible resolution regime can help address these risks by giving policy makers a third option: a controlled unwinding of a large, interconnected institution over time. Structured correctly, such a regime could force market participants to realize the full costs of their decisions and help reduce the ``too-big-to-fail'' dilemma. Structured poorly, such a regime could strengthen market expectations of Government support, thereby fueling ``too-big-to-fail'' risks. ------ CHRG-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-109hhrg22160--145 Mr. Greenspan," The GSEs have a subsidy granted, not by law, but by the marketplace, which therefore gives them unlimited access to capital below the normal competitive rates. And that therefore, given no limits on what they can put in their portfolios, they can, by merely their initiative, create an ever larger increasing portfolio, which given the low levels of capital, means they have to engage in very significant dynamic hedging to hedge interest rate risks. If you get large enough in that type of context and something goes wrong, then we have a very serious problem because the existing conservatorship does not create the funds which would be needed to keep the institutions growing in the event of default, which is what the conservatorship is supposed to be and we have no obvious stabilizing force within the marketplace. So I think that going forward, enabling these institutions to increase in size, and they will once the crisis in their judgment passes. They stopped increasing temporarily. We are placing the total financial system of the future at a substantial risk. Fortunately, at this stage, the risk is, the best I can judge, virtually negligible. I don't believe that will be the case if we continue to expand in this system. " 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. fcic_final_report_full--471 Even today, there are few references in the media to the number of NTMs that had accumulated in the U.S. financial system before the meltdown began. Yet this is by far the most important fact about the financial crisis. None of the other factors offered by the Commission majority to explain the crisis—lack of regulation, poor regulatory and risk management foresight, Wall Street greed and compensation policies, systemic risk caused by credit default swaps, excessive liquidity and easy credit—do so as plausibly as the failure of a large percentage of the 27 million NTMs that existed in the financial system in 2007. It appears that market participants were unprepared for the destructiveness of this bubble’s collapse because of a chronic lack of information about the composition of the mortgage market. In September 2007, for example, after the deflation of the bubble had begun, and various financial firms were beginning to encounter capital and liquidity diffi culties, two Lehman Brothers analysts issued a highly detailed report entitled “Who Owns Residential Credit Risk?” 34 In the tables associated with the report, they estimated the total unpaid principal balance of subprime and Alt-A mortgages outstanding at $2.4 trillion, about half the actual number at the time. Based on this assessment, when they applied a stress scenario in which housing prices declined about 30 percent, they still found that “[t]he aggregate losses in the residential mortgage market under the ‘stressed’ housing conditions could be about $240 billion, which is manageable, assuming it materializes over a five-to six-year horizon.” In the end, of course, the losses were much larger, and were recognized under mark-to-market accounting almost immediately, rather than over a five to six year period. But the failure of these two analysts to recognize the sheer size of the subprime and Alt-A market, even as late as 2007, is the important point. Along with most other observers, the Lehman analysts were not aware of the true composition of the mortgage market in 2007. Under the “stressed” housing conditions they applied, they projected that the GSEs would suffer aggregate losses of $9.5 billion (net of mortgage insurance coverage) and that their guarantee fee income would be more than suffi cient to cover these losses. Based on known losses and projections recently made by the Federal Housing Finance Agency (FHFA), the GSEs’ credit losses alone could total $350 billion—more than 35 times the Lehman analysts’ September 2007 estimate. The analysts could only make such a colossal error if they did not realize that 37 percent—or $1.65 trillion—of the GSEs’ credit risk portfolio consisted of subprime and Alt-A loans (see Table 1, supra ) or that these weak loans would account for about 75% of the GSEs’ default losses over 2007- 34 Vikas Shilpiekandula and Olga Gorodetski, “Who Owns Resident i al Credit Risk?” Lehman Brothers Fixed Income U.S. Securitized Products Research , September 7, 2007. 2010. 35 It is also instructive to compare the Lehman analysts’ estimate that the 2006 vintage of subprime loans would suffer lifetime losses of 19 percent under “stressed” conditions to other, later, more informed estimates. In early 2010, for example, Moody’s made a similar estimate for the 2006 vintage and projected a 38 percent loss rate after the 30 percent decline in housing prices had actually occurred. 36 The Lehman loss rate projection suggests that the analysts did not have an accurate estimate of the number of NTMs actually outstanding in 2006. Indeed, I have not found any studies in the period before the financial crisis in which anyone— scholar or financial analyst—actually seemed to understand how many NTMs were in the financial system at the time. It was only after the financial crisis, when my AEI colleague, Edward Pinto, began gathering this information from various unrelated and disparate sources that the total number of NTMs in the financial markets became clear. As a result, all loss projections before Pinto’s work were bound to be faulty. 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-109hhrg22160--101 Mr. Sanders," Thank you, Mr. Chairman. And nice to see you again, Mr. Greenspan. I am not going to waste a whole lot of time talking about the so-called crisis in Social Security because there is not a crisis. Depending on the studies that you look at, Social Security is solvent for either 37 years or 47 years. With minor modifications like doing away with the cap for wealthy people so they could contribute more into the system, it will be good for 50 or 60 years. So I don't think we have to waste a lot of time on that particular crisis. Let us talk about some real crises facing the American people today. The health care system is clearly disintegrating. We are the only country in the industrialized world without a national health care program. We pay the highest prices in the world for prescription drugs. We have children sleeping out on the streets of America today. We don't give our veterans the benefits that we promise them. Our middle class in general is in a state of collapse, with millions of workers working longer hours for lower wages. There has been an increase in poverty. The gap between the rich and the poor is growing wider, and the richest 1 percent own more wealth than the bottom 90 percent. Now, Mr. Greenspan, representing the CEOs of America and the wealthiest people of America, you consistently come in here every year and you tell us how great the economy is doing, and you tell us how great unfettered free trade is. So that is the crisis I want to talk about. Talk about unfettered free trade that you have been supporting for years. We now have a record-breaking trade deficit of $618 billion. We have a trade deficit with China alone of $160 billion, which has gone up by 30 percent in the last year. There are economists who tell us that trade deficit is going to go up and up and up. People who go Christmas shopping understand that when they walk into a store virtually everything on their shelves is made in China now. You have the heads of large information technology companies in America who basically are telling us, ``Hey, we ain't going to have information technology in America, no long white collar jobs, because in 10 or 20 years China is going to be the information technology center of the world.'' Economists tell us we have lost millions of decent-paying jobs. We have lost 16 percent of our manufacturing sector in the last 4 years alone, and we are going to lose more and more white collar jobs to China. And yet year after year people like you come here, ``Oh, unfettered free trade, it is just great.'' Question, Mr. Greenspan: After record-breaking trade deficits, the loss of blue collar jobs, the beginning hemorrhaging of white collar information technology jobs, the understanding that if we don't change things China is going to be the economic superpower of this world in the next 15 or so years, have you rethought your views on unfettered free trade? " CHRG-111shrg54789--29 Chairman Dodd," Thank you very much. Senator Menendez. Senator Menendez. Thank you, Mr. Chairman. Mr. Secretary, in a panel that will follow you, Mr. Yingling, who is the representative of the American Bankers Association, has a series of critiques, and I would like to go through some of them with you and see what your responses are. First of all, he talks about how community banks are likely to have greatly increased fees to fund a system that falls disproportionately and unfairly on them, as they were not part of the present crisis. Second, he talks about this agency having the power to compel the use of certain products that the agency would define. Third, he talks about two lessons that he believes are fundamental building blocks of any reform of consumer protection oversight: One is that the uniform regulation and supervision of consumer protection performance should be applied to nonbanks as rigorously as it has been applied to the banking industry; and two, that regulatory policymakers for consumer protection should not be divorced from the responsibility for financial institution safety and soundness. And he talks about how the failure of nonbank regulation was the most severe under the current system. So looking at those as some of the main points of critique of the legislation, how do you respond to those? " CHRG-109hhrg22160--216 Mr. Meeks," So I take that to say, as we sit here today, not 2008, but as we sit here in 2005, that it is not a crisis. It could be a crisis. It may sometime in the future, but as we sit here today, it is not a crisis in your humble opinion? " CHRG-111hhrg56241--86 Mr. Stiglitz," I would like to emphasize two things that we did not do when we turned over money to these banks. First, we didn't relate giving them money to their behavior, not just with respect to the issue of compensation schemes, but also with respect to lending, which was the reason we were giving them money. That relates to the issue of jobs that has come up here a number of times. The fact that compensation went out meant there was less money inside the banks and therefore less ability or willingness to lend. The second point is that the U.S. taxpayer was not, when it gave the banks money, compensated for the risk that they bore. In some cases, we got repaid. But we ought to look at the transaction that Warren Buffet had with Goldman Sachs, which was an arm's-length transaction. If we wanted what would have been a fair compensation to the taxpayer, the bailouts would have reflected the same terms, and we would have gotten back a lot more. Mr. Moore of Kansas. Thank you, sir. I am interested in better understanding how the culture of excessive lending, abusive leverage, and excessive compensation contributed to the financial crisis. This applies across-the-board for consumers who are in over their head with maxed-out credit cards and homes they couldn't afford, to major financial firms leveraged 35 to 1. Is there anything the government can and should do in the future to prevent a similar carefree and irresponsible mindset from taking hold and exposing our financial system to another financial crisis? Professor Bebchuk? " FOMC20080929confcall--53 51,CHAIRMAN BERNANKE.," Well, let me just add that I share your concern. There is an increasing concentration. On the other hand, you could also view it as part of a process of consolidation as well, as we have reduced the number of independent investment banks, for example. But I agree with that. We have been very constrained throughout this entire crisis, as you know, by the existing facilities for dealing with failing institutions and mergers being one of the only tools we have. Going forward, I think there is some hope in the near term under the new TARP, which would allow resolutions using capital injections basically without necessarily doing a merger. Then subsequently, I think it's very important, as we look toward restructuring our financial regulatory system, to develop good resolution mechanisms and to think about the issues of concentration and too big to fail. So I take your point, basically. " CHRG-111shrg53822--66 Mr. Baily," The Volcker Commission used this with SIFIs, or ``systemically important financial institutions,'' maybe that is a better word than ``too big too fail,'' but, anyway, certainly institutions in which there is a danger that the whole system will come down. How do you define that? I do not know the answer to that. I think it has to be done through guidelines provided by Congress with some discretion for the regulators. In terms of AIG going down and Lehman going down, I disagree with Peter fundamentally. I think we had to do what was done with AIG to prevent further repercussions. I do think that the failure of Lehman was a mistake, and I think most people looking back would agree that it would not have taken that much to prevent the disorderly collapse of Lehman, which had substantial impacts in London and other parts of the world. So I do think we do need to make sure not that shareholders benefits--because shareholders go down, as they should, but that some of the fallout from those institutions is prevented. You mentioned that we have sort of created these monsters now by putting together some of the banks. I think the Treasury and the Federal Reserve were acting quickly to try to deal with a very difficult crisis. I think with the benefit of hindsight, maybe it would not have been such a great idea to make Bank of America take over Merrill, or whatever. I think some of those mistakes--or some of those decisions that were made rather quickly were not always--may not have been the best ones. But in point of fact, we are now stuck with those institutions. They are SIFIs, and they have to be regulated with additional capital requirements and some of the additional requirements so that they do not pose systemic dangers. Senator Warner. We are down to 7 minutes, and we have got to get over to the capital, so, Professor, briefly. " CHRG-110hhrg44901--19 Mr. Bernanke," Certainly. The recent financial crisis, which has been quite severe, as you know, has revealed a number of weak points in our economy, in our financial system, and they have required attention because we need to have a stable, well-working financial system in order for the economy to recover. In the longer term, I agree that market discipline is the best source of strength in the financial system. We need to take action to make sure that moral hazard doesn't induce excessive risk-taking. I spoke on this subject last week in a speech, and I indicated three directions forward that we could take to make sure that moral hazard is constrained in the future. The first is, now that the investment banks have received some support, in particular they have received access to, at least temporarily, to the discount window, I believe that we need to have legislated consolidated supervisory oversight over those firms that would ensure that they have adequate capital, adequate liquidity, and adequate risk management so they would not be taking advantage of any presumed backstop that they might otherwise see. Secondly, I talked about the need to strengthen our financial infrastructure. Part of the reason that it was a big concern to us when Bear Stearns came to the brink of failure was that we were concerned that there were various markets where the failure of a major counterparty would have created enormous strains on the financial system. One way to address the problem, and I discussed that at some length in my speech and I would be happy to talk more about it, is to make sure that the financial infrastructure, the systems through which lending and borrowing takes place, as well as the risk management of the lenders is strengthened to the point that the system could better withstand a failure, and therefore there would be less expectation of support in that situation. Finally, I think the issues we have approached like the investment banks, these circumstances were not contemplated in other areas like deposit-insured banks. There is a procedure, a set of rules, prompt corrective action, systemic risk, those sorts of things which tell the regulators how Congress wants them to proceed and create clarity in the market about under what circumstances assistance would be forthcoming. As Secretary Paulson has also indicated, I think we ought to be looking at clarifying the congressional expectations for how we would resolve--were the situation to arrive again, how to resolve such a problem. " CHRG-111shrg54533--26 Secretary Geithner," Accepting Senator Bennett's point as I did, which we will have to talk--we will have to spend some time talking through--I did not believe we are proposing here to try to solve problems that were not problems. Fannie and Freddie were a core part of what went wrong in our system, but Congress did legislate last year a comprehensive change in their oversight regime, and just to be fair and frank, we did not believe that we could at this time, in this timeframe, lay out a sensible set of reforms to determine what their future role should be as we get through this crisis. We want to do that carefully and well and we did not think that was necessary to do at this stage. But as we said in the report, we are going to begin a process of looking at broader options for what their future should be and what should be the future role of those agencies in the housing market in the future. We just didn't think it was essential to do just now, but it is an essential thing to do. We couldn't do it carefully enough, thoughtfully, in this timeframe. But as you know, Congress did legislate last year a comprehensive new oversight regime in place over those institutions. If that had been in place before, that might have helped mitigate this crisis. Senator Vitter. Well, I just underscore the point that if we can consider all of these changes on the private sector carefully and thoughtfully in this timeframe, and I have my doubts about that, but if we can do that in this timeframe, I think we can attack the Fannie-Freddie issue in this timeframe, as well. " CHRG-111shrg55117--119 Mr. Bernanke," I do agree. Senator Kohl. Thank you. While consumer spending has remained flat through 2009, the personal savings rate, as you know, has finally started to rise, and quite substantially. The weak economy has made consumers more skeptical of borrowing and increasingly aware of their spending habits, as I am sure you know. As we here consider reforms to the banking system to help financial institutions prepare for possible future economic downturns, we need also to help prepare the American families across the country for their next economic crisis. Do you have any policy recommendations that would help continue the upward trend of the personal savings rate and avoid another bubble based on consumer activity? " 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--168 Mr. Volcker," That is the core. Senator Schumer. Yes. OK. So now I would like to ask a few questions to help us understand and probe it. From what I am told of the questions here, there is still a lot of trying to drill down as to what exactly we are talking about. I would like to talk a little bit about Canada and use it by way of contrast. They have a banking system, as you know, dominated by six large full-service banks, but it was the only G-7 country where the government didn't have to bail out its banking system in the recent crisis. Some people say it was cultural, arguing Canadians are simply more risk averse as a society than Americans and their bankers are no different. But others have argued the answer had more to do with their regulatory system. I tend to believe that. I don't know exactly how it works, but I know enough culture, maybe were the British more risky than the Canadians culturally? Who knows. But this regulatory system, and particularly its willingness to just say no to risky practices. So here are my specific questions and then general. Consumer protection--Canada has a separate Consumer Protection Agency, and despite home ownership levels higher than the United States, the percentage of Canadian mortgages that are subprime is less than half of that in the United States. The default rate is less than 1 percent in Canada compared to 10 percent in the United States. What role do you think Canada's Consumer Protection Agency played in maintaining a safe and robust mortgage market and not allowing billions of dollars of no-doc loans to just be stamped, stamped, stamped, and securitized? " CHRG-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. ------ FinancialCrisisInquiry--66 CHAIRMAN ANGELIDES: All right. But—but it—OK, I’ll leave it there. Thank you. Let’s now move on. Thank you very much, gentlemen. Let’s move on to Mr. Georgiou. GEORGIOU: Gentlemen, I’m a strong believer in the strength of the market system. And although regulation of the financial services industry is proper and necessary, despite their best efforts government regulators often lack the resources and expertise to monitor adequately activities that create undue systemic risk. So it is important for us to focus on creating market mechanisms that reduce the likelihood that risk-taking practices will get out of hand and threaten the stability of the entire financial system. Expert commentators have suggested that the crippling financial crisis was at least partially caused by inadequate accountability of those responsible for the creation of financial instruments for the consequences of their action, because they lacked, quote, “skin in the game.” The investment bankers who undertake the fiduciary duty to conduct due diligence on the integrity of the security, the lawyers who draft the prospectuses, the accountants who audit the financials of the issuer, and the rating agencies, which rate the safety of the security, are paid their fees all in cash from the proceeds of the sale and thereafter suffer no financial consequence, whether the security succeeds or fails. This system places the burden of loss exclusively on the purchasers, often pension and retirement funds investing on behalf of citizens who worked a lifetime, legitimately expecting that there will be sufficient resources available to fund their monthly benefits during retirement. CHRG-110hhrg44903--123 Mr. Geithner," I don't believe that we need a dramatic expansion or redefinition or change of our rule. As I laid out in my testimony, I think there are some areas which represent continuity where there are additional responsibilities, where I think you need to tighten up responsibility and authority and give us a better balance of ability to compensate for the moral hazard that is created by things we have to do in crisis. So I would say, just to repeat them, it is very important that we have, as we do now, a rule in thinking about and setting the capital requirements and other prudential requirements that apply to core institutions. It is very important that we have a rule in consolidated supervision of those institutions, because you will not have good judgments made by this Bank, this Federal Reserve in the future unless we have the direct knowledge that comes with supervision. It is very important in crises that central banks are able to move with force and speed when circumstances require it, and that won't happen unless you have a tighter match between that responsibility for lender of last resort functions and the knowledge that can only come for some role going forward. It is very important in the payments area, where we have substantial responsibilities now, that you have a little more clarity about who is accountable for a level playing field and a broader systemic stability. And it is very important in crises that have systemic implications that we have a consolidated framework. That basic framework is very consistent with the responsibilities we have now, but our system has changed a lot since that was designed, and so we just need to look at how to make sure we get a better match between responsibility and authority. " CHRG-111shrg56262--7 UNIVERSITY OF CONNECTICUT SCHOOL OF LAW Ms. McCoy. Thank you. Chairman Reed, Ranking Member Bunning, and Members of the Subcommittee, thank you for inviting me here today. In the run-up to the crisis, Wall Street financed over half of subprime mortgages through private label securitization. When defaults spiked on those loans and housing prices fell, securitization collapsed in August 2007. It has been on life support ever since. When private label securitization comes back, it is critical to put it on sound footing so that it does not bring down the financial system again. The private label system had basic flaws that fueled the crisis. First, under the originate-to-distribute model, lenders made loans for immediate sale to investors. In addition, lenders made their money on up-front fees. Both features encouraged lenders to ``pass the trash.'' Lenders cared less about underwriting because they knew that investors would bear the brunt if the loans went belly up. In addition, to boost volume and fees, lenders made loans to weaker and weaker borrowers. In fact, when I have examined the internal records of some of the largest nonprime lenders in the United States, I have often found two sets of underwriting standards: lower standards for securitized loans and higher ones for loans held in portfolio. Second, securitizations spread contagion by allowing the same bad loan to serve as collateral for a mortgage-backed security, a collateralized debt obligation, and even the CDO of CDOs. It further spread contagion because investors used tainted subprime bonds as collateral for other types of credit, such as commercial paper and interbank loans. This shook confidence in the entire financial system because investors did not know where the toxic assets were located. Last, securitization resulted in a servicing system that creates thorny barriers to constructive workouts of distressed loans. We have had too many foreclosures as a result. In this, there were three victims: borrowers, who were steered into bafflingly risky mortgages, often at inflated interest rates; investors, who were forced to rely on ratings because securities disclosures were deficient and securitizations were so complex; and, finally, the public, who had to pay to clean up the mess. So how do we fix these problems going forward? There are two aspects: lax underwriting and loan workouts. First, fixing underwriting. One group of proposals seeks to realign incentives indirectly so that mortgage actors do careful underwriting. These include requiring securitizers to retain risk, higher capital requirements, better compensation methods, and stronger representations and warranties along with stiff recourse. I applaud these measures, but they are not enough to ensure good underwriting. I doubt, for example, whether prohibiting issuers from hedging their retained risk is really enforceable. Banks are adept at evading capital standards, and the Basel II standards are badly frayed. And stronger reps and warranties are only as good as the issuer's solvency. Consider the fact that most nonbank subprime lenders are out of business and 128 banks and thrifts have failed since the crisis began. Another group of proposals focuses on better due diligence by investors and rating agency reform. This, too, is badly needed. However, memories of this crisis eventually will grow dim. When that happens, query whether investors will really take the time to do careful due diligence when a high-yield investment is dangled out in front of them. For these reasons, we need to finish the work the Federal Reserve Board began last year and adopt uniform Federal underwriting standards for mortgages that apply to all mortgage actors across the board. A brand-new study by researchers at UNC-Chapel Hill just found that States with similar laws had lower foreclosure rates than States without those laws. And a 2008 study found that State assignee liability laws did not reduce access to credit. Then one last thought: facilitating loan workouts. Here I propose amending Federal tax laws to tax securitized trusts unless they provide ironclad incentives to do loan workouts when cost effective. Thank you, and I welcome any questions. " CHRG-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-111hhrg55814--195 Secretary Geithner," Again, let's just step back. Right now, the Congress of the United States has given more than four Federal agencies and a whole number of other agencies the power to do consumer protection. They just did not do it well and we're proposing to consolidate that responsibility in one place so that it can be done better. Now, outside of consumer and investor protection, what we're proposing to do is to make sure the government has the same tools to manage risk it now has in small banks and thrifts for institutions that now define our modern financial system and can bring the economy to the edge of collapse. That's a necessary function for governments to do because banks can pose enormous risk. If you don't constrain the risk-taking of banks, we'll be consigned to repeat the crisis we just went through. " CHRG-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-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-111hhrg52261--2 Chairwoman Velazquez," I call this hearing to order. One year ago this month, we saw the largest bankruptcy in United States' history when Lehman Brothers filed for Chapter 11. The following weeks were a whirlwind of activity. The FDIC seized Washington Mutual, selling the company's banking assets to JPMorgan Chase. Wachovia was acquired by Wells Fargo and Merrill Lynch, by Bank of America. Attempting to provide relief to our teetering financial system, Congress passed and President Bush signed into law the $700 billion TARP legislation. Since then, it has become evident that the problems leading up to this crisis did not accumulate overnight. In fact, flaws in our risk management systems, both governmental regulations and private mechanisms, had been growing for decades. In coming weeks, Congress and the administration will examine options for strengthening our regulatory structure. This is long overdue; the gaps in the system have grown too large to be ignored. We cannot count on current regulations to prevent another crisis. While considered by many an issue for the financial services industry, how we address those gaps will be critical for all small businesses. It is imperative that as we look at alternatives for updating our financial regulations, we carefully consider how these changes might affect entrepreneurs. Small businesses rely on the healthy functioning of our financial systems in order to access capital. New rules governing how financial institutions extend credit will directly affect entrepreneurs seeking loans at affordable rates. The biggest challenge facing small firms right now is access to affordable capital. We must be careful that regulatory changes do not exacerbate the current capital shortage and undercut our recovery as it begins to take hold. Likewise, financial regulatory reform could unintentionally touch sectors of the small business community that we do not think of as financial institutions. Businesses that allow customers to pay for goods and services after delivery are essentially extending credit. Congress and the administration must be careful not to define the term ""credit"" too broadly. Otherwise, businesses like home builders, physicians, and others may face new rules that were not meant for them. Small businesses come in all shapes and sizes and there are many in the financial sector. Community banks and credit unions could see their business models profoundly affected by many of the proposed changes. Small firms in the financial sector often face higher compliance costs than their larger competitors. Several proposals would result in small lenders answering to a new regulatory entity. I expect some of our witnesses today will testify that small lenders bear less responsibility for the recent turmoil and, therefore, should not carry the brunt of new regulations. This argument seems to at least carry some credibility. The committee should consider it carefully as we proceed. As both lenders and borrowers, small businesses have much at stake when it comes to regulatory reform. The financial crisis of last year and the recession it triggered have hit small firms hard. As much as anyone, entrepreneurs want these problems fixed so that financial markets can again play their vital role in promoting commerce. Numerous strategies have been floated for restoring transparency and stability to our financial systems. Depending on how they are crafted, these proposals could touch every sector of the American economy. For these reasons, we have invited representatives from a range of industries to testify. It is my hope that their testimony will add important perspectives to our discussion. On that note I would like to take the opportunity to thank all the witnesses for taking time out of your busy schedule to be with us here today. And I yield to the ranking member, Mr. Graves, for an opening statement. [The statement of Chairwoman Velazquez is included in the appendix.] " CHRG-111hhrg53238--50 Mr. Yingling," Thank you, Mr. Chairman. ABA believes there are three areas that should be the primary focus of reform: the creation of a systemic regulator; the creation of a mechanism for resolving institutions; and filling the gaps in regulation of the shadow-banking industry. The reforms need to be grounded in a real understanding of what caused the crisis. For that reason, my written testimony discusses continuing misunderstandings of the place of traditional banking in this mess. ABA appreciates the fact that the bipartisan leadership of this committee has often commented that the crisis in large part developed outside the traditional banking industry. The Treasury's plan noted that 94 percent of high-cost mortgages were made outside traditional banking. The ABA strongly supports the creation of an agency to oversee systemic risk. The role of the systemic risk oversight regulator should be one of identifying potential systemic problems and then putting forth solutions. This process is not about regulating specific institutions, which should be left primarily to the prudential regulators. It is about looking at information on trends in the economy and different sectors within the economy. Such problematic trends from the recent past would have included the rapid appreciation of home prices, proliferation of mortgages that ignored the long-term ability to repay, excess leverage in some Wall Street firms, the rapid growth and complexity of mortgage-backed securities and how they were rated, and the rapid growth of the credit default swap market. This agency should be focused and nimble. In fact, involving it in a day-to-day regulation would be a distraction. While much of the early focus was on giving this authority directly to the Fed, now most of the focus is on creating a separate council of some type. This would make sense, but it should not be a committee. The council should have its own dedicated staff, but it should not be a large bureaucracy. The council should primarily use information gathered from institutions through their primary regulators. However, the systemic agency should have some carefully calibrated backup authority when systemic issues are not being addressed. There is currently a debate about the governance of such council. A board consisting of the primary regulators, plus Treasury, would seem logical. As to the Chair of the agency, there would seem to be three choices: Treasury; the Fed; or an independent person appointed by the President. A systemic regulator could not possibly do its job if it cannot have oversight authority over accounting rulemaking. A recent hearing before your Capital Markets Subcommittee clearly demonstrated the disastrous procyclical impact of recent accounting policies, and I appreciate the chairman's reference to that at the beginning of this hearing. Thus a new system for oversight of accounting rules needs to be created in recognition of the critical importance of accounting rules to systemic risk. H.R. 1349, introduced by Representatives Perlmutter and Lucas, would be in a position to accomplish this. ABA has strongly supported this legislation in previous testimony. As the systemic oversight agency is developed, Congress could consider making that agency the appropriate body to which the FASB reports under the approach of H.R. 1349. Let me turn to the resolution issue. We have a successful mechanism for resolving banks. Of course, there is no mechanism for resolution of systemically important nonbank firms. Our regulatory bodies should never again be in the position of making up a solution on the fly to a Bear Stearns or an AIG or not being able to resolve a Lehman Brothers. A critical issue in this regard is ``too-big-to-fail,'' and again I appreciate the chairman's reference to a separate hearing on that critical issue. Whatever is done on the resolution system will set the parameters for too-big-to-fail. We are concerned that the too-big-to-fail concept is not adequately addressed in the Administration's proposal. The goal should be to eliminate, as much as possible, moral hazard and unfairness. When an institution goes into the resolution process, its top management, board, and major stakeholders should be subject to clearly set out rules of accountability, change, and financial loss. No one should want to be considered too-big-to-fail. Finally, the ABA strongly supports maintaining the Federal thrift charter. Mr. Chairman, ABA appreciates your public statements in support of maintaining the thrift charter. There are 800-plus thrift institutions and another 125 mutual holding companies. Forcing these institutions to change their charter and business plan would be disruptive, costly, and wholly unnecessary. Thank you, Mr. Chairman. [The prepared statement of Mr. Yingling can be found on page 187 of the appendix.] " CHRG-111shrg382--39 PREPARED STATEMENT OF MARK SOBEL Acting Assistant Secretary for International Affairs Department of the Treasury September 30, 2009 Chairman Bayh, Ranking Member Corker, members of the Senate Subcommittee on Security and International Trade and Finance, thank you for this opportunity to testify on the subject of international efforts to promote regulatory reform. I commend the Subcommittee for bringing greater public attention to this critical issue and for choosing such a propitious time, coming on the heels of the G-20 Pittsburgh Summit, to hold this hearing. It is also a personal privilege to testify alongside Dan Tarullo and Kathy Casey.G-20 Cooperation and Progress Made The Pittsburgh Summit marks another milestone in the effort to promote a more integrated approach between national and international regulation and supervision. In the wake of the onset of the crisis, and particularly over the last year, policymakers and regulators from across the globe have redoubled their efforts to repair financial systems and put in place a stronger regulatory and supervisory framework to help ensure that a crisis of the magnitude we have witnessed does not occur again, to strengthen our financial systems so they are more robust in the face of duress, and to create a culture of greater integrity and responsibility in financial markets that guards against reckless behavior and excessive risk-taking. Good progress is being made. Last year's Washington G-20 Summit produced a 47-point Action Plan to strengthen regulation. The London Summit in April advanced that work. Already, before we went to Pittsburgh, the international community working through the G-20 had achieved much. For example: Prudential oversight has been strengthened. Capital requirements had been increased for risky trading activities, some off-balance sheet items, and securitized products. Principles had been developed for sound compensation practices to better align compensation with long-term performance. Banks were acting to put in place strengthened liquidity risk management principles. Agreement had been reached to extend the scope of regulation to all systemically significant institutions, markets and products. Non-bank financial institutions, credit rating agencies, and hedge funds are being subjected to greater scrutiny, while the transparency and oversight of securitization and credit default swap (CDS) markets are being improved. International cooperation is being reinforced. More than thirty colleges of supervisors have met to discuss supervision of large, globally active firms. The Financial Stability Board (FSB, previously the Financial Stability Forum--FSF) has been strengthened, including by expanding its membership to include all G-20 countries, promoting financial policy coordination and regulatory cooperation throughout the world. Market integrity has been strengthened. The G-20 has acted to improve adherence to international standards in the areas of prudential supervision, anti-money laundering and counter financing of terrorism, and tax information exchange as part of a U.S. initiative to deal with jurisdictions that fail to commit to high-quality standards in these areas. Core Principles for Effective Deposit Insurance Systems have been developed to protect depositors around the world in a more consistent fashion. On a personal note, I would commend Martin Gruenberg, a former staff member of this Committee and now Vice-Chair at the FDIC and chair of the International Association of Deposit Insurers, for his leadership on this front.Pittsburgh Summit A fundamental objective of the Pittsburgh Summit was to build on these accomplishments and the critical work underway and to identify and gain agreement on the necessary financial supervisory and regulatory reforms to prepare financial institutions to better withstand shocks in the future. G-20 Leaders agreed on timetables to take action in four key priority areas: capital, compensation, over-the-counter (OTC) derivatives and cross-border resolution. Capital. The crisis demonstrated that capital and liquidity requirements were simply too low and that firms were not required to hold increased capital during good times to prepare for bad. Thus, G-20 Leaders agreed to develop rules to improve the quantity and quality of bank capital and to discourage excessive leverage by end-2010. The Leaders' agreement recognizes that strengthening capital standards is at the core of the reform effort and it tracks closely with the Principles for Reforming the United States and International Regulatory Capital Framework for Banking Firms, which Secretary Geithner set forth just before the G-20 Ministerial meeting in London earlier this month. Compensation. Compensation practices at some firms created a misalignment of incentives that amplified a culture of risk- taking. Building on the principles developed by the FSB earlier this year, G-20 Leaders endorsed the implementation of standards to help significant financial institutions and regulators better align compensation with long-term value and risk management. National supervisors will review firms' policies and structures and impose corrective measures on those that fail to implement sound practices. Cross-border banking resolution. The global financial system is more interconnected than it has ever been and the crisis affected financial firms without regard to their legal structure, domicile or location of customers. G-20 Leaders agreed to establish crisis management groups for the major cross-border firms and to strengthen their domestic frameworks for resolution of financial firms. Further, it was agreed that prudential standards for the largest, most interconnected firms should be commensurate with the costs of their failure. Over-the-counter (OTC) derivatives. The OTC derivatives markets, which were mainly used to disperse risk to those most able to bear it, also allowed hidden concentrations of risk to buildup. G-20 Leaders built on the work already undertaken in this area, agreeing that all standardized OTC derivative contracts should be traded on exchanges or electronic trading platforms and cleared through central counterparties by end- 2012. Further, they affirmed that non-centrally cleared contracts should be subject to higher capital requirements. In addition, the Leaders called on international accounting bodies to redouble their efforts to achieve a single set of high quality, global accounting standards. Leaders also reaffirmed their commitment to maintain the momentum to raise standards to deal with tax havens, money laundering, and terrorist finance. These are important achievements. But by no means can we be complacent. Not only must the international community act to make sure that all G-20 commitments are put in place at the international level, each G-20 country must now intensify its effort to help ensure that these commitments are implemented at the national level.The National and International Spheres The financial crisis has highlighted the global sweep of financial markets. As Secretary Geithner has said, we may not all be in the same boat, but we are in the same storm. Firms and markets are now global in scope. We derive benefits from open, interconnected capital markets. However, traditionally, the scope of financial regulation was nationally oriented, stopping at the water's edge. Further, different national standards open the possibility for regulatory arbitrage, gaps in oversight, and a race to the bottom. These pitfalls must be avoided. The recent crisis also highlighted that financial duress can spread quickly across national boundaries. Thus while financial regulation continues to be essentially a national activity--grounded in domestic laws, cultures, and history--and the responsibility for sound regulation begins at home, we must seek to improve international cooperation in the regulatory and supervisory sphere. In particular, the major international financial centers must work together to make national laws and practices more consistent and convergent with high quality regulation.The Machinery for International Supervisory and Regulatory Cooperation Throughout the crisis, a number of bodies, in addition to the G-20, have helped the international community advance its work in strengthening the international financial system. Let me be clear--international cooperation is not new. For many years, independent standard setting bodies--such as the Basel Committee on Banking Supervision, the International Organization of Securities Commissions and the International Association of Insurance Supervisors--have brought together regulators from key countries with the aim of fostering cooperation and forging more consistent global standards. But one body, the Financial Stability Board (FSB), has played a critical role and I would like to highlight it as its history provides meaningful insights into why it is such a useful tool for us today. It was founded in 1999 as the Financial Stability Forum (FSF), in the aftermath of the Asia financial crisis, by the G-7 Finance Ministers and Central Bank Governors. Secretary Geithner, then the Under Secretary of the Treasury for International Affairs, played a seminal role in its establishment. It was charged to promote international financial stability through enhanced information exchange and international cooperation in financial market supervision and surveillance. The unique feature of the FSF was that it brought together G-7 central bank, finance and regulatory officials, plus officials from a number of other financial centers, with the heads of the key standard setting bodies. The focus was not so much on the global macroeconomic situation but on financial sector developments and vulnerabilities as well the work of the standard setting bodies. At the outset of the crisis in September 2007, the G-7 Finance Ministers and Central Bank Governors asked the FSF to analyze the causes and weaknesses producing the crisis and provide recommendations to increase the resilience of markets and institutions. The FSF issued its first report in April 2008 and an update in October of that year. The report set forth recommendations on: strengthened prudential oversight of capital, liquidity and risk management; enhancing transparency and valuation; changes in the role and uses of credit ratings; strengthening the authorities' responsiveness to risks; and robust arrangements for dealing with stress in the financial system. These recommendations have been at the center of the international consensus on the necessary steps to overhaul the global financial regulatory system and tackle the root causes of the crisis and were reflected in the November 2008 and April 2009 G-20 Leaders Declarations. Reconstituted as the Financial Stability Board in April 2009, with an enhanced mandate and membership now encompassing all G-20 countries, the FSB has been a key venue for preparation for both the London and Pittsburgh Leaders Summits. Further, the expansion of the FSB to include all G-20 members has meant that officials around the world are working together to put in place best practices, that are designed to help reduce the potential scope for future regulatory arbitrage. Mr. Chairman, while my testimony today focuses on the role of the G-20, FSB and international standard setting process, the Treasury participates in many other bodies with a view to fostering international financial market cooperation. In particular, we have strong and ongoing dialogues with the European Commission through the U.S./EU Financial Markets Regulatory Dialogue, Japan, China, India, our NAFTA partners and many more countries. These fora offer us the opportunity to delve deeper on a bilateral basis into financial market issues and share our views on the international agenda.The FSB's Role in Promoting International Coordination The FSB is an informal grouping. Working with national policy and regulatory officials and standard setting bodies, it promotes greater consistency and coordination in order to foster more effective regulatory, supervisory and other financial sector policies across the world. Since the onset of the current financial crisis, the FSB has been a critical mechanism for setting forth a comprehensive agenda for reform, reflecting an international consensus, and monitoring the implementation of G-20 Leaders' action points. Its role has been highly valued, and reflecting this, its mandate has been enhanced and its membership expanded, strengthening the network for global financial supervisory and regulatory cooperation. The FSB's Plenary is its decisionmaking body, which meets at least two times per year. Representation is at the level of central bank Governor or deputy; head or deputy of the main supervisory/regulatory agency; and deputy finance minister. The number of seats in the Plenary assigned to member jurisdictions reflects the size of the national economy and financial market activity of the member jurisdiction. Plenary representatives also include the chairs of the main standard setting bodies and committees of central bank experts, and high-level representatives of the IMF, the World Bank, the Bank for International Settlements, and the Organisation for Economic Co-operation and Development. Decisions are taken by consensus. Its Steering Committee provides operational guidance between Plenary Meetings to carry forward the directions of the FSB. The Steering Committee may establish working groups as needed which may include representatives of non-FSB members. Currently, three Standing Committees have been established to support FSB workstreams. These committees are for the Assessment of Vulnerability; Standards Implementation; and Supervisory and Regulatory Cooperation. In addition, there is an Expert Group on Non-Cooperative Jurisdictions and working groups on Cross-border Crisis Management and on Compensation. The Secretariat, located in Basel at the Bank for International Settlements, supports the activities of the FSB, including its Standing Committees and working groups. It also facilitates efficient communication among members. The Chair is the principal spokesperson for the FSB and represents the FSB externally. The Chair is appointed by the Plenary from members for a term of 3 years renewable once. The Chair has recognized expertise and standing in the international financial policy arena but when acting as Chair, owes duty entirely to the FSB and to no other authorities or institutions. The FSB's current Chair is Mario Draghi, who is also the Governor of the central bank of Italy. Given the FSB's vital role, its stature was recently enhanced through its Charter, which was set forth by its members and welcomed by the G-20 Leaders at the Pittsburgh Summit. Under this new Charter, the FSB will assess financial system vulnerabilities, promote coordination and information exchange among authorities, advise and monitor best practices to meet regulatory standards, set guidelines for and support the establishment of international supervisory colleges, and support cross-border crisis management and contingency planning.Alignment of Domestic and International Reforms In the United States, we have set out a proposal for comprehensive regulatory reform. But to promote a global race to the top, we need our G-20 partners to pursue equally ambitious reforms. The agendas pursued by the FSB and United States have been and are closely aligned. This is a function of the close cooperation between U.S. and international officials through the FSB, especially through its Steering Group and Plenary, as well as standard setting bodies. Effective coordination at the international level is only possible by ensuring a cohesive national vision. The President's Working Group on Financial Markets is a key coordinating vehicle. At a working level, Treasury has taken the lead in facilitating coordination among U.S. regulators, hosting weekly calls to share information and discuss work underway within the FSB, standard setting bodies, and other international organizations to implement the vision of G-20 Leaders. This dialog has allowed us to reconcile our perspectives and speak with one voice, positioning the United States as a leader on the global stage as we set the course for a stronger and more stable international financial system. The FSB and standard setting bodies have allowed us to align our vision for the future of financial markets with that of the largest economies across the globe. Our proposed reforms have been informed by the international dialog, and international agreement on the path forward has been shaped by our own swift action domestically to prevent a return to banking as usual. The meaningful progress to emerge from the G-20 dialog on financial regulatory reform over the last eleven months is testament to the success of this strategy. Looking forward, consistent national implementation will increasingly be our point of focus in the G-20. The FSB will be an important forum via which we will assess progress, and thematic peer reviews of members are planned on the implementation of many of the G-20 action items. Already, the FSB is poised to be a critical partner in implementing our strategy for dealing with non cooperative jurisdictions, particularly with respect to compliance with international standards for cooperation and sharing of prudential information. Further, in Pittsburgh, G-20 Leaders explicitly tasked the FSB to monitor implementation of commitments on compensation and OTC derivatives.Conclusion We have made substantial progress in strengthening the international financial system, but much more remains to be done. Strong national and international regulatory coordination and convergence have been driving forces behind our swift and effective response to this global crisis. But some of the flaws in our financial system and regulatory framework that allowed this crisis to occur, and in many ways helped cause it, are still in place. Importantly, our proposals for regulatory reform of our domestic financial markets are firmly entrenched in a shared vision for the future of the international financial system. The United States has been a leader in the effort to create the FSB, shape its agenda, expand its membership and involve it closely in the work of the G-20. In turn, the FSB has been a key instrument for international policy development in response to the global financial crisis. Identifying a global response has been essential to avert regulatory gaps, arbitrage and spillovers and to safeguard market dynamism. In the wake of the most recent G-20 Leaders Summit in Pittsburgh, we can be confident knowing that the international machinery to strengthen the international financial system is in place, has set forth principles and standards for reform that are consistent with the Administration's plans for reform, and is working to bring global standards up. These efforts must continue, but building on the agreements made in the G-20, now is the time for national implementation of reforms. ______ CHRG-111shrg57709--237 PREPARED STATEMENT OF SENATOR TIM JOHNSON As we all know all too well, the financial crisis revealed that our financial services marketplace is desperately in need of reform. We also learned that some financial firms were participating in high risk activities, and that a number of ``too-big-to fail'' institutions were so interconnected that their high risk actions essentially set a series of traps in our financial services marketplace that became a serious threat to consumers, investors and the economy as a whole. As Congress works on legislation to reform our financial system, this Committee has already identified two proposals that can help address this problem. First, better systemic risk regulation can help monitor risky activities by firms, and prevent and stop activities that could pose a threat to the economy as a whole. Second, Resolution Authority will provide a path forward if an institution fails without putting the taxpayer on the hook. These two steps are invaluable to decreasing risk in our nation's marketplace. In addition to these ongoing efforts, the Administration has proposed another idea to minimize economic threats to our system by prohibiting certain high-risk investment activities by banks and bank holding companies. I applaud the Chairman for holding two hearings on this proposal this week. I look forward to hearing more of the details from Chairman Volcker and Deputy Secretary Wolin today. ______ 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-111hhrg74090--49 Mr. Scalise," Thank you, Mr. Chairman. I want to thank you and the ranking member for having this hearing. The Administration is proposing yet another new federal agency with vague, sweeping authority. We all know there have been bad actors in our financial system that took advantage of consumers and contributed to the current economic crisis. Unfortunately, many of the problems that brought on today's financial crisis are not even being addressed in this bill. The proposed legislation does not address the real bad actors in our financial systems, Fannie Mae and Freddie Mac and other institutions that engaged in subprime lending and relaxing their standards to encourage more people to take out loans they could not afford. Those warning signs were brought before Congress for years and yet many of the same people in this Administration and in the leadership in this Congress are the same people who opposed the very reforms that would have prevented this financial crisis from happening in the first place. This proposed new agency represents yet another step in the federal government trying to run all aspects of our lives. The government is running banks and car companies with disastrous results. The so-called stimulus bill, which spent $787 billion of money we don't have, is now being recognized even by this Administration as a failure that didn't create any jobs that were promised. There are even some in this Administration floating the reckless idea of yet another massive spending bill since the last one didn't work. Scores of experts predict that this Administration's cap-and-trade energy tax will cost us millions of jobs while increasing electricity rates on all American families. We are debating a bill that proposes a government takeover of health care, which has been tried and failed in other countries to the point that sick people with the means in those countries come here to get their health care because government-run health care leads to rationing everywhere it has been tried. Now we have this bill to create a consumer czar. Enough is enough. Let us fix the problems that exist and make reforms to federal agencies that are causing these problems rather than adding yet another layer of government bureaucracy that simply covers up the root causes of the problem while punishing those who play by the rules. I look forward to hearing the comments from today's panel and would like to hear how the Administration's plan impacts the FTC. In his testimony, Chairman Leibowitz speaks to the successes the FTC has had in protecting consumers in financial matters, which begs the question why we need a new agency with all these sweeping new powers and spends more money that we don't have. I yield back. " CHRG-111shrg56376--26 Mr. Tarullo," I would say, Senator, Bear Stearns, AIG, Lehman, Fannie and Freddie. There were a lot of problems in this system, and as I said earlier, I think before this crisis is over, we are going to have seen a lot of failures in a lot of kinds of institutions. I don't say that to try to deflect any responsibility. In fact, I think part of what I was trying to say in my prepared remarks and in the introductory remarks was that I and everybody on the Board takes seriously where things didn't get regulated as well as they should have and where the structure needs work, and that is why we started to make the changes we are already making. Senator Shelby. Just for the record, and we all know this, but who is the regulator, the primary regulator of the holding companies, the big banks that got into trouble? You know it is your Federal Reserve, and you are now--you weren't, but you are now a member of the Board of Governors. Let us be honest about it. " fcic_final_report_full--552 Public Hearing on the Shadow Banking System, Dirksen Senate Office Building, Room , Washington DC, Day , May ,  Session : Investment Banks and the Shadow Banking System Paul Friedman, Former Senior Managing Director, Bear Stearns Samuel Molinaro Jr., Former Chief Financial Officer and Chief Operating Officer, Bear Stearns Warren Spector, Former President and Co-chief Operating Officer, Bear Stearns Session : Investment Banks and the Shadow Banking System James E. Cayne, Former Chairman and Chief Executive Officer, Bear Stearns Alan D. Schwartz, Former Chief Executive Officer, Bear Stearns Session : SEC Regulation of Investment Banks Charles Christopher Cox, Former Chairman, U.S. Securities and Exchange Commission William H. Donaldson, Former Chairman, U.S. Securities and Exchange Commission H. David Kotz, Inspector General, U.S. Securities and Exchange Commission Erik R. Sirri, Former Director Division of Trading & Markets, U.S. Securities and Exchange Commission Public Hearing on the Shadow Banking System, Dirksen Senate Office Building, Room , Washington DC, Day , May ,  Session : Perspective on the Shadow Banking System Henry M. Paulson Jr., Former Secretary, U.S. Department of the Treasury Session : Perspective on the Shadow Banking System Timothy F. Geithner, Secretary, U.S. Department of the Treasury; Former President, Federal Reserve Bank of New York Session : Institutions Participating in the Shadow Banking System Michael A. Neal, Vice Chairman, General Electric; Chairman and Chief Executive Officer, GE Capital Mark S. Barber, Vice President and Deputy Treasurer, GE Capital Paul A. McCulley, Managing Director, PIMCO Steven R. Meier, Chief Investment Officer, State Street Public Hearing on Credibility of Credit Ratings, the Investment Decisions Made Based on Those Ratings, and the Financial Crisis, The New School Arnhold Hall, Theresa Lang Community & Student Center,  West th Street, nd Floor, New York, NY, June ,  Session : The Ratings Process Eric Kolchinsky, Former Team Managing Director, US Derivatives, Moody’s Investors Service Jay Siegel, Former Team Managing Director, Moody’s Investors Service Nicolas S. Weill, Group Managing Director, Moody’s Investors Service Gary Witt, Former Team Managing Director, US Derivatives, Moody’s Investors Service Session : Credit Ratings and the Financial Crisis Warren E. Buffett, Chairman and Chief Executive Officer, Berkshire Hathaway Raymond W. McDaniel, Chairman and Chief Executive Officer, Moody’s Corporation Session : The Credit Rating Agency Business Model Brian M. Clarkson, Former President and Chief Operating Officer, Moody’s Investors Service (written testimony only due to a medical emergency) Mark Froeba, Former Senior Vice President, US Derivatives, Moody’s Investors Service Richard Michalek, Former Vice President/Senior Credit Officer, Moody’s Investors Service 549 CHRG-111shrg61651--96 Mr. Johnson," I think Professor Scott made a very deep point with regard to LTCM, certainly. It is the surprise interconnectedness. Now, maybe we can measure these. Maybe the regulator will catch up, to some degree, with the technology. But you are always going to be surprised in a big crisis. And then I think it comes down to two things. First, how big is this problem relative to the economy? Take CIT Group, for example, that failed last year. CIT Group had a balance sheet of $80 billion. There was a big debate, as you know, in Washington about whether they were too big to fail, and it was decided, rightly, despite their interconnections that were known and unknown, that they could fail--and did fail, have essentially failed--without disrupting the system. That is what we know. That is the biggest financial institution we have let fail and it hasn't had the systemic implications. Eighty-billion, that is what we know. In addition to the size, it is about capital. It is about capital and derivative positions. I mean, that is the part that we know about, the part that Professor Scott and Mr. Reed have been emphasizing. These derivative positions with low capital requirements are asking for trouble. They are still there and they are not going away in the existing framework. " 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-110hhrg44901--71 The Chairman," The gentlewoman from Ohio. Ms. Pryce. Thank you, Mr. Chairman. And I want to thank you, Chairman Bernanke, for being with us today. Thank you for your activity over the last several months. It has certainly been a tumultuous few months. My concern is that we as a Nation, you as the Fed, the Administration, and the Congress seems to be working in a reactionary mode, in crisis mode, that everything that has happened as a result of events. Now I know that you have no crystal ball any more than we have a crystal ball. But we as a committee have responsibility for oversight of the safety and soundness of our financial system. And I just want to ask a very simple question because I just haven't found an answer for it yet. And that is, why did such sophisticated market participants misjudge so badly the risk in the U.S. housing market? Is there an answer that you can impart to the committee to help us understand why we blinked and missed this one? " 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-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," " CHRG-111hhrg53234--171 Mr. Meyer," First, let me reiterate what I said before, and I agree with Vice Chairman Kohn here, that what the Treasury proposal does is very incremental and not very dramatic, not a vast expansion of powers--basically asking the Fed to do what it has been doing as bank holding company supervisor and extending that reach to a modest degree over systemically important financial institutions that don't have a bank. I think it is clear that the Federal Reserve didn't distinguish itself in carrying out its responsibilities as supervisor and regulator of banks and bank holding companies. This is an extraordinary period; it is the first financial crisis since the Great Depression, and I don't believe any other financial supervisor or regulator carried out its responsibilities to protect the safety and soundness of the banks and institutions under their control in this circumstance either. So I think what we need to do is not only ask the Fed to carry out its responsibilities, but to encourage it to do what I think it would otherwise do, to change capital standards that make them more onerous for systemically important institutions, carry out more macroprudential supervision than it has done before, although, let me say, the Treasury proposal separates that out and gives that responsibility mainly to Treasury--well, mainly to the risk council that is staffed by Treasury and chaired by the Secretary. " fcic_final_report_full--625 Crisis, day 1, session 1: Overview of Derivatives, June 30, 2010, transcript, p. 26. 58. Depository Trust and Clearing Corporation data provided to the FCIC. 59. “The Global OTC Derivatives Market at End-June 1998,” Bank of International Settlements press release, December 13, 1998; “OTC derivatives market activity in the second half of 2008,” Bank of Inter- national Settlements press release, May 9, 2009, p. 7. 60. “Triennial and Regular OTC Derivatives Market Statistics,” Bank of International Settlements press release, November 16, 2010, p. 7. 61. Moody’s, “Moody’s downgrades WaMu Ratings; outlook negative,” September 11, 2008. 62. “OTS Fact Sheet on Washington Mutual Bank,” OTS 08–046A, September 25, 2008, p. 3. 63. Jamie Dimon, interview by FCIC, October 20, 2010. 64. Sheila Bair, testimony before the FCIC, Hearing on Too Big to Fail: Expectations and Impact of Extraordinary Government Intervention and the Role of Systemic Risk in the Financial Crisis, day 2: ses- sion 2: Federal Deposit Insurance Corporation, September 2, 2010, exchange between Bair and Commis- sioner Douglas Holtz-Eakin, pp. 134, 149. 65. Scott Alvarez, testimony before the FCIC, Hearing on Too Big to Fail: Expectations and Impact of Extraordinary Government Intervention and the Role of Systemic Risk in the Financial Crisis, day 1, Ses- sion 1: Wachovia Corporation, September 1, 2010, transcript, p. 84. 66. Kashkari, interview. 67. Greg Feldberg, “Wachovia Case Study,” presentation at LBO Supervision Conference, November 12–13, 2008, Atlanta, Georgia, p. 15. These rules, embodied in section 23A of the Federal Reserve Act, limit the support that a depository institution can provide to related companies in the same corporate structure; they are aimed at protecting FDIC-insured depositors from activities that occur outside of the bank itself. Exemptions have the effect of funding affiliate, nonbank assets within the federal safety net of insured deposits; they create liquidity for the parent company and/or key affiliates (and reduce bank liq- uidity) during times of market stress. 68. Robert Steel, interview by FCIC, August 18, 2010. 69. Scott Alvarez, written testimony for the FDIC, September 1, 2010, p. 4. 70. Robert Steel, written testimony before the FCIC, Hearing on Too Big to Fail: Expectations and Im- pact of Extraordinary Government Intervention and the Role of Systemic Risk in the Financial Crisis, day 1, session 1: Wachovia Corporation, September 1, 2010, p. 2. 71. David Wilson, interview by FCIC, August 4, 2010. 72. Sheila Bair, interview by FCIC, August 18, 2010. 73. Richard Westerkamp, Federal Reserve Bank of Richmond, interview by FCIC, August 13, 2010. 74. Wachovia was unable to roll $1.1 billion of asset-backed commercial paper that Friday; James Wigand and Herbert Held, memo to the FDIC Board of Directors, September 29, 2008, p. 2. On brokered certificates of deposit, see Westerkamp, interview. 75. John Corston, acting deputy director, Division of Supervision and Consumer Protection, FDIC, written testimony before the FCIC, Hearing on Too Big to Fail: Expectations and Impact of Extraordi- nary Government Intervention and the Role of Systemic Risk in the Financial Crisis, day 1, Session 1: Wachovia Corporation, September 1, 2010, p. 4. 76. Wilson, interview. 77. Rich Westerkamp, email to FCIC, November 2, 2010. Westerkamp said that the estimate of early redemption requests was based on a phone conversation with officials in Wachovia’s treasury depart- ment, describing their conversations with investors; the figures were never verified. 78. Bair, interview. 79. Robert Steel, interview by FCIC, August 18, 2010. 80. Bair, interview; Steel, interview; FDIC staff, interview by FCIC re Wachovia, July 16, 2010. 81. Alvarez, written testimony for the FCIC, September 1, 2010, p. 5. 82. Steel, interview. 83. Ibid. 84. Wigand and Held, memo to the FDIC board, September 29, 2008, pp. 2, 4–5. 85. Federal Reserve staff, memo to the Board of Governors, subject: “Considerations Regarding In- voking the Systemic Risk Exception for Wachovia Bank, NA,” September 28, 2008, p. 7. 86. John A. Beebe, Market Risk Team Leader, Federal Reserve Bank of Richmond, memo to Jennifer fcic_final_report_full--476 The forest metaphor turns out to be an excellent way to communicate the difference between the Commission’s report and this dissenting statement. What Summers characterized as a “cigarette butt” was 27 million high risk NTMs with a total value over $4.5 trillion. Let’s use a little common sense here: $4.5 trillion in high risk loans was not a “cigarette butt;” they were more like an exploding gasoline truck in that forest. The Commission’s report blames the conditions in the financial system; I blame 27 million subprime and Alt-A mortgages—half of all mortgages outstanding in the U.S. in 2008—and a number that appears to have been unknown to most if not all market participants at the time. No financial system, in my view, could have survived the failure of large numbers of high risk mortgages once the bubble began to deflate, and no market could have avoided a panic when it became clear that the number of defaults and delinquencies among these mortgages far exceeded anything that even the most sophisticated market participants expected. This conclusion has significant policy implications. If in fact the financial crisis was caused by government housing policies, then the Dodd-Frank Act was legislative overreach and unnecessary. The appropriate policy choice was to reduce or eliminate the government’s involvement in the residential mortgage markets, not to impose significant new regulation on the financial system. **** The balance of this statement will outline (i) how the high levels of delinquency and default among the NTMs were transmitted as losses to the financial system, and (ii) how the government policies summarized above caused the accumulation of an unprecedented number of NTMs in the U.S. and around the globe. 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-111shrg55278--33 Mr. Tarullo," Senator, I keep referring to my prior life, but it turns out to have been relevant for this job, which I guess is a good thing. I spent a good bit of time as an academic looking at the different ways in which countries structured their regulatory systems, and there are some countries--the U.K. and Japan notable among them--that have tried fundamentally to consolidate all financial regulation in a single entity. I do not think there is any denying that there are some advantages to that. You do get some of the cross-pollination of views. You do balance your incentives to foster the system but protect, for example, the deposit insurance fund. You get a lot of those incentives. I think, though, that many people in those countries would also say there are downsides to that as well. The advent of the crisis in the U.K. suggested to a lot of people that that model was not a fail-safe either. I should say the Fed does not have a position on more consolidation, less consolidation. But just as a kind of policy observation, I think there would be gains to trying to get more focus and consolidation so that you have some sense of who is accountable for what. But I think most of us--and I suspect all three of us at the table here--would also agree that some measure of redundancy is actually not a bad thing; that is, sometimes, you want accountability, but sometimes it is not the worst thing in the world to have multiple pairs of eyes, and even somewhat overlapping authorities. Senator Tester. I would agree with that, but then what happens with the instrument that is developed that has no regulation and falls in those gaps that we talked about and then everybody says it was---- " CHRG-111shrg53822--79 Mr. Rajan," Well, this follows on the comments I just made, which is that if capital on the balance sheet is not going to work that well because banks will find ways to offset it, maybe the idea is to get capital which comes only in bad times. It might be cheaper to arrange for that kind of capital rather than have capital sitting on balance sheets through good times and bad times. And if you can do it in a clever enough way, banks will not be able to exploit that capital and take on more risks a priori, given that they know that capital will come in. So two examples of how this could be done. One, which Mr. Baily has also talked about, which comes from a common group that we work in, is this idea of what is called reversed convertible debt. And this convertible debt is debt which will convert into equity in times like the current ones. So it is a pre-assured source of buffer which will protect the taxpayer from having to fund these institutions. And that debt will convert, provided the bank's capital ratio goes below a certain level. That is one condition. The second condition is that this be a systemic crisis so that banks do not sort of willfully convert this debt and get additional buffers. Another variant of this would be what we call the capital insurance plan, which is you issue bonds, which are called capital insurance bonds. The bank issues these bonds. The proceeds from the bonds are taken and invested in Treasuries. And the holders of these bonds get the Treasury rate of return plus an insurance premium, which the banks pays. In bad times, when the bank's capital goes below a certain level and there is a systemic crisis, the bonds will start, essentially, paying out to the bank. It would be equity at that point for the bank, and the bank would be recapitalized. So the main difference is, in one, the bonds convert to equity; in the other, the bonds just pay in. There is no commensurate equity, which is issued. Both have the effect of recapitalizing the bank in bad times. Senator Akaka. Thank you. Further comment, Mr. Wallison? " CHRG-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. " fcic_final_report_full--10 As our report shows, key policy makers—the Treasury Department, the Federal Reserve Board, and the Federal Reserve Bank of New York—who were best posi- tioned to watch over our markets were ill prepared for the events of  and . Other agencies were also behind the curve. They were hampered because they did not have a clear grasp of the financial system they were charged with overseeing, par- ticularly as it had evolved in the years leading up to the crisis. This was in no small measure due to the lack of transparency in key markets. They thought risk had been diversified when, in fact, it had been concentrated. Time and again, from the spring of  on, policy makers and regulators were caught off guard as the contagion spread, responding on an ad hoc basis with specific programs to put fingers in the dike. There was no comprehensive and strategic plan for containment, because they lacked a full understanding of the risks and interconnections in the financial mar- kets. Some regulators have conceded this error. We had allowed the system to race ahead of our ability to protect it. While there was some awareness of, or at least a debate about, the housing bubble, the record reflects that senior public officials did not recognize that a bursting of the bubble could threaten the entire financial system. Throughout the summer of , both Federal Reserve Chairman Ben Bernanke and Treasury Secretary Henry Paul- son offered public assurances that the turmoil in the subprime mortgage markets would be contained. When Bear Stearns’s hedge funds, which were heavily invested in mortgage-related securities, imploded in June , the Federal Reserve discussed the implications of the collapse. Despite the fact that so many other funds were ex- posed to the same risks as those hedge funds, the Bear Stearns funds were thought to be “relatively unique.” Days before the collapse of Bear Stearns in March , SEC Chairman Christopher Cox expressed “comfort about the capital cushions” at the big investment banks. It was not until August , just weeks before the government takeover of Fannie Mae and Freddie Mac, that the Treasury Department understood the full measure of the dire financial conditions of those two institutions. And just a month before Lehman’s collapse, the Federal Reserve Bank of New York was still seeking information on the exposures created by Lehman’s more than , deriv- atives contracts. In addition, the government’s inconsistent handling of major financial institutions during the crisis—the decision to rescue Bear Stearns and then to place Fannie Mae and Freddie Mac into conservatorship, followed by its decision not to save Lehman Brothers and then to save AIG—increased uncertainty and panic in the market. In making these observations, we deeply respect and appreciate the efforts made by Secretary Paulson, Chairman Bernanke, and Timothy Geithner, formerly presi- dent of the Federal Reserve Bank of New York and now treasury secretary, and so many others who labored to stabilize our financial system and our economy in the most chaotic and challenging of circumstances. • We conclude there was a systemic breakdown in accountability and ethics. The integrity of our financial markets and the public’s trust in those markets are essential to the economic well-being of our nation. The soundness and the sustained prosper- ity of the financial system and our economy rely on the notions of fair dealing, re- sponsibility, and transparency. In our economy, we expect businesses and individuals to pursue profits, at the same time that they produce products and services of quality and conduct themselves well. 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.] " FinancialCrisisInquiry--389 BASS: OK. Thank you. Chairman Angelides, Vice Chairman Thomas and members of the commission, my name is Kyle Bass. I’m the managing partner of Hayman Advisors in Dallas. And I would like to thank you and the members of the committee for the opportunity to share my views with you today as you consider the causes of the recent crisis as well as certain changes that must take place to avoid or minimize future crises. I believe that I have somewhat of a unique perspective with regard to this crisis, as my firm and I were fortunate enough to have seen parts of it coming. Hayman is a global asset management firm that managed several billion dollars of subprime and Alt-A mortgage positions during the crisis. And we remain an active participant in the marketplace today. While I realize the primary objective of the hearing today is to provide baseline information on the current state of the financial crisis and to discuss the roles that four specific banks or investment banks—Goldman, Morgan Stanley, Bank of America and JPMorgan—have played in the crisis, in my opinion, no single bank or group of large institutions single-handedly caused the crisis. While I will address each participant’s structure and problems independently later in my testimony, the problems with the participants and regulatory structure needs to be considered more holistically in order to prevent future systemic breakdowns and taxpayer harm. January 13, 2010 While there are many factors that led to the crisis, I will address what I believe to be the key factors that contributed to the enormity of the crisis. The first of which is the OTC derivatives marketplace. It was brought up in the prior hearing. But with nearly infinite leverage that it—that it afforded and continues to afford the dealer community, it must be changed. AIG, Bear Stearns and Lehman would not have been able to take on as much leverage as they did had they been required to post initial collateral on day one for the risk positions they were assuming. Asset management firms, including Hayman, have always been required to post initial collateral and maintenance collateral for virtually every derivatives trade we engage in. However, in AIG’s case, not only did they have to post initial collateral—or didn’t have to post initial collateral for these positions, when the positions moved against them, the dealer community forgave the so-called variance margin. The dealer community as well as other supposed AAA rated counterparties were, and some still are, able to transact with one another without sending collateral for the risk they are taking. This so-called initial margin was and still is only charged to counterparties that are deemed to be of lesser credit quality. Imagine if you were a 28-year-old mathematics superstar at AIG Financial Products Group, and you were compensated at the end of each year based upon the profitability of your trading book, which was ultimately based upon the risks you were able to take without posting any money initially. How much risk would you take? Well, the unfortunate answer turned out to be many multiples of the underlying equity of many of the firms in question. In AIG’s case, the risks taken in the company’s derivatives book were more than 20 times the firm’s shareholder equity. For a comprehensive look at those leverage ratios we can move to tables in my presentation later. The U.S. taxpayer is still paying huge bonuses to the members of AIG’s Financial Products Group because they’ve convinced the overseers that they possess some unique skill necessary to unwind these complex positions. In reality there are hundreds of out-of-work derivatives traders that would happily take that job for $100,000 a year instead of the many millions being paid to these supposed experts. January 13, 2010 To solve this OTC derivatives problem—I heard a few of the—of the potential solutions this morning. But I’ll go over the three that I think are absolutely mandatory to fix this problem. One is—is the key issue—is homogeneous minimum collateral requirements. All participants in the derivatives marketplace—do not bar the dealers from this— should be required to post initial capital based upon some formulaic determination of the risk by the appropriate regulatory body. Two, centralized clearing and mandatory price reporting of all standardized CDS, FX and interest rate derivatives—we believe close to 90 percent of these derivatives are standardized. Centralized data repository for all cleared and non-cleared derivatives trades—essentially there must be some place where every single transaction is recorded and monitored. As of today, that still doesn’t exist. It’s hard for me to believe that where we are today that that doesn’t exist. The second thing I’d like to talk about is bank leverage. And this is just the fundamental tenants of the U.S. banking system. Under current regulatory guidelines, banks are deemed to be well- capitalized with 6 percent tier one capital and adequately capitalized with 4 percent tier one capital based upon risk weighted assets. As an aside, the concept of risk weighting in assets should also be reviewed. This in turn means that a well-capitalized bank is leveraged 16 times to its capital, much more to its tangible common equity. And an adequately capitalized bank is—or a minimum capitalized bank—sorry—is 25 times levered to its tier one capital. I don’t know how many prudent individuals or institutions can possibly manage a portfolio of assets that is 25 times levered when we hit a crisis. But—but I surely can’t. Unfortunately, the answer so far has been not many of the other banks have been able to manage these risks either. Of the 170 banks that have failed during the crisis to date, the average loss to the FDIC and the taxpayer is well over 25 percent of their assets. When you think about that, that means they’ve lost more than six times their equity, of the banks that have gone down so far. January 13, 2010 Depository institutions like Citibank were able to parlay their deposits into large levered bets in the derivatives marketplace. In fact, at fiscal year-end 2007, Citigroup was 68- times levered to its tangible common equity, including off balance sheet exposures. Clearly, the composition of these assets is important as well, but I am simply trying to illustrate how levered these companies were at the start of the financial crisis. While AIG’s derivatives book was only 20-times levered to their book equity, $64 billion of these derivatives were related to subprime and subprime credit securities, the majority of which were ultimately worth zero. In some cases, excessive leverage cost the underlying company many years of lost earnings, and in other cases it cost them everything. I’ve put a table labeled “exhibit two” in my presentation. What we’ve done is looked back at the cumulative net income that was lost in financial institutions since the third quarter of 2007. Fannie Mae lost 20 ½ years of its profits in the last 18 months. AIG lost 17 ½ years of its profits in the last 18 months. Freddie Mac lost 11 ½ years of profits in a little bit more than a year. The point I’m trying to make is the ridiculousness of what’s gone on in the leverage that was in the system. The key problem with the system is the leverage and we must regulate that leverage. I’m going to—my third point that I’ll talk about briefly here is Fannie and Freddie. With $5.5 trillion of outstanding debt in mortgaged-backed securities, the quasi-public are now in conservatorship, Fannie and Freddie, have obligations that approach the total amount of government-issued bonds the U.S. currently has outstanding. There are so many things that went wrong or are wrong at these so-called “GSEs” that I don’t even know where to start. First, why are there two for-profit companies with boards, shareholders, charitable foundations, and lobbying arms ever given the implicit backing of the U.S. government? The Chinese won’t buy them anymore because our government won’t give them the explicit backing. The U.S. government cannot give them the explicit backing because the resulting federal debt burden will crash through the congressionally January 13, 2010 mandated debt ceiling, which was already recently raised to accommodate more deficit spending. These organizations have been the single largest political contributors in the world over the past decade, with over $200 million being given to 354 lawmakers in the last 10 years or so. Yes, the United States needs low-cost mortgages, but why should organizations created by Congress have to lobby Congress? Fannie and Freddie used the most leverage of any institution that issued mortgages or held mortgage-backed bonds in the crisis. At one point in 2007, Fannie was over 95-times levered to its statutory minimum capital, with just 18 basis points set aside for loss. That’s right -- 18/100ths of 1 percent set aside for potential loss, with 95 times leverage. They must not be able to put Humpty Dumpty back together again. If they are going to exist going forward, Fannie and Freddie should be 100 percent government-owned and the government should simply issue mortgages to the population of the United States directly since this is essentially what is already happening today, with the added burden of supporting a privately funded, arguably insolvent capital structure. I will conclude my testimony there, and—and leave it to questions. CHRG-111hhrg53021Oth--107 Secretary Geithner," It is absolutely recognized, and it is a significant issue of concern. But, what is causing those pressures on both borrowers and banks is the fact that large parts of the financial system in this country just took on too much risk during the boom. And the costs of that--it is fundamentally unfair, but that is what happens in financial crises--fall not just on those who took too much risk, but they fall on a bunch of businesses and banks across the country which were very responsible and prudent. And that is why these things can be so damaging. And that is why it is very important that we do everything we can to put a better foundation for recovery in demand and growth, and try to make sure that the financial system has capital where it is necessary, and that these markets for credit start to get moving again. And that is the basic philosophy that has underpinned everything we have done. You are also right that there is a risk in financial crises that people overcorrect; that, after a period of taking on too much risk, that they take too little. People that got way overextended pull back too much. And that can cause, also, a lot of collateral damage. And, again, that is the basic rationale in a financial crisis for trying to make sure you do as much as you can to provide enough support for the economy to get back on track. But, I am very much aware of the concerns you expressed. I believe that the principal bank supervisors are, too. They are carefully managing those risks. And you are also right that any time you think about reform to legislation in the financial area, that is going to come with a period of uncertainty. We need to minimize that uncertainty. And, that is one reason why we want to bring clarity, relatively quickly, to the rules of the game that govern our financial system, going forward. If we were to wait years to do this, the markets would be left with a greater period of uncertainty, and that might deter more lending and risk taking. " CHRG-111hhrg53021--107 Secretary Geithner," It is absolutely recognized, and it is a significant issue of concern. But, what is causing those pressures on both borrowers and banks is the fact that large parts of the financial system in this country just took on too much risk during the boom. And the costs of that--it is fundamentally unfair, but that is what happens in financial crises--fall not just on those who took too much risk, but they fall on a bunch of businesses and banks across the country which were very responsible and prudent. And that is why these things can be so damaging. And that is why it is very important that we do everything we can to put a better foundation for recovery in demand and growth, and try to make sure that the financial system has capital where it is necessary, and that these markets for credit start to get moving again. And that is the basic philosophy that has underpinned everything we have done. You are also right that there is a risk in financial crises that people overcorrect; that, after a period of taking on too much risk, that they take too little. People that got way overextended pull back too much. And that can cause, also, a lot of collateral damage. And, again, that is the basic rationale in a financial crisis for trying to make sure you do as much as you can to provide enough support for the economy to get back on track. But, I am very much aware of the concerns you expressed. I believe that the principal bank supervisors are, too. They are carefully managing those risks. And you are also right that any time you think about reform to legislation in the financial area, that is going to come with a period of uncertainty. We need to minimize that uncertainty. And, that is one reason why we want to bring clarity, relatively quickly, to the rules of the game that govern our financial system, going forward. If we were to wait years to do this, the markets would be left with a greater period of uncertainty, and that might deter more lending and risk taking. " 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. ------ fcic_final_report_full--440 A persistent debate among members of the Commission was the relative importance of a firm’s legal form and regulatory regime in the failures of large financial institu- tions. For example, Commissioners agreed that investment bank holding companies were too lightly (barely) regulated by the SEC leading up to the crisis and that the Consolidated Supervised Entities program of voluntary regulation of these firms failed. As a result, no regulator could force these firms to strengthen their capital or liquidity buffers. There was agreement among Commissioners that this was a con- tributing factor to the failure of these firms. The Commission split, however, on whether the relatively weaker regulation of investment banks was an essential cause of the crisis. Institutional structure and differential regulation of various types of financial in- stitutions were less important in causing the crisis than common factors that spanned different firm structures and regulatory regimes. Investment banks failed in the United States, and so did many commercial banks, large and small, despite a stronger regulatory and supervisory regime. Wachovia, for example, was a large insured de- pository institution supervised by the Fed, OCC, and FDIC. Yet it experienced a liq- uidity run that led to its near failure and prompted the first-ever invocation of the FDIC’s systemic risk exception. Insurance companies failed as well, notably AIG and the monoline bond insurers. Banks with different structures and operating in vastly differing regulatory regimes failed or had to be rescued in the United Kingdom, Germany, Iceland, Bel- gium, the Netherlands, France, Spain, Switzerland, Ireland, and Denmark. Some of these nations had far stricter regulatory and supervisory regimes than the United States. The bad loans in the United Kingdom, Ireland, and Spain were financed by federally-regulated lenders–not by “shadow banks.” Rather than attributing the crisis principally to differences in the stringency of regulation of these large financial institutions, it makes more sense to look for com- mon factors: • Different types of financial firms in the United States and Europe made highly concentrated, highly correlated bets on housing. • Managers of different types of financial firms in the United States and Europe poorly managed their solvency and liquidity risk. CHRG-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. ______ 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-111shrg54675--77 PREPARED STATEMENT OF CHAIRMAN TIM JOHNSON It is no exaggeration to say that our economy is currently experiencing extraordinary stress and volatility. As Congress and the Administration look at corrective policy changes, I am pleased to hold this hearing today to take a closer look at the role smaller financial institutions, specifically community banks and credit unions, play in our economy, especially in many rural communities. Throughout our Nation's economic crisis there has often been too little distinction made between troubled banks and the many banks that have been responsible lenders. There are many community banks and credit unions that did not contribute to the current crisis--many rural housing markets that didn't experience the boom that other parts of the country did, and community lending institutions didn't sell as many exotic loan products as other lenders sold. Nonetheless, small lending institutions in rural communities and their customers are feeling the effects of the subprime mortgage crisis and the subsequent crisis in credit markets. Jobs are disappearing, ag loans are being called, small businesses can't get the lines of credit they need to continue operation, and homeowners are struggling to refinance. Smaller banks play a crucial role in our economy and in communities throughout our Nation; we need to be mindful that some institutions are now paying the price for the risky strategies employed by some larger financial institutions. In coming weeks, the Banking Committee will continue its review of the current structure of our financial system and develop legislation to create the kind of transparency, accountability, and consumer protection that is now lacking. As this process moves forward, it will be important to consider the unique needs of smaller financial institutions and to preserve their viability as we come up with good, effective regulations that balance consumer protection and allow for sustainable economic growth. I would like to welcome our panel of witnesses, and thank them for their time and for their thoughtful testimony on how small lending institutions in rural communities have been affected by our troubled economy. I would also like to thank Senator Kohl for his interest in today's hearing topic. I will now turn to Senator Crapo, the Subcommittee's Ranking Member, for his opening statement. ______ CHRG-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--106 Mr. Bernanke," I agree that the GSE's are playing a critical role there at this point, a very big part of the existing mortgage market. I think they could do an even better job if they were better supervised and better capitalized. With respect to supervision, I support the call for a GSE reform that has been discussed. With respect to capitalization, I believe that they are well capitalized now in the sense of--in an inventory sense. But I think as we have called upon all financial institutions to expand their capital bases so that they can be even more proactive in providing credit and support for the economy. So I would include the GSE's in that broad call for increased capital. Mr. Moore of Kansas. Thank you, and one follow-up question: Do you still believe the GSE's pose a systemic risk to the economy? And if so, how does that risk compare with the risks that have come to light with our current gaps in regulatory oversight that have in part led to the current crisis? " CHRG-111hhrg53244--10 The Chairman," The gentleman from Texas. There are 2 minutes remaining on the Republican side. We will make it 2\1/2\ minutes. Dr. Paul. Thank you, Mr. Chairman. Good morning, Chairman Bernanke. The Federal Reserve, in collaboration with the giant banks, has created the greatest financial crisis the world has ever seen. The foolish notion that unlimited amounts of money and credit created out of thin air can provide sustained economic growth has delivered this crisis to us. Instead of economic growth and stable prices, it has given us a system of government and finance that now threatens the world's financial and political institutions. Real unemployment is now 20 percent, and there has not been any economic growth since the onset of the crisis in the year 2000, according to nongovernment statistics. Pyramiding debt and credit expansion over the past 38 years has come to an abrupt end, as predicted by free market economists. Pursuing the same policy of excessive spending, debt expansion, and monetary inflation can only compound the problems and prevent the required corrections. Doubling the money supply didn't work. Quadrupling it won't work either. The problem with debt must be addressed. Expanding debt when it was a principal cause of the crisis is foolhardy. Excessive government and private debt is a consequence of loose Federal Reserve monetary policy. Once a debt crisis hits, the solution must be paying it off or liquidating it. We are doing neither. Net U.S. debt is now 372 percent of GDP, and in the crisis of the 1930's, it peaked at 301 percent. Household debt services require 14 percent of disposable income, at an historic high. Between 2000 and 2007, credit debt expanded 5 times as fast as GDP. With no restraint on spending, and revenues dropping due to the weak economy, raising taxes will be poison to the economy. Buying up the bad debt of privileged institutions and dumping worthless assets on the American people is morally wrong and economically futile. Monetizing government debt, as the Fed is currently doing, is destined to do great harm. In the past 12 months, the national debt has risen over $2 trillion. Future entitlement obligations are now reaching $100 trillion. U.S. foreign indebtedness is $6 trillion. Foreign purchase of U.S. securities in May were $7.4 billion, down from a monthly peak of $95 billion in 2006. The fact that the Fed had to buy $38 billion worth of government securities last week indicates that it will continue its complicity with Congress to monetize the rapidly expanding deficit. The policy is used to pay for the socialization of America and for the maintenance of an unwise American foreign policy and to make up for the diminished appetite of foreigners for our debt. Since the attack on the dollar will continue, I would suggest that the problems we have faced so far are nothing compared to what it will be like when the world not only rejects our debt but our dollar as well. That is when we will witness political turmoil, which will be to no one's benefit. " 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. " CHRG-110hhrg46593--265 Mrs. Biggert," Thank you, Mr. Chairman. Mr. Findlay, you have talked about the theory of the current crisis is not a liquidity crisis but instead a transparency crisis as it relates to the pricing of illiquid assets and your belief that the insurance program could help. How will the insurance program affect the financial statements of the participating entities? " CHRG-109hhrg22160--217 Mr. Greenspan," Well, I don't use the word ``crisis'' because I think the same--defining what it is very specifically describes what it is. I think it is a very serious issue. It depends on the way you use the word crisis. I have not chosen to use that word. Others might. " CHRG-110hhrg44901--72 Mr. Bernanke," Well, as we look back on it, we see that there were just some serious failures in the management of risks. There were many firms that had exposure to the housing market in a variety of ways across the firm, including holding mortgages and other ways. And they didn't fully appreciate that in the contingency that the housing boom would turn around, that house prices would begin to drop; they didn't fully appreciate their exposure to that situation. The regulators bear some responsibility on that. It is our job to make sure that they measure and manage their risks appropriately. We have been working on that for a number of years related to bank supervision initiatives like the Basel Initiative, for example, and so on. But it is clear that we need to redouble our efforts to make sure that the risk management is sound, that the underwriting is sound, and that we don't get ourselves into this kind of situation again. Ms. Pryce. Well, you mentioned Basel. Are there further risks ahead to our system and therefore the overall economy that might arise, and the new capital adequacy standards in Basel? You know, if we are trying to have this happen simultaneously, could that create new risk to the system? Effects of a crisis in any overseas market, could that affect our system in a negative way? Further decline in the dollar. There is a list of many things that could potentially happen. One of the things I would like your comment on is the commercial real estate market. You know, many banks astutely avoided the subprime lending, and they instead expanded their commercial real estate lending. So everywhere we turn we see increased vacancy signs and downward pressure on rents. And do we expect another wave of pressure from that market? And are we planning ahead as a country to address these things as opposed to, you know, being reactionary as it seems that we have had to be of late? " FinancialCrisisInquiry--490 HENNESSEY: My apologies. Can you compare the—can you compare Fannie and Freddie, what happened with them to the failures at other large financial institutions? I’m interested in both the competence of management, the risks that they took, and the impacts on the financial system of their failure. As—as we look at what are the causes of the financial crisis and we have to figure out how to allocate our time and other resources, looking into the failure at WaMu or the failure at, you know, Lehman or Bear Stearns and Fannie and Freddie, can you give us a sense how important were those firms relative to other failures, and can you also give us January 13, 2010 a sense of how should we—we’ve heard a lot; we’ve been talking a lot about ability to manage risks and about the risks that they were taking. Can you give us some sense of comparison? Maybe—Mr. Bass, I know you’ve talked about it a lot. CHRG-111shrg54533--34 Secretary Geithner," Well, Senator, as you know, we are proposing--and partly for the reasons you said--to take both rule writing and enforcement authority for the protection of consumers, particularly in the credit product area, and give it to a new agency with sole accountability and responsibility. Now, that will not ensure that that agency acquits itself perfectly over time, but we think that is a necessary step. Now, on your first point about the capacity of any institution, much less the Fed, to predict and anticipate and preempt any future financial crisis, let me just say a basic view that I have about this stuff. I think we need to be realistic in recognizing that. It will be very hard, perhaps impossible, for any authority, any individual to anticipate and preempt all potential sources of future risk. And I do not think we can design a system that is premised on the ability of any institution to carry that out effectively. I think the real important thing to do, though, is to make sure we establish much stronger cushions in the system, shock absorbers in terms of capital and liquidity, better capacity to absorb losses, withstand shocks, so that we are better positioned to deal with potential sources of risk wherever they emerge--and they will emerge. They will emerge. I think that is the only real effective defense, the necessary defense, and I think the critical failure of policy in this country and many countries around the world in coming into this was not to establish up front more conservative constraints on leverage in good times so the system was better positioned to deal with failure wherever it was going to happen. Senator Bunning. Thank you. Do you believe these financial reforms need to be bipartisan? " CHRG-111hhrg48875--5 Mr. Kanjorski," Good morning, Mr. Chairman. The committee will today consider the Treasury Secretary's ideas related to regulatory reform, focusing in particular on his legislative proposal vesting the Executive Branch with a new power to wind down troubled financial institutions. Specifically, this resolution authority would permit the Administration to place into receivership or conservatorship failing non-bank entities that pose systemic risk to the broader economy. During the last 7 months, the entire global economy has often stood in the balance as our government resorted to erratic 11th hour efforts to prevent a catastrophic economic collapse. Without a guidebook, policymakers could only rely on hurried, ad hoc solutions. Such options, however, are inherently flawed and regularly produce unintended consequences. As we deal with the current financial crisis, we find ourselves facing the very difficult task of fixing a leaky regulatory roof while it is raining. We therefore need to provide the Administration with a bigger hammer, a larger tarp, and the other tools needed to step in sooner when institutions are unhealthy, but not as close to death. Establishing resolution authority for all players in our financial markets has the potential to help lessen the severity of not only the present crisis, but also to prepare us for as yet unknown calamities down the road. Today's forum must also include a discussion of what to do about those entities that presently operate in the shadows of the financial system. Hedge funds, private equity pools, and other unregulated bodies have the potential to unleash devastating consequences on our broader economy. Long-term capital management and AIG financial products are two obvious examples here; and, while the extent of regulation required is debatable, we must begin this crucial examination today and we must include them in the resolution authority. We must also consider how the creation of a new Federal power to wind down troubled financial institutions will affect insurance, which is currently only regulated at the State level. Insurance is part of our financial services system, and is increasingly part of the global market, especially when it comes to products like reinsurance. Because insurance is a piece of the puzzle that we must have in order to complete the picture, I am very interested in discerning how the Treasury Secretary currently envisions the resolution authority working in this market. In sum, we now expect regulatory reform to play with at least three acts: establish a resolution authority; create a system of risk regulator; and overhaul our regulatory authority. The gravity of this situation requires that the Congress deliberate and exercise patience so that we lay a thoughtful regulatory structure that will establish the basis of a strong economy for many years to come. " CHRG-111hhrg52400--31 Mr. Baird," Chairman Kanjorski, Ranking Member Garrett, and other members of the subcommittee, I would like to thank you for the opportunity to appear today to present the views of the life insurance business on systemic risk and its implications for financial regulatory reform. I am Pat Baird, CEO of AEGON USA. I live and work in Cedar Rapids, Iowa. I would like to lead off with the premise that the life insurance industry is, by any reasonable measure, systemically important. And, from that, it follows that whatever regulatory reform package you advance must include the life insurance industry in order to assure that the resulting new regulatory structure operates as effectively as possible, and minimizes the likelihood of a similar crisis occurring again. Here are some highlights on the importance of the life insurance business. Life insurance products provide financial protection for some 70 percent of U.S. households, or over 75 million families. There is over $20 trillion in life insurance in force, and our companies hold $2.6 trillion in annuity reserves. Annually, we pay out almost $60 billion in life insurance benefits, over $70 billion in annuity benefits, and more than $7 billion in long-term care benefits. We are the backbone of the employee benefit system. More than 60 percent of all workers in the private sector have employer-sponsored life insurance, and our companies hold over 22 percent of all private employer-provided retirement assets. Life insurers are the single largest source of corporate bond financial, and hold approximately 18 percent of total U.S. corporate bonds. I would also note that without the financial protection provided by the life insurance companies, American families may very well need to rely on the Federal Government for assistance. That said, we don't believe any individual life insurance company poses systemic risk. So the question becomes, how do you deal with an industry that, as a whole, is systemically important, but which doesn't have any individual companies that pose systemic risk? First, we assume life insurers will be covered in whatever broad systemic risk oversight is made applicable to the banking and securities industries. Beyond that, we believe it is imperative that Congress create a Federal functional insurance regulator, and make it available to all life companies within the industry on an optional basis. There was ample justification for the creation of such a regulator prior to the crisis, and the case today is even stronger, after the crisis. Absent a Federal functional insurance regulator, there is a very real question regarding how national regulatory policy will be implemented, vis a vis insurance. Whatever legislation this Congress ultimately enacts will reflect your decisions on a comprehensive approach to financial regulation. Your policies need to govern all systemically significant sectors of the financial services industry, and need to apply to all sectors on a uniform basis, and without any gaps that could lead to systemic problems. It's also worth noting that critical decisions are being made in Washington affecting our business today, but they are being made without any significant input or involvement on the part of our regulators. Some specific examples include: the handling of Washington Mutual, which resulted in life insurers experiencing substantial portfolio losses; and the suspension of dividends on the preferred stock of Fannie and Freddie, which again significantly damaged our portfolios, and directly contributed to the failure of two life insurance companies. The mistaken belief by some that mark-to-market accounting has no adverse implications for life insurance companies, and more recently, provisions in the proposed bankruptcy legislation that could have resulted in unwarranted downgrades to life insurers' AAA-related residential mortgage-backed investments. The industry also supports a level playing field at an international level, as regards financial reporting and solvency. Competition should be about serving customers, operating efficiencies, and basically slugging it out every day and proving your business model. Competition should not be about capital accounting or tax arbitrage. But yet, today, we have no regulator there with authority that can engage with Mr. Skinner and other international regulators. I would also like to make the point that concerns over regulatory arbitrage in the context of an optional Federal insurance charter are without merit. The life insurance business is not seeking, nor did this Congress ever consider enacting a Federal insurance regulatory system that is weak, in terms of consumer protections or solvency oversight. Indeed, the ACLI has consistently advocated for a Federal alternative that is as strong as, if not stronger than, the best State regulatory systems. If anything, a properly constructed optional Federal charter would result in the States being challenged to raise their standards to meet those of the Federal regime. Mr. Chairman, there are a number of ideas being considered on how to address insurance in the context of overall regulatory reform. We applaud you for reintroducing legislation that would create an office of insurance information within the Treasury Department. While our ultimate goal remains an optional Federal charter, an OII would certainly be a step in the right direction. We are also appreciative of Representatives Bean and Royce for introducing the National Insurance Consumer Protection Act, which sets forth the framework for an optional Federal insurance charter. We do, however, caution against a so-called Federal tools approach to insurance regulatory reform. As detailed in my written statement, the constitutional and practical limitations of this concept make it ill-suited to deliver the type of reform that would be in the best interests of the insurance industry and its customers. We again thank you, Mr. Chairman, for holding this hearing, and pledge to work with you and the members of the subcommittee to see that insurance regulatory reform becomes a reality. And we would be happy to answer any questions. Thank you. [The prepared statement of Mr. Baird can be found on page 63 of the appendix.] " CHRG-111shrg50814--86 Mr. Bernanke," Well, the stories that relate this purely to the United States have to account for the fact that the entire industrial world has suffered from this credit crisis and many banks in Europe and in the U.K. have taken very significant losses. The U.K., Irish, and Germans have been involved in some interventions. So I think it depends really country by country. I don't want to generalize and create any misperceptions. But it is obvious that there have been very significant problems in the European banking system, and they face some issues which we may not face to the same degree. For example, there has been recent concern about Eastern Europe and the exposure they may have in that direction. So they are contending with the same set of issues that we are here. Senator Tester. OK. And you made the statement several times that the only way we are going to get out of this is if our financial markets are healthy, to pull us out of this. What impact does Europe, and as far as that goes, the Pacific Rim have if they don't do anything or do far less than they need to do on our economy? " CHRG-111hhrg48873--14 Secretary Geithner," Thank you, Mr. Chairman. Good morning, Ranking Member Bachus, and members of the committee. It is a privilege to be in this room again, testifying before you. We are debating important, consequential issues for the country. I welcome the attention you are bringing to it. I am going to try to answer as many of your questions as I can in my oral statement, but I am sure we will need to go over many of these things in more detail. I am very pleased to be here with Chairman Bernanke and President Bill Dudley of the New York Fed. AIG highlights very broad failures of our financial system. Our regulatory system was not equipped to prevent the buildup of dangerous levels of risk. Compensation practice rewarded short-term profits over long-term financial stability, overwhelming the checks and balances in the system. We came into this crisis as a country--and this is a tragic thing--we came into this crisis without the authority and the tools necessary to contain the damage to the American economy posed by the very severe pressures working through the financial system. Now, I share the anger and frustration of the American people, not just about the compensation practices at AIG and in other parts of our system, but that our financial system permitted a scale of risk-taking that has caused grave damage to the lives of so many Americans. The companies insured by AIG in the United States alone employ one in three Americans. AIG directly guarantees over $30 billion of 401(k) and pension plan investments and is the leading provider of retirement services for teachers and education institutions. In September, at a time of unprecedented financial market stress, losses on derivatives contracts entered into by AIG's Financial Products group forced the entire company to the brink of failure. The Department of the Treasury, the Federal Reserve, and the Federal Reserve Bank of New York acted to prevent the collapse of AIG. That action was based on a judgment, a collective judgment, that AIG's failure would have caused catastrophic damage--damage in the form of sharply lower equity prices and pension values, higher interest rates, and a broader loss of confidence in the world's major financial institutions. This would have intensified an already-deepening global recession, and we did not have the ability to contain that damage through other means. And we did not have the authority to unwind AIG. For these reasons, with extreme reluctance, on September 16th, the Federal Reserve Board authorized an $85 billion revolving credit facility to provide liquidity and avoid default. As a condition of that loan, 79.9 percent of the shares of the company were placed in a trust run by appointees of the Federal Reserve Bank of New York. The government installed a new management team and began the process of restructuring AIG's board. And the new management team committed to return AIG to its core insurance business by winding down its derivatives trading operation and selling non-core businesses. This loan, of course, was only the first step in a series of efforts to stabilize the company and provide the funding and liquidity necessary to execute that restructuring plan. Following that initial action in September, the Federal Reserve Bank of New York initiated a broad review, using outside experts, of the full range of executive compensation plans that exist across this large company. In November, as part of the government's infusion of capital, the Treasury Department imposed the executive compensation conditions and standards that were required under the Emergency Economic Stabilization Act. Earlier this month, in March, when in response to further losses on the company's portfolio we committed additional resources alongside the Fed, we made that assistance subject to forthcoming conditions on executive compensation that were based on both the President's proposals of February 4th and the provisions adopted in the American Reinvestment and Recovery Act. Now, on March 10th, I received a full briefing from my staff on the details and extent of AIG FP's pending retention payments, including information on the details of payments to individual executives. I found those payments, as have so many, deeply troubling. And after consulting with colleagues at the Fed and exploring our legal options, I called Ed Liddy, the CEO of this company, and asked him to seek to renegotiate these payments. He explained that the contracts for the retention payments were legally binding and pointed out the risk that, by breaching the contract, some employees might have a claim under Connecticut law to double payment of the contracted amounts. He committed, however, to renegotiate and reduce future payments totaling hundreds of millions of dollars, and that process is now underway. In addition, Treasury is working with the Department of Justice to determine what legal avenues may be available to recoup retention bonuses that have already been paid out and have not been voluntarily repaid. Treasury will also impose on AIG a contractual commitment to pay the Treasury from the operations of the company the amount of retention awards not recouped. And, finally, Treasury will deduct from the $30 billion in recently committed capital assistance an amount equal to those payments. Now, this issue of executive compensation extends beyond AIG and requires substantial reform of the incentives and compensation throughout the financial sector. As we move forward, we need to ensure that taxpayer resources do not reward failure but are used to get our financial system back to the business of providing credit on reasonable terms to American businesses and families. I know that much of the public anger has fallen on Mr. Liddy, but this is not fair. Mr. Liddy did not create this mess; he did not seek this job. He agreed, in response to a request by the Government of the United States, to work to restructure the company and help us get back the assistance provided by the taxpayer. And in taking on what I think is the most challenging job in the American financial system today, he inherited an enormous range of problems, including these retention contracts that are the understandable source of public outrage. AIG has thousands of employees who are working now, every day, to unwind the very business that got us into this situation and return AIG to the business of insurance. They are working hard to reduce the company's risks and exposures, and it is important that we support them in this effort to wind down AIG in an orderly way that protects the American taxpayer. Now, in addition to the problems with executive compensation, this financial crisis has revealed very problematic gaps in the regulatory structure of governing our financial markets. The lack of an appropriate regulatory regime and resolution authority for large nonbank financial institutions contributed to this crisis and will continue to constrain our capacity to address future crises. I will testify before this committee on Thursday and discuss in that context a broad set of regulatory reform proposals, particularly those related to mitigating systemic risk, to creating a more stable financial system. " CHRG-111shrg57923--7 Mr. Tarullo," Certainly, Senator. So this will not surprise you to hear that I think there are some advantages and disadvantages to each of the different organizational options that you would face. One such option would be the creation of a single, free-standing agency that would have overall responsibility for all the financial data collection and a good bit of the analysis. On the other end of the spectrum would be presumably just giving more authority to a single U.S. Government--existing U.S. Government agency and saying why don't you fill in the gaps? As I suggested in my written testimony, there is probably an option in between as well, particularly as you go forward with thinking about overall reg reform. To the degree that a council emerges, as I think it might, as an important center for coordinating the oversight of systemic risk in the United States among all the various U.S. Government agencies, we may want to lodge some of the data responsibilities in the council as well. The basic advantage, I think, of the single agency is what one would infer, which is you have a single group. They can take an overview. They can say let us try to prioritize, let us try to figure out where the most important unknowns are, and we will devote our activities in that direction, and we will do so in a way that we are not always stumbling over one another because we are just one agency. Some of the costs associated with the single agency--quite apart from out-of-pocket costs, which are nontrivial, but costs in the sense of non-immediate monetary costs--would include, I think, some risk that you detach data collection from the process of supervision, the process of regulation. And I do think it is important and I think our experience over the last couple of years has borne out the importance of having those with the line responsibility for supervising and regulating being able to shape the kinds of data collection that they feel are necessary in order effectively to regulate or to supervise. In the middle of the crisis, for example, it became apparent to some of the people at the Fed that getting information on the kinds of haircuts that were being applied to some securities repurchase agreements was a very important near-term piece of information in trying to assess where the system was at that moment. If that capacity had been lodged in an independent agency, with some of its own priorities perhaps and having to go through a bit more of a process, there may--and I emphasize ``may''--have been some delays in getting to that end. So I think that, as with everything, there are going to be pluses and minuses. It will not surprise you to know that from a somewhat--from the perspective of 20th and Constitution, there would be concerns about losing the capacity to shape and act quickly on informational needs. But I hasten to add that here, as with systemic risk generally, I do not think anybody at the Fed believes that the Fed should be the sole or even the principal collector and analyzer of data. This has got to be a governmentwide priority. Senator Corker. The information that you receive now, the data, how realtime is it? And I would assume during a crisis it is very important that it is daily. And then how granular is it today? " 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-110shrg50414--5 STATEMENT OF SENATOR TIM JOHNSON Senator Johnson. Thank you, Senator Dodd. This administration has asked Congress for the authority to buy up to $700 billion worth of residential and commercial mortgage--related assets from troubled Wall Street financial institutions. They are asking that this package have no strings. In South Dakota, we believe strongly in personal responsibility. When you make mistakes, as many of these companies have, you should be held accountable for those decisions. This package may be a necessary evil, but we cannot allow it to become a gift. It should have teeth, with real oversight from Congress. We should not use this package or American tax dollars to benefit foreign banks. And this package should contain limits on executive compensation. People in South Dakota work hard for the taxes they send to Washington, and their earnings should not be wasted on the bloated compensation of a CEO. Today we need answers from the regulators as to how we got to this point and specifics about how our regulatory system failed us. We also need to begin the dialog between the regulators and this Committee as to how to best change the regulatory structure so that this type of crisis does not happen again. Our system needs good, effective regulation that balances consumer protection and allows for sustainable economic growth. For years many Members of this Committee, and myself included, have been calling for just this sort of regulation. There should be no mistake that change is coming. I look forward to working with the Members of this Committee to institute the changes needed to regulate and to guarantee a responsible, modern regulatory system. Please submit my full statement for the record. " CHRG-111shrg52619--171 PREPARED STATEMENT OF DANIEL K. TARULLO Member, Board of Governors of the Federal Reserve System March 19, 2009 Chairman Dodd, Ranking Member Shelby, and other Members of the Committee, I appreciate this opportunity to present the views of the Federal Reserve Board on the important issue of modernizing financial supervision and regulation. For the last year and a half, the U.S. financial system has been under extraordinary stress. Initially, this financial stress precipitated a sharp downturn in the U.S. and global economies. What has ensued is a very damaging negative feedback loop: The effects of the downturn--rising unemployment, declining profits, and decreased consumption and investment--have exacerbated the problems of financial institutions by reducing further the value of their assets. The impaired financial system has, in turn, been unable to supply the credit needed by households and businesses alike. The catalyst for the current crisis was a broad-based decline in housing prices, which has contributed to substantial increases in mortgage delinquencies and foreclosures and significant declines in the value of mortgage-related assets. However, the mortgage sector is just the most visible example of what was a much broader credit boom, and the underlying causes of the crisis run deeper than the mortgage market. They include global imbalances in savings and capital flows, poorly designed financial innovations, and weaknesses in both the risk-management systems of financial institutions and the government oversight of such institutions. While stabilizing the financial system to set the stage for economic recovery will remain its top priority in the near term, the Federal Reserve has also begun to evaluate regulatory and supervisory changes that could help reduce the incidence and severity of future financial crises. Today's Committee hearing is a timely opportunity for us to share our thinking to date and to contribute to your deliberations on regulatory modernization legislation. Many conclusions can be drawn from the financial crisis and the period preceding it, ranging across topics as diverse as capital adequacy requirements, risk measurement and management at financial institutions, supervisory practices, and consumer protection. In the Board's judgment, one of the key lessons is that the United States must have a comprehensive strategy for containing systemic risk. This strategy must be multifaceted and involve oversight of the financial system as a whole, and not just its individual components, in order to improve the resiliency of the system to potential systemic shocks. In pursuing this strategy, we must ensure that the reforms we enact now are aimed not just at the causes of our current crisis, but at other sources of risk that may arise in the future. Systemic risk refers to the potential for an event or shock triggering a loss of economic value or confidence in a substantial portion of the financial system, with resulting major adverse effects on the real economy. A core characteristic of systemic risk is the potential for contagion effects. Traditionally, the concern was that a run on a large bank, for example, would lead not only to the failure of that bank, but also to the failure of other financial firms because of the combined effect of the failed bank's unpaid obligations to other firms and market uncertainty as to whether those or other firms had similar vulnerabilities. In fact, most recent episodes of systemic risk have begun in markets, rather than through a classic run on a bank. A sharp downward movement in asset prices has been magnified by certain market practices or vulnerabilities. Soon market participants become uncertain about the values of those assets, an uncertainty that spreads to other assets as liquidity freezes up. In the worst case, liquidity problems become solvency problems. The result has been spillover effects both within the financial sector and from the financial sector to the real economy. In my remarks, I will discuss several components of a broad policy agenda to address systemic risk: consolidated supervision, the development of a resolution regime for systemically important nonbank financial institutions; more uniform and robust authority for the prudential supervision of systemically important payment and settlement systems; consumer protection; and the potential benefits of charging a governmental entity with more express responsibility for monitoring and addressing systemic risks in the financial system. In elaborating this agenda, I will both discuss the actions the Federal Reserve is taking under existing authorities and identify areas in which we believe legislation is needed.Effective Consolidated Supervision of Systemically Important Firms For the reasons I have just stated, supervision of individual financial firms is not a sufficient condition for fostering financial stability. But it is surely a necessary condition. Thus a first component of an agenda for systemic risk regulation is that each systemically important financial firm be subject to effective consolidated supervision. This means ensuring both that regulatory requirements apply to each such firm and that the consequent supervision is effective. As to the issue of effectiveness, many of the current problems in the banking and financial system stem from risk-management failures at a number of financial institutions, including some firms under federal supervision. Clearly, these lapses are unacceptable. The Federal Reserve has been involved in a number of exercises to understand and document the risk-management lapses and shortcomings at major financial institutions, including those undertaken by the Senior Supervisors Group, the President's Working Group on Financial Markets, and the multinational Financial Stability Forum. \1\--------------------------------------------------------------------------- \1\ See Senior Supervisors Group (2008), ``Observations on Risk Management Practices during the Recent Market Turbulence'' March 6, www.newyorkfed.org/newsevents/news/banking/2008/SSG_Risk_Mgt_doc_final.pdf; President's Working Group on Financial Markets (2008), ``Policy Statement on Financial Market Developments,'' March 13, www.treas.gov/press/releases/reports/pwgpolicystatemktturmoil_03122008.pdf; and Financial Stability Forum (2008), ``Report of the Financial Stability Forum on Enhancing Market and Institutional Resilience,'' April 7, www.fsforum.org/publications/FSF_Report_to_G7_11_April.pdf.--------------------------------------------------------------------------- Based on the results of these and other efforts, the Federal Reserve is taking steps to improve regulatory requirements and risk management at regulated institutions. Our actions have covered liquidity risk management, capital planning and capital adequacy, firm-wide risk identification, residential lending, counterparty credit exposures, and commercial real estate. Liquidity and capital have been given special attention. The crisis has undermined previous conventional wisdom that a company, even in stressed environments, may readily borrow funds if it can offer high-quality collateral. For example, the inability of Bear Stearns to borrow even against U.S. government securities helped cause its collapse. As a result, we have been working to bring about needed improvements in institutions' liquidity risk-management practices. Along with our U.S. supervisory colleagues, we are closely monitoring the liquidity positions of banking organizations--on a daily basis for the largest and most critical firms--and are discussing key market developments and our supervisory analyses with senior management. We use these analyses and findings from examinations to ensure that liquidity and funding management, as well as contingency funding plans, are sufficiently robust and incorporate various stress scenarios. Looking beyond the present period, we also have underway a broader-ranging examination of liquidity requirements. Similarly, the Federal Reserve is closely monitoring the capital levels of banking organizations on a regular basis and discussing our evaluation with senior management. As part of our supervisory process, we have been conducting our own analysis of loss scenarios to anticipate the potential future capital needs of institutions. These needs may arise from, among other things, future losses or the potential for off-balance-sheet exposures and assets to come on balance sheet. Here, too, we have been discussing our analyses with bankers and ensuring that their own internal analyses reflect a broad range of scenarios and capture stress environments that could impair solvency. We have intensified efforts to evaluate firms' capital planning and to bring about improvements where needed. Going forward, we will need changes in the capital regime as the financial environment returns closer to normal conditions. Working with other domestic and foreign supervisors, we must strengthen the existing capital rules to achieve a higher level and quality of required capital. Institutions should also have to establish strong capital buffers above current regulatory minimums in good times, so that they can weather financial market stress and continue to meet customer credit needs. This is but one of a number of important ways in which the current pro-cyclical features of financial regulation should be modified, with the aim of counteracting rather than exacerbating the effects of financial stress. Finally, firms whose failure would pose a systemic risk must be subject to especially close supervisory oversight of their risk-taking, risk management, and financial condition, and be held to high capital and liquidity standards. Turning to the reach of consolidated supervision, the Board believes there should be statutory coverage of all systemically important financial firms--not just those affiliated with an insured bank as provided for under the Bank Holding Company Act of 1956 (BHC Act). The current financial crisis has highlighted a fact that had become more and more apparent in recent years--that risks to the financial system can arise not only in the banking sector, but also from the activities of financial firms that traditionally have not been subject to the type of consolidated supervision applied to bank holding companies. For example, although the Securities and Exchange Commission (SEC) had authority over the broker-dealer and other SEC-registered units of Bear Stearns and the other large investment banks, it did not have statutory authority to supervise the diversified operations of these firms on a consolidated basis. Instead, the SEC was forced to rely on a voluntary regime for monitoring and addressing the capital and liquidity risks arising from the full range of these firms' operations. In contrast, all holding companies that own a bank--regardless of size--are subject to consolidated supervision for safety and soundness purposes under the BHC Act. \2\ A robust consolidated supervisory framework, like the one embodied in the BHC Act, provides a supervisor the tools it needs to understand, monitor and, when appropriate, restrain the risks associated with an organization's consolidated or group-wide activities. These tools include the authority to establish consolidated capital requirements for the organization, obtain reports from and conduct examinations of the organization and any of its subsidiaries, and require the organization or its subsidiaries to alter their risk-management practices or take other actions to address risks that threaten the safety and soundness of the organization.--------------------------------------------------------------------------- \2\ Through the exploitation of a loophole in the BHC Act, certain investment banks, as well as other financial and nonfinancial firms, acquired control of a federally insured industrial loan company (ILC) while avoiding the prudential framework that Congress established for the corporate owners of other full-service insured banks. For the reasons discussed in prior testimony before this Committee, the Board continues to believe that this loophole in current law should be closed. See Testimony of Scott G. Alvarez, General Counsel of the Board, before the Committee on Banking, Housing, and Urban Affairs, U.S. Senate, Oct. 4, 2007.--------------------------------------------------------------------------- Application of a similar regime to systemically important financial institutions that are not bank holding companies would help promote the safety and soundness of these firms and the stability of the financial system generally. It also is worth considering whether a broader application of the principle of consolidated supervision would help reduce the potential for risk taking to migrate from more-regulated to less-regulated parts of the financial sector. To be fully effective, consolidated supervisors must have clear authority to monitor and address safety and soundness concerns in all parts of an organization. Accordingly, specific consideration should be given to modifying the limits currently placed on the ability of consolidated supervisors to monitor and address risks at an organization's functionally regulated subsidiaries.Improved Resolution Processes The importance of extending effective consolidated supervision to all systemically important firms is, of course, linked to the perception of market participants that such firms will be considered too-big-to-fail, and will thus be supported by the government if they get into financial difficulty. This perception has obvious undesirable effects, including possible moral hazard effects if firms are able to take excessive risks because of market beliefs that they can fall back on government assistance. In addition to effective supervision of these firms, the United States needs improved tools to allow the orderly resolution of systemically important nonbank financial firms, including a mechanism to cover the costs of the resolution if government assistance is required to prevent systemic consequences. In most cases, federal bankruptcy laws provide an appropriate framework for the resolution of nonbank financial institutions. However, this framework does not sufficiently protect the public's strong interest in ensuring the orderly resolution of nondepository financial institutions when a failure would pose substantial systemic risks. Developing appropriate resolution procedures for potentially systemic financial firms, including bank holding companies, is a complex and challenging task that will take some time to complete. We can begin, however, by learning from other models, including the process currently in place under the Federal Deposit Insurance Act (FDIA) for dealing with failing insured depository institutions and the framework established for Fannie Mae and Freddie Mac under the Housing and Economic Recovery Act of 2008. Both models allow a government agency to take control of a failing institution's operations and management, act as conservator or receiver for the institution, and establish a ``bridge'' institution to facilitate an orderly sale or liquidation of the firm. The authority to ``bridge'' a failing institution through a receivership to a new entity reduces the potential for market disruption, limits the value-destruction impact of a failure, and--when accompanied by haircuts on creditors and shareholders--mitigates the adverse impact of government intervention on market discipline. Any new resolution regime would need to be carefully crafted. For example, clear guidelines are needed to define which firms could be subject to the new, alternative regime and the process for invoking that regime, analogous perhaps to the procedures for invoking the so called systemic risk exception under the FDIA. In addition, given the global operations of many large and diversified financial firms and the complex regulatory structures under which they operate, any new resolution regime must be structured to work as seamlessly as possible with other domestic or foreign insolvency regimes that might apply to one or more parts of the consolidated organization. In addition to developing an alternative resolution regime for systemically critical financial firms, policymakers and experts should carefully review whether improvements can be made to the existing bankruptcy framework that would allow for a faster and more orderly resolution of financial firms generally. Such improvements could reduce the likelihood that the new alternative regime would need to be invoked or government assistance provided in a particular instance to protect financial stability and, thereby, could promote market discipline.Oversight of Payment and Settlement Systems As suggested earlier, a comprehensive strategy for controlling systemic risk must focus not simply on the stability of individual firms. Another element of such a strategy is to provide close oversight of important arenas in which firms interact with one another. Payment and settlement systems are the foundation of our financial infrastructure. Financial institutions and markets depend upon the smooth functioning of these systems and their ability to manage counterparty and settlement risks effectively. Such systems can have significant risk-reduction benefits--by improving counterparty credit risk management, reducing settlement risks, and providing an orderly process to handle participant defaults--and can improve transparency for participants, financial markets, and regulatory authorities. At the same time, these systems inherently centralize and concentrate clearing and settlement risks. Thus, if a system is not well designed and able to appropriately manage the risks arising from participant defaults or operational disruptions, significant liquidity or credit problems could result. Well before the current crisis erupted, the Federal Reserve was working to strengthen the financial infrastructure that supports trading, payments, clearing, and settlement in key financial markets. Because this infrastructure acts as a critical link between financial institutions and markets, ensuring that it is able to withstand--and not amplify--shocks is an important aspect of reducing systemic risk, including the very real problem of institutions that are too big or interconnected to be allowed to fail in a disorderly manner. The Federal Reserve Bank of New York has been leading a major joint initiative by the public and private sectors to improve arrangements for clearing and settling credit default swaps (CDS) and other over-the-counter (OTC) derivatives. As a result, the accuracy and timeliness of trade information has improved significantly. In addition, the Federal Reserve, working with other supervisors through the President's Working Group on Financial Markets, has encouraged the development of well-regulated and prudently managed central clearing counterparties for OTC trades. Along these lines, the Board has encouraged the development of two central counterparties for CDS in the United States--ICE Trust and the Chicago Mercantile Exchange. In addition, in 2008, the Board entered into a memorandum of understanding with the SEC and the Commodity Futures Trading Commission to promote the application of common prudential standards to central counterparties for CDS and to facilitate the sharing of information among the agencies with respect to such central counterparties. The Federal Reserve also is consulting with foreign financial regulators regarding the development and oversight of central counterparties for CDS in other jurisdictions to promote the application of consistent prudential standards. The New York Federal Reserve Bank, in conjunction with other domestic and foreign supervisors, continues its effort to establish increasingly stringent targets and performance standards for OTC market participants. In addition, we are working with market participants to enhance the resilience of the triparty repurchase agreement (repo) market. Through this market, primary dealers and other major banks and broker-dealers obtain very large amounts of secured financing from money market mutual funds and other short-term, risk-averse investors. \3\ We are exploring, for example, whether a central clearing system or other improvements might be beneficial for this market, given the magnitude of exposures generated and the vital importance of the market to both dealers and investors.--------------------------------------------------------------------------- \3\ Primary dealers are broker-dealers that trade in U.S. government securities with the Federal Reserve Bank of New York. The New York Reserve Bank's Open Market Desk engages in trades on behalf of the Federal Reserve System to implement monetary policy.--------------------------------------------------------------------------- Even as we pursue these and similar initiatives, however, the Board believes additional statutory authority is needed to address the potential for systemic risk in payment and settlement systems. Currently, the Federal Reserve relies on a patchwork of authorities, largely derived from our role as a banking supervisor, as well as on moral suasion to help ensure that critical payment and settlement systems have the necessary procedures and controls in place to manage their risks. By contrast, many major central banks around the world have an explicit statutory basis for their oversight of these systems. Given how important robust payment and settlement systems are to financial stability, and the functional similarities between many payment and settlement systems, a good case can be made for granting the Federal Reserve explicit oversight authority for systemically important payment and settlement systems. The Federal Reserve has significant expertise regarding the risks and appropriate risk management practices at payment and settlement systems, substantial direct experience with the measures necessary for the safe and sound operation of such systems, and established working relationships with other central banks and regulators that we have used to promote the development of strong and internationally accepted risk management standards for the full range of these systems. Providing such authority would help ensure that these critical systems are held to consistent and high prudential standards aimed at mitigating systemic risk.Consumer Protection Another lesson of this crisis is that pervasive consumer protection problems can signal, and even lead to, trouble for the safety and soundness of financial institutions and for the stability of the financial system as a whole. Consumer protection in the area of financial services is not, and should not be, limited to practices with potentially systemic consequences. However, as we evaluate the range of measures that can help contain systemic problems, it is important to recognize that good consumer protection can play a supporting role by--among other things--promoting sound underwriting practices. Last year the Board adopted new regulations under the Home Ownership and Equity Protection Act to enhance the substantive protections provided high-cost mortgage customers, such as requiring tax and insurance escrows in certain cases and limiting the use of prepayment penalties. These rules also require lenders providing such high-cost loans to verify the income and assets of a loan applicant and prohibit lenders from making such a loan without taking into account the ability of the borrower to repay the loan from income or assets other than the home's value. More recently, the Board adopted new rules to protect credit card customers from a variety of unfair and deceptive acts and practices. The Board will continue to update its consumer protection regulations as appropriate to provide households with the information they need to make informed credit decisions and to address new unfair and deceptive practices that may develop as practices and products change.Systemic Risk Authority One issue that has received much attention recently is the possible benefit of establishing a systemic risk authority that would be charged with monitoring, assessing and, if necessary, curtailing systemic risks across the entire U.S. financial system. At a conceptual level, expressly empowering a governmental authority with responsibility to help contain systemic risks should, if implemented correctly, reduce the potential for large adverse shocks and limit the spillover effects of those shocks that do occur, thereby enhancing the resilience of the financial system. However, no one should underestimate the challenges involved with developing or implementing a supervisory and regulatory program for systemic risks. Nor should the establishment of such an authority be viewed as a panacea that will eliminate periods of significant stress in the financial markets and so reduce the need for the other important reforms that I have discussed. The U.S. financial sector is extremely large and diverse--with value added amounting to nearly $1.1 trillion or 8 percent of gross domestic product in 2007. Systemic risks may arise across a broad range of firms or markets, or they may be concentrated in just a few key institutions or activities. They can occur suddenly, such as from a rapid and substantial decline in asset prices, even if the probability of their occurrence builds up slowly over time. Moreover, as the current crisis has illustrated, systemic risks may arise at nonbank entities (for example, mortgage brokers), from sectors outside the traditional purview of federal supervision (for example, insurance firms), from institutions or activities that are based in other countries or operate across national boundaries, or from the linkages and interdependencies among financial institutions or between financial institutions and markets. And, while the existence of systemic risks may be apparent in hindsight, identifying such risks ex ante and determining the proper degree of regulatory or supervisory action needed to counteract a particular risk without unnecessarily hampering innovation and economic growth is a very challenging assignment for any agency or group of agencies. \4\--------------------------------------------------------------------------- \4\ For example, while the existence of supranormal profits in a market segment may be an indicator of supranormal risks, it also may be the result of innovation on the part of one or more market participants that does not create undue risks to the system.--------------------------------------------------------------------------- For these reasons, any systemic risk authority would need a sophisticated, comprehensive and multi-disciplinary approach to systemic risk. Such an authority likely would require knowledge and experience across a wide range of financial institutions and markets, substantial analytical resources to identify the types of information needed and to analyze the information obtained, and supervisory expertise to develop and implement the necessary supervisory programs. To be effective, however, these skills would have to be combined with a clear statement of expectations and responsibilities, and with adequate powers to fulfill those responsibilities. While the systemic risk authority should be required to rely on the information, assessments, and supervisory and regulatory programs of existing financial supervisors and regulators whenever possible, it would need sufficient powers of its own to achieve its broader mission--monitoring and containing systemic risk. These powers likely would include broad authority to obtain information--through data collection and reports, or when necessary, examinations--from a range of financial market participants, including banking organizations, securities firms, key financial market intermediaries, and other financial institutions that currently may not be subject to regular federal supervisory reporting requirements. How might a properly constructed systemic risk authority use its expertise and authorities to help monitor, assess, and mitigate potentially systemic risks within the financial system? There are numerous possibilities. One area of natural focus for a systemic risk authority would be the stability of systemically critical financial institutions. It also likely would need some role in the setting of standards for capital, liquidity, and risk-management practices for financial firms, given the importance of these matters to the aggregate level of risk within the financial system. By bringing its broad knowledge of the interrelationships between firms and markets to bear, the systemic risk authority could help mitigate the potential for financial firms to be a source of, or be negatively affected by, adverse shocks to the system. It seems most sensible that the role of the systemic risk authority be to complement, not displace, that of a firm's consolidated supervisor (which, as I noted earlier, all systemically critical financial institutions should have). Under this model, the firm's consolidated supervisor would continue to have primary responsibility for the day-to-day supervision of the firm's risk management practices, including those relating to compliance risk management, and for focusing on the safety and soundness of the individual institution. Another key issue is the extent to which a systemic risk authority would have appropriately calibrated ability to take measures to address specific practices identified as posing a systemic risk--in coordination with other supervisors when possible, or independently if necessary. For example, there may be practices that appear sound when considered from the perspective of a single firm, but that appear troublesome when understood to be widespread in the financial system, such as if these practices reveal the shared dependence of firms on particular forms of uncertain liquidity. Other activities that a systemic risk authority might undertake include: (1) monitoring large or rapidly increasing exposures--such as to subprime mortgages--across firms and markets; (2) assessing the potential for deficiencies in evolving risk-management practices, broad-based increases in financial leverage, or changes in financial markets or products to increase systemic risks; (3) analyzing possible spillovers between financial firms or between firms and markets, for example through the mutual exposures of highly interconnected firms; (4) identifying possible regulatory gaps, including gaps in the protection of consumers and investors, that pose risks for the system as a whole; and (5) issuing periodic reports on the stability of the U.S. financial system, in order both to disseminate its own views and to elicit the considered views of others. Thus, there are numerous important decisions to be made on the substantive reach and responsibilities of a systemic risk regulator. How such an authority, if created, should be structured and located within the federal government is also a complex issue. Some have suggested the Federal Reserve for this role, while others have expressed concern that adding this responsibility would overburden the central bank. The extent to which this new responsibility might be a good match for the Federal Reserve, acting either alone or as part of a collective body, depends a great deal on precisely how the Congress defines the role and responsibilities of the authority, and how well they complement those of the Federal Reserve's long-established core missions. Nevertheless, as Chairman Bernanke has noted, effectively identifying and addressing systemic risks would seem to require some involvement of the Federal Reserve. As the central bank of the United States, the Federal Reserve has a critical part to play in the government's responses to financial crises. Indeed, the Federal Reserve was established by the Congress in 1913 largely as a means of addressing the problem of recurring financial panics. The Federal Reserve plays such a key role in part because it serves as liquidity provider of last resort, a power that has proved critical in financial crises throughout modern history. In addition, the Federal Reserve has broad expertise derived from its other activities, including its role as umbrella supervisor for bank and financial holding companies and its active monitoring of capital markets in support of its monetary policy and financial stability objectives. It seems equally clear that each financial regulator must be involved in a successful overall strategy for containing systemic risk. In the first place, of course, appropriate attention to systemic issues in the normal regulation of financial firms, markets, and practices may itself support this strategy. Second, the information and insight gained by financial regulators in their own realms of expertise will be important contributions to the demanding job of analyzing inchoate risks to financial stability. Still, while a collective process will surely be valuable in assessing systemic risk, it will be important to assign clearly any responsibilities and authorities for actual systemic risk regulation, since shared authority without clearly delineated responsibility for action is sometimes a prescription for inaction.Conclusion I have tried today to identify the elements of an agenda for limiting the potential for financial crises, including actions that the Federal Reserve is taking to address systemic risks and several measures that Congress should consider to make our financial system stronger and safer. In doing so, we must avoid responding only to the current crisis, but must instead fashion a system that will be up to the challenge of regulating a dynamic and innovative financial system. We at the Federal Reserve look forward to working with the Congress on legislation that meets these objectives. ______ CHRG-111hhrg56776--268 Mr. Kashyap," Thank you, Chairman Watt, and members of the committee. Besides my affiliation at Chicago Booth, I want to mention I'm also a member of the Squam Lake Group, since I'm going to tout a couple of their recommendations. Today, I'm going to consider whether and how the Fed supervisory role should change by considering three specific questions. First, I want to ask how the most costly mistakes in the United States regarding individual institutions might have differed if the Fed had been stripped of its supervisory powers; second, I want to review the U.K. evidence where the Central Bank was not involved in bank supervision and ask if those outcomes were particularly good; and third, time permitting, I'll look at the overall financial system and ask what might have been done to protect the whole system better. I'm going to skip large parts of my written testimony, but I would be happy to take up questions about that. So let's look at the biggest individual supervisory failures. As has already been mentioned here today, by far the most expensive rescue was for Fannie and Freddie. CBO's latest estimates put the costs to the taxpayer at over $200 billion and the problems of these institutions were well known, and as Chairman Bernanke indicated, the Fed was testifying as early as 2004 about the risks that they posed. So it seems hard to put the blame for these two on the Fed. The next most expensive rescue was for AIG. The cost of this intervention was estimated at probably upwards of $30 billion. In this case, the Fed wrote the check for the rescue, and the Fed actions, particularly regarding the transparency around the transaction, have been legitimately and heavily criticized. AIG's primary regulator was the Office of Thrift Supervision, which had absolutely no experience in understanding what was happening inside AIG Financial Products. So when the decisions that had to be made about AIG were taken, the Fed was flying blind. Chairman Bernanke has said the AIG case causes him the most trouble of anything that happened in the crisis, and I think it also provides the best example of why stripping the Central Bank of its supervisory authority would likely make problems, such as AIG, more probable in the future. No one thinks it's possible to have a modern financial economy without a lender of last resort facility. So let me offer an analogy. As a lender of last resort, you're never sure who is going to come through the door and ask for a date. When your date shows up on Friday night and it's AIG, the question at hand is, would you like to know something about them or would you rather have to pay $85 billion to buy them dinner. If we mandate that the Fed is not involved in supervision, then we make hasty, uninformed decisions inevitable whenever the lender of last resort has to act. The third most expensive rescue is likely to turn out to be Bear Stearns. Here again the primary regulator, in this case the SEC, was clueless about what was going on as Bear's demise approached. The Fed crossed the rubicon in this rescue, but as with AIG, it was forced to act on short notice with very imperfect information about Bear's condition and with no supervisory authority to shape the outcome. Whatever the criticisms one wants to make about the Fed's actions regarding Bear Stearns, the problems didn't come because of incompetent Fed supervision of Bear. If anybody wants to ask about Citigroup, we could talk about that as well. That is a case where the Fed had direct responsibility. My point in reviewing these cases is not to absolve the Fed. As we say in this town, plenty of mistakes were made. But I think this quick summary shows that if another supervisor had taken over the Fed's responsibilities, the U.S. taxpayer still would be on the hook for billions of dollars. One obvious objection to the way I have been reasoning is that I took the rest of the environment as given in contemplating a supervisory system without the Central Bank. Perhaps if the Fed had been out of the picture, other supervisors would have stepped in and built a better system. Here the lessons of the United Kingdom are particularly informative. The U.K. has deep financial markets with many large financial institutions and London is a financial center. The U.K. separated the Central Bank from supervision in the 1990's and set up a separate organization--the Financial Services Agency--to focus on bank supervision. The agreement that was reached required the treasury, the Central Bank, and the FSA to agree on any rescues. The first real test of this system came when Northern Rock got into trouble. The management of Northern Rock notified the FSA of its problems on August 13, 2007; the Bank of England found out the next day. It took over a month of haggling between the Bank of England, the treasury, and the FSA to decide what to do before the Bank of England eventually announced its support for Northern Rock. Even that support was not enough to prevent a run, and the first failure related to a run in the U.K. since 1866. While the distribution of blame is debated, there is complete agreement that the situation was mismanaged and the lack of coordination was important. Besides Northern Rock, several other large British banks, including Lloyd's and Royal Bank of Scotland, required government assistance in the United Kingdom. The total taxpayer burden from these interventions is guesstimated as being about 20 to 50 billion pounds. I expect that if we formed a council to oversee the U.S. financial system, we would arrive at the same arrangement as in the U.K. In particular, it would rely on consensus, and information sharing amongst the different agencies would be poor. The events in the U.K. suggest when this system was actually adopted, it didn't work. And I see no reason to expect it would work in the United States. So, what should we do? Well, the problems with the existing regulatory structure go far beyond the question of which organizations do the supervision of individual institutions. The gaps in supervisory coverage were critical. The fact that institutions could change regulators if the regulator became too tough is appalling, and that let the risks in the system grow for no good reason. But the crisis has also shown us that while there were many sources of fragility, nobody was watching the whole financial system. And when individual regulators did see problems, they were often powerless to do anything about them. Thus, a critical step in reforming regulation must be the creation of a systemic risk regulator that is charged with monitoring the whole financial system. The regulator must have the authority and tools to intervene to preserve the stability of the system. I know Mr. Watt's subcommittee held some very nice hearings in July on exactly this issue, and the lack of progress on this front is disappointing. But even with a vigilant systemic risk regulator, it seems likely that most of the problems in the crisis would have appeared anyway. The Squam Lake Group has argued that the cost of the AIG rescue could have been substantially reduced if we had a package of reforms. And this package would have included: one, just designating the Fed as systemic risk regulator; two, increasing the use of centralized clearing of derivatives; three, creating mandatory living wills for financial institutions and bolstering resolution authority; four, changing capital rules for systemically important institutions; five, improving the disclosure of trading positions; and six, holding back pay at systemically relevant institutions. I would be glad to discuss this in the question-and-answer period. I just want to close with one last thought, which is I don't want to sound like I think that the Fed has a role or comparative advantage in all types of financial regulation, and I want to reiterate the Squam Lake Group's recommendation to get the Fed out of the business of consumer protection regulation. This is a case where there are very few synergies between the staffing requirements of consumer protection and other essential Central Bank duties. The Fed would be far better off handing off these duties to another regulator. Thank you. [The prepared statement of Professor Kashyap can be found on page 80 of the appendix.] " CHRG-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-111hhrg56847--201 The Cost of the Financial Crisis: The Impact of the September 2008 Economic Collapse By Phillip Swagel\1\ The United States pulled back from a financial market meltdown and economic collapse in late 2008 and early 2009--but just barely. Not until we came to the edge of catastrophe were decisive actions taken to address problems that had been building in financial markets for years. By then it was too late to avert a severe recession accompanied by massive job losses, skyrocketing unemployment, lower wages, and a growing number of American families at risk of foreclosure and poverty.--------------------------------------------------------------------------- \1\ Phillip L. Swagel is visiting professor at the McDonough School of Business at Georgetown University, and director of the school's Center for Financial Institutions, Policy, and Governance. This paper was prepared for, and initial results were presented at, the March 18, 2010 public event, ``Financial Reform: Too Important to Fail,'' sponsored by the Pew Financial Reform Project.--------------------------------------------------------------------------- This paper quantifies the economic and budgetary costs resulting from the acute stage of the financial crisis reached in September 2008. This is important on its own, but it can be seen as well as giving a rough indication of the potential value of reforms that would help avoid a future crisis. On a budgetary level, the cost of the stage of the crisis reached in mid-September 2008 is the net cost to taxpayers of the policies used to stem the crisis. This includes the programs undertaken as part of the Troubled Assets Relief Program (TARP), as well as steps taken by the Federal Reserve and the Federal Deposit Insurance Corporation (FDIC) to guarantee bank liabilities. Actions to support Bear Stearns and the two government-sponsored entities, Fannie Mae and Freddie Mac, were taken before the worst part of the crisis, but their costs continued past September and are considered by many to be part of the fiscal costs of the crisis. The costs of the crisis to society, however, go beyond the direct fiscal impacts to include the effect on incomes, wages, and job creation for the U.S. economy as a whole. The crisis reduced U.S. economic growth and caused a weaker job market and other undesirable outcomes. A key challenge in quantifying such a macroeconomic view of the costs of the financial crisis is to identify the particular effects of the crisis and to separate those impacts from other developments. The broadest perspective would look at the overall changes in the economy from the start of the crisis to the end, and perhaps even include an estimate of the long-run future impacts. Implicit in such a calculation would be a decision to include both the effects of the crisis itself and any offsetting impacts from policy responses such as easier monetary policy or fiscal stimulus. A broad accounting of the costs of the crisis could also include the decline in government revenues resulting from the crisis, enactment of policies such as the 2008 and 2009 stimulus packages, as well as the impacts of regulatory changes that came about in the wake of the crisis. Under such a view, the financial crisis had large and long-lasting impacts on the U.S. economy. The Organisation for Economic Co-operation and Development (OECD), for example, estimates that the financial crisis will lead to a 2.4 percent reduction in long-term U.S. GDP, anticipating that both the reduction in employment and the increased cost of capital resulting from the crisis will last far into the future.\2\--------------------------------------------------------------------------- \2\ OECD, 2010. Going for Growth, Chapter 1, Box 1.1, pp. 18-19, March.--------------------------------------------------------------------------- The approach taken in this paper is narrower: to distinguish and quantify costs incurred so far that are directly related to the crisis and, in particular, to focus on the impact of events from the collapse of Lehman Brothers in the middle of September 2008 through the end of 2009. This is the period in which the grinding slowdown associated with the credit disruption that began in August 2007 turned into a sharp downturn. This approach produces smaller estimates for the cost of the crisis than the broad view, because the calculations quantify the costs of the acute phase of the crisis between September 2008 and the end of 2009, and not the overall impact of events both preceding and following that time period. Both approaches are valuable, and this paper is best seen as a complement to the literature on the overall cost of financial crises. This distinction is revisited in the conclusion. The results in this paper complement economic research by Reinhart and Rogoff (2009) that assesses the broad overall costs of banking crises across countries.\3\ Reinhart and Rogoff find that deep economic downturns ``invariably'' follow in the wake of crises; they quantify the average impact across countries on output, asset prices, the labor market, and government finances. Their results are also discussed below.--------------------------------------------------------------------------- \3\ Carmen M. Reinhart and Kenneth S. Rogoff, 2009. ``The Aftermath of Financial Crises,'' American Economic Review, vol. 99(2), pages 466-72, May.--------------------------------------------------------------------------- The cost of the crisis as measured here includes both the fiscal cost and the effects on economic measures such as output, employment, wages, and wealth. The difficulty in quantifying these economic impacts is to isolate the effects of the most acute stage of the crisis--the severe downturn in consumer and business spending that took place following the failure of Lehman Brothers in September 2008. The U.S. economy was already moving sideways in the first half of 2008 and most forecasters expected slow growth to continue for the balance of the year and into 2009. But the events of the fall and the plunge in economic activity that resulted were unexpected. This paper isolates the impact of the acute phase of the crisis by comparing the Congressional Budget Office (CBO) economic forecast made in September 2008, just before the crisis, with actual outcomes. The approach is to compute the difference between the decline in GDP in late 2008 and 2009 and the forecast published by CBO in its ``Budget and Economic Outlook: An Update,'' published on September 9, 2008--the Tuesday before Lehman filed for bankruptcy on Monday, September 15. The difference between actual GDP in the five quarters from October 2008 to December 2009 and the CBO forecast made just on the cusp of the crisis is taken as the unexpected impact of the crisis on GDP. This GDP impact is then used to calculate the impact of the crisis on other measures, including jobs, wages, and the number of foreclosures. The accuracy of CBO economic forecasts is similar to that of the Blue Chip consensus.\4\--------------------------------------------------------------------------- \4\ Congressional Budget Office, 2006. ``CBO's Economic Forecasting Record,'' November 2006.--------------------------------------------------------------------------- While this approach works to isolate the impacts of events from September 2008 forward, it is necessarily imprecise because it is impossible to know a) how accurate the CBO forecast would have been absent the crisis; b) whether the relationships between growth and other economic variables such as employment changed during the crisis; and c) the impact of other events from September 2008 forward that are not related to the crisis. Moreover, the calculations in the paper start with the fourth quarter of 2008 and thus do not attribute to the crisis any output or jobs that were lost in the two weeks of September immediately following the collapse of Lehman Brothers (these are still counted and appear in the charts below, but not as part of the cost of the post-Lehman crisis). The results in the paper should thus be taken as providing a rough approximation of the impact of the crisis. This is hugely meaningful, however, with American families suffering thousands of dollars of losses in incomes and wages and enormous declines in the value of their assets, including both financial assets, such as stock holdings, and real estate properties, such as family homes. These losses run into the trillions of dollars and on average come to a decline of nearly $66,000 per household in the value of stock holdings and a loss of more than $30,000 per household in the value of real estate wealth (though the inequality in wealth holdings means that the losses will vary considerably across families). These impacts on incomes, jobs, and wealth are all very real effects of the crisis. Finally, the paper looks briefly at broader impacts on society, notably the effect of the crisis in boosting foreclosures and potential impacts on human factors such as poverty. direct costs to taxpayers of financial interventions A host of government interventions were aimed at stabilizing banks and other financial sector firms, ranging from loans from the Federal Reserve to the outright injection of public capital into banks through the Treasury's Troubled Assets Relief Program (TARP). The direct budgetary cost of the crisis is taken to equal the expected net losses of these programs. The fiscal impact of the crisis considered here does not include the lower revenues and increased government spending that followed the crisis. Instead, the focus is on the costs of interventions undertaken in direct response to the acute phase of the crisis that began in September 2008, notably the cost of the TARP and related programs to guarantee bank liabilities put into effect by the Federal Reserve (Fed) and the Federal Deposit Insurance Corporation (FDIC). These costs are tallied in Tables 1 and 2, below. These cost estimates are from the January 2010 CBO estimate of TARP commitments and expected losses, and the February 2010 estimate by the Congressional Oversight Panel of the Fed's commitment to several programs run jointly by the Treasury and the Fed (the table provides references to the sources). The TARP authority was part of the Emergency Economic Stabilization Act of 2008 (EESA) enacted on October 3, 2008; this was used by the Treasury Department for a variety of purposes, including capital injections into banks, guarantees for assets of certain banks, foreclosure relief, support for the AIG insurance company, and subsidies to prevent foreclosures. CBO estimates that $500 billion of the $700 billion capacity of the TARP will end up being used or committed, with programs now in existence having a $73 billion net cost to taxpayers. As shown in Table 1, the TARP was used to support a range of activities, including the purchase of stakes in banks under the capital purchase program (CPP); special assistance to Citigroup, Bank of America, and AIG; support to automotive industry firms; support for programs to boost securitization of new lending through the Term Asset-Backed Securities Loan Facility (TALF) run jointly with the Fed; the Public-Private Investment Partnerships (PPIP) to deal with illiquid ``legacy'' assets such as subprime mortgage-backed securities; and the Home Affordable Program aimed at reducing the number of foreclosures. TARP assistance to banks on the whole is projected to generate a $7 billion profit for taxpayers (even though some banks that received TARP funds have failed or stopped paying dividends to the Treasury). Other programs, notably aid to auto firms, AIG, and homeowners at risk of foreclosure, are projected to result in substantial losses of TARP funds, with an overall net cost of $73 billion. As part of the Congressional budget process, the CBO estimates as well that there could be future uses and losses involving TARP resources, but they would not be directly related to the crisis of September 2008. In addition, the Federal Reserve lent $248 billion as part of TARP-related programs to support AIG and to foster securitization through the TALF. These Fed loans are generally well-secured--indeed, Fed lending related to AIG is now over-collateralized (the TARP having replaced the Fed in the risky aspect of the AIG transaction)--but it is possible in principle that there could be future losses and thus further costs. table 1: direct costs of the tarp ($ billions) Sources: Congressional Budget Office, ``The Budget and Economic Outlook: Fiscal Years 2010 to 2020,'' January 2010, Box 1-2, pp. 12-13, and TARP Congressional Oversight Panel ``February Oversight Report,'' February 10, 2010, pp. 176-177. Treasury commitments and costs or profits are from the Congressional Budget Office; Federal Reserve commitments as of December 31, 2009 are from the Congressional Oversight Panel February 2010 report. The $68 billion reported by the Congressional Oversight Panel represents the amount of AIG-lending extended by the Federal Reserve, but not the net cost of this lending. The Federal Reserve Bank of New York reports that the outstanding balance of Federal Reserve lending related to AIG as of September 30, 2009 totaled $36.7 billion with a fair market value of $39.7 billion for the collateral behind the lending, implying that the lending is overcollateralized on a mark-to-market basis. In effect, resources from the TARP replaced part of the initial Fed lending to AIG, leaving the TARP with losses and the Fed's remaining loans over-collateralized. Table 2 also shows certain direct budgetary costs related to the crisis that commenced before September 2008, notably Federal Reserve lending related to the collapse of Bear Stearns in March 2008, and cost to the Treasury of support for the two housing-related GSEs, Fannie Mae and Freddie Mac. These are not directly the result of the September 2008 stage of the crisis, but are shown since they are closely related to those financial market events. The financial rescue of Fannie Mae and Freddie Mac cost taxpayers $91 billion in fiscal year 2009 (October 2008 to September 2009), according to the Congressional Budget Office, and CBO forecasts a total cost to taxpayers of $157 billion through 2015 (these figures are from Table 3-3 in the CBO January 2010 Budget and Economic Outlook). These costs are related to the broader financial crisis, since the activities of the two firms underpinned parts of the housing market that were at the root of the crisis. There is a sense, however, that these costs were the result of losses that largely predated the events of September 2008--namely losses on mortgages guaranteed by the two firms, and losses on subprime mortgage-backed securities they purchased prior to the failure of Lehman Brothers. While the costs grew as a result of the September 2008 crisis and the subsequent economic collapse, it is likely that much of the losses were built into these firms' balance sheets before September 2008. As shown in Table 2, Fed lending related to Bear Stearns involves a loss of $3 billion on a mark-to-market basis--this is the net of the $29 billion in non-recourse lending from the Fed minus the estimated value of the collateral behind those loans as of September 30, 2009 (the most recent date for which estimates are available). table 2: other financial commitments related to the crisis ($ billions) Sources: FDIC: TARP Congressional Oversight Panel ``February Oversight Report,'' February 10, 2010, pp. 176-177. FDIC Temporary Loan Guarantee Program is the amount of senior bank debt covered by FDIC guarantees. Federal Reserve purchases are from www.federalreserve.gov/monetarypolicy. These figures are total (gross) amounts of liabilities guaranteed by the FDIC and assets purchased by the Federal Reserve; they do not provide the net cost or gain to taxpayers. The FDIC and Federal Reserve programs are all likely to make positive returns. Treasury costs for GSEs are from Congressional Budget Office, ``The Budget and Economic Outlook: Fiscal Years 2010 to 2020,'' January 2010, Box 3-3, p. 52. The Federal Reserve Bank of New York reports a fair market value of $26.1 billion for the collateral behind the $29.2 billion loan balance related to Bear Stearns as of September 30, 2009, implying a $3 billion loss on a mark-to-market basis. Other monetary policy actions undertaken by the Federal Reserve in the fall of 2008, such as programs to support commercial paper markets and money market mutual funds, are not included in this tally. These might well have positive budgetary impacts as the Fed collects interest and fees from users of these liquidity facilities. Similarly, the stimulus packages enacted in early 2008 and early 2009 were both arguably brought about because of the impact of the financial crisis on the economy, but these did not directly address financial sector issues and are not included here. In sum, the direct budget costs from efforts to stabilize the financial system following the events of mid-September 2008 are meaningful--with net costs of $73 billion and hundreds of billions of public dollars deployed or otherwise put at risk of loss. These figures, however, are only a modest part of the cost of the financial crisis. The larger impacts are those that affected the private sector as a result of the significant decline in economic activity that followed the crisis. These are tallied by calculating the impact of the September 2008 financial crisis on output, employment, wages, and wealth. economic costs: lost wages, incomes, jobs, and wealth The U.S. economy was already slowing in the first half of 2008, as the slide in housing prices that began in 2006 and the tightening of credit markets from 2007 both weighed on growth. High oil prices added another headwind in 2008. The economy entered a recession in December 2007; while this was not yet announced when the crisis became acute in mid-September 2008, it was clear that growth would remain subdued even under the best of circumstances while the U.S. economy worked through the challenges of housing, credit, and energy markets. Even so, the financial crisis in September 2008 clearly exacerbated the pre-existing economic slowdown, turning a mild downturn into a deep recession. In effect, the events of September and October 2008 were a severe negative shock to American confidence in the economy, and in the ability of our government and our political system to deal with the crisis. All at once, families and businesses across the United States looked at the crisis and stopped spending--even those who had not yet been directly affected by the mounting credit disruption that started in August 2007 put a hold on their plans. Families stopped spending, while firms stopped hiring and paused investment projects. As a result, the economy plunged, with GDP falling by 5.4 percent and 6.4 percent (at annual rates) in the last quarter of 2008 and the first quarter of 2009--the worst six months for economic growth since 1958. Assessing the economic costs associated with the acute phase of the crisis in September 2008 requires separating the impacts of the events of fall 2008 from the pre-existing economic weakness. While this is not possible to do with precision, one practical approach is to take as a baseline the GDP growth forecast published by the CBO on September 9, 2008--just before the crisis. The difference between actual GDP, and the CBO forecast for GDP in the balance of 2008 and over all of 2009, is then taken to reflect the ``surprise'' impact of the crisis. This is an imperfect measure since there is no reason to expect the CBO forecast to have been completely accurate had it not been for subsequent events such as the collapse of Lehman. With these caveats in mind, the September 2008 CBO forecast remains plausible as a guide for what would have happened absent the financial crisis of September 2008. The CBO forecast 1.5 percent real GDP growth in 2008 as a whole, followed by 1.1 percent growth in 2009. With the first half of the year already recorded, 1.5 percent growth for the year as a whole implies that CBO expected GDP to decline at a 0.25 percent annual rate in the second half of 2008.\5\ That is, CBO expected growth to be weak and even slightly negative in the latter part of 2008 but then pick up in 2009--indeed, the CBO forecast implies quite strong growth by the end of 2009.--------------------------------------------------------------------------- \5\ GDP data for 2008 have been revised since the CBO forecast was made; the implied negative GDP growth of 0.25 percent at an annual rate is computed using the GDP data that were available to the CBO in September 2008.--------------------------------------------------------------------------- Figure 1 plots actual real GDP against GDP as implied by the CBO forecast from September 2008 and the CBO's calculation of potential GDP--the level of GDP that would be consistent with full utilization of resources.\6\ As shown on the chart, GDP plunged at the end of 2008 and into early 2009, falling by 5.4 percent and 6.4 percent in the last quarter of 2008 and the first quarter of 2009, against CBO expectations of a nearly flat profile for output over this period. The difference between the CBO forecast and the actual outcome for GDP comes to a total of $648 billion in 2009 dollars for the five quarters from the beginning of October 2008 to the end of December 2009, equal to an average of $5,800 in lost income for each of the roughly 111 million U.S. households.--------------------------------------------------------------------------- \6\ The CBO forecast uses the growth rates in the September 2008 CBO forecast, adjusting the past levels of GDP for subsequent revisions to GDP data that were known prior to September 2008.--------------------------------------------------------------------------- figure 1: impact of the crisis on economy-wide output Note: GDP as plotted in the chart is in billions of 2005 (real) dollars at a seasonally adjusted annual rate. The dollar figures in the boxes, however, are translated into 2009 dollars. The hit to GDP was matched as well across the economy, with declines in jobs, wages, and wealth. The next step is to translate the unexpected GDP decline into an impact on the labor market. To calculate the impact on employment, a statistical relationship is estimated between percent job growth in a quarter and real GDP growth over the past year. The four-quarter change in output is used to capture the fact that the job market is typically a lagging indicator, responding after some delay to an improving or slowing overall economy. The relationship is estimated as a linear regression for quarterly data from 2000 to 2007, capturing a complete business cycle. This regression provides an empirical relationship between GDP growth and job growth--an analogue of what economists term ``Okun's Law.'' The estimated regression is not a structural model, but an empirical relationship that can be used to back out employment under different GDP growth scenarios. The GDP figures corresponding to the CBO forecast are then used to simulate the level of employment that would have occurred with the CBO forecast made before the September 2008 crisis. Figure 2 shows the impact of the acute stage of the crisis on employment: 5.5 million jobs were lost in the five quarters through the end of 2009 as a result of slower GDP growth compared to what would have been the case under the CBO forecast made in September 2008. Slow growth in the first three quarters of 2008 had left employment 1.8 million jobs lower than potential, and the CBO forecast for continued weak growth in the rest of 2008 and 2009 would have meant job losses until the last quarter of 2009, but at a much more moderate pace than actually occurred. Under the CBO forecast, employment by the end of 2009 would have been 4.0 million lower than with growth at potential, but the additional negative shock to GDP from the crisis knocked off another 5.5 million jobs, leaving employment at the end of 2009 9.5 million jobs lower than the potential of the U.S. economy. figure 2: impact of the crisis on employment Note: Employment in thousands. Figure 3 shows that the GDP hit and job losses correspond to lost wages for American families--a total of $360 billion of lost wages in the five quarters from October 2008 through December 2009 as a result of slower growth following September 2008. This equals $3,250 on average per U.S. household. Wage losses are calculated by taking actual wages with the lower growth and adding back both the wages for the jobs that would have existed with stronger growth and the increased wages per job for all jobs had growth not plunged in the fall and dragged down average wages. The additional wage growth per job is calculated using the trend wage growth before the crisis. figure 3: impact of the crisis on wages Note: Wages in billions of 2009 dollars. The value of families' real estate holdings declined sharply over the crisis as well, with a loss of $5.9 trillion from mid-2007 to March 2009, or a loss of $3.4 trillion from mid-2008 to March 2009. These correspond to wealth losses of more than $52,900 per household in the longer period, or $30,300 per household for the shorter one. The modest rebound in the housing market in the latter part of 2009 has meant that the wealth loss from mid-2008 through the end of 2009 is $1.6 trillion, or $14,200 per household. Unlike the economic variables of output, employment, and wages, the wealth measures are not adjusted for the unexpected impact of the events of September 2008. This is because market-based measures of asset values in principle should already reflect the expectation of slower growth from the perspective of mid-2008. The unexpected plunge in the economy in late 2008 and into 2009 would not be reflected in asset values, however, making these valid measures of the impact of the acute stage of the crisis on household wealth. Figure 4 shows that the financial crisis exacted an immense toll on household wealth. The value of families' equity holdings fell by $10.9 trillion from the middle of 2007 to the end of March 2009--the longest period of decline in the value of stock holdings. This equals a loss of $97,000 per household. Looking at the decline in the value of stock holdings only from the middle of 2008 to the end of March 2009 gives a loss of $7.4 trillion, or about $66,200 per household. The measure of stock market wealth includes both stocks owned directly by families and indirectly through ownership of shares of mutual funds. Data on wealth holdings are from the Federal Reserve's Flow of Funds database and are available quarterly. The wealth declines are thus measured starting from the end of June 2008 since the next quarterly value is for the end of September of that year and thus after the acute stage of the crisis had already begun. Stocks have rebounded over 2009, with the value of household equity holdings at the end of the year back to the same level as at the end of June 2008. figure 4: impact of the crisis on household wealth Note: in billions of dollars. Table 3 summarizes the economic impacts of the acute stage of the crisis that began in September 2008. By all measures, the acute phase of the financial crisis had a severe impact on the U.S. economy, with massive losses of incomes, jobs, wages, and wealth. table 3: economic and fiscal impacts of the crisis the human dimension of the crisis Beyond dollars and cents, the financial crisis had substantial negative impacts on American families both at present and, likely, for decades to come as the hardships faced by children translate into changed lives into the future. The poverty rate, for example, increased from 9.8 percent in 2007 to 10.3 percent in 2008, meaning that an additional 395,000 families fell into poverty. There is not a simple relationship between economic growth and poverty, and poverty data are not yet available for 2009, but the weaker growth that resulted following the events of September 2008 surely sent thousands of additional families into poverty. And the crisis will have attendant consequences for other economic outcomes including the future prospects for employment and wage growth of those facing long spells of unemployment. While it is not possible to count all of the ways in which the crisis affects the United States, a glimpse of the human cost of the crisis can be seen in the number of additional foreclosures started as a result of the severe economic downturn that began in September 2008. Millions of foreclosures were already likely even before the acute part of the crisis--the legacy of the housing bubble of these years was that too many American families got into homes that they did not have the financial wherewithal to afford. For other families, however, a lost job as a result of the severe recession translated into a foreclosure, and this can be estimated using a similar methodology as for the economic variables above. figure 5: impact of the crisis on foreclosure starts With the economy projected to remain weak in the second half of 2008 and into early 2009, and with many people deeply underwater with mortgages far greater than the value of their homes, there would still have been millions of foreclosure proceedings started. But the weaker economy following the acute phase of the crisis worsened the problem, layering the impact of an even weaker economy on top of the already difficult situations faced by many American families on the downside of the housing bubble. conclusion The financial crisis of 2007 to 2010 has had a massive impact on the United States. Millions of American families suffered losses of jobs, incomes, and homes--and the effects of these losses will play out on society for generations to come. This paper quantifies some of these impacts, focusing on the aftermath of September 2008 and attempting to isolate the effects of the crisis from other developments. The result was hundreds of billions of dollars of lost output and lower wages, millions of lost jobs, trillions of dollars of lost wealth, and hundreds of thousands of additional foreclosures. An alternative perspective would be to look at the overall impacts of the crisis from start to finish. This would be a broad view but a less well defined calculation: one could calculate economic impacts, for example, from the start of the housing bubble or from its peak. Or one could seek to exclude the offsetting impact of monetary and fiscal policy measures taken in response to the crisis and attempt to isolate the impact of the crisis alone. These are different (and difficult) calculations to make, but some evidence can be garnered on the broader impacts of the crisis from start to finish. The International Monetary Fund, for example, estimates that U.S. banks will take total writedowns of just over $1 trillion on loans and asset losses from 2007 to 2010, including $654 billion of losses on loans and $371 billion of losses on securitized assets such as mortgage-backed securities. The policy response to the crisis has involved massive fiscal costs, with U.S. public debt up substantially due to lower revenues and higher spending in response to the crisis, and this increase is forecast to continue under current law over the years to come. The declines in output and asset values and increases in U.S. public debt mirror the experience of other countries. As discussed by Reinhart and Rogoff (2009), banking crises across countries lead to an average decline in output of 9 percent, a 7 percentage point increase in the unemployment rate, 50 percent decline in equity prices, 35 percent drop in real home prices, and an average 86 percent increase in public debt. Figure 1 of this analysis provides evidence connecting the results of this paper to this broader literature. One measure of the overall economic impact of the crisis is the output gap between actual and potential GDP. In 2008 and 2009 combined, this gap comes to $1.2 trillion, or $10,500 per household. This is a loss of nearly 5 percent of potential GDP in total over the two years--less than the 9 percent average loss across countries found by Reinhart and Rogoff, but the costs of the crisis calculated in this paper cover only part of the crisis and only through the end of 2009. As shown in Figure 1, GDP looks to remain below potential for years into the future, implying higher overall costs of the crisis. The financial crisis of the past several years has had a massive economic cost for the United States--trillions of dollars of wealth and output foregone, millions of jobs lost, and many hundreds of thousands of families suffering hardship. These costs demonstrate the importance of taking steps to avoid future crises, and the value of reforms that help achieve this goal. " CHRG-111shrg52619--166 PREPARED STATEMENT OF JOHN C. DUGAN Comptroller of the Currency, Office of the Comptroller of the Currency March 19, 2009 Chairman Dodd, Ranking Member Shelby, and Members of the Committee, I appreciate this opportunity to discuss reforming the regulation of our financial system. Recent turmoil in the financial markets, the unprecedented distress and failure of large financial firms, the mortgage and foreclosure crises, and growing numbers of problem banks--large and small--have prompted calls to reexamine and revamp thenation's financial regulatory system. The crisis raises legitimate questions about whether our existing complex system has both redundancies and gaps that significantly compromise its effectiveness. At the same time, any restructuring effort that goes forward should be carefully designed to avoid changes that undermine the parts of our current regulatory system that work best. To examine this very important set of issues, the Committee will consider many aspects of financial regulation that extend beyond bank regulation, including the regulation of government-sponsored enterprises, insurance companies, and the intersection of securities and commodities markets. Accordingly, my testimony today focuses on key areas where I believe the perspective of the OCC--with the benefit of hindsight from the turmoil of the last two years--can most usefully contribute to the Committee's deliberations. Specifically, I will discuss the need to-- improve the oversight of systemic risk, especially with respect to systemically important financial institutions that are not banks; establish a better process for stabilizing, resolving or winding down such firms; reduce the number of bank regulators, while preserving a dedicated prudential supervisor; enhance mortgage regulation; and improve consumer protection regulation while maintaining its fundamental connection to prudential supervision.Improving Systemic Risk Oversight The unprecedented events of the past year have brought into sharp focus the issue of systemic risk, especially in connection with the failures or near failures of large financial institutions. Such institutions are so large and so intertwined with financial markets and other major financial institutions that the failure of one could cause a cascade of serious problems throughout the financial system--the very essence of systemic risk. Years ago, systemically significant firms were generally large banks, and our regime of extensive, consolidated supervision of banks and bank holding companies--combined with the market expertise provided by the Federal Reserve through its role as central bank--provided a means to address the systemic risk presented by these institutions. More recently, however, large nonbank financial institutions like AIG, Fannie Mae and Freddie Mac, Bear Stearns, and Lehman began to present similar risks to the system as large banks. Yet these nonbank firms were subject to varying degrees and different kinds of government oversight. In addition, no one regulator had access to risk information from these nonbank firms in the same way that the Federal Reserve has with respect to bank holding companies. The result, I believe, was that the risk these firms presented to the financial system as a whole could not be managed or controlled until their problems reached crisis proportions. One suggested way to address this problem going forward would be to assign one agency the oversight of systemic risk throughout the financial system. This approach would fix accountability, centralize data collection, and facilitate a unified approach to identifying and addressing large risks across the system. Such a regulator could also be assigned responsibility for identifying as systemically significant those institutions whose financial soundness and role in financial intermediation is important to the stability of U.S. and global markets. But the single systemic regulator approach would also face challenges due to the diverse nature of the firms that could be labeled systemically significant. Key issues would include the type of authority that should be provided to the regulator; the types of financial firms that should be subject to its jurisdiction; and the nature of the new regulator's interaction with existing prudential supervisors. It would be important, for example, for the systemic regulatory function to build on existing prudential supervisory schemes, adding a systemic point of view, rather than replacing or duplicating regulation and supervisory oversight that already exists. How this would be done would need to be evaluated in light of other restructuring goals, including providing clear expectations for financial institutions and clear responsibilities and accountability for regulators; avoiding new regulatory inefficiencies; and considering the consequences of an undue concentration of responsibilities in a single regulator. It has been suggested that the Federal Reserve Board should serve as the single agency responsible for systemic risk oversight. This makes sense given the comparable role that the Board already plays with respect to our largest banking companies; its extensive involvement with capital markets and payments systems; and its frequent interaction with central banks and supervisors from other countries. If Congress decides to take this approach, however, it would be necessary to define carefully the scope of the Board's authority over institutions other than the bank holding companies and state-chartered member banks that it already supervises. Moreover, the Board has many other critical responsibilities, including monetary policy, discount window lending, payments system regulation, and consumer protection rulewriting. Adding the broad role of systemic risk overseer raises the very real concerns of the Board taking on too many functions to do all of them well, while at the same time concentrating too much authority in a single government agency. The significance of these concerns would depend very much on both the scope of the new responsibilities as systemic risk regulator, and any other significant changes that might be made to its existing role as the consolidated bank holding company supervisor. Let me add that the contours of new systemic authority may need to vary depending on the nature of the systemically significant entity. For example, prudential regulation of banks involves extensive requirements with respect to risk reporting, capital, activities limits, risk management, and enforcement. The systemic supervisor might not need to impose all such requirements on all types of systemically important firms. The ability to obtain risk information would be critical for all such firms, but it might not be necessary, for example, to impose the full array of prudential standards, such as capital requirements or activities limits on all types of systemically important firms, e.g., hedge funds (assuming they were subject to the new regulator's jurisdiction). Conversely, firms like banks that are already subject to extensive prudential supervision would not need the same level of oversight as firms that are not--and if the systemic overseer were the Federal Reserve Board, very little new authority would be required with respect to banking companies, given the Board's current authority over bank holding companies. It also may be appropriate to allocate different levels of authority to the systemic risk overseer at different points in time depending on whether financial markets are functioning normally, or are instead experiencing unusual stress or disruption. For example, in a stable economic environment, the systemic risk regulator might focus most on obtaining and analyzing information about risks. Such additional information and analysis would be valuable not only for the systemic risk regulator, but also for prudential supervisors in terms of their understanding of firms' exposure to risks occurring in other parts of the financial services system to which they have no direct access. And it could facilitate the implementation of supervisory strategies to address and contain such risk before it increased to unmanageable levels. On the other hand, in times of stress or disruption it may be appropriate to authorize the systemic regulator to take actions ordinarily reserved for prudential supervisors, such as imposing specific conditions or requirements on operations of a firm. Such authority would need to be crafted to ensure flexibility, but the triggering circumstances and process for activating the authority should be clear. Mechanisms for accountability also should be established so that policymakers, regulated entities, and taxpayers can understand and evaluate appropriate use of the authority. Let me make one final point about the systemic risk regulator. Our financial system's ``plumbing''--the major systems we have for clearing payments and settling transactions--are not now subject to any clear, overarching regulatory system because of the variety in their organizational form. Some systems are clearinghouses or banking associations subject to the Bank Service Company Act. Some are securities clearing agencies or agency organizations pursuant to the securities or commodities laws. Others are chartered under the corporate laws of states. \1\--------------------------------------------------------------------------- \1\ For a description of the significance of payment and settlement systems and the various forms under which they are organized in the United States, see U.S. Department of the Treasury, Blueprint for a Modernized Financial Regulatory Structure 100-103 (March 2008) (2008 Treasury Blueprint).--------------------------------------------------------------------------- Certain of these payment and settlement systems are systemically significant for the liquidity and stability of our financial markets, and I believe these systems should be subjected to overarching federal supervision to reduce systemic risk. One approach to doing so was suggested in the 2008 Treasury Blueprint, which recommended establishing a new federal charter for systemically significant payment and settlement systems and authorizing the Federal Reserve Board to supervise them. I believe this approach is appropriate given the Board's extensive experience with payment system regulation.Resolving Systemically Significant Firms Events of the past year also have highlighted the lack of a suitable process for resolving systemically significant financial firms that are not banks. U.S. law has long provided a unique and well developed framework for resolving distressed and failing banks that is distinct from the federal bankruptcy regime. Since 1991, this unique framework, administered by the Federal Deposit Insurance Corporation, has also provided a mechanism to address the problems that can arise with the potential failure of a systemically significant bank--including, if necessary to protect financial stability, the ability to use the bank deposit insurance fund to prevent uninsured depositors, creditors, and other stakeholders of the bank from sustaining loss. Unfortunately, no comparable framework exists for resolving most systemically significant financial firms that are not banks, including systemically significant holding companies of banks. Such firms must therefore use the normal bankruptcy process unless they can obtain some form of extraordinary government assistance to avoid the systemic risk that might ensue from failure or the lack of a timely and orderly resolution. While the bankruptcy process may be appropriate for resolution of certain types of firms, it may take too long to provide certainty in the resolution of a systemically significant firm, and it provides no source of funding for those situations where substantial resources are needed to accomplish an orderly solution. As a result, in the last year as a number of large nonbank financial institutions faced potential failure, government agencies have had to improvise with various other governmental tools to address systemic risk issues at nonbanks, sometimes with solutions that were less than ideal. This gap needs to be addressed with an explicit statutory regime for facilitating the resolution of systemically important nonbank companies as well as banks. This new statutory regime should provide tools that are similar to those the FDIC currently has for resolving banks, including the ability to require certain actions to stabilize a firm; access to a significant funding source if needed to facilitate orderly dispositions, such as a significant line of credit from the Treasury; the ability to wind down a firm if necessary, and the flexibility to guarantee liabilities and provide open institution assistance if necessary to avoid serious risk to the financial system. In addition, there should be clear criteria for determining which institutions would be subject to this resolution regime, and how to handle the foreign operations of such institutions. One possible approach to a statutory change would be to simply extend the FDIC's current authority to nonbanks. That approach would not appear to be appropriate given the bank-centric nature of the FDIC's mission and resources. The deposit insurance fund is paid for by assessments on insured banks, with a special assessment mechanism available for certain losses caused by systemically important banks. It would not be fair to assess only banks for problems at nonbanks. In addition, institutional conflicts may arise when the insurer must fulfill the dual mission of protecting the insurance fund and advancing the broader U.S. Government interests at stake when systemically significant institutions require resolution. Indeed, important changes have recently been proposed to improve the FDIC's systemic risk assessment process to provide greater equity when the FDIC's protective actions extend beyond the insured depository institution to affiliated entities that are not banks. A better approach may be to provide the new authority to the new systemic risk regulator, in combination with the Treasury Department, given the likely need for a substantial source of government funds. The new systemic risk regulator would by definition have systemic risk responsibility, and the Treasury has direct accountability to taxpayers. If the systemic risk regulator were the Federal Reserve, then the access to discount window funding would also provide a critical resource to help address significant liquidity problems. It is worth noting that, in most other countries, it has been the Treasury Department or its equivalent that has provided extraordinary assistance to systemically important financial firms during this crisis, whether in the form of capital injections, government guarantees, or more significant government ownership.Reducing the Number of Bank Regulators It is clear that the United States has too many bank regulators. We have four federal regulators, 12 Federal Reserve Banks, and 50 state regulators, nearly all of which have some type of overlapping supervising responsibilities. This system is largely the product of historical evolution, with different agencies created for different legitimate purposes reflecting a much more segmented banking system from the past. No one would design such a system from scratch, and it is fair to say that, at times, it has not been the most efficient way to establish banking policy or supervise banks. Nevertheless, the banking agencies have worked hard over the years to make the system function appropriately despite its complexities. On many occasions, the diversity in perspectives and specialization of roles has provided real value. And from the perspective of the OCC, I do not believe that our sharing of responsibilities with other agencies has been a primary driver of recent problems in the banking system. That said, I recognize the considerable interest in reducing the number of bank regulators. The impulse to simplify is understandable, and it may well be appropriate to streamline our current system. But we ought not approach the task by prejudging the appropriate number of boxes on the organization chart. The better approach is to determine what would be achieved if the number of regulators were reduced. What went wrong in the current crisis that changes in regulatory structure (rather than regulatory standards) will fix? Will accountability be enhanced? Will the change result in greater efficiency and consistency of regulation? Will gaps be closed so that opportunities for regulatory arbitrage in the current system are eliminated? Will overall market regulation be improved? In this context, while there is arguably an agreement on the need to reduce the number of bank regulators, there is no such consensus on what the right number is or what their roles should be. Some have argued that we should have just one regulator responsible for bank supervision, and that it ought to be a new agency such as the Financial Services Agency in the UK, or that all such responsibilities should be consolidated in our central bank, the Federal Reserve Board. Let me explain why I don't think either of these ideas is the right one for our banking system. The fundamental problem with consolidating all supervision in a new, single independent agency is that it would take bank supervisory functions away from the Federal Reserve Board. In terms of the normal turf wars among agencies, it may sound strange for the OCC to take this position. But as the central bank and closest agency we have to a systemic risk regulator, I believe the Board needs the window it has into banking organizations that it derives from its role as bank holding company supervisor. More important, given its substantial role and direct experience with respect to capital markets, payments systems, the discount window, and international supervision, the Board provides unique resources and perspective to bank holding company supervision. Conversely, I believe it also would be a mistake to move all direct banking supervision to the Board, or even all such supervision for the most systemically important banks. The Board has many other critical responsibilities, including monetary policy, discount window lending, payments system regulation, and consumer protection rulewriting. Consolidating all banking supervision there as well would raise a serious concern about the Board taking on too many functions to do all of them well. There would also be a very real concern about concentrating too much authority in a single government agency. And both these concerns would be amplified substantially if the Board were also designated the new systemic risk regulator and took on supervisory responsibilities for systemically significant payment and clearing systems. Most important, moving all supervision to the Board would lose the very real benefit of having an agency whose sole mission is bank supervision. That is, of course, the sole mission of the OCC, and I realize that, coming from the Comptroller, support for preserving a dedicated prudential banking supervisor may be portrayed by some as merely protecting turf. That would be unfortunate, because I strongly believe that the benefits of dedicated supervision are real. Where it occurs, there is no confusion about the supervisor's goals and objectives, and no potential conflict with competing objectives. Responsibility is well defined, and so is accountability. Supervision takes a back seat to no other part of the organization, and the result is a strong culture that fosters the development of the type of seasoned supervisors that are needed to confront the many challenges arising from today's banking business. In the case of the OCC, I would add that our role as the front-line, on-the-ground prudential supervisor is complementary to the current role of the Federal Reserve Board as the consolidated holding company regulator. This model has allowed the Board to use and rely on our work to perform its role as supervisor for complex banking organizations that are often involved in many businesses other than banking. Such a model would also work well with respect to any new authority provided to a systemic risk regulator, whether or not the Board is assigned that role. In short, there are a number of options for reducing the number of bank regulators, and many detailed issues involved with each. It is not my intent to address these issues in detail in this testimony, but instead to make two fundamental and related points about changes to the banking agency regulatory structure. While it is important to preserve the Federal Reserve Board's role as a holding company supervisor, it is equally if not more important to preserve the role of a dedicated, front-line prudential supervisor for our nation's banks.Enhanced Mortgage Regulation The current financial crisis began and continues with problems arising from poorly underwritten residential mortgages, especially subprime mortgages. While these lending practices have been brought under control, and federal regulators have taken actions to prevent the worst abuses, more needs to be done. As part of any regulatory reform to address the crisis, Congress should establish a mortgage regulatory regime that ensures that the mortgage crisis is never repeated. A fundamental reason for poorly underwritten mortgages was the lack of consistent regulation for mortgage providers. Depository institution mortgage providers--whether state or federally chartered--were the most extensively regulated, by state and federal banking supervisors. Mortgage providers affiliated with depository institutions were less regulated, primarily by federal holding company supervisors, but also by state mortgage regulators. Mortgage providers not affiliated with depository institutions--including mortgage brokers and lenders--were the least regulated by far, with no direct supervision at the federal level, and limited ongoing supervision at the state level. The results have been predictable. As the 2007 Report of the Majority Staff of the Joint Economic Committee recognized, ``[s]ince brokers and mortgage companies are only weakly regulated, another outcome [of the increase in subprime lending] was a marked increase in abusive and predatory lending.'' \2\ Nondepository institution mortgage providers originated the overwhelming preponderance of subprime and ``Alt-A'' mortgages during the crucial 2005-2007 period, and the loans they originated account for a disproportionate percentage of defaults and foreclosures nationwide, with glaring examples in the metropolitan areas hardest hit by the foreclosure crisis. For example, a recent analysis of mortgage loan data prepared by OCC staff, from a well-known source of mortgage loan data, identified the 10 mortgage originators with the highest number of subprime and Alt-A mortgage foreclosures--in the 10 metropolitan statistical areas (MSAs) experiencing the highest foreclosure rates in the period 2005-2007. While each type of mortgage originator has experienced elevated levels of delinquencies and defaults in recent years, of the 21 firms comprising the ``worst 10'' in those ``worst 10'' MSAs, the majority--accounting for nearly 60 percent of nonprime mortgage loans and foreclosures--were exclusively supervised by the states. \3\--------------------------------------------------------------------------- \2\ Majority Staff of the Joint Economic Committee, 110th Cong., Report and Recommendations on the Subprime Lending Crisis: The Economic Impact on Wealth, Property Values and Tax Revenues, and How We Got Here 17 (October 2007). \3\ Letter from Comptroller of the Currency John Dugan to Elizabeth Warren, Chair, Congressional Oversight Panel, February 12, 2009, at http://www.occ.treas.gov/ftp/occ_copresponse_021209.pdf.--------------------------------------------------------------------------- In view of this experience, Congress should take at least two actions in connection with regulatory reform. First, it should establish national mortgage standards that would apply consistently regardless of originator, similar to the mortgage legislation that passed the House of Representatives last year. In taking this extraordinary step, Congress should provide flexibility to regulators to implement the statutory standards through regulations that protect consumers and balance the need for conservative underwriting with the equally important need for access to affordable credit. Second, Congress should also ensure that the new standards are applied and enforced in a comparable manner, again, regardless of originator. This objective can be accomplished relatively easily for mortgages provided by depository institutions or their affiliates: federal banking regulators have ample authority to ensure compliance through ongoing examination and supervision reinforced by broad enforcement powers. The objective is not so easily achieved with nonbank mortgage providers regulated exclusively by the states, however. The state regime for regulating mortgage brokers and lenders typically focuses on licensing, rather than ongoing examination and supervision, and enforcement by state agencies typically targets problems after they have become severe, not before. That difference between the federal and state regimes can result in materially different levels of compliance, even with a common federal standard. As a result, it will be important to develop a mechanism to facilitate a level of compliance at the state level that is comparable to compliance of depository institutions subject to federal standards. The goal should be robust national standards that are applied consistently to all mortgage providers.Enhanced Consumer Protection Regulation Effective protection for consumers of financial products and services is a vital part of financial services regulation. In the OCC's experience, and as the mortgage crisis illustrates, safe and sound lending practices are integral to consumer protection. Indeed, contrary to several recent proposals, we believe that the best way to implement consumer protection regulation of banks--the best way to protect consumers--is to do so through prudential supervision. Let me explain why. First, prudential supervisors' continual presence in banks through the examination process puts them in the very best position to ensure compliance with consumer protection requirements established by statute and regulation. Examiners are trained to detect weaknesses in banks' policies, systems, and procedures for implementing consumer protection mandates, and they gather information both on-site and off-site to assess bank compliance. Their regular communication with the bank occurs through examinations at least once every 18 months for smaller institutions, supplemented by quarterly calls with management, and for the very largest banks consumer compliance examiners are on site every day. We believe this continual supervisory presence creates especially effective incentives for consumer protection compliance, as well as allowing examiners to detect compliance failures much earlier than would otherwise be the case. Second, prudential supervisors have strong enforcement powers and exceptional leverage over bank management to achieve corrective action. Banks are among the most extensively supervised firms in any type of industry, and bankers understand very well the range of negative consequences that can ensue from defying their regulator. As a result, when examiners detect consumer compliance weaknesses or failures, they have a broad range of tools to achieve corrective action, from informal comments to formal enforcement action--and banks have strong incentives to move back into compliance as expeditiously as possible. Indeed, behind the scenes and without public fanfare, bank supervision results in significant reforms to bank practices and remedies for their customers--and it can do so much more quickly than litigation, formal enforcement actions, or other publicized events. For example, as part of the supervisory process, bank examiners identify weaknesses in areas pertaining both to compliance and safety and soundness by citing MRAs--``matters requiring attention''--in the written report of examination. An MRA describes a problem, indicates its cause, and requires the bank to implement a remedy before the matter can be closed. In the period between 2004 and 2007, OCC examiners cited 123 mortgage-related MRAs. By the end of 2008, satisfactory corrective action had been taken with respect to 109 of those MRAs, without requiring formal enforcement actions. Corrective actions were achieved for issues involving mortgage underwriting, appraisal quality, monitoring of mortgage brokers, and other consumer-related issues. We believe this type of extensive supervision and early warning oversight is a key reason why the worst form of subprime lending practices did not become widespread in the national banking system. Third, because examiners are continually exposed to the practical effects of implementing consumer protection rules for bank customers, the prudential supervisory agency is in the best position to formulate and refine consumer protection regulations for banks. Indeed, while most such rule-writing authority is currently housed in the Federal Reserve Board, we believe that the rule-writing process would benefit by requiring more formal consultation with other banking supervisors that have substantial supervisory responsibilities in this area. Recently, alternative models for financial product consumer protection regulation have been suggested. One is to remove all consumer protection regulation and supervision from prudential supervisors, instead consolidating such authority in a new federal agency. This model would be premised on an SEC-style regime of registration and licensing for all types of consumer credit providers, with standards set and compliance achieved through enforcement actions by a new agency. The approach would rely on self-reporting by credit providers, backstopped by enforcement or judicial actions, rather than ongoing supervision and examination. The attractiveness of this alternative model is that it would centralize authority and accountability in a single agency, which could write rules that would apply uniformly to financial services providers, whether or not they are depository institutions. Because the agency would focus exclusively on consumer protection, proponents also argue that such a model eliminates the concern sometimes expressed that prudential supervisors neglect consumer protection in favor of safety and soundness supervision. But the downside of this approach is considerable. It would not have the benefits of on-site examination and supervision and the very real leverage that bank supervisors have over the banks they regulate. That means, we believe, that compliance is likely to be less effective. Nor would this approach draw on the practical expertise that examiners develop from continually assessing the real-world impact of particular consumer protection rules--an asset that is especially important for developing and adjusting such rules over time. More troubling, the ingredients of this approach--registration, licensing and reliance on enforcement actions to achieve compliance with standards--is the very model that has proved inadequate to protect consumers doing business with state regulated mortgage lenders and brokers. Finally, I do not agree that the banking agencies have failed to give adequate attention to the consumer protection laws that they have been charged with implementing. For example, predatory lending failed to gain a foothold in the banking industry precisely because of the close supervision commercial banks, both state and national, received. But if Congress believes that the consumer protection regime needs to be strengthened, the best answer is not to create a new agency that would have none of the benefits of a prudential supervisor. Instead, the better approach is a crisp Congressional mandate to already responsible agencies to toughen the applicable standards and close any gaps in regulatory coverage. The OCC and the other prudential bank supervisors will rigorously apply them. And because of the tools we have that I've already mentioned, banks will comply more readily and consumers will be better protected than would be the case with mandates applied by a new federal agency.Conclusion My testimony today reflects the OCC's views on several key aspects of regulatory reform. We would be happy provide more details or additional views on other issues at the Committee's request. CHRG-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-111hhrg74855--93 Mr. Gensler," As I understand it the 2005 Act which granted the anti-manipulation authorities that have been referred to by many members, I am not aware of something in 3795, nothing in that swaps bill that I am reading carefully because the general counsel for the CFTC wrote this but that it wouldn't affect FERC's anti-manipulation authority under that Act over the markets that they oversee. As you mentioned the electricity crisis, I do think that one of the important lessons out of the Enron crisis and the electricity crisis which was then, you know, complemented in a bad way with this terrible crisis last year is that we have to bring reform to the entire over-the-counter derivatives market and not have an exception for instance for some part of the over-the-counter derivatives marketplace. " CHRG-111shrg53176--47 Mr. Breeden," Thank you very much, Chairman Dodd, Ranking Member Shelby, and Members of the Committee, for the opportunity to offer my views on enhancing investor protection and improving financial regulation. These are really, really critical subjects and it is a great pleasure to have a chance to be back before this important Committee. I was privileged to serve as SEC Chairman from 1989 to 1993. My views here today reflect that experience at the SEC as well as my White House service in 1989, when we had to craft legislation to deal with an earlier banking crisis, that involving the savings and loans. In subsequent years, my firm has worked on the restructuring of many, many companies that encountered financial difficulties, most notably WorldCom in the 2002 to 2005 range. Today, I am an investor and my fund manages approximately $1.5 billion in equity investments in the United States and Europe on behalf of some of the Nation's largest pension plans. By any conceivable yardstick, our Nation's financial regulatory programs have not worked adequately to protect our economy, our investors, or our taxpayers. In little more than a year, U.S. equities have lost more than $7 trillion in value. Investors in financial firms that either failed or needed a government rescue have alone lost about $1 trillion in equity. These are colossal losses without any precedent since the Great Depression. After the greatest investor losses in history, I believe passionately that we need to refocus and rededicate ourselves to putting investor interests at the top of the public policy priority list. We have badly shattered investor confidence at a time when we have never needed private savings and capital formation more. There is much work to be done to restore trust, and I must say, in the public policy debates, we seem to worry endlessly about the banks that created this mess and I believe we need to focus a little more on the investors who are key for the future to get us out of it. Many people today are pointing at gaps in the regulatory structure, including systemic regulatory authority. But the Fed has always worried about systemic risk. I remember back in the Bush task force back in 1982 to 1985, the Fed talking about its role as the lender of last resort and that it worried about systemic risk. And they have been doing that and we still had a global banking crisis. The problems like the housing bubble, the massive leverage in the banks, the shaky lending practices and subprime mortgages, those things weren't hidden. They were in plain sight, except for the swaps market, where I agree with the previous witnesses that there is a need for extending oversight and jurisdiction. But for the most part, the banking and securities regulators did have tools to address many of the abusive practices but often didn't use their powers forcefully enough. Creating a systemic or super-regulator, in my view, is a giant camel's nose under the tent. It is a big, big step toward industrial planning, toward central planning of the economy, and I think the very first thing that creating a systemic regulator will do is to create systemic risk. I fear very much that if you are not extremely helpful, we will have more ``too big to fail,'' more moral hazard, and more bailouts, and that is not a healthy path for us to move forward. I am very concerned that we not shift the burden of running regulated businesses in a sound and healthy manner from management and the boards of directors that are supposed to do that. Unfortunately, in the wake of this crisis, we have seen boards of directors that failed miserably to control risk taking, excessive leverage, compensation without correlation to performance, misleading accounting and disclosure, overstated asset values, failure to perform due diligence before giant acquisitions. These and other factors are things that boards are supposed to control. But over and over again in the big failures, the boards at AIG, Fannie Mae, Lehman Brothers, CitiGroup, Bank of America, Wachovia, WAMU, in those cases, boards were not doing an adequate job. So my view is that we need to step back as part of this process and look and say, why are boards not doing what we need them to do? I think one of the important answers is that we have too much entrenchment of board members, too many staggered boards, too many super voting shares, too many self-perpetuating nominating committees, and a very, very high cost to run a proxy contest to try and replace directors who are not doing their jobs. So I think one of the important things that Congress can look at, and I hope you will look at in the future, is to enact a shareholder voting rights and proxy access act that would deal with proxy access, uninstructed votes by brokers, which is corporate ballot stuffing, majority vote for all directors every year, one share, one vote. There are a number of things where if we give a little more democracy to corporate shareholders, we can bring a little more discipline to misbehavior in corporations and not put quite so much on the idea that some super uber-regulator somewhere is going to save us from all these problems. Thank you very much. " FinancialCrisisInquiry--190 The large banks, who own most of the second liens, are locked in a game of chicken with investors and neither of them will agree to write-down their holdings if the other doesn’t. Servicers, for their part, continue to have conflicting financial incentives that sometimes push against the interests of both the borrowers and the loan owners. The administration fears moral hazard, but we did not let very significant moral hazard concerns stop us when we bailed out the banks. Second, we should require all mortgage loan servicers to attempt loss mitigation prior to initiating foreclosure and to document their efforts. As we all now know, voluntary foreclosure prevention programs do not work. Third, we should lift the ban on judicial modifications of primary residence mortgages. Modifications of loans in bankruptcy court is available for vacation homes, farms, commercial real estate and yachts. Permitting judges to modify mortgages on principal residences carries zero cost to the U.S. taxpayer, would address the moral hazard objections to other proposals, and would serve as a stick to the HAMP’s program’s carrots. Fourth, we should make the MHAP program fairer and more effective, especially by stopping the parallel foreclosure process while loans are being evaluated for modifications. And last, I want to talk about what we need to do stop this crisis from happening again. It’s crucial that we create an independent consumer financial protection agency. Federal bank regulators could have prevented this crisis, but regulatory capture, charter arbitrage, the equating of safety and soundness with profitability, and the ghettoization of consumer protection prevented the system from working. Finally, we must enact common sense rules of the road for mortgage origination. It will be truly stunning if we emerge from the wreckage of this foreclosure crisis without instituting a baseline requirement that lenders make only those loans that borrowers have the ability to pay, and without demanding that all participants along the mortgage securitization chain share an interest in the loan’s performance over time. 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-111hhrg56776--13 Mr. Volcker," I appreciate your invitation to address important questions concerning the link between monetary policy and Federal Reserve responsibilities for the supervision and regulation of financial institutions. Before addressing the specific questions you have posed, I would like to make clear my long-held view, a view developed and sustained by years of experience in the Treasury, the Federal Reserve, and in private finance. Monetary policy and concerns about the structure and condition of banks in the financial system more generally are inextricably intertwined, and if you need further proof of that proposition, just consider the events of the last couple of years. Other agencies, certainly including the Treasury, have legitimate interests in regulatory policy, but I do insist that neither monetary policy nor the financial system will be well served if our central bank is deprived from interest in and influence over the structure and performance of the financial system. Today, conceptual and practical concerns about the extent, the frequency, and the repercussions of economic and financial speculative excesses have come to occupy our attention. The so-called ``bubbles'' are indeed potentially disruptive of economic activity. Then important and interrelated questions arise for both monetary and supervisory policies. Judgment is required about if and when an official response, some form of intervention is warranted. If so, is there a role for monetary policy, for regulatory actions, or for both? How can those judgments and responses be coordinated and implemented in real time in the midst of crisis in a matter of days? The practical fact is the Federal Reserve must be involved in those judgments and that decision-making, beyond this broad responsibility for monetary policy and its influence on interest rates. It is the agency that has the relevant technical experience growing out of working in the financial markets virtually every day. As a potential lender of last resort, the Fed must be familiar with the condition of those to whom it lends. It oversees and participates in the basic payment system, domestically and internationally. In sum, there is no other official institution that has the breadth of institutional knowledge, the expertise, and the experience to identify market and institutional vulnerabilities. It also has the capability to act on very short notice. The Federal Reserve, after all, is the only agency that has financial resources at hand in amounts capable of emergency response. More broadly, I believe the experience demonstrates conclusively that the responsibilities of the Federal Reserve with respect to maintaining economic and financial stability require close attention to manage beyond the specific confines of monetary policy, if we interpret monetary policy narrowly, as influencing monetary aggregates and short-term interest rates. For instance, one recurring challenge in the conduct of monetary policy is to take account of the attitudes and approaches of banking supervisors as they act to stimulate or to restrain bank lending, and as they act to adjust capital standards of financial institutions. The need to keep abreast of rapidly developing activity in other financial markets, certainly including the markets for mortgages and derivatives, has been driven home by the recent crisis. None of this to my mind suggests the need for regulatory and supervisory authority to lie exclusively in the Federal Reserve. In fact, there may be advantages in some division of responsibilities. A single regulator may be excessively rigid and insensitive to market developments, but equally clearly, we do not want competition and laxity among regulators aligning with particular constituencies or exposed to narrow political pressures. We are all familiar in the light of all that has happened with weaknesses in supervisory oversight, with failures to respond to financial excesses in a timely way and with gaps in authority. Those failings spread in one way or another among all the relevant agencies, not excepting the Federal Reserve. Both law and practice need reform. However these issues are resolved, I do believe the Federal Reserve, our central bank, with the broadest economic responsibility, with a perceived mandate for maintaining financial stability, with the strongest insulation against special political or industry pressures, must maintain a significant presence with real authority in regulatory and supervisory matters. Against that background, I respond to the particular points you raised in your invitation. I do believe it is apparent that regulatory arbitrage and the fragmentary nature of our regulatory system did contribute to the nature and extent of the financial crisis. That crisis exploded with a vengeance outside the banking system, involving investment banks, the world's largest insurance company, and government-sponsored agencies. Regulatory and supervisory agencies were neither reasonably equipped nor conscious of the extent of their responsibilities. Money market funds growing over several decades were essentially a pure manifestation of regulatory arbitrage. Attracting little supervisory attention, they broke down under pressure, a point of significant systemic weakness, and the remarkable rise of the subprime mortgage market developed through a variety of channels, some without official oversight. There are large questions about the role and supervision of the two hybrid public/private organizations that came to dominate the largest of all our capital markets, that for residential mortgages. Undeniably, in hindsight, there were weaknesses and gaps in the supervision of well-established financial institutions, including banking institutions, major parts of which the Federal Reserve carries direct responsibility. Some of those weaknesses have been and should have been closed by more aggressive regulatory approaches, but some gaps and ineffective supervision of institutions owning individual banks and small thrifts were loopholed, expressly permitted by legislation. As implied by my earlier comments, the Federal Reserve, by the nature of its core responsibilities, is thrust into direct operational contact with financial institutions and markets. Beyond those contacts, the 12 Federal Reserve banks exercising supervisory responsibilities provide a window into both banking developments and economic tendencies in all regions of the country. In more ordinary circumstances, intelligence gleaned on the ground about banking attitudes and trends will supplement and color forecasts and judgments emerging from other indicators of economic activity. When the issue is timely identification of highly speculative and destabilizing bubbles, a matter that is both important and difficult, then there are implications for both monetary and supervisory policy. Finally, the committee has asked about the potential impact of stripping the Federal Reserve of direct supervisory and regulatory power over the banks and other financial institutions, and whether something can be learned about the practices of other nations. Those are not matters that permit categorical answers good for all time. International experience varies. Most countries maintain a position, often a strong position, and a typically strong position for central banks' financial supervision. In some countries, there has been a formal separation. At the extreme, all form of supervisory regulatory authority over financial institutions was consolidated in the U.K. into one authority, with rather loose consultative links to the central bank. The approach was considered attractive as a more efficient arrangement, avoiding both agency rivalries and gaps or inconsistencies in approach. The sudden pressure of the developing crisis revealed a problem in coordinating between the agency responsible for the supervision, the central bank, which needed to take action, and the Treasury. The Bank of England had to consider intervention with financial support without close and confident appraisals of the vulnerability of affected institutions. As a result, I believe the U.K. itself is reviewing the need to modify their present arrangements. For reasons that I discussed earlier, I do believe it would be a really grievous mistake to insulate the Federal Reserve from direct supervision of systemically important financial institutions. Something important but less obvious would also be lost if the present limited responsibilities for smaller member banks were to be ended. The Fed's regional roots would be weaker and an useful source of information lost. I conclude with one further thought. In debating regulatory arrangements and responsibilities appropriate for our national markets, we should not lose sight of the implications for the role of the United States in what is in fact a global financial system. We necessarily must work with other nations and their financial authorities. The United States should and does still have substantial influence in those matters, including agreement on essential elements of regulatory and supervisory policies. It is the Federal Reserve as much as and sometimes more than the Treasury that carries a special weight in reaching the necessary understandings. That is a matter of tradition, experience, and of the perceived confidence in the authority of our central bank. There is a sense of respect and confidence around the world, matters that cannot be prescribed by law or easily replaced. Clearly, changes need to be made in the status quo. That is certainly true within the Federal Reserve. I believe regulatory responsibilities should be more clearly focused and supported. The crisis has revealed the need for change within other agencies as well. Consideration of broader reorganization of the regulatory and supervisory arrangements is timely. At the same time, I urge in your deliberations that you do recognize what would be lost, not just in the safety and soundness of our national financial system, but in influencing and shaping the global system, if the Federal Reserve were to be stripped of its regulatory and supervisory responsibilities, and no longer be recognized here and abroad as ``primus inter pares'' among the agencies concerned with the safety and soundness of our financial institutions. Let us instead strengthen what needs to be strengthened and demand high levels of competence and performance that for too long we have taken for granted. Thank you, ladies and gentlemen. [The prepared statement of Chairman Volcker can be found on page 100 of the appendix.] " fcic_final_report_full--355 COMMISSION CONCLUSIONS ON CHAPTER 18 The Commission concludes the financial crisis reached cataclysmic proportions with the collapse of Lehman Brothers. Lehman’s collapse demonstrated weaknesses that also contributed to the failures or near failures of the other four large investment banks: inadequate regulatory oversight, risky trading activities (including securitization and over-the-counter (OTC) derivatives dealing), enormous leverage, and reliance on short-term fund- ing. While investment banks tended to be initially more vulnerable, commercial banks suffered from many of the same weaknesses, including their involvement in the shadow banking system, and ultimately many suffered major losses, requiring government rescue. Lehman, like other large OTC derivatives dealers, experienced runs on its de- rivatives operations that played a role in its failure. Its massive derivatives posi- tions greatly complicated its bankruptcy, and the impact of its bankruptcy through interconnections with derivatives counterparties and other financial in- stitutions contributed significantly to the severity and depth of the financial crisis. Lehman’s failure resulted in part from significant problems in its corporate governance, including risk management, exacerbated by compensation to its ex- ecutives and traders that was based predominantly on short-term profits. Federal government officials decided not to rescue Lehman for a variety of reasons, including the lack of a private firm willing and able to acquire it, uncer- tainty about Lehman’s potential losses, concerns about moral hazard and political reaction, and erroneous assumptions that Lehman’s failure would have a manage- able impact on the financial system because market participants had anticipated it. After the fact, they justified their decision by stating that the Federal Reserve did not have legal authority to rescue Lehman. The inconsistency of federal government decisions in not rescuing Lehman af- ter having rescued Bear Stearns and the GSEs, and immediately before rescuing AIG, added to uncertainty and panic in the financial markets. fcic_final_report_full--462 By 2008, the result of these government programs was an unprecedented number of subprime and other high risk mortgages in the U.S. financial system. Table 1 shows which agencies or firms were holding the credit risk of these mortgages- -or had distributed it to investors through mortgage-backed securities (MBS)-- immediately before the financial crisis began. As Table 1 makes clear, government agencies, or private institutions acting under government direction, either held or had guaranteed 19.2 million of the NTM loans that were outstanding at this point. By contrast, about 7.8 million NTMs had been distributed to investors through the issuance of private mortgage-backed securities, or PMBS, 16 primarily by private issuers such as Countrywide and other subprime lenders. The fact that the credit risk of two-thirds of all the NTMs in the financial system was held by the government or by entities acting under government control demonstrates the central role of the government’s policies in the development of the 1997-2007 housing bubble, the mortgage meltdown that occurred when the bubble deflated, and the financial crisis and recession that ensued. Similarly, the fact that only 7.8 million NTMs were held by investors and financial institutions in the form of PMBS shows that this group of NTMs were less important as a cause of the financial crisis than the government’s role. The Commission majority’s report focuses almost entirely on the 7.8 million PMBS, and is thus an example of its determination to ignore the government’s role in the financial crisis. Table 1. 17 Entity No. of Subprime Unpaid Principal Amount and Alt-A Loans Fannie Mae and Freddie Mac 12 million $1.8 trillion FHA and other Federal* 5 million $0.6 trillion CRA and HUD Programs 2.2 million $0.3 trillion Total Federal Government 19.2 million $2.7 trillion Other (including subprime and 7.8 million $1.9 trillion Alt-A PMBS issued by Countrywide, Wall Street and others) Total 27 million $4.6 trillion *Includes Veterans Administration, Federal Home Loan Banks and others. To be sure, the government’s efforts to increase home ownership through the AH goals succeeded. Home ownership rates in the U.S. increased from approximately 64 percent in 1994 (where it had been for 30 years) to over 69 percent in 2004. 18 Almost everyone in and out of government was pleased with this—a long term goal 16 In the process known as securitization, securities backed by a pool of mortgages (mortgage- backed securities, or MBS) and issued by private sector firms were known as private label securities (distinguishing them from securities issued by the GSEs or Ginnie Mae) or private MBS (PMBS). 17 See Edward Pinto’s analysis in Exhibit 2 to the Triggers Memo, April 21, 2010, p.4. http://www.aei.org/ docLib/Pinto-Sizing-Total-Federal-Contributions.pdf. 18 Census Bureau data. 457 of U.S. housing policy—until the true costs became clear with the collapse of the housing bubble in 2007. Then an elaborate process of shifting the blame began. 2. The Great Housing Bubble and Its Effects FinancialCrisisInquiry--175 CHAIRMAN ANGELIDES: Yes. SOLOMON: So the real problem we have is it’s like that movie Hedgehog... CHAIRMAN ANGELIDES: Groundhog. SOLOMON: Groundhog. We wake up every day and it’s the same thing. And the reason I point it out in my testimony, folks have mentioned too is how many crisis we’ve had. This is like recurring non-recurring losses. CHAIRMAN ANGELIDES: Right. By the way, I saw my wife laughing. It’s my favorite movie because if you’ve ever been a candidate it is your life. Mr. Bass? BASS: One thing we talk about around our office is the brevity of financial memory. I think it’s only about five years when you look back through the financial marketplace. So, but to answer your first question with regard to where we are today as what is still a systemic problem, it’s what Mrs. Born is focused on up there and OTC derivatives. We have to nail those down. We have—absolutely need to get not only a clearing house, but a data repository put together so that the appropriate regulator, whoever we deem to be that appropriate regulator can see everything. Right now no one knows anything. You have to go in institution-by-institution, fund-by- fund. And these are just contracts between a buyer and a seller. There needs to be a clearinghouse, a repository and price transparency because I think that will eliminate an enormous amount of systemic risk. And when you require collateral to be posted to enter transactions it will self police the size of that marketplace. So that’s what I think is the biggest risk. 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-111hhrg55814--266 Mr. Tarullo," Thank you, Mr. Chairman, Ranking Member Bachus, and members of the committee. We have three panels, lots of witnesses today, so let me be brief. Systemic crises typically reveal failures across the financial system, and that has certainly been the case with the crisis that has beset our country in the last few years. There were profound failures of risk management in many private institutions. There were supervisory shortcomings at each of our financial regulatory agencies. Supervisory changes need to be and are being made. But we also need changes in legislative authority and instructions under which the regulatory agencies operate. In this regard, the discussion draft put forward by the chairman today provides a strong framework for achieving a safer, more stable financial system. The draft contains the key elements of an effective legislative response to systemic risk and ``too-big-to-fail'' problems. It reflects the need for multiple tools in containing these problems: stronger regulation; more effective supervision; and improved market discipline. In particular, creation of the kind of resolution mechanism contemplated in the discussion draft will give the country a third alternative to the current, often unwelcome, options of either a bailout or disorderly bankruptcy. As a complement to the regulatory and other changes in the legislation, it will give the government a means for letting even a very large institution fail while still safeguarding the financial system. This mechanism will move us away from a situation in which severe financial distress for large financial firms has led to a risk of loss being borne by taxpayers in order to safeguard the system to one in which in losses are borne by shareholders, creditors, managers and, if necessary, other large financial institutions. As always, Mr. Chairman, we would be pleased to work with the committee on any issues that arise as you move this legislation forward. Thank you very much. [The prepared statement of Governor Tarullo can be found on page 291 of the appendix.] Mr. Moore of Kansas. Thank you, sir. Mr. Bowman, you are recognized for 5 minutes, sir.STATEMENT OF JOHN E. BOWMAN, ACTING DIRECTOR, OFFICE OF THRIFT SUPERVISION (OTS) " 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-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-111shrg54789--159 Mr. Plunkett," I wouldn't--Senator, you make some very good points here. What we have heard so far from the financial services industry in terms of their ``reforms,'' I heard a systemic regulator maybe, but I heard no discussion of eliminating regulatory arbitrage. I heard no discussion of consolidating the consumer protection approach in any fashion to make it more effective. I heard no discussion of any systemic approach to improving consumer protection regulation. I heard the regulators are getting a little better, so we might as well leave things as they are. That is not going to work given the current situation. We need something broader, and we need an agency that is focused just on consumers. Senator Menendez. So it just seems to me that when we go down the list of questions of what the average consumer might find themselves in, we see the incentives, for example, in the mortgage crisis for lenders to move people into products that, at the end of the day, may be very beneficial to them but not very beneficial to the consumer. And when millions of people enter into those transactions and then have consequences when those first 5 years end and cannot meet their obligations, then we have systemic challenges to our economy. So it just seems to me why should we have the borrowers simply fend for themselves? I believe all in personal responsibility. I would love us to have greater financial literacy commitments as a country from education, to engagement, even our financial institutions to do so. But at the end of the day, if we allow millions of people based upon incentives that move individuals to try--entities to try to move individuals to products that are good for the lender and/or the broker but bad for the consumer and millions ultimately make a mistake and then create the consequences that we have today in the housing market, it affects all of us. " CHRG-111shrg56376--209 Mr. Ludwig," Well, Senator Corker, I couldn't agree with you more that resolving the largest institutions is a critical issue and I am not in favor of propping them up. That is, if we don't resolve them, we basically create two problems. One is we have public utilities if we don't have an ability to resolve them. And we also disadvantage the community and regional institutions. Rather, this whole structure ought to be one that creates sufficient stability and focuses in a professional way on proper supervision so as to minimize burden and increase the ability of all these institutions to support the economy of the United States. And where one of these institutions is not doing its job correctly and it gets into problems, we have to have a private sector component here--this is really a private sector activity--where it fails, and we have to have the ability to fail it without creating a systemic crisis. If we don't have that, I think we also have the danger that these largest institutions end up controlling the economy and the Governmental mechanism, not vice-versa. " CHRG-110hhrg46596--384 Mr. Kashkari," Congresswoman, thank you for the comment. I will say three things. First, remember, when we started in this hearing, the overall objective of our actions has been to stabilize the financial system and to prevent a collapse, number one. Number two, we are working with the regulators to design the right measurements to look at loan levels, to see if increasing in lending is taking place relative to those who did not take the capital over time, to judge the merits of the Capital Purchase Program by themselves. And third, Mr. Chairman, if you will indulge me for just 30 seconds, to get some sense of the severity of this crisis, think about this: Bear Stearns; Washington Mutual; IndyMac; Fannie Mae; Freddie Mac; AIG; Wachovia; Lehman Brothers--all major U.S. financial institutions that have collapsed in the last 9 or 10 months. This is not a joke. " CHRG-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-111hhrg53021--49 Secretary Geithner," Congressman, thank you for raising that question. I think if you step back and look at where we are today relative to where we were at the end of the year, we have achieved the critically important effect of helping slow the rate of decline in the economy, helped to stabilize the financial system. Business consumer confidence has improved very substantially. The rate of decline in economic activity globally has slowed and stabilized. Financial systems are starting to heal. The cost of credit, broad concern about catastrophic risk in the economy and the financial system has receded very dramatically. Those are critically important signs of initial progress, and they are due entirely to the actions this Congress took and the Administration took to put in place the largest recovery program in peacetime in the United States. The stimulus package is on its expected path, in terms of the rate of change, and in terms of putting money in the pockets of taxpayers, to provide substantial forms of assistance to states to reduce the risks that they are forced to fire tens of thousands of teachers, workers, and firemen. And there are very substantial investments in infrastructure products that have already started to take effect and will have their maximum impact on the economy in the second half of this year. So my own sense is, and I think this is a consensus of broad-based economists, that there has been substantial improvements in arresting what was the worst recession globally we have seen in generations. And those are the result of the actions this Congress took, the Administration put in place, and complementary actions taken by governments around the world to, again, help address what the worst crisis we have seen in a long period of time. " CHRG-111hhrg53021Oth--49 Secretary Geithner," Congressman, thank you for raising that question. I think if you step back and look at where we are today relative to where we were at the end of the year, we have achieved the critically important effect of helping slow the rate of decline in the economy, helped to stabilize the financial system. Business consumer confidence has improved very substantially. The rate of decline in economic activity globally has slowed and stabilized. Financial systems are starting to heal. The cost of credit, broad concern about catastrophic risk in the economy and the financial system has receded very dramatically. Those are critically important signs of initial progress, and they are due entirely to the actions this Congress took and the Administration took to put in place the largest recovery program in peacetime in the United States. The stimulus package is on its expected path, in terms of the rate of change, and in terms of putting money in the pockets of taxpayers, to provide substantial forms of assistance to states to reduce the risks that they are forced to fire tens of thousands of teachers, workers, and firemen. And there are very substantial investments in infrastructure products that have already started to take effect and will have their maximum impact on the economy in the second half of this year. So my own sense is, and I think this is a consensus of broad-based economists, that there has been substantial improvements in arresting what was the worst recession globally we have seen in generations. And those are the result of the actions this Congress took, the Administration put in place, and complementary actions taken by governments around the world to, again, help address what the worst crisis we have seen in a long period of time. " FOMC20070807meeting--141 139,MR. MISHKIN.," But there’s always an issue about what we mean by the word “classic.” What I’m thinking about here is that a lender-of-last-resort operation is really about restoring confidence. It can be done without actually putting any liquidity into the system. If you look at a successful lender-of-last-resort operation, just the announcement that you will be a backstop for the system has tremendous impact. Of course, this is one reason that what was done in ’87—with Greenspan not actually sitting in the tub that morning but getting up early and announcing before the market opened that the Federal Reserve was going to be a backstop—was extremely important. I’m thinking of it in that context, which is that we wanted to provide information to the markets, which was that we were going to be there and that we were not going to be the Bank of Japan and allow something to spiral out of control. Clearly, it was basically taking out insurance, saying that the Fed will be there. Once you don’t need insurance anymore, there’s a really strong argument to take it away. So I’m not talking about this in terms of liquidity per se but what we are trying to do in terms of expectations. That episode was important for doing the right thing, which was critical to the way the financial markets recovered; but I think a problem was created when we didn’t reverse it in the same way that, when you actually do a lender-of-last-resort operation, you put liquidity in and you take it out. That’s the sense in which I mean putting lower interest rates in and then taking them out when the crisis is over." CHRG-110shrg50414--209 Secretary Paulson," I would say to you, sir, when we had--when I have had a discussion with central banks and finance ministers from around the world, their primary concern was that we deal with this situation and they were very complimentary of this action. And I believe from the conversations that I have had with central bankers, China, Japan, around the world, their first and foremost concern was stabilizing our financial system because it is so integrated with the rest of the world. Senator Bunning. OK. I guess maybe I am the only one that has a problem with this, but one of the big problems I am having dealing with your plan and Chairman Bernanke's and others to address this issue is that you are not going to be here after January 20 of 2009, and I am going to have to answer to the 4.2 million people in Kentucky and all these other Senators up here are going to have to answer to their constituents if this plan does not work. And I am frightful to the point of almost panic that I don't see a solution in your plan to address this financial crisis that we are in. " CHRG-111shrg52619--173 PREPARED STATEMENT OF SCOTT M. POLAKOFF Acting Director, Office of Thrift Supervision March 19, 2009Introduction Good morning Chairman Dodd, Ranking Member Shelby, and Members of the Committee. Thank you for inviting me to testify on behalf of the Office of Thrift Supervision (OTS) on Modernizing Bank Supervision and Regulation. It has been pointed out many times that our current system of financial supervision is a patchwork with pieces that date to the Civil War. If we were to start from scratch, no one would advocate establishing a system like the one we have cobbled together over the last century and a half. The complexity of our financial markets has in some cases reached mind-boggling proportions. To effectively address the risks in today's financial marketplace, we need a modern, sophisticated system of regulation and supervision that applies evenly across the financial services landscape. The economic crisis gripping this nation and much of the rest of the world reinforces the theme that the time is right for an in-depth, careful review and meaningful, fundamental change. Any restructuring should take into account the lessons learned from this crisis. Of course, the notion of regulatory reform is not new. When financial crisis strikes, it is natural to look for the root causes and logical fixes, asking whether the nation's regulatory framework allowed problems to occur, either because of gaps in oversight, a lack of vigilance, or overlaps in responsibilities that bred a lack of accountability. Since last year, a new round of studies, reports and recommendations have entered the public arena. In one particularly notable study in January 2009--Financial Regulation: A Framework for Crafting and Assessing Proposals to Modernize the Outdated U. S. Financial Regulatory System--the Government Accountability Office (GAO) listed four broad goals of financial regulation: Ensure adequate consumer protections, Ensure integrity and fairness of markets, Monitor the safety and soundness of institutions, and Ensure the stability of the overall financial system. The OTS recommendations discussed in this testimony align with those goals. Although a review of the current financial services regulatory framework is a necessary exercise, the OTS recommendations do not represent a realignment of the current regulatory system. Rather, these recommendations represent a fresh start, using a clean slate. They present the OTS vision for the way financial services regulation in this country should be. Although they seek to remedy some of the problems of the past, they do not simply rearrange the current regulatory boxes. What we are proposing is fundamental change that would affect virtually all of the current federal financial regulators. It is also important to note that these are high-level recommendations. Before adoption and implementation, many details would need to be worked out and many questions would need to be answered. To provide all of those details and answer all of those questions would require reams beyond the pages of this testimony. The remaining sections of the OTS testimony begin by describing the problems that led to the current economic crisis. We also cite some of the important lessons learned from the OTS's perspective. The testimony then outlines several principles for a new regulatory framework before describing the heart of the OTS proposal for reform.What Went Wrong? The problems at the root of the financial crisis fall into two groups, nonstructural and structural. The nonstructural problems relate to lessons learned from the current economic crisis that have been, or can be, addressed without changes to the regulatory structure. The structural problems relate to gaps in regulatory coverage for some financial firms, financial workers and financial products.Nonstructural Problems In assessing what went wrong, it is important to note that several key issues relate to such things as concentration risks, extraordinary liquidity pressures, weak risk management practices, the influence of unregulated entities and product markets, and an over-reliance on models that relied on insufficient data and faulty assumptions. All of the regulators, including the OTS, were slow to foresee the effects these risks could have on the institutions we regulate. Where we have the authority, we have taken steps to deal with these issues. For example, federal regulators were slow to appreciate the severity of the problems arising from the increased use of mortgage brokers and other unregulated entities in providing consumer financial services. As the originate-to-distribute model became more prevalent, the resulting increase in competition changed the way all mortgage lenders underwrote loans, and assigned and priced risk. During the then booming economic environment, competition to originate new loans was fierce between insured institutions and less well regulated entities. Once these loans were originated, the majority of them were removed from bank balance sheets and sold into the securitization market. These events seeded many residential mortgage-backed securities with loans that were not underwritten adequately and that would cause significant problems later when home values fell, mortgages became delinquent and the true value of the securities became increasingly suspect. Part of this problem stemmed from a structural issue described in the next section--inadequate and uneven regulation of mortgage companies and brokers--but some banks and thrifts that had to compete with these companies also started making loans that were focused on the rising value of the underlying collateral, rather than the borrower's ability to repay. By the time the federal bank regulators issued the nontraditional mortgage guidance in September 2006, reminding insured depository institutions to consider borrowers' ability to repay when underwriting adjustable-rate loans, numerous loans had been made that could not withstand a severe downturn in real estate values and payment shock from changes in adjustable rates. When the secondary market stopped buying these loans in the fall of 2007, too many banks and thrifts were warehousing loans intended for sale that ultimately could not be sold. Until this time, bank examiners had historically looked at internal controls, underwriting practices and serviced loan portfolio performance as barometers of safety and soundness. In September 2008, the OTS issued guidance to the industry reiterating OTS policy that for all loans originated for sale or held in portfolio, savings associations must use prudent underwriting and documentation standards. The guidance emphasized that the OTS expects loans originated for sale to be underwritten to comply with the institution's approved loan policy, as well as all existing regulations and supervisory guidance governing the documentation and underwriting of residential mortgages. Once loans intended for sale were forced to be kept in the institutions' portfolios, it reinforced the supervisory concern that concentrations and liquidity of assets, whether geographically or by loan type, can pose major risks. One lesson from these events is that regulators should consider promulgating requirements that are counter-cyclical, such as conducting stress tests and lowering loan-to-value ratios during economic upswings. Similarly, in difficult economic times, when house prices are not appreciating, regulators could permit loan-to-value (LTV) ratios to rise. Other examples include increasing capital and allowance for loan and lease losses in times of prosperity, when resources are readily available. Another important nonstructural problem that is recognizable in hindsight and remains a concern today is the magnitude of the liquidity risk facing financial institutions and how that risk is addressed. As the economic crisis hit banks and thrifts, some institutions failed and consumers whose confidence was already shaken were overtaken in some cases by panic about the safety of their savings in insured accounts at banks and thrifts. This lack of consumer confidence resulted in large and sudden deposit drains at some institutions that had serious consequences. The federal government has taken several important steps to address liquidity risk in recent months, including an increase in the insured threshold for bank and thrift deposits. Another lesson learned is that a lack of transparency for consumer products and complex instruments contributed to the crisis. For consumers, the full terms and details of mortgage products need to be understandable. For investors, the underlying details of their investments must be clear, readily available and accurately evaluated. Transparency of disclosures and agreements should be addressed. Some of the blame for the economic crisis has been attributed to the use of ``mark-to-market'' accounting under the argument that this accounting model contributes to a downward spiral in asset prices. The theory is that as financial institutions write down assets to current market values in an illiquid market, those losses reduce regulatory capital. To eliminate their exposure to further write-downs, institutions sell assets into stressed, illiquid markets, triggering a cycle of additional sales at depressed prices. This in turn results in further write-downs by institutions holding similar assets. The OTS believes that refining this type of accounting is better than suspending it. Changes in accounting standards can address the concerns of those who say fair value accounting should continue and those calling for its suspension. These examples illustrate that nonstructural problems, such as weak underwriting, lack of transparency, accounting issues and an over-reliance on performance rather than fundamentals, all contributed to the current crisis.Structural Problems The crisis has also demonstrated that gaps in regulation and supervision that exist in the mortgage market have had a negative impact on the world of traditional and complex financial products. In recent years, the lack of consistent regulation and supervision in the mortgage lending area has become increasingly apparent. Independent mortgage banking companies are state-chartered and regulated. Currently, there are state-by-state variations in the authorities of supervising agencies, in the level of supervision by the states and in the licensing processes that are used. State regulation of mortgage banking companies is inconsistent and varies on a number of factors, including where the authority for chartering and oversight of the companies resides in the state regulatory structure. The supervision of mortgage brokers is even less consistent across the states. In response to calls for more stringent oversight of mortgage lenders and brokers, a number of states have debated and even enacted licensing requirements for mortgage originators. Last summer, a system requiring the licensing of mortgage originators in all states was enacted into federal law. The S.A.F.E. Mortgage Licensing Act in last year's Housing and Economic Recovery Act is a good first step. However, licensing does not go far enough. There continues to be significant variation in the oversight of these individuals and enforcement against the bad actors. As the OTS has advocated for some time, one of the paramount goals of any new framework should be to ensure that similar bank or bank-like products, services and activities are scrutinized in the same way, whether they are offered by a chartered depository institution, or an unregulated financial services provider. The product should receive the same review, oversight and scrutiny regardless of the entity offering the product. Consumers do not understand--nor should they need to understand--distinctions between the types of lenders offering to provide them with a mortgage. They deserve the same service, care and protection from any lender. The ``shadow bank system,'' where bank or bank-like products are offered by nonbanks using different standards, should be subject to as rigorous supervision as banks. Closing this gap would support the goals cited in the GAO report. Another structural problem relates to unregulated financial products and the confluence of market factors that exposed the true risk of credit default swaps (CDS) and other derivative products. CDS are unregulated financial products that lack a prudential derivatives regulator or standard market regulation, and pose serious challenges for risk management. Shortcomings in data and in modeling certain derivative products camouflaged some of those risks. There frequently is heavy reliance on rating agencies and in-house models to assess the risks associated with these extremely complicated and unregulated products. In hindsight, the banking industry, the rating agencies and prudential supervisors, including OTS, relied too heavily on stress parameters that were based on insufficient historical data. This led to an underestimation of the economic shock that hit the financial sector, misjudgment of stress test parameters and an overly optimistic view of model output. We have also learned there is a need for consistency and transparency in over-the-counter (OTC) CDS contracts. The complexity of CDS contracts masked risks and weaknesses. The OTS believes standardization and simplification of these products would provide more transparency to market participants and regulators. We believe many of these OTC contracts should be subject to exchange-traded oversight, with daily margining required. This kind of standardization and exchange-traded oversight can be accomplished when a single regulator is evaluating these products. Congress should consider legislation to bring such OTC derivative products under appropriate regulatory oversight. One final issue on the structural side relates to the problem of regulating institutions that are considered to be too big and interconnected to fail, manage, resolve, or even formally deem as problem institutions when they encounter serious trouble. We will discuss the pressing need for a systemic risk regulator with the authority and resources adequate to the meet this enormous challenge later in this testimony. The array of lessons learned from the crisis will be debated for years. One simple lesson is that all financial products and services should be regulated in the same manner regardless of the issuer. Another lesson is that some institutions have grown so large and become so essential to the economic well-being of the nation that they must be regulated in a new way.Guiding Principles for Modernizing Bank Supervision and Regulation The discussion on how to modernize bank supervision and regulation should begin with basic principles to apply to a bank supervision and consumer protection structure. Safety and soundness and consumer protection are fundamental elements of any regulatory regime. Here are recommendations for four other guiding principles: 1. Dual banking system and federal insurance regulator--The system should contain federal and state charters for banks, as well as the option of federal and state charters for insurance companies. The states have provided a charter option for banks and thrifts that have not wanted to have a national charter. A number of innovations have resulted from the kind of focused product development that can occur on a local level. Banks would be able to choose whether to hold a federal charter or state charter. For large insurance companies, a federal insurance regulator would be available to provide more comprehensive, coordinated and effective oversight than a collection of individual state insurance regulators. 2. Choice of charter, not of regulator--A depository institution should be able to choose between state or federal banking charters, but if it selects a federal charter, its charter type and regulator should be determined by its operating strategy and business model. In other words, there would be an option to choose a business plan and resulting charter, but that decision would then dictate which regulator would supervise the institution. 3. Organizational and ownership options--Financial institutions should be able to choose the organizational and ownership form that best suits their needs. Mutual, public or private stock and subchapter S options should continue to be available. 4. Self-sustaining regulators--Each regulator should be able to sustain itself financially through assessments. Funding the agencies differently could expose bank supervisory decisions to political pressures, or create conflicts of interest within the entity controlling the purse strings. An agency that supervises financial institutions must control its funding to make resources available quickly to respond to supervision and enforcement needs. For example, when the economy declines, the safety-and-soundness ratings of institutions generally drop and enforcement actions rise. These changes require additional resources and often an increase in hiring to handle the larger workload. 5. Consistency--Each federal regulator should have the same enforcement tools and the authority to use those tools in the same manner. Every entity offering financial products should also be subject to the same set of laws and regulations.Federal Bank Regulation The OTS proposes two federal bank regulators, one for banks predominately focused on consumer-and-community banking products, including lending, and the other for banks primarily focused on commercial products and services. The business models of a commercial bank and a consumer-and-community bank are fundamentally different enough to warrant these two distinct federal banking charters. The consumer-and-community bank regulator would supervise depository institutions of all sizes and other companies that are predominately engaged in providing financial products and services to consumers and communities. Establishing such a regulator would address the gaps in regulatory oversight that led to a shadow banking system of unevenly regulated mortgage companies, brokers and consumer lenders that were significant causes of the current crisis. The consumer-and-community bank regulator would also be the primary federal regulator of all state-chartered banks with a consumer-and-community business model. The regulator would work with state regulators to collaborate on examinations of state-chartered banks, perhaps on an alternating cycle for annual state and federal examinations. State-chartered banks would pay a prorated federal assessment to cover the costs of this oversight. In addition to safety and soundness oversight, the consumer-and-community bank regulator would be responsible for developing and implementing all consumer protection requirements and regulations. These regulations and requirements would be applicable to all entities that offer lending products and services to consumers and communities. The same standards would apply for all of these entities, whether a state-licensed mortgage company, a state bank or a federally insured depository institution. Noncompliance would be addressed through uniform enforcement applied to all appropriate entities. The current crisis has highlighted consumer protection as an area where reform is needed. Mortgage brokers and others who interact with consumers should meet eligibility requirements that reinforce the importance of their jobs and the level of trust consumers place in them. Although the recently enacted licensing requirements are a good first step, limitations on who may have a license are also necessary. Historically, federal consumer protection policy has been based on the premise that if consumers are provided with enough information, they will be able to choose products and services that meet their needs. Although timely and effective disclosure remains necessary, disclosure alone may not be sufficient to protect consumers against abuses. This is particularly true as products and services, including mortgages, have become more complex. The second federal bank regulator--the commercial bank regulator--would charter and supervise banks and other entities that primarily provide products and services to corporations and companies. The commercial bank regulator would have the expertise to supervise banks and other entities predominately involved in commercial transactions and offering complex products. This regulator would develop and implement the regulations necessary to supervise these entities. The commercial bank regulator would supervise issuers of derivative products. Nonbank providers of the same products and services would be subject to the same rules and regulations. The commercial bank regulator would not only have the tools necessary to understand and supervise the complex products already mentioned, but would also possess the expertise to evaluate the safety and soundness of loans that are based on suchthings as income streams and occupancy rates, which are typical of loans for projects such as shopping centers and commercial buildings. The commercial bank regulator would also be the primary federal supervisor of state-chartered banks with a commercial business model, coordinating with the states on supervision and imposing federal assessments just as the consumer-and-communityregulator would. Because most depositories today are engaged in some of each of these business lines, the predominant business focus of the institution would govern which regulator would be the primary federal regulator. In determining the federal supervisor, a percentage of assets test could apply. If the operations of the institution or entity changed for a significant period of time, the primary federal regulator would change. More discussion and analysis would be needed to determine where to draw the line between institutions qualifying as commercial banks and institutions qualifying as consumer and community banks.Holding Company Regulation The functional regulator of the largest entity within a diversified financial company would be the holding company regulator. The holding company regulator would have authority to monitor the activities of all affiliates, to exercise enforcement authority and to impose information-sharing arrangements between entities in the holding company structure and their functional regulators. To the extent necessary for the safety and soundness of the depository subsidiary or the holding company, the regulator would have the authority to impose capital requirements, restrict activities, issue source-of support requirements and otherwise regulate the operations of the holding company and the affiliates.Systemic Risk Regulation The establishment of a systemic risk regulator is an essential outcome of any initiative to modernize bank supervision and regulation. OTS endorses the establishment of a systemic risk regulator with broad authority to monitor and exercise supervision over any company whose actions or failure could pose a risk to financial stability. The systemic risk regulator should have the ability and the responsibility for monitoring all data about markets and companies, including but not limited to companies involved inbanking, securities and insurance. For systemically important institutions, the systemic risk regulator would supplement, not supplant, the holding company regulator and the primary federal bank supervisor. A systemic regulator would have the authority and resources to supervise institutions and companies during a crisis situation. The regulator should have ready access to funding sources that would provide the capability to resolve problems at these institutions, including providing liquidity when needed. Given the events of the past year, it is essential that such a regulator have the ability to act as a receiver and to provide an orderly resolution to companies. Efficiently resolving a systemically important institution in a measured, well-managed manner is an important element in restructuring the regulatory framework. A lesson learned from recent events is that the failure or unwinding of systemically important companies has a far reaching impact on the economy, not just on financial services. The continued ability of banks and other entities in the United States to compete in today's global financial services marketplace is critical. The systemic risk regulator would be charged with coordinating the supervision of conglomerates that have international operations. Safety and soundness standards, including capital adequacy and other factors, should be as comparable as possible for entities that have multinational businesses. Although the systemic risk regulator would not have supervisory authority over nonsystemically important banks, the systemic regulator would need access to data regarding the health and activities of these institutions for purposes of monitoring trendsand other matters.Conclusion Thank you again, Mr. Chairman, Ranking Member Shelby, and Members of the Committee, for the opportunity to testify on behalf of the OTS on Modernizing Bank Supervision and Regulation. We look forward to continuing to work with the members of this Committee and others to fashion a system of financial services regulation that better serves all Americans and helps to ensure the necessary clarity and stability for this nation's economy. ______ CHRG-111shrg57319--186 Mr. Melby," I am not aware of that. Senator Levin. OK. Now, banks that find out about high rates of fraud affecting their loans and then do not do anything about them is emblematic of how banks contributed to the financial crisis, putting short-term profits first, letting deep-seated problems responsible for poor loan quality fester, churning out and selling billions of dollars of defective-quality loans, and it all helped poison our financial system with toxic mortgages. I have some additional questions, but we have a 10-minute round on this one, so I will turn it back to Dr. Coburn and then come back for a third round. Senator Coburn. I have one serious question, and you can answer it one of two ways, one inside or one being outside. If you were an investor in Washington Mutual and you knew what was going on, would you consider that as being a material adverse risk factor from Washington Mutual? " CHRG-111hhrg54872--117 Mr. John," I think an article from the Washington Post from Sunday has already been cited here. I was deeply disturbed, for instance, to see a Washington Post article last December which pointed out a low-income immigrant couple who were moved into a multi-hundred thousand dollar housing loan despite the fact they had a very low income. We could go through the list. And the list would be very long, both on a State and a Federal area. One of the problems the chairman has pointed out very effectively is that this is not one of the key responsibilities of the regulatory agencies. Now, I think you can make it a responsibility and make it an emphasis just as easy with a coordinating council as you can by massively disrupting the whole consumer regulatory system by creating a new agency. Mr. Moore of Kansas. But you do think existing law and practice worked to prevent the financial crisis last year? " 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-111shrg50814--147 Mr. Bernanke," The outcome of the stress test is not going to be fail or pass. The outcome of the stress test is, how much capital does this bank need in order to meet the needs of the credit--the credit needs of borrowers in our economy. You mentioned having majority ownership and so on. We don't need majority ownership to work with the banks. We have very strong supervisory oversight. We can work with them now to get them to do whatever is necessary to restructure, take whatever steps are needed to become profitable again, to get rid of bad assets. We don't have to take them over to do that. We have always worked with banks to make sure that they are healthy and stable, and we are going to work with them. I don't see any reason to destroy the franchise value or to create the huge legal uncertainties of trying to formally nationalize a bank when it just isn't necessary. I think what we can do is make sure they have enough capital to fulfill their function and at the same time exert adequate control to make sure that they are doing what is necessary to become healthy and viable in the longer term. With respect to your question about too big to exist, as I have said before, there is a too big to fail problem which is very severe. We need to think hard going forward how we are going to address that problem, but right now, we are in the middle of the crisis. Senator Shelby. Have you thought about ways to deal with it? We understand that some banks pose, or some institutions like AIG, systemic risk to the whole financial system---- " CHRG-111hhrg53238--52 Mr. Menzies," Thank you, Mr. Chairman, and members of the committee. As you mentioned, I am president and CEO of Easton Bank and Trust, just 42 miles east of here. We are a $150 million community bank, and I am honored to be the volunteer chairman of the Independent Community Bankers of America, who represent 5,000 community-bank-only members at this important hearing. Less than a year ago, due to the failure of our Nation's largest institutions to adequately manage their highly risky activities, key elements of the Nation's financial system nearly collapsed. Even though our system of locally owned and controlled community banks were not in similar danger, the resulting recession and credit crunch has now impacted the cornerstone of our local economies: community banks. This was, as you know, a crisis driven by a few unmanageable financial entities that nearly destroyed our equity markets, our real estate markets, our consumer loan markets and the global finance markets, and cost American consumers over $7 trillion in net worth. ICBA commends you and President Obama for taking the next step to reduce the chances that taking risky and irresponsible behavior by large or unregulated institutions will ever again lead us into economic calamity. ICBA supports identifying specific institutions that may pose systemic risk and systemic danger and subjecting them to stronger supervision, capital, and liquidity requirements. Our economy needs more than just an early warning system. It needs a real cop on the beat. The President's plan could be enhanced by assessing fees on systemically dangerous holding companies for their supervisory costs and to fund, in advance, not after the fact, a new systemic risk fund. ICBA also strongly supports H.R. 2897, introduced by Representative Gutierrez. This bill would impose an additional fee on banks affiliated with systemically dangerous holding companies and better account for the risk these banks pose, while strengthening the deposit insurance fund. These strong measures are not meant to punish those institutions for being large, but to guard against the risk they do create. These large institutions would be held accountable and discouraged from becoming too-big-to-fail. But to truly prevent the kind of financial meltdown we faced last fall and to truly protect consumers, the plan must go further. It should direct systemic-risk authorities to develop procedures to downsize the too-big-to-fail institutions in an orderly way. This will enhance the diversity and flexibility of our Nation's financial system, which has proven extremely valuable in the current crisis. In that regard, ICBA is pleased the Administration plan maintains the State bank system and believes that any bill should retain the thrift charter. Both charters enable community banks to follow business plans that are best adapted to their local markets and pose no systemic risk. Unregulated individuals and companies perpetrated serious abuses on millions of American consumers. Community banks already do their utmost to serve consumers and comply with consumer protections. Consumers should be protected. Any new legislation must ensure that unregulated or unsupervised people in institutions are subject to examinations just like community banks. My written testimony outlines serious challenges with the proposed Consumer Protection Agency, which we oppose in its current form. For example, we strongly believe that rural writing and supervision for community banks should remain with agencies that also must take safety and soundness into account. Clearly a financial institution that does not adhere to consumer protection rules also has safety and soundness problems. And we, too, are grateful, Mr. Chairman, with your statement that you are committed to preventing conflict between safety and soundness and consumer protection. If we truly want to protect consumers, Congress must enact legislation that effectively ends the too-big-to-fail system, because these institutions are too-big-to-manage and too-big-to-supervise. And we are grateful for your hearings on Monday, Mr. Chairman. ICBA urges Congress to add an Assistant Secretary for Community Financial Institutions at the Treasury Department to provide an internal voice for Main Street concerns. H.R. 2676, introduced by Representative Dennis Cardoza, will provide that important balance between Wall Street and Main Street within the Treasury. Mr. Chairman, community banks are the very fabric of our Nation. We fund growth, we drive new business. Over half of all the small business loans under $100,000 in America are made by community banks. We help families buy homes and finance educations. We, too, are victims of the current financial situation, but we are committed to help the people and businesses of our communities, and we will be a significant force in the economic recovery. Thank you, sir. [The prepared statement of Mr. Menzies can be found on page 158 of the appendix.] " 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-111shrg52619--40 Chairman Dodd," You mentioned the four bank regulators, and I think Mr. Dugan made the point earlier that this could be a briefer hearing---- [Laughter.] " Chairman Dodd," ----given the fact that we have the four regulators involved in all of this. Is this making any sense at all? And I am not jumping to one, but maybe the question ought to be what do we need out there to provide the safety and soundness and consumer protection. And I am not interested in just moving boxes around--take four and make it one--as attractive as that may seem to people, because that may defeat the very purpose of why we gather and talk about this issue. But the question is a basic one. Do we have too many regulators here and has that contributed, in your view, Sheila, to some of the issues we are confronting? Ms. Bair. I think that you probably could have fewer bank regulators. I do think you need at least a national and a State charter. I think you should preserve the dual structure. But I also think in terms of the immediate crisis, the bigger problems are with the bank versus nonbank arbitrage, not arbitrage within the banking system. " fcic_final_report_full--18 Crisis on the Horizon  1 CHRG-111shrg55739--92 Mr. Gellert," I think looking at removing the NRSRO designation and regulations is actually quite a good idea. I agree that they can't all just be stripped out immediately because that can be disruptive, but looked at in a methodical way relatively expeditiously is probably a benefit. I think the Treasury plan calls for a 30-month review of this. I think that is probably a bit more time than anyone really needs to get started or at least to be able to make the statement that this is a road we are marching down. But I would point out that it is not just that there is a tendency for institutional investors to overrely, or a potential for them to overrely and essentially outsource their own credit work. It presents an opportunity to arbitrage the system, because a security that meets a certain standard by their regulatory oversight but has a higher yield, as we saw during this crisis, is something that they can buy and will buy because it is beneficial to them for returns. So, in a handful of ways, it can be complicated, but I do think it is a good initiative. Senator Reed. Professor Coffee. " FOMC20080318meeting--92 90,MR. MISHKIN.," Thank you, Mr. Chairman. Well, I'm quite depressed. That's not my usual personality trait, but the reality is that we've had as bad a set of shocks as I could have imagined, and I want to talk about this set of shocks. We have been hit with things that are making our policy environment as complicated as I possibly could have imagined. The reality is that we are in the worst financial crisis that we've experienced in the post�World War II era. I don't think we should be shy about saying it. We are in a financial crisis, and it is worse than we have experienced in any other episode of financial ""disruption,"" which is the word I use. I will not use ""financial crisis"" in public. ""Financial disruption"" is still a good phrase to use in public, but I really do think that this is a financial crisis. It is surely going to be called that in the next edition of my textbook. PARTICIPANT. When is it coming out? " CHRG-111shrg54533--73 Secretary Geithner," No. I would say that there were limitations both in the strength of the rules that were established and how those were enforced. The rules themselves were probably, I think, almost certainly not sufficiently strong, and it is certain that they were not enforced with sufficient rigor and evenness across the range of institutions that allowed to generate those products. Senator Crapo. How do you respond to the concern, though, that one of the needs we have to focus on, at least in my opinion--and I think this is a pretty broadly held belief--is to streamline and make more efficient our regulatory system? Before we got into this crisis last October, you know, most of the focus on regulatory reform was on how to stop our slide in competitiveness with regard to our foreign capital markets or the world capital markets. And one of the concerns there was that we continue to have this increase in numbers of regulators to the point where we have double-digit regulators for any financial function, and here we are seeing a proposal once again to increase the number of regulatory agencies that will now be managing our financial economy. " FinancialCrisisInquiry--156 In your opinion, if the management systems of these companies had stronger accountability, would that not be an appropriate step before structural change in the industry? SOLOMON: Yes. I mean, great management will take bad situations and make them better, but they’ll be bad situations. I think we are dealing with a structural problem, and we’d better hope that management’s fabulous, and it isn’t always fabulous. It’s a—it’s a reality. Even the best business schools can’t turn out fabulous people for enough places. THOMPSON: Thank you very much. CHAIRMAN ANGELIDES: All right, Mr. Hennessey, if I’m—no? Mr. Georgiou already did it. Aren’t his comments seared into your brain? (CROSSTALK) HENNESSEY: My apologies. Can you compare the—can you compare Fannie and Freddie, what happened with them to the failures at other large financial institutions? I’m interested in both the competence of management, the risks that they took, and the impacts on the financial system of their failure. As—as we look at what are the causes of the financial crisis and we have to figure out how to allocate our time and other resources, looking into the failure at WaMu or the failure at, you know, Lehman or Bear Stearns and Fannie and Freddie, can you give us a sense how important were those firms relative to other failures, and can you also give us a sense of how should we—we’ve heard a lot; we’ve been talking a lot about ability to manage risks and about the risks that they were taking. Can you give us some sense of comparison? CHRG-111shrg54533--53 Secretary Geithner," They were a bit of an orphan in the current structure. But under this regime, we are giving the SEC and the CFTC much more explicit authority. We are pushing the standardized piece of those products onto central clearinghouses, onto exchanges and transparent electronic trading platforms and giving the SEC better authority to deal with potential manipulation and fraud in those areas. That would have helped. If they were behind the curve and failed to act in that context, then the council would have the ability and the authority to bring that to light and to urge them to fix that problem. So I believe under this model, you are going to have the Secretary of the Treasury doing something I don't believe you have ever asked the Secretary of the Treasury to do, which is to come before the Congress on a regular basis and report on evolution of risk in the system and whether the overall system as a whole is doing an adequate job of responding to those risks. Now, we won't have the full authority that Congress has given to the underlying regulatory agency. They will each have a piece of responsibility for that. But in some sense, you will be able to look to the executive branch to say, does the whole thing work? Are we dealing with gaps? Are we adapting to emerging risks? And I think that will be a substantial improvement. Senator Bennet. And then--Mr. Chairman, one more question--and then if all that left us in the position where an institution that was a bank holding company found itself in crisis, we then have a new approach to resolution authority, as well, that you are proposing. " CHRG-111shrg61651--136 PREPARED STATEMENT OF JOHN REED Retired Chairman, Citigroup February 4, 2010 It is probably too early to fully assess the nature and causes of our recent financial meltdown but the conversation about potential remedies is well underway. Given that fact, a few thoughts could be useful. First, some ``framing.'' One, the crisis was clearly ``man made,'' this was not the result of long standing and cumulative imbalances. Second, there seems to have been a key failure that none of us anticipated, namely, individual institutions which are thought to take steps and exercise judgments to ensure their self-preservation turned out ``not to have'' or been incapable of so doing. (This clearly means that in designing a robust system, we cannot count on that capacity.) Third, a financial system cannot be permitted to impact the real economy to the extent that it has. Fourth, while much has been made of the low interest rate environment that accompanied the build up to the crisis, one would not design a financial system that could not function in such an environment. Second, some casual factors that are worth noting. One, a dominant business philosophy focusing on ``shareholder value''. Two, almost frenetic activity in the creation and distribution of securitized products and derivatives. These turned out to be flawed as credits but further were not fully distributed to ``knowledgeable investors'' but to an incredible extent were inventoried on the balance sheet of ``intermediaries'' (e.g., Merrill Lynch, Citi). Third, the absolute failure of the rating agencies in the performance of their only mission. Fourth, the failure of supervision, In allowing the decapitalization of the sector. In ignoring the implications of ``low doc, no doc'' lending. In ignoring the levels of counterparty risk. In ``missing'' the fact that credit default swaps were insurance products, requiring reserves and oversight. Fifth, the failure of policy in pushing the mortgage market through Freddie Mac and Fannie Mae to an uneconomic extent. Third, if the aim is to create rules and limits, which on the one hand would significantly reduce the likelihood of a repeat of our recent experience, and on the other would support a healthy and creative industry, what would the rules and limits be? First, capital should be significantly increased, maybe doubled. (I personally think the concept of Risk Adjusted Capital is flawed.) Second, the funding structure (liquidity) of each institution should be the subject of annual review (not just ``point in time'', averages and extremes over the year) and assessment by regulators and boards. Third, the industry should be compartmentalized so as to limit the propagation of failures and also to preserve cultural boundaries. Fourth, to the extent possible, traded products should flow through Exchanges. Fifth, there is a good reason to create a Consumer Protection Agency with a clear and separate mandate. ______ FinancialCrisisInquiry--327 BORN: Thank you. I’m going to address first issues regarding the enormous and unregulated over-the- counter derivatives market. Your institutions are four of the largest OTC derivatives dealers in the world. The Office of the Comptroller of the Currency has reported that, in September 2009, you collectively held over-the-counter derivatives positions of more January 13, 2010 than $230 trillion in notional amount. Your positions consist of more than a third of the world market in over-the-counter derivatives. Mr. Blankfein, in your written testimony, you’ve stated that standardized derivatives should be exchanged, traded, and cleared through a central clearinghouse. And you further state, quote, “This will do more to enhance price discovery and reduce systemic risk than, perhaps, any specific rule or regulation.” I would like to ask your opinion of the role that over-the- counter derivatives played in causing or contributing to the financial crisis. CHRG-110shrg50415--48 Chairman Dodd," One other quick question on this. Can you make the correlation between what you have just said and the crisis? People talk about these derivatives, and I do not know if it has been clearly explained about why those instruments, as they have been working, actually have affected the very crisis we are in, connecting the dots between the two. I do not think that has been well done. Could you do that for us? " 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-111shrg54533--40 Secretary Geithner," I think, Senator, this framework will meet that test. I mean, it is designed to make sure we are looking forward, not just solving the core problems of this crisis. So we are trying to design a framework that has that capacity, that is flexible in the future, and we made the judgment that--you know, we are proposing--we are proposing for your consideration, we made the judgment that much more substantial changes to force much more consolidation in our oversight structure, although it has much appeal, is not necessary and would not necessarily provide substantial return in addressing the core vulnerabilities in our system. Senator Tester. I look at this from the outside because I am not from the banking industry or the insurance industry or any part of either one of them. But I can tell you some of the concerns brought up by the Chairman and the Ranking Member about gaps and overlap, I still have concerns with this proposal. And I commend you for the combination of the OTS and OCC. I will give you another one that I think could and should be combined, and I want to know why not if just for turf, and that is SEC and CFTC. " CHRG-110hhrg46591--441 Mr. Ryan," Just to get the record straight--at least within our industry representing, really, the financial market players, these are global players--that we do not have the same uniform view expressed by the other panelist on mark to market accounting. So that is from an industry standpoint. From a personal standpoint, and this goes to the point you just made, it is a pretty difficult time period to make a change to the accounting as we are in the middle of a crisis. And that is especially true when pricing and confidence in the system is so critical. So when you at this juncture, just on a personal basis, I have a hard time supporting a change in accounting exactly today. I think that we all need to look at overall accounting standards and how they apply to the financial services business because there are other accounting conventions that have also caused problems. So the whole issue as we start looking at how do we want to be regulated in the future, we need to put the accounting profession into this system and think through broadly the impact the accounting profession has had on this industry. Ms. Speier. To you, Mr. Yingling, you said something earlier in your testimony that kind of stunned me. You said you kind of gasped when you saw the number of loans that were being offered with no money down, and that government should have done something. Well, I guess my first reaction is, why didn't you come to Congress and say, hey, there is a problem here, we need to fix it, instead of sitting back and looking at it? We don't look at your figures on a daily basis. You are in a position to do that. " FinancialCrisisInquiry--177 And so, Mr. Zandi, if you would commence your testimony. Thank you very much. ZANDI: Well, thank you, Mr. Chairman and other distinguished members of the commission. I—I want to thank you for the opportunity to testify today. The views I express are my own and not those of the Moody’s Corporation. The purpose of my testimony is to assess the economic impact of the financial crisis that began nearly three years ago. While the financial crisis has abated and the financial system has stabilized, the system remains troubled. Failures at depository institutions continue at an alarming rate and likely will continue for several years more to come. The securitization markets also remain dysfunctional as investors anticipate more loan losses and are uncertain about various legal and accounting rule changes and regulatory reform. Without support from the Federal Reserve’s TALF program, private bond issuance and securities backing of consumer and business loans would be completely dormant. Households and businesses are struggling with the resulting severe credit crunch. The extraordinary tightening of underwriting standards by nearly all creditors is clear in the lending statistics. Here’s a very astounding statistic. The number of bank credit cards outstanding has fallen by nearly 100 million cards in just over the past year and-a-half, a 20 percent decline. Total household debt, including credit cards, auto loans and mortgage debt has declined a stunning $600 billion, or 5 percent. And outstanding C&I loans, commercial investor loans, have declined by some 20 percent since peaking in late 2008. Some of this reflects the desire of households and businesses to reduce their debt loads. But it also stems from lenders’ inability and unwillingness to lend. Small banks are vital to consumer and small- business lending. And without the ability to sell the loans they originate to investors in the securities market, banks and other lenders don’t have the capital sufficient to significantly expand their lending. The economic recovery will struggle to gain traction until credit flows more freely, which won’t occur until bank failures abate and there’s a well functioning securities market. CHRG-111shrg49488--61 Mr. Nason," Well, the three parts of the plan--first of all, the plan was not created to deal with the financial crisis. It was actually written before the financial crisis happened. Senator McCaskill. You wrote it in March, right? " CHRG-111shrg53176--63 Mr. Breeden," Thank you, Mr. Chairman. I have thought a lot about our experiences, creating the RTC and dealing with the savings and loan crisis as I have watched the current crisis unfold. In a nutshell, our philosophy back then was no bailouts but fast funerals, and it worked pretty darn well. " CHRG-110shrg50415--3 STATEMENT OF SENATOR MIKE CRAPO Senator Crapo. Thank you very much, Mr. Chairman. Our financial markets and the economic crisis that we face today represent a very serious and a real threat, and we need to make sure that we are very clear about what the sequence of events were that occurred and what choices were made to place us in this catastrophic state of affairs. I agree that we have got to figure out how we got here so that we can correctly and properly address it. I was pleased to hear that you intend to pay some very specific attention not only to oversight of the implementation of the recovery plan that Congress passed, but also to the need for regulatory reform and your mention of the blueprint that Secretary Paulson put out. As you know, I am one who has been very involved in regulatory reform and modernization over the past few years, and I have some pretty strong opinions about how we need to approach establishing our regulatory system in this country. And I have noted in the testimony of some of the witnesses an explanation and a recognition of the fact that our regulatory system, developed decades and decades ago, has not kept up with the state of the economy and the types of financial activities and financial products that we are now dealing with on a global basis in our economy. And because of that, I think there is a true need to address what regulatory structure this Nation should have for a whole host of different pieces and aspects of our financial system. I am going to be interested in the witnesses' testimony about that. I personally think that we, collectively, the Congress, as we struggle with this, will probably end up with some very different opinions and points of view about how we should approach that. There will be some who want a much more extensive role for the regulators than others. But the bottom line is we need to figure out how we will move forward, and we need to establish a regulatory system that will allow capital to flow in our country and in the global economy, really, in a free and an efficient and a safe way. And I believe that there is a way for us to achieve that. So I appreciate the fact that you have indicated that you are going to be paying some very close attention to that even before the next Congress starts, and I look forward to working with you in that evaluation. " FinancialCrisisInquiry--594 ZANDI: Well, thank you, Mr. Chairman and other distinguished members of the commission. I—I want to thank you for the opportunity to testify today. The views I express are my own and not those of the Moody’s Corporation. The purpose of my testimony is to assess the economic impact of the financial crisis that began nearly three years ago. While the financial crisis has abated and the financial system has stabilized, the system remains troubled. Failures at depository institutions continue at an alarming rate and likely will continue for several years more to come. The securitization markets also remain dysfunctional as investors anticipate more loan losses and are uncertain about various legal and accounting rule changes and regulatory reform. Without support from the Federal Reserve’s TALF program, private bond issuance and securities backing of consumer and business loans would be completely dormant. Households and businesses are struggling with the resulting severe credit crunch. The extraordinary tightening of underwriting standards by nearly all creditors is clear in the lending statistics. Here’s a very astounding statistic. The number of bank credit cards outstanding has fallen by nearly 100 million cards in just over the past year and-a-half, a 20 percent decline. Total household debt, including credit cards, auto loans and mortgage debt has declined a stunning $600 billion, or 5 percent. And outstanding C&I loans, commercial investor loans, have declined by some 20 percent since peaking in late 2008. Some of this reflects the desire of households and businesses to reduce their debt loads. But it also stems from lenders’ inability and unwillingness to lend. Small banks are vital to consumer and small- business lending. And without the ability to sell the loans they originate to investors in the securities market, banks and other lenders don’t have the capital sufficient to significantly expand January 13, 2010 their lending. The economic recovery will struggle to gain traction until credit flows more freely, which won’t occur until bank failures abate and there’s a well functioning securities market. The economic impact of the financial crisis is very severe. The immediate impact was the great recession, which was the longest, most severe and broadest based downturn since the 1930s Great Depression. Just a few statistics -- household wealth fell some $12.5 trillion as house prices have collapsed some 30 percent. And stock prices, despite the recent rise, are still down 25 percent from their pre- crisis peak. Over 8 million jobs after revisions have been lost in nearly every industry and region of the country. And 26.5 million Americans, over 17 percent of the workforce, are unemployed or under- employed. Due largely to the unprecedented actions taken by the Federal Reserve and fiscal policy makers the recession, the great recession ended this past summer. It’s no coincidence that the downturn ended just as the American Recovery and Reinvestment Act began providing its maximum economic benefit. Help for unemployed workers and hard- pressed state and local government, the cash for clunkers program and the housing tax credits have been particularly efficacious. The stimulus did what it was supposed to do. It short-circuited the recession, and it has spurred economic recovery. Indeed, the recovery strengthened as 2008 -- 2009 came to an end. Real GDP, the value of all the things that we produced, appears to have expanded by a solid well over 4 percent in the last quarter of 2009. But despite the better numbers, the recovery remains very tentative and fragile. Fallout from the financial crisis, including the lack of credit, which I discussed, the loss of household wealth and the pall over sentiment continues to cause businesses to be circumspect in their investment and hiring and consumers in their spending. The ongoing foreclosure crisis, the fiscal problems among state and local governments and the commercial real estate bust also continue to weigh heavily on the economy. January 13, 2010 The current fallout from the financial crisis is most evident in businesses’ lack of hiring. To date businesses have curtailed their cutting as layoffs have abated, but they have yet to add to their payrolls. Initial claims for unemployment insurance, a good proxy for layoffs, are steadily declining. But those unemployed receiving some form of unemployment insurance which should be falling if firms were hiring remains at extraordinarily high levels. Some 10 million unemployed are on U.I. roles. And what’s particularly disconcerting is that many of these lost their jobs at the start of the recession two years ago and are now going to start running out of unemployment insurance benefits. There are some reasons to be optimistic that hiring will begin soon, employment and temp help firms is increasing. Hours worked have risen off record lows. All of this is encouraging because businesses hire temps and ask their existing workers to work more hours before actually going out and hiring—hiring full-time workers. But there are also good reasons to be nervous about the strength of any hiring pickup. Job losses in the payroll survey businesses have moderated since the recession ended this past summer, but in a separate survey of households, employment shows no indication of stabilizing. In past recoveries household employment has increased either sooner or more vigorously than payroll employment, probably reflecting what’s going on in small businesses. It’s not happened, and that’s somewhat discouraging. Small businesses have historically been vital to restoring the job machine coming out of a recession. Small businesses are having difficulty getting the credit necessary to expand their operations. Card lenders and small banks so important to small business credit have been particularly aggressive in tightening their lending standards, given changing laws and regulations and mounting loan losses. And nearly all businesses lack the animal spirits needed to aggressively expand. Confidence remains fragile, probably because so many businesses suffered near-death experiences during the recession and because of the heightened policy uncertainty created by debates on health care, financial regulatory reform, cap and trade and taxes. January 13, 2010 Odds are that the recovery will evolve into a self-sustaining expansion in the coming year. But these odds will remain uncomfortably high unless hiring revives. At the very least, the transition from our current recovery to expansion will be less than graceful and may require policy makers to provide even more support to the economy. The longer-term fallout from the economic crisis will also be very substantial. Based on the experiences of other global economies that have suffered similar financial crises, GDMP and employment will be lower and unemployment higher for many years to come. The unemployment rate is expected to peak between 10.5 and 11 percent this fall. And it will not decline back to a rate consistent with full employment until 2013. The full employment/unemployment rate is also rising as those losing their jobs are staying unemployed for increasingly long stretches, undermining their skills and marketability as workers. There’s also increasing, given the weakening in the labor force mobility, given the large number of homeowners that are under water on their homes. Historically those losing their jobs in one part of the country could readily move to another part of the country where a job was available. This is much more difficult to do if a homeowner needs to put more equity into their home before they move. The full employment/unemployment rate was probably about 5 percent before the recession began. I wouldn’t be surprised if it were to rise to closer to 6 percent when it’s all said and done. But arguably, the most serious long-term casualty of the financial crisis is the nation’s fiscal situation. The budget deficit, as you know, ballooned to $1.4 trillion in fiscal year 2009 and is expected to be similar this year. The red ink reflects in significant part the expected close to $2 trillion price tag to taxpayers of the financial crisis. This is equal to 14 percent of GDP. Just to give you a context, by my calculation, the savings and loan crisis of the early ‘90s cost $315 billion in today’s dollars, 6 percent of GDP. It’s not that policy makers had a choice in running these massive deficits. The cost to taxpayers would have been measurably greater if policy makers had not acted January 13, 2010 aggressively to the financial crisis. The great recession would likely still be in full swing undermining tax revenues, and driving up spending on Medicaid, welfare, and other income support for distressed families. It is a tragedy that the nation has been forced to spend so much to tame the financial crisis. Yet it has been money, in my view, well spent. But while the fiscal outlook was daunting prior to the financial crisis, it now feels overwhelming. Without significant changes to tax, and government spending policy, the budget outlook will deteriorate rapidly, even after the cost associated with the financial crisis abate. The nation’s federal debt to GDP ratio will balloon to almost 85 percent a decade from now, double the approximately 40 percent that prevailed prior to the financial crisis. Policy makers must remain aggressive in supporting the economy to ensure that the current recovery evolves into a self-sustaining economic expansion. The coast is not yet clear. But they must also work quickly to—to provide a credible response to the nation’s long-term fiscal situation. Unless they do, the fiscal crisis will ensure—ensue resulting in higher interest rates, immeasurably weaker dollar, lower stock and housing values, and a weakened U.S. economy. The financial crisis has put us in a very difficult bind, but if history is any guide, and the good work of public officials like yourself is any guide, then we will successfully find our way free. Thank you. 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-111hhrg53241--28 Mr. Ireland," Good morning, Chairman Frank, Mr. Hensarling, and members of the committee. I am a partner in the financial services practice in the Washington, D.C., office of Morrison & Foerster. I previously spent 26 years with the Federal Reserve System, 15 years as an Associate General Counsel at the Board in Washington. I am pleased to be here today to address the Administration's financial regulatory reform proposals and, in particular, the consumer protection aspects of the proposals. The current recession was sparked by problems in subprime and Alt-A residential mortgages. As a result, investors lost confidence in subprime and Alt-A mortgage-backed securities. The loss in confidence spread to other mortgage-backed securities, disrupting the flow of funds for mortgage credit and leading to a downward spiral in housing prices and a panoply of new government programs and extraordinary actions by Federal regulators. Clearly, these events warrant a rethinking of what has worked, what has not worked, and why, in financial regulation. The Administration has proposed to create a new stand-alone Consumer Financial Protection Agency to protect consumers of financial products and services. Although I strongly support the goal of consumer protection, I believe that creating a separate stand-alone agency for this purpose ignores the increasingly vertically integrated nature of the market for consumer financial services. A primary reason for regulating consumer financial services is that we believe these services are beneficial for consumers. Leading up to the current crisis, excess demand for mortgage-backed securities encouraged mortgage origination practices that later triggered the panic in the secondary market. The relationship between these steps and the mortgage lending process was interactive, and neither is fully understood by looking at only one step in the process. In order to foster an efficient market for home mortgages, it is necessary to have an understanding of the entire market, from the consumer borrower to the ultimate investor, and the role of that market in the economy as a whole. The oversight and regulation of each component of the market needs to take into consideration its effect on the other components. Bifurcating regulation of the market, as is contemplated by creation of a dedicated consumer protection agency, is likely to create conflicts between the agency and prudential supervisors. The expertise of each regulator will be less available to the others than under the current regulatory structure, making each of their jobs more difficult rather than easier and leading to a less efficient, rather than a more efficient, market for home mortgages. These considerations weigh strongly against creation of a separate agency. The countervailing argument is, of course, that the current system did not work to prevent the mortgage crisis and that changes are needed. The mortgage crisis has been a product of multiple failures at all levels, both in the public and private sectors. The fact that regulators may have made errors suggests that steps should be taken to prevent similar errors in the future. However, my view, it does not mean the architecture of the regulatory system is the problem. There is a strong relationship between consumer issues, prudential supervision and, ultimately, monetary policy. In the end, these interests are not in conflict. Rather, they all seek the same goal, a healthy economy and a high standard of living for all Americans. The goal of regulatory policy should be to ensure that prudential and consumer interest are harmonized, rather than that they are in conflict. The creation of a separate agency is a recipe for conflict, rather than harmonization. Thank you for the opportunity to be here today to address this important issue, and I will be happy to answer questions. [The prepared statement of Mr. Ireland can be found on page 45 of the appendix.] " CHRG-111shrg56376--125 PREPARED STATEMENT OF JOHN E. BOWMAN Acting Director, Office of Thrift Supervision August 4, 2009I. Introduction Good morning, Chairman Dodd, Ranking Member Shelby, and Members of the Committee. Thank you for the opportunity to testify today on the Administration's Proposal for Financial Regulatory Reform. It is my pleasure to address the Committee for the first time in my role as Acting Director of the Office of Thrift Supervision (OTS). We appreciate this Committee's efforts to improve supervision of financial institutions in the United States. We share the Committee's commitment to reforms to prevent any recurrence of our Nation's current financial problems. We have studied the Administration's Proposal for Financial Regulatory Reform and are pleased to address the questions you have asked us about specific aspects of that Proposal. Specifically, you asked for our opinion of the merits of the Administration's Proposal for a National Bank Supervisor and the elimination of the Federal thrift charter. You also requested our opinion on the elimination of the exceptions in the Bank Holding Company Act for thrifts and certain special purpose banks and about the Federal Reserve System's prudential supervision of holding companies.II. Goals of Regulatory Restructuring The recent turmoil in the financial services industry has exposed major regulatory gaps and other significant weaknesses that must be addressed. Our evaluation of the specifics of the Administration's Proposal is predicated on whether or not those elements address the core principles OTS believes arc essential to accomplishing true and lasting reform: 1. Ensure Changes to Financial Regulatory System Address Real Problems--Proposed changes to financial regulatory agencies should be evaluated based on whether they would address the causes of the economic crisis or other true problems. 2. Establish Uniform Regulation--All entities that offer financial products to consumers must be subject to the same consumer protection rules and regulations, so under-regulated entities cannot gain a competitive advantage over their more regulated counterparts. Also, complex derivative products, such as credit default swaps, should be regulated. 3. Create Ability To Supervise and Resolve Systemically Important Firms--No provider of financial products should be too big to fail, achieving through size and complexity an implicit Federal Government backing to prevent its collapse--and thereby gaining an unfair advantage over its more vulnerable competitors. 4. Protect Consumers--One Federal agency should have as its central mission the regulation of financial products and that agency should establish the rules and standards for all consumer financial products rather than the current, multiple number of agencies with fragmented authority and a lack of singular accountability. As a general matter the OTS supports all of the fundamental objectives that are at the heart of the Administration's Proposal. By performing an analysis based on these principles, we offer OTS' views on specific provisions of the Administration's Proposal.III. Administration Proposal To Establish a National Bank Supervisor We do not support the Administration's Proposal to establish a new agency, the National Bank Supervisor (NBS), by eliminating the Office of the Comptroller of the Currency, which charters and regulates national banks, and the OTS, which charters Federal thrifts and regulates thrifts and their holding companies. There is little dispute that the ad hoc framework of financial services regulation cobbled together over the last century-and-a-half is not ideal. The financial services landscape has changed and the economic crisis has revealed gaps in the system that must be addressed to ensure a sustainable recovery and appropriate oversight in the years ahead. We believe other provisions within the Administration's proposal would assist in accomplishing that goal. While different parts of the system were created to respond to the needs of the time, the current system has generally served the Nation well over time, despite economic downturns such as the current one. We must ensure that in the rush to address what went wrong, we do not try to ``fix'' nonexistent problems nor attempt to fix real problems with flawed solutions. I would like to dispel the two rationales that have been alleged to support the proposal to eliminate the OTS: (1) The OTS was the regulator of the purportedly largest insured depository institutions that failed during the current economic turmoil, and, (2) Financial institutions ``shopping'' for the most lenient regulator allegedly flocked to OTS supervision and the thrift charter. Both of those allegations are false. There are four reasons why the first allegation is untrue: First, failures by insured depository institutions have been no more severe among OTS-regulated thrifts than among institutions supervised by other Federal banking regulators. OTS-regulated Washington Mutual, which failed in September 2008 at no cost to the deposit insurance fund, was the largest bank failure in U.S. history because anything larger has been deemed ``too big to fail.'' By law, the Federal Government can provide ``open-bank assistance'' only to prevent a failure. Institutions much larger than Washington Mutual, for example, Citigroup and Bank of America, had collapsed, but the Federal Government prevented their failure by authorizing open bank assistance. The ``too big to fail'' institutions are not regulated by the OTS. The OTS did not regulate the largest banks that failed; the OTS regulated the largest banks that were allowed to fail. Second, in terms of numbers of bank failures during the crisis, most banks that have failed have been State-chartered institutions, whose primary Federal regulator is not the OTS. Third, the OTS regulates financial institutions that historically make mortgages for Americans to buy homes, By law, thrift institutions must keep most of their assets in home mortgages or other retail lending activities, The economic crisis grew out of a sharp downturn in the residential real estate market, including significant and sustained home price depreciation, a protracted decline in home sales and a plunge in rates of real estate investment. To date, this segment of the market has been hardest hit by the crisis and OTS-regulated institutions were particularly affected because their business models focus on this segment. Fourth, the largest failures among OTS-regulated institutions during this crisis concentrated their mortgage lending in California and Florida, two of the States most damaged by the real estate decline, These States have had significant retraction in the real estate market, including double-digit declines in home prices and record rates of foreclosure, \1\ Although today's hindsight is 20/20, no one predicted during the peak of the boom in 2006 that nationwide home prices would plummet by more than 30 percent.--------------------------------------------------------------------------- \1\ See, Office of Thrift Supervision Quarterly Market Monitor, May 7, 2009, (http://files.ots.treas.gov/131020.pdf).--------------------------------------------------------------------------- The argument about regulator shopping, or arbitrage, seems to stem from the conversion of Countrywide, which left the supervision of the OCC and the Board of Governors of the Federal Reserve System (FRB) in March 2007--after the height of the housing and mortgage boom--and came under OTS regulation, Countrywide made most of its high-risk loans through its holding company affiliates before it received a thrift charter. An often-overlooked fact is that a few months earlier, in October 2006, Citibank converted two thrift charters from OTS supervision to the OCC. Those two Citibank charters totaled more than $232 billion--more than twice the asset size of Countrywide ($93 billion)--We strongly believe that Citibank and Countrywide applied to change their charters based on their respective business models and operating strategies. Any suggestion that either company sought to find a more lenient regulatory structure is without merit. In the last 10 years (1999-2008), there were 45 more institutions that converted away from the thrift charter (164) than converted to the thrift charter (119). Of those that converted to the OTS, more than half were State-chartered thrifts (64). In dollar amounts during the same 10-year period, $223 billion in assets converted to the thrift charter from other charter types and $419 billion in assets converted from the thrift charter to other charter types. We disagree with any suggestion that banks converted to the thrift charter because OTS was a more lenient regulator. Institutions chose the charter type that best fits their business model. If regulatory arbitrage is indeed a major issue, it is an issue between a Federal charter and the charters of the 50 States, as well as among the States. Under the Administration's Proposal, the possibility of such arbitrage would continue. The OTS is also concerned that the NBS may tend, particularly in times of stress, to focus most of its attention on the largest institutions, leaving midsize and small institutions in the back seat. It is critical that all regulatory agencies be structured and operated in a manner that ensures the appropriate supervision and regulation of all depository institutions, regardless of size.IV. Administration Proposal To Eliminate the Thrift Charter The OTS does not support the provision in the Administration's Proposal to eliminate the Federal thrift charter and require all Federal thrift institutions to change their charter to the National Bank Charter or State bank. We believe the business models of Federal banks and thrift institutions are fundamentally different enough to warrant two distinct Federal banking charters. It is important to note that elimination of the thrift charter would not have prevented the current mortgage meltdown, nor would it help solve current problems or prevent future crises. Savings associations generally are smaller institutions that have strong ties to their communities. Many thrifts never made subprime or Alt-A mortgages; rather they adhered to traditional, solid underwriting standards. Most thrifts did not participate in the private originate-to-sell model; they prudently underwrote mortgages intending to hold the loans in their own portfolios until the loans matured. Forcing thrifts to convert from thrifts to banks or State chartered savings associations would not only be costly, disruptive, and punitive for thrifts, but could also deprive creditworthy U.S. consumers of the credit they need to become homeowners and the extension of credit this country needs to stimulate the economy. We also strongly support retaining the mutual form of organization for insured institutions. Generally, mutual institutions are weathering the current financial crisis better than their stock competitors. The distress in the housing markets has had a much greater impact on the earnings of stock thrifts than on mutual thrifts over the past year. For the first quarter 2009, mutual thrills reported a return on average assets (ROA) on 0.42 percent, while stock thrifts reported an ROA of 0.04 percent. We see every reason to preserve the mutual institution charter and no compelling rationale to eliminate it. OTS also supports retention of the dual banking system with both Federal and State charters for banks and thrifts. This system has served the financial markets in the United States well. The States have provided a charter option for banks and thrifts that have not wanted to have a Federal charter. Banks and thrifts should be able to choose whether to operate with a Federal charter or a State charter.V. Administration Proposal To Eliminate the Exceptions in the Bank Holding Company Act for Thrifts and Special Purpose BanksA. Elimination of the Exception in the Bank Holding Company Act for Thrifts Because a thrill is not considered a ``bank'' under the Bank Holding Company Act of 1956 (BHCA), \2\ the FRB does not regulate entities that own or control only savings associations. However, the OTS supervises and regulates such entities pursuant to the Home Owners Loan Act (HOLA).--------------------------------------------------------------------------- \2\ 12 U.S.C. 1841(c)(2)(B) and (j).--------------------------------------------------------------------------- As part of the recommendation to eliminate the Federal thrift charter, the Administration Proposal would also eliminate the savings and loan holding company (SLHC). The Administration's draft legislation repeals section 10 of the HOLA, concerning the regulation of SLHCs and also eliminates the thrift exemption from the definition of ``bank'' under the BHCA. A SLHC would become a bank holding company (BHC) by operation of law and would be required to register with the FRB as a BHC within 90 days of enactment of the act. Notably, these provisions also apply to the unitary SLHCs that were explicitly permitted to continue engaging in commercial activities under the Gramm-Leach-Bliley Act of 1999. \3\ Such an entity would either have to divest itself of the thrift or divest itself of other subsidiaries or affiliates to ensure that its activities are ``financial in nature.'' \4\--------------------------------------------------------------------------- \3\ 12 U.S.C. 1467a(c)(9)(C). \4\ 12 U.S.C. 1843(k).--------------------------------------------------------------------------- The Administration justifies the elimination of SLHCs, by arguing that the separate regulation and supervision of bank and savings and loan holding companies has created ``arbitrage opportunities.'' The Administration contends that the intensity of supervision has been greater for BHCs than SLHCs. Our view on this matter is guided by our key principles, one of which is to ensure that changes to the financial regulatory system address real problems. We oppose this provision because it does not address a real problem. As is the case with the regulation of thrift institutions, OTS does not believe that entities became SLHCs because OTS was perceived to be a more lenient regulator. Instead, these choices were guided by the business model of the entity. The suggestion that the OTS does not impose capital requirements on SLHCs is not correct. Although the capital requirements for SLHCs are not contained in OTS regulations, savings and loan holding company capital adequacy is determined on a case-by-case basis for each holding company based on the overall risk profile of the organization. In its review of a SLHCs capital adequacy, the OTS considers the risk inherent in an enterprise's activities and the ability of capital to absorb unanticipated losses, support the level and composition of the parent company's and subsidiaries' debt, and support business plans and strategies. On average SLHCs hold more capital than BHCs. The OTS conducted an internal study comparing SLHC capital levels to BHC capital levels. In this study. OTS staff developed a Tier 1 leverage proxy and conducted an extensive review of industry capital levels to assess the overall condition of holding companies in the thrift industry. We measured capital by both the Equity/Assets ratio and a Tier 1 Leverage proxy ratio. Based on peer group averages, capital levels (as measured by both the Equity/Assets ratio and a Tier 1 Leverage proxy ratio) at SLHCs were higher than BHCs, prior to the infusion of Troubled Asset Relief Program funds, in every peer group category. The consistency in results between both ratios lends credence to the overall conclusion, despite any differences that might result from use of a proxy formula. As this study shows, the facts do not support the claim that the OTS docs not impose adequate capital requirements on SLHCs. The proposal to eliminate the SLHC exception from the BHCA is based on this and other misperceptions. Moreover, in our view the measure penalizes the SLHCs and thrifts that maintained solid underwriting standards and were not responsible for the current financial crisis. The measure is especially punitive to the unitary SLHCs that will be forced to divest themselves of their thrift or other subsidiaries. We believe SLHCs should be maintained and that the OTS should continue to regulate SLHCs, except in the case of a SLHC that would be deemed to be a Tier 1 Financial Holding Company. These entities should be regulated by the systemic risk regulator.B. Elimination of the Exception in the Bank Holding Company Act for Special Purpose Banks The Administration Proposal would also eliminate the BHCA exceptions for a number of special purpose banks, such as industrial loan companies, credit card banks, [rust companies, and the so-called ``nonbank banks'' grandfathered under the Competitive Equality Banking Act of 1987. Neither the FRB nor OTS regulates the entities that own or control these special purpose banks, unless they also own or control a bank or thrill. As is the case with unitary SLHCs, the Administration Proposal would force these entities to divest themselves of either their special purpose bank or other entities. The Administration's rationale for the provision is to close all the so-called ``loopholes'' under the BHCA and to treat all entities that own or control any type of a bank equally. Once again our opinion on this aspect of the Administration Proposal is guided by the key principle of ensuring that changes to the financial regulatory system address real problems that caused the crisis. There are many causes of the financial crisis, but the inability of the FRB to regulate these entities is not one of them. Accordingly, we do not support this provision. Forcing companies that own special purpose banks to divest one or more of their subsidiaries is unnecessary and punitive. Moreover, it does not address a problem that caused the crisis or weakens the financial system.VI. Prudential Supervision of Holding CompaniesA. In General The Administration's Proposal would provide for the consolidated supervision and regulation of any systemically important financial firm (Tier 1 FHC) regardless of whether the firm owns an insured depository institution. The authority to supervise and regulate Tier 1 FHCs would be vested in the FRB. The FRB would be authorized to designate Tier 1 FHCs if it determines that material financial distress at the company could pose a threat, globally or in the United States, to financial stability or the economy during times of economic stress. \5\ The FRB, in consultation with Treasury, would issue rules to guide the identification Tier 1 FHCs. Tier 1 FHCs would be subjected to stricter and more conservative prudential standards than those that apply to other BHCs, including higher standards on capital, liquidity, and risk management. Tier 1 FHCs would also be subject to Prompt Corrective Action.--------------------------------------------------------------------------- \5\ The FRB would be required to base its determination on the following criteria: (i) the amount and nature of the company's financial assets; (ii) the amount and types of the company's liabilities, including the degree of reliance on short-term funding; (iii) the extent of the company's off-balance sheet exposures; (iv) the extent of the company's transactions and relationships with other major financial companies: (v) the company's importance as a source of credit for households, businesses, and State and local governments and as a source of liquidity for the financial system; (vi) the recommendation, if any, of the Financial Services Oversight Council; and (vii) any other factors that the Board deems appropriate. Title II, Section 204. Administration Draft Legislation. http://www.financialstability.gov/docs/regulatoryreform/07222009/titleII.pdf.--------------------------------------------------------------------------- The Proposal also calls for the creation of a Financial Services Oversight Council (Council) made up of the Secretary of the Treasury and all of the Federal financial regulators. Among other responsibilities, the Council would make recommendations to the FRB concerning institutions that should be designated as Tier 1 FHCs. Also, the FRB would consult the Council in setting material prudential standards for Tier 1 FHCs and in setting risk management standards for systemically important systems and activities regarding payment, clearing and settlement. The Administration's Proposal provides a regime to resolve Tier 1 FHCs when the stability of the financial system is threatened. The resolution authority would supplement and be modeled on the existing resolution regime for insured depository institutions under the Federal Deposit Insurance Act. The Secretary of the Treasury could invoke the resolution authority only after consulting with the President and upon the written recommendation of two-thirds of the members of the FRB, and the FDIC or SEC as appropriate. The Secretary would have the ability to appoint a receiver or conservator for the tailing firm. In general, that role would be filled by the FDIC, though the SEC could be appointed in certain cases. In order to fund this resolution regime, the FDIC would be authorized to impose risk-based assessments on Tier 1 FHCs. OTS's views on these aspects of the Administration Proposal is guided by our key principle that any financial reform package should create the ability to supervise and resolve all systemically important financial firms. The U.S. economy operates on the principle of healthy competition. Enterprises that are strong, industrious, well-managed and efficient succeed and prosper. Those that fall short of the mark struggle or fail and other, stronger enterprises take their places. Enterprises that become ``too big to fail'' subvert the system when the Government is forced to prop up failing, systemically important companies in essence, supporting poor performance and creating a ``moral hazard.'' The OTS supports this aspect of the Proposal and agrees that there is a pressing need for a systemic risk regulator with broad authority to monitor and exercise supervision over any company whose actions or failure could pose unacceptable risk to financial stability. The systemic risk regulator should have the ability and the responsibility for monitoring all data about markets and companies, including, but not limited to, companies involved in banking, securities, and insurance. We also support the establishment of a strong and effective Council. Each of the financial regulators would provide valuable insight and experience to the systemic risk regulator. We also strongly support the provision providing a resolution regime for all Tier 1 FHCs. Given the events of recent years, it is essential that the Federal Government have the authority and the resources to act as a conservator or receiver and to provide an orderly resolution of systemically important institutions, whether banks, thrifts, bank holding companies or other financial companies. The authority to resolve a distressed Tier 1 FHC in an orderly manner would ensure that no bank or financial firm is ``too big to fail.'' A lesson learned from recent events is that the failure or unwinding of systemically important companies has a far reaching impact on the economy, not just on financial services. The continued ability of banks, thrifts, and other entities in the United States to compete in today's global financial services marketplace is critical. The systemic risk regulator should be charged with coordinating the supervision of conglomerates that have international operations. Safety and soundness standards, including capital adequacy and other factors, should be as comparable as possible for entities that have multinational businesses,B. Role of the Prudential Supervisor in Relation to the Systemic Risk Regulator You have asked for our views on what we consider to be the appropriate role of the prudential supervisor in relation to the systemic risk regulator. In other words, what is the proper delineation of responsibilities between the agencies? Generally, we believe that for systemically important institutions, the systemic risk regulator should supplement, not supplant, the primary Federal bank supervisor. In most cases the work of the systemic regulator and the prudential regulator will complement one another, with the prudential regulator focused on the safety and soundness of the depository institution and the systemic regulator focused more broadly on financial stability globally or in the United States. One provision in the Proposal provides the systemic risk regulator with authority to establish, examine, and enforce more stringent standards for subsidiaries of Tier 1 FHCs--including depository institution subsidiaries--to mitigate systemic risk posed by those subsidiaries. If the systemic risk regulator issues a regulation, it must consult with the prudential regulator. In the case of an order, the systemic regulator must: (1) have reasonable cause to believe that the functionally regulated subsidiary is engaged in conduct, activities, transactions, or arrangements that could pose a threat to financial stability or the economy globally or in the United States; (2) notify the prudential regulator of its belief, in writing, with supporting documentation included and with a recommendation that the prudential regulator take supervisory action against the subsidiary; and (3) not been notified in writing by the prudential regulator of the commencement of a supervisory action, as recommended, within 30 days of the notification by the systemic regulator. We have some concerns with this provision in that it supplants the prudential regulator's authority over depository institution subsidiaries of systemically significant companies. On balance, however, we believe such a provision is necessary to ensure financial stability. We recommend that the provision include a requirement that before making any determination, the systemic regulator consider the effects of any contemplated action on the Deposit Insurance Fund and the United States taxpayers.C. Regulation of Thrifts and Holding Companies on a Consolidated Basis You have asked for OTS's views on whether a holding company regulator should be distinct from the prudential regulator or whether a consolidated prudential bank supervisor could also regulate holding companies. \6\--------------------------------------------------------------------------- \6\ With respect to this question we express our opinion only concerning thrifts and their holding companies. We express no opinion as to banks and BHCs.--------------------------------------------------------------------------- The OTS supervises both thrifts and their holding companies on a consolidated basis. Indeed, SLHC supervision is an integral part of OTS oversight of the thrift industry. OTS conducts holding company examinations concurrently with the examination of the thrift subsidiary, supplemented by offsite monitoring. For the most complex holding companies, OTS utilizes a continuous supervision approach. We believe the regulation of the thrift and holding company has enabled us to effectively assess the risks of the consolidated entity, while retaining a strong focus on protecting the Deposit Insurance Fund. The OTS has a wealth of expertise regulating thrifts and holding companies. We have a keen understanding of small, medium-sized and mutual thrifts and their holding companies. We are concerned that if the FRB became the regulator of these holding companies, it would focus most of its attention on the largest holding companies to the detriment of small and mutual SLHCs. With regard to holding company regulation, OTS believes thrifts that have nonsystemic holding companies should have strong, consistent supervision by a single regulator. Conversely, a SLHC that would be deemed to be a Tier 1 FHC should be regulated by the systemic regulator. This is consistent with our key principle that any financial reform package should create the ability to supervise and resolve all systemically important financial firms.VII. Consumer Protection The Committee did not specifically request input regarding consumer protection issues and the Administration's Proposal to create a Consumer Financial Protection Agency (CFPA); however, we would like to express our views because adequate protection of consumers is one of the key principles that must be addressed by effective reform. Consumer protection performed consistently and judiciously fosters a thriving banking system to meet the financial services needs of the Nation. The OTS supports the creation of a CFPA that would consolidate rulemaking authority over all consumer protection regulations in one regulator. The CFPA should be responsible for promulgating all consumer protection regulations that would apply uniformly to all entities that offer financial products, whether a federally insured depository institution, a State bank, or a State-licensed mortgage broker or mortgage company. Making all entities subject to the same rules and regulations for consumer protection could go a long way towards accomplishing OTS's often stated goal of plugging the gaps in regulatory oversight that led to a shadow banking system that was a significant cause of the current crisis. Although we support the concept of a single agency to write all consumer rules, we strongly believe that consumer protection-related examinations, supervision authority and enforcement powers for insured depository institutions should be retained by the FBAs and the National Credit Union Administration (NCUA). In addition to rulemaking authority, the CFPA should have regulation, examination and enforcement power over entities engaged in consumer lending that are not insured depository institutions. Regardless of whether a new consumer protection agency is created, it is critical that, for all federally insured depository institutions, the primary Federal safety and soundness regulator retain authority for regulation, examination, and enforcement of consumer protection regulations.VIII. Conclusion In conclusion, we support the goals of the Administration and this Committee to create a reformed system of financial regulation that fills regulatory gaps and prevents the type of financial crisis that we have just endured. Thank you again, Mr. Chairman, Ranking Member Shelby, and Members of the Committee for the opportunity to testify on behalf of the OTS. We look forward to working with the Members of this Committee and others to create a system of financial services regulation that promotes greater economic stability for providers of financial services and the Nation. CHRG-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-111hhrg53240--71 Mr. Meeks," But the problem is that it seems no one picked up. We are in this crisis now. There is enough blame to go around. I am not blaming just the Fed. And no one seemed to pick up the problems that we were having, and the Fed is the one that is supposed to be the independent authority on monetary policy; now we get the systemic risk on top of that. Then what concerns many individuals is the fact that the Fed had authority, for example, to issue rules implementing the Home Ownership and Equity Protection Act beginning in 1994, yet it chose not to do anything or issue any rules until 2008, which would be important to the consumer. Why is that? Can you explain that? Ms. Duke. Again, in hindsight, we could have and should have acted faster on that. Since that time, however, the Fed has been very proactive in the areas of regulations governing mortgages and credit cards, in consumer testing and issuing new consumer disclosures which would be much more helpful to consumers, and also in community outreach for foreclosure prevention and neighborhood stabilization. I would say since learning that lesson, the Fed has been extremely proactive. " 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. CHRG-111shrg56376--96 Chairman Dodd," I thank you very much, Senator Merkley. We will leave the record open for further questions, by the way, for all of you. Senator Bennett. Senator Bennett. Thank you very much. Probably, given the time, this will be more of a statement that you can ponder than questions that I want answers to, but I would like to get some answers later on. It will come as no surprise that I want to talk about ILCs, and no one has discussed the ILC charter in their written testimony. Let us point out that the growth of ILCs over the last 20 years has been one of the great successes in the financial services markets. They are the best capitalized and safest banks in the country. They were in no part a contributor to the financial crisis. They provide credit in places that it has not been available before, niche markets, a diverse set of products, and the Administration's proposal says, let us eliminate them. Now, I find that incredible, that something--we talk about Conseco, Lehman Brothers, CIT. All had ILCs, and as they were wound down, the ILCs were the assets that were the crown jewels. The ILCs were the assets that had the most value. And yet the proposal is, let us eliminate them. Let us eliminate the charter. Now, Mr. Tarullo, you made a comment that the center of this crisis is too big to fail and much of this discussion has been in that area of ``too big to fail.'' May I respectfully suggest that the center of the crisis is not ``too big to fail.'' ``Too big to fail'' is a manifestation that came out of the center of the crisis, and to put it in my very much layman's terms, the crisis was caused because of this game of musical chairs with respect to risk. And we built more and more risk into the system because while the music was playing, more and more institutions passed the risk on to somebody else thinking, to use the phrase that Sheila used, I have no skin in this game anymore, this game being this particular instrument. And you go with the change. It starts with the borrower. He has no risk whatsoever because there is no equity in the house. He is getting a 100 percent loan. Sometimes it is a liar loan. The broker who arranges the loan has no risk in the game because he passes it on to the lender. The lender has no risk in the game because he passes it on to the GSE. The GSE has no risk because with the rating agency that has no risk has rated it, and he can pass it on, securitize it, to somebody else. And at every step in the way, in the path, somebody makes money, on a fee, on a commission, whatever it might be. And when the music stops, it turns out that everybody had risk in the game because the whole thing collapses. And I would like to know a regulator who can focus on that question, not how big you are, but where are you in this chain of musical passing on of risk, musical chairs, if you will, that says somebody can say, no more loans in the beginning. No more liar loans. To brokers, no, you can't pass this on. You have to have some kind of a risk if you get involved in brokering this loan so you will then by market pressure do your job better to see to it that you don't pass it on. To the lender, you maintain some kind of risk as the chain goes forward. The GSE, you maintain some kind of risk. The rating agencies, you will get a risk. But no one had any risk and the bubble, therefore, grew and grew and grew because everybody was making money with no exposure. And that is the problem that I want to solve with this restructuring rather than working around some of the turf battles that we have talked about. Now I will go save the republic and you can respond to Chairman Warner. [Laughter.] Senator Warner [presiding]. Does anybody want to respond? " 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--243 CASE STUDY OF MOODY’S AND STANDARD & POOR’S Moody’s Investors Service, Inc. (Moody’s) and Standard & Poor’s Financial Services LLC (S&P), the two largest credit rating agencies (CRAs) in the United States, issued the AAA ratings that made residential mortgage backed securities (RMBS) and collateralized debt obligations (CDOs) seem like safe investments, helped build an active market for those securities, and then, beginning in July 2007, downgraded the vast majority of those AAA ratings to junk status. 953 The July mass downgrades sent the value of mortgage related securities plummeting, precipitated the collapse of the RMBS and CDO secondary markets, and perhaps more than any other single event triggered the financial crisis. In the months and years of buildup to the financial crisis, warnings about the massive problems in the mortgage industry were not adequately addressed within the ratings industry. By the time the rating agencies admitted their AAA ratings were inaccurate, it took the form of a massive ratings correction that was unprecedented in U.S. financial markets. The result was an economic earthquake from which the aftershocks continue today. Between 2004 and 2007, taking in increasing revenue from Wall Street firms, Moody’s and S&P issued investment grade credit ratings for the vast majority of the RMBS and CDO securities issued in the United States, deeming them safe investments even though many relied on subprime and other high risk home loans. In late 2006, high risk mortgages began to go delinquent at an alarming rate. Despite signs of a deteriorating mortgage market, Moody’s and S&P continued for six months to issue investment grade ratings for numerous subprime RMBS and CDO securities. In July 2007, as mortgage defaults intensified and subprime RMBS and CDO securities began incurring losses, both companies abruptly reversed course and began downgrading at record numbers hundreds and then thousands of their RMBS and CDO ratings, some less than a year old. Investors like banks, pension funds, and insurance companies were suddenly forced to sell off their RMBS and CDO holdings, because they had lost their investment grade status. RMBS and CDO securities held by financial firms lost much of their value, and new securitizations were unable to find investors. The subprime RMBS market initially froze and then collapsed, leaving investors and financial firms around the world holding unmarketable subprime RMBS securities plummeting in value. A few months later, the CDO market collapsed as well. Traditionally, investments holding AAA ratings have had a less than 1% probability of incurring defaults. But in the financial crisis, the vast majority of RMBS and CDO securities with AAA ratings incurred substantial losses; some failed outright. Investors and financial institutions holding those AAA securities lost significant value. Those widespread losses led, in turn, to a loss of investor confidence in the value of the AAA rating, in the holdings of major U.S. financial institutions, and even in the viability of U.S. financial markets. Inaccurate AAA 953 S&P issues ratings using the “AAA” designation; Moody’s equivalent rating is “Aaa.” For ease of reference, this Report will refer to both ratings as “AAA.” credit ratings introduced systemic risk into the U.S. financial system and constituted a key cause of the financial crisis. CHRG-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-111hhrg52400--156 Mr. McRaith," First, I understand the EU is working to bring together 27 different countries, and they intend to implement Solvency II within a few years. And, again, I commend that effort, it's a significant achievement. As for the States, we have been working together collaboratively for over 100 years. We have, as I mentioned earlier, 64,000 years combined of company regulation. We understand the importance of working together, so that the consumers in Illinois understand the impact of an AIG challenge, for example, that the regulators in Illinois collaborate with AIG in New York, and Pennsylvania, all the other States. So, the primary and essential systemic--let me back up. One other key component of insurance regulation that was raised by Congressman Capuano, we restrict not only what types of investments insurance companies can have, but how much any one company can invest in any one type of investment. That type of conservative capital and accounting requirement prevents the crisis in the insurance industry that we have seen in the banking and other sectors. So-- " CHRG-111hhrg55809--124 Mr. Meeks," A crisis brewing? " CHRG-109hhrg22160--218 Mr. Meeks," What about Medicare? Is that a crisis? " CHRG-109hhrg22160--211 Mr. Meeks," Yes or no. Is it a crisis or is it not? " FinancialCrisisInquiry--181 It is a tragedy that the nation has been forced to spend so much to tame the financial crisis. Yet it has been money, in my view, well spent. But while the fiscal outlook was daunting prior to the financial crisis, it now feels overwhelming. Without significant changes to tax, and government spending policy, the budget outlook will deteriorate rapidly, even after the cost associated with the financial crisis abate. The nation’s federal debt to GDP ratio will balloon to almost 85 percent a decade from now, double the approximately 40 percent that prevailed prior to the financial crisis. Policy makers must remain aggressive in supporting the economy to ensure that the current recovery evolves into a self-sustaining economic expansion. The coast is not yet clear. But they must also work quickly to—to provide a credible response to the nation’s long-term fiscal situation. Unless they do, the fiscal crisis will ensure—ensue resulting in higher interest rates, immeasurably weaker dollar, lower stock and housing values, and a weakened U.S. economy. The financial crisis has put us in a very difficult bind, but if history is any guide, and the good work of public officials like yourself is any guide, then we will successfully find our way free. Thank you. CHAIRMAN ANGELIDES: Thank you, Mr. Zandi. Mr. Rosen? ROSEN: (Inaudible). CHAIRMAN ANGELIDES: 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.] " fcic_final_report_full--632 Survey, fourth-quarter 2008, p. 8. 23. Elizabeth Duke, governor, Federal Reserve Board, “Small Business Lending,” testimony before the House Committee on Financial Services and Committee on Small Business, February 26, 2010, p. 1. 24. National Federation of Independent Businesses, “NFIB Small Business Economic Trends,” De- cember 2010, p. 12. 25. Ben Bernanke, “Restoring the Flow of Credit to Small Business,” speaking at the Federal Reserve Meeting Series: “Addressing the Financing Needs of Small Businesses,” Washington, DC, July 12, 2010. 26. C. R. “Rusty” Cloutier, past chairman, Independent Community Bankers of America, testimony before the FCIC, First Public Hearing of the FCIC, day 1, panel 3: Financial Crisis Impacts on the Econ- omy, January 13, 2010, transcript, p. 194. 27. Federal Reserve Statistical Release, E.2 Survey of Terms of Business Lending, E.2 Chart Data: “Commercial and Industrial Loan Rates Spreads over Intended Federal Funds Rate, by Loan Size,” spread for all sizes. 28. William J. Dennis Jr., “Small Business Credit in a Deep Recession,” National Federation of Inde- pendent Businesses, February 2010, p. 18. 29. Jerry Jost, interview by FCIC, August 20, 2010. 30. Board of Governors of the Federal Reserve System, Senior Loan Officer Opinion Survey on Bank Lending Practices, April 2010. 31. Board of Governors of the Federal Reserve System, Senior Loan Officer Opinion Survey on Bank Lending Practices, July 2010. 32. Emily Maltby, “Small Biz Loan Failure Rate Hits 12%,” CNN Money, February 25, 2009; “SBA Losses Climb 154% in 2008,” Coleman Report (www.colemanpublishing.com/public/343.cfm). 33. Michael A. Neal, chairman and CEO, GE Capital, testimony before the FCIC, Hearing on the Shadow Banking System, day 2, session 3: Institutions Participating in the Shadow Banking System, May 6, 2010, transcript, p. 242. 34. GE, 2008 Annual Report, p. 38. 35. Mark S. Barber, testimony before the FCIC, Hearing on the Shadow Banking System, day 2, ses- sion 3: Institutions Participating in the Shadow Banking System, May 6, 2010, transcript, p. 263. 36. International Monetary Fund, International Financial Statistics database, World Exports. 37. International Monetary Fund, International Financial Statistics, World Tables: Exports, World Ex- ports. 38. Jane Levere, “Office Deals, 19 Months Apart, Show Market’s Move,” New York Times, August 10, 2010. 39. National Association of Realtors, Commercial Real Estate Quarterly Market Survey, December 2010, pp. 4, 5. 40. Brian Gordon, principal, Applied Analysis, testimony before the FCIC, Hearing on the Impact of the Financial Crisis—State of Nevada, session 3: The Impact of the Financial Crisis on Nevada Real Es- tate, September 8, 2010, transcript, p. 155. 41. Anton Troianovski, “High Hopes as Builders Bet on Skyscrapers,” Wall Street Journal, September 29, 2010. 42. Ibid.; Gregory Bynum, president, Gregory D. Bynum & Associates, Inc., testimony before the FCIC, Hearing on the Impact of the Financial Crisis—Greater Bakersfield, session 3: Residential and Community Real Estate, September 7, 2010, transcript, pp. 77–80, 77–78. 43. Federal Deposit Insurance Commission, “Failed Bank List,” January 2, 2010. 44. February Oversight Report, “Commercial Real Estate Losses and the Risk to Financial Stability,” Congressional Oversight Panel, February 10, 2010, pp. 2, 41, 45. 45. TreppWire, “CMBS Delinquency Rate Nears 9%, Up 21 BPs in August after Leveling in July, Rate Now 8.92%” Monthly Delinquency Report, September 2010, p. 1. 46. Allen Kenney, “CRE Mortgage Default Rate to Double by 2010,” REIT.com, June 18, 2009. See also “Default Rates Reach 16-Year High,” Globe St., February 24, 2010. 47. Ibid. Green Street Advisors, “Commercial Property Values Gain More Than 30% from ‘09 Lows,” December 2, 2010, pp. 3, 1. 48. “Moody’s/REAL Commercial Property Price Indices, December 2010,” Moody’s Investors Service Special Report, December 21, 2010; Moody’s Investors Service, “US Commercial Real Estate Prices Rise 1.3% in October,” December 20, 2010. 49. Congressional Oversight Panel, “Commercial Real Estate Losses,” February Oversight Report, CHRG-111shrg55278--117 RESPONSES TO WRITTEN QUESTIONS OF SENATOR BUNNING FROM SHEILA C. BAIRQ.1. Many proposals call for a risk regulator that is separate from the normal safety and soundness regulator of banks and other firms. The idea is that the risk regulator will set rules that the other regulators will enforce. That sounds a lot like the current system we have today, where different regulators read and enforce the same rules different ways. Under such a risk regulator, how would you make sure the rules were being enforced the same across the board?A.1. The significant size and growth of unsupervised financial activities outside the traditional banking system--in what is termed the shadow financial system--has made it all the more difficult for regulators or market participants to understand the real dynamics of either bank credit markets or public capital markets. The existence of one regulatory framework for insured institutions and a much less effective regulatory scheme for nonbank entities created the conditions for arbitrage that permitted the development of risky and harmful products and services outside regulated entities. We have proposed a Systemic Risk Council composed of the principal prudential regulators for banking, financial markets, consumer protection, and Treasury to look broadly across all of the financial sectors to adopt a ``macroprudential'' approach to regulation. The point of looking more broadly at the financial system is that reasonable business decisions by individual financial firms may, in aggregate, pose a systemic risk. This failure of composition problem cannot be solved by simply making each financial instrument or practice safe. Rules and restrictions promulgated by the proposed Systemic Risk Council would be uniform with respect to institutions, products, practices, services, and markets that create potential systemic risks. Again, a distinction should be drawn between the direct supervision of systemically significant financial firms and the macroprudential oversight and regulation of developing risks that may pose systemic risks to the U.S. financial system. The former appropriately calls for the identification of a prudential supervisor for any potential systemically significant holding companies or similar conglomerates. Entities that are already subject to a prudential supervisor, such as insured depository institutions and financial holding companies, should retain those supervisory relationships. In addition, for systemic entities not already subject to a Federal prudential supervisor, this Council should be empowered to require that they submit to such oversight, presumably as a financial holding company under the Federal Reserve--without subjecting them to the activities restrictions applicable to these companies. We need to combine the current microprudential approach with a macroprudential approach through the Council. The current system focuses only on individual financial instruments or practices. Each agency is responsible for enforcing these regulations only for their institutions. In addition, there are separate regulatory schemes used by the SEC and the CFTC as well as the State level regulation of insurance companies. The macroprudential oversight of systemwide risks requires the integration of insights from a number of different regulatory perspectives--banks, securities firms, holding companies, and perhaps others. Thus, the FDIC supports the creation of a Council to oversee systemic risk issues, develop needed prudential policies, and mitigate developing systemic risks.Q.2. Before we can regulate systemic risk, we have to know what it is. But no one seems to have a definition. How do you define systemic risk?A.2. We would anticipate that the Systemic Risk Council, in conjunction with the Federal Reserve would develop definitions for systemic risk. Also, mergers, failures, and changing business models could change what firms would be considered systemically important from year-to-year.Q.3. Assuming a regulator could spot systemic risk, what exactly is the regulator supposed to do about it? What powers would they need to have?A.3. The failure of some large banks and nonbanks revealed that the U.S. banking agencies should have been more aggressive in their efforts to mitigate excessive risk concentrations in banks and their affiliates, and that the agencies' powers to oversee systemically important nonbanks require strengthening. As discussed in my testimony, the FDIC endorses the creation of a Council to oversee systemic risk issues, develop needed prudential policies, and mitigate developing systemic risks. For example, the Council could ensure capital standards are strong and consistent across significant classes of financial services firms including nonbanks and GSEs. Prior to the current crisis, systemic risk was not routinely part of the ongoing supervisory process. The FDIC believes that the creation of a Council would provide a continuous mechanism for measuring and reacting to systemic risk across the financial system. The powers of such a Council would ultimately have to be developed through a dialogue between the banking agencies and Congress, and empower the Council to ensure appropriate oversight of unsupervised nonbanks that present systemic risk. Such nonbanks should be required to submit to such oversight, presumably as a financial holding company under the Federal Reserve.Q.4. How do you propose we identify firms that pose systemic risks?A.4. The proposed Systemic Risk Council could establish what practices, instruments, or characteristics (concentrations of risk or size) that might be considered risky, but should not identify any set of firms as systemic. We have concerns about formally designating certain institutions as a special class. We recognize that there may be very large interconnected financial entities that are not yet subject to Federal consolidated supervision, although most of them are already subject to such supervision as a result of converting to banks or financial holding companies in response to the crisis. Any recognition of an institution as systemically important, however, risks invoking the moral hazard that accompanies institutions that are considered too-big-to-fail. That is one reason why, most importantly, a robust resolution mechanism, in addition to enhanced supervision, is important for very large financial organizations.Q.5. Any risk regulator would have access to valuable information about the business of many firms. There would be a lot of people who would pay good money to get that information. How do we protect that information from being used improperly, such as theft or an employee leaving the regulator and using his knowledge to make money?A.5. The FDIC, as deposit insurer and supervisor of over 5,000 banks, prides itself on maintaining confidentiality with our stakeholders. We have a corporate culture that demands strict confidentiality with regard to bank and personal information. Our staff is trained extensively on the use, protection, and disclosure of nonpublic information as well as expectations for the ethical conduct. Disclosure of nonpublic information is not tolerated and any potential gaps are dealt with swiftly and disclosed to affected parties. The FDIC's Office of Inspector General has a robust process for dealing with improper disclosures of information both during and postemployment with FDIC. These ethical principles are supported by criminal statutes which provide that Federal officers and employees are prohibited from the disclosure of confidential information generally (18 U.S.C. 1905) and from the disclosure of information from a bank examination report (18 U.S.C. 1906). All former Federal officers and employees are subject to the postemployment restrictions (18 U.S.C. 207), which prohibit former Government officers and employees from knowingly making a communication or appearance on behalf of any other person, with the intent to influence, before any officer or employee of any Federal agency or court in connection with a particular matter in which the employee personally and substantially participated, which involved a specific party at the time of the participation and representation, and in which the U.S. is a party or has a direct and substantial interest. In addition, an officer or employee of the FDIC who serves as a senior examiner of an insured depository institution for at least 2 months during the last 12 months of that individual's employment with the FDIC may not, within 1 year after the termination date of his or her employment with the FDIC, knowingly accept compensation as an employee, officer, director, or consultant from the insured depository institution; or any company (including a bank holding company or savings and loan holding company) that controls such institution (12 U.S.C. 1820(k). ------ fcic_final_report_full--474 Of course, in the early 2000s there was no generally understood definition of the term “subprime,” so Fannie and Freddie could define it as they liked, and the assumption that the GSEs only made prime loans continued to be supported by their public disclosures. So when Fannie and Freddie reported their loan acquisitions to various mortgage information aggregators they did not report those mortgages as subprime or Alt-A, and the aggregators continued to follow industry practice by placing virtually all the GSEs’ loans in the “prime” category. Without understanding Fannie and Freddie’s peculiar and self-serving loan classification methods, the recipients of information about the GSEs’ mortgage positions simply seemed to assume that all these mortgages were prime loans, as they had always been in the past, and added them to the number of prime loans outstanding. Accordingly, by 2008 there were approximately 12 million more NTMs in the financial system—and 12 million fewer prime loans—than most market participants realized. Appendix 1 shows that the levels of delinquency and default would be 86 percent higher than expected if there were 12 million NTMs in the financial system instead of 12 million prime loans. Appendix 2 shows that the levels of delinquency would be 150 percent higher than expected if the feedback effect of mortgage delinquencies—causing lower housing prices, in a downward spiral—were taken into account. These differences in projected losses could have misled the rating agencies into believing that, even if the bubble were to deflate, the losses on mortgage failures would not be so substantial as to have a more than local effect and would not adversely affect the AAA tranches in MBS securitizations. The Commission never looked into this issue, or attempted to determine what market participants believed to be the number of subprime and other NTMs outstanding in the system immediately before the financial crisis. Whenever possible in the Commission’s public hearings, I asked analysts and other market participants how many NTMs they believed were outstanding before the financial crisis occurred. It was clear from the responses that none of the witnesses had ever considered that question, and it appeared that none suspected that the number was large enough to substantially affect losses after the collapse of the bubble. It was only on November 10, 2008, after Fannie had been taken over by the federal government, that the company admitted in its 10-Q report for the third quarter of 2008 that it had classified as subprime or Alt-A loans only those loans that it purchased from self-denominated subprime or Alt-A originators, and not loans that were subprime or Alt-A because of their risk characteristics. Even then Fannie wasn’t fully candid. After describing its classification criteria, Fannie stated, “[H]owever, we have other loans with some features that are similar to Alt-A and subprime loans that we have not classified as Alt-A or subprime because they do not meet our classification criteria.” 43 This hardly described the true nature of Fannie’s obligations. On the issue of the number of NTMs outstanding before the crisis the Commission studiously averted its eyes, and the Commission majority’s report 43 Fannie Mae, 2008 3rd quarter 10-Q. p.115, http://www.fanniemae.com/ir/pdf/earnings/2008/q32008. pdf. 469 never addresses the question. HUD’s role in pressing for a reduction in mortgage underwriting standards escaped the FCIC’s attention entirely, the GSEs’ AH goals are mentioned only in passing, CRA is defended, and neither HUD’s Best Practices Initiative nor FHA’s activities are mentioned at all. No reason is advanced for the accumulation of subprime loans in the bubble other than the idea—implicit in the majority’s report—that it was profitable. In sum, the majority’s report is Hamlet without the prince of Denmark. FOMC20080625meeting--308 306,MR. MISHKIN.," Thank you, Mr. Chairman. I also strongly support the short-term strategy that was laid out by the Chairman. I don't see that we really have an alternative in that context. There are a lot of issues here. The reality is that this is super complex, and we have a lot of work over the next year to be ready for the next Administration, when all these issues are going to become extremely relevant. In general terms, regarding the long-term issues, although we got here under exigent circumstances, in a financial disruption, we might have gotten here anyway. The reality is that there was a fundamental change in the way the financial system works. When banks are not so dominant, the distinction between investment banks and commercial banks in terms of the way the financial system works is really much less. It would be nice to think that we could limit the kinds of lending facilities that we have so that we didn't have to worry about regulating or supervising other institutions, but I don't think that is realistic. The nature of the changes in the financial system means that we extended the government safety net but it probably would have been extended anyway. It was just unfortunate that it had to happen in such a crisis atmosphere. So I think we have to think very hard about the issue of limiting moral hazard in terms of a much wider range of institutions. I am very sympathetic to the issues that President Stern raised, which is that we have to think about the kind of things that we have thought about more in terms of the banking industry: How do we actually set things up so that it is easier for firms to fail and not be systemic? There are a smaller number of firms that we actually have to supervise and regulate, and the reality is that we have to think very hard about how we're going to extend regulation and supervision to a wider range of firms. We just can't escape that. It would be nice to say that we could limit it, but we are not going to be able to limit it except to the extent that we can think about some of these issues. But it is going to be a huge issue going forward, and we really have to be ready to deal with the political process. The way we are proceeding makes a lot of sense. It is not committing us in a way that creates a problem, but we have to be ready when this issue is dealt with. It will be one of the hottest issues that the next Administration and the next Congress will have to deal with. We have to be really on point and to have positions very carefully thought out, not just by the Board but by the entire FOMC and the entire System, so that we can have a unified position to make sure that crazy stuff doesn't happen and that sensible stuff does. Thank you. " CHRG-110hhrg34673--82 Mr. Bernanke," I would focus on general problem-solving skills that are most flexible. On real estate brokerage, the Federal Reserve and the Treasury have never had an opportunity to make a determination about whether this fits under the Gramm-Leach-Bliley law. Congress has not permitted us to go ahead with that, and so we have had an opportunity to look at it. With respect to financial crises, I would just say that the Federal Reserve takes financial crisis management extremely seriously, and we have made a number of efforts to improve our monitoring of the financial markets to study and assess vulnerabilities, and to strengthen our own crisis management procedures and our business continuity plans. And, I hope we never have another financial crisis, but should one ever occur, we want to be well prepared for that. I would have to get back to you on the Iranian question. " CHRG-110hhrg46591--424 Mr. Ryan," Clearly, we have cyclicality at work and there are certain types of institutions that are affected more by the pressures they are under--15 years ago it was the smaller banks, and now it is, I use the word ``interconnected'' financial institutes. That is the principal issue. It is why our principal recommendation is to have a systemic regulator. And we need one on a global basis. So that is as to the first question. As to the second question, you know, your litany of the problems we have been dealing with over the last 2 months, it tells the whole story as far as the crisis atmosphere. The issues with money markets are also interconnected with many of the other issues because the market funds were investing in what they thought were very high-level AAA and AA bonds to support the money markets. We are, I would say, very, very pleased at the way the Treasury stepped in, because we cannot afford to have the money markets break the buck. So the fact that they used the emergency stabilization fund quickly and then came to you in the form of TARP, we think was critical in stemming the tide. So we thank you for your help on that. " CHRG-111shrg56376--142 Mr. Carnell," Mr. Chairman and Members of the Committee, our current bank regulatory structure is and remains a source of serious problems. Its defects are significant and longstanding. The system is needlessly complex, needlessly expensive, and imposes needless compliance burdens on banks. It impedes--it blunts regulators' accountability with a tangled web of overlapping jurisdictions and responsibilities, and it gives credence to the old saying, when everyone is responsible, no one is responsible. The system wastes time, wastes energy. It hinders timely action by regulators. It brings policy down to the lowest common denominator that four agencies can agree on. And it takes a particular toll on far-sighted action, action aimed at preventing future problems. That is because so often in policymaking, there is someone who says, if it ain't broke, don't fix it. So it is a lot easier to get agreement when you wait until you are confronted with a problem than when you are trying to look ahead and head off problems to begin with. Now, there is a straightforward solution to the problems we see from our fragmented regulatory system, and that solution is to unify the supervision of FDIC-insured depository institutions, banks and thrifts, in a single agency. Treasury Department Lloyd Bentsen offered that solution here in this room 15 years ago and it made sense at the time. I worked with him in preparing that proposal, and I think the events of the last 15 years bear out the wisdom of that approach. This new agency would take on the existing bank regulatory responsibilities of the OCC, OTS, Federal Reserve, and FDIC. The Federal Reserve would retain all its existing central banking functions, including monetary policy, the discount window, and the payment system. The FDIC would retain all its deposit insurance powers and responsibilities, including back-up examination and enforcement authority. On top of that, under the approach I propose, the Fed and the FDIC would be on the board of the new agency, let us say a five- or seven-member board with those two agencies represented. The Fed and FDIC could have their examiners participate in examinations conducted by the new agency, and they would have full access to supervisory information. So the Fed and FDIC would get all the information they get now and their examiners could be part of teams in all FDIC-insured banks, which is more access than they customarily enjoy now. This straightforward structure would be a major improvement over the current fragmented structure. It would promote clarity, efficiency, accountability, and timely action. Equally important, it would give the bank regulator greater independence from special interest pressure. That is, this new agency would regulate the full spectrum of FDIC-insured institutions. There wouldn't be the sort of subspecialization category like we see with thrift institutions. Now, if you look at the thrift debacle, for example, you see that thrift regulation was better when it was done by agencies that had a broad jurisdiction than when it was done by specialized thrift-only regulators. So, for example, at the Federal level, we had thrifts regulated by both the FDIC, which regulated the traditional savings banks, and we had thrifts regulated by the specialized Federal Home Loan Bank Board. FDIC-regulated thrifts were much less likely to fail and, if they did fail, caused smaller losses than the Home Loan Bank Board-regulate thrifts, and we see the same thing at the State level. At the State level, in about two-thirds, three-quarters of the States, the State Banking Commissioners supervise thrifts, and in those States, the losses to the insurance fund were much lower than we saw in States with specialized thrift regulators, and that is basically because the thrift regulators had no reason for being if there wasn't a thrift industry, and so they looked for every way to keep thrift institutions going, even when, in fact, it was unrealistic at that point. The result was a failure to deal effectively with troubled thrifts, much larger losses to the Deposit Insurance Fund. A unified structure would have another major advantage. It would recognize the reality of how banking organizations actually operate, and Dr. Baily already touched on this, as well. Under the existing system, each agency looks at only part of the organization. But in these organizations, you may, in fact, have the various parts doing business with each other extensively, and to evaluate risk, you need to look at the whole, think about the whole, and it sure helps in doing that to be responsible for the whole. So the fragmented system hinders the agency from getting the full picture. Here is how Secretary Bentsen described the problem. Under our current system, any one regulator may see only a limited piece of a dynamic, integrated banking organization when a larger perspective is crucial, both for effective supervision of the particular organization and for an understanding of broader industry conditions and interests. Mr. Chairman, if I could, I wanted to speak a bit to the question of holding company regulation, which came up earlier. First, I want to note something that may not be widely appreciated, and that is that holding companies as a major subject of regulation, that thing is unique to the United States. In other countries, the regulation focuses on the bank. Regulators look out, reach out, but it is not like we have got people devoting their careers to the Bank Holding Company Act. And here is what two of the leading experts, Pauline Heller and Melanie Fein, say. Bank holding companies have no inherent necessity in a banking system. They developed in the United States only because of our unique banking laws which historically limited geographic location and activities of banks. Their only material purpose has been to serve as vehicles for getting into things banks couldn't get into directly. So this puts it into perspective. There is nothing magical. There is nothing high priestly about bank holding company regulation. There is no need for a separate holding company regulator. A bank regulator can fully handle all the functions of a holding company regulator, policing the banks' transactions with the banks and looking at overall risk. In conclusion, Secretary Bentsen, speaking from this table in 1994, underscored the risk of continuing to rely on what he called ``a dilapidated regulatory system that is ill-defined to prevent future banking crises and ill-equipped to cope with crises when they occur.'' He observed in words eerily applicable to the present that our country had just emerged from its worst financial crisis since the Great Depression, a crisis that our bank regulatory system did not adequately anticipate or resolve. And he issued this warning, which we would yet do well to heed. If we fail to fix the system now, the next financial crisis we face will again reveal its flaws, and who suffers then? Our banking industry, our economy, and potentially the taxpayers. You have the chance to help prevent that result. Thank you, Mr. Chairman. " CHRG-111hhrg53238--116 Mr. Bartlett," Congresswoman, there is a crisis, the crisis of delinquencies. There are some 3 million mortgage delinquencies today. We--as an industry, we are providing modifications for about 250,000 a month. That is woefully inadequate. We are doing everything we can to increase that number by as much as double, and we are seeking to do that. I believe we will do that. There are real barriers to keep us from it, but that is no excuse. We are going to increase those modifications because it has to be done for the economy to recover. There is a crisis. Ms. Waters. You are right. You have done a terrible job of modifications. How many of you own or are connected with service agencies in addition to your banking interests? Financial Services Roundtable? " 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-110hhrg46591--7 Mr. Ackerman," A major contributing factor to the economic crisis facing the country is that our financial regulatory system is broken and needs to be fixed. Without question, at least part of the blame for the seizure of our credit markets rests with the credit rating agencies. The credit ratings that were assigned to many mortgage-backed securities over the past 3 years were not based on sound historical data and for good reason. There was none. The types of securities that were bought and sold in the secondary market contain new subprime mortgage products that had no historical data on which to base any rating. Accordingly, the AAA ratings assigned to securities that contained subprime loans had absolutely no statistical basis whatsoever, but the pension fund managers and investors who placed their trust in the ratings took the credit rating agencies at their word and purchased these exotic products. That the credit rating agencies would rate these securities without any statistical data is bad enough, but continuing to do so is absolutely bewildering. Mr. Chairman, if we are to fix the cause of this crisis, that area surely needs to be addressed. Mr. Castle and I have introduced legislation that would require nationally rated statistical rating organizations, those who are registered with the SEC, to assign two classes of ratings. One class, SRO ratings, would be reserved solely for homogenous securities whose ratings are based on historical statistical data and whose ratings pension fund managers and risk adverse investors could rely on. The other class of ratings would permit the rating agencies to continue to rate heterogeneous riskier products that may not have data. " CHRG-111hhrg48873--94 Secretary Geithner," I think that is a very important thing. I mean, it is very important that the American people understand we are going to devote these resources to things that are going to get credit flowing again, get interest rates down, and improve the access for businesses and consumers to credit. That is the central obligation and purpose of this authority. And if you look at what we have done over the last several weeks, you can see we have moved quickly to put in place very substantial measures to address the housing crisis. You are seeing the actions of the Fed and the Treasury together bring down interest rates, allow Americans to refinance and take advantage of lower interest rates. You have seen us move to put in place very important new programs to help support small business lending, to get lending flowing again across the financial system as a whole. Those are very important things. But as part of that, we need better clarity on the rules of the game going forward. I completely agree. " CHRG-109hhrg22160--219 Mr. Greenspan," It is a very serious problem. I mean, again, it has got the same characteristics. And I would not use the word crisis because I don't think that that properly identifies what the nature of the problem is. Crisis to me usually refers to something which is going to happen tomorrow or is on the edge of going into a very serious change. That is not going to happen in either Social Security or Medicare over the next several years. " CHRG-111hhrg51591--95 Mr. Webel," Well, I mean, the point is that--I mean, the question of competitiveness at an international level is frequently brought up when you talk about too-big-to-fail. The Citibanks, the Bank of Americas, are competing on a global level with Deutsche Bank, with Royal Bank of Scotland, with--in a globalized financial system. And this gains the country an immense amount. But if you approach too-big-to-fail and say, we are just not going to let things get too big, you know, one way to do that, one way to say is, okay, you have a systematically significant institution. We are going to put additional capital controls on it. We are going to put additional regulations on it to make sure that it is not as likely to fail. Another option would be to just say, we are just not going to let things get that big. One of the counter examples that people frequently point to is this lack of competitiveness, that you are not--you know, other countries are doing this. They are letting their institutions do this. Our balance of trade will suffer. And that is true. I would just point out that there are a lot of places in policy where the government basically says, okay, we could let the market go this way and it might make more profit. But for a social reason, we are not going to let it go that way. You know, you could mine in Yellowstone National Park, but as a society, we say we are not going to do that. If you look at the cost of the crisis that we are in, one might conclude that it would be worth it to say, okay, if other people, like Iceland, want to let their banks get to be 40 times the size of their GDP or whatever it was, and then collapse when their banks collapse, they can go that route. We are going to say no. We are going to accept the fact that we are going to be uncompetitive in this particular area. But at least when the crisis hits, we are not going to suffer like they do. " CHRG-111hhrg63105--72 Mr. Gensler," I think we have the goal to get it done and we can get it done. And I will say, I think that Congress laid out the 360 days. So by completing our work by July 15 of next year it will help lower regulatory uncertainty, and that is a very important thing. And, of course, we also had a crisis in 2008. And that was a very real crisis. " CHRG-111hhrg55814--158 Secretary Geithner," Congressman, there is one part of that quote you omitted, which is, I said, monetary policy around the world was too loose, too long. But I think it's very, you're right to say that this crisis was not just about the judgment of individuals to borrow too much or banks to lend too much. It wasn't just about failures in regulation supervision. It was partly because you had a set of policies pursued around the world that created a large credit boom, asset price boom. And I think you're right to emphasis that getting those judgments better in the future is an important part of the solution. Dr. Paul. Okay. On the issue that it's worldwide and we don't have the full responsibility, there's a big issue when you are running and managing the reserve currency in the world and other countries are willing to take those dollars and use those as their asset and expand and monetize their own debt, so it's all, we're not locked in a narrow economy, it's a worldwide economy and it's our dollar policy and our spending habits and our debt that really generated this worldwide crisis. That's why it's not a national crisis; it's a worldwide crisis. " CHRG-109hhrg22160--67 Mr. Greenspan," The crisis today is largely---- " CHRG-109hhrg22160--214 Mr. Greenspan," I did not use it---- " Mr. Meeks,"----it is or is not a crisis. " CHRG-111hhrg55814--386 Mr. Yingling," Chairman Frank, Congressman Bachus, and members of the committee, thank you for inviting me to testify. It has been over a year since I first testified before this committee in favor of broad financial reform. This week, the committee is considering legislation that addresses the critical issues that we identified in that testimony, and the ABA continues to support such reform. The key issues addressed include the creation of a systemic oversight council, addressing key gaps in the regulation of non-banks, addressing ``too-big-to-fail,'' and establishing a regulatory approach to the payment system. My written testimony addresses these issues more fully, and I want to emphasize we appreciate the progress that has been made in these areas, the areas that are most critical to reform. One very important change in the draft from the original Administration proposal is that the draft maintains the thrift charter. The ABA wishes to thank Chairman Frank for his leadership on this important issue. In my remaining time, I want to talk about a few areas that need further work, in our opinion. First, there is one glaring omission in the Administration's original proposal and in the draft, the failure to address accounting policy. A systemic risk oversight council cannot possibly do its job if does not have oversight authority over accounting rule-making. Accounting policies are increasingly influencing financial policy and the very structure of our financial system. Thus, accounting standards must now be part of a systemic risk calculation. We believe the Federal Accounting Standards Board should continue to function as it does today, but it should no longer report only to the SEC. The SEC's view is simply too narrow. Accounting policies contribution to this crisis has now been well-documented, and yet the SEC is not charged with considering systemic or structural effects. ABA has strongly supported H.R. 1349, introduced by Representatives Perlmutter and Lucas, in this area. Second, I want to reiterate the ABA's strong opposition to using the FDIC directly for non-bank resolutions. Several weeks ago, the ABA provided a comprehensive approach to resolutions and to ending ``too-big-to-fail.'' The draft, in many ways, mirrors that proposal. However, using the FDIC directly as opposed to indirectly is fraught with problems and is unnecessary. Putting the FDIC directly in charge of such resolutions would greatly undermine public confidence in the FDIC's insurance for the public's deposits. This confidence is critical and it's the reason we have had no runs on banks for over 70 years, even during this very difficult period. The importance of this public confidence should not be taken for granted. Witness the lines that formed in front of the British bank, Northern Rock, at the beginning of this crisis, where they did have classic runs. Yet our own research and polling shows that while consumers trust FDIC insurance, their understanding of how it works is not all that deep. Headlines saying, ``FDIC in charge of failed XYZ non-bank'' would greatly undermine that trust. Just imagine if the FDIC were trying to address the AIG situation this year, dealing with AIG bonuses and that type of thing. We urge the Congress not to do anything that would confuse consumers or undermine confidence in the FDIC. We also believe it's a mistake to use existing bank resolution policies in the case of non-bank creditors. Basic bankruptcy principles should be applied in those cases. Finally, we want to work with the committee to achieve the right balance on securitization reform. We want to work with you to provide for skin in the game on securitization. We understand why there is interest in that, but we need to address the very thorny accounting and business issues involved in having skin in the game. ABA has been a strong advocate for reform. A good deal of progress has been made through the constructive debate in this committee, and we really appreciate the consideration members have given to our views. Thank you. [The prepared statement of Mr. Yingling can be found on page 321 of the appendix.] " CHRG-111shrg49488--72 Chairman Lieberman," Thank you, Senator McCaskill. Thanks for participating this afternoon. We will do a second round insofar as Members want to be here or can be here. The Paulson plan, the Treasury Department's plan, issued last March, as you probably know, envisioned a regulatory system similar to Australia's, which was objectives based. The report was controversial here, although, unfortunately, it got overwhelmed by the growing crisis, so it did not receive the discussion I think it deserved. But it called for consolidation and dissolution of some existing agencies. One controversial reform, which we have referred to briefly here this morning, was the consolidation of the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC). I wanted to ask our three witnesses from outside the United States--I think I know the answer, but not totally--if any of the three countries divide the regulation of securities and futures the way we do here in the United States, or are they regulated under one roof? Mr. Green, everything is under one roof? " CHRG-110hhrg46591--15 Mr. Manzullo," Thank you, Mr. Chairman, for holding this hearing today. This committee needs to examine ways to ameliorate the impact of this crisis while examining long-term solutions to ensure that a crisis of this magnitude never happens again. As we examine the underlying causes of this crisis, it is clear to me that Fannie Mae and Freddie Mac were right in the thick of things. Some of us in Congress have been fighting the unethical, illegal, and outright stupid underwriting practices at Fannie and Freddie for many years. Our efforts are a matter of public record, at least in the last 8 years, of going so far as to publicly confront Franklin Raines, who took $90 million in 6 years from Fannie Mae, and with regard to his fraudulent, unethical lobbying campaign in 2000 and in regard to the use of unethical accounting practices to inflate the bonuses of Fannie Mae's executives in 2004. In 2005, we finally got a bill to the Floor, a vote in favor of GSE reform, including the tough Royce amendment, to make even more difficult the types of practices to continue that we see have led to this crisis. Any solution to this crisis undoubtedly needs to include a serious reexamination of the role that these GSEs will play in any future housing market. It is obvious that new regulations are necessary both to ease this crisis and to ensure that it never happens again. One thing for sure is that these two organizations need to be dissected, ripped apart, and examined thoroughly. Because once we find out what happened there as the root cause of the problem, we will make sure it never occurs again. 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-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-111shrg54533--47 Secretary Geithner," You are right. That goes to the core of the basic judgment we are making. We are giving the council the power to collect information, the responsibility to look across the system, and the power to recommend changes, but not the power to compel or force changes because that would fundamentally change and qualify the underlying statutory responsibilities of those agencies and I think that would create the risk of more confusion and less accountability, frankly. But that is a difficult balance to get. I am not sure we have got the balance perfect, but I think that to invest in a committee responsibility to force those kind of changes would, I think, lead to more diffusion of accountability and more uncertainty. Senator Menendez. But under your proposal, you give the Federal Reserve significantly, for example, significantly more authority, yet the reality is they had knowledge and authority to address the mortgage problem long before it became a crisis and they didn't act. And so in my mind, how is it that we ensure that at the end of the day, the regulators do their job, because from my perspective, they were asleep at the switch instead of being the cop on the beat. So how do we ensure that in this policy? " CHRG-111hhrg51591--30 Mr. Harrington," Chairman Kanjorski, Ranking Member Garrett, and members of the subcommittee, I am very pleased to be here to talk about issues of such fundamental importance to businesses and individuals. I have three main points. First, I want to stress that insurance is fundamentally different from banking and should not be regulated the same way. The anomaly of AIG notwithstanding, compared to banking, insurance markets are characterized by much less systemic risk and by reasonably strong market discipline for safety and soundness. Any new regulatory initiatives that affect insurance should be designed not to undermine that market discipline. Systemic risks, the risk that problems at one or a few institutions may affect many other institutions and the overall economy, is much greater in banking than in insurance. Depositor and creditor runs on banks threaten the entire payment system. The bills don't get paid. The checks don't get written. Banking crises involve immediate and widespread harm to economic activity and employment. Systemic risk in banking provides some rationale for relatively broad government guarantees such as deposit insurance. But because guarantees undermine market discipline, they create a need for tighter regulation and more stringent capital requirements. That in turn creates significant pressure for many banks to relax capital requirements and improve their accuracy, or to circumvent the requirements through regulatory arbitrage. Insurance is inherently different, especially property/casualty insurance and health insurance. There is much less systemic risk and then much less need for broad government guarantees to prevent runs that would destabilize the economy. Guarantees through the State guarantee associations have been appropriately narrow in insurance, or narrower than in banking, and capital requirements have been much less binding. And because they have been much less binding overall, their accuracy is less important. This is good economics. Any new insurance regulatory initiatives should follow this model and recognize the distinctions between banking and insurance. They should also recognize that apparently sophisticated capital regulation can produce significant distortions without sufficiently constraining excessive risk-taking. My second main point is the creation of a systemic risk regulator with authority to regulate systematically significant insurance organizations would likely have several adverse consequences. And I apologize for a bit of redundancy here, going last as I am. In general, the potential benefits of creating a systemic risk regulator encompassing non-bank institutions strike me as modest and highly uncertain. Regarding insurance specifically, if an entity were created with authority to regulate any insurer deemed systematically significant, market discipline could easily be undermined with an attendant increase in moral hazard and excessive risk-taking. An insurer designated as systematically significant would be regarded by many market participants very simply as too-big-to-fail. Implicit or explicit government backing would lower its funding costs and increase its incentives to take on risk. I am skeptical that truly tougher capital requirements or tighter regulation would be adopted for such firms, and if so, whether they would be effective in limiting risk-taking. Over time, government/taxpayer bailouts could become more rather than less prevalent. Even if moral hazard would not increase under that scenario, it is hardly certain that a systemic risk regulator would effectively limit risk in a dynamic global environment. It could well be ineffective in preventing a future crisis, especially once memories of the current crisis fade. In addition, level competition by insurers designated as systematically significant and those not so designated would simply not be possible. The former would likely have a material competitive advantage. The results would likely include higher market concentration. The big will get bigger. Less competition and more moral hazard. Apart from AIG and specialized bond insurers, we have already heard insurance markets have withstood recent problems tolerably well. It is not surprising that some life insurers have been stressed, given what has happened in the asset markets and the nature of their products. My third and last point is that legislative proposals for Federal intervention in insurance regulation, such as optional Federal chartering, should specifically seek to avoid expanding the scope of explicit or implicit government guarantees of insurers' obligations. The goal should be central to any debate. Insurance markets, with the AIG exception, have been largely outside the scope of too-big-to-fail regulatory policy. Consistent with relatively low systemic risks, State guarantees have been relatively narrow. State guarantee associations have performed reasonably well. The post-insolvency assessment scheme works well, and I elaborate in my statement how it has various advantages. So I encourage you, when you consider those issues about optional Federal chartering, to remember not--to keep very close attention to the nature of guarantees and how they can create moral hazard. And last, I would also urge you, as part of that debate, to consider alternatives to optional Federal chartering, whether it be preemption of anti-competitive State activity or some sort of system that would create greater regulatory competition among the States. Thank you. [The prepared statement of Professor Harrington can be found on page 85 of the appendix.] " CHRG-110shrg50414--3 STATEMENT OF SENATOR RICHARD C. SHELBY Senator Shelby. Thank you, Chairman Dodd. This may be the most important hearing that this Committee has conducted, at least in the 22 years I have been a Member here. Over the last 10 years, trillions of dollars were poured into our mortgage finance markets, often with the encouragement of well-intended Government programs. At first, the money backed conventional mortgages with standard downpayments and properly verified incomes. Over time, however, the number of homebuyers that met conventional loan requirements dwindled rapidly. In order to fuel the upward spiral, mortgage products became more exotic, requiring less of borrowers and involving more risk. Without regard for fiscal prudence and simple economics, bankers, investment bankers, mortgage brokers, realtors, home builders, mortgage bankers, and homebuyers created the conditions that helped inflate the housing bubble. At the same time, Wall Street was developing ever more sophisticated financing vehicles to ensure that money continued to flow into the mortgage markets to meet the demand. Mortgages were pooled, packaged, and rated so-called investment grade by the credit rating agencies. They were then sold into a market eager to purchase securities with a wide range of risks and yields. Many purchasers employed massive amounts of leverage, layering risk upon risk in an effort to maximize return. To cover their risks, many of the buyers also bought credit protection from one another, entered into derivatives contracts with nominal values in the hundreds of trillions of dollars. All the while, our financial regulators appeared to be unaware as they sat on the sidelines. As early as July of 2003 here at the Banking Committee, I asked Chairman Greenspan, then Chairman of the Federal Reserve, whether he was concerned about the growing number of loans to borrowers with weak credit histories and the number of homeowners who spent more than 50 percent of their income on housing. I also asked him if he was concerned whether an economic downturn could lead to increasing delinquencies and foreclosures. Chairman Greenspan at this very Committee assured us that increasing home prices provided an equity cushion for mortgagors and that lending to such borrowers would pose ``a rather small risk to the mortgage market and the economy as a whole.'' As recently as March of this year, Vice Chairman of the Federal Reserve Cohn, testifying before this very Committee, assured us that the banking system was in, and I will quote his words, ``sound overall condition'' and that losses ``should not threaten their viability.'' Now, we now know that was not the case. Eventually, economic reality caught up with our housing market, and housing prices stalled and then began falling. Many who bought homes with unconventional loans found that they were unable to afford their rising payments. Because home values were dropping, they were unable to refinance, and delinquency rates skyrocketed, as we all know. Once homeowners began defaulting, the value of mortgage-backed securities plummeted. Collateralized debt obligations--we call them ``CDOs''--that were comprised of the riskiest mortgage-backed securities became worthless. As a result, financial institutions holding securitized assets have suffered enormous losses and have been desperately trying to raise new capital. Of the five investment banks regulated at the beginning of the year by the Securities and Exchange Commission under its Consolidated Supervised Entities Program, two have failed, one was forced to merge with a bank, and the remaining two have now left the program to become bank holding companies. The recent demise of our investment banks lies in stark contrast to the vote of confidence we received in the Banking Committee from Chairman Cox in February of this year, when he assured us that the CSE program was up to the task, and I will now quote Chairman Cox. According to Chairman Cox's words, ``The purpose of the CSE program is to monitor far and to act quickly in response to financial or operational weakness in a CSE holding company that might place regulated entities or the broader financial system at risk. The Commission''--that is the SEC he is speaking of--``seeks to ensure that the holding company has sufficient stand-alone liquidity and financial resources to meet its expected cash outflows in a stressed liquidity environment for a period of at least 1 year.'' That was earlier this year. In late 2007, Mr. Erik Sirri, head of Market Regulation for the Securities and Exchange Commission, described a consolidated supervision program that had ``demonstrated its effectiveness during the current credit market difficulties.'' Nothing can be further from the truth. He likewise assured us that the SEC's consolidated supervision had achieved ``the goal of reducing the likelihood that weakness within the holding company or an unregulated affiliate will place a regulated entity or the broader financial system at risk. Notwithstanding assurances to the contrary, uncertainty about housing prices and the value of mortgage-backed securities have brought our markets to a halt. We are now facing the most serious economic crisis, as Chairman Dodd said, in a generation. So far, the Treasury Department and the Fed's response to the crisis has been a series of ad hoc measures. First came the bailout of Bear Stearns, which we were told was unavoidable. Then came Lehman Brothers, which was allowed to fail. And then, just last week, the Fed and Treasury organized a bailout of AIG. I believe the absence of a clear and comprehensive plan for addressing this crisis has injected additional uncertainty into our markets and has undermined the ability of our markets to tackle this crisis on their own. Unfortunately, the Treasury Department's latest proposal continues, I believe, its ad hoc approach, but on a much grander scale. The plan contemplates the purchase, as we know, of up to $700 billion in troubled, toxic, mortgage-related assets from financial institutions that nobody would buy. Treasury expects, but is not required, to purchase most assets through a type of reverse auction process. There are very few details in this legislation. In fact, Treasury officials admit that they will have to figure out the mechanics as they go along. Rather than establishing a comprehensive, workable plan for resolving this crisis, I believe this legislation merely codifies Treasury's ad hoc approach. My hope is that this hearing will give us an opportunity to explore the parameters of the plan and why Secretary Paulson believed it will work. I also hope to hear why the plan does nothing to address the root cause of the crisis: the rise in default rates on mortgages. While Wall Street banks get to sell their bad investments to the Treasury Department, homeowners will still be saddled with mortgages that they cannot afford. My record is very clear on taxpayer-funded bailouts. I have long opposed Government bailouts for individuals and corporate America alike. As a young Congressman, I voted against the loan guarantees for Chrysler, I believe in 1979 or 1980. However, if the Government is going to get into the bailout business, shouldn't we also be focusing our resources on average Americans, the taxpayers, rather than sophisticated and well-compensated Wall Street bankers? The Treasury's plan has little for those outside of the financial industry. It is aimed at rescuing the same financial institutions that created this crisis with the sloppy underwriting and reckless disregard for the risk they were creating, taking, or passing onto others. Wall Street bet that the Government would rescue them if they got into trouble. It appears that bet may be the one that pays off. Once again, what troubles me most is that we have been given no credible assurances that this plan will work. We could very well spend $700 billion or $1 trillion and not resolve the crisis. Before I sign off on something of this magnitude, I would want to know that we have exhausted all reasonable alternatives. But I do not believe we can do that in a weekend. Unfortunately, the incredibly accelerated process for considering this bill means that Congress does not have time to determine if there are better alternatives or any alternatives to the Treasury's plan. I am very concerned that the express need to pass something now may prevent us from devising a plan that would actually work. Without question, our markets and financial institutions need serious attention. I do not believe, however, that we can solve this crisis by spending a massive amount of money on bad securities. It is time for this administration and the Congress to do the work of devising as quickly as possible a comprehensive and workable plan for resolving this crisis before we waste $700 billion to $1 trillion of taxpayer money. Thank you, Mr. Chairman. " CHRG-111shrg56376--136 Mr. Ludwig," Chairman Dodd, and to Ranking Member Shelby, who is not here, and other distinguished Members of this Committee, I am honored to be here today and I want to commend you and the staff for the thoughtful way in which you have examined the causes of the financial crisis and the need for reform in this area. Under your leadership, Chairman Dodd and Ranking Member Shelby, the bipartisan and productive traditions of the Senate Banking Committee have continued. In this regard, it should be noted that the need for an end-to-end independent consolidated banking regulator, the subject you have asked me to address today, has been championed over the years by Members of the Senate Banking Committee, including its Chairman, as well as Treasury Secretaries from both sides of the aisle. Consistent with this tradition, the Administration's white paper is directionally helpful and commendable. While refinements to the white paper are needed, this is an inevitable part of the policymaking process. I also want to commend the Treasury Department of former Secretary Henry Paulson for having developed its so-called ``Blueprint,'' which also has added important and positive developments to the debate in this area. Lamentably, the financial regulatory problem we face is not just the current crisis. Over the past 20-plus years, we have witnessed the failure of hundreds of U.S. banks and bank holding companies, supervised by every one of our regulatory agencies. By the end of this year alone, well over 100 U.S. banks will have failed, costing the Deposit Insurance Fund tens of billions of dollars. Before this crisis is over, we will witness the failure of hundreds more. In the face of this irrefutable evidence, it is impossible to say there is not a very serious problem with our regulation of financial services organizations. There are three things, however, this problem is not. It is not about the lack of talented people in our regulatory agencies. It is not about weak regulation or weaker bankers. The problem is in large part--the problem stems from a dysfunctional regulatory structure, a structure that exists nowhere else in the world and no one wants to copy, a structure that reflects history, not deliberation. The recent financial crisis has accentuated many of the shortcomings of the current regulatory system. Needless burdens that weaken safety and soundness focus, lack of scale needed to address problems in technical areas, regulatory arbitrage where the ability to select or threaten to select a weaker supervisor tears at the fabric of solid regulation, delayed rulemaking, regulatory gaps, limitations on investigations, where one agency cannot seamlessly examine and resolve a problem from a bank to its nonbank affiliate, and diminished international leadership. What is needed and what would resolve these problems is an end-to-end independent consolidated banking supervisor. Now, there have been a number of misconceptions about what a consolidated end-to-end institutional bank regulator is and what it is not. First, an end-to-end supervisor is not a super-regulator along the lines of Britain's FSA. The end-to-end consolidated institutional supervisor would not regulate financial markets like the FSA, would not establish consumer protection rules like the FSA, would not have resolution authority, would not have deposit insurance authority or any central banking functions. The consolidated end-to-end institutional regulator would focus only on the prudential issues applicable to financial institutions, and this model has been quite successful elsewhere in the world. I think this is really quite important. For example, the Office of the Superintendent of Financial Institutions, OSFI, in Canada, and the Australian Prudential Regulatory Authority, called APRA, in Australia have been quite successful consolidated supervisors even in the current crisis, where Canadian and Australian banks have fared much better than our own. There has been a second misconception that a consolidated regulator that regulates enterprises chartered at the national level cannot fairly supervise smaller community organizations and that it would do violence to our dual banking system. I might say as an aside, I, like the Chairman, believe the dual banking system is alive and well and an important fabric of our banking system and this would not do violence to it. In fact, interesting enough, even today, the OCC supervises well over a thousand community banking organizations whose businesses are local in character. That is, the national supervisor supervises over a thousand small banks. In fact, it is the majority of the banks it supervises, the vast majority, and they choose that as a matter of their own predilection, not by rule. Indeed, today, all our Federal regulators regulate large institutions and smaller institutions. A new consolidated supervisor at the Federal level would merely pick up the FDIC and Federal Reserve examination and supervisory authorities. To emphasize, all the consolidated supervisor would do is take the Federal component and move it to another Federal box. It would not change the regulation or the fabric of that supervision. Third, some have claimed that a consolidated institutional supervisor would not have the benefit of other regulatory voices. This would clearly not be the case, as a consolidated institutional supervisor would fulfill only one piece of the regulatory landscape. The Federal Reserve, Treasury, SEC, FDIC, CFTC, FINRA, FINCEN, OFAC, and the FHFA would continue to have important responsibilities with respect to the financial sector. In addition, proposals are being made to add additional elements to the U.S. financial regulatory landscape, the Systemic Risk Council and a new financial consumer agency. This would leave multiple financial regulators at the Federal level and 50 bank regulators, 50 insurance regulators, and 50 securities regulators at the State level. It seems to me that is a lot of voices. Fourth, some have also claimed that the primary work of the Federal Reserve--monetary policy, payment system, and acting as the bank of last resort--and the FDIC--deposit insurance--would be seriously hampered if they did not have supervisory responsibility. The evidence does not support these claims. One, a review of FOMC minutes does not suggest much, if any, use is made of supervisory data in monetary policy activities. In the case of the FDIC, it has long relied on a combination of publicly available data and examination data from the other agencies. Two, there are not now, to my knowledge, any limitations on the ability of the Federal Reserve or the FDIC to collect any bank supervisory data. Indeed, if need be, the Federal Reserve or the FDIC can accompany another agency's examination team to obtain relevant data or review relevant practices. Three, if the FDIC or the Federal Reserve does not have adequate cooperation on gathering information, Congress can make clear by statute that this must be the case. And four, even if the FDIC were not the supervisor of State chartered banking entities, the FDIC would continue to have back-up supervisory authority and be able to be resident--resident--in any bank it chose. Finally, I would note that it is important that the new consolidated supervisor be an independent agency for at least three reasons. First, banking supervision should not be subject to political influence. Second, the agency and the agency head needs the stature of the Federal Reserve, SEC, or FDIC to attract talented people and to be taken seriously by the other agencies. Third, and this, I think, is critically important, Congress, in fulfilling its oversight function--its critical oversight function--must hear the unfettered truth about the banking system from the head of its supervisory agency, not views filtered through another department or agency. And indeed, I would go further. I think it is incredibly difficult for you to fulfill your oversight responsibilities with an alphabet soup of regulators. Indeed, having regulators that have clear missions, it seems to me, makes it possible for you to exercise your critical function in a more effective way. If one pushed these together even more, as has been suggested by some, I think it becomes almost unmanageable for Congress. In sum, our country greatly needs a consolidated independent end-to-end institutional regulator. Without one, we will not have financial stability, in my view, and we will continue to be victimized by periods of bank failures and follow-on credit crunches that deteriorate our economy. Thank you very much. " CHRG-111shrg55278--16 Mr. Tarullo," Well, Senator, let me say a couple of things about that. First, as you know, in my prior capacity, I had a fairly broad-based set of criticisms about the Fed and the regulatory system as a whole. I continue to believe that when the final history of the financial crisis is written, there is going to be a lot of blame to go around to regulatory agencies and private institutions. This was not a single failing. This was a broad-based failing at home and, as we have seen, internationally as well. Let me be clear. I think that includes an inadequate or flawed approach to supervision at the banking agencies, including the Fed. Second, I will say that I think that history shifts. History shifts and the relative positions of agencies shift over time. I remember when I was in law school studying this set of issues that the Federal Reserve was regarded as the most aggressive of the regulatory agencies and the other agencies were regarded as somewhat more accommodating. So I think there is a rhythm that goes with the times, with the leadership of an agency, and with the general orientation of public policy. So, since I have gotten to the Fed--actually before that, since I began having conversations with you and other Members of the Committee--what I have been trying to determine is the degree to which the capacity and the resources are present to do what is in some sense the same job that should have been done better. But to be honest, in some sense, it is a different job because I don't think anybody actually was focused on the systemic part of the problem as much as they ought to have been. It was a more siloed approach to regulation. And that is why I also think some changes should be made in prevailing law so that it is clear that the supervisor of the holding companies has authority to do examinations of functionally regulated subsidiaries when it is necessary. Those sorts of things need to move forward. But, I think more fundamentally, what has to be done is the kind of thing I mentioned a moment ago, which is to put in place a system within the agency that has its own kind of cross-checks, drawing upon the substantial resources of the agency. There are substantial resources in the research and monetary affairs parts of the Board to provide exactly the kinds of information that will enhance supervision. And that is, I think, the task which someone is going to have to perform, Senator, and it is either going to be done by the Federal Reserve or another agency. It has got to be done somewhere. My belief is, based upon my 6 months' experience at the Fed, that under Chairman Bernanke's leadership, it can be done. But I don't think anyone should underestimate the task and I would just second something you said in your introductory remarks. I hope people are not expecting that anything that the Fed or the SEC or the FDIC or anybody else does is going to eliminate all potential for systemic risk. That is just not going to happen. And I think we have got to keep that in mind. Let me just say one final thing. The Administration's proposal and other proposals vary in how much authority they really mean to invest in a particular agency. Back at our March hearing, you and I talked back and forth a good bit about the different possible functions of a systemic risk regulator. With the possible exception of some of the proposals for the council as they have been described, most proposals don't talk about a systemic risk regulator. They talk about allocating a particular set of responsibilities to particular agencies or collective groups, and I think that is probably the way it should be. I really don't think you need or want so much responsibility, as well as authority, lodged in any one agency to say, you have responsibility for figuring out anywhere in the financial system there is a problem and you have authority to do whatever you think is necessary. " CHRG-111shrg57923--46 Financial Hurricanes Will Come Again When the financial hurricane of 2008 made landfall, the regulators and policymakers charged with keeping our financial system safe were taken by surprise. Although there were some indications of financial uncertainty, this financial storm hit with the same unexpected suddenness as the New England Hurricane of 1938--which slammed into Suffolk County, Long Island, and then continued into Connecticut, Rhode Island, Massachusetts, New Hampshire, Vermont and finally Canada. The Martha's Vineyard Gazette noted at the time, ``This tragedy was not the loss of nearly 10,000 homes and business along the shore. It was the psychic destruction of summer for an entire generation.'' Earlier hurricanes had brought structural responses from the U.S. Government. In 1807 the United States Coast and Geodetic Survey was established by Thomas Jefferson, a quarter century after the Great Hurricane of 1780--the deadliest on record, killing over 27,500 people. The Weather Bureau was formed in 1870 under President Ulysses S. Grant to gather data on the weather and provide warnings of approaching storms. Even though the Weather Bureau was in place, it was not able to offer any warning for the Category 4 Hurricane that devastated Galveston, Texas on September 8th, 1900. By 1926 reports from sea could be delivered with a varying level of reliability, which was part of the reason that there were a few hours warning for the Miami Hurricane of September 18th, 1929. By the time the New England Hurricane of 1938 hit, the Weather Bureau had better data and better models. Still, as the New York Times observed, ``Except for Charlie Pierce, a junior forecaster in the U.S. Weather Bureau who predicted the storm but was overruled by the chief forecaster, the Weather Bureau experts and the general public never saw it coming''. Are our regulators and policymakers any better equipped today than the Weather Bureau of 1938? In his opening remarks to the Senate Banking Committee on June 18, 2009, Secretary Geithner observed, ``If this crisis has taught us anything, it has taught us that risk 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.'' In 1970, President Richard Nixon created the National Oceanic and Atmospheric Administration (NOAA), with the mandate to: i) develop data collection networks to document natural variability and support predictive models, ii) develop new analytical and forecasting tools to improve weather services and earlier warnings of natural disasters and iii) conduct experiments to understand natural processes. While NOAA's real-time data collection and analysis infrastructure are significant and continue to bring a range of substantial benefits to society, they were made possible largely through the research arm of NOAA--the Office of Oceanic and Atmospheric Research (OAR)--with its seven research laboratories, six undersea laboratories and a range of research partners. Clearly our financial markets are at least as important and as complicated as the weather. Why don't we have the equivalent of NOAA or OAR for the financial markets? The current regulatory reform legislation that was passed in the House charges a new Financial Services Oversight Council (FSOC) with the task of monitoring systemic risk--watching for future financial hurricanes--and provides some new legal authorities to intervene in the time of crisis. However, it fails to provide a NOAA type mandate to collect system-wide data and build realistic system-wide models, which can only be built upon a deep understanding of how our financial system works. The FSOC will have no permanent staff and no specific authority to collect the many kinds of system-wide data needed. As it stands the FSOC represents a hollow promise that will leave us unprepared for the financial hurricanes that will surely come. The Senate has an opportunity to strengthen the FSOC in their version of the legislation by creating a National Institute of Finance along the lines of NOAA's key components: providing regulators with better data and better models--built on a sustained research effort. When it comes to safeguarding our financial system our goals should be bold, our expectations realistic and our dedication to the task substantial. Although it will take time, the benefits will far outweigh the cost, just as they have done with hurricanes.Richard Foster, Senior Faculty Fellow, Yale School of Management; Emeritus Director, McKinsey & CompanyJohn Liechty, Associate Professor, Penn State University; Co-Founder, Committee to Establish the National Institute of Finance ______ FinancialCrisisReport--52 Washington Mutual was far from the only lender that sold poor quality mortgages and mortgage backed securities that undermined U.S. financial markets. The Subcommittee investigation indicates that Washington Mutual was emblematic of a host of financial institutions that knowingly originated, sold, and securitized billions of dollars in high risk, poor quality home loans. These lenders were not the victims of the financial crisis; the high risk loans they issued became the fuel that ignited the financial crisis. A. Subcommittee Investigation and Findings of Fact As part of its investigation into high risk lending and the Washington Mutual case study, the Subcommittee collected millions of pages of documents from Washington Mutual, JPMorgan Chase, OTS, the FDIC, eAppraiseIT, Lenders Service Inc., Moody’s, Standard & Poor’s, various investment banks, Fannie Mae, Freddie Mac, and others. The documents included email, correspondence, internal memoranda, reports, legal pleadings, financial analysis, prospectuses, and more. The Subcommittee also conducted more than 30 interviews with former WaMu employees and regulatory officials. The Subcommittee also spoke with personnel from the Offices of the Inspector General at the Department of Treasury and the FDIC, who were engaged in a joint review of WaMu’s regulatory oversight and the events leading to its demise. In addition, the Subcommittee spoke with nearly a dozen experts on a variety of banking, accounting, regulatory, and legal issues. On April 13, 2010, the Subcommittee held a hearing which took testimony from former WaMu officials and released 86 exhibits. 106 In connection with the hearing, the Subcommittee released a joint memorandum from Chairman Carl Levin and Ranking Member Tom Coburn summarizing the investigation to date into Washington Mutual and the role of high risk home loans in the financial crisis. The memorandum contained the following findings of fact, which this Report reaffirms. 1. High Risk Lending Strategy. Washington Mutual (WaMu) executives embarked upon a High Risk Lending Strategy and increased sales of high risk home loans to Wall Street, because they projected that high risk home loans, which generally charged higher rates of interest, would be more profitable for the bank than low risk home loans. 2. Shoddy Lending Practices. WaMu and its affiliate, Long Beach Mortgage Company (Long Beach), used shoddy lending practices riddled with credit, compliance, and operational deficiencies to make tens of thousands of high risk home loans that too often contained excessive risk, fraudulent information, or errors. 106 “Wall Street and the Financial Crisis: The Role of High Risk Loans,” before the U.S. Senate Permanent Subcommittee on Investigations, S.Hrg. 111-67 (April 13, 2010) (hereinafter “April 13, 2010 Subcommittee Hearing”). 3. Steering Borrowers to High Risk Loans. WaMu and Long Beach too often steered borrowers into home loans they could not afford, allowing and encouraging them to make low initial payments that would be followed by much higher payments, and presumed that rising home prices would enable those borrowers to refinance their loans or sell their homes before the payments shot up. 4. Polluting the Financial System. WaMu and Long Beach securitized over $77 billion in subprime home loans and billions more in other high risk home loans, used Wall Street firms to sell the securities to investors worldwide, and polluted the financial system with mortgage backed securities which later incurred high rates of delinquency and loss. 5. Securitizing Delinquency-Prone and Fraudulent Loans. At times, WaMu selected and securitized loans that it had identified as likely to go delinquent, without disclosing its analysis to investors who bought the securities, and also securitized loans tainted by fraudulent information, without notifying purchasers of the fraud that was discovered. 6. Destructive Compensation. WaMu’s compensation system rewarded loan officers and loan processors for originating large volumes of high risk loans, paid extra to loan officers who overcharged borrowers or added stiff prepayment penalties, and gave executives millions of dollars even when their High Risk Lending Strategy placed the bank in financial jeopardy. 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-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-111hhrg56847--41 Mr. Bernanke," I am familiar with her study, and I would say that her book with Ken Rogoff on debt crisis and financial crisis is an extraordinary piece of work that includes analyses of, as you say, dozens of crises. On this particular issue, I agree with the general point that as debt increases, interest rates increase. That tends to make investments more costly, tax rates go up. " CHRG-111shrg62643--11 Mr. Bernanke," Thank you. Chairman Dodd, Senator Shelby, and Members of the Committee, I am pleased to present the Federal Reserve's semiannual Monetary Policy Report to the Congress. The economic expansion that began in the middle of last year is proceeding at a moderate pace, supported by stimulative monetary and fiscal policies. Although fiscal policy and inventory restocking will likely be providing less impetus to the recovery than they have in recent quarters, rising demand from households and businesses should help sustain growth. In particular, real consumer spending appears to have expanded at about a 2\1/2\-percent annual rate in the first half of this year, with purchases of durable goods increasing especially rapidly. However, the housing market remains weak, with the overhang of vacant or foreclosed houses weighing on home prices and construction. An important drag on household spending is the slow recovery in the labor market and the attendant uncertainty about job prospects. After 2 years of job losses, private payrolls expanded at an average of about 100,000 per month during the first half of this year, a pace insufficient to reduce the unemployment rate materially. In all likelihood, a significant amount of time will be required to restore the nearly 8\1/2\ million jobs that were lost over 2008 and 2009. Moreover, nearly half of the unemployed have been out of work for longer than 6 months. Long-term unemployment not only imposes exceptional near-term hardships on workers and their families, it also erodes skills and may have long-lasting effects on workers' employment and earnings prospects. In the business sector, investment in equipment and software appears to have increased rapidly in the first half of the year, in part reflecting capital outlays that had been deferred during the downturn and the need of many businesses to replace aging equipment. In contrast, spending on nonresidential structures--weighed down by high vacancy rates and tight credit--has continued to contract, though some indicators suggest that the rate of decline may be slowing. Both U.S. exports and U.S. imports have been expanding, reflecting growth in the global economy and the recovery of world trade. Stronger exports have in turn helped foster growth in the U.S. manufacturing sector. Inflation has remained low. The price index for personal consumption expenditures appears to have risen at an annual rate of less than 1 percent in the first half of the year. Although overall inflation has fluctuated, partly reflecting changes in energy prices, by a number of measures underlying inflation has trended down over the past 2 years. The slack in labor and product markets has damped wage and price pressures, and rapid increases in productivity have further reduced producers' unit labor costs. My colleagues on the Federal Open Market Committee and I expect continued moderate growth, a gradual decline in the unemployment rate, and subdued inflation over the next several years. In conjunction with the June FOMC meeting, Board members and reserve bank presidents prepared forecasts of economic growth, unemployment, and inflation for the years 2010 through 2012 and over the longer run. The forecasts are qualitatively similar to those we released in February and in May, although progress in reducing unemployment is now expected to be somewhat slower than we previously projected, and near-term inflation now looks likely to be a little lower. Most FOMC participants expect real GDP growth of 3 to 3\1/2\ percent in 2010, and roughly 3\1/2\ to 4\1/2\ percent in 2011 and 2012. The unemployment rate is expected to decline to between 7 and 7\1/2\ percent by the end of 2012. Most participants viewed uncertainty about the outlook for growth and unemployment as greater than normal, and the majority saw the risks to growth as weighted to the downside. Most participants projected that inflation will average only about 1 percent in 2010 and that it will remain low during 2011 and 2012, with the risks to the inflation outlook roughly balanced. One factor underlying the Committee's somewhat weaker outlook is that financial conditions--though much improved since the depth of the financial crisis--have become less supportive of growth in recent months. Notably, concerns about the ability of Greece and a number of other euro-area countries to manage their sizable budget deficits and high levels of public debt spurred a broad-based withdrawal from risk taking in global financial markets in the spring, resulting in lower stock prices and wider risk spreads in the United States. In response to these fiscal pressures, European leaders put in place a number of strong measures, including an assistance package for Greece and 500 billion euros of funding to backstop the near-term financing needs of euro-area countries. To help ease strains in U.S. dollar funding markets, the Federal Reserve reestablished temporary dollar liquidity swap lines with the ECB and several other major central banks. To date, drawing under the swap lines has been limited, but we believe that the existence of these lines has increased confidence in dollar funding markets, helping to maintain credit availability in our own financial system. Like financial conditions generally, the state of the U.S. banking system has also improved significantly since the worst of the crisis. Loss rates on most types of loans seem to be peaking, and in the aggregate, bank capital ratios have risen to new highs. However, many banks continue to have a large volume of troubled loans on their books, and bank lending standards remain tight. With credit demand weak and with banks writing down problem credits, bank loans outstanding have continued to contract. Small businesses, which depend importantly on bank credit, have been particularly hard hit. At the Federal Reserve, we have been working to facilitate the flow of funds to creditworthy small businesses. Along with the other supervisory agencies, we have issued guidance to banks and examiners emphasizing that lenders should do all they can to meet the needs of creditworthy borrowers, including small businesses. We also have conducted extensive training programs for our bank examiners, with the message that lending to viable small businesses is good for the safety and soundness of our banking system as well as for our economy. We continue to seek feedback from both banks and potential borrowers about credit conditions. For example, over the past 6 months we have convened more than 40 meetings around the country of lenders, small business representatives, bank examiners, Government officials, and other stakeholders to exchange ideas about the challenges faced by small businesses, particularly in obtaining credit. A capstone conference on addressing the credit needs of small businesses was held at the Board of Governors in Washington last week. This testimony includes an addendum that summarizes the findings of this effort and possible next steps. The Federal Reserve's response to the financial crisis and the recession has included several components. First, in response to the periods of intense illiquidity and dysfunction in financial markets that characterized the crisis, the Federal Reserve undertook a range of measures and set up emergency programs designed to provide liquidity to financial institutions and markets in the form of fully secured, mostly short-term loans. Over time, these programs helped to stem the panic and to restore normal functioning in a number of key financial markets, supporting the flow of credit to the economy. As financial markets stabilized, the Federal Reserve shut down most of these programs during the first half of this year and took steps to normalize the terms on which it lends to depository institutions. The only such programs currently open to provide new liquidity are the recently reestablished dollar liquidity swap lines with major central banks that I noted earlier. Importantly, our broad-based programs achieved their intended purposes with no loss to the taxpayers. All of the loans extended through the multiborrower facilities that have come due have been repaid in full, with interest. In addition, the Board does not expect the Federal Reserve to incur a net loss on any of the secured loans provided during the crisis to help prevent the disorderly failure of systemically significant financial institutions. A second major component of the Federal Reserve's response to the financial crisis and recession has involved both standard and less conventional forms of monetary policy. Over the course of the crisis, the FOMC aggressively reduced its target for the Federal funds rate to a range of 0 to \1/4\ percent, which has been maintained since the end of 2008. And as indicated in the statement released after the June meeting, the FOMC continues to anticipate that economic conditions--including low rates of resource utilization, subdued inflation trends, and stable inflation expectations--are likely to warrant exceptionally low levels of the Federal funds rate for an extended period. In addition to the very low Federal funds rate, the FOMC has provided monetary policy stimulus through large-scale purchases of longer-term Treasury debt, Federal agency debt, and agency mortgage-backed securities, or MBS. A range of evidence suggests that these purchases helped to improve conditions in mortgage markets and other private credit markets and put downward pressure on longer-term private borrowing rates and spreads. Compared with the period just before the financial crisis, the System's portfolio of domestic securities has increased from about $800 billion to $2 trillion and has shifted from consisting of 100 percent Treasury securities to having almost two-thirds of its investments in agency-related securities. In addition, the average maturity of the Treasury portfolio has nearly doubled, from 3\1/2\ years to almost 7 years. The FOMC plans to return the System's portfolio to a more normal size and composition over the longer term, and the Committee has been discussing alternative approaches to accomplishing that objective. One approach is for the committee to adjust its reinvestment policy--that is, its policy for handling repayments of principal on the securities--to gradually normalize the portfolio over time. Currently, repayments of principal from agency debt and MBS are not being reinvested, allowing the holdings of these securities to run off as the repayments are received. By contrast, the proceeds from maturing Treasury securities are being reinvested in new issues of Treasury securities with similar maturities. At some point, the committee may want to shift its reinvestment of the proceeds from maturing Treasury securities to shorter-term issues so as to gradually reduce the average maturity of our Treasury holdings toward pre-crisis levels, while leaving the aggregate value of those holdings unchanged. At this juncture, however, no decision to change reinvestment policy has been made. A second way to normalize the size and composition of the Federal Reserve's securities portfolio would be to sell some holdings of agency debt and MBS. Selling agency securities, rather than simply letting them run off, would shrink the portfolio and return it to a composition of all Treasury securities more quickly. FOMC participants broadly agree that sales of agency-related securities should eventually be used as part of the strategy to normalize the portfolio. Such sales will be implemented in accordance with a framework communicated well in advance and will be conducted at a gradual pace. Because changes in the size and composition of the portfolio could affect financial conditions, however, any decisions regarding the commencement or pace of asset sales will be made in light of the committee's evaluation of the outlook for employment and inflation. As I noted earlier, the FOMC continues to anticipate that economic conditions are likely to warrant exceptionally low levels of the Federal funds rate for an extended period. At some point, however, the committee will need to begin to remove monetary policy accommodation to prevent the buildup of inflationary pressures. When that time comes, the Federal Reserve will act to increase short-term interest rates by raising the interest rate it pays on reserve balances that depository institutions hold at Federal reserve banks. To tighten the linkage between the interest rate paid on reserves and other short-term market interest rates, the Federal Reserve may also drain reserves from the banking system. Two tools for draining reserves from the system are being developed and tested and will be ready when needed. First, the Federal Reserve is putting in place the capacity to conduct large reverse repurchase agreements with an expanded set of counterparties. Second, the Federal Reserve has tested a term deposit facility, under which instruments similar to the certificates of deposit could be auctioned to depository institutions. Of course, even as the Federal Reserve continues prudent planning for the ultimate withdrawal of extraordinary monetary policy accommodation, we also recognize that the economic outlook remains unusually uncertain. We will continue to carefully assess ongoing financial and economic developments, and we remain prepared to take further policy actions as needed to foster a return to full utilization of our Nation's productive potential in a context of price stability. Last week, the Congress passed landmark legislation to reform the financial system and financial regulation, and the President signed the bill into law this morning. That legislation represents significant progress toward reducing the likelihood of future financial crises and strengthening the capacity of financial regulators to respond to risks that may emerge. Importantly, the legislation encourages an approach to supervision designed to foster the stability of the financial system as a whole as well as the safety and soundness of individual institutions. Within the Federal Reserve, we have already taken steps to strengthen our analysis and supervision of the financial system and systemically important financial firms in ways consistent with the new legislation. In particular, making full use of the Federal Reserve's broad expertise in economics, financial markets, payment systems, and bank supervision, we have significantly changed our supervisory framework to improve our consolidated supervision of large, complex bank holding companies, and we are enhancing the tools we use to monitor the financial sector and to identify potential systemic risks. In addition, the briefings prepared for meetings of the FOMC are now providing increased coverage and analysis of potential risks to the financial system, thus supporting the Federal Reserve's ability to make effective monetary policy and to enhance financial stability. Much work remains to be done, both to implement through regulation the extensive provisions of the new legislation and to develop the macroprudential approach called for by the Congress. However, I believe that the legislation, together with stronger regulatory standards for bank capital and liquidity now being developed, will place our financial system on a sounder foundation and minimize the risk of a repetition of the devastating events of the past 3 years. Thank you, Mr. Chairman. I would be pleased to respond to your questions. " CHRG-109hhrg22160--209 Mr. Meeks," Thank you. Thank you, Mr. Chair. I am really somewhat puzzled from some of the answers that I have heard today. Let me just see if I can clear up my own mind. The first question that I have is, I know the President has described it as a crisis, et cetera, but I don't think I have ever heard what your opinion is. The question on Social Security is it or is it not, in your opinion, a crisis? " FinancialCrisisInquiry--664 VICE CHAIRMAN THOMAS: That was the savings and loan crisis. CHRG-109hhrg22160--68 Mr. Kanjorski," You agree with the President, it is a crisis today. " CHRG-109hhrg22160--66 Mr. Kanjorski," So you would conclude that--then why is the crisis today? What happened? " CHRG-111hhrg54868--150 Mr. Green," Did it cause the crisis? Ms. Bair. No, it did not. No. " CHRG-111hhrg55809--11 Mr. Garrett," I thank the chairman for holding this hearing, and I welcome Chairman Bernanke back again to the committee. I note in the Chairman's testimony you continue to advocate that the Federal Reserve should be given authority for consolidated oversight for all ``systemically important financial institutions.'' And, quite candidly, I do have a number of concerns about this proposal, many that I have expressed before. Among them, first of all, specifically designating institutions as systemically critical leads to unfair competitive agendas, disadvantages, increased moral hazard, and makes it more likely such institutions will be considered ``too-big-to-fail.'' Secondly, the Federal Reserve already has consolidated supervision over many of the large bank holding companies, including Citi and Bank of America, which the Federal Government has pumped billions of dollars into due to the fact that such consolidated supervision apparently failed in the past. Furthermore, Fed policy itself--that is, keeping interest rates too low for too long, primarily before you were here--was one of the major factors leading to this crisis. I am not alone in my concerns about the Fed as a systemic regulator. There seems to be a universal distaste for the Fed in such a role on the Senate Banking Committee. Such a political reality would seem to make it less likely that the House would confer such new powers on the Fed either. And as has been stated previously, rather than give the Fed additional powers, Republicans on the committee have proposed as part of a reform plan that the powers of the Fed be focused primarily on monetary policy and others be reduced. So preventing future taxpayer-funded bailouts is a primary aim of the GOP plan and is also the primary aim of a piece of legislation I plan to introduce later today that will call for raising the minimum downpayment for the FHA loans as well as a study to examine what is an appropriate leverage ratio for the FHA. There have been increasing reports of a likely necessity of a taxpayer-funded bailout for the FHA, and this legislation aims to implement-- " CHRG-111shrg53176--3 Chairman Dodd," Yes, I know. Well, he was a good Governor and he is a good Senator. We welcome him to this Committee. Then I am going to ask my colleagues--we are going to have one round on the first panel. As much as there are many questions, obviously, we have for both of you, but if we end up with too many rounds, we will never get to the second and third panels, and colleagues have busy schedules as well, as do our witnesses. So we will cut it off after one round. Then we will go to the second panel, which I will leave a little more open, given the backgrounds of our witnesses, and the third panel. With that, let me share some opening comments and then turn to Senator Shelby, and then we will go right to our witnesses this morning. Today, the Committee meets, as I said, for our second hearing to examine the securities market regulation, the ninth hearing on this general matter of modernization of Federal regulations. This hearing is to discuss how investors and our entire financial system are protected, or lack of protection, in the future from the kind of activities that led to the current crisis. This hearing is one of a series, as I mentioned, of nine we have already convened to modernize the overall regulatory framework and to rebuild our financial system. And I saw this morning the headlines of our local newspaper here, the direction that the Secretary of the Treasury is heading. I welcome that. This is all within about 60 days of this administration coming to office. We will not have all the time this morning to go over that. This Committee will be meeting at the request of the Treasury tomorrow with Democrats and Republicans to listen to some of these thoughts. It is not a formal hearing. We will have one of those. But given the time constraints and the fact that the administration is heading overseas to the meeting coming up with the G-20, we thought it would be worthwhile to have at least a briefing as to where this thing is heading. So we welcome that and are excited over the fact that they are going to be proposing some thoughts in this area as well. We are also very excited to have two witnesses who are not only former Chairmen of the SEC but also, I might add, residents of my own State as well, having Arthur Levitt and Richard Breeden with us. From the outset, I have argued that our financial system is not really in need of reform but modernization, that truly protecting consumers and investors in the decades to come will require a vast overhaul of our financial architecture that recognizes the extraordinary transformation that has occurred over the last quarter of a century, and it is extraordinary. And nowhere has that transformation been clearer than in the area of securities, which have come to dominate our financial system, now representing 80 percent--80 percent--of all financial assets in the United States. With pension funds, the proliferation of 401(k)s and the like, today half of all households in the United States are invested in some way in the securities markets. As Federal Reserve Governor Dan Tarullo said at our last hearing on this subject matter, ``The source of systemic risk in our financial system has, to some considerable extent, migrated from traditional banking activities to markets over the last 20 or 25 years.'' In essence, as the assets of our financial system have shifted from banking deposits to securities, so too have the dangers posed to our economy as a whole. We need regulators with the expertise, tools, and resources to regulate this new type of financial system. At our last hearing on this subject, this Committee heard about the need to watch for trends that could threaten the safety of our financial system. Our witnesses had different views on what regulatory body should perform that function. Some felt it should be given to a special commission made up of the heads of existing agencies. Others have argued for a new agency or to give that authority to an existing regulator. As I have said, given the regulatory failures we saw in the lead-up to this crisis, I have concerns, and I think many of my colleagues have also expressed, about this authority residing exclusively within one body. And I re-express those views this morning. For instance, we have seen problems with the regulated bank holding companies where they have not been well regulated at the holding company level. And while there are many aspects to our financial system, systemic risk itself has many parts as well. One is the regulation of practices and products which pose systemic risk, from subprime mortgages to credit default swaps, and that is why I remain intrigued by the idea of a council approach to address this aspect of systemic risk. And I know our previous witnesses Paul Stevens with the Investment Company Institute and Damon Silvers with the AFL-CIO have both recommended this type of concept. Of course, systemic risk is only one issue which we are examining. At our last hearing on this subject matter, we heard how we could increase transparency by addressing the risks posed by derivatives. We heard ways to improve the performance of credit rating agencies, who failed the American people terribly, by requiring them to verify the information they used to make those ratings. And, more recently, Secretary of Treasury Geithner has proposed the creation of a resolution mechanism for systemically important nonbank financial institutions, and I will be very interested in hearing from you, Chairman Schapiro, on that subject matter, what your thoughts are and the role the SEC should play. In providing this authority to the FDIC, I am pleased that they have recognized the need to ensure that powerful new tools do not all reside, again, with any single agency. These are all ideas that deserve careful examination, which we will engage in here at this Committee. Today's diverse panel, including representatives from hedge funds, credit rating agencies, retail investors, industry self-regulatory organizations, paints a very vivid picture of the numerous issues facing the securities markets at this moment. The goals of modernization are clear, in my view: consistent regulation across our financial architecture with strong cops on the beat in every neighborhood; checks and balances to ensure our regulators and the institutions that oversee them are held accountable; and transparency so that consumers and investors are never in the dark about the risks they will be taking on. The time has come for a new era of responsibility in financial services. That begins with the rebuilding of our 21st century financial architecture from the bottom up, with the consumer clearly in our minds in the forefront. It begins with the work of this Committee, and, again, this is now almost the tenth hearing on the subject matter. Senator Shelby and I and our colleagues here are determined to play a constructive and positive role as we help shape this debate in the coming weeks. With that, let me turn to Senator Shelby. FinancialCrisisInquiry--31 CHAIRMAN ANGELIDES: Let me ask you one final question on this topic very quickly in terms of—as a principal which is: In September 2004, the FBI’s head of the criminal division warned that mortgage fraud was so rampant in this country that it was a potential quote-unquote, “epidemic” and that, if unchecked, it would result in a crisis as big as the S&L crisis. Did you take any specific steps in the wake of that 2004 crisis to evaluate the mortgages that you were selling into the marketplace? BLANKFEIN: Well... CHAIRMAN ANGELIDES: If you don’t... BLANKFEIN: We were not an originator of mortgages... CHAIRMAN ANGELIDES: No, but… BLANKFEIN: We acquired mortgage. CHAIRMAN ANGELIDES: Correct. BLANKFEIN: 32 CHRG-111shrg57709--78 Mr. Volcker," On the last crisis, not going really far back in history, I recall at the beginning of the crisis there was a very large lawsuit on a French bank from a single rogue trader. It was one trader that went out and cost them hundreds of millions of dollars. Senator Corker. In the United States of America, there has not been a single institution. I just want to point that out. We can move on, but it is a fact. " fcic_final_report_full--479 The best summary of how the deflation of the housing bubble led to the financial crisis was contained in the prepared testimony that FDIC chair Sheila Bair delivered to the FCIC in a September 2 hearing: Starting in mid 2007, global financial markets began to experience serious liquidity challenges related mainly to rising concerns about U.S. mortgage credit quality. As home prices fell , recently originated subprime and non-traditional mortgage loans began to default at record rates . These developments led to growing concerns about the value of financial positions in mortgage-backed securities and related derivative instruments held by major financial institutions in the U.S. and around the world. The diffi culty in determining the value of mortgage-related assets and, therefore, the balance-sheet strength of large banks and non-bank financial institutions ultimately led these institutions to become wary of lending to one another, even on a short-term basis. 47 [emphasis supplied] All the important elements of what happened are in Chairman Bair’s succinct statement: (i) in mid 2007, the markets began to experience liquidity challenges because of concerns about the credit quality of NTMs; (ii) housing prices fell; NTMs began to default at record rates; (iii) it was diffi cult to determine the value of MBS, and thus the financial condition of the institutions that held them; and, (iv) finally, as a consequence of this uncertainty—especially after the failure of Lehman—financial institutions would not lend to one another. That phenomenon was the financial crisis. The following discussion will show how each of these steps operated to bring down the financial system. Markets Began to Experience Liquidity Challenges To understand the transmission mechanism, it is necessary to distinguish between PMBS, on the one hand, and the MBS that were distributed by government agencies such as FHA/Ginnie Mae and the GSEs (referred to jointly as “Agencies” in this section). As shown in Table 1, by 2008, the 27 million NTMs in the U.S. financial system were held as (i) whole mortgages, (ii) MBS guaranteed by the GSEs, or insured or held by a government agency or a bank under the CRA, or (iii) as PMBS securitized by private firms such as Countrywide. The 27 million NTMs had an aggregate unpaid principal balance of more than $4.5 trillion, and the portion represented by PMBS consisted of 7.8 million mortgages with an aggregate unpaid principal balance of approximately $1.9 trillion. As mortgage delinquencies and defaults multiplied in the U.S. financial system, the losses were transmitted to financial institutions through their holdings of PMBS. How did this happen, and what role was played by government housing policy? Both Agency MBS and PMBS pass through to investors the principal and interest received on the mortgages in a pool that backs an issue of securities; the difference between them is the way they protect investors against credit risk—i.e., the possibility of losses in the event that the mortgages in the pool begin to default. The Agencies insure or place a guarantee on all the securities issued by a pool they or some other entity creates. Because of the Agencies’ real or perceived government 47 Sheila C. Bair, “Systemically Important Institutions and the Issue of ‘Too-Big-to-Fail,’” Testimony to the FCIC, September 2, 2010, p.3. backing, all these securities are rated or considered to be AAA. 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-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-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. " 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-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-111hhrg53248--195 Mrs. Bachmann," I appreciate the nuance. I do. Thank you so much for that. My concern really goes back also to the concerns in the opening statement that was given by Mr. Hensarling early and also by others. I share those concerns. I am very concerned that the President's proposal that came before this committee is silent on any true, meaningful GSE reform, because nowhere in the President's White Paper that I could surmise does he propose any substantive ideas to fix the fatal flaws that I think many of us would agree are inherent in the GSEs, the too-big-to-fail philosophy that drove Bailout Nation. These are flaws that significantly contributed in many of our estimations to the financial crisis the country experienced. So my question would be for members of the panel, how can the only plan be, and I am quoting from the White Paper, how can the only plan be to engage in a wide-ranging initiative to develop recommendations on the future of Fannie Mae and Freddie Mac and the Federal Home Loan Bank system which will be punted until the President's release of his 2011 budget? It just seems to me that real reform could have been, had Congress included placing Freddie and Fannie in receivership rather than in conservatorship, and how can we ever expect to fix the problems with our financial system without making changes at the root cause? If we have effectively nationalized these GSEs, what is our way out? I mean literally, will Starbucks be too-big-to-fail? Will these be considered financial Tier 1 organizations? I think, at this point, we need to ask those questions. We saw that the government backed away from CIT, which I think many of us were happy to see. But I would ask again, do you believe that we should be acting sooner to reform the GSEs? And that is for anyone on the panel. Ms. Bair. I think the hesitancy to address the GSE issue is that it transcends financial policy and perhaps extends to housing policy, and this is really not an area where any of us have direct responsibilities at this point. But certainly, as the GSEs are functioning now and have functioned before, I believe they are quite profoundly systemic. They were sources of systemic risk that had built up over the years, as we know now. So I think if they do continue to exist, clearly this is something that an oversight council should have some input and responsibility for. But as you say, the long-term future of those entities seems somewhat unclear right now, and it is really not within our purview as banking regulators to influence that policy decision. " FOMC20080625meeting--310 308,VICE CHAIRMAN GEITHNER.," I obviously support the strategy laid out. I just want to underscore, particularly in response to Governor Warsh's comments, that this is in effect a conditional extension, in the sense that we are being careful to get ourselves more comfortable with where these four firms in particular are on capital and liquidity before we announce an extension. We are trying to get clarity on the ongoing supervisory relationship with the SEC before we announce an extension. We have already gotten the 18 major dealers in the world to commit themselves to a path to improve the capacity of the OTC derivatives infrastructure to withstand failure before announcing. We have already begun to get the resources held against default risk in the existing central counterparties higher, in satisfaction of President Stern's general admonition that we want the system better able to withstand failure. I think we are just beginning the delicate process of taking some of the air out of the vulnerable tri-party repos before the extension is announced. So, in that sense, we have left ourselves in this strategy that the Chairman laid out with a little less vulnerability to the possible impression that we would just willy-nilly extend with no effort to make the system safer. We are not going to get far enough. We are not going to know what's far enough. But I think we have a credible plan to say, ""We took the initiative, even in a moment of incredible delicacy for dealing with the system, to try to get these institutions and the system in a better capacity to withstand the possibility of failure."" In that sense it's a defensible and sensible strategy. I really don't know what the right mix of boundaries is on access to liquidity in normal times and in extremis and what mix of supervisory authority conditions with what type of resolution regime is optimal. I just don't have a sense. I feel as though I know the broad tradeoffs in it, but I don't know what really looks ideal in terms of the mix of those things. You can make a pretty reasonable case for a whole bunch of variance in that mix of things. The complication for us is that we won't be able to fully control the outcome because it is going to require legislation. Part of the consequence of the system that we live with and part of the reason that we live with the system we have today is that policymakers and regulators don't fully control the outcome in terms of the incentives created in the legislation for these kinds of things. So it will be difficult for us, but all we can do is focus on the merits, think through those ahead of everybody else, and try to have the best package of suggestions that we can. But just to come back to what we spent most of the last two days talking about, let's not lose sight of the fact that we are in the middle of this still. It likely has a long way to go. It is very hard for us to know now what we are going to decide at the end was the most critical source of vulnerability and, therefore, what to do to fix it. We don't know what the market is going to think the new equilibrium should be in terms of the return on equity across different types of financial institutions and models. Another reason to be careful as we try to contain the risks in this crisis and make the system stronger in the near term is so that we don't prejudge some of those longer-term questions. Thank you. " CHRG-111shrg55278--27 Chairman Dodd," Thank you, Senator Reed. Senator Corker. Senator Corker. Mr. Chairman, thank you, and I thank each of you for your testimony. Chairman Bair, I very much, as you know, support your outlook as it relates to the resolution issue, and I am surprised at the Administration's proposal and wanting to continue to support companies that fail, much like is being done with TARP, and I hope that that will evolve. But let me just ask you this: On the issue of systemic risk, if there had been a resolution mechanism in place, would that not have actually--even though there was risk in the market, would that not have actually reduced the risk to some degree? In other words, if you had the appropriate ability to deal with a Lehman Brothers or an AIG, would that actually have reduced the risk to the system in the first place? Ms. Bair. I think it would have, for two reasons. One, if it had already been in place for some time, I think we would have had better market discipline across the system. Second, when the problems hit--and we will always have cycles, hopefully never as severe as this one, but we will always have cycles--there would have been a consistent statutory mechanism in place that could be applied to all of these institutions which would have reduced market uncertainty about who was going to be next and who was going to win and who was going to lose. So I absolutely think it would have reduced risk in the system going into this crisis if we had had such a resolution mechanism in place. Senator Corker. I think that is really a big point. I think that is something that--you know, we are looking at creating something new, and I know we will debate that, and we may come up with the right solution. But the fact of the matter is if we had just had effective market disciplines in the first place where there were not entities that were too-big-to-fail, they could actually fail, the risk itself would have been less, and I think that is an important point. Let me ask you another question. I have served on several public company boards, and certainly not the size of the companies we are talking about here, but I have been before lots of them, and each of the board members typically are respected individuals that have a focus on their own companies, and I respect people in that position very much. But is there something we should be thinking about as it relates to boards? My guess is most board members show up, really do not know, excuse the language, squat about what is going on inside the company. It is a nice social event. It is just the way boards are set up, and most CEOs like it that way. " FinancialCrisisInquiry--540 WALLISON: OK. I want to—I’d like to go into some other things. Mr. Bass, you laid a lot of the losses in the financial crisis on the question of derivatives, presumably, credit-default swaps. How then do you explain why the credit-default swap market continued to function throughout the entire financial crisis without any obvious disruption of any kind even after Lehman failed? FinancialCrisisInquiry--677 CLOUTIER: Correct. I mean, you know, one example is if they had to live with my capital levels. I had 12 percent capital. When I heard them talk about their capital levels here earlier today, I wondered how in the world they got away with that. Because I guarantee you, if I walked and told my regulator I was going to have 6 percent capital, I’d have a C&D in the morning on my desk. You know, it’s an unfair system. So when they say send more regulation, more regulation only means that’s more stuff that I don’t have to worry about and that’s an easy way to go out the back door. You know, when we had the crisis at Enron, they passed—which by the way, Citicorp and them were deeply involved in. You know, they paid big fines for. It didn’t affect them at all. It was crushing to small business. It was a crushing event. Gramm-Leach-Bliley, when they changed the rules, it didn’t affect them. It affected us. So more regulation usually doesn’t have much effect. My question is, and the question this commission should ask: Why wasn’t the regulations on the books enforced? And then that would be an amazing question to ask. And I think most of the answer is is that they’re a member of the FAC they’re very closely interlinked into the Washington circles. CHRG-110hhrg34673--198 Mr. Bernanke," Well, the approach that regulators have taken since the report of the President's Working Group after the LTCM crisis has been a market-based approach, an indirect regulation approach, whereby we put a lot of weight on good risk management by the counterparties to the hedge funds such as the prime dealers, the lenders, as well as the good oversight of the investors, the institutions and so on that invest in hedge funds. And we found that is a very useful way to control leverage and to provide market discipline on those funds. The original report of the President's Working Group also suggested disclosures, and that never went anywhere in Congress, and I think part of the problem was it was difficult to agree upon what should be disclosed and what would be useful. The hedge funds are naturally reluctant to disclose proprietary information about their trading strategies and approaches, and their positions change very quickly, and so therefore position information can be overwhelming and perhaps not very useful. I think it is important to continue to think about hedge funds. They certainly play an important role in our financial system. Exactly, you know, what a disclosure regime would look like, though, is not yet clear to me how that best would be organized. " CHRG-111shrg53176--57 Mr. Atkins," With respect to the subject of regulatory reform, your hearings have so far been a very good start and I would suggest that you ask some very hard questions in subsequent hearings. For example, why was the SEC in the course of the last dozen years or so has the SEC experienced such catastrophic failures in basically every one of its four competencies--rulemaking, filing review, enforcement, and examinations? What led to the failures of the SEC and other regulatory agencies, both in the United States and globally, to discern the increasing risk to financial institutions under their jurisdiction? What led the failures at financial institutions to recognize the inadequacy of their own risk management systems and strategy in time to avert a collapse? How did so many investors get lulled into complacency and not adequately do their own due diligence? What is the proper role of credit rating agencies, and has regulation, in fact, fostered an oligopoly by recognizing the opinions of a few as being more privileged than those of the rest? These are hard questions, and if there are to be changes to the Federal securities laws, I think they need to be made carefully through a robust analysis of the costs and benefits of various potential actions and how those actions might affect human behavior in the market. The current situation is certainly no time to wing it or to act on gut instincts because investors ultimately pay for regulation. And if Congress doesn't get it right, severe consequences could be in store for the U.S. Once on the books, laws, especially in this area, seem to be very hard to change and unintended consequences live on. Prior to the recent crisis, the subject of regulatory balance was being discussed. Senator Schumer, Mayor Bloomberg, the U.S. Chamber of Commerce, and others cited many reasons why the U.S. as a marketplace was not so competitive. In fact, in 2006, the value of Rule 144A unregistered offerings in the U.S. for the first time exceeded that of public offerings. 2006 seems like a long time ago, but it still is very much a valid concern, especially once the global financial system recovers. The worrisome thing to me is that if care is not taken to have solid analysis, the wrong lessons may be gleaned from this latest crisis and that will ultimately hurt investors. It takes a long time, as I said, to change legislation in this area. So what we need is an analysis to determine how we can effectively and efficiently promote honesty and transparency in our markets and ensure that criminality is not tolerated. For example, I disagree with the assertion that deregulation in the past four, eight, ten, or what have you years has led to the current problems in the financial markets. One can hardly say that the past eight to 10 years have been deregulatory with the adoption of new laws and rules, such as Sarbanes-Oxley. More regulation for regulation's sake is not the answer What we need is smarter regulation. The global crisis has primarily affected regulated versus nonregulated entities all around the world, not just in the supposedly deregulatory United States. The question is, how did so many regulators around the world operating under vastly different regimes with differing powers and differing requirements all get it wrong? Indeed, how did so many firms with some of the best minds in the business get it wrong? During the past dozen years, the SEC has experienced catastrophic operational failures in its four core functions of filing review, rulemaking, enforcement, and examinations. ENRON's corporate filings were not reviewed for years in the 1990s. Tips were not pursued regarding Bernie Madoff and regarding the late trading of mutual funds in 2003. It took literally an Act of Congress led by this Committee to get transparency and a reformed SEC process with respect to credit rating agencies. These mistakes, I think, were a long time in the making and were caused by failures of the system of senior staff management. First, management applied faulty motivational and review criteria, and second, since resources are always limited, there is an opportunity cost in choosing to spend time and resources on one thing because then, of course, there is less time and less resources to spend on other things. With respect to opportunity costs, I believe that the SEC, especially in the years 2003 to 2005, was distracted by controversial, divisive rulemaking that lacked any grounding in cost-benefit analysis during this very crucial period right when many instruments, like CDOs and CDSs, took off and established their trajectory. Because these rules and the arguments for them were ultimately invalidated by the courts after both long litigation and much distraction for the agency and the industry, a lot of essential time was wasted. Because life is full of choices, if you devote resources to one thing, you have less to devote to another, and the one risk that you haven't focused on just may blow up in your face. That is, in fact, exactly what happened to the SEC, and it was really through back office processes and documentation that weren't attended to that led to the current crisis. There are other things that I would be happy to talk about that I put into my written testimony. With respect to that, I have mentioned in my written testimony an article on enforcement and the processes at SEC. I ask that I be able to submit that for the record. " fcic_final_report_full--226 THE BUST CONTENTS Delinquencies: “The turn of the housing market” .............................................  Rating downgrades: “Never before” ...................................................................  CDOs: “Climbing the wall of subprime worry” .................................................  Legal remedies: “On the basis of the information” .............................................  Losses: “Who owns residential credit risk?” ......................................................  What happens when a bubble bursts? In early , it became obvious that home prices were falling in regions that had once boomed, that mortgage originators were floundering, and that more and more families, especially those with subprime and Alt-A loans, would be unable to make their mortgage payments. What was not immediately clear was how the housing crisis would affect the fi- nancial system that had helped inflate the bubble. Were all those mortgage-backed securities and collateralized debt obligations ticking time bombs on the balance sheets of the world’s largest financial institutions? “The concerns were just that if people . . . couldn’t value the assets, then that created . . . questions about the solvency of the firms,” William C. Dudley, now president of the Federal Reserve Bank of New York, told the FCIC.  In theory, securitization, over-the-counter derivatives and the many byways of the shadow banking system were supposed to distribute risk efficiently among investors. The theory would prove to be wrong. Much of the risk from mortgage-backed securi- ties had actually been taken by a small group of systemically important companies with outsized holdings of, or exposure to, the super-senior and triple-A tranches of CDOs. These companies would ultimately bear great losses, even though those in- vestments were supposed to be super-safe. As  went on, increasing mortgage delinquencies and defaults compelled the ratings agencies to downgrade first mortgage-backed securities, then CDOs. Alarmed investors sent prices plummeting. Hedge funds faced with margin calls from their repo lenders were forced to sell at distressed prices; many would shut down. Banks wrote down the value of their holdings by tens of billions of dollars.  CHRG-111hhrg51698--431 Mr. Massa," We have great agility in our ability to shift. The point being, sir, you said just because we think it is illegal, we should tolerate it, because it might move overseas. If you could give me an example, singularly or in numerous quantities, of things that this country, based on our value systems, think that are illegal that we have made illegal, that you think we should bring back here because it is being processed or conducted elsewhere in the world, I would love to consider those options. I happen to believe that is a specious argument, and that it is the requirement of this argument to ferret out potentially illegal activity and protect the citizens of this nation. So if you would be willing to engage in a conversation in writing with me on that, I would very much welcome that. Last, not many people understand out of New York how badly New York has been hit by our current financial situation. I am honored to know that Chairman Morelle has been at the forefront of the forensic investigation as to many of the things that have happened. We heard here today a lot of what did not contribute to the failure of AIG. Mr. Morelle, in 1 minute or less, and then perhaps followed up under a special hearing, could you tell me what you think the factors are that did in fact cause the AIG crisis? " CHRG-111shrg54533--9 Chairman Dodd," Well, I appreciate the answer to that. Let me go to the issue--and, again, I want to state--I think all of us have had a chance to talk about this, and obviously the debate about, one, whether or not you want a systemic risk regulator, which I certainly do, and then the question who does it and what authorities do you give them. From my standpoint, I am open on the issue. I have not made up my own mind what is the best alternative. Obviously, you have submitted a plan that gives that authority to the Fed. But let me raise some questions that have been raised by others about the wisdom of that move to the Fed and not looking at the more collegial approach or some other alternative. A fellow by the name of Mark Williams, a professor of finance and economics at Boston University and a former Fed examiner, said the following: ``Giving the Fed more responsibility at this point''--and he had a rather amusing analogy--``is like a parent giving his son a bigger, faster car right after he crashed the family station wagon.'' SEC former Chairman Richard Breeden testified before this Committee, and he said the following: ``The Fed has always worried about systemic risk. I remember in 1982 and 1985 the Fed talking about that it worried about systemic risk. They have been doing that, and still we had a global banking crisis. The problems like the housing bubble, the massive leverage in the banks, the shaky lending practices, and subprime mortgages, those things were not hidden. They were in plain sight.'' And perhaps most significantly, Chairman Volcker in response to a question by Richard Shelby back in February in a hearing we had in this Committee testified that he had concerns about giving the Fed too many responsibilities that would undermine their ability to conduct monetary policy. So the question that many are asking, not just myself but others on this Committee and elsewhere, is: Given the concerns that have been expressed by the former Chairman of the Federal Reserve, the former Chairman of the SEC, and others about the Fed's track record as well as the multiple responsibilities that the Fed already has, why is it your judgment that the Fed should be given this additional extraordinary authority and power? And does it not conflict in many ways or could it not conflict with their fundamental responsibility of conducting monetary policy? " CHRG-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-111hhrg56776--52 Mr. Volcker," I do think it has to be mandatory because I have been a regulator, I have been a supervisor, and I have observed regulators and supervisors. It is very hard to take tough restrictive measures before the crisis, and after the crisis, of course, it is too late. I really think in an area like this where the rationale to me at least is quite clear, the law should say as specifically and as mandatorily as possible, and I think the Dodd bill, as I understand it, goes considerably in that direction. " CHRG-111shrg53176--121 Mr. Stack," Thank you very much. Good morning, Chairman Dodd, Ranking Member Shelby, and Members of the Committee. I am Ronald Stack, Chair of the Municipal Securities Rulemaking Board. By way of background, I have been involved in the municipal market since 1975 when I was a member of the staff of Governor Hugh Carey during the New York City fiscal crisis. I am pleased today to testify on behalf of the MSRB at the Committee's second hearing on Enhancing Investor Protection and the Regulation of the Securities Markets. The MSRB was created by the Congress in 1975 to write rules for municipal securities dealers, at that time many of whom were unregulated, unsupervised, and not even registered by the SEC. Our mission was set in statute, and it remains clear and unambiguous, and that is, to protect the investing public and to promote a fair and efficient market for municipal securities. This is a $2.7 trillion municipal market, and it is fundamental to financing our Nation's infrastructure. Indeed, over 55,000 entities issue $400 billion in municipal securities each year. We are absolutely committed to preserving municipal access to capital, the municipal market's integrity, and investor protection. This is our mission, this is our commitment. We believe one of the important ways to protect investors and preserve market integrity is through a culture of transparency, one that makes information available to all. Historically, access to public disclosure about municipal bonds has been hindered by a severely fragmented disclosure system that was cobbled together over the years. This system did not promote public access to disclosure documents, and it did nothing to shine a light on the disclosure practices of issuers, good or bad. So what have we done? The MSRB has developed a comprehensive Web site that is transforming municipal disclosure and transparency for all investors, large and small, institutional and retail. It is called the Electronic Municipal Market Access system, which we call it EMMA, and it is so advanced that we believe it exceeds disclosure systems for any other fixed-income market, and that includes corporate bonds. With EMMA, all investors have free access on the Web to an incredible amount of information about municipal securities. We have had real-time trading information up since 2005. We have added official statements and information about auction rates. Starting next week, we will add information about variable rates, and finally, in July of this year, pursuant to a rule amendment that was passed by the SEC in December, we will be including what is called ``continuing disclosure filings,'' which are up-to-date material changes from bond issuers. Our new system of making continuing disclosure available easily and on the Web will be a vast improvement over the current system. EMMA will serve as a red flag for poor disclosure by issuers, just as it reveals good disclosure practices. But good, timely dissemination of disclosure is only one of our myriad responsibilities. We require municipal securities dealers to observe the highest professional standards in their dealings with investors: full disclosure, suitability, fair pricing. We are the only Federal regulator that has successfully implemented a ban on ``pay to play.'' If you are a municipal securities professional, you cannot do business with an issuer if you have contributed to one of its officials. We test professionals' qualifications and we require them to take continuing education courses. We have a complete set of rules regulating municipal dealers that we constantly review, modify, and change as necessary. And I emphasize all of our rules are sent out for comment and then are subject to strict review and approval by the SEC itself. Unfortunately, we continue to read reports--and I think this is something which I think Chairman Levitt was referring to--about other municipal market participants who engage in ``pay to play'' and similar activities. Some are alleged and some are still under investigation, but whatever the outcome, the market suffers from an appearance problem, and that is not good for the muni market or for any market. Earlier this year, we wrote to you and your colleagues in the House Financial Services Committee about the potential for regulation of some or all of these other market participants. They serve critical roles in many of the complex financing and related derivative transactions that have become commonplace. They advise State and local governments, big and small, on how to structure a bond issue, how to sell it, how to market it, what type of securities to sell, how to invest bond proceeds, whether to use swaps or other related derivatives. We believe these and other similar market participants should be registered with the SEC and regulated by the MSRB with rules similar to those already applied to dealers. Many of these people are fiduciaries, and they should be subject to the standards of professional conduct. ``Pay to play'' should be prohibited, just like it was prohibited for dealers by the MSRB in 1994. I want to emphasize that I know many of these participants, and many of the individuals are ethical and well qualified, but, unfortunately, not all of them are and activities of a few can taint the entire market if not by fact, by appearance. That is something we cannot afford, especially in the current crisis. During this time of stress, it is crucial that we have clear guideposts and that investor confidence in the municipal securities market is not undermined by questionable practices. Also, as Treasury seeks to find solutions to assist the municipal bond market through the crisis, ensuring that all market participants adhere to the highest professional standards is essential. The MSRB looks forward to working with the Committee, as well as other regulators and market participants, to ensure that the level of investor protection provided in the municipal market is second to none. Senators, thank you for inviting the MSRB to participate in this very important hearing. " CHRG-111shrg54789--10 Mr. Barr," Thank you, Mr. Chairman. I think we have had a long experiment with having the prudential supervisors over banks responsible for consumer protection supervision, having another agency--the Federal Reserve--responsible for rule writing, having yet another agency--the Federal Trade Commission--responsible for after-the-fact enforcement in the nonbanking sector. And I think what we have seen and what the American public has just experienced is a massive failure of that system. And it was a massive failure of that system because of the very structure of the system. There were good people at the Federal Reserve, for example, who wanted to effectuate strong consumer protections. You might even say there were heroic people at the Federal Reserve who wanted to effectuate consumer protection. Ned Gramlich, who was a dear friend of mine, the Vice Chair of the Federal Reserve, wanted to get consumer protection done, and the very structure of the Federal Reserve, its very focus on what it viewed as prudential supervision, its inability to move quickly on consumer protection blocked reform in the mortgage market that could have helped avert this crisis. So I think we have had a long and disastrous experience with having bank agencies with a mixed mission, with no one focused on protecting consumers, with no one able to set rules and supervise across the financial services marketplace, with no one able to say there is going to be a level playing field with high standards for everybody. And what we saw is the market tipped to bad practices. We saw it tip to bad practices in credit cards, practices which you and Mr. Shelby so effectively blocked in the credit card bill this spring. We saw it shift, tilt to bad practices in the mortgage market in ways that were disastrous for the American people. And I just don't think we can afford that experiment any longer. We have to have a fresh start with a new agency whose sole mission is standing up for the American people. " CHRG-111hhrg56847--67 Mr. Bernanke," We had a financial crisis and a recession that led to a big increase in the deficit, no question about it. " 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.] " CHRG-111hhrg54872--20 The Chairman," The gentleman from Kansas, Mr. Moore, for 2 minutes. Mr. Moore of Kansas. Thank you, Mr. Chairman. Last year's financial crisis exposed an out-of-date regulatory structure in need of a complete overhaul. The proposed Consumer Financial Protection Agency is a key component of the proposal to create stronger oversight of our financial system. I commend the chairman for the improvements he made that revised the draft bill released last week. In today's hearing, I hope we will explore some of the more difficult questions on CFPA: one, transferring consumer protection enforcement away from bank regulators; and two, the proper role of States' enforcement of policymaking power in relation to the new Federal agency. I welcome the chairman's ideas on coordinated exams and a dispute resolution mechanism. I hope these and other ideas generate a discussion of not if, but how best to implement the CFPA to fully protect consumers. And I yield back my time. Thank you, sir. " fcic_final_report_full--452 In this environment, the government’s rescue of Bear Stearns in March of 2008 temporarily calmed investor fears but created a significant moral hazard; investors and other market participants reasonably believed after the rescue of Bear that all large financial institutions would also be rescued if they encountered financial diffi culties. However, when Lehman Brothers—an investment bank even larger than Bear—was allowed to fail, market participants were shocked; suddenly, they were forced to consider the financial health of their counterparties, many of which appeared weakened by losses and the capital writedowns required by mark- to-market accounting. This caused a halt to lending and a hoarding of cash—a virtually unprecedented period of market paralysis and panic that we know as the financial crisis of 2008. Weren’t There Other Causes of the Financial Crisis? Many other causes of the financial crisis have been cited, including some in the report of the Commission’s majority, but for the reasons outlined below none of them alone—or all in combination—provides a plausible explanation of the crisis. Low interest rates and a flow of funds from abroad . Claims that various policies or phenomena—such as low interest rates in the early 2000s or financial flows from abroad—were responsible for the growth of the housing bubble, do not adequately explain either the bubble or the destruction that occurred when the bubble deflated. The U.S. has had housing bubbles in the past—most recently in the late 1970s and late 1980s—but when these bubbles deflated they did not cause a financial crisis. Similarly, other developed countries experienced housing bubbles in the 2000s, some even larger than the U.S. bubble, but when their bubbles deflated the housing losses were small. Only in the U.S. did the deflation of the most recent housing bubble cause a financial meltdown and a serious financial crisis. The reason for this is that only in the U.S. did subprime and other risky loans constitute half of all outstanding mortgages when the bubble deflated. It wasn’t the size of the bubble that was the key; it was its content. The 1997-2007 U.S. housing bubble was in a class by itself. Nevertheless, demand by investors for the high yields offered by subprime loans stimulated the growth of a market for securities backed by these loans. This was an important element in the financial crisis, although the number of mortgages in this market was considerably smaller than the number fostered directly by government policy. Without the huge number of defaults that arose out of U.S. housing policy, defaults among the mortgages in the private market would not have caused a financial crisis. Deregulation or lax regulation . Explanations that rely on lack of regulation or deregulation as a cause of the financial crisis are also deficient. First, no significant deregulation of financial institutions occurred in the last 30 years. The repeal of a portion of the Glass-Steagall Act, frequently cited as an example of deregulation, had no role in the financial crisis. 1 The repeal was accomplished through the Gramm-Leach-Bliley Act of 1999, which allowed banks to affi liate for the first time since the New Deal with firms engaged in underwriting or dealing in securities. There is no evidence, however, that any bank got into trouble because of a securities affi liate. The banks that suffered losses because they held low quality mortgages or MBS were engaged in activities—mortgage lending—always permitted by Glass- Steagall; the investment banks that got into trouble—Bear Stearns, Lehman and Merrill Lynch—were not affi liated with large banks, although they had small bank affi liates that do not appear to have played any role in mortgage lending or securities trading. Moreover, the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA) substantially increased the regulation of banks and savings and loan institutions (S&Ls) after the S&L debacle in the late 1980s and early 1990s, and it is noteworthy that FDICIA—the most stringent bank regulation since the adoption of deposit insurance—failed to prevent the financial crisis. CHRG-110hhrg46593--321 Mr. Royce," Thank you. Let me ask a question of our two economists here. Because one of the occurrences that we listen to over and over again in this committee is the Federal Reserve coming up here and also Treasury Secretaries saying that there was a systemic risk to the economy because of the leveraging that was occurring in the system. And, specifically, they were identifying the leveraging, which I guess got up to about 100 to 1 at a point, with the GSEs, with Fannie Mae and Freddie Mac doing what somebody described as arbitraging, but borrowing at one rate and then--I guess they borrowed about $1 billion and then went out into the market and had $1.5 billion in these mortgage-backed securities in the portfolios. And, as they described it, one of the consequences of this was that the financial system worldwide was relying heavily on the mortgage-backed securities and, I guess, also, the debt a lot of the banks were holding as part of their collateral, these instruments from Fannie and Freddie. So maybe one of the things we weren't thinking about at the time was that there was also all of this leveraging going on not just in the institutions themselves--maybe that got up to 100 to 1--but also, because it was collateral for loans, there was this additional leveraging that was leveraged into the system. And then, along the way, there was a little bit of nudging from Congress to Fannie and Freddie, in terms of the type of loans that they should be purchasing, the goals that they should have. And so, as a consequence, Alt-A loans, you know, and subprime loans, I mean, this was a place then that those who were writing those loans could get Fannie and Freddie to purchase them, as they got near the end of the year especially and needed to make that target. And so, as they ended up buying those back into their portfolio, and that being 10 percent of the portfolio, the argument that I have seen is that 50 percent of their losses at one point were these Alt-A loans and subprime loans that they had repurchased. And so one of the questions was: We have tried creating a charter, we have tried giving direction to a quasi-governmental entity or a private entity, however we want to define Fannie and Freddie, but might it be wiser, going forward, for us to just let market principles play out, rather than take a scheme like securitization through Fannie and Freddie and then disallow or prevent the regulator--in this case, OFHEO, because OFHEO testified here maybe a month ago or so, the Director of OFHEO. He said, if they had gotten the legislation that they wanted, which would have allowed them to regulate for systemic risk, they could have deleveraged the situation, forced more capital. And they felt that even as, you know, 16 months from today, if they could have gotten that authority, they could have deleveraged this problem and made it a lot less of a crisis for at least the GSEs. And that might have staved off--they said it would have staved off the GSE problem. Be that as it may--that is their opinion--I had carried legislation in 2005 that the Federal Reserve had asked for to try to give them the ability to regulate for systemic risk in this way. But that is the question I wanted to ask you gentlemen. Do you think, going forward, that perhaps we should back off of the portfolio arrangement there that we have, or the leveraging arrangement, and look at simply market principles maybe, in terms of the way that Fannie and Freddie would conduct itself in the future? Because I can see, going out 4 years, 5 years from now as we get this thing resolved, that same dynamic occurring again as long as we have that-- " CHRG-111hhrg56847--23 Mr. Ryan," Thank you, Chairman. It is good to have you back. Sovereign CDS spreads have driven back upwards in recent weeks. Some countries' bond yields, I think Spain and Italy, reached fresh highs this week. And the European funding markets are still pretty tight. In your opinion, is the ECB doing everything it needs to do from a policy action standpoint to stem this crisis? How do you gauge the risk of contagion with this crisis spilling over? And what is the endgame if conditions get worse? " CHRG-111shrg52619--164 PREPARED STATEMENT OF SENATOR JIM BUNNING Thank you, Mr. Chairman. This is a very important hearing, and I hope our witnesses will give us some useful answers. AIG has been in the news a lot this week, but it is not the only problem in our financial system. Other firms, including some regulated by our witnesses, have failed or been bailed out. We all want to make any changes we can that will prevent this from happening again. But before we jump to any conclusions about what needs to be done to prevent similar problems in the future, we need to consider whether any new regulations will really add to stability or just create a false sense of security. For example, I am not convinced that if the Fed had clear power to oversee all of AIG they would have noticed the problems or done anything about it. They clearly did not do a good enough job in regulating their holding companies, as we discussed at the Securities Subcommittee hearing yesterday. Their poor performance should throw cold water on the idea of giving them even more responsibility. Finally, I want to say a few words about the idea of a risk regulator. While the idea sounds good, there are several questions that must be answered to make such a plan work. First, we have to figure out what risk is and how to measure it. This crisis itself is evidence that measuring risk is not as easy as it sounds. Second, we need to consider what to do about that risk. In other words, what powers would that regulator have, and how do you deal with international companies? Third, how do we keep the regulator from always being a step behind the markets? Do we really believe the regulator will be able to recruit the talent needed to see and understand risk in an ever-changing financial system on government salaries? Finally, will the regulator continue the expectation of government rescue whenever things go bad? We should at least consider if we can accomplish the goal of a more stable system by making sure the parties to financial deals bear the consequences of their actions and thus act more responsibly in the first place. Thank you, Mr. Chairman. ______ FinancialCrisisInquiry--248 MOYNIHAN: Well, I think in terms of discussions, again, I wasn’t party to those discussions. But I think, as Mr. Blankfein said earlier, on the darkest days, all of us had to go to bed thinking if this thing doesn’t stop, what could happen. And we all have very concerned at that time. In terms of your view of what investors thought of our companies, I think if you look at spreads in our debt and from, say, August of ‘08 and into the first quarter of January 13, 2010 2009, you’ll see that they’ve widened out dramatically and, therefore, the investors would take a position that they were requiring a substantially different yield, multiples of the yield that they required prior to the time the crisis really hit in earnest. Many people got preferred stocks, and other things you’d see the same. The yields reached, in some cases, I know, at least as high as 30 percent. So I think the investors, actually, are pricing in a deep discount. What they individually did, you’d have to ask— you could get panels of investors to say, but during those tough times, I don’t think any of us in the industry didn’t think about the ramifications of what could happen if we could—if the liquidity and stuff was not at least restored in the system in some regard. CHRG-110shrg50418--286 Mr. Nardelli," Mr. Chairman, we have heard that idea and obviously we would be the last to turn down any offer of help. My concern, back to my testimony, was that before you could get the credit, you have to be able to buy the vehicle, and today, relative to the crisis, the liquidity crisis, the FICO scores that are necessary to qualify, my concern would be that it would--while it would be great if we can get consumers into cars, our biggest immediate challenge is to get our affiliate finance companies, whether they get bank holding company status---- " fcic_final_report_full--8 Many of these institutions grew aggressively through poorly executed acquisition and integration strategies that made effective management more challenging. The CEO of Citigroup told the Commission that a  billion position in highly rated mortgage securities would “not in any way have excited my attention,” and the co- head of Citigroup’s investment bank said he spent “a small fraction of ” of his time on those securities. In this instance, too big to fail meant too big to manage. Financial institutions and credit rating agencies embraced mathematical models as reliable predictors of risks, replacing judgment in too many instances. Too often, risk management became risk justification. Compensation systems—designed in an environment of cheap money, intense competition, and light regulation—too often rewarded the quick deal, the short-term gain—without proper consideration of long-term consequences. Often, those systems encouraged the big bet—where the payoff on the upside could be huge and the down- side limited. This was the case up and down the line—from the corporate boardroom to the mortgage broker on the street. Our examination revealed stunning instances of governance breakdowns and irre- sponsibility. You will read, among other things, about AIG senior management’s igno- rance of the terms and risks of the company’s  billion derivatives exposure to mortgage-related securities; Fannie Mae’s quest for bigger market share, profits, and bonuses, which led it to ramp up its exposure to risky loans and securities as the hous- ing market was peaking; and the costly surprise when Merrill Lynch’s top manage- ment realized that the company held  billion in “super-senior” and supposedly “super-safe” mortgage-related securities that resulted in billions of dollars in losses. • We conclude a combination of excessive borrowing, risky investments, and lack of transparency put the financial system on a collision course with crisis. Clearly, this vulnerability was related to failures of corporate governance and regulation, but it is significant enough by itself to warrant our attention here. In the years leading up to the crisis, too many financial institutions, as well as too many households, borrowed to the hilt, leaving them vulnerable to financial distress or ruin if the value of their investments declined even modestly. For example, as of , the five major investment banks—Bear Stearns, Goldman Sachs, Lehman Brothers, Merrill Lynch, and Morgan Stanley—were operating with extraordinarily thin capital. By one measure, their leverage ratios were as high as  to , meaning for every  in assets, there was only  in capital to cover losses. Less than a  drop in asset values could wipe out a firm. To make matters worse, much of their borrowing was short-term, in the overnight market—meaning the borrowing had to be renewed each and every day. For example, at the end of , Bear Stearns had . billion in equity and . billion in liabilities and was borrowing as much as  billion in the overnight market. It was the equivalent of a small business with , in equity borrowing . million, with , of that due each and every day. One can’t really ask “What were they thinking?” when it seems that too many of them were thinking alike. CHRG-111hhrg48674--346 Mr. Bernanke," I think that is a critical principle for the longer term, but we are in the middle right now of an extraordinary crisis. " CHRG-111hhrg56847--253 Mr. Bernanke," That is certainly true. But the financial crisis, I think, was a somewhat separate set of factors that hit the economy. " 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-111shrg57322--1096 Mr. Blankfein," There are disclosure materials, yes. Senator Pryor. OK. In the past 25 years, America has seen an increasing number and severity of financial crises. You have the savings and loan crisis, Enron, the dot-com bubble, the housing bubble. What steps will Wall Street take to assure that there is not another financial crisis? " 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. ______ 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-111hhrg54868--117 Mr. Dugan," We agree with that. And even though I would say that, in a crisis, it brings regulators more together to have to share than-- " fcic_final_report_full--11 Unfortunately—as has been the case in past speculative booms and busts—we witnessed an erosion of standards of responsibility and ethics that exacerbated the fi- nancial crisis. This was not universal, but these breaches stretched from the ground level to the corporate suites. They resulted not only in significant financial conse- quences but also in damage to the trust of investors, businesses, and the public in the financial system. For example, our examination found, according to one measure, that the percent- age of borrowers who defaulted on their mortgages within just a matter of months after taking a loan nearly doubled from the summer of  to late . This data indicates they likely took out mortgages that they never had the capacity or intention to pay. You will read about mortgage brokers who were paid “yield spread premiums” by lenders to put borrowers into higher-cost loans so they would get bigger fees, of- ten never disclosed to borrowers. The report catalogues the rising incidence of mort- gage fraud, which flourished in an environment of collapsing lending standards and lax regulation. The number of suspicious activity reports—reports of possible finan- cial crimes filed by depository banks and their affiliates—related to mortgage fraud grew -fold between  and  and then more than doubled again between  and . One study places the losses resulting from fraud on mortgage loans made between  and  at  billion. Lenders made loans that they knew borrowers could not afford and that could cause massive losses to investors in mortgage securities. As early as September , Countrywide executives recognized that many of the loans they were originating could result in “catastrophic consequences.” Less than a year later, they noted that certain high-risk loans they were making could result not only in foreclosures but also in “financial and reputational catastrophe” for the firm. But they did not stop. And the report documents that major financial institutions ineffectively sampled loans they were purchasing to package and sell to investors. They knew a significant percentage of the sampled loans did not meet their own underwriting standards or those of the originators. Nonetheless, they sold those securities to investors. The Commission’s review of many prospectuses provided to investors found that this crit- ical information was not disclosed. T HESE CONCLUSIONS must be viewed in the context of human nature and individual and societal responsibility. First, to pin this crisis on mortal flaws like greed and hubris would be simplistic. It was the failure to account for human weakness that is relevant to this crisis. CHRG-111hhrg52406--199 Mr. Hughes," Without disagreeing with your premise, I think your question is an interesting one. Again, if you go back to at least what we understood the Administration had in mind here, which was a focus on products, it was to say, if there are products that have harmed consumers as part of the crisis, if there are products that contributed to the crisis--worsened it, deepened it--then perhaps there is a way to get at that; but I think the people on this panel would be saying generally the products that we deal with do not fit that model. That is why, I think, as we look at the proposal on this agency that we do not think it is the right way to address insurance products. " 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. ______ fcic_final_report_full--47 Traditional and Shadow Banking Systems The funding available through the shadow banking system grew sharply in the 2000s, exceeding the traditional banking system in the years before the crisis. IN TRILLIONS OF DOLLARS $15 12 9 6 $13.0 Traditional Banking $8.5 Shadow Banking 3 0 1980 1985 1990 1995 2000 2005 2010 NOTE: Shadow banking funding includes commercial paper and other short-term borrowing (bankers acceptances), repo, net securities loaned, liabilities of asset-backed securities issuers, and money market mutual fund assets. SOURCE: Federal Reserve Flow of Funds Report Figure . Figure . shows that during the s the shadow banking system steadily gained ground on the traditional banking sector—and actually surpassed the bank- ing sector for a brief time after . Banks argued that their problems stemmed from the Glass-Steagall Act. Glass- Steagall strictly limited commercial banks’ participation in the securities markets, in part to end the practices of the s, when banks sold highly speculative securities to depositors. In , Congress also imposed new regulatory requirements on banks owned by holding companies, in order to prevent a holding company from endan- gering any of its deposit-taking banks. Bank supervisors monitored banks’ leverage—their assets relative to equity— because excessive leverage endangered a bank. Leverage, used by nearly every finan- cial institution, amplifies returns. For example, if an investor uses  of his own money to purchase a security that increases in value by , he earns . However, if he borrows another  and invests  times as much (,), the same  in- crease in value yields a profit of , double his out-of-pocket investment. If the investment sours, though, leverage magnifies the loss just as much. A decline of  costs the unleveraged investor , leaving him with , but wipes out the leveraged investor’s . An investor buying assets worth  times his capital has a leverage ratio of :, with the numbers representing the total money invested compared to the money the investor has committed to the deal. FinancialCrisisReport--47 H. Financial Crisis Timeline This Report reviews events from the period 2004 to 2008, in an effort to identify and explain four significant causes of the financial crisis. A variety of events could be identified as the start of the crisis. Candidates include the record number of home loan defaults that began in December 2006; the FDIC’s March 2007 cease and desist order against Fremont Investment & Loan which exposed the existence of unsafe and unsound subprime lending practices; or the collapse of the Bear Stearns hedge funds in June 2007. Still another candidate is the two-week period in September 2008, when half a dozen major U.S. financial institutions failed, were forcibly sold, or were bailed out by U.S. taxpayers seeking to prevent a collapse of the U.S. economy. This Report concludes, however, that the most immediate trigger to the financial crisis was the July 2007 decision by Moody’s and S&P to downgrade hundreds of RMBS and CDO securities. The firms took this action because, in the words of one S&P senior analyst, the investment grade ratings could not “hold.” By acknowledging that RMBS and CDO securities containing high risk, poor quality mortgages were not safe investments and were going to incur losses, the credit rating agencies admitted the emperor had no clothes. Investors stopped buying, the value of the RMBS and CDO securities fell, and financial institutions around the world were suddenly left with unmarketable securities whose value was plummeting. The financial crisis was on. CHRG-111hhrg54868--119 Mr. Dugan," I would say, first of all, we have to work together on a bunch of things because we have to put out common rules on things. And John Bowman and I are both on the FDIC Board. We vote on things like the assessment that we were talking about earlier. So we inevitably have a lot of interaction with each other, unlike some other regulatory agencies. And I think the caldron and the crucible of a crisis brings you even more together. But I think it is also true that this crisis has identified issues that need to be addressed through changes in the regulatory framework and structure, which I think we all support. " 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-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-111shrg55117--84 Mr. Bernanke," We are not aware of any such situation, but it is true, if there were something that was outside of our purview---- Senator Warner. Let me go back to something the Chairman raised, and Senator Schumer and Senator Martinez raised. I do fear that one of the casualties of this crisis may be small business lending, not just in the short term but over a longer period of time, and not just for particularly already performing firms, but I used to be in a startup business, and while I think venture and early stage capital will reemerge, interim financing, startup capital for smaller businesses. I would echo what Senator Schumer said. I would hope that we could see some actual numbers in terms of take-up rates of TALF for small business. I know the Treasury is taking some actions with SBA, although that has always had some mixed results. I just wonder from a general comment whether--I know you don't like to give policy advice, but as we think about trying to get the financial system back in place, obviously large cap financial markets has kind of reopened, but I could see the small business area being really stymied for a long, long time and the startup business also being stymied for a long time. Comments? Suggestions? " CHRG-109hhrg22160--16 Mr. Frank," I am struck by your last point, Mr. Chairman, because the President has been talking, I think, in exaggerated terms about a crisis in Social Security, and I haven't heard him talk about Medicare. And I welcome your assertion that the Medicare problem is, if I heard you correctly, several magnitudes greater. And it seems to me we are talking about an ideological agenda. When you put the Social Security issue up front and ignore the Medicare issue, I do not think you are simply following what economic necessity would dictate. On the question of capital formation, it is a question I would like to ask. We have this problem with the deficit. We have a problem of money being used up. One of the areas of federal spending growth that is obviously, perhaps, the fastest is in the military budget. Now, some of that is necessary, brought on us by outside enemies. I voted for the war in Afghanistan--not for the war in Iraq. But we have some problems here. On the other hand--and I cited my eagerness to support conservatives as we defend the administration's effort to dismantle the bloated agricultural system--I also look forward to working alongside intellectually honest fiscal conservatives in supporting proposals to de-fund Cold War weapons that no longer have a major justification. The administration is going to be proposing, I am told, the reduction. Now, I don't ask you to opine about whether or not the weapons are necessary, but I do solicit your opinion on the economic impact. To the extent that the Defense Department can identify expensive weapon systems that it believes are no longer of a high priority because they were originally designed with a different enemy in mind, a thermonuclear enemy, to the extent that we could reduce the spending there, what is the effect economically for the country? " 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-111shrg55278--93 PREPARED STATEMENT OF CHAIRMAN CHRISTOPHER J. DODD The economic crisis introduced a new term to our national vocabulary--systemic risk. It is the idea that in an interconnected global economy, it's easy for some people's problems to become everybody's problems. 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--their jobs, homes, retirement security, gone in a flash because of Wall Street greed and regulatory neglect. After years of focusing on short term profits while ignoring long term risks, a number of companies, giants of the financial industry found themselves in serious trouble. Some failed. Some were sold under duress. And an untold number only survived because of Government intervention: loans, guarantees, and direct injections of capital. Taxpayers had no choice but to step in, assuming billions of dollars of risk, and save companies because our system wasn't set up to withstand their failure. These efforts saved our economy from catastrophe, but real damage remains. Investors, who lost billions, were scared to invest. Credit markets dried up. With no one willing to make loans, businesses couldn't make payroll, employees were laid off, and families couldn't get mortgages or loans to buy an automobile. Wall Street's failures have hit Main Streets across the country. It will take years, perhaps decades, to undo damage that a stronger regulatory system could have prevented. While many Americans understand why we had to take extraordinary measures this time, it doesn't mean they aren't angry. It doesn't mean they aren't worried. And it doesn't mean they don't expect us to fix the problems that allowed this to happen. First and foremost, we need somebody 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 solely 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's a thoughtful proposal. But the devil is in the details and I expect changes to be made. I share my colleagues' concerns about giving the Fed additional authority to regulate systemic risk. The Fed hasn't done a perfect job 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 for any one regulator to oversee. And so, I am especially interested to hear from our witnesses your ideas on how we 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 rock, not on sand. Today, we continue our work to lay the cornerstones for that foundation--strong, smart, effective regulation that protects working families without hindering growth. ______ CHRG-111shrg57709--77 Mr. Volcker," Pardon me? Senator Corker. The last crisis. I know we spoke---- " FinancialCrisisInquiry--7 One contributing factor to the attractiveness of the housing market was public policy’s active support of the expansion of homeownership, recognizing the societal benefits. For our industry, it is important to reflect on some of the lessons learned and mistakes made over the course of the crisis. At the top of my list are the rationalizations that we made to justify that the downward pricing of risk was different. While we recognize that credit standards were loosening, we rationalized the reasons with arguments such as: the emerging markets were growing more rapidly, the risk mitigants were better, there was more than enough liquidity in the system. A systemic lack of skepticism was equally true with respect to credit ratings. Rather than undertake their own analysis, too many financial institutions relied on the rating agencies to do the central work of risk analysis. Another failure of risk management concerned the fact that risk models, particularly those predicated on historical data, were too often allowed to substitute for judgment. Next, size mattered. Whether you owned $5 billion or $50 billion of supposedly no-risk super-senior debt in a CDO, the likelihood of loss rate would appear to be the same. But the consequences of a miscalculation were obviously much bigger if you had a $50 billion exposure. Third, risk monitoring failed to capture the risk inherent in off-balance sheet activities such as structured investment vehicles, or SIVs. It seems clear now that financial institutions with large off-balance sheet exposure didn’t appreciate the full magnitude of the economic risks they were exposed to. Equally worrying, their counter parties were unaware of the full extent of those vehicles and therefore, could not accurately assess the risk of doing business. fcic_final_report_full--566 Fed could have granted up to three one-year extensions of that exemption. 15. FCIC staff computations based on data from the Center for Responsive Politics. “Financial sector” here includes insurance companies, commercial banks, securities and investment firms, finance and credit companies, accountants, savings and loan institutions, credit unions, and mortgage bankers and brokers. 16. U.S. Department of the Treasury, Modernizing the Financial System (February 1991); Fed Chair- man Alan Greenspan, “H.R. 10, the Financial Services Competitiveness Act of 1997,” testimony before the House Committee on Banking and Financial Services, 105th Cong., 1st sess., May 22, 1997. 17. Katrina Brooker, “Citi’s Creator, Alone with His Regrets,” New York Times, January 2, 2010. 18. John Reed, interview by FCIC, March 24, 2010. 19. FDIC Institution Directory; SNL Financial. 20. Fed Governor Laurence H. Meyer, “The Implications of Financial Modernization Legislation for Bank Supervision,” remarks at the Symposium on Financial Modernization Legislation, sponsored by Women in Housing and Finance, Washington, D.C., December 15, 1999. 21. Ben S. Bernanke, written testimony before the FCIC, Hearing on Too Big to Fail: Expectations and Impact of Extraordinary Government Intervention and the Role of Systemic Risk in the Financial Crisis, day 1, session 1: The Federal Reserve, September 2, 2010, p. 14. 22. Patricia A. McCoy et al., “Systemic Risk through Securitization: The Result of Deregulation and Regulatory Failure,” Connecticut Law Review 41 (2009): 1345–47, 1353–55. 23. Fed Chairman Alan Greenspan, “Lessons from the Global Crises,” remarks before the World Bank Group and the International Monetary Fund, Program of Seminars, Washington, DC, September 27, 1999. 24. David A. Marshall, “The Crisis of 1998 and the Role of the Central Bank,” Federal Reserve Bank of Chicago, Economic Perspectives (1Q 2001): 2. 25. Commercial and industrial loans at all commercial banks, monthly, seasonally adjusted, from the Federal Reserve Board of Governors H.8 release; FCIC staff calculation of average change in loans out- standing over any two consecutive months in 1997 and 1998. 26. Franklin R. Edwards, “Hedge Funds and the Collapse of Long-Term Capital Management,” Jour- nal of Economic Perspectives 13 (1999): 198. 563 27. “Hedge Funds, Leverage, and the Lessons of Long-Term Capital Management,” Report of the Pres- ident’s Working Group on Financial Markets, April 1999, p. 14. 28. Edwards, “Hedge Funds and the Collapse of Long-Term Capital Management,” pp. 200, 197; and CHRG-109hhrg22160--74 Mr. Kanjorski," And did you realize that when you were supporting the tax cuts of 2001, 2002 and 2003, that you were substantially reducing the revenues of the United States government in spite of the fact that you knew a major problem or crisis in Social Security exists, that a major problem or crisis in Medicare exists, and that a major problem in Medicaid exists, and you were supporting a policy to reduce the revenues of the United States. Is that correct? " CHRG-111shrg55278--11 EXCHANGE COMMISSION Ms. Schapiro. Thank you. Chairman Dodd, Ranking Member Shelby, and Members of the Committee, I am very pleased to be here today with my colleagues from the Fed and FDIC. There are many lessons to be learned from the recent financial crisis, and a key one is that we as regulators need to identify, monitor, and reduce systemic risk before they threaten the stability of the financial system. However, in our efforts to minimize the potential for institutional failures to threaten the system, we must take care not to unintentionally facilitate the growth of large, interconnected institutions whose failure might later pose even greater systemic risk. To best address these risks, I believe we must rely on two lines of defense. First, there is traditional oversight and regulation. This includes enhancing existing regulations, filling gaps, increasing transparency, and strengthening enforcement to prevent systemic risks from developing. And, second, we should establish a workable macroprudential regulatory framework and resolution regime that can identify, reduce, and unwind systemic risks if they do develop. Closing regulatory gaps is an important part of reducing systemic risk. If financial participants realize they can achieve the same economic ends with fewer costs by flocking to a regulatory gap, they will do so quickly, often with size and leverage. We have seen this time and again, most recently with over-the-counter derivatives, instruments through which major institutions engage in enormous, virtually unregulated trading in synthetic versions of other, often highly regulated financial products. We can do much to reduce systemic risk if we close these gaps and ensure that similar products are regulated similarly. In addition to filling gaps, we need to ensure greater transparency of risk. Transparency helps reduce systemic risk by enabling market participants to better allocate capital and giving regulators more information about risks that are building in the financial system. Transparency has been utterly lacking in the world of unregulated over-the-counter derivatives, hedge funds, and dark pools. Additionally, we need to recognize the importance that vigorous enforcement plays in sending a strong message to market participants. As a second line of defense, I believe there is a need to establish a framework for macroprudential oversight, a key element of the Administration's financial regulatory plan. Within that framework, I believe the most appropriate approach consists of a single systemic risk regulator and a very strong council. In terms of a systemic risk regulator, I agree there needs to be a governmental entity responsible for monitoring our financial markets for systemwide risks. This role could be performed by the Federal Reserve or by a new entity specifically designed for this task. The systemic risk regulator should have access to information across the financial markets about institutions that pose significant risk. And it should be able to monitor whether institutions are maintaining appropriate capital levels, and it should have clear delegated authority from the council to respond quickly in extraordinary circumstances. Most importantly, the systemic risk regulator should serve as a second set of eyes upon those institutions whose failure might put the system at risk. At the same time, I agree with the Administration that the systemic risk regulator must be combined with a newly created council, but I believe that any council must be strengthened well beyond the framework set forth in the Administration's white paper. The council should have authority to identify institutions, practices, and markets that create potential systemic risks and to set standards for liquidity, capital, and other risk management practices at systemically important institutions. This hybrid approach can help minimize systemic risk in a number of ways. First, a council would bring different perspectives to the identification of risks that individual regulators might miss or consider too small to warrant attention. Second, the members on the council would have experience regulating different types and sizes of institutions so that the council would be more likely to ensure that risk-based capital and leverage requirements do not unintentionally foster greater systemic risk. And, third, the council would include multiple agencies, thereby significantly reducing potential conflicts of interest and regulatory capture. Finally, the council would monitor the growth and development of financial institutions to prevent the creation of institutions that are either too-big-to-fail or too-big-to-succeed. At most times, I would expect the council and systemic risk regulator to work with and through primary regulators who are experts on the products and activities of their regulated entities. The systemic risk regulator, however, can provide a second layer of review over the activities, capital, and risk management procedures of systemically important institutions as a backstop to ensure that no red flags are missed. To ensure that authority is checked and decisions are not arbitrary, the council would remain the place where general policy is set, and if differences remain between the council and the primary regulator, the more stringent standards should apply. For example, on questions of capital, the new systemic risk framework should only be in a position to raise standards for regulatory capital for these institutions, not lower them. This will reduce the ability of any single regulator to compete with other regulators by lowering standards, driving a race to the bottom. And, finally, the Government needs a credible resolution mechanism for unwinding systemically important institutions. Currently, banks and broker-dealers are subject to resolution processes, but no corresponding resolution process exists for the holding companies of systemically significant financial institutions. I believe we have an opportunity to create a regulatory framework that will help prevent the type of systemic risk that created havoc in our financial system, and I believe we can create a credible regulatory regime that will help restore investor confidence. I look forward to working with you to address these issues and doing all we can to foster a safer, dynamic, and more nimble financial system. Thank you. " 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--562 Chapter 2 1. Ben Bernanke, written testimony before the FCIC, Hearing on Too Big to Fail: Expectations and Impact of Extraordinary Government Intervention and the Role of Systemic Risk in the Financial Crisis, day 1, session 1, September 2, 2010, p. 2. 2. Alan Greenspan, “The Evolution of Banking in a Market Economy,” remarks at the Annual Confer- ence of the Association of Private Enterprise Education, Arlington, Virginia, April 12, 1997. 3. Charles Calomiris and Gary Gorton, “The Origins of Banking Panics: Models, Facts, and Bank Regulation,” in Calomiris, U.S. Bank Deregulation in Historical Perspective (Cambridge: Cambridge Uni- versity Press, 2000), pp. 98–100. Prior to the end of the Civil War, banks issued notes instead of holding deposits. Runs on that system occurred in 1814, 1819, 1837, 1839, 1857, and 1861 (ibid., pp. 98–99). 4. R. Alton Gilbert, “Requiem for Regulation Q: What It Did and Why It Passed Away,” Federal Re- serve Bank of St. Louis Review 68, no. 2 (February 1986): 23. 5. FCIC, “Preliminary Staff Report: Shadow Banking and the Financial Crisis,” May 4, 2010, pp. 18– 25. 6. Arthur E. Wilmarth Jr., “The Transformation of the U.S. Financial Services Industry, 1975–2000: Competition, Consolidation, and Increased Risks,” University of Illinois Law Review (2002): 239–40. 7. Frederic S. Mishkin, “Asymmetric Information and Financial Crises: A Historical Perspective,” in Financial Markets and Financial Crises, ed. R. Glenn Hubbard (Chicago: University of Chicago Press, 1991), p. 99; Wilmarth, “The Transformation of the U.S. Financial Services Industry, 1975–2000,” p. 236. 8. Federal Reserve Board Flow of Funds Release, table L.208. Accessed December 29, 2010. 9. Kenneth Garbade, “The Evolution of Repo Contracting Conventions in the 1980s,” Federal Reserve Bank of New York Economic Policy Review 12, no. 1 (May 2006): 32–33, 38–39 (available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=918498). To implement monetary policy, the Fed- eral Reserve Bank of New York uses the repo market: it sets interest rates by borrowing Treasuries from and lending them to securities firms, many of which are units of commercial banks. 10. Alan Blinder, interview by FCIC, September 17, 2010. 11. Paul Volcker, interview by FCIC, October 11, 2010. 12. Fed Chairman Alan Greenspan, “International Financial Risk Management,” remarks before the Council on Foreign Relations, November 19, 2002. 13. Richard C. Breeden, interview by FCIC, October 14, 2010. 14. Wilmarth, “The Transformation of the U.S. Financial Services Industry, 1975–2000,” p. 241 and n. 102. 15. Thereafter, banks were only required to lend on collateral and set terms based upon what the mar- ket was offering. They also could not lend more than 10% of their capital to one subsidiary or more than 20% to all subsidiaries. Order Approving Applications to Engage in Limited Underwriting and Dealing in Certain Securities,” Federal Reserve Bulletin 73, no. 6 (Jul. 1987): 473–508; “Revenue Limit on Bank-Inel- igible Activities of Subsidiaries of Bank Holding Companies Engaged in Underwriting and Dealing in Se- curities,” Federal Register 61, no. 251 (Dec. 30, 1996), 68750–56. 16. Julie L. Williams and Mark P. Jacobsen, “The Business of Banking: Looking to the Future,” Busi- ness Lawyer 50 (May 1995): 798. 17. Fed Chairman Alan Greenspan, prepared testimony before the House Committee on Banking and Financial Services, H.R. 10, the Financial Services Competitiveness Act of 1997, 105th Cong., 1st sess., May 22, 1997. 18. FCIC staff calculations. 19. FCIC staff calculations. 20. FCIC staff calculations using First American/CoreLogic, National HPI Single-Family Combined (SFC). 21. This data series is relatively new. Those series available before 2009 showed no year-over-year na- tional house price decline. First American/CoreLogic, National HPI Single-Family Combined (SFC). 22. For a general overview of the banking and thrift crisis of the 1980s, see FDIC, History of the Eight- ies: Lessons for the Future, vol. 1, An Examination of the Banking Crises of the 1980s and Early 1990s (Washington, DC: Federal Deposit Insurance Corporation, 1997). 559 23. Specifically, between 1980 and 1994, 1,617 federally insured banks with $302.6 billion in assets and 1,295 savings and loans with $621 billion in assets either closed or received FDIC or FSLIC assis- tance. See Federal Deposit Insurance Corp., Managing the Crisis: The FDIC and RTC Experience, 1980– 1994 (Aug. 1998), pp. 4, 5. 24. William K. Black, Associate Professor of Economics and Law, University of Missouri–Kansas City, written testimony for the FCIC, Hearing on the Impact of the Financial Crisis, session 1: Overview of Mortgage Fraud, September 21, 2010, p. 4. And see Kitty Calavita, Henry N. Pontell, and Robert H. Till- man, Big Money Crime: Fraud and Politics in the Savings and Loan Crisis (Berkeley: University of Califor- nia Press, 1997), p. 28. 25. FDIC, History of the Eighties: Lessons for the Future, 1:39. 26. U.S. Treasury Department, “Modernizing the Financial System: Recommendations for Safer, More CHRG-111shrg52619--183 RESPONSE TO WRITTEN QUESTIONS OF SENATOR CRAPO FROM JOHN C. DUGANQ.1. The convergence of financial services providers and financial products has increased over the past decade. Financial products and companies may have insurance, banking, securities, and futures components. One example of this convergence is AIG. Is the creation of a systemic risk regulator the best method to fill in the gaps and weaknesses that AIG has exposed, or does Congress need to reevaluate the weaknesses of federal and state functional regulation for large, interconnected, and large firms like AIG?A.1. The financial crisis has highlighted significant regulatory gaps in the oversight of our financial system. Large nonbank financial institutions like AIG, Fannie Mae and Freddie Mac, Bear Steams, and Lehman were subject to varying degrees and different kinds of government oversight. No one regulator had access to risk information from these nonbank firms in the same way that the Federal Reserve has with respect to bank holding companies. The result was that the risk these firms presented to the financial system as a whole could not be managed or controlled before their problems reached crisis proportions. Assigning to one agency the oversight of systemic risk throughout the financial system could address certain of these regulatory gaps. For example, such an approach would fix accountability, centralize data collection, and facilitate a unified approach to identifying and addressing large risks across the system. However, a single systemic regulator approach also would face challenges due to the diverse nature of the firms that could be labeled systemically significant. Key issues would include the type of authority that should be provided to the regulator; the types of financial firms that should be subject to its jurisdiction; and the nature of the new regulator's interaction with existing prudential supervisors. It would be important, for example, for the systemic regulatory function to build on existing prudential supervisory schemes, adding a systemic point of view, rather than replacing or duplicating regulation and supervisory oversight that already exists. How this would be done would need to be evaluated in light of other restructuring goals, including providing clear expectations for financial institutions and clear responsibilities and accountability for regulators; avoiding new regulatory inefficiencies; and considering the consequences of an undue concentration of responsibilities in a single regulator. Moreover, the contours of new systemic authority may need to vary depending on the nature of the systemically significant entity. For example, prudential regulation of banks involves extensive requirements with respect to risk reporting, capital, activities limits, risk management, and enforcement. The systemic supervisor might not need to impose all such requirements on all types of systemically important firms. The ability to obtain risk information would be critical for all such firms, but it might not be necessary, for example, to impose the full array of prudential standards, such as capital requirements or activities limits on all types of systemically important firms, e.g., hedge funds (assuming they were subject to the new regulator's jurisdiction). Conversely, firms like banks that are already subject to extensive prudential supervision would not need the same level of oversight as firms that are not--and if the systemic overseer were the Federal Reserve Board, very little new authority would be required with respect to banking companies, given the Board's current authority over bank holding companies.Q.2. Recently there have been several proposals to consider for financial services conglomerates. One approach would be to move away from functional regulation to some type of single consolidated regulator like the Financial Services Authority model. Another approach is to follow the Group of 30 Report which attempts to modernize functional regulation and limit activities to address gaps and weaknesses. An in-between approach would be to move to an objectives-based regulation system suggested in the Treasury Blueprint. What are some of the pluses and minuses of these three approaches?A.2. A number of options for regulatory reform have been put forward, including those mentioned in this question. Each raises many detailed issues. The Treasury Blueprint offers a thoughtful approach to the realities of financial services regulation in the 21st century. In particular, the Blueprint's recommendation to establish a new federal charter for systemically significant payment and settlement systems and authorizing the Federal Reserve Board to supervise them is appropriate given the Board's extensive experience with payment system regulation. The Group of 30 Report compares and analyzes the financial regulatory approaches of seventeen jurisdictions--including the United Kingdom, the United States and Australia--in order to illustrate the implications of the four principal models of supervisory oversight. The Group of 30 Report then sets forth 18 proposals for banks and nonbanks. For all countries, the Report recommends that bank supervision be consolidated under one prudential regulator. Under the proposals, banks that are deemed systemically important would face restrictions on high-risk proprietary activities. The report also calls for raising the level at which banks are considered to be well-capitalized, Proposals for nonbanks include regulatory oversight and the production or regular reports on leverage and performance. For banks and nonbanks alike, the Report calls for a more refined analysis of liquidity in stressed markets and more robust contingency planning. The Financial Services Authority model is one in which all supervision is consolidated in one agency. As debate on these and other proposals continues, the OCC believes two fundamental points are essential. First, it is important to preserve the Federal Reserve Board's role as a holding company supervisor. Second, it is equally if not more important to preserve the role of a dedicated, front-line prudential supervisor for our nation's banks. The Financial Services Authority model raises the fundamental problem that consolidating all supervision in a new, single independent agency would take bank supervisory functions away from the Federal Reserve Board. As the central bank and closest agency we have to a systemic risk regulator, the Board needs the window it has into banking organizations that it derives from its role as bank holding company supervisor. Moreover, given its substantial role and direct experience with respect to capital markets, payments systems, the discount window, and international supervision, the Board provides unique resources and perspective to bank holding company supervision. Second, and perhaps more important, is preserving the very real benefit of having an agency whose sole mission is bank supervision. The benefits of dedicated supervision are significant. Where it occurs, there is no confusion about the supervisor's goals and objectives, and no potential conflict with competing objectives. Responsibility is well defined, and so is accountability. Supervision does not take a back seat to any other part of the organization, and the result is a strong culture that fosters the development of the type of seasoned supervisors that are needed to confront the many challenges arising from today's banking business.Q.3. If there are institutions that are too big to fail, how do we identify that? How do we define the circumstance where a single company is so systemically significant to the rest of our financial circumstances and our economy that we must not allow it to fail? We need to have a better idea of what this notion of too big to fail is--what it means in different aspects of our industry and what our proper response to it should be. How should the federal government approach large, multinational and systemically significant companies? What does ``fail'' mean? In the context of AIG, we are talking about whether we should have allowed an orderly Chapter 11 bankruptcy proceeding to proceed. Is that failure?A.3. There a number of ways ``too big to fail'' can be defined, including the size of an institution, assets under management, interrelationships or interconnections with other significant economic entities, or global reach. Likewise, ``failure'' could have several definitions, including bankruptcy. But whatever definition of these terms Congress may choose, it is important that there be an orderly process for resolving systemically significant firms. U.S. law has long provided a unique and well developed framework for resolving distressed and failing banks that is distinct from the federal bankruptcy regime. Since 1991, this unique framework, contained in the Federal Deposit Insurance Act, has also provided a mechanism to address the problems that can arise with the potential failure of a systemically significant bank--including, if necessary to protect financial stability, the ability to use the bank deposit insurance fund to prevent uninsured depositors, creditors, and other stakeholders of the bank from sustaining loss. No comparable framework exists for resolving most systemically significant financial firms that are not banks, including systemically significant holding companies of banks. Such firms must therefore use the normal bankruptcy process unless they can obtain some form of extraordinary government assistance to avoid the systemic risk that might ensue from failure or the lack of a timely and orderly resolution. While the bankruptcy process may be appropriate for resolution of certain types of firms, it may take too long to provide certainty in the resolution of a systemically significant firm, and it provides no source of funding for those situations where substantial resources are needed to accomplish an orderly solution. This gap needs to be addressed with an explicit statutory regime for facilitating the resolution of systemically important nonbank companies as well as banks. This new statutory regime should provide tools that are similar to those currently available for resolving banks, including the ability to require certain actions to stabilize a firm; access to a significant funding source if needed to facilitate orderly dispositions, such as a significant line of credit from the Treasury; the ability to wind down a firm if necessary; and the flexibility to guarantee liabilities and provide open institution assistance if needed to avoid serious risk to the financial system. In addition, there should be clear criteria for determining which institutions would be subject to this resolution regime, and how to handle the foreign operations of such institutions. ------ CHRG-111hhrg48868--578 Mr. Baca," You know, it is appalling to me that we are giving out these bonuses, and to the American people and the taxpayer--we have teachers right now across the Nation who are receiving pink slips, especially in the State of California. They are doing excellent jobs, and yet they are not getting bonuses. I wish we would have given those teachers bonuses, because they're getting the pink slips, and yet, these individuals out here, when you look at the crisis that we're in, they haven't gotten us out of the crisis, they received the bonuses. Isn't that a shame? " CHRG-110hhrg46596--429 Mr. Kashkari," Congressman, in the negotiations as we worked with the Congress to design the legislation, we worked very heard to build in flexibility because we knew the credit crisis is unpredictable. And so, as the crisis deteriorated in just the 2 weeks before when we first came to the Congress and when the Congress acted and then the 2 weeks that followed, we made rapid adjustments as facts changed on the ground. And the legislation provided us the flexibility that we needed to be nimble and adjust our strategy. " fcic_final_report_full--19 BEFORE OUR VERY EYES In examining the worst financial meltdown since the Great Depression, the Financial Crisis Inquiry Commission reviewed millions of pages of documents and questioned hundreds of individuals—financial executives, business leaders, policy makers, regu- lators, community leaders, people from all walks of life—to find out how and why it happened. In public hearings and interviews, many financial industry executives and top public officials testified that they had been blindsided by the crisis, describing it as a dramatic and mystifying turn of events. Even among those who worried that the housing bubble might burst, few—if any—foresaw the magnitude of the crisis that would ensue. Charles Prince, the former chairman and chief executive officer of Citigroup Inc., called the collapse in housing prices “wholly unanticipated.”  Warren Buffett, the chairman and chief executive officer of Berkshire Hathaway Inc., which until  was the largest single shareholder of Moody’s Corporation, told the Commission that “very, very few people could appreciate the bubble,” which he called a “mass delusion” shared by “ million Americans.”  Lloyd Blankfein, the chairman and chief executive officer of Goldman Sachs Group, Inc., likened the financial crisis to a hurricane.  Regulators echoed a similar refrain. Ben Bernanke, the chairman of the Federal Reserve Board since , told the Commission a “perfect storm” had occurred that regulators could not have anticipated; but when asked about whether the Fed’s lack of aggressiveness in regulating the mortgage market during the housing boom was a failure, Bernanke responded, “It was, indeed. I think it was the most severe failure of the Fed in this particular episode.”  Alan Greenspan, the Fed chairman during the two decades leading up to the crash, told the Commission that it was beyond the abil- ity of regulators to ever foresee such a sharp decline. “History tells us [regulators] cannot identify the timing of a crisis, or anticipate exactly where it will be located or how large the losses and spillovers will be.”  In fact, there were warning signs. In the decade preceding the collapse, there were many signs that house prices were inflated, that lending practices had spun out of control, that too many homeowners were taking on mortgages and debt they could ill afford, and that risks to the financial system were growing unchecked. Alarm bells  were clanging inside financial institutions, regulatory offices, consumer service or- ganizations, state law enforcement agencies, and corporations throughout America, as well as in neighborhoods across the country. Many knowledgeable executives saw trouble and managed to avoid the train wreck. While countless Americans joined in the financial euphoria that seized the nation, many others were shouting to govern- ment officials in Washington and within state legislatures, pointing to what would become a human disaster, not just an economic debacle. “Everybody in the whole world knew that the mortgage bubble was there,” said Richard Breeden, the former chairman of the Securities and Exchange Commission appointed by President George H. W. Bush. “I mean, it wasn’t hidden. . . . You cannot look at any of this and say that the regulators did their job. This was not some hidden problem. It wasn’t out on Mars or Pluto or somewhere. It was right here. . . . You can’t make trillions of dollars’ worth of mortgages and not have people notice.”  Paul McCulley, a managing director at PIMCO, one of the nation’s largest money management firms, told the Commission that he and his colleagues began to get wor- ried about “serious signs of bubbles” in ; they therefore sent out credit analysts to  cities to do what he called “old-fashioned shoe-leather research,” talking to real es- tate brokers, mortgage brokers, and local investors about the housing and mortgage markets. They witnessed what he called “the outright degradation of underwriting standards,” McCulley asserted, and they shared what they had learned when they got back home to the company’s Newport Beach, California, headquarters. “And when our group came back, they reported what they saw, and we adjusted our risk accord- ingly,” McCulley told the Commission. The company “severely limited” its participa- tion in risky mortgage securities.  CHRG-111hhrg74855--17 Mr. Stearns," Thank you very much, Mr. Chairman. I think the consensus on both sides is that FERC has done a good job of closely regulating and monitoring the regional transmission organizations and independent systems operator through the use of tariffs and audits and investigations and they should, I think the consensus is at least both parties here that they should remain the sole regulatory authority over such markets. However, obviously this bill acts in such a way to establish a new and I believe overly expansive definition of swap that would give the Commodity Futures Trading Commission this exclusive authority over a number of transactions that are already extensively regulated by FERC. Now, the regulation by FERC for 15 years here has been successful and, my colleagues, the products that they regulate did not contribute to the meltdown so it is not clear to me why we are moving forward on this. We all agree that transparency is important. Accountability and stability in the nation's financial market is important to minimize systematic risk and prevent another financial crisis but the organized power in the markets and the FERC regulatory system did not cause this meltdown. Any over-the-counter derivative legislation should address problems associated with unregulated financial derivatives and not inadvertently include FERC regulated markets that do not involve this type pf risk that this legislation is proposing. Continued unhindered operation of our energy markets are vital obviously to meeting our electricity needs of millions of Americans and obviously many of us don't see there is a need for a major shift in the oversight of these markets. So I think, Mr. Chairman, you and Mr. Waxman and Mr. Upton have all voiced this clearly and I think that it is very good that we have a hearing and confirm that we all believe. " 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--17 Mr. Skinner," Thank you very much, Chairman Kanjorski, Congressman Garrett, and honorable members of the subcommittee, for inviting me here today. I know this is a special occasion for me, if nothing else, for the fact that I have just been re-elected, but also to come here, to know that I am usually sitting on your side of this table, rather than here. But it is a great honor to be here, and I appreciate that. I am Peter Skinner. I have been a member of the European Parliament since 1994. And this month, yes, I was elected for my fourth term. I am a member of the economic and monetary affairs committee and directly involved in the--what's known as the transatlantic regulatory dialogue, a discussion between Congressman--Shelley Berkley, I believe, chairs this subcommittee with the European Parliament. So we talk regularly about issues like this. I was previously sponsor for the bill in the reinsurance directive in 2005, and Solvency II, which is now being passed as a law recently in the European Union, and will actually pass into the statute books of individual member countries by 2012. But each country is already moving towards that introduction. Let me say I fully understand and respect, from the start, the need for each trading block to establish its own sovereign rules and practices, and therefore, wish this committee every success in its deliberations. We have to take into account what I think we have already heard, however, that taking divergent approaches during a global recession, matched by the kinds of things that we know about across the Atlantic and around the globe, will actually lead to the wrong conclusions. We need to agree on common approaches, common regulatory structures. But this doesn't mean we have to say exactly the same thing. In terms of systemic risk and the insurance industry, it is the management of that risk that is important for the European Union. It is the chain of events which leads to systemic risks. And this begins with the failure of management and the supervision of such risks. The EU's focus has been to try to eliminate any failure by predicting behavior, using reasonable models, and testing against them. In fact, we have been having impact assessments which involve American companies inside the European Union giving evidence as to that effect. In Europe, a committee led by Jacques de Larosiere--you may have heard of him--a former managing director of the International Monetary Fund--has proposed sweeping changes to the way the European financial services are regulated. These changes would result in the creation of a European systemic risk council, an independent body responsible for safeguarding financial stability and conducting macro-prudential supervision at the European level. Europe gets its information on the insurance business from the 27 regulators it has representing all of the individual member states of the European Union, and these meet under one body: CEIOPS, it's called, the Committee of European Supervisors. It sits in Frankfurt, and agrees common standards which are applied, through the Solvency II law, across the European Union. In terms of that cross-border oversight, we have developed a system which is coming, again, from the de Larosiere report, which highlights the need for greater integrated supervision. The proposal is to bring together the work of the three committees in the capital markets and insurance and in banking through the supervision through one financial sector type of regulatory body. In terms of developments from abroad which may affect the U.S. market--and, again, I come from a European perspective; I can only talk really about how our markets are interconnected, and we have seen that the near-financial meltdown and has meant that, actually, when you get a cough or a cold in California, we feel the sneeze effect in London, in Frankfurt, and in Rome. Solvency II was set outside of this financial crisis, and was trying to look and predict what might go wrong already. It is a radical overhaul of the prudential regime for insurers in the European Union. The objectives of Solvency II are to deepen integration in the EU insurance market, enhance policyholder protection, and improve the international competitiveness of EU insurers and re-insurers. International communications amongst regulators can be difficult. And you know, in order to be able to get this move-in, we have to try and do something about this. It is difficult if we don't have a single regulatory person to speak to. In fact, the United States, I understand, is the only country around the world not represented by a single national insurance regulator at the International Association of Insurance Supervisors. And that's where it begins on third country equivalents in the context of Solvency II. We will be faced with the same question we always face: Who are we going to talk to? Who speaks for the United States, as a whole, on insurance? And I believe, for us, this is a question about how we move on. That is up to you. But our maintaining the standards and enforcing the rules at the European level, I can tell you that, along with the regulators, we have the European Commission, which ensures, at the administrative level, that the European directives are sensibly applied in each country. And as those laws are applied with American countries doing business in Europe and European countries doing business across the whole of the European Union, it allows for each country to do business, State by State, by member country by member country. On systemic risk and insurance, just a short comment, if I might. During the current crisis, the insurance companies that were most likely to be affected--and I have heard it already today--were those involved in significant quasi-banking activities. That's a fact. There are second order effects, as well. We are aware of that, and I think that we have to appreciate that. But they were not the directly involved facts which may lead to greater systemic risk. It is the failure to use appropriate controls and manage risk that we believe leads to the problem of systemic risk. On Europe's attitude to guaranty funds, burden sharing and compensation schemes are not necessarily practiced in every member state across the European Union, but we are now considering how to change that to introduce it. So, in conclusion, Mr. Chairman, if I can say that if there is anyone who has been close to this committee's work and what you are going to do, it is I. And I look forward in any way to help, to offer to help, to be a resource in any way from the European Union, and through our committee in the European Parliament, to offer fraternal greetings and respect to what you do here to come up with common approaches and common deliberations to face a global crisis. Thank you. [The prepared statement of Mr. Skinner can be found on page 131 of the appendix.] " CHRG-111shrg55479--137 EXHIBIT V Principles for Responding to the Financial Markets Crisis (2009)[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT] CHRG-111shrg51303--154 Mr. Kohn," Generally to creditworthy companies. We have, I would say, pushed the boundaries in dealing with this crisis. " CHRG-111hhrg53244--47 Mr. Watt," But it is clear that the Fed had not been real proactive in that area prior to this crisis. Is that right? " CHRG-109hhrg22160--64 Mr. Kanjorski," And did you see the crisis coming, or did you see the problem, or your fix not solving this problem? " CHRG-111hhrg54868--118 Mr. Cleaver," Yes, but the question, Mr. Dugan, is what brings them together, the crisis and the declaration that we should come together? " CHRG-110shrg50416--47 Mr. Kashkari," So the 125 seems like a lot for nine institutions, but those nine institutions have 50 percent of the deposits in the country. So it is the same proportion for the first nine and number 4,000. There is no preference, first of all. Second, again, this is a program, we want healthy institutions to use the capital. And we encourage the institutions to participate so that there would be no stigma. The healthy institutions who were in a strong position today can become even stronger and make even more loans. That is better for our system as a whole, Senator. Senator Shelby. But the Comptroller of the Currency, FDIC, the Federal Reserve--we have Governor Duke here--these are all regulators of the banking system. When one bank acquires another one, you have to get approval from the regulator. So you still have that whip in there to deal with any acquisition of any bank, either kind of suggested, forced, or voluntary, do you not? All of you. Is that fair, Chairman? Allowing firms to fail, Mr. Secretary, over the past year, Treasury, the Fed, and FDIC have devised a broad array of programs to help prevent the failure of various financial institutions, including banks, money market funds, broker-dealers, and insurance companies. To what extent have these programs propped up insolvent firms and prolonged the current economic crisis by delaying their inevitable failure? Because some firms are going to fail whatever you do to them. How long can we--the Government, the taxpayer--continue to prop up so many institutions? And at what point does it become more cost-effective to allow firms to fail? Chairman Bair, you have to do that from time to time, and you have. First, you. Ms. Bair. Well, we do, and it is always a difficult decision, and the primary federal regulator actually is one that makes the decision. We have back-up authority to close banks, but we almost always defer to the primary regulator. The primary regulator makes the decision. I think banks are a little different than other sectors of the financial services system. I think it needs to be repeated, reiterated that banks overall are very well capitalized. Yes, we have some banks with some challenges, but the vast majority are well capitalized. This is not a solvency crisis along the lines of what we saw during the S&L days. We are dealing with liquidity issues right now, and liquidity issues are harder. Sometimes the liquidity issue is the market signaling a longer-term capital solvency problem. But as the confidence problem has grown and grown, irrational fear has overtaken us somewhat. So we see institutions that otherwise are viable being threatened with closure because they cannot meet their obligations. So that is the balancing act we are trying to strike here. With the additional liquidity guarantees and the additional capital infusion, we are trying to keep banks, that are otherwise viable, healthy and lending and to prevent unnecessary closures because of liquidity drains for institutions that otherwise have plenty of capital. Senator Shelby. But there are still going to be plenty of failures out there---- Ms. Bair. There will be. Senator Shelby [continuing]. Whatever you do. Correct? Ms. Bair. And we agree with you, Senator. When it is there and it is clear, we want them closed early, because if we wait it will increase our resolution costs. We absolutely agree with that. Senator Shelby. Secretary Kashkari, as the Treasury moves assets from institutions by way of the TARP program, the participating institutions will have already taken out insurance on those assets in the form of credit default swaps. Will Treasury allow firms to retain the credit default swaps that they have used to hedge the securities that they sell to the Government? " CHRG-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-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-111shrg62643--186 PREPARED STATEMENT OF BEN S. BERNANKE Chairman, Board of Governors of the Federal Reserve System July 21, 2010 Chairman Dodd, Senator Shelby, and Members of the Committee, I am pleased to present the Federal Reserve's semiannual Monetary Policy Report to the Congress.Economic and Financial Developments The economic expansion that began in the middle of last year is proceeding at a moderate pace, supported by stimulative monetary and fiscal policies. Although fiscal policy and inventory restocking will likely be providing less impetus to the recovery than they have in recent quarters, rising demand from households and businesses should help sustain growth. In particular, real consumer spending appears to have expanded at about a 2\1/2\ percent annual rate in the first half of this year, with purchases of durable goods increasing especially rapidly. However, the housing market remains weak, with the overhang of vacant or foreclosed houses weighing on home prices and construction. An important drag on household spending is the slow recovery in the labor market and the attendant uncertainty about job prospects. After 2 years of job losses, private payrolls expanded at an average of about 100,000 per month during the first half of this year, a pace insufficient to reduce the unemployment rate materially. In all likelihood, a significant amount of time will be required to restore the nearly 8\1/2\ million jobs that were lost over 2008 and 2009. Moreover, nearly half of the unemployed have been out of work for longer than 6 months. Long-term unemployment not only imposes exceptional near-term hardships on workers and their families, it also erodes skills and may have long-lasting effects on workers' employment and earnings prospects. In the business sector, investment in equipment and software appears to have increased rapidly in the first half of the year, in part reflecting capital outlays that had been deferred during the downturn and the need of many businesses to replace aging equipment. In contrast, spending on nonresidential structures--weighed down by high vacancy rates and tight credit--has continued to contract, though some indicators suggest that the rate of decline may be slowing. Both U.S. exports and U.S. imports have been expanding, reflecting growth in the global economy and the recovery of world trade. Stronger exports have in turn helped foster growth in the U.S. manufacturing sector. Inflation has remained low. The price index for personal consumption expenditures appears to have risen at an annual rate of less than 1 percent in the first half of the year. Although overall inflation has fluctuated, partly reflecting changes in energy prices, by a number of measures underlying inflation has trended down over the past 2 years. The slack in labor and product markets has damped wage and price pressures, and rapid increases in productivity have further reduced producers' unit labor costs. My colleagues on the Federal Open Market Committee (FOMC) and I expect continued moderate growth, a gradual decline in the unemployment rate, and subdued inflation over the next several years. In conjunction with the June FOMC meeting, Board members and Reserve Bank presidents prepared forecasts of economic growth, unemployment, and inflation for the years 2010 through 2012 and over the longer run. The forecasts are qualitatively similar to those we released in February and May, although progress in reducing unemployment is now expected to be somewhat slower than we previously projected, and near-term inflation now looks likely to be a little lower. Most FOMC participants expect real GDP growth of 3 to 3\1/2\ percent in 2010, and roughly 3\1/2\ to 4\1/2\ percent in 2011 and 2012. The unemployment rate is expected to decline to between 7 and 7\1/2\ percent by the end of 2012. Most participants viewed uncertainty about the outlook for growth and unemployment as greater than normal, and the majority saw the risks to growth as weighted to the downside. Most participants projected that inflation will average only about 1 percent in 2010 and that it will remain low during 2011 and 2012, with the risks to the inflation outlook roughly balanced. One factor underlying the Committee's somewhat weaker outlook is that financial conditions--though much improved since the depth of the financial crisis--have become less supportive of economic growth in recent months. Notably, concerns about the ability of Greece and a number of other euro-area countries to manage their sizable budget deficits and high levels of public debt spurred a broad-based withdrawal from risk-taking in global financial markets in the spring, resulting in lower stock prices and wider risk spreads in the United States. In response to these fiscal pressures, European leaders put in place a number of strong measures, including an assistance package for Greece and =500 billion of funding to backstop the near-term financing needs of euro-area countries. To help ease strains in U.S. dollar funding markets, the Federal Reserve reestablished temporary dollar liquidity swap lines with the ECB and several other major central banks. To date, drawings under the swap lines have been limited, but we believe that the existence of these lines has increased confidence in dollar funding markets, helping to maintain credit availability in our own financial system. Like financial conditions generally, the state of the U.S. banking system has also improved significantly since the worst of the crisis. Loss rates on most types of loans seem to be peaking, and, in the aggregate, bank capital ratios have risen to new highs. However, many banks continue to have a large volume of troubled loans on their books, and bank lending standards remain tight. With credit demand weak and with banks writing down problem credits, bank loans outstanding have continued to contract. Small businesses, which depend importantly on bank credit, have been particularly hard hit. At the Federal Reserve, we have been working to facilitate the flow of funds to creditworthy small businesses. Along with the other supervisory agencies, we issued guidance to banks and examiners emphasizing that lenders should do all they can to meet the needs of creditworthy borrowers, including small businesses. \1\ We also have conducted extensive training programs for our bank examiners, with the message that lending to viable small businesses is good for the safety and soundness of our banking system as well as for our economy. We continue to seek feedback from both banks and potential borrowers about credit conditions. For example, over the past 6 months we have convened more than 40 meetings around the country of lenders, small business representatives, bank examiners, government officials, and other stakeholders to exchange ideas about the challenges faced by small businesses, particularly in obtaining credit. A capstone conference on addressing the credit needs of small businesses was held at the Board of Governors in Washington last week. \2\ This testimony includes an addendum that summarizes the findings of this effort and possible next steps.--------------------------------------------------------------------------- \1\ See Board of Governors of the Federal Reserve System, Federal Deposit Insurance Corporation, National Credit Union Administration, Office of the Comptroller of the Currency, Office of Thrift Supervision, and Conference of State Bank Supervisors (2010), ``Regulators Issue Statement on Lending to Creditworthy Small Businesses'', joint press release, February 5, www.federalreserve.gov/newsevents/press/bcreg/20100205a.htm. \2\ For more information, see Ben S. Bernanke (2010), ``Restoring the Flow of Credit to Small Businesses'', speech delivered at ``Addressing the Financing Needs of Small Businesses,'' a forum sponsored by the Federal Reserve Board, Washington, July 12, www.federalreserve.gov/newsevents/speech/bernanke20100712a.htm.---------------------------------------------------------------------------Federal Reserve Policy The Federal Reserve's response to the financial crisis and the recession has involved several components. First, in response to the periods of intense illiquidity and dysfunction in financial markets that characterized the crisis, the Federal Reserve undertook a range of measures and set up emergency programs designed to provide liquidity to financial institutions and markets in the form of fully secured, mostly short-term loans. Over time, these programs helped to stem the panic and to restore normal functioning in a number of key financial markets, supporting the flow of credit to the economy. As financial markets stabilized, the Federal Reserve shut down most of these programs during the first half of this year and took steps to normalize the terms on which it lends to depository institutions. The only such programs currently open to provide new liquidity are the recently reestablished dollar liquidity swap lines with major central banks that I noted earlier. Importantly, our broad-based programs achieved their intended purposes with no loss to taxpayers. All of the loans extended through the multiborrower facilities that have come due have been repaid in full, with interest. In addition, the Board does not expect the Federal Reserve to incur a net loss on any of the secured loans provided during the crisis to help prevent the disorderly failure of systemically significant financial institutions. A second major component of the Federal Reserve's response to the financial crisis and recession has involved both standard and less conventional forms of monetary policy. Over the course of the crisis, the FOMC aggressively reduced its target for the Federal funds rate to a range of 0 to \1/4\ percent, which has been maintained since the end of 2008. And, as indicated in the statement released after the June meeting, the FOMC continues to anticipate that economic conditions--including low rates of resource utilization, subdued inflation trends, and stable inflation expectations--are likely to warrant exceptionally low levels of the federal funds rate for an extended period. \3\--------------------------------------------------------------------------- \3\ See, Federal Reserve Board of Governors (2010), ``FOMC Statement'', press release, June 23, www.federalreserve.gov/newsevents/press/monetary/20100623a.htm.--------------------------------------------------------------------------- In addition to the very low Federal funds rate, the FOMC has provided monetary policy stimulus through large-scale purchases of longer-term Treasury debt, Federal agency debt, and agency mortgage-backed securities (MBS). A range of evidence suggests that these purchases helped improve conditions in mortgage markets and other private credit markets and put downward pressure on longer-term private borrowing rates and spreads. Compared with the period just before the financial crisis, the System's portfolio of domestic securities has increased from about $800 billion to $2 trillion and has shifted from consisting of 100 percent Treasury securities to having almost two-thirds of its investments in agency-related securities. In addition, the average maturity of the Treasury portfolio nearly doubled, from 3\1/2\ years to almost 7 years. The FOMC plans to return the System's portfolio to a more normal size and composition over the longer term, and the Committee has been discussing alternative approaches to accomplish that objective. One approach is for the Committee to adjust its reinvestment policy--that is, its policy for handling repayments of principal on the securities--to gradually normalize the portfolio over time. Currently, repayments of principal from agency debt and MBS are not being reinvested, allowing the holdings of those securities to run off as the repayments are received. By contrast, the proceeds from maturing Treasury securities are being reinvested in new issues of Treasury securities with similar maturities. At some point, the Committee may want to shift its reinvestment of the proceeds from maturing Treasury securities to shorter-term issues, so as to gradually reduce the average maturity of our Treasury holdings toward precrisis levels, while leaving the aggregate value of those holdings unchanged. At this juncture, however, no decision to change reinvestment policy has been made. A second way to normalize the size and composition of the Federal Reserve's securities portfolio would be to sell some holdings of agency debt and MBS. Selling agency securities, rather than simply letting them run off, would shrink the portfolio and return it to a composition of all Treasury securities more quickly. FOMC participants broadly agree that sales of agency-related securities should eventually be used as part of the strategy to normalize the portfolio. Such sales will be implemented in accordance with a framework communicated well in advance and will be conducted at a gradual pace. Because changes in the size and composition of the portfolio could affect financial conditions, however, any decisions regarding the commencement or pace of asset sales will be made in light of the Committee's evaluation of the outlook for employment and inflation. As I noted earlier, the FOMC continues to anticipate that economic conditions are likely to warrant exceptionally low levels of the Federal funds rate for an extended period. At some point, however, the Committee will need to begin to remove monetary policy accommodation to prevent the buildup of inflationary pressures. When that time comes, the Federal Reserve will act to increase short-term interest rates by raising the interest rate it pays on reserve balances that depository institutions hold at Federal Reserve Banks. To tighten the linkage between the interest rate paid on reserves and other short-term market interest rates, the Federal Reserve may also drain reserves from the banking system. Two tools for draining reserves from the system are being developed and tested and will be ready when needed. First, the Federal Reserve is putting in place the capacity to conduct large reverse repurchase agreements with an expanded set of counterparties. Second, the Federal Reserve has tested a term deposit facility, under which instruments similar to the certificates of deposit that banks offer their customers will be auctioned to depository institutions. Of course, even as the Federal Reserve continues prudent planning for the ultimate withdrawal of extraordinary monetary policy accommodation, we also recognize that the economic outlook remains unusually uncertain. We will continue to carefully assess ongoing financial and economic developments, and we remain prepared to take further policy actions as needed to foster a return to full utilization of our Nation's productive potential in a context of price stability.Financial Reform Legislation Last week, the Congress passed landmark legislation to reform the financial system and financial regulation, and the President signed the bill into law this morning. That legislation represents significant progress toward reducing the likelihood of future financial crises and strengthening the capacity of financial regulators to respond to risks that may emerge. Importantly, the legislation encourages an approach to supervision designed to foster the stability of the financial system as a whole as well as the safety and soundness of individual institutions. Within the Federal Reserve, we have already taken steps to strengthen our analysis and supervision of the financial system and systemically important financial firms in ways consistent with the new legislation. In particular, making full use of the Federal Reserve's broad expertise in economics, financial markets, payment systems, and bank supervision, we have significantly changed our supervisory framework to improve our consolidated supervision of large, complex bank holding companies, and we are enhancing the tools we use to monitor the financial sector and to identify potential systemic risks. In addition, the briefings prepared for meetings of the FOMC are now providing increased coverage and analysis of potential risks to the financial system, thus supporting the Federal Reserve's ability to make effective monetary policy and to enhance financial stability. Much work remains to be done, both to implement through regulation the extensive provisions of the new legislation and to develop the macroprudential approach called for by the Congress. However, I believe that the legislation, together with stronger regulatory standards for bank capital and liquidity now being developed, will place our financial system on a sounder foundation and minimize the risk of a repetition of the devastating events of the past 3 years. Thank you. I would be pleased to respond to your 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.] " 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. " fcic_final_report_full--118 As the United States ran a large current account deficit, flows into the country were unprecedented. Over six years from  to , U.S. Treasury debt held by foreign official public entities rose from . trillion to . trillion; as a percentage of U.S. debt held by the public, these holdings increased from . to .. For- eigners also bought securities backed by Fannie and Freddie, which, with their im- plicit government guarantee, seemed nearly as safe as Treasuries. As the Asian financial crisis ended in , foreign holdings of GSE securities held steady at the level of almost  years earlier, about  billion. By —just two years later— foreigners owned  billion in GSE securities; by ,  billion. “You had a huge inflow of liquidity. A very unique kind of situation where poor countries like China were shipping money to advanced countries because their financial systems were so weak that they [were] better off shipping [money] to countries like the United States rather than keeping it in their own countries,” former Fed governor Frederic Mishkin told the FCIC. “The system was awash with liquidity, which helped lower long-term interest rates.”  Foreign investors sought other high-grade debt almost as safe as Treasuries and GSE securities but with a slightly higher return. They found the triple-A assets pour- ing from the Wall Street mortgage securitization machine. As overseas demand drove up prices for securitized debt, it “created an irresistible profit opportunity for the U.S. financial system: to engineer ‘quasi’ safe debt instruments by bundling riskier assets and selling the senior tranches,” Pierre-Olivier Gourinchas, an economist at the Uni- versity of California, Berkeley, told the FCIC.  Paul Krugman, an economist at Princeton University, told the FCIC, “It’s hard to envisage us having had this crisis without considering international monetary capital movements. The U.S. housing bubble was financed by large capital inflows. So were Spanish and Irish and Baltic bubbles. It’s a combination of, in the narrow sense, of a less regulated financial system and a world that was increasingly wide open for big international capital movements.”  It was an ocean of money. MORTGAGES: “A GOOD LOAN ” The refinancing boom was over, but originators still needed mortgages to sell to the Street. They needed new products that, as prices kept rising, could make expensive homes more affordable to still-eager borrowers. The solution was riskier, more ag- gressive, mortgage products that brought higher yields for investors but correspond- ingly greater risks for borrowers. “Holding a subprime loan has become something of a high-stakes wager,” the Center for Responsible Lending warned in .  Subprime mortgages rose from  of mortgage originations in  to  in .  About  of subprime borrowers used hybrid adjustable-rate mortgages (ARMs) such as /s and /s—mortgages whose low “teaser” rate lasts for the first two or three years, and then adjusts periodically thereafter.  Prime borrowers also used more alternative mortgages. The dollar volume of Alt-A securitization rose almost  from  to .  In general, these loans made borrowers’ monthly mortgage payments on ever more expensive homes affordable—at least initially. Pop- ular Alt-A products included interest-only mortgages and payment-option ARMs. Option ARMs let borrowers pick their payment each month, including payments that actually increased the principal—any shortfall on the interest payment was added to the principal, something called negative amortization. If the balance got large enough, the loan would convert to a fixed-rate mortgage, increasing the monthly payment—perhaps dramatically. Option ARMs rose from  of mortgages in  to  in .  FinancialCrisisReport--4 In April 2010, the Subcommittee held four hearings examining four root causes of the financial crisis. Using case studies detailed in thousands of pages of documents released at the hearings, the Subcommittee presented and examined evidence showing how high risk lending by U.S. financial institutions; regulatory failures; inflated credit ratings; and high risk, poor quality financial products designed and sold by some investment banks, contributed to the financial crisis. This Report expands on those hearings and the case studies they featured. The case studies are Washington Mutual Bank, the largest bank failure in U.S. history; the federal Office of Thrift Supervision which oversaw Washington Mutual’s demise; Moody’s and Standard & Poor’s, the country’s two largest credit rating agencies; and Goldman Sachs and Deutsche Bank, two leaders in the design, marketing, and sale of mortgage related securities. This Report devotes a chapter to how each of the four causative factors, as illustrated by the case studies, fueled the 2008 financial crisis, providing findings of fact, analysis of the issues, and recommendations for next steps. B. Overview (1) High Risk Lending: Case Study of Washington Mutual Bank The first chapter focuses on how high risk mortgage lending contributed to the financial crisis, using as a case study Washington Mutual Bank (WaMu). At the time of its failure, WaMu was the nation’s largest thrift and sixth largest bank, with $300 billion in assets, $188 billion in deposits, 2,300 branches in 15 states, and over 43,000 employees. Beginning in 2004, it embarked upon a lending strategy to pursue higher profits by emphasizing high risk loans. By 2006, WaMu’s high risk loans began incurring high rates of delinquency and default, and in 2007, its mortgage backed securities began incurring ratings downgrades and losses. Also in 2007, the bank itself began incurring losses due to a portfolio that contained poor quality and fraudulent loans and securities. Its stock price dropped as shareholders lost confidence, and depositors began withdrawing funds, eventually causing a liquidity crisis at the bank. On September 25, 2008, WaMu was seized by its regulator, the Office of Thrift Supervision, placed in receivership with the Federal Deposit Insurance Corporation (FDIC), and sold to JPMorgan Chase for $1.9 billion. Had the sale not gone through, WaMu’s failure might have exhausted the entire $45 billion Deposit Insurance Fund. This case study focuses on how one bank’s search for increased growth and profit led to the origination and securitization of hundreds of billions of dollars in high risk, poor quality mortgages that ultimately plummeted in value, hurting investors, the bank, and the U.S. financial system. WaMu had held itself out as a prudent lender, but in reality, the bank turned increasingly to higher risk loans. Over a four-year period, those higher risk loans grew from 19% of WaMu’s loan originations in 2003, to 55% in 2006, while its lower risk, fixed rate loans fell from 64% to 25% of its originations. At the same time, WaMu increased its securitization of subprime loans sixfold, primarily through its subprime lender, Long Beach Mortgage Corporation, increasing such loans from nearly $4.5 billion in 2003, to $29 billion in 2006. From 2000 to 2007, WaMu and Long Beach together securitized at least $77 billion in subprime loans. 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.] " FOMC20081216meeting--530 528,CHAIRMAN BERNANKE.," You have to have a deep recession and a financial crisis. That's pretty unusual. Twice a century, or once a century so far. " 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-111shrg54533--33 Secretary Geithner," Our plan does not address a range of other causes of this crisis, including policies pursued around the world that helped produce a long period of very low interest rates and a very, very substantial boom in asset prices, housing prices, not just in this country but in countries around the world. And I think you are right to underscore the basic fact that a lot of things contributed to this crisis. It was not just failures in supervision and regulation. And as part of what the world does, major countries around the world, in trying to reduce the risk we have a crisis like this in the future, it will require thinking better through how to avoid the risk that monetary macroeconomic policies contribute to future booms and asset prices and credit bubbles of this magnitude. Senator Bunning. Your plan puts a lot of faith in the Federal Reserve's ability to spot risk and exercise its power to prevent the next crisis. However, if the Fed and other regulators have been doing their jobs and paying attention to what the banks and other firms were doing earlier this decade, they almost certainly could have prevented the mess. And the Fed has proven it is unwilling to use its power it has. Let me give you an example. Just look how slow it addressed the credit card abuses, and it took 14 years for the Fed to write one regulation on mortgages after we gave them the power to do that. So giving them the power and making them act are two different things. What makes you think that the Fed will do better this time around? " CHRG-111hhrg55814--384 The Chairman," The next witness is Jane D'Arista, from Americans for Financial Reform. STATEMENT OF JANE D'ARISTA, AMERICANS FOR FINANCIAL REFORM Ms. D'Arista. Thank you, Chairman Frank, Ranking Member Bachus, and members of the committee for inviting me. And I want to say that I'm representing a very large group of organizations that are consumer and non-financial or nonprofit and concerned with the issues of reform, not just consumer issues but the entire panoply. I would say that President Trumka has laid out many of our concerns about this draft legislation today. I'm going to take the opportunity, if I may, to go into something else, which is to say that obviously it is important that we begin by dealing with crisis management, as you have done in this legislation. But we must not forget that the important thing to do is not just manage these problems but to prevent them. And I find that the legislation so far comes up short in the preventive era. I would like to talk about two particular issues. One of them is what I see as an equally important underlying cause of the crisis, and that's the combination of excessive leverage, proprietary trading, and the new funding strategies that go into the repurchase agreements, markets and the commercial paper markets, etc., for financial institutions. We have here a situation in which leverage has, in effect, monetized debt, because assets are used as backing for new borrowing to add more assets. The evidence of this is that the financial sector has grown 50 percent in the decade from 1997 to 2007, rising to 114 percent of GDP. That is pretty shocking in and of itself. Proprietary trading is an issue that must be addressed, and it is of concern for a lot of different reasons, one of which of course is that it erodes the fiduciary responsibility of intermediaries. But equally important is the issue of the fact that what is at stake here is institutions trading for their own bottom line without any contribution to their customers or to the economy as a whole. What money goes in to the financial sector comes from our earnings and our savings, and they have skimmed it off to game it. It is our money that is at risk in this game. The funding strategies that have been used in order to support leverage and proprietary trading have been the major contribution, in my view, to the interconnectedness of the financial sector. These institutions are borrowing from one another, not from, primarily, from the outside non-financial sector, as a result of which over half of those positions are supplied by other financial institutions. This is the counterparty issue, this is what we were dealing with when we were dealing with Lehman, AIG, etc., and it is something that absolutely must be addressed. Finally, briefly, about securitization. Securitization has changed the structure of the U.S. financial system. We have gone from a bank-based system to a market-based system with new rules of the game. We have eroded the bank-based rules that shielded the consumer and the household in this country since the 1930's. These new rules expose households to interest rate risks, market rate risk, etc., but they do so to institutions as well because of the mark to market phenomena they require. You cannot have a market without marking it to market. But the chart drops against capital that we have seen here, and we have not fully evaluated, have turned capital of our financial institutions into a conduit to insolvency--not a cushion, but a conduit to insolvency. So what I think is that this committee has a very large plate to deal with going into the future as a preventive set of resolutions. I would urge you to do so not in the direction you're going now, which is to give discretion to too many institutions that we know--the Federal Reserve in particular--but to actually craft the rules of the game that need to be followed in the future. Thank you very much. [The prepared statement of Ms. D'Arista can be found on page 138 of the appendix.] " CHRG-111shrg57709--43 Mr. Volcker," Well, in following the development of the financial crisis, which was the mother of all financial crises, it was quite clear, particularly in the American perspective, that the financial crisis, the panic, the defaults, were proceeding through proprietary trading-oriented institutions, beginning with Bear Stearns and losses in hedge funds, and they were a trading institution. Lehman was very much a trading institution, Merrill Lynch, so forth. Some of them got saved by---- Senator Shelby. But none of these firms were banks, commercial banks, at that time, were they not? " CHRG-111hhrg67816--10 Mr. Waxman," Thank you very much, Mr. Chairman. I want to commend you for holding this hearing, and the fact that your subcommittee is taking a close look at consumer protection in the area of credit and debt. This committee has an important role in ensuring that consumers are protected from unfair, abusive, and deceptive practices throughout the marketplace, including the credit market, and I am pleased to join you in welcoming the chairman, the new chairman, of the Federal Trade Commission, Jon Leibowitz. Congratulations on your appointment. I look forward to working with you on this and other issues before our committee. The current financial crisis has brought to light a host of schemes that have hurt both individual consumers and the economy as a whole, mortgages have required no money down and no proof of income or assets, pay-day lenders who charge 500 percent interest for a short-term loan, companies that take money from individuals based on false offers or they offer to fix a credit report or save a home from foreclosure. These are schemes, and they are allowed to happen because of a fierce anti-regulatory ideology that was prevailing at least in the last 8 years. The philosophy was the government was the source of the problem, that it posed obstacles to success and that it should be slashed wherever feasible. This was the ideology that led to FEMA's failure during Hurricane Katrina, billons of dollars of contracting abuse at the Defense Department, and a food safety system that could not keep unsafe peanuts and spinach off the grocery shelves. The agencies of government responsible for protecting our financial system and Americans' hard-earned assets also suffered under this ideology. There was a feeling that government should step aside and markets should be allowed to work with little or no regulatory intervention. Now we have an opportunity to move beyond the flawed system of the previous 8 years and strengthen consumer protections across the financial system. Today's hearing focuses on the Federal Trade Commission which plays an essential role in overseeing consumer credit. An aggressive and rejuvenated FTC could prevent unfair and deceptive practices before they become commonplace, and it could use its enforcement authority to deter fraudulent schemes. I look forward to working with you, Mr. Chairman, and the members of this committee to making sure that the FTC has the authority, the resources, and the will to be an aggressive consumer protection agency. I yield back the balance of my time. " CHRG-110hhrg44901--21 Mr. Capuano," Chairman Bernanke, I have been listening to the GSE issue, and some people think this is nothing more than a crisis of confidence; maybe we should not do anything and let it wait. It amazes to me to hear this when I have an oil crisis, a food crisis, a Consumer Price Index going up through the roof, job losses all over the place, a trade deficit, a budget deficit going through the roof, corporate losses all across-the-board, and the stock market shaky every single day. I would argue very clearly that this is a little more than a crisis of confidence; I think we have a crisis of leadership. When I say that, I want to except you from that position. I say that because of the actions you have taken. They have been dramatic, bold, and courageous. That doesn't mean I agree with every little detail; I don't want to pretend that. But as far as I am concerned, you have been the leader in this Congress in proving that taking bold action, sometimes action that is a little bit on the edge, helps the economy. It is something that is necessary. I think you are following in the footsteps of some people who really saved this country from disaster in the 1930's. People tend to forget this. In the 1930's, there was no one action, no one silver bullet that pulled us out of the Depression. It was a series of actions, over a decade. Many of those actions were to correct prior actions that maybe they made a mistake on, maybe they acted too quickly and had to adjust it. I don't see that there is anything we can do, unless anyone has a single action that this Congress and this country should take. I think we need more action, and that includes Congress as well. I think we are going to try to do something in the next week or so. We need it from the regulators. I personally think we need more action from the SEC. I think we need faster action by everybody. I think we need more dramatic action by everybody. And I think we need more coordinated action by everybody. Right now, I think we have too many people running around on their own. All that being said, again, I want to thank you for what you have done thus far and to thank you for your bold and courageous moves, as I see it, most recently in the predatory lending area. I would just like to hear your opinion in general, not about the specific proposals we have. I guess I can't escape them right now when the GSE proposal is floating around in all its different iterations. In general, in the crisis that we are in, do you believe that government--that includes Congress, regulators, and everybody across-the-board--but that government should be acting relatively quickly, or do you think that we should simply sit back and say it is a confidence problem and people just need to get over it? Because, honestly, especially in the last day or so, I have been shocked at the number of people who have pretty much said that. I understand people differ as to what we should do. That is fair. That is what this is all about. But to imply or to state that no action is necessary, to me, is completely wrong, and I would just like to hear your opinion on that issue. " CHRG-111shrg55278--114 RESPONSES TO WRITTEN QUESTIONS OF SENATOR SHELBY FROM SHEILA C. BAIRQ.1. Too-Big-To-Fail--Chairman Bair, the Obama administration's proposal would have regulators designate certain firms as systemically important. These firms would be classified as Tier 1 Financial Holding Companies and would be subject to a separate regulatory regime. If some firms are designated as systemically important, would this signal to market participants that the Government will not allow these firms to fail? If so, how would this worsen our ``too-big-to-fail'' problem?A.1. We have concerns about formally designating certain institutions as a special class. Any recognition of an institution as systemically important risks invoking the moral hazard that accompanies institutions that are considered too-big-to-fail. That is why, most importantly, a robust resolution mechanism, in addition to enhanced supervision, is important for very large financial organizations. A vigorous systemic risk regulatory regime, along with resolution authority for bank holding companies and systemically risky financial firms would go far toward eliminating ``too-big-to-fail.''Q.2. Government Replacing Management?--In your testimony, while discussing the need for a systemic risk regulator to provide a resolution regime, you state that ``losses would be borne by the stockholders and bondholders of the holding company, and senior management would be replaced.'' Could you expand upon how the senior management would be replaced? Would the systemic risk regulator decide who needed to be replaced and who would replace them?A.2. When the FDIC takes over a large insured bank and establishes a bridge bank, the normal business practice is to replace certain top officials in the bank, usually the CEO, plus any other senior officials whose activities were tied to the cause of the bank failure. The resolution authority would decide who to replace based on why the firm failed.Q.3. ``Highly Credible Mechanism'' for Orderly Resolution--Chairman Bair, in your testimony you suggest that we must redesign our system to allow the market to determine winners and losers, ``and when firms--through their own mismanagement and excessive risk taking--are no longer viable, they should fail.'' You also suggest that the solution must involve a ``highly credible mechanism'' for orderly resolution of failed institutions similar to that which exists for FDIC-insured banks. Do you believe that our current bankruptcy system is inadequate, or do you believe that we must create a new resolution regime simply to fight the perception that we will not allow a systemically important institution to fail?A.3. In the United States, liquidation and rehabilitation of most failing corporations are governed by the Federal bankruptcy code and administered primarily in the Federal bankruptcy courts. Separate treatment, however, is afforded to banks, which are resolved under the Federal Deposit Insurance Act and administered by the FDIC. \1\ The justifications for this separate treatment are banks' importance to the aggregate economy, and the serious adverse effect of their insolvency on others.--------------------------------------------------------------------------- \1\ Another exception would be the liquidation or rehabilitation of insurance companies, which are handled under State law.--------------------------------------------------------------------------- Bankruptcy focuses on returning value to creditors and is not geared to protecting the stability of the financial system. When a firm is placed into bankruptcy, an automatic stay is placed on most creditor claims to allow management time to develop a reorganization plan. This can create liquidity problems for creditors--especially when a financial institution is involved--who must wait to receive their funds. Bankruptcy cannot prevent a meltdown of the financial system when a systemically important financial firm is troubled or failing. Financial firms--especially large and complex financial firms--are highly interconnected and operate through financial commitments. Most obtain a significant share of their funding from wholesale markets using short-term instruments. They provide key credit and liquidity intermediation functions. Like banks, financial firms (holding companies and their affiliates) can be vulnerable to ``runs'' if their short-term liabilities come due and cannot be rolled over. For these firms, bankruptcy can trigger a rush to the door, since counterparties to derivatives contracts--which are exempt from the automatic stay placed on other contracts--will exercise their rights to immediately terminate contracts, net out their exposures, and sell any supporting collateral. The statutory right to invoke close-out netting and settlement was intended to reduce the risks of market disruption. Because financial firms play a central role in the intermediation of credit and liquidity, tying up these functions in the bankruptcy process would be particularly destabilizing. However, during periods of economic instability this rush-to-the-door can overwhelm the market and even depress market prices for the underlying assets. This can further destabilize the markets and affect other financial firms as they are forced to adjust their balance sheets. By contrast, the powers that are available to the FDIC under its special resolution authority prevent the immediate close-out netting and settlement of financial contracts of an insured depository institution if the FDIC, within 24 hours after its appointment as receiver, decides to transfer the contracts to another bank or to an FDIC-operated bridge bank. As a result, the potential for instability or contagion caused by the immediate close-out netting and settlement of qualified financial contracts can be tempered by transferring them to a more stable counterparty or by having the bridge bank guarantee to continue to perform on the contracts. The FDIC's resolution powers clearly add stability in contrast to a bankruptcy proceeding. For any new resolution regime to be truly ``credible,'' it must provide for the orderly wind-down of large, systemically important financial firms in a manner that is clear, comprehensive, and capable of conclusion. Thus, it is not simply a matter of ``perception,'' although the new resolution regime must be recognized by firms, investors, creditors, and the public as a mechanism in which systemically important institutions will in fact fail.Q.4. Firms Subject to New Resolution Regime--Chairman Bair, in your testimony, you continuously refer to ``systemically significant entities,'' and you also advocate for much broader resolution authority. Could you indicate how a ``systemically significant entity'' would be defined? Will the list of systemically significant institutions change year-to-year? Do you envision it including nonfinancial companies such as GM? Would all financial and ``systemically significant entities'' be subject to this new resolution regime? If not, how would the market determine whether the company would be subject to a traditional bankruptcy or the new resolution regime? Why do we need a systemic risk regulator if we are going to allow institutions to become ``systemically important''?A.4. We would anticipate that the Systemic Risk Council, in conjunction with the Federal Reserve would develop definitions for systemic risk. Also, mergers, failures, and changing business models could change what firms would be considered systemically important from year-to-year. While not commenting on any specific company, nonfinancial firms that become major financial system participants should have their financial activities come under the same regulatory scrutiny as any other major financial system participant.Q.5. Better Deal for the Taxpayer--Chairman Bair, you advocate in your testimony for a new resolution mechanism designed to handle systemically significant institutions. Could you please cite specific examples of how this new resolution regime would have worked to achieve a better outcome for the taxpayer during this past crisis?A.5. A proposed new resolution regime modeled after the FDIC's existing authorities has a number of characteristics that would reduce the costs associated with the failure of a systemically significant institution. First and foremost, the existence of a transparent resolution scheme and processes will make clear to market participants that there will be an imposition of losses according to an established claims priority where stockholders and creditors, not the Government, are in the first loss position. This will provide a significant measure of cost savings by imposing market discipline on institutions so that they are less likely to get to the point where they would have otherwise been considered too-big-to-fail. Also, the proposed resolution regime would allow the continuation of any systemically significant operations, but only as a means to achieve a final resolution of the entity. A bridge mechanism, applicable to the parent company and all affiliated entities, would allow the Government to preserve systemically significant functions. Also, for institutions involved in derivatives contracts, the new resolution regime would provide an orderly unwinding of counterparty positions as compared to the rush to the door that can occur during a bankruptcy. In contrast, since counterparties to derivatives contracts are exempt from the automatic stay placed on other contracts under the Bankruptcy Code, they will exercise their rights to immediately terminate contracts, net out their exposures, and sell any supporting collateral, which serves to increase the loss to the failed institution. In addition, the proposed resolution regime enables losses to be imposed on market players who should appropriately bear the risk, including shareholders and unsecured debt investors. This creates a buffer that can reduce potential losses that could be borne by taxpayers. Further, when the institution and its assets are sold, this approach creates the possibility of multiple bidders for the financial organization and its assets, which can improve pricing and reduce losses to the receivership. The current financial crisis led to illiquidity and the potential insolvency of a number of systemically significant financial institutions during 2008. Where Government assistance was provided on an open-institution basis, the Government exposed itself to significant loss that would otherwise have been mitigated by these authorities proposed for the resolution of systemically significant institutions. A new resolution regime for firms such as Lehman or AIG would ensure that shareholders, management, and creditors take losses and would bar an open institution bail-out, as with AIG. The powers of a receiver for a financial firm would include the ability to require counterparties to perform under their contracts and the ability to repudiate or terminate contracts that impose continuing losses. It also would have the power to terminate employment contracts and eliminate many bonuses. ------ CHRG-110shrg50414--58 STATEMENT OF SENATOR JON TESTER Senator Tester. I do. Thank you, Mr. Chairman, and thank you for allowing me to just ask a few questions. Ten years ago, I got involved in politics because of electrical deregulation in the State of Montana. It was a total disaster. I have got plenty of questions to ask about the plan, and I will as they come forth. But I guess my concern is this: Six months ago, we heard about Bear Stearns, and then we have had Fannie and Freddie, and we have had some other ones come down the pike. A week ago, you came forth with a $700 billion bailout plan--$700 billion, and it was made clear that this was going to be--there was going to be nothing added on to it. Accountability, demand of re-regulation was not going to be accounted. And my question--and this is the concern I have. You guys are a lot smarter in financials than I am. I am a dirt farmer. You guys have been in the business, former Chairman of Goldman Sachs. Why do we have 1 week to determine $700 billion that has to be appropriated or this country's financial systems go down the pipes? Wasn't there some opportunity sometime down the line where we could have been informed of how serious this crisis was so we could take some preventative steps before this got to this point? That is it. Thank you, Mr. Chairman. " CHRG-111shrg54533--50 Secretary Geithner," That challenge is at the heart of bank regulation. With the establishment of deposit insurance, with access by banks to borrow from the Fed against collateral, you do create the risk. You do create a lower borrowing cost and you create the risk that there is an implicit support from the government coming in crisis. The only ways we know to counteract that risk are to make sure there is strong oversight, a consolidated basis, more conservative capital requirements, and better capacity to let institutions fail when they get themselves to the point where they have managed themselves to the point of vulnerability. I am not trying to oversimplify it, but if we don't get those two things right, nothing is possible and they will get us a substantial distance to the point where we are limiting the moral hazard created by the role they play in the system. Senator Martinez. On the GSEs' future, I just wanted to find out from you what your thoughts were in terms of when this consultation process might conclude and would the FHFA be involved in this process? I presume they would be. In other words, who will be the coordinating council or whatever this group is going to be called that is going to analyze and study and make recommendations on the GSEs and what opportunity will there be to comment, for people to participate, et cetera? " CHRG-111hhrg48874--86 Mr. Baca," Anybody else want to tackle this? Yes, we are at a crisis. Praise the Lord, we will say a prayer. " CHRG-110hhrg45625--4 Mr. Sherman," Mr. Chairman, thank you for your hard work in this time of crisis. Thank you for the opportunity. " CHRG-111hhrg56847--89 Mr. Bernanke," Well, I think they were stimulative to some extent. Remember, we had a recession in 2001, and we had some recovery from that. The meltdown we had was a financial crisis which was somewhat unrelated to some of these fiscal issues. " 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-111hhrg61852--12 The Chairman," We will reconvene. I am going to ask my questions, and then I have to go to another meeting. The gentleman from North Carolina will preside, the chair of the subcommittee. For all three of the witnesses, we have some agreement that the statistics show that things were on an upward path starting last year. I read from the Republican Budget Committee summary that said that after a long and deep recession, things began to get better in the second half of 2009, and that the credit markets and the financial institutions were getting more normal, that the economy was starting to get back. And then they said by the early part of 2010, by 2010, they said, most economists saw a modest recovery. And then they said, but a new crisis threatens that. So my question is, what could that new crisis be? It is probably my question to you, Mr. Meltzer. You talk about uncertainty, but I don't understand why there would be more uncertainty today than there was a year ago, 3 years ago, or 5 years ago. In fact, to some extent we have passed some legislation that may have diminished it. During the period of transition from Clinton to Bush or from Bush to Obama, there was clearly uncertainty about public policies. One Administration with a very different view replaces another, and that happens in a democracy. So I guess it is a combined question. What happened in April or May of this year? The Fed's estimate goes from more optimistic in April than it is today. The Republican Budget Committee comment that I talked about said things were going well in 2010, but now a new crisis threatens. What is the new crisis, and when did it arise? Mr. Meltzer, let me start with you and ask each of you to talk about it for a minute or so. " CHRG-110shrg50417--144 Mr. Eakes," No. 1, it limits the loans going backwards. I think it was January 1st, 2004 or 2003. So loans that were made after that date. In several of the versions, it limited it to existing loans, which means that you have an inherent sunset because those loans, as they get modified or go through payoff or refinance, there are a new loan. And then there was on top of that a sunset of--I can't remember exactly, but it was 2 or 3 years afterwards. So during the current crisis, it is as narrowly tailored as any piece of legislation could possibly be to this specific problem. Senator Crapo. All right. Thank you very much. In my questions this round, if I have time for it, I want to cover two issues: one, credit default swaps, which I think we can talk about very quickly; and then, second, as I indicated in my opening comments, regulatory reform. But particularly, again, for the banking witnesses, but for anybody who would like to, let me just say I strongly support the efforts of our financial institutions today and our regulators to strengthen the infrastructure for clearing and settling credit default swaps by creating a central clearing system. And recent events in the credit market I think have highlighted the need for greater attention to risk management practices and, in particular, counterparty risk. A number of private sector initiatives are being developed to diminish counterparty risks to credit default swaps by achieving multilateral netting of trades and by imposing more robust risk controls on market participants. I just want to ask a general question to those who are engaged and would like to respond to this as to how you feel progress is being made here, and when do you anticipate that we might have a central clearing system up and operating. Do you want to start out, Mr. Zubrow? " CHRG-111hhrg56766--10 The Chairman," I thank the gentleman from North Carolina. The gentleman from North Carolina will have 2 minutes and 10 seconds. The gentleman from Texas is now recognized, the ranking member of the Subcommittee on Domestic and International Monetary Policy, for 3 minutes. Dr. Paul. Thank you, Mr. Chairman. Welcome, Chairman Bernanke. I am interested in the suggestion that Mr. Volcker has made recently about curtailing some of the investment banking risk they are taking. In many ways, I think he brings up a very important subject and touches on it, but I think it is much bigger than what he has addressed. Back when we repealed Glass-Steagall, I voted against this, even though as a free market person, I endorse the concept that banks ought to be allowed to do commercial and investment banking. The real culprit, of course, is the insurance, the guarantee behind this, and the system of money that we have. In a free market, of course, the insurance would not be guaranteed by the taxpayers or by the Federal Reserve creating more money. The FDIC is an encouragement of moral hazard as well. I think the Congress contributes to this by pushing loans on individuals who do not qualify, and I think the Congress has some responsibility there, too. I also think there has been a moral hazard caused by the tradition of a line of credit to Fannie Mae and Freddie Mac and this expectation of artificially low interest rates helped form the housing bubble, but also the concept still persists, even though it has been talked about, that it is too-big-to-fail. It exists and nobody is going to walk away. There is always this guarantee that the government will be there along with the Federal Reserve, the Treasury, and the taxpayers to bail out anybody that looks like it is going to shake it up. It does not matter that the bad debt and the burden is dumped on the American taxpayer and on the value of the dollar, but it is still there. ``Too-big-to-fail'' creates a tremendous moral hazard. Of course, the real moral hazard over the many decades has been the deception put into the markets by the Federal Reserve creating artificially low interest rates, pretending there has been savings, pretending there is actually capital out there, and this is what causes the financial bubbles, and this is the moral hazard because people believe something that is not true, and it leads to the problems we have today because it is unsustainable. It works for a while, but eventually, we have to pay the price. The moral hazard catches up with us and then we see the disintegration of the system that we have artificially created. We are in a situation coming up soon, even though we have been already in a financial crisis, we are going to see this get much worse and we are going to have to address this subject of the monetary system and whether we want to have a system that does not guarantee that we will always bail out all the banks and dump these bad debts on the people, and that it is filled with moral hazard, the whole system is. When that time comes, I hope we come to our senses and decide that the free market works pretty well. It gets rid of these problems much sooner and much smoother than when it becomes politicized that some firms get bailed out and others get punished. It is an endless battle. Hopefully, we will see the light and do a better job in the future. " 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-111shrg53822--69 Mr. Baily," Thank you. First of all, I agree with you very much that we failed to address the risks and companies failed to manage their risks. One of the most interesting and revealing documents that I read in all of this was written by UBS, the Swiss Bank, at the insistence of the Swiss Central Bank, that described its own risk management procedures and how they had failed. And it is an extraordinary document of how they did not follow their own internal risk management. They jeopardized their own company. They subsequently had to be supported by the Swiss Central Bank, which in turn has had to rely, to some extent, on our federal reserve. It is an extraordinary story, which goes to the point that you mentioned. I agree with Peter, generally, in the remarks that he made, that we require these very large banks. When the crisis hit, for example, there was a huge collapse in global trade. Traders in India could not import and export because they had relied on financing coming through New York. So I agree with him very much that we need these large banks, particularly if they are growing and providing services to the U.S. and the global economy and are doing it efficiently. At the same time--and I think, again, we have some not complete agreement, but some broad agreement, that as banks become bigger or more interconnected--it is not always size, obviously--that we need special supervision, either increased cap requirements, increased supervision of their portfolios, or some mechanism to make sure that we do not get a repeat of what happened to UBS. Now, I do not think we are going to get that next year because I think a lot of people have learned their lesson. But we have to have in place a system that 10 years from now, 20 years from now, when some of these lessons have been forgotten, that we have in place a better regulatory regime. I would say one more thing about that regulatory regime. We cannot, probably in this country, ever pay regulators what people earn on Wall Street. Some countries pay their regulators very high salaries. There are limits to what we can do here. But I do think it would make a difference if we could pay reasonably competitive salaries, more than they are currently making. We should insist on training regulators so we give ourselves the best chance of avoiding some of the regulatory failures that happened in the course of this crisis. Thank you. Senator Akaka. Thank you very much, Mr. Baily. " Mr. Rajan," " CHRG-111shrg57709--122 Mr. Volcker," The Chairman made the point that I would emphasize, that the problem today is look ahead and try to anticipate the problems that may arise, that will give rise to the next crisis. And I tell you, sure as I am sitting here, that if banking institutions are protected by the taxpayer and they are given free rein to speculate, I may not live long enough to see the crisis, but my soul is going to come back and haunt you. Senator Johanns. That may be. There will be a lot of people. You would have to stand in line maybe. [Laughter.] " CHRG-111hhrg56847--182 Mr. Bernanke," I don't remember the exact number. But clearly, most of that deficit was the result of the recession and the financial crisis, which in late 2008, we already knew about it. " CHRG-111hhrg54867--7 Mr. Gutierrez," Mr. Secretary, first of all, thank you for appearing. Exactly 1 year ago, we experienced the most agonizing week of the current financial crisis. And this committee began to address the root causes of the social and economic trauma that crippled our economy and caused millions of Americans--and we should remember this--to lose trillions of dollars of their hard-earned wealth. Let me repeat that: Trillions of dollars of hard-earned wealth were lost by the American people. Not so much the guys on Wall Street, they lost, but the people on Main Street lost. Predatory mortgage lending, combined with risky investment practices and poor underwriting standards, financed by some of the largest financial institutions in this country, created the financial and economic debacle that we must now address. Over a decade ago, the Federal Reserve was given the power by this committee--I was here; I got elected in 1993--to stop predatory mortgage practices through the Homeowners' Equity Protection Act. It took the Federal Reserve 12 years to implement the rules and regulations that could have prevented many, if not all, of the worst abuses by predatory lenders and originators, abuses that were a direct and immediate cause of our current crisis. Why did it take so long? While there were many theories to explain this, I believe it took the Fed this ridiculously long time, including the FDIC, which did absolutely nothing either, because it was distracted by their other regulatory obligations and by a sense in Washington, D.C., of do less, do nothing, leave it alone, it is okay. The default of these toxic mortgages and the securitized products based on them caused trillions of dollars in losses and caused the 2008 freeze in credit markets, which nearly destroyed not only our financial system but the entire international financial system. The message to those of us who want to restore the stability to the financial system could be no clearer or louder. If we do not include a strong, effective Consumer Financial Protection Agency within our regulatory reform legislation, Congress will have failed to address the current and any future economic challenges facing our country. We must also address the economic threat inherent in institutions known as ``too-big-to-fail.'' I believe we must work to a comprehensive, risk-based pricing regime which eliminates the incentives for these financial firms to grow to the point of becoming ``too-big-to-fail.'' One of the ways we can prevent an institution from becoming ``too-big-to-fail'' is through a pricing regime which discourages banks from growing so large and interconnected. We must not only increase capital requirements, but we should also require decreased leverage ratios and increased contributions to the Deposit Insurance Fund. Let me ask that this be submitted for the record, my complete statement, because it is clear to me, Mr. Chairman, we are going to have, you know, our classical debate. Our colleagues on the other side have already thrown health care into this, big government. I hear ``socialism'' coming any second. They are going to say, ``No, no, no. Global warming doesn't exist, no. We don't need to do anything about global warming. We really don't need to do anything about this.'' We do need to do something, and Mr. Geithner knows it probably better than anybody else. We can never allow a Lehman Brothers again to have a 30:1 ratio. We can't allow that kind of leverage. And government is the only one that is going to stop it from happening again. Thank you very much, Mr. Chairman. " fcic_final_report_full--569 Chapter 5 1. Gail Burks, written testimony for the FCIC, Hearing on the Impact of the Financial Crisis—State of Nevada, session 3: The Impact of the Financial Crisis on Nevada Real Estate, September 8, 2010, p. 3. 2. Tom C. Putnam, president, Putnam Housing Finance Consulting, written testimony for the FCIC, Hearing on the Impact of the Financial Crisis—Sacramento, session 2: Mortgage Origination, Mortgage Fraud and Predatory Lending in the Sacramento Region, September 23, 2010, pp. 3–4. 3. Board of Governors of the Federal Reserve System, Federal Reserve Statistical Release Z.1: Flow of Funds Accounts of the United States, release date, December 9, 2010, Table L.1: Credit Market Debt Out- standing, and Table L.126: Issuers of Asset-Backed Securities (ABS) 4. Jim Callahan, interview by FCIC, October 18, 2010. 5. Lewis Ranieri, former vice chairman of Salomon Brothers, interview by FCIC, July 30, 2010. 6. Federal Deposit Insurance Corporation, “Managing the Crisis: The FDIC and RTC Experience” (August 1998), pp. 29, 6–7, 407–8, 38. 7. Ibid., 417. 8. Ibid., pp. 9, 32, 36, 48 9. The figures throughout this discussion of CMLTI 2006-NC2 are FCIC staff calculations, based on analysis of loan-level data from Blackbox Inc. and Standard & Poor’s; Moody’s PDS database; Moody’s CDO EMS database; and Citigroup, Fannie Mae Term Sheet, CMLTI 2006-NC2, September 7, 2006, pp. 1, 3. See also Brad S. Karp, counsel for Citigroup, letter to FCIC, November 4, 2010, p. 1, pp. 2–3. All rat- ings of its tranches are as given by Standard & Poor’s. 10. Technically, this deal had two unrated tranches below the equity tranche, also held by Citigroup and the hedge fund. 11. Fed Chairman Ben S. Bernanke, “The Community Reinvestment Act: Its Evolution and New Challenges,” speech at the Community Affairs Research Conference, Washington, D.C., March 30, 2007. 12. Ibid. 13. See Glenn Canner and Wayne Passmore, “The Community Reinvestment Act and the Profitability of Mortgage-Oriented Banks,” Working Paper, Federal Reserve Board, March 3, 1997. Under the Com- munity Reinvestment Act, low- and moderate-income borrowers have income that is at most 80% of area median income. 14. Fed Chairman Alan Greenspan, “Economic Development in Low- and Moderate-Income Com- munities,” speech at Community Forum on Community Reinvestment and Access to Credit: California’s Challenge, in Los Angeles, January 12, 1998. 15. John Dugan, interview by FCIC, March 12, 2010. 16. Lawrence B. Lindsey, interview by FCIC, September 20, 2010. 17. Souphala Chomsisengphet and Anthony Pennington-Cross, “The Evolution of the Subprime Mortgage Market,” Federal Reserve Bank of St. Louis Review 88, no. 1 (January/February 2006): 40 18. Southern Pacific Funding Corp, Form 8-K, September 14, 1998 19. The top 10 list is as of 1996, according to FCIC staff calculations using data from the following sources: Inside Mortgage Finance, The 2009 Mortgage Market Statistical Annual, vol. 1, The Primary Mar- ket (Bethesda, Md.: Inside Mortgage Finance Publications, 2009), p. 214, “Top 25 B&C Lenders in 1996”; Thomas E. Foley, “Alternative Financial Ratios for the Effects of Securitization: Tools for Analysis,” Moody’s Investor Services, September 19, 1997, p. 5; and Moody’s Investor Service, “Subprime Home Eq- uity Industry Outlook—The Party’s Over,” Moody’s Global Credit Research, October 1998. 20. “FDIC Announces Receivership of First National Bank of Keystone, Keystone, West Virginia,” Federal Deposit Insurance Corporation and Office of the Comptroller of the Currency joint press release, September 1, 1999. 21. FCIC staff calculations using data from Inside MBS & ABS . 22. See Marc Savitt, interview by FCIC, November 17, 2010. 23. Henry Cisneros, interview by FCIC, October 13, 2010. 24. Glenn Loney, interview by FCIC, April 1, 2010. 25. Senate Committee on Banking, Housing, and Urban Affairs, The Community Development, Credit Enhancement, and Regulatory Improvement Act of 1993, 103rd Cong., 1st sess., October 28, 1993, S. Rep. 103–169, p. 18. 26. Ibid., p. 19. 27. 15 U.S.C. § 1639(h) 2006. 28. Loans were subject to HOEPA only if they hit the interest rate trigger or fee trigger: i.e., if the an- nual percentage rate for the loan was more than 10 percentage points above the yield on Treasury securi- ties having a comparable maturity or if the total charges paid by the borrower at or before closing exceeded $400 or 8% of the loan amount, whichever was greater. See Senate Committee on Banking, Housing, and Urban Affairs, S. Rep. 103–169, p. 54. 29. Ibid., p. 24. 30. Board of Governors of the Federal Reserve System and Department of Housing and Urban Devel- opment, “Joint Report Concerning Reform to the Truth in Lending Act and the Real Estate Settlement Procedures Act” (July 1998), p. 56. 31. Griffith L. Garwood, director, Division of Consumer and Community Affairs, Board of Gover- nors of the Federal Reserve System, “To the Officers and Managers in Charge of Consumer Affairs Ex- amination and Consumer Complaint Programs,” Consumer Affairs Letter CA 98–1, January 20, 1998 32. GAO, “Large Bank Mergers: Fair Lending Review Could Be Enhanced with Better Coordination,” GAO/GGD-00–16 (Report to the Honorable Maxine Waters and the Honorable Bernard Sanders, House of Representatives), November 1999, p. 20. 33. Fed and HUD, “Joint Report,” pp. I–XXVII. 34. Griffith L. Garwood, director, Division of Consumer and Community Affairs, Board of Gover- nors of the Federal Reserve System, memorandum to the Committee on Consumer and Community Af- fairs, “Memorandum concerning the Board’s Report to the Congress on the Truth in Lending and Real Estate Settlement Procedures Acts,” April 8, 1998, p. 42. 35. Board of Governors of the Federal Reserve System, Federal Deposit Insurance Corporation, Office of the Comptroller of the Currency, and Office of Thrift Supervision, “Interagency Guidance on Sub- prime Lending” (March 1, 1999), p. 1 36. Ibid., pp. 1–7; quotation, p. 5. 37. U.S. Department of the Treasury and U.S. Department of Housing and Urban Development, “Curbing Predatory Home Lending” (June 1, 2000), pp. 13–14, 1–2, 81 (quotations, 2, 1–2). 38. Gail Burks, president and chief executive officer, Nevada Fair Housing Center, Inc., testimony be- fore the FCIC, Hearing on the Impact of the Financial Crisis—State of Nevada, session 3: The Impact of the Financial Crisis on Nevada Real Estate, September 8, 2010, transcript, p. 242–43.See also Kevin Stein, associate director, California Reinvestment Coalition, written testimony for the FCIC, Hearing on the Impact of the Financial Crisis—Sacramento, session 2: Mortgage Origination, Mortgage Fraud and Predatory Lending in the Sacramento Region, September 23, 2010, pp. 8–9. See also his testimony at the same hearing, transcript, pp. 73–74. See Diane E. Thompson, of counsel, National Consumer Law Cen- ter, Inc., and Margot F. Saunders, of counsel, National Consumer Law Center, Inc., interview by FCIC, September 10, 2010. 39. Diane E. Thompson and Margot F. Saunders, both of counsel, National Consumer Law Center, in- terview by FCIC, September 10, 2010. 40. Gary Gensler, interview by FCIC, May 14, 2010. 41. Sheila Bair, testimony before the FCIC, First Public Hearing of the FCIC, day 2, panel 1: Current Investigations into the Financial Crisis—Federal Officials, January 14, 2010, transcript, p. 97. 42. Sheila Bair, interview by FCIC, March 29, 2010. 43. Sandra F. Braunstein, interview by FCIC, April 1, 2010, pp. 31–34. 44. Bair, interview. 45. Treasury and HUD, “Curbing Predatory Home Lending,” p. 31. 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-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-111hhrg54867--271 Secretary Geithner," We can't take that risk. And I don't think that is a risk now we face. I mean, we have an independent Federal Reserve whose job is to make sure that we keep prices low and stable over time, growth sustainable. And they are committed to doing that. They have an exceptionally good record of doing that over time because they are independent. But, as a country, on the fiscal side, we are going to have to go back to living within our means to bring these deficits down. But our big risk still at the moment is that we make sure we have a recovery under way that is led by private demand. And we want that to be strong enough and sustainable before we step on the brakes. Again, you know, the big lesson of the United States in the 1930's and Japan in the 1990's, countries throughout history, was to move too quickly out of the hope it was all going to be okay, and put on the brakes in a way that deepened the recession, raised the ultimate costs of recovery. We need to make sure we avoid that risk. But you are absolutely right to emphasize the importance, and no one feels more strongly about it than I do, about the importance that we go back to living within our means and that we walk back these exceptional measures necessary to fix the crisis as quickly as possible. And if you look at what we have done, you are already seeing dramatic reduction in the amount of support the government is providing to the financial system as we, you know, see things starting to improve. " fcic_final_report_full--584 April 1, 2010. 144. Office of Thrift Supervision, letter to the SEC, February 11, 2004. 145. Lehman Brothers, Inc., letter to the SEC, March 8, 2004; J.P. Morgan Chase & Co., letter to the SEC, February 12, 2004; Deutsche Bank A.G. and Deutsche Bank Secs., letter to the SEC, February 18, 2004. 146. Harvey Goldschmid, interview by FCIC, April 8, 2010. 147. Closed meeting of the Securities and Exchange Commission, April 28, 2004. 148. In 2005, the Division of Market Regulation became the Division of Trading and Markets. For the sake of simplicity, throughout this report it is referred to as the Division of Market Regulation. 149. Erik Sirri, interview by FCIC, April 1, 2010. Although there are more than 1,000 SEC examiners, collectively they regulate more than 5,000 broker-dealers (with more than 750,000 registered representa- tives) as well as other market participants. 150. Michael Macchiaroli, interview by FCIC, March 18, 2010. 151. The monitors met with senior business and risk managers at each CSE firm every month about general concerns and risks the firms were seeing. Written reports of these meetings were given to the di- rector of market regulation every month. In addition, the CSE monitors met quarterly with the treasury and financial control functions of each CSE firm to discuss liquidity and funding issues. 152. Erik Sirri, written testimony for the FCIC, Hearing on the Shadow Banking System, day 1, ses- sion 3: SEC Regulation of Investment Banks, May 5, 2010. 153. Internal SEC memorandum, Re: “CSE Examination of Bear Stearns & Co. Inc.,” November 4, 2005. 154. Securities and Exchange Commission, Office of Inspector General, “SEC’s Oversight of Bear Stearns and Related Entities: The Consolidated Supervised Entity Program,” Report No. 446-A, Septem- ber 25, 2008, pp. 17–18. 155. Michael Macchiaroli, interview by FCIC, April 13, 2010. 156. Robert Seabolt, email to James Giles, Steven Spurry, and Matthew Eichner, October 1, 2007. 157. Matt Eichner, interview by FCIC, April 14, 2010; SEC, OIG, “SEC’s Oversight of Bear Stearns and Related Entities: The Consolidated Supervised Entity Program,” p. 109. 158. Goldschmid, interview. 159. GAO, “Financial Markets Regulation: Financial Crisis Highlights Need to Improve Oversight of Leverage at Financial Institutions,” GAO-09-739 (Report to Congressional Committees), July 2009, pp. 38–42. 160. Erik Sirri, “Securities Markets and Regulatory Reform,” remarks at the National Economists Club, Washington, D.C., April 9, 2009. 161. Harvey Goldschmid, interview, April 8, 2010. 162. “Chairman Cox Announces End of Consolidated Supervised Entities Program,” SEC press re- lease, September 26, 2008. 163. Mary Schapiro, testimony before the FCIC, First Public Hearing of the Financial Crisis Inquiry Commission, day 2, panel 1: Current Investigations into the Financial Crisis—Federal Officials, January 14, 2010, transcript, p. 39. 164. The Fed remained the supervisor of JP Morgan at the holding company level. 165. Mark Olson, interview by FCIC, October 4, 2010. 166. Federal Reserve System, “Financial Holding Company Project,” January 25, 2008, p. 3. Chapter 9 1. Warren Peterson, written testimony for the FCIC, Hearing on the Impact of the Financial Crisis— Greater Bakersfield, session 3: Residential and Community Real Estate, September 7, 2010, pp. 1, 3. 2. Gary Crabtree, principal owner, Affiliated Appraisers, written testimony for the FCIC, Hearing on the Impact of the Financial Crisis—Greater Bakersfield, session 4: Local Housing Market, September 7, 2010, p. 2. 581 3. Lloyd Plank, Lloyd E. Plank Real Estate Consultants, written testimony for the FCIC, Hearing on the Impact of the Financial Crisis—Greater Bakersfield, session 4: Local Housing Market, September 7, 2010, p. 2. 4. CoreLogic Single Family Combined (SFC) Home Price Index, data accessed August 2010. FCIC calculation of change from January 1997 to April 2006, peak. 5. Professor Robert Shiller, Historical Housing data.. 6. Final Report of Michael J. Missal, Bankruptcy Court Examiner, In RE: New Century TRS Holdings, Chapter 11, Case No. 07-10416 (KJC), (Bankr. D.Del), February 29, 2008, pp. 145, 138, 139–40 (hereafter Missal). 7. Ibid., p. 3. 8. Nomura Fixed Income Research, “Notes from Boca Raton: Coverage from Selected Sessions of ABS FinancialCrisisInquiry--510 WALLISON: If I told you it was half, would it have differed—would that have caused your view of what the problems might be to change the order of the various causes of the financial crisis that you describe? CHRG-110hhrg44900--184 Mr. Sherman," Well, now that there's not a crisis situation, wouldn't you want competitive bidding on such an important contract? " CHRG-111hhrg56776--281 Mr. Foster," Where are you on the debate over the extent to which monetary policy was responsible for the crisis we just went through versus regulatory failure? " FOMC20080318meeting--79 77,MR. FISHER., I believe that the efficacy of the cuts that we have undertaken has been diminished by virtue of the liquidity�solvency crisis. CHRG-111hhrg55814--64 Secretary Geithner," Then the only authority we would have is to manage their failure without causing the economy to go through what this economy went in this crisis. That's the basic-- " CHRG-111hhrg52400--26 Mr. Spence," Chairman Kanjorski, Ranking Member Garrett, and subcommittee members, thank you for the opportunity to testify today on systemic risk and insurance. My name is Ken Spence, and I am executive vice president and general counsel of Travelers. Travelers offers a wide variety of property casualty insurance products, and surety and risk management services to numerous businesses, organizations, and individuals in the United States and abroad. Our products are distributed primarily in the United States through independent insurance agents and brokers. And the company is a member of the American Insurance Association. There appears to be an emerging consensus that there should be systemic risk regulation at the Federal level. I will share some of Travelers's specific systemic risk regulation recommendations in a moment. However, for any systemic level oversight to be meaningful across financial service sectors, there must be an insurance regulatory presence at the Federal level, to ensure that appropriate information is provided and analyzed, and to ensure that any systemic-level directives are effectively implemented. To that end, the creation of an office of insurance information, as the chairman has proposed in his legislation, would bolster the Federal Government's presence in, and understanding of, the insurance sector. The OII would bring needed information about the insurance market place to Washington and to any national systemic regulator, and would give the United States a single voice with which to speak on international insurance policy and trade matters. We believe a comprehensive approach to Federal financial services modernization will not be complete unless it also includes a broader Federal insurance presence that encompasses Federal chartering for insurers. This will ensure robust and consistent regulatory oversight, strong consumer protections, and a healthy competitive insurance industry. We have been carefully considering the notion of systemic risk regulation. As an initial matter, we are mindful that the determination as to whether a company is systemically important does not necessarily depend upon its size or industry, but rather to the extent to which its financial condition is potentially so inter-related with other institutions that its failure could cause widespread and substantial economic harm, extending beyond those stakeholders who would assume the risk. For example, any unregulated holding company with a strong credit rating from its underlying operations could have underwritten credit default swaps which played an important role in the current financial crisis. In addition, we think it is also relevant to consider the systemic risk that may be presented on an aggregate industry-wide basis. For example, even if a particular community bank or insurance company would not present systemic risk, the widespread failure of community banks or insurance companies could. A natural or manmade catastrophic event or series of events, for example, could cause more than an isolated failure of property casualty insurance companies, which in turn, could be systemically significant. There are two elements in particular that we recommend for your consideration in a reform proposal: mandated internal enterprise risk oversight through board-level risk committees; and substantially enhanced disclosure requirements related to risk. I must emphasize at the outset that our two recommendations are not intended to be a comprehensive solution. But we believe that any such solution should include these two essential elements. First, corporate governance reform should require systemically important companies to assign responsibility for risk oversight to a committee of their board of directors with a management risk officer that reports directly to the board committee on a regular basis. Travelers has, for many years, had a board risk committee and a CRO, and the relationship is akin to a board audit committee relationship with the company's chief internal auditor, who often reports directly to that committee. A board's risk committee would be responsible for overseeing the company's risk-related controls and procedures, and the chief risk officer would be responsible for implementing and managing those controls and procedures. This protocol recognizes the importance of risk management, and provides clear responsibility and accountability for the management of risk. Second, systemically or potentially systemically important financial institutions should be subject to a robust disclosure regime in order to provide regulators, rating agencies, and the public with the information necessary to provide a comprehensive understanding of an institution's overall risk profile, and to be able to identify those institutions that pose--or that could pose--a systemic risk to the economy. Market forces would, in turn, help to limit a company's incentive to take risks that could potentially undermine its own long-term success, and, as a result, the larger economy. A more robust disclosure regime should be principles-based and flexible, but include additional quantitative disclosure of transactions and risks and other factors, including mandated stress testing that could cause a systemically important company to fail. Thank you for affording me the opportunity to testify today, and I will be happy to respond to any questions you may have. [The prepared statement of Mr. Spence can be found on page 137 of the appendix.] " CHRG-111shrg55278--21 Mr. Tarullo," Senator, as I said in my introductory comments, there are multiple ways to organize or to reorganize financial services regulation. Many times you have got competing ideas, each of which has merits and each of which has some demerits. With respect to the consumer protection issue, the Administration has made a proposal which I think a lot of people have some sympathy with because it focuses on consumer protection. We say we are going to give one agency the exclusive authority to regulate on consumer matters and thus they will be 100 percent devoted to doing that. My testimony is meant only to suggest that there are some things that would be lost by doing that as well as some things that would be gained, and what the Chairman, I think, was suggesting yesterday is that there is a synergy or interaction between prudential regulation and consumer protection regulation, at least if they are both being done well. That synergy is both in the substance of things--that is, having some sense of what makes an effective consumer protection regulation because you know the way in which the institutions operate--but also in the practical sense that as you have one corps of examiners, there is a certain economy of scope in having them looking at the multiple sets of issues within the same organization. So, I definitely think there are synergies. There are some benefits that go back and forth. If you take consumer protection away and put it in another agency, you probably lose some of those. I guess the Administration's position would be, yes, but you gain some things along the way. Senator Shelby. Chairman Bair, the Obama administration's proposal, as I understand it, would have regulators designate certain firms as systemically important. You alluded to that earlier. 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? And if so, how would this worsen our ``too-big-to-fail'' problem? Ms. Bair. We do have concerns about formally designating certain institutions as a special class. At the same time, we recognize there may be very large interconnected financial entities out there that are not yet subject to Federal consolidated supervision. I think almost all of them already are subject to Federal consolidated supervision as a result of the crisis. But, some type of formal designation, I think, you would need to think hard about for just the reasons you expressed. Any recognition of an institution as being systemic, though, should be a stigmatizing designation, not something that is favorable. This is why we do feel so strongly that a robust resolution mechanism--for very large financial organizations needs to be combined with any type of new supervisory entity or to even recognize whether some institutions may be systemic. Senator Shelby. Governor, I want to get back on the consumer protection. I have just got a second. There was testimony here last week on that, that this would change the whole model from a classical approach to consumer protection to a behavioral approach. Have you done some work in that area? Have you looked at that closely yet? " CHRG-111shrg57709--203 Mr. Volcker," There is another point here, if I may add to that answer. With the resolution authority, which you haven't brought up, what seems too big to fail today may not be too big to fail tomorrow because you have a better arrangement for putting that institution to sleep without disturbing the whole market. That is the whole purpose of this resolution authority, to handle big failures. Senator Menendez. Now, it seems to me that one of the--asking whether proprietary trading played a role in this crisis is missing the biggest lesson of this crisis, which is how do you avert the next one. And we know proprietary trading can be dangerous and contribute to the downfall of some investment banks. Mr. Chairman, you talked about not having taxpayer support for speculative activity. So it just seems to me that we should be attributing that to commercial banks, as well, so that we, at the end of the day, can ensure that customer deposits don't end up being part of the speculative nature that can create a crisis. So that is, in essence, what you are trying to do here. " CHRG-111shrg56376--65 Chairman Dodd," In fact, I would just say, John--and I will leave you more time--Senator Reed and Senator Bunning, in fact, are working on an idea that--in fact, a number of our colleagues here are working on various ideas to be part of the larger bill. The Subcommittee is working on it. Senator Tester. I think it is good. It is somewhat distressing that, quite frankly, from my perspective--and I am not an expert in this field at all--we have a lot of people who are trying to do good work; but there are still gaps, and obvious gaps. And then at the banking level, we have got a myriad of regulators out there. Quite frankly, if I was a banker, I would be going crazy. I would. I would not know--I really would not know which person to be--knowing who I have to deal with, let us just put it that way, because we are coming at it from a lot of different angles. Then, you know, if you take into consideration--I think, Sheila, you said this. Community banks were not really a problem here, but yet they are getting pressed just as hard as anybody, from my perspective, as far as regulation goes. And I just think that this is an opportune time in the middle of a potential--not a potential--in the middle of a crisis to really take a lot at our regulation system and say let us simplify it, let us make it lean and mean and simplified. And I do not think that can happen unless we are willing to think outside the box and do things differently than we have done in the past. Thank you all for being here. " CHRG-111shrg57709--76 Mr. Volcker," Now wait a minute. I do not know how far back in history you want to go. Senator Corker. I am talking about this last crisis. " fcic_final_report_full--451 What Caused the Financial Crisis? George Santayana is often quoted for the aphorism that “Those who cannot remember the past are condemned to repeat it.” Looking back on the financial crisis, we can see why the study of history is often so contentious and why revisionist histories are so easy to construct. There are always many factors that could have caused an historical event; the diffi cult task is to discern which, among a welter of possible causes, were the significant ones—the ones without which history would have been different. Using this standard, I believe that the sine qua non of the financial crisis was U.S. government housing policy, which led to the creation of 27 million subprime and other risky loans—half of all mortgages in the United States— which were ready to default as soon as the massive 1997-2007 housing bubble began to deflate. If the U.S. government had not chosen this policy path—fostering the growth of a bubble of unprecedented size and an equally unprecedented number of weak and high risk residential mortgages—the great financial crisis of 2008 would never have occurred. Initiated by Congress in 1992 and pressed by HUD in both the Clinton and George W. Bush Administrations, the U.S. government’s housing policy sought to increase home ownership in the United States through an intensive effort to reduce mortgage underwriting standards. In pursuit of this policy, HUD used (i) the affordable housing requirements imposed by Congress in 1992 on the government- sponsored enterprises (GSEs) Fannie Mae and Freddie Mac, (ii) its control over the policies of the Federal Housing Administration (FHA), and (iii) a “Best Practices Initiative” for subprime lenders and mortgage banks, to encourage greater subprime and other high risk lending. HUD’s key role in the growth of subprime and other high risk mortgage lending is covered in detail in Part III. Ultimately, all these entities, as well as insured banks covered by the CRA, were compelled to compete for mortgage borrowers who were at or below the median income in the areas in which they lived. This competition caused underwriting standards to decline, increased the numbers of weak and high risk loans far beyond what the market would produce without government influence, and contributed importantly to the growth of the 1997-2007 housing bubble. When the bubble began to deflate in mid-2007, the low quality and high risk loans engendered by government policies failed in unprecedented numbers. The effect of these defaults was exacerbated by the fact that few if any investors— including housing market analysts—understood at the time that Fannie Mae and Freddie Mac had been acquiring large numbers of subprime and other high risk loans in order to meet HUD’s affordable housing goals. Alarmed by the unexpected delinquencies and defaults that began to appear in mid-2007, investors fled the multi-trillion dollar market for mortgage-backed 445 securities (MBS), dropping MBS values—and especially those MBS backed by subprime and other risky loans—to fractions of their former prices. Mark-to- market accounting then required financial institutions to write down the value of their assets—reducing their capital positions and causing great investor and creditor unease. The mechanism by which the defaults and delinquencies on subprime and other high risk mortgages were transmitted to the financial system as a whole is covered in detail in Part II. fcic_final_report_full--173 As one recent study argues, many economists were “agnostics” on housing, un- willing to risk their reputations or spook markets by alleging a bubble without find- ing support in economic theory.  Fed Vice Chairman Donald Kohn was one. “Identification [of a bubble] is a tricky proposition because not all the fundamental factors driving asset prices are directly observable,” Kohn said in a  speech, cit- ing research by the European Central Bank. “For this reason, any judgment by a cen- tral bank that stocks or homes are overpriced is inherently highly uncertain.”  But not all economists hesitated to sound a louder alarm. “The situation is begin- ning to look like a credit-induced boom in housing that could very well result in a systemic bust if credit conditions or economic conditions should deteriorate,” Federal Deposit Insurance Corporation Chief Economist Richard Brown wrote in a March  report. “During the past five years, the average U.S. home has risen in value by , while homes in the fastest-growing markets have approximately doubled in value.” While this increase might have been explained by strong market fundamen- tals, “the dramatic broadening of the housing boom in  strongly suggests the in- fluence of systemic factors, including the low cost and wide availability of mortgage credit.”  A couple of months later, Fed economists in an internal memo acknowledged the possibility that housing prices were overvalued, but downplayed the potential im- pacts of a downturn. Even in the face of a large price decline, they argued, defaults would not be widespread, given the large equity that many borrowers still had in their homes. Structural changes in the mortgage market made a crisis less likely, and the financial system seemed well capitalized. “Even historically large declines in house prices would be small relative to the recent decline in household wealth owing to the stock market,” the economists concluded. “From a wealth-effects perspective, this seems unlikely to create substantial macroeconomic problems.”  CHRG-111hhrg53245--72 Mr. Zandi," I think that the reason why this financial crisis evolved into a financial panic last September--I think it was a manageable, albeit greater than garden variety crisis prior to September, it turned into a panic in September because policy makers, including the regulators, the Federal Reserve, the Administration, did not have a clear understanding of what their authority was and how they should use it. That begins with Fannie Mae and Freddie Mac in early September. That extends to Lehman Brothers. That extends to AIG. That extends to Citigroup. I think that goes to a key failing of the current regulatory structure. " FOMC20081029meeting--101 99,MR. LOCKHART.," You know, the atmosphere right now is largely precautionary on their part--they are well capitalized with foreign currency reserves. But if we want to deal with hypotheticals, let's assume that some of these recipients of the swap lines get into a liquidity crisis. Is the European Central Bank being approached for swap lines? I recognize that they need dollar liquidity, but in a general liquidity crisis, the euro would do as well to help. Do we have any sense of whether the ECB is considering swap lines for some of these emerging markets? " CHRG-111shrg54533--45 Secretary Geithner," Senator, let me just begin by saying you are right to underscore the risk we still face in the economy going forward. You know, what we have achieved is some stabilization. Output and demand are no longer falling at the same pace it was at the end of last year. That is an important beginning. But it is just a beginning. There are substantial risks ahead. And I think you are absolutely right that a critical part of getting a recovery in place is going to be to convince the American people and investors around the world that we are going to have the will, working with the Congress to bring those deficits down over time. But, remember, we started with deficits in the range of 10 percent of GDP when the administration came into office because of both the cost of the crisis and the impact of policies put in place the last 8 years, and the additions we have made--we have proposed with the Congress to get us out of recession were modest increments to those deficits, and we believe they were necessary to avoid the risk of a deeper recession, and even higher future deficits. But I understand those concerns, and we share those concerns. It will be absolutely critical to get our fiscal position down to a sustainable position once we get recovery back on track. In terms of the Fed, I think I just would say it this way: We are very committed and it is very important that we preserve the independence of the Fed and its basic credibility over its responsibilities for monetary policy. And we would not recommend proposals that would limit that flexibility or put that at risk in some sense because that is important to any effort to build a well-functioning economy in the future. If we lose that credibility, that would be very damaging. So I share that concern very much, and we have been very careful not to create risk. In fact, as I said, some of the proposals we are making to scale back and limit are designed to reduce the risk that in carrying out its core financial stability functions we do not put them in the position where it would risk greater tensions with that core mandate for price stability and sustainable growth in the future. You are right, and the council does try to strike a balance. The council does bring together at one place around one table with clear responsibility for looking at the system as a whole. Each of these underpinning parts of the system we are preserving do have responsibility because I think they could cause systemic damage. That is an important check and balance in some sense on the scope of independence, without confusing accountability. I think it does not change their statutory framework. It does not qualify their authority in that context, but it does provide the ability to recommend and induce changes if they are behind the curve or their big gaps are not closing. So we are trying to get that balance right. I agree some people will say it is too weak, but we do not believe we could give a council the authority and the accountability for doing core supervision, for example, of large institutions or for responding to crises given the speed with which they can evolve. Senator Johanns. Mr. Chairman, thank you very much, and, again, Mr. Secretary, thanks for giving us this starting point here. Senator Johnson. Senator Menendez. Senator Menendez. Thank you, Mr. Chairman. Mr. Secretary, thank you for your service and particularly at incredibly challenging times. You know, I have heard some of the criticisms already leveled, and while I do not agree with every element, I think it is a great foundation, actually. But I think it takes a pretty short memory to ignore what got us into this crisis and dismiss the need for accountability. That is basically like saying let us do this all over in 10 years again, and I do not think the American people want to go down that road. So I appreciate the effort here. You know, throughout these hearings, I have asked a fundamental question--at least for me it is a fundamental question. If we have institutions that are too big to fail, have we not failed already because they create systemic risk, and they also leave for potentially bad decisions along the way because they know that they will ultimately be bailed out? So I saw the road that you have traveled here in trying to, I think, deal with that question with reference to increased capital requirements, but is that really sufficient to get to the heart of that question? You know, I understand bringing up those capital requirements now, but how is it going to be a continuing function so that we ensure that if that is one of our major vehicles to avoid too big to fail, that it will be a constant movement that will ensure us that that is a break on that possibility? " 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-111shrg51290--24 Mr. Bartlett," We think that accounting standard should give the investors transparency and strength and we think that is not happening right now in the case of fair value accounting. So in some part, our call for the Fed to help is out of desperation because all of the Federal agencies at this point, individually and collectively, are telling us that it is somebody else's problem and yet it is that misapplication of fair value accounting that is a large source of the current liquidity crisis portion of the crisis. So perhaps my call for the Fed to do it is just simply knowing that somebody has to do it and so we are looking for help. Ms. Seidman. Can I respond briefly to that, too? " FinancialCrisisInquiry--118 To solve this OTC derivatives problem—I heard a few of the—of the potential solutions this morning. But I’ll go over the three that I think are absolutely mandatory to fix this problem. One is—is the key issue—is homogeneous minimum collateral requirements. All participants in the derivatives marketplace—do not bar the dealers from this— should be required to post initial capital based upon some formulaic determination of the risk by the appropriate regulatory body. Two, centralized clearing and mandatory price reporting of all standardized CDS, FX and interest rate derivatives—we believe close to 90 percent of these derivatives are standardized. Centralized data repository for all cleared and non-cleared derivatives trades—essentially there must be some place where every single transaction is recorded and monitored. As of today, that still doesn’t exist. It’s hard for me to believe that where we are today that that doesn’t exist. The second thing I’d like to talk about is bank leverage. And this is just the fundamental tenants of the U.S. banking system. Under current regulatory guidelines, banks are deemed to be well- capitalized with 6 percent tier one capital and adequately capitalized with 4 percent tier one capital based upon risk weighted assets. As an aside, the concept of risk weighting in assets should also be reviewed. This in turn means that a well-capitalized bank is leveraged 16 times to its capital, much more to its tangible common equity. And an adequately capitalized bank is—or a minimum capitalized bank—sorry—is 25 times levered to its tier one capital. I don’t know how many prudent individuals or institutions can possibly manage a portfolio of assets that is 25 times levered when we hit a crisis. But—but I surely can’t. Unfortunately, the answer so far has been not many of the other banks have been able to manage these risks either. Of the 170 banks that have failed during the crisis to date, the average loss to the FDIC and the taxpayer is well over 25 percent of their assets. When you think about that, that means they’ve lost more than six times their equity, of the banks that have gone down so far. fcic_final_report_full--184 CDOs were issued under a different regulatory framework from the one that ap- plied to many mortgage-backed securities, and were not subject even to the minimal shelf registration rules. Underwriters typically issued CDOs under the SEC’s Rule A, which allows the unregistered resale of certain securities to so-called qualified institutional buyers (QIBs); these included investors as diverse as insurance compa- nies like MetLife, pension funds like the California State Teachers’ Retirement Sys- tem, and investment banks like Goldman Sachs.  The SEC created Rule A in , making securities markets more attractive to borrowers and U.S. investment banks more competitive with their foreign counter- parts; at the time, market participants viewed U.S. disclosure requirements as more onerous than those in other countries. The new rule significantly expanded the mar- ket for these securities by declaring that distributions which complied with the rule would no longer be considered “public offerings” and therefore would not be subject to the SEC’s registration requirements. In , Congress reinforced this exemption with the National Securities Markets Improvements Act, legislation that Denise Voigt Crawford, a commissioner on the Texas Securities Board, characterized to the Com- mission “as prohibit[ing] the states from taking preventative actions in areas that we now know have been substantial contributing factors to the current crisis.”  Under this legislation, state securities regulators were preempted from overseeing private placements such as CDOs. In the absence of registration requirements, a new debt market developed quickly under Rule A. This market was liquid, since qualified investors could freely trade Rule A debt securities. But debt securities when Rule A was enacted were mostly corporate bonds, very different from the CDOs that dominated the private placement market more than a decade later.  After the crisis unfolded, investors, arguing that disclosure hadn’t been adequate, filed numerous lawsuits under federal and state securities laws. As we will see, some have already resulted in substantial settlements. REGULATORS: “MARKETS WILL ALWAYS SELF CORRECT ” Where were the regulators? Declining underwriting standards and new mortgage products had been on regulators’ radar screens in the years before the crisis, but dis- agreements among the agencies and their traditional preference for minimal interfer- ence delayed action. Supervisors had, since the s, followed a “risk-focused” approach that relied extensively on banks’ own internal risk management systems.  “As internal systems improve, the basic thrust of the examination process should shift from largely dupli- cating many activities already conducted within the bank to providing constructive feedback that the bank can use to enhance further the quality of its risk-management systems,” Chairman Greenspan had said in .  Across agencies, there was a “his- toric vision, historic approach, that a lighter hand at regulation was the appropriate way to regulate,” Eugene Ludwig, comptroller of the currency from  to , told the FCIC, referring to the Gramm-Leach-Bliley Act in .  The New York Fed, in a “lessons-learned” analysis after the crisis, pointed to the mistaken belief that “markets will always self-correct.” “A deference to the self-correcting property of markets inhib- ited supervisors from imposing prescriptive views on banks,” the report concluded.  The reliance on banks’ own risk management would extend to capital standards. Banks had complained for years that the original  Basel standards did not allow them sufficient latitude to base their capital on the riskiness of particular assets. After years of negotiations, international regulators, with strong support from the Fed, in- troduced the Basel II capital regime in June , which would allow banks to lower their capital charges if they could show they had sophisticated internal models for es- timating the riskiness of their assets. While no U.S. bank fully implemented the more sophisticated approaches that it allowed, Basel II reflected and reinforced the super- visors’ risk-focused approach. Spillenkothen said that one of the regulators’ biggest mistakes was their “acceptance of Basel II premises,” which he described as display- ing “an excessive faith in internal bank risk models, an infatuation with the specious accuracy of complex quantitative risk measurement techniques, and a willingness (at least in the early days of Basel II) to tolerate a reduction in regulatory capital in re- turn for the prospect of better risk management and greater risk-sensitivity.”  Regulators had been taking notice of the mortgage market for several years before the crisis. As early as , they recognized that mortgage products and borrowers had changed during and following the refinancing boom of the previous year, and they began work on providing guidance to banks and thrifts. But too little was done, and too late, because of interagency discord, industry pushback, and a widely held view that market participants had the situation well in hand. “Within the board, people understood that many of these loan types had gotten to an extreme,” Susan Bies, then a Fed governor and chair of the Federal Reserve Board’s subcommittees on both safety and soundness supervision and consumer protection supervision, told the FCIC. “So the main debate within the board was how tightly [should we] rein in the abuses that we were seeing. So it was more of ‘to a degree.’”  Indeed, in the same June  Federal Open Market Committee meeting de- scribed earlier, one FOMC member noted that “some of the newer, more intricate and untested credit default instruments had caused some market turmoil.” Another participant was concerned “that subprime lending was an accident waiting to hap- pen.” A third participant noted the risks in mortgage securities, the rapid growth of subprime lending, and the fact that many lenders had “inadequate information on borrowers,” adding, however, that record profits and high capital levels allayed those concerns. A fourth participant said that “we could be seeing the final gasps of house price appreciation.” The participant expressed concern about “creative financing” and was “worried that piggybacks and other non-traditional loans,” whose risk of default could be higher than suggested by the securities they backed, “could be making the books of GSEs look better than they really were.” Fed staff replied that the GSEs were not large purchasers of private label securities.  CHRG-111shrg62643--2 Chairman Dodd," The Committee will come to order. We are here today to hear from the Chairman of the Federal Reserve on the semiannual monetary policy report to the Congress, and, Mr. Chairman, we welcome you to our Committee once again. We thank you for your service to our country, and at least on my part, let me thank you and congratulate you for the tremendous work you and the staff of the Federal Reserve have been doing through these very difficult days in our country, and we are very fortunate to have you, in my view, as the Chair. I want to make some brief opening comments, and then I will turn to Senator Shelby for any opening comments he may have, and I will leave it up to the members themselves--we do not have a full complement here, but there are several who would like to be heard briefly before we turn to you for your thoughts, and then the questions we will have for you this afternoon. Let me express my gratitude to the Chairman and the other Members of the Committee. Normally, we would have had this Committee hearing in the morning, and because of the bill-signing ceremony this morning, we delayed it until this afternoon. So I appreciate you being able to accommodate us. We are pleased to welcome you again, Mr. Chairman, to the Committee. Today he will deliver his semiannual monetary policy report, as I have said, to the Congress. The timing of this testimony could not be better, in our view. Key questions about both financial regulation and our current economic policy will be answered in the coming months. The Federal Reserve will play a key role in answering both of those series of questions. Today the President, as many know, signed into law the Wall Street reform bill. This bill, in my view, is a comprehensive response to our financial crisis that devastated our economy. The bill demands that regulators change the oversight of the financial markets and financial institutions in very fundamental ways. It sets up a Financial Stability Oversight Council which will function as an early warning system, we hope, be responsible for spotting and addressing threats to the overall financial stability of our country and institutions and even in other nations around the world. It creates a new orderly liquidation authority to provide for the wind-down of large financial institutions whose failure threatens overall financial stability. Further, it makes the markets for financial derivatives much more transparent. It requires regulators to establish capital standards and margin requirements for large derivative dealers. That will reduce the risk, we believe, posed by these financial instruments. Further, it limits the ability of banks and their owners to engage in risky trading strategies or to invest in hedge funds or private equity funds. Further, it requires higher prudential standards, including capital and liquidity for large bank holding companies and nonbank financial firms that have the potential to put the financial system at risk. The bill establishes for the first time a Consumer Financial Protection Bureau with a mandate to focus exclusively on protecting consumers from financial abuses and ensuring that consumers get the financial information that they need in a form that they can understand. But while the bill gives regulators substantial new authority, it does not contain the specific regulations that will translate authority into action. Congress is not in the position to write them. It is above the capacity of this institution to do that. Those rules and regulations require expert knowledge, and they must adapt over time to changing circumstances. Congress must rely on regulatory agencies to implement the goals of this reform bill. However, it is the role of Congress to oversee the actions of our regulators, and given the importance of getting financial reform right, it is a role that should be pursued with great vigor, attention, and diligence in the coming months and years. The Federal Reserve is one of the institutions on which Congress will rely most heavily. The additional authority it has been given is remarkable in this bill. The Federal Reserve will be a member of the Oversight Council, and the insights of its supervisors and researchers will play an important part in identifying developing risks to the financial system. It will be the Fed's job to set the heightened prudential standards for the Nation's large banks and nonbank financial companies designated by the Oversight Council. The Fed will help to decide when a failing financial firm needs to be put into the new resolution process, and the Fed will have the responsibility to oversee important financial utilities, including, for example, the clearinghouses that will become increasingly central in derivatives markets. As you are aware, Mr. Chairman, I have been critical of the Fed's past performance and, in fact, advocated striking the Fed's supervisory role. While the Fed managed the financial crisis superbly, in my view, it did less well in the run-up to the crisis. It failed to use the authority in HOEPA to prevent the serious deterioration in mortgage underwriting standards and abusive and fraudulent mortgage lending practices that, in my view, fueled the financial crisis we have been going through. It also failed, in my view, to adequately supervise some of our largest bank holding companies. These holding companies were allowed to accumulate significant exposures to mortgage-related assets. The losses they suffered when the house price bubble burst helped to produce the financial crisis from which we have not yet fully recovered. However, as the financial reform bill worked its way through the legislative process, the Congress in its wisdom decided not only to preserve the Fed's existing supervisory power but to bolster it. Indeed, Mr. Chairman, you sought those additional powers, and as a result, the Fed is central to maintaining our financial stability. I think it is fair to say that the success of the financial reform law depends in large measure on how the Federal Reserve meets its new responsibilities. It is my fervent hope that under your stewardship the Fed will exercise these authorities wisely. Of course, the financial reform law left the Fed's responsibilities for monetary policy unchanged, and this gives the Fed even more crucial work to do. The devastation brought by the financial crisis is still with us, and while output has begun to grow, it is not growing rapidly enough to replace the millions of jobs lost during this crisis. In the first quarter of this year, GDP grew at an unimpressive 2.7 percent. The unemployment rate in June was still at 9.5 percent, and nearly 7 million workers have been unemployed for 27 weeks or more. As you have acknowledged in previous testimony, Mr. Chairman, the effects of long-term unemployment, which destroys job skills and demoralizes those who suffer from it, has the potential to create serious long-term problems in our Nation. And although firms with access to credit markets are able to borrow at relatively low interest rates, the businesses and households that depend upon banks for credit continue to find difficulty in accessing credit. Apart from inventories, investment demand remains anemic, and real fixed investment declined in the first quarter of this year. In this less than robust environment, it is not surprising that price inflation is hardly an issue. Over the past year, the CPI has increased by only 1.1 percent, and core CPI has increased by only 0.9 percent. In short, it looks like our economy is in need of additional help. It is evident that the Fed takes this issue seriously, and I applaud you for that. The Federal funds rate is now near zero, and the banks are now sitting on extraordinary quantities of excessive reserves. But one of the issues I would like to explore with you today is whether the Fed can do more to help expand output and employment in our Nation. Now I would like to turn to my good friend and colleague, the former Chairman of the Committee, Senator Shelby, for any opening comments he may have. fcic_final_report_full--467 Association (MBA). 25 This data allows a comparison between the foreclosure starts that have thus far come out of the 1997-2007 bubble and the foreclosure starts in the two most recent housing bubbles (1977-1979 and 1985-1989) shown in Figure 1. After the housing bubble that ended in 1979, when almost all mortgages were prime loans of the traditional type, foreclosure starts in the ensuing downturn reached a high point of only .87 percent in 1983. After the next bubble, which ended in 1989 and in which a high proportion of the loans were the traditional type, foreclosure starts reached a high of 1.32 percent in 1994. However, after the collapse of the 1997-2007 bubble—in which half of all mortgages were NTMs—foreclosure starts reached the unprecedented level (thus far) of 5.3 percent in 2009. And this was true despite numerous government and bank efforts to prevent or delay foreclosures. All the foregoing data is significant for a proper analysis of the role of government policy and NTMs in the financial crisis. What it suggests is that whatever effect low interest rates or money flows from abroad might have had in creating the great U.S. housing bubble, the deflation of that bubble need not have been destructive. It wasn’t just the size of the bubble; it was also the content. The enormous delinquency rates in the U.S. (see Table 3 below) were not replicated elsewhere, primarily because other developed countries did not have the numbers of NTMs that were present in the U.S. financial system when the bubble deflated. As shown in later sections of this dissent, these mortgage defaults were translated into huge housing price declines and from there—through the PMBS they were holding—into actual or apparent financial weakness in the banks and other firms that held these securities. Accordingly, if the 1997-2007 housing bubble had not been seeded with an unprecedented number of NTMs, it is likely that the financial crisis would never have occurred. 3. Delinquency Rates on Nontraditional Mortgages NTMs are non-traditional because, for many years before the government adopted affordable housing policies, mortgages of this kind constituted only a small portion of all housing loans in the United States. 26 The traditional residential mortgage—known as a conventional mortgage—generally had a fixed rate, often for 15 or 30 years, a downpayment of 10 to 20 percent, and was made to a borrower who had a job, a steady income and a good credit record. Before the GSE Act, even subprime loans, although made to borrowers with impaired credit, often involved substantial downpayments or existing equity in homes. 27 Table 3 shows the delinquency rates of the NTMs that were outstanding on June 30, 2008. The grayed area contains virtually all the NTMs. The contrast in quality, based on delinquency rates, between these loans and Fannie and Freddie prime loans in lines 9 and 10 is clear. 25 26 Mortgage Bankers Association National Delinquency Survey. See Pinto, “Government Housing Policies in the Lead-Up to the Financial Crisis: A Forensic Study,” November 4, 2010, p.58, http://www.aei.org/docLib/Government-Housing-Policies-Financial-Crisis- Pinto-102110.pdf. 27 Id., p.42. CHRG-111hhrg53234--223 Mr. Bachus," Okay. I agree. Do we need to determine the causes of the present financial crisis before we start legislating a fix? And have we done that? " CHRG-111shrg55479--2 Chairman Reed," Let me call the hearing to order and welcome our witnesses. Thank you, ladies and gentlemen. We expect momentarily that the Ranking Member will arrive, and I thank Senator Corker and Senator Menendez for joining us. Today's hearing will focus on corporate boardrooms and try to help us better understand the misaligned incentives that drove Wall Street executives to take harmful risks with the life savings and retirement income of so many people. This Subcommittee has held several hearings in recent months to focus on gaps in our financial regulatory system, including the largely unregulated markets for over-the-counter derivatives, hedge funds, and other private investment pools. We have also examined problems that resulted from regulators simply failing to use the authority they had, such as our hearing in March that uncovered defective risk management systems at major financial institutions. But although regulators play a critical role in policing the markets, they will always struggle to keep up with evolving and cutting-edge industries. Today's hearing will examine how we can better empower shareholders to hold corporate boards accountable for their actions and make sure that executive pay and other incentives are used to help companies better focus on long-term performance goals over day-to-day profits. In this latter regard, this is a timely hearing based on the action yesterday of the House Financial Services Committee. Wall Street executives who pursued reckless products and activities they did not understand brought our financial system to this crisis. Many of the boards that were supposed to look out for shareholders' interests failed at this most basic of jobs. This hearing will help determine where the corporate governance structure is strong, where it needs improvement, and what role the Federal Government should play in this effort. I will ask our witnesses what the financial crisis has revealed about current laws and regulations surrounding corporate governance, including executive compensation, board composition, election of directors and other proxy rules, and risk management. In particular, we will discuss proposals to improve the quality of boards by increasing shareholder input into board membership and requiring annual election of and majority voting for each board member. We will also discuss requiring ``say-on-pay,'' or shareholder endorsements of executive compensation. We need to find ways to help public companies align their compensation practices with long-term shareholder value and for financial institutions overall firm safety and soundness. We also need to ensure that compensation committee members who play key roles in setting executive pay are appropriately independent from the firm managers that they are paying. Other key proposals would require public companies to create risk management activities on their boards and separate the chair and CEO positions to ensure that the CEO is held accountable by the board and an independent chair. I hope today's hearing will allow us to examine these and other proposals and take needed steps to promote corporate responsiveness to the interests of shareholders, and I welcome today's witnesses and look forward to the testimony. Now let me recognize Senator Bunning. CHRG-111hhrg52406--187 FOR RESPONSIBLE LENDING Ms. Keest. Thank you to the chairman and to Ranking Member Bachus, although, I guess he is not here anymore. Thank you very much for inviting us to testify. The Center for Responsible Lending brings a unique perspective to the question of how to structure a regulatory system that best serves the public, the institutions, and the financial needs of American households. Ours is a research-based policy organization, but it is affiliated with a financial institution that is directly affected by regulations and the regulatory system. I, myself, am a former credit code administrator and assistant attorney general in Iowa, so we bring three perspectives to this proposal. From all of these perspectives, we wholeheartedly welcome the proposal of a separate, independent regulator that is focused on the bottom lines of both the providers and of the households who are their customers. Today's crisis has many origins, but a big one is a fatally flawed regulatory system that has led to where we are today. There were flawed regulators in not seeing what they were doing, but the structure, itself, has made it unlikely that any of the current lessons that today's regulators may have learned will have any staying power. The OTS is a good example of that. They were created after the savings and loan industry self-destructed 20 years ago. Yet, today, when OTS' full-time, on-site safety and soundness examiners were at WaMu, they failed to notice that half of the real estate loans that WaMu was making from 2004 to 2006 were inherently risky, badly underwritten loans. It is a little bit difficult to understand why we are talking about vesting these agencies with the consumer protection fair lending compliance, calling them ``prudential regulators'' when they have been no more prudent than the customers of those agencies, which is what they call their supervised institutions. Financial autopsies by inspectors general have pointed to regulatory failures in both the OCC and the OTS for not doing their jobs, and the attitude of those regulators who consider their supervisees their customers is at the heart of the problem. For the market to work as intended, we need to have a level playing field. We need rules of the game and we need referees. We need referees, not cheerleaders, but the charter competition and the legal systems for sales structure that we have now inevitably led to the so-called ``prudential regulators'' being cheerleaders. That is why we believe that this needs to be an independent regulator. That regulator needs to have all three tools that a regulator's toolbox should have. It needs to have the authority to set standards, the ability to monitor them in real-time, and the ability to enforce those standards. As a former regulator, I can tell you that, if you are not able to be onsite and monitoring things in real-time and are left to dealing with them when they become big enough to become a law enforcement problem, then the damage has already been done, and at the velocity that today's market moves, that does not take very long. The second question that I would like to address is that about insurance. One of the things that we think is key is that insurance products that are inextricably linked with the financial products have to be there. We have proposed a ``but for'' test, which is to say, if this insurance product would not exist except for the underlying transaction and if it is intrinsically intertwined with it, then it should be there. We think that it is important to remember that credit insurance was one of the key tools used by predatory mortgage lenders 10, 15 years ago, and it was used to strip billions of dollars of equity out of people's homes when they still had some equity to steal. Fifteen years ago, Congress had a chance to nip it in the bud then by making it a HOEPA trigger fee, but you did not. You did give the Fed the authority to do so later, but it was about 5 years later after billions of dollars of equity had been lost and after State legislatures, law enforcement and the FRB all clamped down on it. So we would simply like to remind you that we think it is important to have learned both from the lessons of the S&L crisis 20 years ago and from the predatory lending problem 15 years ago and to say, let's learn from those mistakes and not do the same thing over again. Thank you for the opportunity to testify, and I will look forward to your questions. [The prepared statement of Ms. Keest can be found on page 94 of the appendix.] " 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-111hhrg48674--348 Mr. Bernanke," We need to get through that crisis, but I very much agree with Mr. Lacker that we need to clarify regulatory responsibilities, and that lending and other such interventions ought to be aligned with those authorities and with congressional intent. " 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-110hhrg46596--36 Mrs. Maloney," Thank you, Mr. Chairman, for having this hearing. Regrettably, the report from GAO today makes clear that Treasury is not taking responsibility for making sure that the moneys are used consistently with the purposes of the Act. We will have to legislate that we want accountability, transparency, a systemic system with regulators so that we can track and find out where this money is going. A prime purpose of this Congress was to help people stay in their homes. I completely support FDIC Commissioner Sheila Bair's program, and am willing to legislate it with my colleagues. But we urge Treasury to put it in place. We do not know what banks are doing with their money because Treasury will not tell us. But the press tells us that they are buying highways in Europe, that they are buying other banks, or that they are holding on to the money. What my constituents tell me is they cannot have access to capital. We have put $7.8 trillion of taxpayers' money out there for the purpose of creating credit, and it has been a dismal failure. The car dealers were in my office yesterday from New York State. Americans want to buy their cars in New York State, but they cannot get credit from banks. What I am getting calls on is the proposed 4.5 percent interest rate to get new homes in the pipeline and get our economy moving. We need to get credit out in our communities in order to revive our economy. Economist after economist has told us we will not solve this crisis until we solve the problem of keeping people in their homes and getting the housing market moving again. I look forward to your proposal on the 4.5 percent interest rate--my phone has been ringing off the hook in support of it--or any ideas or programs you have to get credit out into our economy to get our economy moving again. Thank you. " 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-111shrg61513--117 Mr. Bernanke," No, we have gone beyond that. We have a general principle that there are regulatory minima and then above that, you know, we reserve the right to push banks to do more, depending on the risks they take and so on. So to give two examples, one, we have actually worked with international colleagues to develop new liquidity principles. That was one of the, I think, real big shortcomings that was made evident in the crisis, that they didn't have enough liquidity, and we have pushed banks to expand their liquidity and we have been pretty successful in doing that. The other example I would give is that another thing that was illustrated by the crisis was that a lot of the capital, quote-unquote, was not really very high quality. It wasn't of much use when the crisis came. And so, for example, as we have worked with banks in the stress tests or as we work with banks who want to repay TARP, we have put very heavy emphasis on raising new common equity as the highest quality form of capital. So yes, and every bank is required to do an internal capital assessment that we work with them on to make sure that not only are they meeting all the regulatory minima, but they are prepared for serious stresses that might come down the road. Senator Reed. Can I presume that you would not object to statutory language requiring multiple tests that are readily made and disclosed? " CHRG-111shrg56376--101 Mr. Bowman," Yes, I would agree with that. I mean, in terms of people choosing a charter at the outset, the thrift charter is somewhat unique in terms of some of the limitations that are placed upon the kinds of business that an entity would want to engage in. Our thought is that people choose a charter based upon their business plan. In terms of others who are attempting to switch charters because of some perceived favorable difference between, say, a State charter and a Federal charter, within the State charters you have got 50 to choose from, or 52 to choose from. The Federal charter, you have two, the Federal thrift charter and the national bank charter. Anyone who is looking to avoid or evade some kind of supervisory action or enforcement action, I think as we have talked about here, we as a collective group, interagency basis, have tried to take steps to avoid that from happening or to slow it down, to make sure that it doesn't happen for the wrong reasons. Senator Warner. One common theme from all of you has been--and I think accurately--reflecting that a great deal of the source of the crisis has come from the nonbank financial sector. Another issue I am struggling with and would like to get all of your comments on is, assume whichever way, consolidating a single entity or maintaining the current structure, how do we get our arms around this nonbank financial arena? Clearly, one approach the Administration has talked about is on the consumer end, the consumer product end, looking at specific financial products coming from this array of institutions. Another is that if they kind of bump up to the level of becoming systemically risky, the Council, or in the Administration's proposal the Fed would have oversight. What I am not clear on is should these nonbank--this nonbank financial sector have some level of day-to-day prudential regulation, and I have not seen anybody propose where that--one, is it needed, and two, where that day-to-day prudential regulation in terms of safety and soundness would land. Comments? Ms. Bair. You have prudential supervision of banks because of deposit insurance and other vehicles as part of the safety net. With the nonbanks, you do not have that. They are not federally insured. Senator Warner. Should you have some? Ms. Bair. I don't think you need to. I don't think you need to go that far. I think the consumer abuses for the smaller entities were really more of a significant driver, the lax underwriting which then spilled over into the larger institutions because of the competitive situation it created. But no, I don't think you do. I think if you have the ability to impose prudential requirements on systemic institutions or systemic practices, then I don't think you need institutional---- Senator Warner. So the Council up here for systemic and the consumer down here, but no need for---- Ms. Bair. Yes. " 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-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.] " CHRG-111hhrg53245--200 Mr. Johnson," I think you have to apply it to entities other than banks. I realize that I am quite far from the consensus view on this, but I think that it is really very important. When we are talking about all financial institutions, I think we have not talked enough about insurance companies today actually. The conversation has tended to gravitate towards commercial banks. I would not assume that the next financial crisis is going to be just like this financial crisis. They tend to mutate. They tend to involve other kinds of risk-taking institutions where we do not fully understand to measure the risk. So I think your point is very important, it has to be broad and it has to be across a lot of financial institutions. " CHRG-110shrg50418--71 Chairman Dodd," Yes. Let me ask you something one of my colleagues raised, and I will raise it and they may want to raise it, as well. Again, going back in the early 2003/2005, when interest rates were the lowest they had been in 45 or 50 years, there was a real pushing money out the door. That is when you get to the 17 million, I think, those numbers, which are high numbers, and obviously the oversupply. The question was raised earlier, aside from talking about obviously the financial crisis we are in, looking back introspectively, what mistakes did the industry make that contributed in addition to this? Is it only the financial crisis, or were there other decisions that were made by the industry that could have helped avoid this or minimized the kind of problems we are looking at today? " CHRG-110hhrg46591--108 Mr. Seligman," I agree with Mr. Johnson that there have to be multiple objectives, and clearly law enforcement would be one of them. I think that when you look at the recent failures, the reality is the failure of inspection, examination, and supervision is a pivotal part. The Office of Inspector General of the Securities and Exchange Commission recently did a report on Bear Stearns. And it noted that among other apparent causes of the failure, there were rules that didn't adequately address liquidity, the Commission did not have sufficient staff to engage in sufficient examinations, and it did not respond to red flags in a meaningful way. Apparently someone on the staff changed the requirement that was in the so-called consolidated supervised entity structure of the SEC that you use outside auditors to internal and that didn't rise to the Commission's level for review. There wasn't a sense as you saw the Bear Stearns devastation in the spring that you almost needed to say what is going on here, how systemic is this, this is a crisis, we have to look much harder and change rules much faster than we would otherwise. There were a lot of different causes. Sometimes regulatory agencies have the right rules, sometimes even the right people, but don't have the right sense of urgency. Too often, though, what you find is they are understaffed, they are underbudgeted and they get stuck in a kind of rut of doing the same things over and over again and don't respond effectively to changes in fundamental dynamics. " 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. " FinancialCrisisInquiry--250 DIMON: You raise a very interesting question, and because at no point before the crisis did the market price these firms like they’re too big to fail. And all you have to do is look at what they paid... CHRG-109hhrg22160--69 Mr. Greenspan," The word crisis depends on in what terms. We have a very serious problem with the existing structure is what I would stipulate. The terms of how you describe it are far less important than defining what it is. " CHRG-109hhrg22160--62 Mr. Kanjorski," At that time, did you prepare and submit to the Congress your recommendations as to how to solve the problem that we are now facing, in the President's word, as a crisis? " CHRG-111hhrg48867--248 Mr. Ellison," Reclaiming my time, Mr. Silvers, are Fannie Mae and Freddie Mac responsible for this financial crisis we are in now? " 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-111shrg53176--4 STATEMENT OF SENATOR RICHARD C. SHELBY Senator Shelby. Thank you, Mr. Chairman. I look forward to hearing from our witnesses today. I am particularly interested in hearing from SEC Chairman Schapiro about the steps that she is taking to address the agency's recent regulatory failures. This includes the disappearance of the investment banks, the SEC's largest regulated entities there; the systemically devastating failures by the credit rating agencies that enjoy the SEC's implicit seal of approval; and the Madoff fraud. I believe that changes in the way the agency is managed and how its resources are used will be of utmost importance in getting the SEC back on the right track. The insights of former SEC Chairmen and Commissioners, State securities regulators, and self-regulatory organizations will also be useful in determining what changes may be needed. For that reason, I am pleased that we have representatives of each of these groups here today. Only by hearing a wide range of perspectives and by digging deep inside these agencies and failed financial institutions will we be able to fully understand how we got into this crisis, how we can get out of it, and how we can prevent them in the future. Mr. Chairman, I think we are on the right road here breaking all this down into the various parts, and I commend you for that. " CHRG-111hhrg56847--3 Mr. Ryan," Thank you, Mr. Chairman. And thank you for opening this hearing. I too want to start off by welcoming our newest member, Congressman Charles Djou of Hawaii. We look forward to working with you to tackle our fiscal and economic challenges. And it is exciting to see you and your family here and being sworn into Congress. And we are really looking forward to working with you. Welcome to the Nation's capital. And welcome to you, Chairman Bernanke. It is appropriate you are coming here before our committee today to talk about the state of the economy because the health of the U.S. and global economy is increasingly intertwined with the budget and our fiscal issues that we deal with here in this committee. Over the past few months we have watched as a sovereign debt crisis in Europe has boiled into a real troubling problem. We are seeing that the continent's economic recovery is being threatened and we see even global financial stability in general is being threatened. In some ways, we are seeing a replay of a similar dynamic which impaired global financial markets in 2008. The fear then was the systemic exposure to bad mortgage-related assets, but the fear now is driven by exposure to sovereign credit and the possibility of a debt-induced economic slump. Ominously, interbank lending rates, like LIBOR, are on the rise and credit spreads have widened as investors have become much more risk averse. Volatility is up and the stock market is down. What we are watching in real-time is the rough justice of the marketplace and the severe economic turmoil that can be inflicted on profligate countries mired in debt. At the moment, the U.S. is at the periphery of the European debt crisis and has even reaped some short-term benefits like lower long-term interest rates as a result of the renewed global flight to safety. But Americans are left to wonder. Could we one day find ourselves at the epicenter of such a crisis? Could a European style debt crisis one day happen right here in the United States? The answer is undoubtedly yes. And the sad truth is that inaction by policymakers to change our fiscal course is hastening this day of reckoning. A brief look at the budget numbers shows that our current fiscal situation and its trajectory going forward is very dire. The budget deficit this year stands at $1.5 trillion, or just over 10 percent of GDP. Under the President's budget, the budget we are living under right now, the CBO tells us that the level of U.S. debt will triple by the end of the decade, meaning that in just a few short years, the U.S. is poised to join that group of troubled countries whose public debt absorbs a large and growing share of their economic output. A fiscal crisis in the U.S. is no longer an economic hypothetical but a clear and present risk to our economy, to society's most vulnerable citizens, and America's standing in the world. As the example of Greece has shown, market forces and investor sentiment do not offer countries the luxury of time and delayed promises to get their fiscal house in order. Empty rhetoric is no substitute for results. Foreigners now own roughly half of the U.S. publicly held debt and their willingness to fund our borrowing at record low interest rates will not continue forever. The size of our current and future funding needs makes us quite vulnerable to a shift in market sentiment and higher than expected interest rates. The reemergence of the bond vigilantes and exposure to the rough justice of the marketplace would certainly make our bad fiscal situation even worse. The main point here is the need for policymakers to reassure credit markets that the U.S. is engaged in charting a clear course back to sustainable deficit and debt levels soon. It is clear to me that this means reining in government spending, not simply ramping up taxes. In particular, we need to reform our entitlement programs, which threaten to grow themselves right into extinction, collapse our safety net, overwhelm the entire Federal budget and sink the economy in the process. The budding sovereign debt problems in other parts of the world provide us with a great cautionary tale that it is always best to take action to shore up budget deficits before market forces demand it. So what has this Congress and administration done to respond? Two new entitlement programs and no budget. The majority's failure to even offer a budget and its commitment to continue spending money we don't have, creating brand new entitlements and plunging our Nation deeper into debt tells me, and tells the bond markets more importantly, that Washington still doesn't recognize the severity of our fiscal and economic challenges. I look forward to your testimony today, Chairman Bernanke, and remain hopeful that policymakers will heed your warnings and chart a sustainable course to avert the next crisis. Thank you. " CHRG-111shrg52619--87 Mr. Dugan," I guess what I would say, Senator, is there is a tension with financial institutions that depend so heavily on confidence, particularly because of the run risk that was described earlier. And I am not just talking about depositors getting in line. I am talking about funding. That has always informed and is very deeply embedded in our whole system of financial regulation. There is much about what we do and how we do it that is by design confidential supervisory information and we do have to be careful in everything we do and how we talk about it, about not creating or making a situation worse. And at the same time, the tension you quite rightly talk about is knowing that there are problems that need to be addressed and finding ways to address them in public forums without running afoul of that earlier problem, and it gets harder when we have bigger problems in a financial crisis like the one we have and we all have to work hard to get through that and to try to work with that tension, and I think we can do that by the kinds of hearings that you have had. I think we have to avoid commenting about specific open institutions, but there are many things we can talk about and get at and I think that is what we need to do. Senator Reed. Ms. Bair, and I will try to get around briefly because of the time limit. Ms. Bair? Ms. Bair. Well, I hope we are cheerleaders for depositors. I think we are all about stability and public confidence, so I think it is important to keep perspective, though, for all bank regulators, that what we do should always be tied to the broader public interest. It is not our job to protect banks. It is our job to protect the economy and the system, and to the extent our regulatory functions relate to that, that is how they should be focused. I do think that the market is confused now because different situations have been handled in different ways, and I hate to sound like a Johnny-one-note, but I think a lot of it does come back to this inability to have a legal structure for resolving institutions once they get into trouble. I think whatever that structure might eventually look like, just clarity for the market--for investors and creditors--about how they will be treated and the consistency of the treatment, would go a long way to promoting financial stability and confidence. Senator Reed. Mr. Fryzel. " CHRG-111hhrg53244--361 Mr. Bernanke," It was zero before the crisis, yes. This was part of the process, working with other central banks, again, to try to get dollar money markets working normally in the global economy. " 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-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-110hhrg44900--174 Mr. Bernanke," Well, that is one advantage of having a deliberate process. If you take time to do it right and then take some time to get this done it will be evident to the market that you're not addressing some immediate crisis, but rather, thinking about the next set of issues. " CHRG-111hhrg53241--30 Mr. Mierzwinski," Thank you, Mr. Chairman, Congressman Hensarling, and members of the committee. I am Ed Mierzwinski of U.S. PIRG, as are several of the witnesses here. U.S. PIRG is a founding member of Americans for Financial Reform, ourfinancialsecurity.org, a coalition of civil society members across the spectrum supporting broad reform. My written testimony goes into detail about a number of aspects of the Obama plan, including its new investor protections to provide for greater fiduciary responsibilities on broker dealers, its limits on executive pay, and tying risk to longer-term-pay incentives rather than the greedy, short-term incentives that have helped precipitate the crisis. I also talk about the aspects of prudential regulation and the notion of a new systemic risk regulator. We point out that if it is to be the Fed, the Fed needs democratization and greater transparency. First of all, I also want to mention that one area where we think the proposal is extremely deficient is in the area of credit rating agencies. There needs to be much more regulation of credit rating agencies. We also are disappointed that it doesn't include enough on solving the mortgage and homeowner and foreclosure crises. I want to spend the bulk of my time talking about the centerpiece of the reform, and that is the Consumer Financial Protection Agency. We look at this as a game changer, as a critically important new solution to a failed regulatory system. The system failed because the regulators had conflicts of interest, and the regulators did not impose the civil penalties that they had available to them. The regulators did not establish rules to protect consumers in the marketplace. Those rules could have helped prevent the mortgage crisis, as everyone knows. Fourteen years after the Congress gave the Fed authority over the Homeownership and Equity Protection Act to create rules on predatory lending, didn't do anything until after the crisis had passed. Complaints about credit cards reached a fever pitch while the OCC slept, the overdraft loan problem. And so Congress had to step in and act under the leadership of Congresswoman Maloney and this committee. The regulators finally created some rules on credit cards, but the Congress, fortunately, had already suggested the rules, and then the Congress went further and made the rules into a law. The issue of overdraft fees, banks are now making the bulk of their income on an unfair business model, overdraft fees where the regulators have allowed them to trick consumers into using their debit cards even when they have no money in their accounts. And the regulators have allowed the banks to change the order that deposited checks and items are cleared so that consumers will face more overdraft charges at the end of the day. We have a number of other problems that we describe in our testimony, in our written testimony, both this month and last month, where the regulators have simply failed to go after the banks. So the idea of a new regulator that has only one job, protecting consumers, is one of the best ideas this Congress has had. It will not have conflicts of interest. It will not have two jobs to do. It will focus on consumer protection. But you cannot set the new regulator up to fail. You must keep it independent, and you must also do the other things that the Obama Administration has suggested and that your bill, Mr. Chairman, retains. You must keep the Federal law as a floor of consumer protection and allow the States to go higher. The States are nimbler. Often, they respond more quickly, and they provide good ideas to the Congress. In my testimony, I outline how in the 2003 FACT Act, Congress allowed the States to continue to investigate identity theft. Forty-six States and the District of Columbia came up with a security freeze model that allows consumers to protect themselves. Giving the States the ability to go further is the best way that we can protect consumers from new threats, because the States can act more quickly. And the idea that State attorneys general can enforce the law is not balkanization. Providing State attorneys general at the enforcement level the ability to enforce the law, that is an area where you want competition. You want many enforcers. You don't want many rule writers. You don't want many agencies where banks can choose to charter shop to avoid regulation, but you do want a lot of cops on the beat, and you do want to give consumers the right to enforce the laws. We wish the bill went further on giving consumers a private right of action, but we are very pleased that the new agency will have the authority to ban unfair forced arbitration in consumer contracts. Thank you. [The prepared statement of Mr. Mierzwinski can be found on page 55 of the appendix.] " CHRG-111hhrg53238--200 Mr. Himes," The reason I am going down this path is, look, this is a complicated topic, and we have to get it right. There is merit on both sides and many different sides, and we have to get it right. But to me it is a no-brainer, and as people with some economic training here, it is a no-brainer that you need a fully informed consumer. And you repeat here there is no evidence that the financial crisis was spawned by a systematic lack of understanding. No evidence that consumer ignorance was a substantial cause. Nobody is saying that it was spawned by consumer ignorance. Was not a substantial contributing factor to this crisis the lack of education, the lack of knowledge, the lack of information that consumers had? " CHRG-111hhrg53244--72 Mr. Bernanke," Congressman, our policies, using our balance sheet, have been to try to improve the functioning of credit markets, which have been disrupted by the financial crisis. So, for example, we have been purchasing mortgage-backed securities, which has lowered mortgage rates for everyday Americans down to about 5 percent. We have opened up a program that is called the TALF, which has helped increase funding and reduce rates on consumer loans like auto loans, student loans, and small business loans. We have taken actions to improve the function of the commercial paper market. So all these various steps have tried to address the fact that, during the crisis, many markets have become disrupted, and our actions have been ways of trying to stimulate improvements. And we have been fairly successful in doing that. " CHRG-111hhrg48674--117 Mr. Bernanke," A two-part answer. First of all, the financial crisis has been extraordinarily severe, and those financial effects are incredibly powerful. And the intensification of the financial crisis in September knocked the global economy for a loop, which it is now just beginning to get its feet. So I think that the actions that were taken prevented a much worse situation, a meltdown that would have led to a catastrophic and long-term low level of activity. So the fact that we haven't gotten back to normal is just consistent with the experience that financial crises are very, very serious matters. The second answer I would make, though, and I would just like to emphasize that all these programs I talked about, the program for consumer and small business lending, the mortgage-backed security program, the interbank lending program that affects LIBOR, all these things have already shown up as improvements in those credit markets which directly affect people in South Carolina. They are not banks and investment banks. The 30-year mortgage rate affects your constituents. The commercial paper rate affects the company they work for. The rate on auto loans, on student loans, on credit card loans, all those rates will be affected by the programs we are undertaking. We are doing this, not because we have some nefarious scheme; we are trying to help the American economy recover, and we are using whatever methods we have to overcome what has been an enormous blow from this financial crisis. " FinancialCrisisInquiry--195 Despite a quarterly decline of net loans and leases, at 2.6 percent annual, community banks with less than a billion dollars in assets were the only group to show a year over year increase in net loans and leases of 0.5 percent. While modest, these gains were the best in the financial sector. Our nation’s biggest banks, who were here earlier today, cut back on lending the most. The institutions with more than $100 billion in assets showed a quarterly decline of 10.9 percent annual rate and a 10.5 percent decrease, year over year. Banks $10 billion to $100 billion asset banks, had net loans and leases decline at an astounding 17.8 percent annual rate over the previous quarter. In conclusion, highly regulated community bank sector did not trigger the financial crisis. We must end too big to fail, reduce systemic risk and focus regulation on the unregulated financial entities that caused this economic meltdown on Wall Street. The best financial reform will protect small business from being crushed by the devastating effects of one giant financial institution stumbling. A diverse, competitive financial system will best serve the needs of small business in America. Thank you, and I’m prepared to answer any questions. CHAIRMAN ANGELIDES: So, let’s start with our questioning, and I will lead off. Let me ask each of you a question or two. And, again, brief, succinct, direct. Mr. Zandi, and I shouldn’t do this, but if people haven’t read your book, it’s worth reading, “Financial Shock.” How’s that for a cheap plug? ZANDI: Yes. I hear it’s good on Kindle, too. (LAUGHTER) fcic_final_report_full--71 Indeed, the regulators, including the Fed, would fail to identify excessive risks and unsound practices building up in nonbank subsidiaries of financial holding compa- nies such as Citigroup and Wachovia.  The convergence of banks and securities firms also undermined the supportive relationship between banking and securities markets that Fed Chairman Greenspan had considered a source of stability. He compared it to a “spare tire”: if large commer- cial banks ran into trouble, their large customers could borrow from investment banks and others in the capital markets; if those markets froze, banks could lend us- ing their deposits. After , securitized mortgage lending provided another source of credit to home buyers and other borrowers that softened a steep decline in lending by thrifts and banks. The system’s resilience following the crisis in Asian financial markets in the late s further proved his point, Greenspan said.  The new regime encouraged growth and consolidation within and across bank- ing, securities, and insurance. The bank-centered financial holding companies such as Citigroup, JP Morgan, and Bank of America could compete directly with the “big five” investment banks—Goldman Sachs, Morgan Stanley, Merrill Lynch, Lehman Brothers, and Bear Stearns—in securitization, stock and bond underwriting, loan syndication, and trading in over-the-counter (OTC) derivatives. The biggest bank holding companies became major players in investment banking. The strategies of the largest commercial banks and their holding companies came to more closely re- semble the strategies of investment banks. Each had advantages: commercial banks enjoyed greater access to insured deposits, and the investment banks enjoyed less regulation. Both prospered from the late s until the outbreak of the financial cri- sis in . However, Greenspan’s “spare tire” that had helped make the system less vulnerable would be gone when the financial crisis emerged—all the wheels of the system would be spinning on the same axle. LONG TERM CAPITAL MANAGEMENT: “THAT ’S WHAT HISTORY HAD PROVED TO THEM ” In August , Russia defaulted on part of its national debt, panicking markets. Rus- sia announced it would restructure its debt and postpone some payments. In the af- termath, investors dumped higher-risk securities, including those having nothing to do with Russia, and fled to the safety of U.S. Treasury bills and FDIC-insured de- posits. In response, the Federal Reserve cut short-term interest rates three times in seven weeks.  With the commercial paper market in turmoil, it was up to the com- mercial banks to take up the slack by lending to corporations that could not roll over their short-term paper. Banks loaned  billion in September and October of —about . times the usual amount  —and helped prevent a serious disruption from becoming much worse. The economy avoided a slump. Not so for Long-Term Capital Management, a large U.S. hedge fund. LTCM had devastating losses on its  billion portfolio of high-risk debt securities, including the junk bonds and emerging market debt that investors were dumping.  To buy these securities, the firm had borrowed  for every  of investors’ equity;  lenders included Merrill Lynch, JP Morgan, Morgan Stanley, Lehman Brothers, Goldman Sachs, and Chase Manhattan. The previous four years, LTCM’s leveraging strategy had produced magnificent returns: ., ., ., and ., while the S&P  yielded an average .  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-110hhrg46595--365 Mr. Sachs," Mr. Chairman, thank you very much. Let me start by commending this committee for keeping at this, because this is of extraordinary importance for the American economy. Nobody likes this crisis, nobody likes these bailouts. History will record that this committee made a great service to the country in passing the TARP legislation. We have a crisis that is unprecedented in its speed and ferocity. It is hard to get everything right. You are doing the right thing. I would plead with you to stay in session to get this one done as well, otherwise we will have a meltdown in this economy that is of absolutely extraordinary proportions. This industry has enormous value worth preserving. These are some of the largest companies in the entire world. This is absolutely the worst financial crisis since the Great Depression. We all agree, aside from specific tactics on the need for a large government loan and a government involvement, so we are down to the details. In my view, Chapter 11 is not the best option right now. It is extraordinarily unpredictable. The last time we did a Chapter 11 was Lehman Brothers. That turned out to be the single biggest financial shock in modern history. And I think that we want to avoid going to that route as a first resort. In my view, it is the last resort. There are tremendous unpredictabilities on the consumer side, the finance side and the supplier side, possibilities of cascading disasters that I think we would do best to avoid right now. Now, we all agree that we need a significant restructuring. What GM put forward in detail, for example, is a very significant balance sheet restructuring. I believe that it can be done outside of Chapter 11, and I think that is what should be attempted right now. And I think it is enormously impressive what they put forward and enormously important for us to support that process. They call for an oversight board that can help that process. I agree with that. And I think that this is the basic structure in which this should proceed. Who should pay for this? This is the hot potato that everybody is worrying about, understandably. There are three sources of funds it seems to me, not just two. One is a direct loan by the Fed. I think Chairman Bernanke is the missing personality at these negotiations, quite frankly. I do not understand the reticence of the Fed right now. The Fed lent against Bear Stearns assets. The Fed lent against Citibank assets. The Fed can lend against GM collateral. This is a big mistake that is being made right now. This is a systemic financial risk in this country and a substantial one. And we need the Fed here as well. So in my opinion, this is the first place where we should be looking for financing. Second is TARP. It fits perfectly with the intentions of the TARP that this be used for this purpose. And I am so happy with the testimony of Mr. Dodaro yesterday and again today. This is absolutely appropriate that the TARP should be used for this purpose. The third is section 136. I also support that. Let's be pragmatic. Get this job done so that we don't have a meltdown. Have a new Administration come in. It is going to have to take a longer term look at this in early 2009 to help this process go forward. This is not the end of the story; this is the beginning. That does not mean endless amounts of new money. That is not what I am implying. What I am implying is government support for a basic restructuring of this industry to achieve financial restructuring, balance sheet change, and model change along the lines of the environmental goals that we all share. So we need to get there because otherwise we will have a meltdown. I think at this point the double standard with Wall Street is so painful and so palpable it is hard actually to understand, how one throws a $306 billion guarantee over Citigroup without a single hearing or a single plan or a single datum, but we can't get even a loan effectively senior and collateralized for millions of workers is a shock to me. I don't even understand what they are thinking right now. Because this is absolutely as systemic as Citigroup or absolutely as systemic as the other financial matters. This is our largest industry. Are we going to watch it melt down by Christmas? That is what we are talking about, with all of the disintegration of value that would go along with this. So I think we have to frankly, in my opinion, have Chairman Bernanke and Treasury Secretary Paulson here at the table. We have three sources of funds. It needs to be worked out. This is not an endless open-ended process. There are plans on the table which your committee has successfully elicited, a great contribution of these hearings I might add. And it is going to be a process now to get to the next Administration for a longer term considered strategy. Let me finally add that all around the world, governments are supporting their automobile industries. Just yesterday, President Sarkozy made announcements about France. This is going to be a worldwide phenomenon given that we are in the sharpest downturn in modern history. And so please do not leave this weekend. I don't want to open up to see what the markets look like on Monday morning because Congress has gone home and hasn't been able to figure out how to do $25 billion when we have trillions of dollars at stake. Thank you very much. " CHRG-111hhrg54867--147 Mr. Sherman," The key thing then is that the Executive Branch have the power to commit, not just $700 billion, but a trillion or more without having to have Congress be involved at the time of the crisis. " FinancialCrisisInquiry--352 BORN : Thank you. Have you—have any of your institutions changed your operations in terms of over-the-counter derivatives dealing in light of what was learned through the financial crisis? Mr. Moynihan? FinancialCrisisInquiry--274 WALLISON: Thank you, Mr. Chairman. I’d like to focus on a couple of things—a few things for all of you that relate specifically to what caused the financial crisis. The newspapers have covered this somewhat, but I’d like to get it in the record. 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-111shrg56415--6 ADMINISTRATION Ms. Matz. Thank you, Chairman Johnson, Senator Crapo, and members of the Subcommittee. I am pleased to provide NCUA's views on the state of the industry. As you have heard from my counterparts, the stress on the entire financial sector has translated into a challenging time for financial institutions, including credit unions. Nonetheless, I am confident that credit unions can and will weather the storm. Corporate credit unions pose the most serious challenges to the credit union industry. Corporate credit unions are wholesale credit unions created by retail credit unions to provide investment services, liquidity, and payment systems. For four decades, this system worked well. However, in 2008, corporate exposure to mortgage-backed securities created tangible liquidity difficulties. In response to a growing crisis, NCUA asked Congress to increase the borrowing ceiling on our back-up liquidity source--the Central Liquidity Facility. Congress granted NCUA's request, and it is clear to me that if you had not acted in such a swift and decisive manner, the entire credit union system, not just the corporate network, would have been in serious jeopardy. Despite this successful intervention, problems continued. In March, the two largest corporates were placed into conservatorship by NCUA due to the deterioration in their portfolios. Losses flowed through the system and resulted in writedowns of capital not only by other corporates but by retail credit unions that invested in these institutions. Given the tenuous real estate market, NCUA expects additional losses to materialize. These conservatorships permit the corporate system to continue to function and to serve retail credit unions and, most importantly, their 90 million members. Again, a mechanism was developed, the Corporate Credit Union Stabilization Fund, which permitted replenishment by the industry over a 7-year period. This spreading out of costs was critical as credit union earnings were already experiencing pressures. The Corporate Stabilization Fund has permitted NCUA to maintain its mandated equity ratio in the Share Insurance Fund. At no point during this crisis has the equity ratio fallen below the 1.2 percent established by Congress, and today it stands at 1.3 percent, assuring consumers that their insured deposits are safe. Retail credit unions have their own challenges independent of the corporates. The good news is that, despite the troubled economy, credit union lending has increased by almost 8 percent since 2007. However, delinquencies and loan losses have also increased, particularly in real estate lending. In 2007, about 0.3 percent of such loans were delinquent. The figure now stands at 1.62 percent. Industry-wide capital, while still strong, has declined from 11.8 percent in 2007 to 10 percent. On the one hand, I am encouraged by the fact that 98 percent of the 7,700 federally insured credit unions are at least adequately capitalized. On the other hand, 21 credit unions have failed so far this year compared to 18 in all of 2008. That number could well rise in 2010. Most troubling is the increase in credit unions which have been downgraded to CAMEL 4 and 5. Between December 2008 and August 2009, the assets of credit unions in these categories have almost doubled. Clearly, credit unions have not been spared from the harsh effects of the economic downturn. In tandem with the assessment of corporate losses described above, this presents a difficult road for credit unions to travel in 2010 and beyond. NCUA has been proactive in our efforts to mitigate the situation. NCUA examiners work with credit unions to avoid the riskiest types of mortgage lending, and this oversight was complemented by the fact that, as member-owned cooperatives, credit unions try to put their members into lending products they can afford. As a result, the industry largely steers clear of exotic mortgage lending. Only 2.3 percent of all credit union mortgage loans are exotic. Additionally, NCUA has enhanced our supervision. We shortened our examination cycle. We added 50 examiners in 2009 and anticipate adding 57 more in 2010, and we upgraded our risk management system to identify and resolve problems more quickly. NCUA has an obligation to consumers. As a safety and soundness regulator, we will be successful if we preserve strong credit unions capable of meeting the financial needs of their members. Credit union members rightfully expect a reliable and well-capitalized deposit insurance regime. While the year ahead will be challenging, I am confident that we and the credit union industry we regulate will be stronger in the end. I welcome the opportunity to answer your questions. Senator Johnson. Thank you, Ms. Matz. " Mr. Ward," STATEMENT OF TIMOTHY T. WARD, DEPUTY DIRECTOR, EXAMINATIONS, fcic_final_report_full--427 STAGES OF THE CRISIS As of December , the United States is still in an economic slump caused by a fi- nancial crisis that first manifested itself in August  and ended in early . The primary features of that financial crisis were a financial shock in September  and a concomitant financial panic . The financial shock and panic triggered a severe con- traction in lending and hiring beginning in the fourth quarter of . Some observers describe recent economic history as a recession that began in December  and continued until June , and from which we are only now be- ginning to recover. While this definition of the recession is technically accurate, it ob- scures a more important chronology that connects financial market developments with the broader economy. We describe recent U.S. macroeconomic history in five stages: • A series of foreshocks beginning in August , followed by an economic slowdown and then a mild recession through August , as liquidity prob- lems emerged and three large U.S. financial institutions failed; • A severe financial shock in September , in which ten large financial institu- tions failed, nearly failed, or changed their institutional structure; triggering • A financial panic and the beginning of a large contraction in the real economy in the last few months of ; followed by • The end of the financial shock, panic, and rescue at the beginning of ; followed by • A continued and deepening contraction in the real economy and the beginning of the financial recovery and rebuilding period. As of December , the United States is still in the last stage. The financial sys- tem is still recovering and being restructured, and the U.S. economy struggles to re- turn to sustained strong growth. The remainder of our comments focuses on the financial crisis in the first three stages by examining its ten essential causes. THE TEN ESSENTIAL CAUSES OF THE FINANCIAL AND ECONOMIC CRISIS The following ten causes, global and domestic, are essential to explaining the finan- cial and economic crisis. I. Credit bubble. Starting in the late s, China, other large developing countries, and the big oil-producing nations built up large capital surpluses. They loaned these savings to the United States and Europe, causing interest rates to fall. Credit spreads narrowed, meaning that the cost of borrowing to finance risky investments declined. A credit bubble formed in the United States and Europe, the most notable manifestation of which was increased investment in high-risk mortgages. U.S. monetary policy may have con- tributed to the credit bubble but did not cause it. CHRG-111shrg56415--16 Mr. Tarullo," Thank you, Senator. So, let me echo the approach that Comptroller Dugan took, which is to say in any proposal, you are going to have some benefits and you are going to have some costs. I think on this one, I would just add two points, or reiterate one point and make an additional point. The reiteration is the point that Chairman Bair made, which is you lose something, and part of what you lose here is the insight that the Federal Deposit insurer or the monetary policy authority gets into the functioning of the banking system by being an examiner, and that is something that does require experience. It does require actually being involved in the guts of examination and supervision. Second, in terms of priorities, again, it is certainly debatable what model you want to have, and a lot of countries around the world have debated it, but I don't think that the existence of multiple banking regulators at the Federal level played a particularly important role in the genesis of this crisis. There are a lot of problems. There was a lot of blame to go around for a lot of reasons. But I don't think it was the coexistence of the FDIC and the Comptroller that was a particular problem here. Senator Crapo. Thank you. Ms. Matz. Ms. Matz. The Administration proposal kept NCUA as an independent regulator, and we support that. Senator Crapo. So you are willing to stick with that? Ms. Matz. Yes. Senator Crapo. All right. " Mr. Ward," " FOMC20080130meeting--313 311,CHAIRMAN BERNANKE., Okay. Let's reconvene. We have a special presentation on policy issues raised by financial crisis. Let me turn to Pat Parkinson to introduce the presentation. CHRG-111hhrg56766--68 Mr. Bernanke," Clearly, they did not. I would add the liquidity issue also, that during the crisis, many banks were technically well-capitalized, but they did not have enough cash on hand to meet the run that was coming on them. Higher liquidity is also a part of this. " CHRG-111shrg57923--18 Mr. Liechty," Thank you, Mr. Chairman, Senator Corker. I appreciate the opportunity to be here and to again also speak about or on behalf of the Committee to Establish the National Institute of Finance. I would like to just give a little history. The Committee to Establish the National Institute of Finance started a little over a year ago at a workshop that was jointly sponsored by the Office of the Comptroller of the Currency and the National Institute of Statistical Sciences. As an academic and a professional statistician, I was really interested in the topic of the workshop, which is exploring statistical issues in financial risk and in bank regulation. I consult with some of the big investment banks, specifically helping them with issues related to modeling and valuing many of these complicated credit derivative securities that played a part in the recent crisis and I was hoping that the workshop would focus on systemic risk. But it was primarily focused on Basel I and Basel II and assessing the safety and soundness of individual institutions. And focusing on the safety and soundness of individual institutions is important, but that in and of itself will not ensure the safety and soundness of our financial system. In some ways, this approach is similar to ensuring that a group of cars going on a freeway or around a racetrack are all individually safe and sound, but then ignoring the larger dynamics of the traffic, for example, whether the cars are bunched together, they are observing safe stopping rules, or going too fast as a collective group. Now, because there was a broad collection of regulators, academics, and practitioners at this workshop, I asked a very simple question in my mind. Does anybody have the data necessary to monitor and measure systemic risk? And the informal consensus I got from that workshop is the same consensus I have heard over and over again as we have gone forward with this effort. The regulators do not have the correct data, and in addition, to get the data they need, it will probably require additional legislation. Now, I spent the bulk of my professional career developing methods and systems to go from data to information and I know that just collecting data is not enough. We have to have the appropriate analytic tools if we are going to turn that data into the useful information to be able to really monitor and measure systemic risk, and it will not only take more than data collection, it will take more than just building the models itself. In my view, in some sense, it is a fundamental scientific problem, that we have to put forward fundamental research efforts in order to be able to understand the frameworks, be able to frame the metrics, be able to get the models in place and then know what data we need. In some sense, I echo the finding that came from the National Academy of Sciences workshop which was that we really don't actually know all the data and we are not going to know until we have an iterative process, which is the fundamental part of the research process. Let me illustrate with an analogy from the weather, which is very appropriate given our last couple of days. This focuses on hurricanes. When the financial crisis of 2008 hit, the regulators and policymakers charged with keeping our financial system safe were taken by surprise. Although there were some indications of uncertainty, this financial storm hit with the same unexpected suddenness as the New England Hurricane of 1938. The Martha's Vineyard Gazette noted at that time, this tragedy was not the loss of nearly 10,000 homes and businesses along that shore. It was the psychic destruction of summer for an entire generation. Earlier hurricanes had brought structural responses from the U.S. Government. The Weather Bureau was formed in 1870 under President Ulysses S. Grant with a mandate to gather data on the weather and provide warnings of approaching storms. Even though the Weather Bureau was in place, it was not able to offer any warnings for the Category 4 hurricane that hit Galveston, Texas, September 8, 1900, and it only offered a few hours of warning for the hurricane that hit Miami September 18, 1929. By 1938, the Weather Bureau had better models, it had better data, but as the New York Times observed regarding that hurricane, the Weather Bureau experts and the general public never saw it coming. I would ask, are our regulators and policymakers any better equipped today than the Weather Bureau of 1938? In 1970, President Richard Nixon created the National Oceanic and Atmospheric Administration, NOAA, with the mandate to do three things. One, collect data to document natural variability and support predictive models. Two, to develop new analytic and forecasting tools. And three, to conduct essential long-term research to underlie these models. Now, NOAA's current real-time data collection and analysis infrastructure is very impressive. It is significant. It continues to bring substantial benefits to our society. But they were made possible mainly through and largely through the research efforts of NOAA. At this point, I would like to offer an observation and a question. Clearly, I put forward to you that our financial markets are at least as important and as complicated as the weather. If that is the case, why don't we have the equivalent of NOAA for the financial markets? When it comes to safeguarding our system, our goal should be bold, our expectations realistic, and our dedication to the task substantial. Although it will take time, the benefits will far outweigh the cost, just as they have done for hurricanes. This concludes my oral remarks. I would be open to any questions you might have. Thank you. Senator Reed. Thank you very much, Professor. Professor Engle, please. STATEMENT OF ROBERT ENGLE, PROFESSOR OF FINANCE, STERN SCHOOL CHRG-111shrg54675--12 Mr. Johnson," Chairman Johnson, Ranking Member Crapo, and Members of the Subcommittee, my name is Art, and I am the Chairman and CEO of United Bank of Michigan, and I am the Chairman-Elect of the American Bankers Association. I am pleased to share the banking industry's perspective on banking and the economy in rural America. Community banks continue to be one of the most important resources supporting the economic health of rural communities. Not surprisingly, the banks that serve our Nation's small towns also tend to be small community banks. Less well known is that over 3,500 banks--41 percent of the banking industry--have fewer than 30 employees. These banks understand fully the needs of their customers and their community. This is not the first recession faced by banks. Most banks have been in their communities for decades and intend to be there for many decades to come. My bank was chartered in 1903. We have survived the Great Depression and many other ups and downs for over a century. And we are not alone. Over 2,500 banks--nearly one-third of the industry--have been in been in business for more than a century. These numbers tell a dramatic story about the staying power of community banks and their commitment to their communities. We cannot be successful unless we develop and maintain long-term relationships and treat our customers fairly. In spite of the downturn, community banks in rural communities expanded lending by 7 percent since the recession began. Loans made by banks that focus on farmers and ranchers also increased by 9 percent. Considerable challenges remain, of course. In my home State of Michigan, for example, we are facing our eighth consecutive year of job losses. Other rural areas with manufacturing employment bases are also suffering similar problems. In this environment, businesses are reevaluating their credit needs and, as a result, loan demand is declining. Banks, too, are being prudent in underwriting, and our regulators demand it. Accordingly, it is unlikely that loan volumes will increase this year. With the recession, credit quality has suffered and losses have increased. Fortunately, community banks entered this recession with strong capital levels. However, it is very difficult to raise new capital today. Without access to capital, maintaining the flow of credit in rural communities will be increasingly difficult. We believe the Government can take action to help viable community banks weather the current downturn. The success of local economies depends on the success of these banks. Comparatively small steps now can make a huge difference to these banks, their customers, and their communities--keeping capital and resources focused where they are needed most. Importantly, the amount of capital required to provide an additional cushion for all community banks--which had nothing to do with the current crisis--is tiny compared to the $182 billion provided to AIG. In fact, the additional capital needed is less than $3 billion for all smaller banks to be well capitalized, even under a baseline stress test. Simply put, capital availability means credit availability. In addition to providing avenues for new capital for community banks, we believe there are three key policy issues that deserve congressional action: one, creating a systemic regulator; two, providing a strong mechanism for resolving troubled systemically important firms; and, three, filling gaps in the regulation of the shadow banking industry. The critical issue in this regard is ``too-big-to-fail.'' This concept has profound moral hazard implications and competitive effects that need to be addressed. In an ideal world, no institution would be ``too-big-to-fail,'' and that is ABA's goal. While recent events have shown how difficult that is to accomplish, whatever is done on the systemic regulator and on a resolution system should narrow dramatically the range of circumstances that might be expected to prompt Government action. These actions would address the causes of the financial crisis and constitute major reform. We believe there is a broad consensus in addressing these issues. I would be happy to answer any questions that you may have. " CHRG-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.] " FOMC20080121confcall--25 23,MR. HOENIG.," Yes, Mr. Chairman. I am troubled by this, I will admit. I understand the arguments, and it is difficult to argue against dodging a crisis. It is a very daunting thought to think about a crisis that you might have avoided had you just taken certain actions. I would echo Bill Poole a bit in terms of understanding what we will get out of this and how we will deal with backing away from this in the future because part of the reason we have the problem today, of course, is the last crisis. The desire is to intervene, to get the market rates down, and to bring confidence; but then our ability to pull out of that is compromised because we can't be sure in an uncertain world of how strongly the economy might be coming out of something. Therefore, we often delay and create the next issue that we have to deal with--as we are today. So I am troubled. I know the risk coming in tomorrow. I know we are being driven heavily by these markets. At the same time, I think doing an intermeeting move commits us to another move down the way. It will be hard to stay at rates that are not going to at least invite another series of problems down the road because I see us at 3 percent by nine days from now. So how do we deal with that? I would at least like to hear some discussion as we consider this pretty substantial action tonight. Those are my comments. " 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-111shrg49488--39 Chairman Lieberman," So those are examples that suggest that structure had some kind of causal effect, or at least enabling effect on the crisis. Dr. Carmichael, what would you say? And they are good examples, I think. " CHRG-111shrg54589--55 Mr. Gensler," Well, I think that--it has never happened, but we cannot rule it out, and we should make sure that--and it is one of the lessons of this crisis, is that we have to make sure that our statutes are up to date so that in an extreme circumstance---- Senator Bunning. That is all we are trying to go through. " CHRG-111shrg55479--22 Mr. Castellani," Thank you. Good afternoon, Mr. Chairman, Ranking Member Bunning, Members of the Committee. I am John Castellani, President of the Business Roundtable. The Business Roundtable has long been at the forefront of efforts to improve corporate governance. We have, in fact, been issuing best practice statements in this area for more than three decades. All of those best practice statements are driven by one principle: To further U.S. companies' ability to create jobs, product service benefits, and shareholder value that improve the well-being of all Americans. At the outset, I must respectfully take issue with the premise that the most significant cause of the current financial crisis was problems in corporate governance. The financial crisis likely stemmed from a variety of complex factors, including failures of the regulatory system, over-leveraged financial markets, a real estate bubble, as well as failures in risk management. The recently established Financial Crisis Inquiry Commission is just starting its work, and any attempt to make policy in response to the purported causes would seem premature. In fact, to do so could well exacerbate factors that may have contributed to the crisis, such as the emphasis on short-term gains at the expense of long-term sustainable growth. Moreover, the problems giving rise to the financial crisis occurred at a specific group of companies, financial institutions. Responding by enacting a one-size-fits-all corporate governance regime applicable to all 12,000 publicly traded companies really does not make much sense. This approach fails to consider a number of factors that I would like to spend the remainder of my time this afternoon discussing. First, there has been sweeping transformation of corporate governance practices in the past 6 years, many of which have been proactively adopted by companies. For example, the average board independence of S&P 1500 companies increased from 69 percent in 2003 to 78 percent in 2008. That same group of companies that have a separate chairman of the board increased from 30 percent in 2003 to 46 percent in 2008. Many companies have appointed an independent lead or presiding director who, among other things, presides over executive sessions of the independent directors. Companies have adopted majority voting standards for the election of directors. In fact, more than 70 percent of the S&P 500 companies have done so. And many companies have moved to the annual election of directors. Second, applying a single one-size-fits-all approach to corporate governance regardless of a company's size, shareholder base, and other circumstances simply will not work. While there is a multitude of guidance about best practices in corporate governance, each company must periodically assess the practices that will best enable it to operate most effectively to create long-term shareholder value. In this regard, we share the concerns recently expressed by New Jersey Investment Council in the letter to SEC Chairman Schapiro, that it is, quote, ``troubled by the proliferation of rigid, prescriptive responses which are costly, time consuming, unresponsive to individual fact settings surrounding specific companies and industries, and which may correlate only randomly with the creation of shareholder value.'' Third, for more than 200 years, State corporate law has been the bedrock upon which the modern business corporation has been created and has thrived. It remains the most appropriate and effective source of corporate governance. In large part, this stems from the flexibility provided by its enabling nature and by its responsiveness in adjusting to current developments. The amendments to Delaware and other States' laws over the past several years have facilitated majority voting and director elections, and the very recent amendments in Delaware law to facilitate proxy access and proxy reimbursement bylaws are examples of this responsiveness and flexibility. Fourth, to the extent that shareholders desire change in a particular company's corporate governance, many avenues are available to them to make their views known and for companies to respond. For example, shareholders may seek to have their proposals included in company proxy statements. In recent years, many companies have responded to these proposals by adopting significant corporate governance changes, including majority voting for directors, special meetings called by shareholders, and the elimination of super-majority voting requirements. Recently, some companies have implemented an advisory vote on compensation, so-called ``say-on-pay,'' in response to shareholder proposals. Shareholders often engage in withhold campaigns against particular directors. And further, shareholders can engage in proxy contests to elect their director nominees to a company's board. Finally, the SEC has an important role in seeing that shareholders receive the disclosures that they need to make informed decisions. In this regard, the SEC has issued a number of corporate governance-related proposals that are aimed at improving disclosure about director experience, board leadership structure, oversight of risk management, executive compensation, and potential conflicts of interest with compensation consultants. The Business Roundtable generally supports those. Another more controversial SEC proposal seeks to amend the proxy rules to permit shareholders to nominate directors in a company's proxy materials. We have serious concerns with this proposal, and we will share those concerns with the SEC in our comments. But briefly, we believe that the adoption of this proposal could promote short-termism, deter qualified directors from serving on corporate boards, and lead to the election of special interest directors, increase the influence of the proxy advisory services, and highlight voting integrity problems in the system. In closing, let me emphasize the Roundtable's commitment to effective governance practices and enabling U.S. companies to compete globally, create jobs, and generate economic growth. However, we must be careful that in a zeal to address our current financial crisis, we do not adopt a one-size-fits-all approach that can undermine the stability of boards of directors and place companies under even greater pressure for short-term performance. We must be cautious that we don't jeopardize the engine of American wealth and prosperity. Thank you. " CHRG-111shrg50814--25 Chairman Dodd," Thank you, Senator. Senator Reed. Senator Reed. Thank you very much, Mr. Chairman, and thank you, Chairman Bernanke. Let me associate myself with Chairman Dodd's remarks about in a crisis, you have been providing very helpful and thoughtful leadership. I also would associate myself with consumer protections and other supervisory activities which we will correct going forward, but thank you for your leadership in this crisis. You point out repeatedly in your comments and the Open Market Committee statement that unemployment is a significant problem in the country. In fact, the Open Market Committee indicates that it could reach 9.2 percent in 2009 and 2010, even with an improving financial market and the credit markets. Is that the conclusion, for the record? " 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-111shrg50814--41 Mr. Bernanke," Well, Senator, as I discussed in my testimony, the whole period from mid-September to early October was an intense financial crisis that was, in turn, triggered to some extent by a weakening economic condition both in the United States and around the world. To some extent, Lehman was a result of the broad financial crisis that was hitting a number of firms. You know, quite a number of large firms came under pressure during that period. And so in some sense, Lehman was a symptom as well as a cause. But I do think that the failure of Lehman was a major---- Senator Bunning. But there was picking and choosing between winner and loser here. You picked Bear Stearns to save and you let Lehman Brothers go down the tubes. " FOMC20081029meeting--303 301,CHAIRMAN BERNANKE.," Okay. Thank you. Let me just offer some thoughts that may be somewhat more expansive than usual in response to the questions that have been raised. Some of this is extemporaneous, so you'll have to bear with me. Let me first talk about the strategy we pursued thus far and where we are and then think about where we might go as a country as well as an institution going forward. Without going through all of the familiar discussion about how the crisis began, what the sources of it were, I think that the Federal Reserve's responses are essentially three. First, we were relatively early and aggressive in our monetary policy easing, particularly compared with other countries. Second, we have been creative and expansive in our use of liquidity tools, including a wide variety of lending programs. Third, we have used our available, but not always adequate, tools to try to stabilize systemically critical failing institutions and to try to mitigate systemic risk. Without sounding too defensive, I will try to argue that I think on all three of these we have been more or less in the right direction. First, on the early and aggressive monetary policy easing, obviously there was a lot of concern--a lot expressed abroad that we were going to create a stagflationary 1970s type of situation and that we were going to destroy the dollar and its role as an international currency. Our response essentially was that we thought that the increases in commodity prices were mostly a relative price change induced by changes in real demand for commodities and in the supply of commodities across the globe and that, at some point, those commodity price increases would stabilize, which would lead to a moderation of the inflationary effects and concerns. It took longer than we had expected; but once it began, it was more pronounced than we had expected. Inflation has not become the problem that was anticipated by many early on, and the dollar, of course, is now stronger than it was before we began our cutting of interest rates. So in retrospect, I think our monetary policy, although not perfect certainly--and our communication was not always perfect--broadly speaking was appropriate given what has turned out to be a very severe economic situation. Liquidity expansion also received some criticism early on. There was a view that this was inducing moral hazard. There was also some question of whether this was an effective approach. We were helped in this respect by the fact that the ECB joined us very early in this type of aggressive policy. I don't know the counterfactual. It has obviously not solved all of the problems. But I think there's a strong perception in the markets and in the general public that these actions have been supportive, and they helped mitigate the effects of the crisis on the functioning of the financial system. So I feel comfortable also with that approach. The attempts to stabilize failing systemically critical institutions, beginning with Bear Stearns, have obviously been very controversial. There have been criticisms from the right and from the left. From the right, the initial criticism was that we have no business interfering with the market process. We should let them fail. The market will take care of it. What are we doing? We heard this as recently as Jackson Hole. I never took this seriously. I just don't believe that you can allow systemically critical institutions to fail in the middle of financial crises and expect it to be not a problem. I don't want to get into the issue about the inconsistency. It's true that we treated senior debt differently between Fannie and Freddie and WaMu and Wachovia, but I don't think that that is the reason we are having the financial crisis we're having. I think there was a panic brought about by the underlying concerns about the solvency of our financial institutions. That panic essentially turned into a run. Companies like Wachovia that had adequate Basel capital faced a run on their deposits, which was self-fulfilling. The investment banks essentially faced runs. We did our best to stabilize them, but I think that it was that run, that panic, and then the impact the panic had on these major institutions that was the source of the intensification of financial crisis. So I don't buy the argument that we should stay out of the business of protecting the financial system, and I think that the major factor was, in fact, the panic that was generated by the underlying uncertainties and the effect that had on critical institutions. Also more recently we have heard more of a critique from the left, which is, What in the heck were you guys doing letting Lehman fail? This is interesting given that the critique had been the other one for quite a while. I think that critique is unfair at a narrow level in that, first, Lehman was a symptom as well as a cause of the recent crisis and, second, the Fed and the Treasury simply had no tools to address both Lehman and the other companies that were under stress at that time. I think that criticism is appropriate, though, as directed toward the United States as a whole. We did not have--as the Europeans have or as we have FDICIA for banks--a system that was set up to allow a reasonable and responsible orderly resolution of nonbank systemically critical institutions. I think we now have made a lot of progress there. The TARP will provide a good interim solution. It is very important that in the future we address the too-big-to-fail problem that we have, that we find ways to reduce that problem, and that we find ways to deal systematically with firms that are in crisis. So given the fog of war--which has, of course, been intense going back for more than a year--I would defend what we've done in terms of the general direction, acknowledging that execution is not always perfect and that communication is not always perfect. Now, what about the future? History suggests that, whenever a financial crisis becomes sufficiently severe, ultimately the only solution is a fiscal solution, and we will have a fiscal solution. There are two possibilities. One is that the financial system will muddle through, in which case the fiscal solution will be of the sort we've already seen: injections of capital, support for critical firms, support for the credit markets in general; Keynesian-style demand support. That's one possibility. I hope that's where we're going to be. In my own testimony, I argued that we should try to focus whatever stimulus we have in solving the underlying problems rather than simply handing out money and that we could do that, again, by addressing credit markets. I would add, foreclosure, homeownership, and some of those issues as well. So I hope that's where the fiscal policy will be. I hope that will take the lead from us going forward. Obviously, we'll have to continue to play a supporting role in a lot of different ways. The other possibility, of course, is that things get much worse and that we are in the same situation as Sweden or Japan, in which case a massive recapitalization of the banking system will be necessary. That will eventually happen, but I just note that, in all of these fiscal dynamics, there is a political economy overlay. You have to get to the point that it is not only the right policy to induce fiscal support but also that it is politically possible. That's one reason that I think the TARP was not possible before the most recent period. In fact, it was barely possible recently. So, again, I believe that fiscal policy will have to be a critical part of the solution going forward. Another part that we should not forget about is the international response, which is now just beginning really to become serious. The responses after the G7 weekend on banks and bank guarantees were important and suggested a commitment by other countries to stabilize the system. That's very important. I think we will see aggressive monetary policy going forward, and I think we'll see increasingly aggressive fiscal policy in other countries because they recognize that the decoupling is no longer a realistic story. So that's going to be important as well. With respect to the Federal Reserve, just generally speaking--and I'll come back to the specific recommendation for today--again, I think that our liquidity provision has been constructive. It has allowed the use of our balance sheet to help push in the deleveraging process that's been going on now for more than a year. My guess is it will probably expand some more, but I don't see it expanding a lot more, if for no other reason than we are reaching the limits of our operational capacity as well as balance sheet capacity. I think we have been reasonably successful in staying on the side of liquidity provision and not straying into credit or taking credit risk. I want to stay on that side of the line both for legal reasons and because that's the way monetary policy and lender-of-last-resort policy are supposed to work. Again, I hope that the fiscal interventions will now be able to take away some of these responsibilities from us, but we'll have to see how they play out. I confess that I hear President Plosser's concerns about reversing these programs. I recognize that it's something we'll have to do carefully. But I just don't see it as being something that will be a huge problem if the economy begins to recover and credit markets begin to function more normally. I think we'll be able to do it. Japan was able to get out the quantitative easing without too much difficulty. But I acknowledge the point that it is something we're going to have to plan for and think about. On monetary policy, I think it is important for us to be responsive. Even if we stipulate for the moment that the interest rate changes we might make today have a minimal effect on the cost of capital--and I don't necessarily agree with that, but let me stipulate it--there is still the importance of the signaling and what we're trying to tell the markets about what we plan to do in the future. Frankly, I don't think that we should try to signal that we are going to stand pat, that we are reluctant or refuse to move lower. We have to be prepared to move as low as makes sense. By that I mean in part that there are institutional factors that affect the efficacy of monetary policy at very low interest rates. We're all aware of that. I asked yesterday, and I'll ask again, for the staff to go back to the 2003 work, to update it, and to think it through and help us understand what I would call the effective zero. What is the real zero? Is it zero? Is it 50 basis points? Is it 75 basis points? We have to recognize that if we do go to literal zero, it would have very substantial effects on a number of financial markets, and we would have to ask ourselves whether the benefits from that are worth the dislocations. The Japanese thought they were, and for example, they did shut down the interbank market for a long time. Maybe doing it is worth that. Those are decisions that we need to make before the next meeting, and we will have opportunities to talk about this together and in public as well. But I do think that monetary policy needs to be proactive and to continue to be part of the solution here going forward. What about today's action? I essentially accept the general change in outlook as proposed by the Greenbook. Since our last meeting there has been an effective tightening in financial conditions, which has overwhelmed the 50 basis point cut that we did with the other central banks. The outlook has become much worse. So it is important for us to act aggressively and to signal essentially that we're willing to do whatever is necessary to support the recovery of this economy. There has been a lot of talk about confidence. I think the best thing we can do for confidence is to say that we're going to do whatever it takes, even if it involves extraordinary actions, to get this economy back onto a path where it can begin to grow in a reasonable way again. Signaling coyness, being cute, is not a safe strategy right now. We just need to be straightforward and say that we're going to do what it takes. In my view, just to be specific, 50 basis points is the right step today. Now, a number of concerns and objections have been raised. Let me address just a few of them. One is President Bullard's very interesting presentation on the inflation trap, and intuitively it's clear that, for a given real interest rate, you can have an equilibrium at which you have a high nominal rate and a high expected inflation rate or you can have a low nominal rate and deflation. Both of those things are possible. That was the trap that Japan got into. We obviously want to avoid the deflation trap. The question is, How do you avoid it? As far as I can see--obviously we can get further into this--the best two ways to avoid it are, first, as President Lacker suggested, reaffirm our commitment to price stability defined as 1� to 2 percent or whatever our Committee's general view is. We're going to try to do that with our projections and potentially with the trial projection that we're doing, and I think we can continue to strengthen our commitment to maintaining a positive inflation rate. The other thing, in terms of the dynamics, is to be aggressive in trying to avoid getting to a deflationary situation, where those expectations move in that direction. I don't think deflation expectations will arise spontaneously because we're cutting interest rates. I think they'll arise because the economy is expected to be extremely weak, and anything we can do to eliminate that expectation in my view would be helpful. The second objection I've heard is the question of whether or not these actions are effective. I think they are effective. Maybe they're not as effective as under normal circumstances, but let me put it to you this way. If we cut 50 basis points today and the LIBOR�OIS spread rises 50 basis points tomorrow, I will accept that there's a problem. But if the LIBOR spread doesn't move much and the overall LIBOR drops 50 basis points, then I think that we're having an effect. If you look at LIBOR over the past year, you'll see a dramatic decline even though the spreads have widened. I don't think you can argue that we're not having any effect. To the extent that we're having a muted effect, you can just as well argue that we should be more aggressive because you need to do more to get the same impact. So I understand those concerns, and I reiterate, responding to Governor Duke and others, that as we get very low, there are side effects on certain institutions and financial markets. We need to understand those, and that's part of our decision process. But I don't think it's the case that monetary policy has zero impact. The third argument I've heard is the ""keep the power dry"" argument. Unless you think that movements in the rate are entirely psychological in their effect, I don't think that that's a strong argument in this particular circumstance. Again, we analyzed this quite a bit in the 2003 episode, and the general outcome from the literature and from simulations done by our own staff--Dave Reifschneider, John Williams, and others have published research on this--is that the best way to avoid the zero bound is to be more aggressive than normal to try to avoid the accumulation of weakness and try to avoid getting into that trap. So more-preemptive strategies are, in fact, consistent with what we've done for the last year. My recommendation for today is 50 basis points and the language in alternative A. I do think that it will be at least moderately beneficial both in terms of psychology and in terms of reducing the cost of funding and giving some additional support to funding markets. I hope that in these remarks, which again are somewhat extemporaneous, I have addressed to some extent the future steps. We ought, again, to think very hard in the next six weeks about what the real zero is and what the implications are of going below, say, 75 basis points. Then we ought to make a determination, and it may be that we can sit still in December. It may be that things improve quite a bit in the markets, for example. It's possible. One advantage of doing 50 today is that we almost certainly will not have to do anything intermeeting because we will have done this significant step today. So in December we'll be able to look at the situation. We may be able to do little or nothing--it is possible. But if we decide that further action is needed, at that point we should be prepared to decide what the regime is going to be, how far we're going to go, and what the effective zero is, and I think that we shouldn't hesitate to do that if that's what the situation calls for. So I think there is a way forward. I understand the need to withdraw all these policy actions at an appropriate time. But I don't think that focusing on the near term for the moment is at all inconsistent with the fact that at some point these things will have to be reversed. So, any further questions or comments? President Fisher. " CHRG-111hhrg53234--10 Mr. Kohn," Thank you, Chairman Watt, Ranking Member Paul, and members of the subcommittee. I do appreciate this opportunity to discuss with you the important public policy issues associated with the Congress' grant to the Federal Reserve of a substantial degree of independence in the conduct of monetary policy and the interaction of this degree of independence with the possible enhancement of our responsibilities for financial stability. A well-designed framework for monetary policy includes a careful balance between independence and accountability. In 1977, the Congress amended the Federal Reserve Act by establishing maximum employment and price stability as our monetary policy objectives. At the same time, the Congress has correctly, in my view, given the Federal Reserve considerable scope to design and implement the best approaches to achieving those statutory objectives, subject to a well-calibrated system of checks and balances in the form of transparency and accountability to the public and the Congress. Considerable experience shows that this approach tends to yield a monetary policy that best promotes economic growth and price stability. Operational independence, that is, independence to pursue legislative goals, reduces the odds on two types of policy errors that result in inflation and economic instability. First, it prevents governments from succumbing to the temptation to use the central bank to fund budget deficits; and second, it enables policymakers to look beyond the short term as they weigh the effects of their monetary policy actions on price stability and employment. The current financial crisis has clearly demonstrated the need for the United States to have a comprehensive and multifaceted approach to containing systemic risk. The Administration recently released a proposal for strengthening the financial system that would provide new or enhanced responsibilities to a number of Federal agencies, assigning to the Federal Reserve certain new responsibilities for overseeing systemically important financial institutions and payment clearing and settlement arrangements. These incremental new responsibilities are a natural outgrowth of the Federal Reserve's existing supervisory and regulatory responsibilities. The Federal Reserve already regulates bank holding companies, which now include large investment banks, and we have been moving to incorporate a more macroprudential approach to our supervision and regulatory programs, as evidenced by the recently completed Supervisory Capital Assessment Program. The Federal Reserve has also long been a leader in the development of strong international risk management standards for payment clearing and settlement systems, and we have implemented these standards for the systems we supervise. In our supervision of bank holding companies, and our oversight of some payment systems, we already work closely with other Federal and State agencies. These responsibilities and close working relationships have not impinged on our monetary policy independence, and we do not believe that the enhancements to our existing supervisory and regulatory authority proposed by the Administration would undermine our ability to pursue our monetary policy objectives effectively and independently. Our independence in the conduct of monetary policy is accompanied by substantial accountability and transparency. For instance, the Federal Reserve reports on its efforts to achieve its statutory objectives in the semiannual monetary reports and associated testimony. The Federal Open Market Committee releases a statement immediately after each regularly scheduled meeting and detailed minutes of the meeting on a timely basis. We publish summaries of the economic forecasts of FOMC participants 4 times a year, and Federal Reserve officials frequently testify before the Congress. In addition, the Federal Reserve provides the public and the Congress with detailed annual reports on the consolidated financial activities of the system. These are audited by an independent public accounting firm. We publish a detailed balance sheet on a weekly basis. This year, we expanded our Web site to include considerable background information on our financial condition and our policy programs. We recently initiated a monthly report to Congress on Federal Reserve liquidity programs that provides even more information on our lending, associated collateral, and other facets of the programs established to address the financial crisis. The Congress also recently clarified the GAO's ability to audit the Term Asset-Backed Securities Loan Facility, a joint Treasury-Federal Reserve initiative, and it granted the GAO new authority to conduct audits of the credit facilities extended by the Federal Reserve to single and specific companies under the authority provided by Section 13(3) of the Federal Reserve Act. As this committee is aware, the Federal Reserve is already subject to frequent audits by the GAO on a broad range of our functions, including, for example, supervision and regulatory functions. The Congress, however, has purposefully and for good reason excluded monetary policy deliberations and operations from the scope of potential GAO audits. The Federal Reserve strongly believes that removing the statutory limits on GAO audits of monetary policy matters would be contrary to the public interest. Financial markets likely would see the grant of such authority as tending to undermine monetary independence, and this would have adverse consequences for interest rates and economic stability. An additional concern is that permitting GAO audits of the broad facilities the Federal Reserve uses to affect credit conditions could reduce the effectiveness of these facilities in helping promote financial stability, maximum employment, and price stability. Thank you, Mr. Chairman, for inviting me to present the Board's views, and I look forward to answering your questions. [The prepared statement of Vice Chairman Kohn can be found on page 57 of the appendix.] " CHRG-111shrg55117--132 RESPONSE TO WRITTEN QUESTIONS OF SENATOR BUNNING FROM BEN S. BERNANKEQ.1. Back in March, Secretary Geithner, who was FOMC Vice-Chair under you and Chairman Greenspan, said he now thinks easy money policies by central banks were a cause of the housing bubble and financial crisis. Do you agree with him?A.1. I do not believe that money policies by central banks in advanced economies were a significant cause of the recent boom and bust in the U.S. housing sector and the associated financial crisis. The accommodative stance of monetary policy in the United States was necessary and appropriate to address the economic weakness and deflationary pressures earlier in this decade. As I have noted previously, I believe that an important part of the crisis was caused by global saving imbalances. Those global saving imbalances increased the availability of credit to the U.S. housing sector and to other sectors of the U.S. economy, leading to a boom in housing construction and an associated credit boom. The role of global savings imbalances in the credit and housing boom and bust was amplified by a number of other factors, including inadequate mortgage underwriting, inadequate risk management practices by investors, regulatory loopholes that allowed some key financial institutions to assume very large risk positions without adequate supervision, and inaccurate assessments of risks by credit ratings agencies.Q.2. You said you think you can stop the expansion of the money supply from being inflationary. Does that mean you think the expansion of the money supply is permanent?A.2. Broad measures of the money supply, such as M2, have not grown particularly rapidly over the course of the financial crisis. By contrast, narrower measures, such as the monetary base, have grown significantly more rapidly. That growth can be attributed to the rapid expansion of bank reserves that has resulted from the liquidity programs that the Federal Reserve has implemented in order to stabilize financial markets and support economic activity. Nearly all of the increase in reserve is excess reserves--that is, reserves held by banks in addition to the level that they must hold to meet their reserve requirements. As long as banks are willing to hold those excess reserves, they will not contribute to more rapid expansion of the money supply. Moreover, as the Federal Reserve's acquisition of assets slows, growth of reserves will also slow. When economic conditions improve sufficiently, the Federal Reserve will begin to normalize the stance of monetary policy; those actions will involve a reduction in the quantity of excess reserves and an increase in short-term market rates, which will likely result in a reduction in some narrow measures of the money supply, such as the monetary base, and will keep the growth of the broad money aggregates to rates consistent with sustainable growth and price stability. As a result of appropriate monetary policy actions, the above-trend expansion of narrow measures of money supply will not be permanent and will not lead to inflation pressures.Q.3. Do you think a permanent expansion of the money supply, even if done in a noninflationary matter, is monetization of Federal debt?A.3. As noted above, growth of broad measures of the money supply, such as M2, has not been particularly rapid, and any above-trend growth of the money stock will not be permanent. Monetization of the debt generally is taken to mean a purchase of Government debt for the purpose of making deficit finance possible or to reduce the cost of Government finance. The Federal Reserve's liquidity programs, including its purchases of Treasury securities, were not designed for such purposes; indeed, it is worth noting that even with the expansion of the Federal Reserve's balance sheet, the Federal Reserve's holdings of Treasury securities are lower now than in 2007 before the onset of the crisis. The Federal Reserve's liquidity programs are intended to support growth of private spending and thus overall economic activity by fostering the extension of credit to households and firms.Q.4. Do you believe forward-looking signs like the dollar, commodity prices, and bond yields are the best signs of coming inflation?A.4. We use a variety of indicators, including those that you mention, to help gauge the likely direction of inflation. A rise in commodity prices can add to firms' costs and so create pressure for higher prices; this is especially the case for energy prices, which are an important component of costs for firms in a wide variety of industries. Similarly, a fall in the value of the dollar exerts upward pressure on prices of both imported goods and the domestic goods that compete with them. A central element in the dynamics of inflation, however, is the role played by inflation expectations. Even if firms were to pass higher costs from commodity prices or changes in the exchange rate into domestic prices, unless any such price increases become built into expectations of inflation and so into future wage and price decisions, those price increases would likely be a one-time event rather than the start of a higher ongoing rate of inflation. In this regard, it should be noted that survey measures of long-run inflation expectations have thus far remained relatively stable, pointing to neither a rise in inflation nor a decline in inflation to unwanted levels. A rise in bond yields--the third indicator you mention--could itself be evidence of an upward movement in expected inflation. More specifically, a rise in yields on nominal Treasury securities that is not matched by a rise in yields on inflation-indexed securities (TIPS) could reflect higher expected inflation. Indeed, such movements in yields have occurred so far this year. However, the rise in nominal Treasury yields started from an exceptionally low level that likely reflected heightened demand for the liquidity of these securities and other special factors associated with the functioning of Treasury markets. Those factors influencing nominal Treasury yields have made it particularly difficult recently to draw inferences about expected inflation from the TIPS market. The FOMC will remain alert to these and other indicators of inflation as we gauge our future policy actions in pursuit of our dual mandate at maximum employment and price stability.Q.5.a. Other central banks that pay interest on reserves set their policy rate using that tool. Now that you have the power to pay interest on excess reserves, are you going to change the method of setting the target rate?A.5.a. At least for the foreseeable future, the Federal Reserve expects to continue to set a target (or a target range) for the Federal funds rate as part of its procedures for conducting monetary policy. The authority to pay interest on reserves gives the Federal Reserve an additional tool for hitting its target and thus affords the Federal Reserve the ability to modify its operating procedures in ways that could make the implementation of policy more efficient and effective. Also, the Federal Reserve is in the process of designing various tools for reserve management that could be helpful in the removal of policy accommodation at the appropriate time and that use the authority to pay interest on reserves. However, the Federal Reserve has made no decisions at this time on possible changes to its framework for monetary policy implementation.Q.5.b. Assuming you were to make such a change, would that lead to a permanent expansion of the money supply?A.5.b. No. These tools are designed to implement monetary policy more efficiently and effectively. Their use would have no significant effect on broad measures of the money supply. It is possible that such a change could involve a permanently higher level of reserves in the banking system. However, the level of reserves under any such regime would still likely be much lower than at present and, in any case, would be fully consistent with banks' demand for reserves at the FOMC's target rate. As a result, the higher level of reserves in such a system would not have any implication for broad measures of money.Q.5.c. Would such an expansion essentially mean you have accomplished a one-time monetization of the Federal debt?A.5.c. No. If the Federal Reserve were to change its operating procedures in a way that involved a permanently higher level of banking system reserves, it is possible that the corresponding change on the asset side of the Federal Reserve's balance sheet would be a permanently higher level of Treasury securities, but the change could also be accounted for by a higher level of other assets--for example, repurchase agreements conducted with the private sector. The purpose of any permanent increase in the level of the Federal Reserve's holdings of Treasury securities would be to accommodate a higher level of reserves in the banking system rather than to facilitate the Treasury's debt management.Q.6. Is the Government's refusal to rescue CIT a sign that the bailouts are over and there is no more ``too-big-to-fail'' problem?A.6. The Federal Reserve does not comment on the condition of individual financial institutions such as CIT.Q.7. Do you plan to hold the Treasury and GSE securities on your books to maturity?A.7. The evolution of the economy, the financial system, and inflation pressures remain subject to considerable uncertainty. Reflecting this uncertainty, the way in which various monetary policy tools will be used in the future by the Federal Reserve has not yet been determined. In particular, the Federal Reserve has not developed specific plans for its holdings of Treasury and GSE securities.Q.8. Which 13(3) facilities do you think are monetary policy and not rescue programs?A.8. The Federal Reserve developed all of the facilities that are available to multiple institutions as a means of supporting the availability of credit to firms and households and thus buoying economic growth. Because supporting economic growth when the economy has been adversely affected by various types of shocks is a key function of monetary policy, all of the facilities that are available to multiple institutions can be considered part of the Federal Reserve's monetary policy response to the crisis. In contrast, the facilities that the Federal Reserve established for single and specific institutions would ordinarily not be considered part of monetary policy.Q.9. Given the central role the President of the New York Fed has played in all the bailout actions by the Fed, why shouldn't that job be subject to Senate confirmation in the future?A.9. Federal Reserve policy makers are highly accountable and answerable to the Government of the United States and to the American people. The seven members of the Board of Governors of the Federal Reserve System are appointed by the President and confirmed by the Senate after a thorough process of public examination. The key positions of Chairman and Vice Chairman are subject to presidential and congressional review every four years, a separate and shorter schedule than the 14-year terms of Board members. The members of the Board of Governors account for seven seats on the FOMC. By statute, the other five members of the FOMC are drawn from the presidents of the 12 Federal Reserve Banks. District presidents are appointed through a process involving a broad search of qualified individuals by local boards of directors; the choice must then be approved by the Board of Governors. In creating the Federal Reserve System, the Congress combined a Washington-based Board with strong regional representation to carefully balance the variety of interests of a diverse Nation. The Federal Reserve Banks strengthen our policy deliberations by bringing real-time information about the economy from their district contacts and by their diverse perspectives.Q.10. The current structure of the regional Federal Reserve Banks gives the banks that own the regional Feds governance powers, and thus regulatory powers over themselves. And with investment banks now under Fed regulation, it gives them power over their competitors. Don't you think that is conflict of interest that we should address?A.10. Congress established the makeup of the boards of directors of the Federal Reserve Banks. The potential for conflicts of interest that might arise from the ownership of the shares of a Federal Reserve Bank by banking organizations in that Bank's district are addressed in several statutory and policy provisions. Section 4 of the Federal Reserve Act provides that the board of directors of Reserve Banks ``shall administer the affairs of said bank fairly and impartially and without discrimination in favor of or against any member bank or banks.'' 12 U.S.C. 301. Reserve Bank directors are explicitly included among officials subject to the Federal conflict of interest statute, 18 U.S.C. 208. That statute imposes criminal penalties on Reserve Bank directors who participate personally and substantially as a director in any particular matter which, to the director's knowledge, will affect the director's financial interests or those of his or her spouse, minor children, or partner, or any firm or person of which the director is an officer, director, trustee, general partner, or employee, or any other firm or person with whom the director is negotiating for employment. Reserve Banks routinely provide training for their new directors that includes specific training on section 208, and Reserve Bank corporate secretaries are trained to respond to inquiries regarding possible conflicts in order to assist directors in complying with the statute. The Board also has adopted a policy specifically prohibiting Reserve Bank directors from, among other things, using their position for private gain or giving unwarranted preferential treatment to any organization. Reserve Bank directors are not permitted to be involved in matters relating to the supervision of particular banks or bank holding companies nor are they consulted regarding bank examination ratings, potential enforcement actions, or similar supervisory issues. In addition, while the Board of Governors' rules delegate to the Reserve Banks certain authorities for approval of specific types of applications and notices, Reserve Bank directors are not involved with oversight of those functions. Moreover, in order to avoid even the appearance of impropriety, the Board of Governors' delegation rules withdraw the Reserve Banks' authority where a senior officer or director of an involved party is also a director of a Reserve Bank or branch. Directors are also not involved in decisions regarding discount window lending to any financial institution. Finally, directors are not involved in awarding most contracts by the Reserve Banks. In the rare case where a contract requires director approval, directors who might have a conflict as a result of affiliation or stock ownership routinely recuse themselves or resign from the Reserve Bank board, and any involvement they would have in such a contract would be subject to the prohibitions in section 208 discussed above.Q.11. Do you think access to the discount window should be opened to nonbanks by Congress?A.11. The current episode has illustrated that nonbank financial institutions can occasionally experience severe liquidity needs that can pose significant systemic risks. In many cases, the Federal Reserve's 13(3) authority may be sufficient to address these situations, which should arise relatively infrequently. However, a case could be made that certain types of nonbank institutions, such as primary dealers, should have ongoing access to the discount window; any such increased access would need to be coupled with more stringent regulation and supervision. The Federal Reserve also believes that the smooth functioning of various types of regulated payment, clearing, and settlement utilities, some of which are organized as nonbanks, is critical to financial stability; a case could also be made that such organizations should be granted ongoing access to discount window credit.Q.12. Do you think any of the 13(3) facilities should be made permanent by Congress?A.12. As noted above, the issue of appropriate access to central bank credit by certain types of nonbank financial institutions deserves careful consideration by policy makers. The financial crisis has illustrated that various types of nonbank financial institutions can experience severe liquidity strains that pose risks to the entire financial system. However, whether access to the discount window should be granted to such institutions depends on a wide range of considerations and any decision would need to be based on careful study of all of the relevant issues.Q.13. For several reasons, I am doubtful that the Fed or anyone else can effectively regulate systemic risk. A better approach may be to limit the size and scope of firms so that future failures will not pose a danger to the system. Do you think that is a better way to go?A.13. I believe that it is important to improve the U.S. financial regulatory system so as to contain systemic risk and to address the related problem of ``too-big-to-fail'' financial institutions. The Federal Reserve and the Administration have proposed a number of ways to limit systemic risk and the problem of ``too-big-to-fail'' financial institutions. Imposing artificial limits on the size of scope of individual firms will not necessarily reduce systemic risk and could reduce competitiveness. A challenge of this approach would be to address the financial institutions that already are large and complex. Such institutions enjoy certain competitive benefits including global access to credit. At any point in time, the systemic importance of an individual firm depends on a wide range of factors. Size is only one relevant consideration. The impact of a firm's financial distress depends also on the degree to which it is interconnected, either receiving funding from, or providing funding to, other potentially systemically important firms, as well as on whether it performs crucial services that cannot easily or quickly be executed by other financial institutions. In addition, the impact varies over time: the more fragile the overall financial backdrop and the condition of other financial institutions, the more likely a given firm is to be judged systemically important. If the ability of the financial system to absorb adverse shocks is low, the threshold for systemic importance will more easily be reached. Judging whether a financial firm is systemically important is thus not a straightforward task, especially because a determination must be based on an assessment of whether the firm's failure would likely have systemic effects during a future stress event, the precise parameters of which cannot be fully known. I am confident that the Federal Reserve is well positioned both to identify systemically important firms and to supervise them. We look forward to working with Congress and the Administration to enact meaningful regulatory reform that will strengthen the financial system and reduce both the probability and severity of future crises.Q.14. Given your concerns about opening monetary policy to GAO review, what monetary policy information, specifically, do you not want in the hands of the public?A.14. The Federal Reserve believes that a substantial degree of transparency in monetary policymaking is appropriate and has initiated numerous measures to increase its transparency. In addition to a policy announcement made at the conclusion of each FOMC meeting, the Federal Reserve releases detailed minutes of each FOMC meeting 3 weeks after the conclusion of the meeting. These minutes provide a great deal of information about the range of topics discussed and the views of meeting participants at each FOMC meeting. Regarding its liquidity programs, the Federal Reserve has provided a great deal of information regarding these programs on its public Web site at http://www.federalreserve.gov/monetarypolicy/bst.htm. In addition, the Federal Reserve has initiated a monthly report to Congress providing detailed information on the operations of its programs, types, and amounts of collateral accepted, and quarterly updates on Federal Reserve income and valuations of the Maiden Lane facilities. This information is also available on the Web site at http://www.federalreserve.gov/monetarypolicy/bst_reportsresources.htm. The Federal Reserve believes that it should be as transparent as possible consistent with the effective conduct of the responsibilities with which it has been charged by the Congress. The Federal Reserve has noted its effectiveness in conducting monetary policy depends critically on the confidentiality of its policy deliberations. It has also noted that the effectiveness of its tools to provide liquidity to the financial system and the economy depends importantly on the willingness of banks and other entities in sound financial condition to use the Federal Reserve's credit facilities when appropriate. That willingness is supported by assuring borrowers that their usage of credit facilities will be treated as confidential by the Federal Reserve. As a result of these considerations, the Federal Reserve believes that the release of detailed information regarding monetary policy deliberations or the names of firms borrowing from Federal Reserve facilities would not be in the public interest. ------ CHRG-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-111hhrg56766--285 Mr. Bernanke," There are two classes of loans. There are a whole bunch of programs that were established under emergency authorities. These are now being shut down. We essentially are offering full transparency on all those programs, including the names of the borrowers. There is another program which is pretty small in size, but is very important, called a ``discount window.'' The discount window, we think it is very important to keep the names of the borrowers confidential, and the reason is the banks will only come to the discount window in a period of crisis or panic, and if they believe their names will be revealed, that would indeed intensify the crisis or panic, and therefore, the whole purpose of the discount window, to try to eliminate financial panics, would be severely damaged. We are concerned about that. " fcic_final_report_full--448 The inability to find funding, financial firm deleveraging, and macroeconomic weakness translated into tighter credit for consumers and businesses. Securitization markets for other kinds of debt collapsed rapidly in  and still have not recovered fully, cutting off a substantial source of financing for credit cards, car loans, student loans, and small business loans. Decreased credit availability, the collapse of the housing bubble, and additional wealth losses from a declining stock market led to a sharp contraction in consump- tion and output and an increase in unemployment. Real GDP contracted at an annual rate of . percent in the third quarter of , . percent in the fourth quarter, and . percent in the first quarter of . The eco- nomic contraction in the fourth quarter of  was the worst in nearly three decades. Firms and households that had not previously been directly affected by the financial crisis suddenly pulled back–businesses stopped hiring and halted new in- vestments, while families put spending plans on hold. After the panic began, the rate at which the economy shed jobs jumped, going from an average of , jobs lost per month in the first three quarters of , to an average of over , jobs lost per month in the fourth quarter of  and the first quarter of . The economy continued to lose jobs through most of , with the unemployment rate peaking at . percent in October  and remaining above . percent for the rest of  and the first eleven months of . While the shock and panic therefore appear to have ended in early , the harm to the real economy continues through today. Firms and families are still deleverag- ing and are uncertain about both future economic growth and the direction of future policy. The final tragedy of the financial and economic crisis is that the needed recov- ery is slow and looks to be so for a while longer. NOTES 1. A vote of the Commission on December 6, 2010, limited dissenters to nine pages each in the approximately 550-page commercially published book. No limits apply to the official version sub- mitted to the President and the Congress. 2. Ben S. Bernanke, “Monetary Policy and the Housing Bubble,” Speech at the Annual Meeting of the American Economic Association, Atlanta, Georgia, January 3, 2010 (www.federalreserve.gov/ newsevents/speech/bernanke20100103a.htm). 3. Ibid. 4. “Risky borrowers” does not mean poor. While many risky borrowers were low-income, a borrower with unproven income applying for a no-documentation mortgage for a vacation home was also risky. 5. Bernanke, “Monetary Policy and the Housing Bubble.” 6. The Commission vigorously debated the relative importance and the motivations of the dif- ferent types of securitizers in lowering credit quality. We think that both types of securitizers were in part responsible and that these debates are less important than the existence of lower standards and how this problem fits into the broader context. 7. While bad information created by credit rating agencies was an essential cause of the crisis, it is less clear why they did this. Important hypotheses include: (1) bad analytic models that failed to account for correlated housing price declines across wide geographies, (2) an industry model that encouraged the rating agencies to skew their ratings upward to generate business, and (3) a lack of market competition due to their government-induced oligopoly. 8. In most cases during the crisis, the three key policymakers were Treasury Secretary Henry Paulson, Federal Reserve Chairman Ben Bernanke, and Federal Reserve Bank of New York Presi- dent Timothy Geithner. Other officials were key in particular cases, such as FHFA Director Jim Lockhart’s GSE actions and FDIC Chairman Sheila Bair’s extension of temporary loan guarantees to bank borrowing in the fall of 2008. During the financial recovery and rebuilding stage that be- gan in early 2009, the three key policymakers were Treasury Secretary Timothy Geithner, Fed Chairman Ben Bernanke, and White House National Economic Council Director Larry Summers. 9. Ben S. Bernanke, testimony before the FCIC, Hearing on Too Big to Fail: Expectations and Impact of Extraordinary Government Intervention and the Role of Systemic Risk in the Financial Crisis, session 1: The Federal Reserve, September 2, transcript, p. 78.  FinancialCrisisInquiry--588 SOLOMON: Groundhog. We wake up every day and it’s the same thing. And the reason I point it out in my testimony, folks have mentioned too is how many crisis we’ve had. This is like recurring non-recurring losses. CHRG-111hhrg74090--88 Mr. Radanovich," And I understand the reason for looking at this because we have all experienced this financial crisis but doesn't this end up providing consumers with less choice and driving up the cost of credit for consumers? " CHRG-111hhrg54867--27 Mr. Bachus," Not have more bailouts. " Secretary Geithner," --abolish the fire station, lock the doors of the fire station when the crisis breaks out. It is not a strategy that works. " CHRG-110shrg50369--108 Mr. Bernanke," Senator, I have not worked through any proposals like that. This is really an Accounting Board responsibility. I agree there is a severe problem. It is difficult to change the rules in the middle of a crisis. Senator Schumer. I know. " CHRG-111shrg62643--12 Chairman Dodd," Thank you very much, and what I will do is I will ask the Clerk to--let us try 7 minutes a round. Again, I won't be banging down the gavel too hard, but if people try and keep them in that timeframe, it will be helpful since we have got a pretty good turnout, if we can. Let me begin by raising the issue--Senator Shelby made note of the reference to the recent crisis in Europe. Let me start out there, if I can. As the European Union announced its financial stabilization program in May, you briefed us, in fact, here on the Committee on the Fed's decision to temporarily reopen the dollar swap lines with the ECB and other foreign central banks to support liquidity in the dollar funding markets. Clearly, the Fed identified a need to protect the American economy from events in Europe. With continued downgrades of European sovereigns--I noticed Ireland, just the other day, they downgraded a bit--European bank stress test results expected this week, and again, there has been a lot written about that, how successful they may be, and the uncertainty about future economic growth, as well, what challenges lie ahead, in your view, for the efforts you and your counterparts in Europe have made to stabilize the financial system? " 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. " fcic_final_report_full--484 Thus, about 27 percent of Bear’s readily available sources of funding consisted of PMBS that became unusable for repo financing when the PMBS market disappeared. The loss of this source of liquidity put the firm in serious jeopardy; rumors swept the market about Bear’s condition, and clients began withdrawing funds. Bear’s offi cers told the Commission that the firm was profitable in its first 2008 quarter—the quarter in which it failed; ironically they also told the Commission’s staff that they had moved Bear’s short term funding from commercial paper to MBS because they believed that collateral-backed funding would be more stable. In the week beginning March 10, 2008, according to the FCIC staff report, Bear had over $18 billion in cash reserves, but by March 13 the liquidity pool had fallen to $2 billion. 51 It was clear that Bear—solvent and profitable or not—could not survive a run that was fueled by fear and uncertainty about its liquidity and the possibility of its insolvency. Parenthetically, it should be noted that the Commission’s staff focused on Bear because the Commission’s majority apparently believed that the business model of investment banks, which relied on relatively high leverage and repo or other short term financing, was inherently unstable. The need to rescue Bear was thought to be evidence of this fact. Clearly, the five independent investment banks—Bear, Lehman Brothers, Merrill Lynch, Morgan Stanley and Goldman Sachs—were badly damaged in the financial crisis. Only two of them remain independent firms, and those two are now regulated as bank holding companies by the Federal Reserve. Nevertheless, it is not clear that the investment banks fared any worse than the much more heavily regulated commercial banks—or Fannie and Freddie which were also regulated more stringently than the investment banks but not as stringently as banks. The investment banks did not pass the test created by the mortgage meltdown and the subsequent financial crisis, but neither did a large number of insured banks— IndyMac, Washington Mutual (WaMu) and Wachovia, to name the largest—that were much more heavily regulated and, in addition, offered insured deposits and had access to the Fed’s discount window if they needed emergency funds to deal with runs. The view of the Commission majority, that investment banks—as part of the so-called “shadow banking system”—were special contributors to the financial crisis, seems misplaced for this reason. They are better classified not as contributors to the financial crisis but as victims of the panic that ensued after the housing bubble and the PMBS market collapsed. Bear went down because the delinquencies and failures of an unprecedentedly large number of NTMs caused the collapse of the PMBS market; this destroyed the 50 51 FCIC, “Investigative Findings on Bear Stearns (Preliminary Draft),” April 29, 2010, p.16. Id., p.45. 479 usefulness of AAA-rated PMBS as assets that Bear and others relied on for both capital and liquidity, and thus raised questions about the firm’s ability to meet its obligations. Investment banks like Bear Stearns were not commercial banks; instead of using short term deposits to hold long term assets—the hallmark of a bank— their business model relied on short-term funding to carry the short term assets of a trading business. Contrary to the views of the Commission majority, there is nothing inherently wrong with that business model, but it could not survive an unprecedented financial panic as severe as that which followed the collapse in value of an asset class as large and as liquid as AAA-rated subprime PMBS. CHRG-111hhrg56766--100 Mr. Bernanke," Yes. We have two broad sets of policies, roughly speaking. One was a set of special facilities, lending facilities that were intended to stabilize our financial system which obviously was extremely disrupted by the crisis. Those facilities have been quite successful. They have helped stabilize the money market mutual funds, commercial paper market, the repo market, many other important financial markets. With the improvement and stabilization of those markets, we have been shutting those down. So many of them were shut down on February 1st and this was a question Congresswoman Waters asked about the discount rate and so on. So we believe that, as those financial markets are normalizing, we can begin to reduce that source of support. The other approach, the other policy, set of policies we have is monetary policies intended to support the recovery which includes the low interest rates and the purchases of mortgage-backed securities and treasuries. Those remain at a very accommodative level. It is true that we will stop buying new mortgage-backed securities at the end of this quarter, but we will continue to hold one and a quarter trillion dollars of agency mortgage-backed securities and that taking that off the market itself will keep mortgage rates below what they otherwise would be. So we believe that there will still be stimulus coming from our holdings of those securities as well as our low interest rates. So we think the economy as opposed to the money markets, for example, still requires support for recovery. " FinancialCrisisInquiry--602 GORDON: January 13, 2010 Good afternoon Chairman Angelides, Vice Chairman Thomas, and members of the commission. Thank you so much for the invitation to participate in this hearing. I’m Julia Gordon, Senior Policy Counsel at the Center for Responsible Lending, a non-profit, non- partisan research and policy organization. We’re an affiliate of the Community—of the Center for Community Self Help—a community development financial institution that makes mortgage loans in lower income communities. At the end of 2006 our organization published a study projecting that one out of five subprime mortgages would fail. At the time we were called “wildly pessimistic.” Given the resulting devastation, we sincerely wish our projections had been wrong. Instead, we were far too optimistic. In this morning’s panel, several of the CEOs talked about some sleepless nights last September right before the government came in to bail out the banks. Right now there’s 6.5 million people having a sleepless night, night after night, because they fear that their family won’t have a roof over their head tomorrow. These families are either late with their payments, or many are already in the foreclosure process. More than two million foreclosures have occurred in the past two years alone, and the problem has spread far beyond the subprime market. By 2014 we expect that up to 13 million foreclosures may have taken place. Beyond the losses to the foreclosed owners themselves, the spill over cost of this crisis are massive. Millions of families who pay their mortgage very month are suffering hundreds of billions of dollars in lost wealth, just because they live close to homes in foreclosure. Those who don’t own homes suffer too. One study found that 40 percent of those who have lost their home due to this crisis are renters who’s landlords were foreclosed on. And of course foreclosures hurt all of us through lost tax revenue, and increased costs for fire, police, and other municipal services. I can summarize my testimony this way. Today’s foreclosure crisis was foreseeable and avoidable. And the loan products offered absolutely no benefit whatsoever to America’s January 13, 2010 consumers over standard loan products. Subprime lending didn’t even increase home ownership. Through 2006 first time home buyers accounted for only 10 percent of all subprime loans. And now in the aftermath of the melt down, there’s been a net loss of home ownership that set us back a decade. The only reason for these products to have been mass marketed to consumers was for Wall Street, lenders, and brokers to make a huge profit by selling, flipping, and securitizing large numbers of unsustainable mortgages. And the bank regulators who, as many have talked about today, had ample warning about the dangers posed by these loans, either were asleep at the switch or actively encouraging this high-profit, high-risk lending. The impact of foreclosures has been particularly hard on African American and Latino communities. This crisis has widened the already sizable wealth gap between whites and minorities in this country and has wiped out the asset base of entire neighborhoods. The foreclosure crisis was not caused by greedy or risky borrowers. The average subprime loan amount nationally was just over $200,000 and is much lower if you exclude the highest priced markets such as California. A majority of subprime borrowers had credit scores that would qualify them for prime loans with much better terms, and researchers have found that abusive loan terms such as exploding rates and prepayment penalties created an elevated risk of foreclosure even after controlling for differences in borrowers’ credit scores. It’s also not the case that widespread unemployment is in and of itself the reason for the spread of this crisis to the prime market. For the past 30 years, foreclosure rates remained essentially flat during periods of high unemployment because people who lost their jobs could sell their homes or tap into home equity to tide them over. Unemployment is now triggering an unprecedented number of home losses because loan flipping and the housing bubble have left so many families underwater. Most important, it’s crucial to put to rest any idea that the crisis was caused by efforts to extend home ownership opportunities to traditionally underserved communities. Many January 13, 2010 financial institutions, our own included, have long lent safely and successfully to these communities without experiencing outsize losses. Legal requirements such as those embodied in the CRA had been in effect for more than two decades with no ill effect before the increase in risky subprime loans, and fully 94 percent of all subprime loans were not covered by the CRA. What caused this problem was, as has been stated by previous panelists, risky loan products that existed for only one purpose. It was these loan products forced repeated refinancings that would continue to line the pockets of originators. It’s also important to note that contrary to what we heard earlier today, Wall Street was not just an impartial ATM giving out money to originators. Wall Street was asking for the riskiest loans. In one New York Times article, a CEO of a lending company told the reporter, “They were paying me more for no-doc loans, so I told my people to have the customers put their W- 2s away.” For the most part, consumers did not ask for these products. These products were push- marketed to consumers. Lenders paid their independent broker originators extra money for placing consumers into interest rates above par, and got even more money for locking them into those rates with prepayment penalties. Both private and public responses to the foreclosure crisis have been too little and too late. The Obama administration has created a promising framework with the Making Home Affordable program, but the program has not lived up to expectations because servicers either can’t or won’t make the necessary modifications. Considerations of both economic recovery and basic fairness demand that we do much more to help. We consider the following four steps to be crucial to mitigating the foreclosure crisis. First, we should ensure that families have adequate equity in their homes to continue with successful home ownership. With one out of four mortgage holders underwater, a modification program will not be successful at avoiding re-defaults unless mortgages are realigned with current values. Yet even as loan modification activity ramps up, principal reduction is still relatively rare. January 13, 2010 The large banks, who own most of the second liens, are locked in a game of chicken with investors and neither of them will agree to write-down their holdings if the other doesn’t. Servicers, for their part, continue to have conflicting financial incentives that sometimes push against the interests of both the borrowers and the loan owners. The administration fears moral hazard, but we did not let very significant moral hazard concerns stop us when we bailed out the banks. Second, we should require all mortgage loan servicers to attempt loss mitigation prior to initiating foreclosure and to document their efforts. As we all now know, voluntary foreclosure prevention programs do not work. Third, we should lift the ban on judicial modifications of primary residence mortgages. Modifications of loans in bankruptcy court is available for vacation homes, farms, commercial real estate and yachts. Permitting judges to modify mortgages on principal residences carries zero cost to the U.S. taxpayer, would address the moral hazard objections to other proposals, and would serve as a stick to the HAMP’s program’s carrots. Fourth, we should make the MHAP program fairer and more effective, especially by stopping the parallel foreclosure process while loans are being evaluated for modifications. And last, I want to talk about what we need to do stop this crisis from happening again. It’s crucial that we create an independent consumer financial protection agency. Federal bank regulators could have prevented this crisis, but regulatory capture, charter arbitrage, the equating of safety and soundness with profitability, and the ghettoization of consumer protection prevented the system from working. Finally, we must enact common sense rules of the road for mortgage origination. It will be truly stunning if we emerge from the wreckage of this foreclosure crisis without instituting a baseline requirement that lenders make only those loans that borrowers have the ability to pay, and without demanding that all participants along the mortgage securitization chain share an interest in the loan’s performance over time. January 13, 2010 We stand ready to assist the commission over the coming year and we look forward to your findings on these matters of utmost importance to America’s families. Thank you very much. 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-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." fcic_final_report_full--33 Indeed, Greenspan would not be the only one confident that a housing downturn would leave the broader financial system largely unscathed. As late as March , after housing prices had been declining for a year, Bernanke testified to Congress that “the problems in the subprime market were likely to be contained”—that is, he ex- pected little spillover to the broader economy.  Some were less sanguine. For example, the consumer lawyer Sheila Canavan, of Moab, Utah, informed the Fed’s Consumer Advisory Council in October  that  of recently originated loans in California were interest-only, a proportion that was more than twice the national average. “That’s insanity,” she told the Fed gover- nors. “That means we’re facing something down the road that we haven’t faced before and we are going to be looking at a safety and soundness crisis.”  On another front, some academics offered pointed analyses as they raised alarms. For example, in August , the Yale professor Robert Shiller, who along with Karl Case developed the Case-Shiller Index, charted home prices to illustrate how precip- itously they had climbed and how distorted the market appeared in historical terms. Shiller warned that the housing bubble would likely burst.  In that same month, a conclave of economists gathered at Jackson Lake Lodge in Wyoming, in a conference center nestled in Grand Teton National Park. It was a “who’s who of central bankers,” recalled Raghuram Rajan, who was then on leave from the University of Chicago’s business school while serving as the chief economist of the International Monetary Fund. Greenspan was there, and so was Bernanke. Jean-Claude Trichet, the president of the European Central Bank, and Mervyn King, the governor of the Bank of England, were among the other dignitaries.  Rajan presented a paper with a provocative title: “Has Financial Development Made the World Riskier?” He posited that executives were being overcompensated for short-term gains but let off the hook for any eventual losses—the IBGYBG syn- drome. Rajan added that investment strategies such as credit default swaps could have disastrous consequences if the system became unstable, and that regulatory in- stitutions might be unable to deal with the fallout.  He recalled to the FCIC that he was treated with scorn. Lawrence Summers, a for- mer U.S. treasury secretary who was then president of Harvard University, called Ra- jan a “Luddite,” implying that he was simply opposed to technological change.  “I felt like an early Christian who had wandered into a convention of half-starved lions,” Rajan wrote later.  Susan M. Wachter, a professor of real estate and finance at the University of Penn- sylvania’s Wharton School, prepared a research paper in  suggesting that the United States could have a real estate crisis similar to that suffered in Asia in the s. When she discussed her work at another Jackson Hole gathering two years later, it received a chilly reception, she told the Commission. “It was universally panned,” she said, and an economist from the Mortgage Bankers Association called it “absurd.”  CHRG-111shrg51290--30 Mr. Bartlett," Well, Senator, it is awfully tempting, given the crisis that we are in now, to sit around this table and say, well, let us design the financial products and we will have three of them, but that would be a disaster for the American people, if not in the short-run, at least in the medium-run. Innovation does help consumers. That is why it is innovative. That is not to say that nothing should happen. In fact, I am calling for some massive additional more effective regulation to regulate the standards, responsibility, accepting the responsibility and accountability both by the agencies and by the companies, uniform national standards, and a system of enforcement. But the idea to then convert over to a system where the government simply in whatever form designs what a financial product should look like, I think would do a great disservice, both in the near-term and the long-term. Senator Bennet. Mr. Chairman, that is not what I am suggesting, but I think that even the most simple products, in some respects, at the consumer level, I think what we are seeing now is that in their aggregation and in the secondary markets into which they are sold, there is a level of complexity at that point that has, at the very least, created a lack of transparency about what is going on on the balance sheets of our major banks, and in the worst cases helped contribute to where we are. I think I am just trying to, with the other Committee members, figure out what we can do to redesign things so that we don't find ourselves here again, not to rewrite these rules. Professor McCoy, just one question. You mentioned this in your testimony, both written and spoken. I just wanted to come back to it. Tell us a little more about--and you proposed setting up a separate agency for consumer protection. But one of the reasons for that is your observation that you think there has been a reluctance on the part of the existing regulatory agencies to exercise their enforcement authority. Can you talk more about where you think that reluctance springs from? Ms. McCoy. I think there are various sources. One is this longstanding bank regulatory culture of dialog and cooperation with regulated banks. It may, in fact, be that the reluctance to bring formal enforcement action is part of a longstanding tradition of secrecy, lack of transparency in bank regulation due to fears about possible runs on deposit. But what we have ended up with is an enforcement system that is entirely opaque. It is very, very difficult to see what is happening behind the curtain. One other thing I failed to mention was that the late Governor Gramlich in 2007 stated that the Federal Reserve had not been doing routine examinations of the mortgage lending subsidiaries that were under its watch. It was not going in and examining at all except in emergency situations. Thank you. Senator Bennet. Thank you, Mr. Chairman. " CHRG-111hhrg53234--224 Mr. Galbraith," It would be very helpful, in my view, to conduct a full and independent investigation into the cause of the financial crisis, similar to the Pecora Committee investigations of the early 1930's. " fcic_final_report_full--383 Wachovia, but without success. The Wells Fargo deal would close at midnight on De- cember , for  per share. IRS Notice - was repealed in . The Treasury’s inspector general, who later conducted an investigation of the circumstances of its issuance, reported that the purpose of the notice was to encourage strong banks to acquire weak banks by re- moving limitations on the use of tax losses. The inspector general concluded that there was a legitimate argument that the notice may have been an improper change of the tax code by Treasury; the Constitution allows Congress alone to change the tax code. A congressional report estimated that repealing the notice saved about  bil- lion of tax revenues over  years.  However, the Wells controller, Richard Levy, told the FCIC that to date Wells has not recognized any benefits from the notice, because it has not yet had taxable income to offset.  TARP: “COMPREHENSIVE APPROACH ” Ten days after the Lehman bankruptcy, the Fed had provided nearly  billion to investment banks and commercial banks through the PDCF and TSLF lending facili- ties, in an attempt to quell the storms in the repo markets, and the Fed and Treasury had announced unprecedented programs to support money market funds. By the end of September, the Fed’s balance sheet had grown  to . trillion. But the Fed was running out of options. In the end, it could only make collateral- ized loans to provide liquidity support. It could not replenish financial institutions’ capital, which was quickly dissolving. Uncertainty about future losses on bad assets made it difficult for investors to determine which institutions could survive, even with all the Fed’s new backstops. In short, the financial system was slipping away from its lender of last resort. On Thursday, September , the Fed and Treasury proposed what Secretary Paul- son called a “comprehensive approach” to stem the mounting crisis in the financial system by purchasing the toxic mortgage-related assets that were weighing down many banks’ balance sheets.  In the early hours of Saturday, September , as Gold- man Sachs and Morgan Stanley were preparing to become bank holding companies, Treasury sent Congress a draft proposal of the legislation for TARP. The modest length of that document—just three pages—belied its historical significance. It would give Treasury the authority to spend as much as  billion to purchase toxic assets from financial institutions. The initial reaction was not promising. For example, Senate Banking Committee Chairman Christopher Dodd said on Tuesday, “This proposal is stunning and un- precedented in its scope—and lack of detail, I might add.” “There are very few details in this legislation,” Ranking Member Richard Shelby said. “Rather than establishing a comprehensive, workable plan for resolving this crisis, I believe this legislation merely codifies Treasury’s ad hoc approach.”  Paulson told a Senate committee on Tuesday, “Of course, we all believe that the very best thing we can do is make sure that the capital markets are open and that lenders are continuing to lend. And so that is what this overall program does, it deals with that.”  Bernanke told the Joint Economic Committee Wednesday: “I think that this is the most significant financial crisis in the post-War period for the United States, and it has in fact a global reach. . . . I think it is extraordinarily important to understand that, as we have seen in many previous examples of different countries and different times, choking up of credit is like taking the lifeblood away from the economy.”  He told the House Financial Services Committee on the same day, “People are saying, ‘Wall Street, what does it have to do with me?’ That is the way they are thinking about it. Unfortunately, it has a lot to do with them. It will affect their company, it will affect their job, it will affect their economy. That affects their own lives, affects their ability to borrow and to save and to save for retirement and so on.”  By the evening of Sunday, September , as bankers and regulators hammered out Wachovia’s rescue, congressional negotiators had agreed on the outlines of a deal. Senator Mel Martinez, a former HUD secretary and then a member of the Bank- ing Committee, told the FCIC about a meeting with Paulson and Bernanke that Sunday: CHRG-111hhrg52261--91 Mr. Hirschmann," Access to credit is a significantly enhanced problem in this crisis. What our study finds is that even before the crisis, half of the smallest firms had access-to-credit problems. It is clearly magnified. I don't know whether you point--obviously, you don't want banks to make loans that are being given to inadequate--people that don't have adequate credit. On the other hand, you want to make sure that the small businesses have credit. That is why this secondary credit market, the ability of small firms to rely on their personal credit, especially when they are starting a business, is vital to start-ups and vital to creating new jobs in this country. " CHRG-111shrg52966--71 PREPARED STATEMENT OF ROGER T. COLE Director, Division of Banking Supervision and Regulation Board of Governors of the Federal Reserve System March 18, 2009 Chairman Reed, Ranking Member Bunning and members of the Subcommittee, it is my pleasure to appear today to discuss the state of risk management in the banking industry and steps taken by Federal Reserve supervisors to address risk management shortcomings at banking organizations. In my testimony, I will describe the vigorous and concerted steps the Federal Reserve has taken and is taking to rectify the risk management weaknesses revealed by the current financial crisis. I will also describe actions we are taking internally to improve supervisory practices and apply supervisory lessons learned. This includes a process spearheaded by Federal Reserve Vice Chairman Donald Kohn to systematically identify key lessons revealed by recent events and to implement corresponding recommendations. Because this crisis is ongoing, our review is ongoing.Background The Federal Reserve has supervisory and regulatory authority over a range of financial institutions and activities. It works with other Federal and State supervisory authorities to ensure the safety and soundness of the banking industry, foster the stability of the financial system, and provide for fair and equitable treatment of consumers in their financial transactions. The Federal Reserve is not the primary Federal supervisor for the majority of commercial bank assets. Rather, it is the consolidated supervisor of bank holding companies, including financial holding companies, and conducts inspections of all of those institutions. As I describe below, we have recently enhanced our supervisory processes on consolidated supervision to make them more effective and efficient. The primary purpose of inspections is to ensure that the holding company and its nonbank subsidiaries do not pose a threat to the soundness of the company's depository institutions. In fulfilling this role, the Federal Reserve is required to rely to the fullest extent possible on information and analysis provided by the appropriate supervisory authority of the company's bank, securities, or insurance subsidiaries. The Federal Reserve is also the primary Federal supervisor of State-member banks, sharing supervisory responsibilities with State supervisory agencies. In this role, Federal Reserve supervisory staff regularly conduct onsite examinations and offsite monitoring to ensure the soundness of supervised State member banks. The Federal Reserve is involved in both regulation--establishing the rules within which banking organizations must operate--and supervision--ensuring that banking organizations abide by those rules and remain, overall, in safe and sound condition. A key aspect of the supervisory process is evaluating risk management practices, in addition to assessing the financial condition of supervised institutions. Since rules and regulations in many cases cannot reasonably prescribe the exact practices each individual bank should use for risk management, supervisors design policies and guidance that expand upon requirements set in rules and regulations and establish expectations for the range of acceptable practices. Supervisors rely extensively on these policies and guidance as they conduct examinations and to assign supervisory ratings. We are all aware that the U.S. financial system is experiencing unprecedented disruptions that have emerged with unusual speed. The principal cause of the current financial crisis and economic slowdown was the collapse of the global credit boom and the ensuing problems at financial institutions, triggered by the end of the housing expansion in the United States and other countries. Financial institutions have been adversely affected by the financial crisis itself, as well as by the ensuing economic downturn. In the period leading up to the crisis, the Federal Reserve and other U.S. banking supervisors took several important steps to improve the safety and soundness of banking organizations and the resilience of the financial system. For example, following the September 11, 2001, terrorist attacks, we took steps to improve clearing and settlement processes, business continuity for critical financial market activities, and compliance with Bank Secrecy Act, anti-money laundering, and sanctions requirements. Other areas of focus pertained to credit card subprime lending, the growth in leveraged lending, credit risk management practices for home equity lending, counterparty credit risk related to hedge funds, and effective accounting controls after the fall of Enron. These are examples in which the Federal Reserve took aggressive action with a number of financial institutions, demonstrating that effective supervision can bring about material improvements in risk management and compliance practices at supervised institutions. In addition, the Federal Reserve, working with the other U.S. banking agencies, issued several pieces of supervisory guidance before the onset of the recent crisis--taking action on nontraditional mortgages, commercial real estate, home equity lending, complex structured financial transactions, and subprime lending--to highlight emerging risks and point bankers to prudential risk management practices they should follow. Moreover, we identified a number of potential issues and concerns and communicated those concerns to the industry through the guidance and through our supervisory activities.Supervisory Actions to Improve Risk Management Practices In testimony last June, Vice Chairman Kohn outlined the immediate supervisory actions taken by the Federal Reserve to identify risk management deficiencies at supervised firms related to the current crisis and bring about the necessary corrective steps. We are continuing and expanding those actions. While additional work is necessary, we are seeing progress at supervised institutions toward rectifying issues identified amid the ongoing turmoil in the financial markets. We are also devoting considerable effort to requiring bankers to look not just at risks from the past but also to have a good understanding of their risks going forward. The Federal Reserve has been actively engaged in a number of efforts to understand and document the risk management lapses and shortcomings at major financial institutions revealed during the current crisis. In fact, the Federal Reserve Bank of New York organized and leads the Senior Supervisors Group (SSG), which published a report last March on risk management practices at major international firms.\1\ I do not plan to summarize the findings of the SSG report and similar public reports, since others from the Federal Reserve have already done so.\2\ But I would like to describe some of the next steps being taken by the SSG.--------------------------------------------------------------------------- \1\ Senior Supervisors Group (2008). ``Observations on Risk Management Practices during the Recent Market Turbulence'' March 6, www.newyorkfed.org/newsevents/news/banking/2008/SSG_Risk_Mgt_doc_final.pdf. \2\ President's Working Group on Financial Markets (2008), ``Policy Statement on Financial Market Developments,'' March 13, www.treas.gov/press/releases/reports/pwgpolicystatemktturmoil_03122008.pdf. Financial Stability Forum (2008), ``Report of the Financial Stability Forum on Enhancing Market and Institutional Resilience,'' April 7, www.fsforum.org/publications/FSF_Report_to_G7_11_April.pdf.--------------------------------------------------------------------------- A key initiative of the Federal Reserve and other supervisors since the issuance of the March 2008 SSG report has been to assess the response of the industry to the observations and recommendations on the need to enhance key risk management practices. The work of the SSG has been helpful, both in complementing our evaluation of risk management practices at individual firms and in our discussions with bankers and their directors. It is also providing perspective on how each individual firm's risk management performance compares with that of a broad cross-section of global financial services firms. The continuation of the SSG process requires key firms to conduct self-assessments that are to be shared with the organization's board of directors and serve to highlight progress in addressing gaps in risk management practices and identify areas where additional efforts are still needed. Our supervisory staff is currently in the process of reviewing the firms' self assessments, but we note thus far that in many areas progress has been made to improve risk management practices. We plan to incorporate the results of these reviews into our future examination work to validate management assertions. The next portion of my remarks describes the supervisory actions we have been taking in the areas of liquidity risk management, capital planning and capital adequacy, firm-wide risk identification, residential lending, counterparty credit risk, and commercial real estate. In all of these areas we are moving vigorously to address the weaknesses at financial institutions that have been revealed by the crisis.Liquidity risk management Since the beginning of the crisis, we have been working diligently to bring about needed improvements in institutions' liquidity risk management practices. One lesson learned in this crisis is that several key sources of liquidity may not be available in a crisis. For example, Bear Stearns collapsed in part because it could not obtain liquidity even on a basis fully secured by high-quality collateral, such as U.S. Government securities. Others have found that back-up lines of credit are not made available for use when most needed by the borrower. These lessons have heightened our concern about liquidity and improved our approach to evaluating liquidity plans of banking organizations. Along with our U.S. supervisory colleagues, we are monitoring the major firms' liquidity positions on a daily basis, and are discussing key market developments and our supervisory views with the firms' senior management. We also are conducting additional analysis of firms' liquidity positions to examine the impact various scenarios may have on their liquidity and funding profiles. We use this ongoing analysis along with findings from examinations to ensure that liquidity and funding risk management and contingency funding plans are sufficiently robust and that the institutions are prepared to address various stress scenarios. We are aggressively challenging those assumptions in firms' contingency funding plans that may be unrealistic. Our supervisory efforts require firms to consider the potential impact of both disruptions in the overall funding markets and idiosyncratic funding difficulties. We are also requiring more rigor in the assessment of all expected and unexpected funding uses and needs. Firms are also being required to consider the respective risks of reliance on wholesale funding and retail funding, as well as the risks associated with off-balance sheet contingencies. These efforts include steps to require banks to consider the potential impact on liquidity that arises from firms' actions to protect their reputation, such as an unplanned increase in assets requiring funding that would arise with support given to money market funds and other financial vehicles where no contractual obligation exists. These efforts also pertain to steps banks must take to prepare for situations in which even collateralized funding may not be readily available because of market disruptions or concern about the health of a borrowing institution. As a result of these efforts, supervised institutions have significantly improved their liquidity risk management practices, and have taken steps to stabilize and improve their funding sources as market conditions permit. In conducting work on liquidity risk management, we have used established supervisory guidance on liquidity risk management as well as updated guidelines on liquidity risk management issued by the Basel Committee on Banking Supervision last September--a process in which the Federal Reserve played a lead role. So that supervisory expectations for U.S. depository institutions are aligned with these international principles, the U.S. banking agencies plan to update their own interagency guidance on liquidity risk management practices in the near future. The new guidance will emphasize the need for institutions of all sizes to conduct meaningful cash-flow forecasts of their funding needs in both normal and stressed conditions and to ensure that they have an adequately diversified funding base and a cushion of liquid assets to mitigate stressful market conditions. Our supervisory efforts at individual institutions and the issuance of new liquidity risk management guidance come on top of broader Federal Reserve efforts outside of the supervision function to improve liquidity in financial markets, such as introduction of the Term Auction Facility and the Term Asset-Backed Securities Loan Facility.Capital planning and capital adequacy Our supervisory activities for capital planning and capital adequacy are similar to those for liquidity. We have been closely monitoring firms' capital levels relative to their risk exposures, in conjunction with reviewing projections for earnings and asset quality and discussing our evaluations with senior management. We have been engaged in our own analysis of loss scenarios to anticipate institutions' future capital needs, analysis that includes the potential for losses from a range of sources as well as assumption of assets currently held off balance sheet. We have been discussing our analysis with bankers and requiring their own internal analyses to reflect a broad range of scenarios and to capture stress environments that could impair solvency. As a result, banking organizations have taken a number of steps to strengthen their capital positions, including raising substantial amounts of capital from private sources in 2007 and 2008. We have stepped up our efforts to evaluate firms' capital planning and to bring about improvements where they are needed. For instance, we recently issued guidance to our examination staff--which was also distributed to supervised institutions--on the declaration and payment of dividends, capital repurchases, and capital redemptions in the context of capital planning processes. We are forcefully requiring institutions to retain strong capital buffers-above the levels prescribed by minimum regulatory requirements--not only to weather the immediate environment but also to remain viable over the medium and long term. Our efforts related to capital planning and capital adequacy are embodied in the interagency supervisory capital assessment process, which began in February. We are conducting assessments of selected banking institutions' capital adequacy, based on certain macroeconomic scenarios. For this assessment, we are carefully evaluating the forecasts submitted by each financial institution to ensure they are appropriate, consistent with the firm's underlying portfolio performance, and reflective of each entity's particular business activities and risk profile. The assessment of capital under the two macroeconomic scenarios being used in the capital assessment program will permit supervisors to ascertain whether institutions' capital buffers over the regulatory capital minimum are appropriate under more severe but plausible scenarios. Federal Reserve supervisors have been engaged over the past few years in evaluating firms' internal processes to assess overall capital adequacy as set forth in existing Federal Reserve supervisory guidance. A portion of that work has focused on how firms use economic capital practices to assess overall capital needs. We have communicated our findings to firms individually, which included their need to improve some key practices, and demanded corrective actions. We also presented our overall findings to a broad portion of the financial industry at a System-sponsored outreach meeting last fall that served to underscore the importance of our message.Firm-wide risk identification and compliance risk management One of the most important aspects of good risk management is risk identification. This is a particularly challenging exercise because some practices, each of which appears to present low risk on its own, may combine to create unexpectedly high risk. For example, in the current crisis, practices in mortgage lending--which historically has been seen as a very low-risk activity--have become distorted and, consequently riskier, as they have been fueled by another activity that was designed to reduce risk to lenders--the sale of mortgage assets to investors outside the financial industry. Since the onset of the crisis, we have been working with supervised institutions to improve their risk identification practices where needed, such as by helping identify interconnected risks. These improvements include a better understanding of risks facing the entire organization, such as interdependencies among risks and concentrations of exposures. One of the key lessons learned has been the need for timely and effective communication about risks, and many of our previously mentioned efforts pertaining to capital and liquidity are designed to ensure that management and boards of directors understand the linkages within the firm and how various events might impact the balance sheet and funding of an organization. We have demanded that institutions address more serious risk management deficiencies so that risk management is appropriately independent, that incentives are properly aligned, and that management information systems (MIS) produce comprehensive, accurate, and timely information. In our 2006 guidance on nontraditional mortgage products, we recognized that poor risk management practices related to retail products and services could have serious effects on the profitability of financial institutions and the economy; in other words, there could be a relationship between consumer protection and financial soundness. For example, consumer abuses in the subprime mortgage lending market were a contributing cause to the current mortgage market problems. Here, too, we are requiring improvements. The Federal Reserve issued guidance on compliance risk management programs to emphasize the need for effective firm-wide compliance risk management and oversight at large, complex banking organizations. This guidance is particularly applicable to compliance risks, including its application to consumer protection, that transcend business lines, legal entities, and jurisdictions of operation.Residential lending Financial institutions are still facing significant challenges in the residential mortgage market, particularly given the rising level of defaults and foreclosures and the lack of liquidity for private label mortgage-backed securities. Therefore, we will continue to focus on the adequacy of institutions' risk management practices, including their underwriting standards, and re-emphasize the importance of a lender's assessment of a borrower's ability to repay the loan. Toward that end, we are requiring institutions to maintain risk management practices that more effectively identify, monitor, and control the risks associated with their mortgage lending activity and that more adequately address lessons learned from recent events. In addition to efforts on the safety and soundness front, last year we finalized amendments to the rules under the Home Ownership and Equity Protection Act (HOEPA). These amendments establish sweeping new regulatory protections for consumers in the residential mortgage market. Our goal throughout this process has been to protect borrowers from practices that are unfair or deceptive and to preserve the availability of credit from responsible mortgage lenders. The Board believes that these regulations, which apply to all mortgage lenders, not just banks, will better protect consumers from a range of unfair or deceptive mortgage lending and advertising practices that have been the source of considerable concern and criticism. Given escalating mortgage foreclosures, we have urged regulated institutions to establish systematic, proactive, and streamlined mortgage loan modification protocols and to review troubled loans using these protocols. We expect an institution (acting either in the role of lender or servicer) to determine, before proceeding to foreclosure, whether a loan modification will enhance the net present value of the loan, and whether loans currently in foreclosure have been subject to such analysis. Such practices are not only consistent with sound risk management but are also in the long-term interests of borrowers, lenders, investors, and servicers. We are encouraging regulated institutions, through government programs, to pursue modifications that result in mortgages that borrowers will be able to sustain over the remaining maturity of their loan. In this regard, just recently the Federal Reserve joined with other financial supervisors to encourage all of the institutions we supervise to participate in the Treasury Department's Home Affordable loan modification program, which was established under the Troubled Assets Relief Program.\3\ Our examiners are closely monitoring loan modification efforts of institutions we supervise.--------------------------------------------------------------------------- \3\ See http://www.Federalreserve.gov/newsevents/press/bcreg/20090304a.htm.---------------------------------------------------------------------------Counterparty credit risk The Federal Reserve has been concerned about counterparty credit risk for some time, and has focused on requiring the industry to have effective risk management practices in place to deal with risks associated with transacting with hedge funds, for example, and other key counterparties. This focus includes assessing the overall quality of MIS for counterparty credit risk and ensuring that limits are complied with and exceptions appropriately reviewed. As the crisis has unfolded, we have intensified our monitoring of counterparty credit risk. Supervisors are analyzing management reports and, in some cases, are having daily conversations with management about ongoing issues and important developments. This process has allowed us to understand key linkages and exposures across the financial system as specific counterparties experience stress during the current market environment. Federal Reserve supervisors now collect information on the counterparty credit exposures of major institutions on a weekly and monthly basis, and have enhanced their methods of assessing this exposure. Within counterparty credit risk, issues surrounding the credit default swap (CDS) market have been particularly pertinent. As various Federal Reserve officials have noted in past testimony to congressional committees and in other public statements, regulators have, for several years, been addressing issues surrounding the over-the-counter (OTC) derivatives market in general and the CDS market in particular. Since September 2005, an international group of supervisors, under the leadership of the Federal Reserve Bank of New York, has been working with dealers and other market participants to strengthen arrangements for processing, clearing, and settling OTC derivatives. An early focus of this process was on CDS. This emphasis includes promoting such steps as greater use of electronic-confirmation platforms, adoption of a protocol that requires participants to request counterparty consent before assigning trades to a third party, and creation of a contract repository that maintains an electronic record of CDS trades. More recently, and in response to the recommendations of the President's Working Group on Financial Markets and the Financial Stability Forum, supervisors are working to bring about further improvements to the OTC derivatives market infrastructure. With respect to credit derivatives, this agenda includes: (1) further increasing standardization and automation; (2) incorporating an auction-based cash settlement mechanism into standard documentation; (3) reducing the volume of outstanding CDS contracts; and (4) developing well-designed central counterparty services to reduce systemic risks. The most important potential change in the infrastructure for credit derivatives is the creation of one or more central counterparties (CCPs) for CDS. The Federal Reserve supports CCP clearing of CDS because, if properly designed and managed, CCPs can reduce risks to market participants and to the financial system. In addition to clearing CDS through CCPs, the Federal Reserve believes that exchange trading of sufficiently standardized contracts by banks and other market participants can increase market liquidity and transparency, and thus should be encouraged. In a major step toward achieving that goal, the Federal Reserve Board, on March 4, 2009, approved the application by ICE US Trust LLC (ICE Trust) to become a member of the Federal Reserve System. ICE Trust intends to provide central counterparty services for certain credit default swap contracts.Commercial real estate For some time, the Federal Reserve has been focused on commercial real estate (CRE) exposures. For background, as part of our onsite supervision of banking organizations in the early 2000s, we began to observe rising CRE concentrations. Given the central role that CRE lending played in the banking problems of the late 1980s and early 1990s, we led an interagency effort to issue supervisory guidance on CRE concentrations. In the 2006 guidance on CRE, we emphasized our concern that some institutions' strategic- and capital-planning processes did not adequately acknowledge the risks from their CRE concentrations. We stated that stress testing and similar exercises were necessary for institutions to identify the impact of potential CRE shocks on earnings and capital, especially the impact from credit concentrations. Because weaker housing markets and deteriorating economic conditions have clearly impaired the quality of CRE loans at supervised banking organizations, we have redoubled our supervisory efforts in regard to this segment. These efforts include monitoring carefully the impact that declining collateral values may have on CRE exposures as well as assessing the extent to which banks have been complying with the interagency CRE guidance. We found, through horizontal reviews and other examinations, that some institutions would benefit from additional and better stress testing and could improve their understanding of how concentrations--both single-name and sectoral/geographical concentrations--can impact capital levels during shocks. We have also implemented additional examiner training so that our supervisory staff is equipped to deal with more serious CRE problems at banking organizations as they arise, and have enhanced our outreach to key real estate market participants and obtained additional market data sources to help support our supervisory activities. As a result of our supervisory work, risk management practices related to CRE are improving, including risk identification and measurement. To sum up our efforts to improve banks' risk management, we are looking at all of the areas mentioned above--both on an individual and collective basis--as well as other areas to ensure that all institutions have their risk management practices at satisfactory levels. More generally, where we have not seen appropriate progress, we are aggressively downgrading supervisory ratings and using our enforcement tools.Supervisory Lessons Learned Having just described many of the steps being taken by Federal Reserve supervisors to address risk management deficiencies in the banking industry, I would now like to turn briefly to our internal efforts to improve our own supervisory practices. The current crisis has helped us to recognize areas in which we, like the banking industry, can improve. Since last year, Vice Chairman Kohn has led a System-wide effort to identify lessons learned and to develop recommendations for potential improvements to supervisory practices. To benefit from multiple perspectives in these efforts, this internal process is drawing on staff from around the System. For example, we have formed System-wide groups, led by Board members and Reserve Bank Presidents, to address the identified issues in areas such as policies and guidance, the execution of supervisory responsibilities, and structure and governance. Each group is reviewing identified lessons learned, assessing the effectiveness of recent initiatives to rectify issues, and developing additional recommendations. We will leverage these group recommendations to arrive at an overall set of enhancements that will be implemented in concert. As you know, we are also meeting with Members of the Congress and other government bodies, including the Government Accountability Office, to consult on lessons learned and to hear additional suggestions for improving our practices. One immediate example of enhancements relates to System-wide efforts for forward-looking risk identification efforts. Building on previous System-wide efforts to provide perspectives on existing and emerging risks, the Federal Reserve has recently augmented its process to disseminate risk information to all the Reserve Banks. That process is one way we are ensuring that risks are identified in a consistent manner across the System by leveraging the collective insights of Federal Reserve supervisory staff. We are also using our internal risk reporting to help establish supervisory priorities, contribute to examination planning and scoping, and track issues for proper correction. Additionally, we are reviewing staffing levels and expertise so that we have the appropriate resources, including for proper risk identification, to address not just the challenges of the current environment but also those over the longer term. We have concluded that there is opportunity to improve our communication of supervisory and regulatory policies, guidance, and expectations to those we regulate. This includes more frequently updating our rules and regulations and more quickly issuing guidance as new risks and concerns are identified. For instance, we are reviewing the area of capital adequacy, including treatment of market risk exposures as well as exposures related to securitizations and counterparty credit risk. We are taking extra steps to ensure that as potential areas of risk are identified or new issues emerge, policies and guidance address those areas in an appropriate and timely manner. And we will increase our efforts to ensure that, for global banks, our policy and guidance responses are coordinated, to the extent possible, with those developed in other countries. One of the Federal Reserve's latest enhancements related to guidance, a project begun before the onset of the crisis, was the issuance of supervisory guidance on consolidated supervision. This guidance is intended to assist our examination staff as they carry out supervision of banking institutions, particularly large, complex firms with multiple legal entities, and to provide some clarity to bankers about our areas of supervisory focus. Importantly, the guidance is designed to calibrate supervisory objectives and activities to the systemic significance of the institutions and the complexity of their regulatory structures. The guidance provides more explicit expectations for supervisory staff on the importance of understanding and validating the effectiveness of the banking organization's corporate governance, risk management, and internal controls that are in place to oversee and manage risks across the organization. Our assessment of nonbank activities is an important part of our supervisory process to understand the linkages between depository and nondepository subsidiaries, and their effects on the overall risks of the organization. In addition to issues related to general risk management at nonbank subsidiaries, the consolidated supervision guidance addresses potential issues related to consumer compliance. In this regard, in 2007 and 2008 the Board collaborated with other U.S. and State government agencies to launch a cooperative pilot project aimed at expanding consumer protection compliance reviews at selected nondepository lenders with significant subprime mortgage operations. This interagency initiative has clarified jurisdictional issues and improved information-sharing among the participating agencies, along with furthering its overarching goal of preventing abusive and fraudulent lending while ensuring that consumers retain access to beneficial credit. As stated earlier, there were numerous cases in which the U.S. banking agencies developed policies and guidance for emerging risks and issues that warranted the industry's attention, such as in the areas of nontraditional mortgages, home equity lending, and complex structured financial transactions. It is important that regulatory policies and guidance continue to be applied to firms in ways that allow for different business models and that do not squelch innovation. However, when bankers are particularly confident, when the industry and others are especially vocal about the costs of regulatory burden and international competitiveness, and when supervisors cannot yet cite recognized losses or writedowns, we must have even firmer resolve to hold firms accountable for prudent risk management practices. It is particularly important, in such cases, that our supervisory communications are very forceful and clear, directed at senior management and boards of directors so that matters are given proper attention and resolved to our satisfaction. With respect to consumer protection matters, we have an even greater understanding that reviews of consumer compliance records of nonbank subsidiaries of bank holding companies can aid in confirming the level of risk that these entities assume, and that they assist in identifying appropriate supervisory action. Our consumer compliance division is currently developing a program to further the work that was begun in the interagency pilot discussed earlier. In addition to these points, it is important to note that we have learned lessons and taken action on important aspects of our consumer protection program, which I believe others from the Federal Reserve have discussed with the Congress. In addition, we must further enhance our ability to develop clear and timely analysis of the interconnections among both regulated and unregulated institutions, and among institutions and markets, and the potential for these linkages and interrelationships to adversely affect banking organizations and the financial system. In many ways, the Federal Reserve is well positioned to meet this challenge. In this regard, the current crisis has, in our view, demonstrated the ways in which the Federal Reserve's consolidated supervision role closely complements our other central bank responsibilities, including the objectives of fostering financial stability and deterring or managing financial crises. The information, expertise, and powers derived from our supervisory authority enhance the Federal Reserve's ability to help reduce the likelihood of financial crises, and to work with the Treasury Department and other U.S. and foreign authorities to manage such crises should they occur. Indeed, the enhanced consolidated supervision guidance that the Federal Reserve issued in 2008 explicitly outlines the process by which we will use information obtained in the course of supervising financial institutions--as well as information and analysis obtained through relationships with other supervisors and other sources--to identify potential vulnerabilities across financial institutions. It will also help us identify areas of supervisory focus that might further the Federal Reserve's knowledge of markets and counterparties and their linkages to banking organizations and the potential implications for financial stability. A final supervisory lesson applies to the structure of the U.S. regulatory system, an issue that the Congress, the Federal Reserve, and others have already raised. While we have strong, cooperative relationships with other relevant bank supervisors and functional regulators, there are obvious gaps and operational challenges in the regulation and supervision of the overall U.S. financial system. This is an issue that the Federal Reserve has been studying for some time, and we look forward to providing support to the Congress and the Administration as they consider regulatory reform. In a recent speech, Chairman Bernanke introduced some ideas to improve the oversight of the U.S. financial system, including the oversight of nonbank entities. He stated that no matter what the future regulatory structure in the United States, there should be strong consolidated supervision of all systemically important banking and nonbanking financial institutions. Finally, Mr. Chairman, I would like to thank you and the Subcommittee for holding this second hearing on risk management--a crucially important issue in understanding the failures that have contributed to the current crisis. Our actions, with the support of the Congress, will help strengthen institutions' risk management practices and the supervisory and regulatory process itself--which should, in turn, greatly strengthen the banking system and the broader economy as we recover from the current difficulties. I look forward to answering your questions. ______ CHRG-111shrg55479--148 RESPONSES TO WRITTEN QUESTIONS OF SENATOR VITTER FROM J.W. VERRETQ.1. Professor, in your testimony you suggest alternative contributing factors for the Committee to investigate to determine the ``culprit'' of the financial crisis. The first factor you suggest to investigate is the moral hazard problems created by the prospect of the Government bailout. Do you think that moral hazard problem is stronger cause of the than corporate pay structure? Do you think the distortions to the housing market cause by Fannie Mae and Freddie Mac played a larger role in causing the financial crisis of 2008 than how a company pays its CEO?A.1. Answer not received by time of publication. ------ 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-111shrg61651--65 Mr. Reed," So my honest belief, having experienced it and having lived with it for years, is that the system would be stronger if we could provide for some separation where major depositories are not major actors in the capital markets. And you will notice that as I made my comments about these cultures, I didn't talk only about proprietary trading and proprietary investing. I talk about this interface with the capital markets. I believe that it is very difficult to manage these cultures. It is not impossible, but it is very difficult. They are hard to contain. They have big impacts on the risk taking sort of attitudes at the top of the company and the nature of the people who are working in the company. I think the system would be sounder if we had a couple major institutions that were a little pedestrian and that weren't occupied by all my colleagues from MIT who are pretty good at math. So I have come to the conclusion, having lived it, that the system would be better if we allowed for some compartmentalization. And as I said in my testimony, as I said in my written remarks, I would look at compartmentalization of culture as much as of economic function because it is the people within the company. So I have learned from my experience, and I think probably there wasn't a much more relevant experience around, and my conclusion is the system would be better. I am not speaking for the stockholders. The system would be better if we allowed for the type of separation that Mr. Volcker is talking about, and I think he probably comes at it from the same point of view. I saw him recently and he said, ``John, it is the first time you and I have ever agreed, isn't it,'' because we have had a number of issues where we didn't. But I think he saw it from the same point of view. Too big to fail, Senator, I am totally on your side. We have to come up with a mechanism that, regardless of the particular interconnectedness--Gerry is correct, we may need time to get this organized, but you have to be able to let institutions fail and I think you have to wipe the stockholders out. I think you have to wipe the board and the management out. And we have to have that mechanism. And it is true that Citi, in its current structure, would be very difficult to unwind, and the global issue would come up right away. And this global issue is real. There is no question. I forget the name of the British institution that failed in Singapore--Barings failed in Singapore. The Bank of England could not control the unwinding of this because the Singaporian authorities got into the middle of it and you had this cross-legal jurisdiction problem. So I do think Professor Johnson is correct in that regard, but I am on your side totally that we must come up with an architecture that allows us to say any person that gets in big trouble must be permitted to fail, and the bias has to be in that direction. The question, Senator, why did we save Long-Term Capital? It was alone. It could have been allowed to fail. But the instinct of regulators is to organize a rescue mission. And so I think you need a structure that sort of dampens that instinct. Senator Corker. I would love to hear from everybody, and I don't want to be rude to my colleagues by asking another question, but I do hope in another setting we can, on the phone or by e-mail, talk more about the interconnectedness Professor Scott and many of you have brought up. I thank each of you for your testimony and I do hope we figure out a way to deal with the interconnectedness in a way that, through legislation or some other mechanism, regulation, that allows big companies to fail. I just want to say, it seems like every crisis we have had since I have been alive, and I am 57, has centered on real estate--just about--and somehow or another we still don't talk about that and we talk about all these other things, but that is a subject for another day. Thank you, Mr. Chairman. Thank you for your testimony. " CHRG-110hhrg45625--17 CONGRESS FROM THE STATE OF KANSAS Mr. Moore of Kansas. Mr. Chairman, thank you for giving me the opportunity to express my views on the economic crisis facing our country. In the last year, the housing credit crisis which occurred primarily due to lax oversight and questionable borrowing practices by borrowers and lenders alike has steadily worsened, threatening not only the housing market but other sectors of our economy as well. Despite efforts over the past year by the Federal Reserve, the Treasury, and Congress to stem the crisis, global financial markets remain under extreme stress. As we all know, experts are working around the clock to deal with this situation and forestall a complete meltdown of the world's financial markets. I want to thank the chairman and his staff for the nonstop work dedicated to this process since we received the Treasury Department's 2\1/2\ page legislative proposal on Saturday morning. I know that work was done by the chairman and his staff throughout the weekend to reach the point in the negotiations where we are today. The current crisis is the result of a combination of irresponsible financiers pushing the limits of the marketplace and the Administration that failed to properly regulate the financiers' actions in the public interest. Until 2007, Congress did not provide effective oversight of these regulators or of this marketplace. In the long term, we must uncover those who failed in their responsibilities and hold them accountable. Any package approved by Congress must include aggressive, informed, impartial oversight of the rescue programs both by Congress and the Judiciary. It is imperative that we keep several things in mind as we continue to deal with this crisis. Any program we implement must be designed to take effect immediately and be substantial enough to restore market confidence as quickly as possible. But it is crucial that any undertaking protects the American people to the greatest extent possible. Every American whose personal life or business involves the use of credit will suffer the consequences of this financial crisis. The choking off of credit will increase the cost and difficulties for anyone who borrows to pay a mortgage, buy a car, purchase property, purchase inventory for a small business, or invest for retirement. Our people must be our first priority as we develop a solution to this looming disaster. Additionally, we must do everything possible to protect the interests of the taxpayers in this process, including securing warrants in these troubled firms so that when the market recovers, these equity stakes will ensure that taxpayers are paid back with a share of new profits generated by these firms. It is appropriate, too, Madam Chairwoman, that the FBI is investigating whether any one of the firms at the center of the crisis committed corporate fraud or broke laws. But I am also concerned that executives of troubled financial institutions may receive large bonuses as part of the bailout package if this package becomes law in fact. We must do all that we can to ensure that CEOs of failing financial institutions are not permitted to leave with their golden parachutes paid for by taxpayers. Like many of my colleagues, I have heard from many of my constituents over the past few days who are concerned about the financial market crisis and are skeptical about the details of any kind of plan to buy illiquid assets from financial institutions in order to create liquidity in the markets. I share their concerns and believe that when so many of the American people speak out so strongly and so loudly we are wise to listen. This is not the time for partisan politics. We should put ``Republican'' and ``Democrat'' aside and work on this together. We must work quickly and efficiently in a bipartisan basis to restore confidence in our shaken financial markets and stabilize our economy. This rescue package is the most important legislation that many Members of Congress will consider in their entire careers. It is important to move expeditiously, but it is more important that we get this right and work out the details. Both parties in both Houses of Congress must work together to produce a measure that can win overwhelming support of both parties in both Houses. For this reason, we should not adjourn this session of Congress. We should stay in this session of Congress until we have completed our work and resolved this issue. The stakes are too high to go home. I look forward to hearing testimony from Secretary Paulson and Chairman Bernanke and working with them to address this crisis. I would also like to note that President Bush has kind of been missing in action for about the last 2 weeks, and I would like to see the President come on television and talk to the American people about this and talk to Members of Congress about some solution here to bring Republicans and Democrats together for the benefit of our Nation. Thank you very much. Ms. Waters. [presiding] Thank you very much. The gentleman from Texas, Mr. Green. STATEMENT OF THE HONORABLE AL GREEN, A REPRESENTATIVE IN fcic_final_report_full--333 Paulson told the FCIC that he was “naive” enough to believe that the action would halt the crisis because it “would put a floor under the housing market decline, and provide confidence to the market.” He realized he was wrong on the next day, when, as he told the FCIC, “Lehman started to go.”  Former Treasury Assistant Secretary Neel Kashkari agreed. “We thought that after we stabilized Fannie and Freddie that we bought ourselves some time. Maybe a month, maybe three months. But they were such profound interventions, stabilizing such a huge part of the financial markets, that would buy us some time. We were surprised that Lehman then happened a week later, that Lehman had to be taken over or it would go into bankruptcy.”  The firms’ failure was a huge event and increased the magnitude of the crisis, ac- cording to Fed Governor Kevin Warsh and New York Fed General Counsel Tom Bax- ter.  Warsh also told the FCIC that the events surrounding the GSE takeover led to “a massive, underreported, underappreciated jolt to the system.” Then, according to Warsh, when the market grasped that it had misunderstood the risks associated with the GSEs, and that the government could have conceivably let them fail, it “caused in- vestors to panic about the value of every asset, to reassess every portfolio.”  FHFA Director Lockhart described the decision to put the GSEs into conservator- ship in the context of Lehman’s failure. Given that the investment bank’s balance sheet was about one-fifth the size of Fannie Mae’s, he felt that the fallout from Lehman’s bankruptcy would have paled in comparison to a GSE failure. He said, “What happened after Lehman would have been very small compared to these . trillion institutions failing.”  Major holders of GSE securities included the Chinese and Russian central banks, which, between them, owned more than half a trillion dollars of these securities, and U.S. financial firms and investment funds had even more extensive holdings. A  Fed study concluded that U.S. banks owned more than  trillion in GSE debt and securities—more than  of the banks’ Tier  cap- ital and  of their total assets at the time.  Testifying before the FCIC, Mudd claimed that failure was all but inevitable. “In , the companies had no refuge from the twin shocks of a housing crisis followed by a financial crisis,” he said. “A monoline GSE structure asked to perform multiple tasks cannot withstand a multiyear  home price decline on a national scale, even without the accompanying global financial turmoil. The model allowed a balance of business and mission when home prices were rising. When prices crashed far beyond the realm of historical experience, it became ‘The Pit and the Pendulum,’ a choice be- tween horrible alternatives.”  “THE WORSTRUN FINANCIAL INSTITUTION ” When interviewed by the FCIC, FHFA officials were very critical of Fannie’s manage- ment. John Kerr, the FHFA examiner (and an OCC veteran) in charge of Fannie ex- aminations, minced no words. He labeled Fannie “the worst-run financial institution” he had seen in his  years as a bank regulator. Scott Smith, who became associate director at FHFA after that agency replaced OFHEO, concurred; in his view, Fannie’s forecasting capabilities were not particularly well thought out, and lacked a variety of stress scenarios. Both officials noted Fannie’s weak forecasting models, which included hundreds of market simulations but scarcely any that contemplated declines in house prices. To Austin Kelly, an OFHEO examination specialist, there was no relying on Fannie’s numbers, because their “processes were a bowl of spaghetti.” Kerr and a colleague said that that they were struck that Fannie Mae, a multitrillion-dollar company, employed unsophisticated technology: it was less tech- savvy than the average community bank.  CHRG-111shrg57322--650 Mr. Viniar," Thank you. I think I see it. Senator Levin. ``[B]usiness has taken proactive steps to position the firm strategically in the ensuing mortgage credit and liquidity crisis,'' and this is all the things you did. " 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. ------ fcic_final_report_full--45 These funds differed from bank and thrift deposits in one important respect: they were not protected by FDIC deposit insurance. Nevertheless, consumers liked the higher interest rates, and the stature of the funds’ sponsors reassured them. The fund sponsors implicitly promised to maintain the full  net asset value of a share. The funds would not “break the buck,” in Wall Street terms. Even without FDIC insur- ance, then, depositors considered these funds almost as safe as deposits in a bank or thrift. Business boomed, and so was born a key player in the shadow banking indus- try, the less-regulated market for capital that was growing up beside the traditional banking system. Assets in money market mutual funds jumped from  billion in  to more than  billion in  and . trillion by .  To maintain their edge over the insured banks and thrifts, the money market funds needed safe, high-quality assets to invest in, and they quickly developed an ap- petite for two booming markets: the “commercial paper” and “repo” markets. Through these instruments, Merrill Lynch, Morgan Stanley, and other Wall Street in- vestment banks could broker and provide (for a fee) short-term financing to large corporations. Commercial paper was unsecured corporate debt—meaning that it was backed not by a pledge of collateral but only by the corporation’s promise to pay. These loans were cheaper because they were short-term—for less than nine months, sometimes as short as two weeks and, eventually, as short as one day; the borrowers usually “rolled them over” when the loan came due, and then again and again. Be- cause only financially stable corporations were able to issue commercial paper, it was considered a very safe investment; companies such as General Electric and IBM, in- vestors believed, would always be good for the money. Corporations had been issuing commercial paper to raise money since the beginning of the century, but the practice grew much more popular in the s. This market, though, underwent a crisis that demonstrated that capital markets, too, were vulnerable to runs. Yet that crisis actually strengthened the market. In , the Penn Central Transportation Company, the sixth-largest nonfinancial corpora- tion in the U.S., filed for bankruptcy with  million in commercial paper out- standing. The railroad’s default caused investors to worry about the broader commercial paper market; holders of that paper—the lenders—refused to roll over their loans to other corporate borrowers. The commercial paper market virtually shut down. In response, the Federal Reserve supported the commercial banks with almost  million in emergency loans and with interest rate cuts.  The Fed’s ac- tions enabled the banks, in turn, to lend to corporations so that they could pay off their commercial paper. After the Penn Central crisis, the issuers of commercial pa- per—the borrowers—typically set up standby lines of credit with major banks to en- able them to pay off their debts should there be another shock. These moves reas- sured investors that commercial paper was a safe investment. FOMC20080430meeting--310 308,MR. KOHN.," Thank you, Mr. Chairman. I thought this was a great piece of work by the staff, and I thank them all. You did a good job of organizing it and laying out the general principles in a way that people can understand. Despite President Yellen's comments, I have no regrets about my testimony in favor of paying interest, perhaps because I bore so much of the administrative costs over the years [laughter]--along with Stephanie Martin and her predecessors in the Legal Division. Those costs that were borne were considerable, in addition to the dead weight losses. I think we should consider options 2 and 5 for sure. On option 4, I think we need to understand a bit--other people have said this--what the third objective, ""promoting efficient and resilient money markets,"" means exactly, what is entailed, and how that would intersect with option 4. So I think that needs to be fleshed out a little more. Because you have planned to get a white paper out soon, I think perhaps including option 4 would be easier than not including it, just to get people's comments. Perhaps because of my administrative burden experience, I would like to see reserve requirements at zero, ruling out option 1. On option 3, I just don't think, at least with our system and in periods of crisis, that the top of the band would hold, so I don't think that option would really work very well. Thank you all for your work. " fcic_final_report_full--443 These losses wiped out capital throughout the financial sector. Policymakers were not just dealing with a single insolvent firm that might transmit its failure to others. They were dealing with a scenario in which many large, midsize, and small financial institutions took large losses at roughly the same time. Conclusion: Some financial institutions failed because of a common shock: they made similar failed bets on housing. Unconnected financial firms were failing for the same reason and at roughly the same time because they had the same problem of large housing losses. This common shock meant the problem was broader than a single failed bank–key large financial institutions were undercapitalized because of this common shock. We examine two frequently debated topics about the events of September . “The government should not have bailed out _____” Some argue that no firm is too big to fail, and that policymakers erred when they “bailed out” Bear Stearns, Fannie and Freddie, AIG, and later Citigroup. In our view, this misses the basic arithmetic of policymaking. Policymakers were presented, for example, with the news that “AIG is about to fail” and counseled that its sudden and disorderly failure might trigger a chain reaction. Given the preceding failures of Fan- nie Mae and Freddie Mac, the Merrill Lynch merger, Lehman’s bankruptcy, and the Reserve Primary Fund breaking the buck, market confidence was on a knife’s edge. A chain reaction could cause a run on the global financial system. They feared not just a run on a bank, but a generalized panic that might crash the entire system–that is, the risk of an event comparable to the Great Depression. For a policymaker, the calculus is simple: if you bail out AIG and you’re wrong, you will have wasted taxpayer money and provoked public outrage. If you don’t bail out AIG and you’re wrong, the global financial system collapses. It should be easy to see why policymakers favored action–there was a chance of being wrong either way, and the costs of being wrong without action were far greater than the costs of being wrong with action. “Bernanke, Geithner, and Paulson should not have chosen to let Lehman fail” This is probably the most frequently discussed element of the financial crisis. To make this case one must argue: • Bernanke, Geithner, and Paulson had a legal and viable option available to them other than Lehman filing bankruptcy. • They knew they had this option, considered it, and rejected it. • They were wrong to do so. • They had a reason for choosing to allow Lehman to fail. 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-110shrg50415--2 Chairman Dodd," The Committee will come to order. Let me welcome everyone to the hearing this morning. I want to welcome my colleagues who are here. Senator Crapo, I welcome you and thank you very much for being here this morning. Senator Akaka, Senator, how are you this morning? Good to see you as well. And, Sherrod, thanks for being here this morning. Let me thank our witnesses as well. What I am going to do, if we can here this morning, is to make an opening statement, turn to my colleagues for any opening comments they would like to have this morning, and then we will get to our witnesses. Any and all statements or supporting documents that you would like to have included in the record, we will certainly make it a part of the record. Just so people can be aware, my intention over the coming weeks is to have a series of hearings and meetings--some of them more informal, some of them more formal--to do what we are doing today, obviously, to go back and examine how we arrived at the situation we are in today; but just as importantly--in fact, I would argue even more importantly--what do we need to do from here forward so as to minimize these problems from ever occurring again. Second, we want to watch and we are going to monitor very carefully, of course, the rescue plan that was adopted several weeks ago. As I think all of you are aware, there are provisions in that bill that literally require almost hourly reporting, every 48 hours or so on various transactions that occur, and we want to watch very carefully following the auditing process that we wrote into the legislation with the GAO and the Inspector General as well. And so the Committee will be working at that almost on a daily basis. Then, third, the issue of financial regulatory reform. Secretary Paulson a number of weeks ago now, months ago, submitted a proposal on regulatory financial reform, and we never got to having the hearings we wanted to have on that, frankly, over the summer because of events with the foreclosure crisis and more recently with the broader economic crisis. But I would like over these coming weeks between now and the first of the year to have this Committee, both formally and informally, meet with knowledgeable people--and there are some at this very panel who could be of help in this regard--as to what the architecture and structures of our financial services system ought to look like in light of the changes that have obviously occurred, updating a system that in many instances actually dates back more than 80 years. The world has obviously changed dramatically, as we are all painfully aware, and having an architecture and a structure that reflects the world we're in today is going to be a critical challenge. This is not an easy task. It will require a lot of thought, and careful thought, about how you do this. But I thought it would be worthwhile to begin that process, and then with a new administration arriving on January 20th, to already have sort of an up-and-running effort that we could then work with the new administration, be it a McCain administration or an Obama administration, to move that process along rather than just wait until after January 20th to begin a process that I think will take some time, quite candidly, given the complexity involved, going back to the 1933 act and other provisions. And as I said, several of you on this panel here have a wealth of knowledge about those laws and how they work or do not work. So I may very well be calling on some of you to participate, either informally or more formally, in that conversation and discussion. Today's hearing is entitled ``Turmoil in the U.S. Credit Markets: The Genesis of the Current Economic Crisis,'' and I want to share some opening comments if I can on this and, again, turn to Senator Crapo and then to others to share some thoughts as well, if they care to, before we turn to our witnesses. This morning the Committee examines the genesis, as I said a moment ago, of the crisis in our credit markets. Such an examination is in keeping with this Committee's extensive work over the past 21 months to understand the implosion of the mortgage markets and how that implosion has infected the wider economy. All told, this Committee has held 73 hearings and meetings since January of 2007 when I first became the Chairman of this Committee. No less than 31 of those hearings have addressed in one form or another the origins and nature of the current market turmoil. Today's meeting is essential to understand not only how we got here, but just as importantly--and I would argue even more importantly--where we as a nation need to go. Only if we undertake a thorough and complete postmortem examination of the corpus of this damaged economy will we have any chance to create a world where the mistakes of the past are less likely to be repeated and where all Americans will have a fair chance at achieving security and prosperity. It is by now beyond dispute that the current conflagration threatening our economy started several years ago in what was then a relatively discreet corner of the credit markets known as subprime mortgage lending. The Chairman of the Federal Reserve, Ben Bernanke, and Treasury Secretary Hank Paulson and many other respected individuals have all agreed on that fact. Mortgage market participants, from brokers to lenders to investment banks to credit rating agencies formed an unholy alliance conceived in greed and dedicated to exploiting millions of unsuspecting, hard-working American families seeking to own or refinance their homes. Relying on two faulty assumptions that housing prices would continue to rise maybe forever and that new financial instruments would allow them to shift the risk to others, these market participants flouted the fundamentals of prudent lending. Certainly some borrowers themselves sought unjust enrichment in the process. They deserve neither our sympathy nor our assistance. But the millions of American homebuyers who today face foreclosure and financial ruination, the vast majority were victims, not perpetrators, of what will be remembered as the financial crime of the century. Indeed, the misdeeds of a few have robbed nearly every American. Whether they suffer from the loss of a home, retirement security, a job, or access to credit, Americans are reeling from the credit crisis. Sadly, in my view, this crisis was entirely preventable. It is clear to me that greed and avarice overcame sound judgment in the marketplace, causing some very smart people to act in very stupid ways. But what makes this scandal different from others is the abject failure of regulators to adequately police the markets. Regulators exist to check the tendency to excess of the regulated. They are supposed to step in to maintain transparency, competition, and fairness in our economy. In this case, though, our Nation's financial regulators willfully ignored abuses taking place on their beat, choosing to embrace the same faulty assumptions that fueled the excessive risk taking in the marketplace. Instead of checking the tendency to excess, they permitted and in some ways even encouraged it. They abandoned sensible and appropriate regulation and supervision. No one can say that the Nation's financial regulators were not aware of the threats posed by reckless subprime lending to homeowners, communities, and, indeed, the entire country. That threat had already been recognized by Congress. In fact, the Congress had already taken strong steps to neutralize it. In 1994, 14 years ago, then President Clinton signed into law the Home Owners and Equity Protection Act. This law required--let me repeat, required, mandated--the Federal Reserve Board as the Nation's chief financial regulator, and I quote, ``to prohibit unfair, deceptive, and excessive acts and practices in the mortgage lending market.'' Despite this direct requirement and mandate, the Federal Reserve Board under its previous leadership decided to simply ignore the law--not for days, not for weeks, not for months, but for years. Indeed, instead of enforcing the law by simply imposing the common-sense requirements that a mortgage loan be based on a borrower's ability to repay it, the Fed leadership actually encouraged riskier mortgage products to be introduced into the marketplace. And the public information on this point is massive. The Fed's defiance of the law and encouragement of risky lending occurred even as the Fed's own officials warned that poor underwriting in the subprime mortgage market threatened homeownership and wealth accumulation. And it was incompatible with safe and sound lending practices. The Fed's defiance of the law and encouragement of risky lending occurred despite warnings issued by Members of Congress, I would add, including some of us who served on this Committee, that occurred despite warnings from respected economists and others that the Fed and its sister agencies were playing with fire. It was only this year, 14 years after the enactment of the 1994 law, that the Fed finally published regulations to enforce the bill's provisions, the needed protections. By that time, of course, the proverbial horse was out of the barn. Trillions of dollars in subprime mortgages had already been brokered, lent, securitized, and blessed with unrealistic credit ratings. Millions of American homeowners faced foreclosure, nearly 10,000 a day in our country. I spoke to a housing group from my State yesterday. There are 1,000 legal foreclosure proceedings every week in the State of Connecticut, and we have a foreclosure rate that is lower than the national average. A thousand cases a week in the courts in Connecticut in foreclosures. Tens of millions more are watching as their most valuable asset--their homes--decline in value. And the entire global financial marketplace has been polluted by toxic financial instruments backed by these subprime mortgages, which has caused a financial meltdown of unprecedented proportions and laid low our economy. The evidence is overwhelming. This crisis is a direct consequence of years of regulatory failures by government officials. They ignored the law. They ignored the risks to homeowners. And they ignored the harm done to our economy. Despite this clear and unimpeachable evidence, there are still some who point fingers of blame to the discretion of Fannie Mae, Freddie Mac, and the Community Reinvestment Act. These critics are loud and they are shrill. They are also very wrong. It is no coincidence that they are some of the very same sources who were the greatest cheerleaders for the very deregulatory policies that created the financial crisis. Let's look at the facts, or as Pat Moynihan used to say, ``Everyone's entitled to their own opinions, but not their own facts.'' On Fannie Mae and Freddie Mac, the wrong-headed critics say Fannie and Freddie lit the match of the subprime crisis. In fact, Fannie and Freddie lagged in the subprime market. They did not lead it. Between 2004 and 2006, the height of the subprime lending boom, Fannie and Freddie's share of subprime securitizations plummeted from 48 percent to 24 percent. The dominant players were not Fannie and Freddie, but the Wall Street firms and their other private sector partners: the mortgage brokers and the unregulated lenders. In fact, in 2006, the height of the subprime boom, more than 84 percent of subprime mortgages were issued by private lenders. Private lenders. One of the reasons Fannie and Freddie lagged is because they were subject to tougher underwriting standards than those rogue private unregulated lenders. So it was the private sector not the Government or Government-sponsored enterprises that was behind the soaring subprime lending at the core of this crisis. At the risk of stating the obvious, it is worth noting that at the height of the housing boom, the President and his supporters in and out of Government did nothing to criticize or stop predatory lending. They did nothing to support, much less advance, the legislation that some of us were working on to move in the Congress that would have cracked down on predatory lending. Regarding the Community Reinvestment Act, the critics are also speaking in ignorance of the facts. The overwhelming majority of predatory subprime loans were made by lenders and brokers who were not, I repeat were not, subject to CRA. In 2006, for example, 24 of the top 25 subprime lenders were exempt--exempt--from the CRA. In fact, CRA lending is in no way responsible for the subprime crisis. CRA has been the law of the land for three decades. If it were responsible for creating a crisis, this crisis would have occurred decades ago. The late Ned Gramlich, the former Fed Governor, put it well when he said that two-thirds of CRA loans did not have interest rates high enough to be considered subprime. Rather than being risky, lenders have found CRA loans to have low default rates. According to former Governor Gramlich, ``Banks that have participated in CRA lending have found that this new lending is good business.'' So people are entitled to their own opinions, as Pat Moynihan would say, but they are not entitled to their own facts. And Ronald Reagan once said, ``Facts are stubborn things.'' Indeed, they are, as they should be in this regard. Let me also say that I have learned over the years from this debacle that the American consumers, when all is said and done, remain the backbone of the American economy and deserve far better than they have been getting from too many people. The lessons, obviously, of this crisis are already becoming clear to us. One of the central lessons is that never again should we permit the kind of systematic regulatory failures that allowed reckless lending practices to mushroom in the global credit crisis. Anther is that never again should we allow Federal financial regulators to treat consumer protection as a nuisance or of secondary importance to safety and soundness regulation. If we have learned one thing from all of this, it is, as I said a moment ago, the American consumer, when all is said and done, remains the backbone of the American economy, that consumer protection and safe and sound operation of financial institutions are inextricably linked. I look forward to hearing from our distinguished panel of witnesses and from my colleagues this morning as we go back and look at what occurred here and the ideas that can be put forward as to how do we minimize these problems from ever occurring again. Again, I thank the witnesses very much and my colleagues for interrupting their time back in their respective States and districts to be here this morning to participate in the hearing. With that, Senator Crapo. CHRG-110hhrg44900--5 Mr. Bachus," I thank the chairman for holding this hearing on systemic risk and the appropriate regulatory responses to managing that risk and I know there will be short-term responses, and at some time in the future maybe a new regulatory structure which will take time. The two public servants before us today I think are eminently qualified to speak to these issues and we welcome Secretary Paulson and Chairman Bernanke. They had agencies whose mandates and responsibilities are broad and are deep, but the issue of systemic risk also requires the involvement of other significant and capable regulators, including particularly the SEC and the Federal banking regulators. It is my expectation that the leaders of these agencies will appear at a subsequent hearing with their comments and that will supplement our understanding and the testimony we gather today on this difficult issue, and I trust that Secretary Paulson and Chairman Bernanke agree that a collaborative effort that includes these agencies is going to be needed if we are to have a successful outcome. To say we are living through interesting times in our financial markets is to state the painfully obvious. We have seen a run on what was then the Nation's 5th largest investment bank, Bear Stearns. We have seen the Federal Reserve intervene in order to avoid a cascading effect from Bear Stearns's collapse that could have spread throughout the financial system with what I believe would have been decidedly negative implications for the larger economy. And we have seen the Federal Reserve take steps or a series of steps that in the short term at least have brought a measure of confidence and stability to the financial markets. But now that the immediate crisis created by the run on Bear Stearns has passed, we face some difficult, long-term policy questions. Perhaps the most critical question is, have we arrived at the place where virtually every primary dealer is considered too big or too interconnected to fail? The logical extension of this too big to fail perception is that markets no longer work and that the government must not only exercise greater control of our capital markets, but also be the ultimate guarantor of financial solvency; that would be a conclusion I could not endorse. And in reading over the remarks of Secretary Paulson in London, I see that you did not endorse it, either. A far better alternative is to restore market discipline within appropriate regulatory bounds. I believe we have reached a consensus that we must establish a modern, regulatory structure to strengthen the safety and soundness of our institutions and discourage unsound practices and conduct. However, these regulations should not and cannot ensure that institutions will never fail. And if one does fail, we must ensure that taxpayers are not left holding the bag. Thanks to the fast action of the Federal Reserve in cooperation with the SEC and the Treasury, we dodged a bullet when Bear Stearns collapsed. We may not be so lucky next time. For that reason, I look forward to hearing from today's witnesses about what we can do to provide for an orderly resolution in the event a large financial institution fails. The regulatory regime we establish and follow must accomplish three things: ensure market discipline; provide a shock absorber against systemic risk; and, first and foremost, protect the taxpayer. To preserve market discipline and discourage moral hazard, we must see to it that no firm should be considered too big or interconnected to fail. To protect against systemic risk, we must ensure that when a firm fails, it does not bring down the entire financial system with it, i.e., an orderly liquidation. And to protect the taxpayer, we have to make sure that the cost of that failure is borne by the firm's shareholders and creditors, and not passed on to the taxpaying public. In conclusion, of necessity we have to plan for how to handle the failure of a major institution. It is important, however, that we create a system focused not on failure, but on success. In doing so, we must also resist the temptation to over-regulate in our zeal to discourage practices such as overleveraging an excessive risk-taking that put institutions at risk of failure. This is a tall order. Thank you, Mr. Chairman, for holding this hearing, and thank you to our witnesses. " CHRG-110hhrg46591--438 The Chairman," The gentlewoman from California. Ms. Speier. Thank you, Mr. Chairman. And thank you for being here and for your participation. I will make this painless because I know I am the last to ask questions here. One of the things that is very apparent to me, and I think to all of us really, is if you have no skin in the game it is really easy to make mischief and get out there. And a lot of that went on in this crisis. You all are supportive of ceasing mark to market. And yet I worry that if we do in fact get rid of mark to market, that it is going to create an environment where banks can take on risks because there is not going to be the accountability that mark to market requires. So my question is, are you interested in seeing mark to market suspended for a short period of time because we are in this crisis, and then return to it? Or are you supporting doing away with mark to market completely? " CHRG-111hhrg55809--201 Mr. Bernanke," Well, it is first certainly true that we are better off than we were with the system in crisis. It is also true that the banks have not returned to normal lending by any means. I think the low interest rates do have positive effects on the economy, for example, operating through other markets, like the mortgage market or the corporate bond market. But getting the banking system back into a lending mode is very important. We continue to work with the banks to encourage them to raise equity so they have sufficient capital to support their lending. We have provided them with an enormous amount of liquidity so they are able to have the funds to lend. We are encouraging them to lend, in that going back to November, the bank regulators had a joint statement encouraging banks to lend to creditworthy borrowers as being in the interest both of the banks and of the economy. And we continue to try to follow up on all those things. In addition, as you may know, we have some programs, including the Term Asset-Backed Securities Loan Facility, which is trying to open up sources of funding from the capital markets, for example, for consumer loans and small business loans. I would add, I guess, that there are also some efforts taking place from the Treasury to support small-business lending. It is a difficult problem, but we are trying it attack it in a number of fronts. Just to conclude, I would say that it is true that as long as the banks are as reluctant to lend as they are, to some extent, it weakens the effect of our stimulative policies. Mr. Miller of California. You recall last September, we were having a very lengthy debate, and you and I had some conversations requiring the $700 billion to going to buy mortgage-backed securities, which we approved the first $350 billion. But it seems like we went through a tremendous amount of debate to make that decision; yet the Federal Reserve last week decided to buy a trillion and quarter dollars of mortgage-backed securities. And your previous comments, we have talked about the Fed's role in injecting liquidity in the marketplace and being able to fight inflation as needed, but you can't do that with assets you are buying. They are not liquid. Unless you are going to have a barn sale and just get rid of them for liquidity, how can you justify those two? They seem to be-- " CHRG-111hhrg52406--197 Mr. Kanjorski," All right. Could you help me out a little bit and explain to me what tremendous contribution consumers have made to the most recent recession and financial crisis? Ms. Keest. Are you asking me? " CHRG-111shrg50564--26 Mr. Volcker," Well, that is an interesting experience. That was rather widely acclaimed, and other countries attempted to or did follow that pattern. But then when they had a crisis, they found out it did not work so well. Senator Shelby. It did not work. " 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-111shrg50815--54 Mr. Ausubel," Clearly, the financial crisis has led to the reduction in credit lines and this has been adverse to consumers. However, there is no evidence that credit card regulation or the Dodd bill would cause any further contraction in the availability of credit or increase the cost of credit. This has all been presented as industry rhetoric with no hard evidence. The other thing just to add is people are using things--this is always done--people are using random recent events, like the cutback in the securitization market--I should say the freezing of the securitization market to raise red flags here. The reason for the securitization market's freeze is the financial crisis and it is not a matter of concern whether banks can impose penalty rates on consumers. Senator Johnson. Thank you. I yield back. " CHRG-111hhrg52400--180 Mr. McRaith," Right. Thank you for that question, because securities lending has come up in other comments, as well. It is important to understand that the problem--first of all, that the New York Department of Insurance was working to reduce the level of securities lending in the AIG subsidiaries before the crisis. The crisis, remember, was a result of the--essentially, a collateral call on the AIG holding company, resulting from the credit default swaps. This would not have been a problem, but for the CDS failure. And it is also important to remember that the securities which were involved were AAA-rated securities at the time. So it points to the need for better regulation of the credit default swap market. The-- Ms. Bean. So where would the $44 billion have come from? " FinancialCrisisInquiry--180 Odds are that the recovery will evolve into a self-sustaining expansion in the coming year. But these odds will remain uncomfortably high unless hiring revives. At the very least, the transition from our current recovery to expansion will be less than graceful and may require policy makers to provide even more support to the economy. The longer-term fallout from the economic crisis will also be very substantial. Based on the experiences of other global economies that have suffered similar financial crises, GDMP and employment will be lower and unemployment higher for many years to come. The unemployment rate is expected to peak between 10.5 and 11 percent this fall. And it will not decline back to a rate consistent with full employment until 2013. The full employment/unemployment rate is also rising as those losing their jobs are staying unemployed for increasingly long stretches, undermining their skills and marketability as workers. There’s also increasing, given the weakening in the labor force mobility, given the large number of homeowners that are under water on their homes. Historically those losing their jobs in one part of the country could readily move to another part of the country where a job was available. This is much more difficult to do if a homeowner needs to put more equity into their home before they move. The full employment/unemployment rate was probably about 5 percent before the recession began. I wouldn’t be surprised if it were to rise to closer to 6 percent when it’s all said and done. But arguably, the most serious long-term casualty of the financial crisis is the nation’s fiscal situation. The budget deficit, as you know, ballooned to $1.4 trillion in fiscal year 2009 and is expected to be similar this year. The red ink reflects in significant part the expected close to $2 trillion price tag to taxpayers of the financial crisis. This is equal to 14 percent of GDP. Just to give you a context, by my calculation, the savings and loan crisis of the early ‘90s cost $315 billion in today’s dollars, 6 percent of GDP. It’s not that policy makers had a choice in running these massive deficits. The cost to taxpayers would have been measurably greater if policy makers had not acted aggressively to the financial crisis. The great recession would likely still be in full swing undermining tax revenues, and driving up spending on Medicaid, welfare, and other income support for distressed families. CHRG-111shrg57321--45 Mr. Kolchinsky," Second of all, I do not believe in the cause of the crisis there was a lot of instances of outright fraud, legal fraud. There may have been some on the front end with the mortgage brokers in filing applications that were clearly fraudulent. But the way the system worked, you had a chain--it was almost like a game of telephone where you pass some information down the line, and everybody changes it just a little bit--not enough to jump over the fraud, but because the length of the chain from the mortgage broker to the originator to the aggregator to the CDO, by the time everybody takes a little cut, changes it a little bit, by the time you got to the end of the line, the information or the product was garbage. So that is why you have not seen a lot of cases of outright fraud because everybody pushed the envelope, clearly pushed the envelope. But because of everybody pushing the envelope, the end product was garbage. Senator Kaufman. Yes, but, I can see that in 1 day, I can see it 2 days, I can see it 5 days, I can see it a month, I can see it 2 months, I can see it 3 months. I just find it--these are very smart people. I mean, when you look and see you are in the middle of a chain and you see what is happening, at some point you say, there is something really going on here. And maybe it is nonfeasance. It is not malfeasance. They are not doing it to be bad. They just do not go back and look to find out what they do not want to know, what actually happened. " fcic_final_report_full--490 III. THE U.S. GOVERNMENT ’S ROLE IN FOSTERING THE GROWTH OF THE NTM MARKET The preceding section of this dissenting statement described the damage that was done to the financial system by the unprecedented number of defaults and delinquencies that occurred among the 27 million NTMs that were present there in 2008. Given the damage they caused, the most important question about the financial crisis is why so many low quality mortgages were created. Another way to state this question is to ask why mortgage standards declined so substantially before and during the 1997-2007 bubble, allowing so many NTMs to be created. This massive and unprecedented change in underwriting standards had to have a cause—some factor that was present during the 1990s and thereafter that was not present in any earlier period. Part III addresses this fundamental question. The conventional explanation for the financial crisis is the one given by Fed Chairman Bernanke in the same speech at Morehouse College quoted at the outset of Part II: Saving inflows from abroad can be beneficial if the country that receives those inflows invests them well. Unfortunately, that was not always the case in the United States and some other countries. Financial institutions reacted to the surplus of available funds by competing aggressively for borrowers, and, in the years leading up to the crisis, credit to both households and businesses became relatively cheap and easy to obtain . One important consequence was a housing boom in the United States, a boom that was fueled in large part by a rapid expansion of mortgage lending. Unfortunately, much of this lending was poorly done, involving, for example, little or no down payment by the borrower or insuffi cient consideration by the lender of the borrower’s ability to make the monthly payments . Lenders may have become careless because they, like many people at the time, expected that house prices would continue to rise--thereby allowing borrowers to build up equity in their homes--and that credit would remain easily available, so that borrowers would be able to refinance if necessary. Regulators did not do enough to prevent poor lending, in part because many of the worst loans were made by firms subject to little or no federal regulation. [Emphasis supplied] 59 In other words, the liquidity in the world financial market caused U.S. banks to compete for borrowers by lowering their underwriting standards for mortgages and other loans. Lenders became careless. Regulators failed. Unregulated originators made bad loans. One has to ask: is it plausible that banks would compete for borrowers by lowering their mortgage standards? Mortgage originators—whether S&Ls, commercial banks, mortgage banks or unregulated brokers—have been competing for 100 years. That competition involved offering the lowest rates and the most benefits to potential borrowers. It did not, however, generally result in 59 Speech at Morehead College April 14, 2009. 485 or involve the weakening of underwriting standards. Those standards—what made up the traditional U.S. mortgage—were generally 15 or 30 year amortizing loans to homebuyers who could provide a downpayment of at least 10-to-20 percent and had good credit records, jobs and steady incomes. Because of its inherent quality, this loan was known as a prime mortgage. CHRG-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-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-111shrg57709--200 Mr. Volcker," I wish I lived in Connecticut. Exactly. [Laughter.] Senator Menendez. All right. Well, the offer still stands. I am reminded at the mantle of the Archives Building it says, ``What is past is prologue,'' and it seems to me that a lot of people want to dance around here, but at the end of the day, if we don't act, we are destined at some point in the future to relive a crisis, and that would be the worst situation perpetuated on the American people. So I think this is incredibly important. In the wake of the financial crisis, the surviving banks have actually grown bigger, not smaller, and the Volcker Rule doesn't force existing banks to downsize. So does that mean that you are comfortable with the current size of the banks that still exist? " CHRG-111hhrg55814--267 Mr. Bowman," Good afternoon, Congressman Moore, Ranking Member Bachus, and members of the committee. Thank you for the opportunity to present the views of the Office of Thrift Supervision on the Financial Stability Improvement Act of 2009. As Acting Director of OTS, I have testified several times about various aspects of financial regulatory reform, including OTS' strong support for maintaining a thrift charter, supervising systemically important financial firms, establishing resolution authority over systemically important financial firms, establishing a strong Financial Services Oversight Council, establishing a Consumer Protection Agency with rule-making authority over all entities offering financial products, and addressing real problems that caused this financial crisis and could cause the next one. I have also testified about OTS' opposition to consolidating bank and thrift regulatory agencies, believing that such an action would not have prevented the current crisis, and that the existence of charter choice was not a cause of the crisis. During this time, I have told OTS employees that based on a review of the Administration's initial proposal, they could take some comfort in assurances that whatever happened, they would be protected, treated fairly, and valued equally with their counterparts at other agencies. After reviewing the draft bill, I can only conclude that this is no longer the case. We know that major changes were made to this portion of the bill recently. Instead of abolishing both OTS and the Office of the Comptroller of the Currency and establishing a new agency called the National Bank Supervisor, the bill would merge the OTS into the OCC. What we do not know is why these changes were made. If Congress concludes that merging agencies would accomplish an important public policy goal, then we believe Congress should build a Federal bank supervisory framework for the 21st Century by establishing a strong, new agency with a name that is recognizable to consumers and accurately reflects its mission. If this bill were to pass as currently drafted, OTS employees would be unfairly singled out and cast under a shadow. The impact of this approach would be particularly onerous for the one third of all OTS employees who are not examiners and who would not work in the OCC's proposed new Division of Thrift Supervision. Instead of having an equal opportunity to obtain a position in the reconstituted agency based on merit and on-the-job performance, they would be folded into current divisions of the OCC. I believe that if all employees had an equal opportunity to compete for positions, then the resulting agency would be more cohesive and would benefit from the most qualified and capable workforce and leadership. It is also critical that the bill include strong protections for all employees of the reconstituted agency, most importantly the same 5-year protection from a reduction in force that is contained in the bill to establish the Consumer Financial Protection Agency. I am concerned that OTS employees could regard the current bill as punitive, and that such an approach would send the wrong signal, not only to the OTS workforce but to all Federal employees about how they would be treated in a similar situation. The timing of such a signal could hardly be worse when a large percentage of Federal employees are nearing retirement age and Federal agencies are redoubling their efforts to attract the workforce of the future to respond to the call of Federal service. In conclusion, Congressman Moore and members of the committee, I strongly urge you to affirm that Congress values the service of all Federal employees and to ensure that this bill would promote a fair, even-handed approach that would result in a harmonious agency with employees hopeful about the future of their agency and their role in it. Thank you, and I would be happy to respond to questions. [The prepared statement of Acting Director Bowman can be found on page 127 of the appendix. ] Mr. Moore of Kansas. Thank you, Mr. Bowman. The Chair next recognizes Commissioner Sullivan for 5 minutes. STATEMENT OF THE HONORABLE THOMAS R. SULLIVAN, INSURANCE COMMISSIONER OF THE STATE OF CONNECTICUT, ON BEHALF OF THE NATIONAL ASSOCIATION OF INSURANCE COMMISSIONERS (NAIC) " fcic_final_report_full--558 Bakersfield, session 2: Local Banking, September 7, 2010, transcript pp. 25, 61. 9. William Martin, testimony before the FCIC, Hearing on the Impact of the Financial Crisis—State of Nevada, session 2: The Impact of the Financial Crisis on Businesses of Nevada, September 8, 2010, transcript, p. 76. 10. Inside Mortgage Finance, The 2009 Mortgage Market Statistical Annual, vol. 1, The Primary Mar- ket (: Inside Mortgage Finance, 2009), p. 4, “Mortgage Product by Origination.” 11. Data provided to the FCIC by National Association of Realtors: national home price data from sales of existing homes, comparing second-quarter 1998 ($135,800) and second-quarter 2006 ($227,100), the national peak in prices. 12. Core-based statistical area house prices for Sacramento–Arden–Arcade–Roseville CA Metropoli- tan Statistical Area, CoreLogic data. 13. Data provided by CoreLogic, Home Price Index for Urban Areas. FCIC staff calculated house price growth from January 2001 to peak of each market. Prices increased at least 50% in 401 cities, at least 75% in 217 cities, at least 100% in 112 cities, at least 125% in 63 cities, and more than 150% in 16 cities. 14. Updated data provided by James Kennedy and Alan Greenspan, whose data originally appeared in “Sources and Uses of Equity Extracted from Homes,” Finance and Economics Discussion Series, Federal Reserve Board, 2007-20 (March 2007). 15. “Mortgage Originations Rise in First Half of 2005; Demand for Interest Only, Option ARM and Alt-A Products Increases,” Mortgage Bankers Association press release, October 25, 2005. 16. In 2007, the weekly wage of New York investment banker was $16,849; of the average privately employed worker, $841. 17. Federal Reserve Survey of Consumer Finances, tabulated by FCIC. 18. Angelo Mozilo, interview by FCIC, September 24, 2010. 19. Michael Mayo, testimony before the First Public Hearing of the FCIC, day 1, panel 2: Financial Market Participants, January 13, 2010, transcript, p. 114. 20. “Mortgage Originations Rise in First Half of 2005,” MBA press release, October 27, 2005. 21. Yuliya Demyanyk and Yadav K. Gopalan, “Subprime ARMs: Popular Loans, Poor Performance,” Federal Reserve Bank of St. Louis, Bridges (Spring 2007). 22. Ann Fulmer, vice president of Business Relations, Interthinx (session 1: Overview of Mortgage Fraud), and Ellen Wilcox, special agent, Florida Department of Law Enforcement (session 2: Uncovering Mortgage Fraud in Miami), testimony before the FCIC, Hearing on the Impact of the Financial Crisis— Miami, September 21, 2010. 23. Julia Gordon and Michael Calhoun, Center for Responsible Lending, interview by FCIC, Septem- ber 16, 2010. 24. Faith Schwartz, at Consumer Advisory Council meeting, Thursday, March 30, 2006. 25. Federal Reserve Board, “Mean Value of Mortgages or Home-Equity Loans for Families with Hold- ings,” in SCF Chartbook, June 15, 2009, tables updated to February 18, 2010. 26. Christopher Cruise, interview by FCIC, August 24, 2010. 27. Ibid. 28. Robert Kuttner, interview by FCIC, August 5, 2010. 29. Timothy Geithner, testimony before the FCIC, Hearing on the Shadow Banking System, day 2, session 2: Perspective on the Shadow Banking System, May 6, 2010, transcript, p. 146. 30. James Ryan, chief marketing officer at CitiFinancial and John Schachtel, executive vice president of CitiFinancial, interview by FCIC, February 3, 2010. 31. These points were made to the FCIC by consumer advocates: e.g., Kevin Stein, associate director, California Reinvestment Coalition, at the Hearing on the Impact of the Financial Crisis—Sacramento, ses- sion 2: Mortgage Origination, Mortgage Fraud and Predatory Lending in the Sacramento Region, Septem- ber 23, 2010; Gail Burks, president and CEO, Nevada Fair Housing Center, at the Hearing on the Impact of the Financial Crisis—State of Nevada, session 3: The Impact of the Financial Crisis on Nevada Real Estate, September 8, 2010. See also Federal Reserve Consumer Advisory Council transcripts, March 25, 2004; June 24, 2004; October 28, 2004; March 17, 2005; October 27, 2005; June 22, 2006; October 26, 2006. 555 32. Bob Gnaizda, interview by FCIC, March 25, 2010. 33. James Rokakis, interview by FCIC, November 8, 2010. 34. Ibid. 35. Fed Governor Edward M. Gramlich, “Tackling Predatory Lending: Regulation and Education,” remarks at Cleveland State University, Cleveland, Ohio, March 23, 2001. 36. Rokakis, interview. 37. John Taylor, chairman and chief executive officer, National Community Reinvestment Coalition, letter to Office of Thrift Supervision, July 3, 2000, provided to the FCIC. 38. Stein, testimony before the FCIC, transcript, pp. 73–74, 71. 39. U.S. Department of the Treasury and U.S Department of Housing and Urban Development, “Joint CHRG-111hhrg54867--148 Secretary Geithner," No. That is not--would not be a fair description of our strategy. And again, the critical test is, do you want to put this country in the position again where we come into the worst financial crisis in generations without the ability to protect the taxpayer-- " CHRG-111shrg57322--665 Mr. Viniar," It was the big short offsetting the big long which helped very much us get through that crisis. Senator Levin. Well, if it weren't for the big short, you would have been deeply in the red that year, wouldn't you? " CHRG-110hhrg46593--47 Mr. Hensarling," Well, you appear to be going where perhaps no Federal Reserve Chairman has gone before. And this may be a very good thing, given the crisis at hand. But just how much more are you prepared to commit and expose present and future taxpayers' liability to? " CHRG-110hhrg46591--79 The Chairman," Thank you, Mr. Seligman. I am going to recognize Ms. Velazquez and take 15 seconds to say that I think what we intend to pursue, or what I hope we will pursue, is what Mr. Stiglitz said, namely that mark to market is one thing, the automatic consequences that result from that are a separate thing, and that it is possible to leave mark to market in place, but then to make sure that all these negative consequences, as the gentleman said, put more cash aside, which have a procyclical effect. And my own view was that there is a consensus forming about a two-step process in which you have mark to market, but which you then get flexibility on the consequences. And that will be--the ranking member had asked that this be particularly part of this hearing. That will be part of our agenda next year. The gentlewoman from New York. Ms. Velazquez. Thank you, Mr. Chairman. If I may, Ms. Rivlin, I would like to address my first question to you. In the recent economic crisis, several of our Nation's largest financial firms received unprecedented levels of Federal resources because regulators believed that they were too big to fail. At the same time, many community banks and credit unions who did nothing to contribute to our current situation are equally affected by the crisis but have been largely left out of the Treasury's rescue plans. Given this reality, how will this affect consumers in those areas that rely upon community banks and credit unions for the credit needs, especially small businesses? Every day that we read the news, newspapers, there are different stories across the Nation where it is very difficult for small businesses to access credit. Ms. Rivlin. I think this is a very real problem. The hope was that at least stabilizing the major institutions first would get credit flowing and that it would help with the rest of the system. How to intervene at the community bank and credit union level is another question. Part of it, I think, goes to intervention in the mortgage markets themselves and to finding better ways and with larger amounts of money behind them to buy up the mortgages and renegotiate them so that you can keep the homeowner in the house where possible or re-sell it or re-rent it to somebody else. That strikes me, and Dr. Stiglitz mentioned this, as a really important part of this puzzle. Ms. Velazquez. So let me ask you, Dr. Stiglitz, should a revised regulatory framework eliminate this dichotomy where some firms are too big to fail and others are too small to save? " CHRG-111shrg54789--13 Chairman Dodd," Two final questions for you. I made the point in my opening statement that I thought if this were done well and right--as I plan to do so--that it is not only going to be beneficial to consumers, but the one argument we do not hear is that it is very beneficial to business, very beneficial to the financial institutions themselves to have a consumer protection agency, number one. And, number two, a witness who will appear in the second panel, Mr. Wallison from the American Enterprise Institute, says in his statement here, ``If we are looking for a primary cause of today's financial crisis, it is here,'' referring to the Community Reinvestment Act. Why don't you respond to the issue of whether or not you believe the Community Reinvestment Act was the primary cause of the financial crisis as well? " fcic_final_report_full--371 Cost of S h ort -T erm Borro wi ng During the crisis, the cost of borrowing for lower-rated nonfinancial firms spiked. IN PERCENT, DAILY 7 % 6 5 4 3 2 1 0 200 7 2008 2009 Figure . cash and assets every day and upon which consumers rely—for example, to use their credit cards and debit cards. “At that point, you don’t need to map out which particu- lar mechanism—it’s not relevant anymore—it’s become systemic and endemic and it needs to be stopped,” Palumbo said.  The government responded with two new lending programs on Friday, Septem- ber . Treasury would guarantee the  net asset value of eligible money market funds, for a fee paid by the funds.  And the Fed would provide loans to banks to pur- chase high-quality-asset-backed commercial paper from money market funds.  In its first two weeks, this program loaned banks  billion, although usage declined over the ensuing months. The two programs immediately slowed the run on money market funds. With the financial sector in disarray, the SEC imposed a temporary ban on short- selling on the stocks of about  banks, insurance companies, and securities firms. This action, taken on September , followed an earlier temporary ban put in place over the summer on naked short-selling—that is, shorting a stock without arranging to deliver it to the buyer—of  financial stocks in order to protect them from “un- lawful manipulation.” Meanwhile, Treasury Secretary Henry Paulson and other senior officials had de- cided they needed a more systematic approach to dealing with troubled firms and troubled markets. Paulson started seeking authority from Congress for TARP. “One thing that was constant about the crisis is that we were always behind. It was always morphing and manifesting itself in ways we didn’t expect,” Neel Kashkari, then assis- tant secretary of the treasury, told the FCIC. “So we knew we’d get one shot at this au- thority and it was important that we provided ourselves maximum firepower and maximum flexibility. We specifically designed the authority to allow us basically to do whatever we needed to do.” Kashkari “spent the next two weeks basically living on Capitol Hill.”  As discussed below, the program was a tough sell. CHRG-109hhrg31539--79 Mr. Capuano," I think that is a very fair statement. I am glad to hear that, because some of the quotes that I read from you got me a little concerned. And I guess--jumping off of that into the next point, at some point regulation--I am not convinced it is necessary yet, but I guess I am leaning that way at some point. I have a quote here from you--actually, let me back up. The president of Bear Stearns is--well, he is not quoted, but it is reported that he considers hedge funds risky and have become a focus of concern because of their rapid growth and concentration in the industry. And it is reported that he has suggested that this could trigger a financial crisis. And obviously Bear Stearns, I don't think anybody would consider them radical left wing, over-regulating types of supporters. Here I have a quote from you--and again, maybe misquoted, ``Direct regulation may be justified when market discipline is ineffective at constraining excessive leverage in risk taking.'' Well, I guess the question I have is does this suggest that we shouldn't even consider regulation until after there is a crisis of some sort, until after we find out that the market forces may not work, until after pension funds are looking to cover my mother's pension, or--I understand your hesitancy, and I am not suggesting we should rush into it at all, but I also think that there might be a balance at some point as hedge funds grow, that we might want to consider the possibility of reviewing some regulation. Again, I am not suggesting we jump into it headlong, but I think there is something between no regulation and waiting until after a crisis. And I want to see if I can clarify at least that quote that is attributed to you. " CHRG-111hhrg55814--368 Mr. Trumka," Thank you, Mr. Chairman. And thank you to Ranking Member Bachus. My name is Rich Trumka, and I am the president of the AFL-CIO. The AFL-CIO is a federation of 57 unions representing 11\1/2\ million members. Our members were not invited to Wall Street's party, but we have paid for it with devastation to our pension funds, lost jobs, and public bailouts of private sector losses. Our goal is a financial system that is transparent, accountable, and stable, a system that is the servant of the real economy rather than its master. The AFL-CIO is also a coalition member of Americans for Financial Reform, and we join that coalition in complimenting the committee for its work on the Consumer Financial Protection Agency, and we endorse the testimony of AFR's witness here today; however, we are concerned with the working draft, that the committee's work thus far on the fundamental issues of regulating shadow financial markets and institutions will allow in large part the very practices that led to the financial crisis to continue. The loopholes in the derivatives bill and the failure to require any public disclosures by hedge funds and private equity funds fundamentally will leave the shadow markets in the shadows. And we urge the committee to work with the leadership to strengthen these bills before they come to the House Floor. The subject of today's hearing, of course, is systemic risk. And the AFL-CIO strongly supports the concepts in the Treasury Department White Paper, that a systemic risk regulator must have the power to set capital requirements for all systematically significant financial institutions, and be able to place a failing institution in a resolution process run by the FDIC. We are glad to see that the committee bill actually does those things. Although we have some concerns with the discussion draft that was made public earlier this week, we really haven't had a chance to go through it. And our understanding so far is that some of the intention of the committee, we may have read things at variance with that, and we think they can be worked out. But our concern is that this bill gives pretty dramatic new powers to the Federal Reserve without reforming the governance by ending the banks' involvement in selecting the boards of the regional Fed banks, where the Fed's regulatory capacity is located. The discussion draft would appear to give power to the Federal Reserve to preempt a wide range of rules regulating the capital market, power which could be used, unfortunately, to gut investor and consumer protections. If the committee wishes to give more power to the Federal Reserve, we think it should make clear that this power is only to strengthen safety and soundness regulation, and that it must simultaneously reform the Federal Reserve's governance. These powers must be given to a fully public body, and one that is able to benefit from the information and perspective of the routine regulators of the financial system. We believe a new agency with a board made up of a mixture of the heads of the routine regulators and direct presidential appointees would be the best structure. However, if the Federal Reserve were made a fully public body, it would be an acceptable alternative. Unfortunately, it is reported today that the Fed has rejected Treasury Secretary Geithner's request for a study of the Fed's governance and structure. We are also troubled by the provision in the discussion draft that would allow the Federal Government to provide taxpayer funds to failing banks and then bill other non-failing banks for the costs. We realize that it is not intended that this be a rescue, but rather a wind-down. The incentive structure created by this system seems likely to increase systemic risk, from our point of view. We believe it would be more appropriate to require financial institutions to pay into an insurance fund on an ongoing basis. Financial institutions should be subject to progressively higher fee assessments and stricter capital requirements as they get larger, and we think this would actually discourage ``too-big-to-fail.'' Finally, the discussion draft appears to envision a regulatory process that is secretive and optional. In other words, the list of systemically significant institutions is not public, and the Federal Reserve could actually choose to take no steps to strengthen the safety and soundness regulation of those systemically significant institutions. We think that in these respects, the discussion draft appears to take some of the problematic and unpopular aspects of the TARP and make them a model for permanent legislation. In closing, Mr. Chairman, I would say that instead of repeating some of the things we did in the bank bailout, Congress should be looking to create a transparent, fully public, accountable mechanism for regulating systemic risk and for acting to protect our economy in any future crises. On behalf of the AFL-CIO, I want to thank you for the opportunity to testify today. [The prepared statement of Mr. Trumka can be found on page 308 of the appendix.] " FOMC20051213meeting--30 28,MS. JOHNSON.," Well, two or three things come to mind. No one of them alone would seem to explain it, but in conjunction they may be a partial answer to your question. One is that following the Asian financial crisis, and no doubt in part in response to what has been happening in the United States, particularly since say, ’95 or ’96, most of these countries have been running current account surpluses and acquiring international reserves. The Asian countries have been doing it to the extreme. They’ve been piling up reserves and protecting themselves from being dependent upon the whims of foreign investors ever since that crisis. And they’re still doing it, although I noted an article in today’s Wall Street Journal quoting some Chinese officials as saying that maybe they now had enough. So I December 13, 2005 16 of 100 The Latin American countries—for many of the same reasons, but without quite the same capacity—have nonetheless put themselves in a position of an external plus instead of a minus. Now, the Latin Americans, in particular, and some of the Asians have outstanding debts, so they have payments schedules they have to meet. It’s not as if they are not in some sense still embroiled in the consequences of their histories and so forth. But their position vis-à-vis global capital flows has turned around enormously, and they have never gone back to policies that reflect an attitude of “the crisis is over, full steam ahead.” They have retained this preference for keeping themselves net lenders in a flow sense in the international capital flow. There are many reasons to view that as a problem as much as a good thing, but it explains, I think, why Argentina didn’t have much contagion effect and why these countries seem to us to be doing better." FinancialCrisisInquiry--206 CLOUTIER: It has been primarily a couple of things. A number of them have failed because they did buy Fannie and Freddie preferred stock and that has closed a number of them. The second thing that has closed some of them is, you know, in markets that have just been devastated—and let me tell you, in 1980, I lived in Louisiana and Texas and went through the ‘80s recession or depression there that was very bad, and I’ve seen how far real estate could fall, and it’s brought down a lot of banks. VICE CHAIRMAN THOMAS: That was the savings and loan crisis. CLOUTIER: Well, it was a bank crisis. If we would have—let me—let me make a comment here. If we were to fail, Continental Illinois and failed Chrysler in 1980, I don’t think we’d be here today. That’s when too-big-to-fail started. And it was a banking crisis. Every bank in Texas failed—the large banks. There’s only one exception, that’s Frost National. So we had a lot of experience with that. But what happened, Vice Chairman Thomas, is that a lot of banks, when the whole economy goes down, is I had a good friend in Merced that lost his bank. The unemployment in Merced is just rampant right now and it’s hard for a community bank that is in one community to survive, but when it comes apart—I listened to the governor of California the other day about all the problems in California. A community bank has a very difficult time when unemployment skyrockets in the community. VICE CHAIRMAN THOMAS: FinancialCrisisInquiry--24 In conclusion, I want all of you and the American people to know that I fully understand and appreciate the gravity of the crisis that we are now just coming through. We are grateful for the courage shown by government leaders to take bold, unprecedented action to preserve the financial system. We support regulatory reform efforts designed to prevent any recurrence of this episode. But most of all, we as managers have to run our companies never to let this happen again. Thank you for your time. And I’d welcome any questions you might have. CHAIRMAN ANGELIDES: Thank you very much, Mr. Moynihan. Thank you very much, all of you, for your thoughtful statements. We are now going to move to questions. And we have got a lot of ground to cover, so I’m going to ask that you be as, obviously, incisive and compelling as possible, but brief, succinct, direct answers. I’ll start the questioning today. And what I’d like to do is I’d like to start by asking some questions about specific types of business practices and risk management practices that may have contributed to the financial crisis as a way of making this tangible and real. And I want to pick up on your comment, Mr. Dimon, here. I’d like to be brutally honest. Mr. Blankfein, I’m going to start my questioning with you today. And I want to actually pick up on your comment in your testimony about the fact that there were—and—and I think I’m paraphrasing this correctly. That there were financial products and practices that may have served no, essentially, good or productive purpose in the financial system. Recently you’ve made a few comments. And I’d like to just read you a couple of quotes. You said in November of last year, “Listen, there was a lot of negligent behavior and proper bad behavior that has to be fixed and sorted through. We don’t take ourselves out of that. I include ourselves in that.” You also said, “We participated in things that were clearly wrong and we have reasons to regret and apologize for.” What I’d like to ask you is can you tell me very specifically what are the two most significant instances of negligent, improper and bad behavior in which your firm engaged and for which you would apologize. (BUZZER SOUNDS) That’s a vote. January 13, 2010 BLANKFEIN: Oh I see. I’d say the—the biggest—the biggest—and I referred to this in my—in my oral testimony just now. I think we in our behavior got up—got caught up in—and this is a general remark, I’ll get specific in a second got caught up in and participated in and therefore, contributed to elements of froth in the market. So, for example, in leverage finance, which was our biggest exposure, we are a top service provider to the private equity world. We are—we are a top mergers and acquisitions firm in connection with rendering that advice for mergers and acquisitions. We helped finance those transactions. Increasingly those transactions took on higher and higher leverage, which they could not have but for the willingness of financiers to participate in that. And we were a major financier. And moreover, we held those positions for too long, too much concentration in our books. In other words, we sold them down. And if you go through a continuum of people who have had these positions I don’t think—you know, relative to our size, we had more than we should have had. And therefore, we had to—when you go back and look at them, too much leverage in transactions and too much concentration remained from that leverage on our books. CHAIRMAN ANGELIDES: OK. Would you characterize—looking back on this now—and obviously, hindsight’s 20/20. But would you look back on some of the financings as negligent or improper? BLANKFEIN: Again, in the context of the world that we were in—and when you use terms like that, I always think about standards of behavior and in the context. I think those were very typical behaviors in the context that we were in. CHAIRMAN ANGELIDES: Let me ask you, have you done any kind of internal investigation, kind of large sweep of your activities? And is that—what did you find? And is that something we could have? CHRG-111hhrg74855--8 Mr. Waxman," Thank you very much, Mr. Chairman. Today we are examining whether the derivatives reform legislation reported out of the House Agriculture Committee could disrupt the Federal Energy Regulatory Commission's current regulation of critical regional electricity markets. The pending legislation is intended to bring greater transparency and accountability to derivative markets. I absolutely support that goal however the bill's broad definition of swaps is so inclusive that it threatens to displace comprehensive FERC regulation over regional electricity market products. The bill could be read to assign exclusive and mandatory authority over those products to the Commodities Futures Trading Commission. In 2000 and 2001, California experienced a severe energy crisis. There were blackouts. There was economic chaos. Energy prices in the State skyrocketed. We were being victimized by unscrupulous traders in both power and transmission rights. FERC, at the time, was soundly asleep and unresponsive to the alarms we raised. But in the wake of that California energy crisis, Congress amended and Mr. Markey indicated he was the author, changes in the Federal Power Act to give FERC authority to prevent and punish fraud in market manipulation. We thought FERC had that authority but during that period of time, they claimed they needed clearer statutory authority. Well, if the legislation reported out of the Agriculture Committee is not adjusted to preserve the authority of FERC, it could undermine authorities that Congress gave FERC in the aftermath of that energy crisis to investigate and penalize market manipulation. FERC has strengthened its monitoring and enforcement practices. No one, including the CFTC or sponsors of H.R. 3795, has suggested to us that the current regulatory regime to prevent market manipulation or abuse in FERC's organized regional markets is broken, so we need to ensure that efforts to strengthen derivative regulation don't weaken existing regulation. Before H.R. 3795 is considered on the House floor, members need to understand how it would affect the organized regional markets FERC has created and comprehensively regulated pursuant to detailed tariffs. These markets not only exist because FERC created them, the products traded in these markets are directly linked to the physical limits of the transmission system and are not traded on broad exchanges. We need to make sure that the legislation doesn't unintentionally displace FERC as the regulator of the markets FERC has created. This hearing is an important opportunity for us to find out what impact the proposed legislation may have on these critical markets and what changes to the legislation may be appropriate. I appreciate the expert witnesses here to help us understand its implications. Our committee has a tradition of acting only on the basis of a thorough understanding of the issues before it and I believe we can help to improve H.R. 3795 before it is voted upon. And I believe we are going to need changes in that legislation that is reported out of the Agriculture Committee to make sure that we don't have consequences that would be harmful to what the good job that FERC is doing in this regard and should continue to be able to do. Thank you, Mr. Chairman. " CHRG-111hhrg56776--275 Mr. Foster," Well, thank you. Let's see. My first question, briefly, if you could all three comment on where you are on the discussion that was touched on with Chairman Bernanke about whether it was monetary policy or regulatory failure that was responsible for the crisis we have just gone through. So just go down in order, if you could. " 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-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-111hhrg48674--37 Mr. Bernanke," Congressman, that was very interesting. Could I respond to a couple of points you made? First of all, in the Great Depression, Milton Friedman's view was that the cause was the failure of the Federal Reserve to avoid excessively tight monetary policy in the early 1930's. That was Friedman and Schwartz's famous book. And with that lesson in mind, the Federal Reserve has reacted very aggressively to cut interest rates in this current crisis. And moreover, we have also tried to avoid the collapse of the banking system, which was another reason for the Depression in the 1930's. On the prices of housing and the like, we are not trying to prop up the price of housing. What we are trying to do is get the credit markets working again so that the free market can begin to function in a normal way instead of a seized-up way in which it is currently acting. And finally, on price fixing of so-called toxic or legacy assets, the plan that Secretary Geithner described this morning would have as an important component private asset managers making purchases based on their own profit-maximizing analysis. So that would be true market prices that would free up what is now a frozen market to get transactions flowing again and should restore real price discovery to those markets. Dr. Paul. But so far, every one of these suggestions over the past year was more money, more credit, more government involvement. Nothing seems to be working. Even today, the markets weren't very happy with these announcements. I think the market is still pretty powerful. " CHRG-111shrg57319--474 Mr. Killinger," As I mentioned in my comments, I think Washington Mutual was very well positioned with its capital and operating plan to work itself through this financial crisis and I think it was making excellent progress on that. And I think that it was seized, in my opinion, in an unnecessary manner. Clearly, there was a lot of pressure on the financial system and regulators and policy leaders at that point in time in the wake of the collapse of Lehman. However, I just don't think the company was treated in the same equal-handed, fair manner that all other financial institutions were. And it is very much like oxygen--I will use an analogy of oxygen. None of us can live if oxygen is choked off for a brief period of time, and liquidity is that equivalent in financial services. Liquidity did start to become tight, not just for Washington Mutual, but for the entire industry for a brief period of time. But policy leaders elected to open up those tubes of oxygen for most banks and gave them a huge amount of benefits and Washington Mutual inexplicably, in my opinion, was not allowed to have the benefits of having that oxygen come to them for that brief period of time. And now, in hindsight, we can see for those that were able to get through that brief period and start to get back on the mend that the financial position is just extraordinarily different today than it was 12 months ago, and I believe Washington Mutual could have and should have been able to be one of those surviving banks. Senator Kaufman. Why was Washington Mutual specifically? I mean, is it just bad luck? " CHRG-110hhrg34673--145 Mr. Clay," Thank you, Mr. Chairman, and thank you for holding this hearing. Mr. Bernanke, welcome. I represent the First Congressional District of Missouri, which is comprised of north St. Louis City and north St. Louis County. Continuing with the same line of questioning as the gentleman from New Jersey about housing, in my district, and in many other districts across the country, we have a tremendous housing crisis. This must be addressed, and it must be done with urgency, especially when it comes to affordable housing. What changes in housing policy can be made that the United States can better foster an urban housing policy that puts people in homes in the inner cities so that they can build wealth through ownership and pass it on to future generations? What are your ideas on this, and what is your approach to this housing crisis? " CHRG-111hhrg55814--242 Secretary Geithner," We are in the process now, as required by law, to provide a comprehensive evaluation of the range of actions the government was forced to take in this crisis, both my predecessor and me, and we're going to be putting out that report in mid-December. " CHRG-111hhrg54867--144 Secretary Geithner," Congressman, it is important to make people understand and make sure people understand the following thing, this Congress put in law, after the S&L crisis, a very important authority to allow for resolution--not a great word. " CHRG-111hhrg53021--98 Secretary Geithner," The proposal the President laid out reflects--and, of course, I played a substantial role in shaping those proposals--my judgment, our collective judgment about what is appropriate, given the risk we have seen illustrated by this crisis. " CHRG-111hhrg55809--72 Mrs. Biggert," Thank you. If Congress overreacts to this crisis and overregulates, for example, with derivatives regulation, requiring all customized and standardized transactions to be conducted on an exchange, could U.S. businesses and jobs move overseas? " CHRG-111hhrg53021Oth--98 Secretary Geithner," The proposal the President laid out reflects--and, of course, I played a substantial role in shaping those proposals--my judgment, our collective judgment about what is appropriate, given the risk we have seen illustrated by this crisis. " CHRG-110shrg50415--69 Mr. Levitt," I think we are entering a decade of transparency. Everything that we do, every rule that is made, every regulation that is considered for the next 10 years will be viewed in terms of is it transparent. In that connection, I cannot possibly accept a notion of saying that the banks can take a product that may well be worth what they paid for it at the end of a certain period of time and consider that it is worth it right now. I believe in mark-to-the-market. I think the U.S. and global economies do have cycles. They did before we had mark-to-the-market accounting, and I think they will afterward. But it is not mark-to-the-market anything that created or made worse the cycles, including the present crisis. It was created by lenders making bad loans they could not collect on, thereby taking capital out of the system. Accounting has only informed the public of what those losses were. As loans began to reset after these unconscionable gimmicky loans were created and then securitized, as foreclosures grew more homes came into the market, and eventually supply overtook demand, depressing home prices at a faster rate. As losses got worse, as more homes went into foreclosure, accounting only informed the public that, in fact, it was getting worse. So I understand the problem of valuing instruments that are so difficult to value, and there are no absolutes here. I think we have got to look to some way to deal with this, but I feel very strongly that mark-to-the-market is a principle that is so much part of an era of transparency. " 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.] " 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. fcic_final_report_full--207 And if a relatively small number of the underlying loans were to go into fore- closure, the losses would render virtually all of the riskier BBB-rated tranches worth- less. “The whole system worked fine as long as everyone could refinance,” Steve Eisman, the founder of a fund within FrontPoint Partners, told the FCIC. The minute refinancing stopped, “losses would explode. . . . By , about half [the mortgages sold] were no-doc or low-doc. You were at max underwriting weakness at max hous- ing prices. And so the system imploded. Everyone was so levered there was no ability to take any pain.”  On October , , James Grant wrote in his newsletter about the “mysterious alchemical processes” in which “Wall Street transforms BBB-minus-rated mortgages into AAA-rated tranches of mortgage securities” by creating CDOs. He es- timated that even the triple-A tranches of CDOs would experience some losses if na- tional home prices were to fall just  or less within two years; and if prices were to fall , investors of tranches rated AA- or below would be completely wiped out.  In , Eisman and others were already looking for the best way to bet on this disaster by shorting all these shaky mortgage-related securities. Buying credit default swaps was efficient. Eisman realized that he could pick what he considered the most vulnerable tranches of the mortgage-backed bonds and bet millions of dollars against them, relatively cheaply and with considerable leverage. And that’s what he did. By the end of , Eisman had put millions of dollars into short positions on credit default swaps. It was, he was sure, just a matter of time. “Everyone really did believe that things were going to be okay,” Eisman said. “[I] thought they were certifi- able lunatics.”  Michael Burry, another short who became well-known after the crisis hit, was a doctor-turned-investor whose hedge fund, Scion Capital, in Northern California’s Silicon Valley, bet big against mortgage-backed securities—reflecting a change of heart, because he had invested in homebuilder stocks in . But the closer he looked, the more he wondered about the financing that supported this booming mar- ket. Burry decided that some of the newfangled adjustable rate mortgages were “the most toxic mortgages” created. He told the FCIC, “I watched those with interest as they migrated down the credit spectrum to the subprime market. As [home] prices had increased on the back of virtually no accompanying rise in wages and incomes, I came to the judgment that in two years there will be a final judgment on housing when those two-year [adjustable rate mortgages] seek refinancing.”  By the middle of , Burry had bought credit default swaps on billions of dollars of mortgage- backed securities and the bonds of financial companies in the housing market, in- cluding Fannie Mae, Freddie Mac, and AIG. Eisman, Cornwall, Paulson, and Burry were not alone in shorting the housing mar- ket. In fact, on one side of tens of billions of dollars worth of synthetic CDOs were in- vestors taking short positions. The purchasers of credit default swaps illustrate the im- pact of derivatives in introducing new risks and leverage into the system. Although these investors profited spectacularly from the housing crisis, they never made a single subprime loan or bought an actual mortgage. In other words, they were not purchasing insurance against anything they owned. Instead, they merely made side bets on the risks undertaken by others. Paulson told the FCIC that his research indicated that if home prices remained flat, losses would wipe out the BBB-rated tranches; meanwhile, at the time he could purchase default swap protection on them very cheaply.  On the other side of the zero-sum game were often the major U.S. financial insti- tutions that would eventually be battered. Burry acknowledged to the FCIC, “There is an argument to be made that you shouldn’t allow what I did.” But the problem, he said, was not the short positions he was taking; it was the risks that others were ac- cepting. “When I did the shorts, the whole time I was putting on the positions . . . there were people on the other side that were just eating them up. I think it’s a catas- trophe and I think it was preventable.”  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-111shrg55479--138 EXHIBIT VI 2008 Business Roundtable Survey[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT] PREPARED STATEMENT OF J.W. VERRET Assistant Professor of Law, George Mason University School of Law July 29, 2009The Misdirection of Current Corporate Governance Proposals Chairman Reed, Ranking Member Bunning, and distinguished Members of the Subcommittee, it is a privilege to testify in this forum today. My name is J.W. Verret, and I am an Assistant Professor of Law at George Mason Law School, a Senior Scholar at the Mercatus Center at George Mason University and a member of the Mercatus Center Financial Markets Working Group. I also direct the Corporate Federalism Initiative, a network of scholars dedicated to studying the intersection of State and Federal authority in corporate governance. I will begin by addressing proxy access and executive compensation rules under consideration and close with a list of contributing causes for the present crisis. I am concerned that some of the corporate governance proposals recently advanced impede shareholder voice in corporate elections. This is because they leave no room for investors to design corporate governance structures appropriate for their particular circumstances. Rather than expanding shareholder choice, these reforms actually stand in the way of shareholder choice. Most importantly, they do not permit a majority of shareholders to reject the Federal approach. The Director of the United Brotherhood of Carpenters said it best, ``we think less is more, fewer votes and less often would allow us to put more resources toward intelligent analysis.'' The Brotherhood of Carpenters opposes the current proposal out of concern about compliance costs. The proposals at issue today ignore their concerns, as well as concerns of many other investors. Consider why one might limit shareholders from choosing an alternative means of shareholder access. It can only be because a majority of the shareholders at many companies might reject the Federal approach if given the opportunity. Not all shareholders share similar goals. Public Pension Funds run by State elected officials and Union Pension Funds are among the most vocal proponents of shareholder power. Main street investors deserve the right to determine whether they want the politics of Unions and State Pension funds to take place in their 401(k)s. The current proposals also envision more disclosure about compensation consultants. Such a discussion would be incomplete without mentioning conflicts faced by proxy advisory firms. Proxy advisory firms advise institutional investors on how to vote. Current proposals have failed to address this issue. The political clout enjoyed by these firms is evidenced by the fact that the CAO of RiskMetrics, the dominant firm in the industry, was recently hired as special advisor to the SEC Chairman. To close the executive compensation issue, I will note that if executive compensation were to blame for the present crisis, we would see significant difference between compensation policies at those financial companies that recently returned their TARP money and those needing additional capital. We do not. Many of the current proposals also seek to undermine, and take legislative credit for, efforts currently underway at the State level and in negotiations between investors and boards. This is true for proxy access, the subject of recent rule making at the State level, and it is true for Federal proposals on staggered boards, majority voting, and independent Chairmen. The Sarbanes-Oxley Act passed in 2002 and was an unprecedented shift in corporate governance designed to prevent poor management practices. Between 2002 and 2008, the managerial decisions that led to the current crisis were in full swing. I won't argue that Sarbanes-Oxley caused the crisis, but this suggests that corporate governance reform does a poor job of preventing crisis. And yet, the financial crisis of 2008 must have a cause. I salute this Committee's determination to uncover it, but challenge whether corporate governance is the culprit. Let me suggest six alternative contributing factors for this Committee to investigate: i. The moral hazard problems created by the prospect of Government bailout; ii. The market distortions caused by subsidization of the housing market through Fannie Mae, Freddie Mac, and Federal tax policy; iii. Regulatory failure by the banking regulators and the SEC in setting appropriate risk-based capital reserve requirements for investment and commercial banks; iv. Short-term thinking on Wall Street fed by institutional investor fixation on firms making, and meeting, quarterly earnings predictions; v. A failure of credit-rating agencies to provide meaningful analysis, caused by an oligopoly in that market supported by regulation; vi. Excessive write downs in asset values under mark-to-market accounting, demanded by accounting firms who refused to sign off on balance sheets out of concern about exposure to excessive securities litigation risk. Corporate governance is the foundation of American capital markets. If this Committee tinkers with the American corporate governance system merely for the appearance of change, it risks irreparable damage to that foundation. I thank you for the opportunity to testify, and I look forward to answering your questions. ______ FinancialCrisisInquiry--178 The economic impact of the financial crisis is very severe. The immediate impact was the great recession, which was the longest, most severe and broadest based downturn since the 1930s Great Depression. Just a few statistics -- household wealth fell some $12.5 trillion as house prices have collapsed some 30 percent. And stock prices, despite the recent rise, are still down 25 percent from their pre- crisis peak. Over 8 million jobs after revisions have been lost in nearly every industry and region of the country. And 26.5 million Americans, over 17 percent of the workforce, are unemployed or under- employed. Due largely to the unprecedented actions taken by the Federal Reserve and fiscal policy makers the recession, the great recession ended this past summer. It’s no coincidence that the downturn ended just as the American Recovery and Reinvestment Act began providing its maximum economic benefit. Help for unemployed workers and hard- pressed state and local government, the cash for clunkers program and the housing tax credits have been particularly efficacious. The stimulus did what it was supposed to do. It short-circuited the recession, and it has spurred economic recovery. Indeed, the recovery strengthened as 2008 -- 2009 came to an end. Real GDP, the value of all the things that we produced, appears to have expanded by a solid well over 4 percent in the last quarter of 2009. But despite the better numbers, the recovery remains very tentative and fragile. Fallout from the financial crisis, including the lack of credit, which I discussed, the loss of household wealth and the pall over sentiment continues to cause businesses to be circumspect in their investment and hiring and consumers in their spending. The ongoing foreclosure crisis, the fiscal problems among state and local governments and the commercial real estate bust also continue to weigh heavily on the economy. CHRG-111hhrg56776--159 Mr. Bernanke," They were hidden. We are currently the principal regulator of Goldman Sachs, and we have about a dozen people onsite, and another dozen people who are looking at the company. We had, in this case, I think two people assigned to Lehman. And their main obligation was to make sure we got paid back our loans. So, it was not our responsibility, or our capacity, in the middle of the crisis, to look at that. " CHRG-109hhrg22160--232 Mr. Price," Thank you, Madam Chair. I appreciate that. It is an honor to be a part of this committee, and it is indeed a privilege to personally witness your wisdom. And I commend you for your dexterity and your persistence in your answers to many of the questions that have come to you today. I have a comment and then a couple of questions. I am so pleased to hear you in your written testimony and in your spoken testimony identify 2008 as the pivotal date as it relates to the Social Security issue, for two ones. One, as you appropriately identified, that is when the baby boomers begin to retire. The second reason that I believe that needs to be pointed out, and that is that on the wonderful graph of the incoming money as it relates to FICA and when we begin to dip, that is the top of that crest. And then we begin to go down where there is money going out than coming in. So I commend you for that. And I don't care whether you call it a crisis or a near crisis or a looming crisis, as President Clinton called it in 1998, a rose is a rose is a rose. I think the important issue is that you said clearly, ``There is a call for action before the leading edge of the baby boomer retirement becomes evident in 2008,'' and that is within 3 years. My question relates to our savings rate as a nation. And it is my understanding that the household savings rate is low as it relates to our history as a nation, and also as it relates to other industrialized nations. And so I would ask you what your thoughts are on anything that we might do in terms of policy that would positively and significantly affect our savings rate as a nation. " CHRG-111hhrg52400--177 Mr. Posey," Thank you very much, Mr. Chairman. We have really heard about two issues today: one is international harmony; and the other is about regulation. I won't go into the harmony, because there is just not time. And besides the EU, we know what happens when Asia gets in and South America gets in. I mean, it's really too large even to discuss too far here today. But as you have heard most of our colleagues discuss today, many of us believe clearly that the regulation of insurance is a State's right. That's purely and simply a State's right. It's reserved under the States. And the biggest violation of consumers that I have seen, quite frankly, has been by companies that write health insurance, for example, under ERISA. They will do business in 49 States, every State except the State in which they reside, collect premiums, and don't pay claims, because the Federal Government does nothing about it. And it wasn't until a consortium of States got together just several years ago and crossed State lines for the first time in history to prosecute health insurance fraud. If we left it to the Federal Government, they would still be plundering people in 49 States, unfortunately. It is clear that if your testimony today was true, very few of you need any more useless bureaucratic regulation. And who would have ever thought that, after the S&L crisis, so relatively shortly after the S&L crisis, with all the additional regulation that was put in place following the crisis, that we would again find ourselves in this hole of a financial crisis. I mean, if regulation would have solved the problem, we wouldn't be here today, because brighter minds, creative lawmakers threw a bunch of regulation into the S&L crisis, and obviously it didn't do anything. And why we would think that we could be successful in trying to advance, out-think a creative risk-taker, kind of defies logic. I think the answer is to hold people who harm people accountable. You know, we pretty much, I think, agree that the cause of the crisis that we're in now has been caused by greed. We have greedy executives--and it apparently is not illegal--who put the long-term best interests of the financial--fiduciary relationship that they have with their customers, their clients, their stockholders, behind their personal ambition for short-term gains and grossly exorbitant bonuses. And that's why we're in the problem that we're in now. I think everybody pretty much agrees with that. And I don't think that you are going to be able to ever craft a law that is going to outwit these creative--I hate to use the term--geniuses. Some of the schemes that they come up with seem pretty good for the short term, to improve their own lot. I think the only answer is going to be if you hold the people responsible who violate these fiduciary relationships, like they do in some industries. And for that, I realize there is not enough time for all of you to respond. I don't expect all of you to agree with that. But I would appreciate it if you would respond with your thoughts in writing to the chairman--and he can see that the rest of us would get a copy of it--what your thoughts would be, where you would draw the bar, what kind of boundaries you would recommend to legislate better accountability for these people who have plundered this Nation. They have plundered the world, so to speak. And, I mean, if regulation would take care of it, the SEC's 1,100 attorneys would have prosecuted Bernard Madoff 10 years ago when his scheme was exposed to them, and they refused to take any action. So, I think it's going to have to be a matter of criminal and civil accountability on a personal level if we are going to change the course of the future in this regard. Thank you, Mr. Chairman. " CHRG-111hhrg56766--24 Mr. Bernanke," Thank you, Mr. Chairman. I will try not to abuse that. Chairman Frank, Ranking Member Bachus, and other members of the committee, I am pleased to present the Federal Reserve's semi-annual Monetary Policy Report to the Congress. I will begin today with some comments on the outlook for the economy and for monetary policy, then touch briefly on several other important issues. Although the recession officially began more than 2 years ago, U.S. economic activity contracted particularly sharply following the intensification of the global financial crisis in the fall of 2008. Concerted efforts by the Federal Reserve, the Treasury Department, and other U.S. authorities to stabilize the financial system, together with highly stimulative monetary and fiscal policies, helped arrest the decline and are supporting a nascent economic recovery. Indeed, the U.S. economy expanded at about a 4 percent annual rate during the second half of last year. A significant portion of that growth, however, can be attributed to the progress that firms have made in working down unwanted inventories of unsold goods, which have left them more willing to increase production. As the impetus provided by the inventory cycle is temporary, and as the fiscal support for economic growth will likely diminish later this year, a sustained recovery will depend on continued growth in private-sector final demand for goods and services. Private-sector final demand does seem to be growing at a moderate pace, buoyed in part by a general improvement in financial conditions. In particular, consumer spending has recently picked up, reflecting gains in real disposable income and household wealth and tentative signs of stabilization in the labor market. Business investment in equipment and software has risen significantly. And international trade--supported by a recovery in the economies of many of our trading partners--is rebounding from its deep contraction of a year ago. However, starts of single-family homes, which rose notably this past spring, have recently been roughly flat, and commercial construction is declining sharply, reflecting poor fundamentals and continued difficulty in obtaining financing. The job market has been hit especially hard by the recession, as employers reacted to sharp sales declines and concerns about credit availability by deeply cutting their workforces in late 2008 and in 2009. Some recent indicators suggest that the deterioration in the labor market is abating: Job losses have slowed considerably, and the number of full-time jobs in manufacturing rose modestly in January. Initial claims for unemployment insurance have continued to trend lower, and the temporary services industry, often considered a bellwether for the employment outlook, has been expanding steadily since October. Notwithstanding these positive signs, the job market remains quite weak, with the unemployment rate near 10 percent and job openings scarce. Of particular concern because of its long-term implications for worker's skills and wages, is the increasing incidence of long-term unemployment; indeed, more than 40 percent of the unemployed have been out of work for 6 months or more, nearly double the share of a year ago. Increases in energy prices resulted in a pick-up in consumer price inflation in the second half of last year, but oil prices have flattened out over recent months, and most indicators suggest that inflation likely will be subdued for some time. Slack in labor and product markets has reduced wage and price pressures in most markets, and sharp increases in productivity have further reduced producers' unit labor costs. The cost of shelter, which receives a heavy weight in consumer price indexes, is rising very slowly, reflecting high vacancy rates. In addition, according to most measures, longer-term inflation expectations have remained relatively stable. The improvement in financial markets that began last spring continues. Conditions in short-term funding markets have returned to near pre-crisis levels. Many (mostly larger) firms have been able to issue corporate bonds or new equity and do not seem to be hampered by a lack of credit. In contrast, bank lending continues to contract, reflecting both tightened lending standards and weak demand for credit amid uncertain economic prospects. In conjunction with the January meeting of the Federal Open Market Committee, Board members and Reserve Bank presidents prepared projections for economic growth, unemployment, and inflation for the years 2010 through 2012 and over the longer run. The contours of these forecasts are broadly similar to those I reported to the Congress last July. FOMC participants continue to anticipate a moderate pace of economic recovery, with economic growth of roughly 3 to 3\1/2\ percent in 2010 and 3\1/2\ to 4\1/2\ percent in 2011. Consistent with moderate economic growth, participants expect the unemployment rate to decline only slowly, to a range of roughly 6\1/2\ to 7\1/2\ percent by the end of 2012, still well above their estimate of the long-run sustainable rate of about 5 percent. Inflation is expected to remain subdued, with consumer prices rising at rates between 1 and 2 percent in 2010 through 2012. In the longer term, inflation is expected to be between 1\3/4\ and 2 percent, the range that most FOMC participants judge to be consistent with the Federal Reserve's dual mandate of price stability and maximum employment. Over the past year, the Federal Reserve has employed a wide array of tools to promote economic recovery and preserve price stability. The target for the Federal funds rate has been maintained at a historically low range of 0 to \1/4\ percent since December 2008. The FOMC continues to anticipate that economic conditions--including low rates of resource utilization, subdued inflation trends, and stable inflation expectations--are likely to warrant exceptionally low levels of the Federal funds rate for an extended period. To provide support to mortgage lending and housing markets and to improve overall conditions in private credit markets, the Federal Reserve is in the process of purchasing $1.25 trillion of agency mortgage-backed securities and about $175 billion of agency debt. We have been gradually slowing the pace of these purchases in order to promote a smooth transition in markets and anticipate that these transactions will be completed by the end of March. The FOMC will continue to evaluate its purchases of securities in light of the evolving economic outlook and conditions in financial markets. In response to the substantial improvements in the functioning of most financial markets, the Federal Reserve is winding down the special liquidity facilities created during the crisis. On February 1st, a number of these facilities, including credit facilities for primary dealers, lending programs intended to help stabilize money market mutual funds and the commercial paper market, and temporary liquidity swap lines with foreign central banks, were all allowed to expire. The only remaining lending program for multiple borrowers created under the Federal Reserve's emergency authorities, the Term Asset-Backed Securities Loan Facility or TALF, is scheduled to close on March 31st for loans backed by all types of collateral except newly issued commercial mortgage-backed securities (CMBS) and on June 30th, for loans backed by newly issued CMBS. In addition to closing its special facilities, the Federal Reserve is normalizing its lending to commercial banks through the discount window. The final auction of discount-window funds to depositories for the Term Auction Facility, which was created in the early stages of the crisis to improve the liquidity of the banking system, will occur on March 8th. Last week, we announced that the maximum term of discount window loans, which was increased to as much as 90 days during the crisis, would be returned to overnight for most banks, as it was before the crisis erupted in August 2007. To discourage banks from relying on the discount window rather than private funding markets for short-term credit, last week we also increased the discount rate by 25 basis points, raising the spread between the discount rate and the top of the target range for the Federal funds rate to 50 basis points. These changes, like the closure of most of the special lending facilities earlier this month, are in response to the improved functioning of financial markets, which has reduced the need for extraordinary assistance from the Federal Reserve. These adjustments are not expected to lead to tighter financial conditions for households and businesses and should not be interpreted as signaling any change in the outlook for monetary policy, which remains about the same as it was at the time of the January meeting of the FOMC. Although the Federal funds rate is likely to remain exceptionally low for an extended period, as the expansion matures, the Federal Reserve will at some point need to begin to tighten monetary conditions to prevent the development of inflationary pressures. Notwithstanding the substantial increase in the size of its balance sheet associated with its purchases of Treasury and agency securities, we are confident that we have the tools we need to firm the stance of monetary policy at the appropriate time. Most importantly, in October 2008, the Congress gave statutory authority to the Federal Reserve to pay interest on banks' holdings of reserve balances at Federal Reserve banks. By increasing the interest rate on reserves, the Federal Reserve will be able to put significant upward pressure on all short-term interest rates. Actual and prospective increases in short-term interest rates will be reflected in longer-term interest rates and in financial conditions more generally. The Federal Reserve has also been developing a number of additional tools to reduce the large quantity of reserves held by the banking system, which will improve the Federal Reserve's control of financial conditions by leading to a tighter relationship between the interest rate paid on reserves and other short-term interest rates. Notably, our operational capacity for conducting reverse repurchase agreements, a tool that the Federal Reserve has historically used to absorb reserves from the banking system, is being expanded so that such transactions can be used to absorb large quantities of reserves. The Federal Reserve is also currently refining plans for a term deposit facility that could convert a portion of depository institutions' holdings reserve balances into deposits that are less liquid and cannot be used to meet reserve requirements. In addition, the FOMC has the option of redeeming or selling securities as a means of reducing outstanding bank reserves and applying monetary restraint. Of course, the sequencing of steps and the combination of tools that the Federal Reserve uses as it exits from its currently very accommodative policy stance will depend on economic and financial developments. I have provided more discussion of these options and possible sequencing in a recent testimony. The Federal Reserve is committed to ensuring that the Congress and the public have all the information needed to understand our decisions and to be assured of the integrity of our operations. Indeed, on matters related to the conduct of monetary policy, the Federal Reserve is already one of the most transparent central banks in the world, providing detailed records and explanations of its decisions. Over the past year, the Federal Reserve also took a number of steps to enhance the transparency of its special credit and liquidity facilities, including the provision of regular extensive reports to the Congress and the public; we have worked closely with the Government Accountability Office (GAO), the Office of the Special Inspector General for the Troubled Asset Relief Program (SIG TARP), the Congress, and private-sector auditors on a range of matters relating to these facilities. While the emergency credit and liquidity facilities were important tools for implementing monetary policy during the crisis, we understand that the unusual nature of those facilities creates a special obligation to assure the Congress and the public of the integrity of their operation. Accordingly, we would welcome a review by the GAO of the Federal Reserve's management of all facilities created under emergency authorities. In particular, we would support legislation authorizing the GAO to audit the operational integrity, collateral policies, use of third-party contractors, accounting, financial reporting, and internal controls of these special credit and liquidity facilities. The Federal Reserve will, of course, cooperate fully and actively in all reviews. We are also prepared to support legislation that would require the release of the identities of the firms that participated in each special facility after an appropriate delay. It is important that the release occur after a lag that is sufficiently long that investors will not view an institution's use of one of the facilities as a possible indication of ongoing financial problems, thereby undermining market confidence in the institution or discourage use of any future facility that might become necessary to protect the U.S. economy. Looking ahead, we will continue to work with the Congress in identifying approaches for enhancing the Federal Reserve's transparency that are consistent with our statutory objectives of fostering maximum employment and price stability. In particular, it is vital that the conduct of monetary policy continue to be insulated from short-term political pressures so that the FOMC can make policy decisions in the longer-term economic interests of the American people. Moreover, the confidentiality of discount window lending to individual depository institutions must be maintained so that the Federal Reserve continues to have effective ways to provide liquidity to depository institutions under circumstances where other sources of funding are not available. The Federal Reserve's ability to inject liquidity into the financial system is critical for preserving financial stability and for supporting depositories' key role in meeting the ongoing credit needs of firms and households. Strengthening our financial regulatory system is essential for the long-term economic stability of the Nation. Among the lessons of the crisis are the crucial importance of macroprudential regulation--that is, regulation and supervision aimed at addressing risks to the financial system as a whole--and the need for effective consolidated supervision of every financial institution that is so large or interconnected that its failure could threaten the functioning of the entire financial system. The Federal Reserve strongly supports the Congress' ongoing efforts to achieve comprehensive financial reform. In the meantime, to strengthen the Federal Reserve's oversight of banking organizations, we have been conducting an intensive self-examination of our regulatory and supervisory responsibilities and have been actively implementing improvements. For example, the Federal Reserve has been playing a key role in international efforts to toughen capital and liquidity requirements for financial institutions, particularly systemically critical firms, and we have been taking the lead in ensuring that compensation structures at banking organizations provide appropriate incentives without encouraging excessive risk-taking. The Federal Reserve is also making fundamental changes in its supervision of large, complex bank holding companies, both to improve the effectiveness of consolidated supervision and to incorporate a macroprudential prospective that goes beyond the traditional focus on safety and soundness of individual institutions. We are overhauling our supervisory framework and procedures to improve coordination within our own supervisory staff and with other supervisory agencies and to facilitate more-integrative assessments of risks within each holding company and across groups of companies. Last spring, the Federal Reserve led the successful Supervisory Capital Assessment Program, popularly known as the ``bank stress test.'' An important lesson of that program was that combining on-site bank examinations with a suite of quantitative and analytical tools can greatly improve comparability of the results and better identify potential risks. In that spirit, the Federal Reserve is also in the process of developing an enhanced quantitative surveillance program for large bank holding companies. Supervisory information will be combined with firm-level, market-based indicators and aggregate economic data to provide a more complete picture of the risks facing these institutions and the broader financial system. Making use of the Federal Reserve's unparalleled breath of expertise, this program will apply a multidisciplinary approach that involves economists, specialists in particular financial markets, payment systems experts, and other professionals, as well as bank supervisors. The recent crisis has also underscored the extent to which direct involvement in the oversight of banks and bank holding companies contributes to the Federal Reserve's effectiveness in carrying out its responsibilities as a central bank, including the making of monetary policy and the management of the discount window. Most important, as the crisis has once again demonstrated, the Federal Reserve's ability to identify and address diverse and hard-to-predict threats to financial stability depends critically on the information, expertise, and powers that it has by virtue of being both a bank supervisor and a central bank. The Federal Reserve continues to demonstrate its commitment to strengthening consumer protections in the financial services arena. Since the time of the previous Monetary Policy Report in July, the Federal Reserve has proposed a comprehensive overhaul of the regulations governing consumer mortgage transactions, and we are collaborating with the Department of Housing and Urban Development to assess how we might further increase transparency in the mortgage process. We have issued rules implementing enhanced consumer protections for credit card accounts and private student loans as well as new rules to ensure that consumers have meaningful opportunities to avoid overdraft fees. In addition, the Federal Reserve has implemented an expanded consumer compliance supervision program for nonbank subsidiaries of bank holding companies and foreign banking organizations. More generally, the Federal Reserve is committed to doing all that can be done to ensure that our economy is never again devastated by a financial collapse. We look forward to working with the Congress to develop effective and comprehensive reform of the financial regulatory framework. Thank you, Mr. Chairman. [The prepared statement of Chairman Bernanke can be found on page 71 of the appendix.] " CHRG-110hhrg45625--41 Mr. Foster," Mr. Chairman, fellow members of the committee, as a freshman member of this panel, thank you for letting me testify. As a scientist and businessman and also one of the newest Members of Congress, I hope to provide some useful comments that may help us solve our problems and find solutions. First, I accept the need for speed and overpowering force in this situation. With the credit system locked, small and large businesses are being told to prepare contingency plans for what to do if their operating lines of credit are not extended. Banks are refusing to lend each other at normal rates, or not at all. If nothing is done, and the situation persists for even a few weeks, we are facing an economic downturn unprecedented in our lifetimes. This is not a situation where we need long and thoughtful congressional deliberations. We have no choice other than to act, and to act quickly. This is also not the time for ideological fighting about class warfare from the left or blind adherence to the principles of unfettered free marked and zero government regulation from the right. This is the time for serious people from both parties to work fast, work smart, and map a way out of this crisis. The second point I want to make is that there are two routes mapped out of this crisis by the legislation that we will be considering: The so-called auction route and the so-called equity route. I wish to express my strong preference for the equity route, and I believe that the American taxpayer and business owner will agree. In the auction route, the taxpayer funds are used to buy off toxic assets left over from bad loans at a price well above anything you can get in the current market. Financial firms are bailed out and life pretty well goes on as usual for these firms, with the exception that they have learned that whenever they make a whole batch of bad loans, that they can pretty much count on the U.S. taxpayer to at least partially come and bail them out. The government is left with the mess of managing, administering, and liquidating these toxic assets. In the equity route, also allowed by the proposed legislation, the firms are bailed out, but at the price of government getting a big share in the companies. I believe that this is a far better deal for the taxpayer. The companies will be required to write down the value of their toxic assets, essentially admitting that their worthless paper is worthless, and in exchange the government injects cash by buying a large fraction of these banks. This is not dissimilar to the recent AIG bailout. And over time, as the market recovers, then the banks are sold back to private investors. The equity route has a number of advantages. First, the government does not end up owning and managing the bank's bad assets. The government is simply a more or less passive owner in a bank that is now adequately capitalized. Nobody gets fired on the day after a government equity injection, and financial life goes on. The equity route also depends somewhat less on getting an exact evaluation for the toxic assets. If it turns out, for example, that the assets are worth a lot more than anyone thought at the time of the bailout, that is okay; the taxpayer still owns most of the bank and most of the profits as the bank's assets appreciate. Finally, the equity route has been tried before, and it works. In the 1990's, Sweden faced an almost identical crisis, bad real estate debt and banks accounting for about 4 percent of GDP, and successfully used the equity route to work their way out of the crisis at a relatively small cost to taxpayers. This process is described in Tuesday's New York Times, and I urge everyone to read these articles. The next point I wish to make regards financial compensations for CEOs. One issue that is often mentioned is the overall scope of compensation, and while this concerns me, an equally important issue is the misalignment of incentives between CEO pay and shareholder interest. This is at the route of the crisis. If you are the CEO of an investment bank that makes $1 billion a year for 5 years, and is wiped out in the 6th year, the shareholders are also wiped out, but the CEO is left personally very well off. This is a fundamental misalignment of incentives that encourages extreme risk-taking behavior. As a former small businessman, I carried an unlimited personal guarantee for the success of my business. If my business went under, I lost my house, and I guarantee you that I paid very, very careful attention to the debt situation of our company. So demanding both up-side and down-side compensation incentives for CEOs is a crucial element of any reform. Finally, I believe that more of an effort needs to be made to secure foreign assistance with this program. Given the fact that the tentacles spread globally and given the fact that foreign firms could receive assistance under proposals floating around and given the fact that foreign governments have an overwhelming interest in the stable and prosperous American economy, it is vital we do more to ensure they aid us in this effort, and share the burden. Thank you. I yield back the balance of my time. " 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-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. ------ FinancialCrisisInquiry--665 CLOUTIER: Well, it was a bank crisis. If we would have—let me—let me make a comment here. If we were to fail, Continental Illinois and failed Chrysler in 1980, I don’t think we’d be here today. That’s when too-big-to-fail started. And it was a banking crisis. Every bank in Texas failed—the large banks. There’s only one exception, that’s Frost National. So we had a lot of experience with that. But what happened, Vice Chairman Thomas, is that a lot of banks, when the whole economy goes down, is I had a good friend in Merced that lost his bank. The unemployment in Merced is just rampant right now and it’s hard for a community bank that is in one community to survive, but when it comes apart—I listened to the governor of California the other day about all the problems in California. A community bank has a very difficult time when unemployment skyrockets in the community. CHRG-111hhrg53021--96 Secretary Geithner," I think there has been dramatic changes in the basic scale, design, and development of those markets. And even though, as I said in my testimony, the failures in those markets were not the principal cause of this crisis, they did cause substantial damage. And I think that justifies substantial reform. " CHRG-111hhrg53021Oth--96 Secretary Geithner," I think there has been dramatic changes in the basic scale, design, and development of those markets. And even though, as I said in my testimony, the failures in those markets were not the principal cause of this crisis, they did cause substantial damage. And I think that justifies substantial reform. " 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-111shrg61513--30 Mr. Bernanke," We are just paying them interest on their deposits on our balance sheet. Senator Bunning. OK. That isn't the answer that I wanted. Given what you learned during the AIG crisis and the bailout, do you think Congress should be doing something to address insurance regulation or the commercial paper markets? " CHRG-111hhrg74090--46 CONGRESS FROM THE STATE OF FLORIDA Ms. Castor. Thank you, Chairman Rush, for calling this critically important hearing on the Obama Administration's proposal for a Consumer Financial Protection Agency. Last Congress, in the wake of widespread concerns about toxic lead in paint on children's toys and other toxic consumer products, this subcommittee originated legislation to reorganize and strength the Consumer Product Safety Commission, and last year as the economy plunged, there were some analogous terms being used to describe some of the mortgage and investment products. We heard about toxic assets, poisoning banks balance sheets and toxic mortgage products, leaving millions of our neighbors facing foreclosure. Predatory lenders wreaked havoc on my community and the subsequent significant decline in property values has affected millions of folks in my home State, and unfortunately consumers could not count on State oversight of these mortgage brokers. In my home State, they just turned a blind eye and I recommend the Miami Herald expose that documented how many convicted felons entered into the subprime mortgage loan marketing business. So this financial crisis has taught us that in order to maintain a healthy economy, effective regulation must focus on protecting consumers from abusive, deceptive and unfair lending practices. The FTC has the enforcement authority to go after only non-depository lending institutions that deal unfairly with their borrowers but the abuses that led to the financial crisis spread deep into the banking system. So in light of the need for more-effective regulation of all lending institutions, depository and non-depository, the Obama Administration has rightly proposed a reorganization, and I think all of us can agree that regulation of financial institutions must be improved to better protect consumers. However, we must be aware not only of the impact of granting authority to a new Consumer Financial Protection Agency but also the consequences to consumers of the changes that have been proposed to the FTC. The Administration's proposal would reshape the FTC by shifting authority over consumer credit but also by streamlining its rulemaking process and allowing it to assess civil penalties on bad actors. So I look forward to your testimony on what this new FTC might look like and how its ability to achieve its mandate of consumer protection will be affected. I yield back. " CHRG-111hhrg51698--391 Mr. Goodlatte," Thank you, Mr. Chairman. Mr. Masters, just to clarify your testimony, the CFTC, by allowing an excessive speculation bubble, amplified and deepened the housing and banking crisis. Is that your conclusion? " CHRG-110hhrg46596--433 Mr. Kashkari," I believe that, Congressman. And the actions that the Congress took in passing the legislation in just 2 weeks is truly remarkable. The crisis was intensifying at such a rate that even 2 weeks may not have been fast enough. " CHRG-111hhrg74090--90 Mr. Radanovich," But weren't there existing authorities that have and could and should deal with the current crisis that we are in? Doesn't the added restrictions and regulations that you are going to be putting on the credit industry will drive up the cost of credit to consumers? " CHRG-111hhrg48868--58 Mr. Ario," Thank you, Chairman Kanjorski, Ranking Member Garrett, and members of the subcommittee. I appreciate the opportunity to provide an insurance regulator's perspective on what has happened at AIG. Ben Bernanke, Chairman of the Federal Reserve, recently described AIG as, ``A hedge fund attached to a large and stable insurance company.'' He was right on both counts. The hedge fund is AIG Financial Products, which, according to Chairman Bernanke, made, ``Irresponsible bets and took huge losses.'' The large and stable insurance company is, of course, 71 State regulated insurance subsidiaries, including 11 companies in my State of Pennsylvania. The reason the Federal Government decided to rescue AIG was because of the systemic risk created by Financial Products. That risk materialized last September when it became apparent that Financial Products had bet twice the value of AIG on risky credit default swaps and failed to hedge its own bets. To make matters worse, the counterparties to those swaps included many of the world's leading financial institutions. It was to protect those institutions that the Federal Government acted. In Chairman Bernanke's words, ``We are not doing this to bail out AIG or their shareholders certainly. We are doing this to protect our financial system and to avoid a much more severe crises in our global economy. We know that the failure of major financial firms can be disastrous for the economy. We really had no choice.'' To put it bluntly, AIG Financial Products, the hedge fund that failed to hedge its own bets, has become the poster child for systemic risk. Although the September crisis at Financial Products produced collateral damage within the AIG insurance companies, the fact is that these companies do perform well--they are not in a death spiral--well enough that competitors accuse AIG of using its Federal assistance to unfair advantage in the marketplace. The allegations are most prominent in commercial insurance where the Nation's largest insurers routinely bid against each other on multi-million dollar accounts. AIG's competitors claim that AIG is deliberately underpricing in a desperate attempt to maintain premium value. AIG has fired back that its competitors are selectively underpricing to exploit a vulnerable company. Such disputes typically reflect insurers trying to protect profit margins in a soft market, but there is a point at which low pricing can threaten long-term stability. So we have carefully reviewed, we being State insurance regulators, carefully reviewed charges on both sides and to date, have not seen any clear evidence of underpricing on either side. What have we learned from the AIG ordeal? First, we have seen stable insurance companies that demonstrate the efficacy of State insurance regulation. Indeed, the Federal rescue of AIG would have been an even tougher call were it not for the well-capitalized insurance companies providing the possibility that the AIG loans will be paid back. That was true in September. It is true today. The insurance companies have the value they do because State regulation requires healthy reserves backed by conservative investments all dedicated to protecting policyholders and other claimants. This is not to say that regulation is perfect, to the chairman's introductory comment, which brings me to securities lending. Securities lending did not pose systemic risk and would have been resolved without any Federal assistance, but for the Financial Products debacle, which caused the run on the bank that took a net of $20 billion in Federal funds to fully resolve. It is more than $40 billion out, but $20 billion held by the Federal Government today. This was unfortunate and it is a problem for State regulation, but it does not compare to the $440 billion credit default swap mess that continues to pose systemic risk. The securities lending problem: solved today. Completely solved. My written testimony contains more details about securities lending, but let me conclude with a few thoughts on the most important lesson we can learn from the abuses at Financial Products: the need to identify and manage systemic risk. As AIG illustrates, insurance companies are more likely to be the recipients rather than the creators of systemic risk, but as AIG also illustrates, the systemic risk that is received can have significant repercussions. In this case, a manageable securities lending problem turned into a run on the bank back in September. State insurance regulators recognize that Federal action is needed to address systemic risk, but the solution should be a collaborative one that builds on the strength of State regulation (multiple eyes on any problem) by adding the eyes of other functional regulators in a transparent structure that holds all functional regulators accountable and does not compromise one company within the enterprise for the benefit of another. Such a structure would give us, as State regulators, the ability to do what we do best, protect the insurance buying public. Thank you. [The prepared statement of Mr. Ario can be found on page 136 of the appendix.] " CHRG-111hhrg56847--193 Mr. Austria," Thank you, Mr. Chairman. And Dr. Bernanke, thank you for being here today and sharing your thoughts on the economy and the financial markets. And certainly I appreciate you sharing your thoughts about needing a system that is more resilient and having a plan in place for stabilization. And I appreciate the Federal Reserve being cautious about the U.S. economic outlook. Although you have also noted that there has been some recovery and it looks as though there might be modest recovery over the next couple of years, but I think there is also a growing risk out there that the economy could be dampened or even undercut by the ripple effects of the debt crisis in Europe right now, what is happening in Europe. And also, when you combine that with the concerns that I am hearing out there, from our small businesses, the concerns about getting the necessary financing, the necessary credit to continue their operations and wanting to expand their operations and businesses, the concerns about the consistently high rates of unemployment that we have right now and underemployment and the lack of private jobs that are being created right now that I believe are the long-term sustainable jobs that will turn this economy around. When you combine that with the massive government spending and debt, all those being a major threat to sustainable growth, I wanted to get your views on the spending and debt control, on the uncertainty that is bringing to our economy right now and the direction that you think that we are moving and whether or not--you know, I think there is a fundamental difference here on the types of jobs that are being created with all this, government jobs versus the private sector jobs. " CHRG-111shrg61513--109 Mr. Bernanke," Thank you. Senator Menendez. I was pleased to support you. Let me ask you, over the next few years, there is going to be more than $1 trillion in short-term commercial real estate loans that will reach maturity, and the ongoing credit crunch will make it very difficult for owners of viable commercial real estate to secure long-term financing. In 2007, at this Committee hearing with others, I said we were going to have a tsunami of foreclosures in the housing market. I was told that was an exaggeration. I wish they had been right and I had been wrong. And I see this as the next looming crisis. You know, it seems to me that the Federal Government failed to act on the warning signs about the home foreclosure crisis, and I am very concerned that we are not acting on increasingly clear warning signs about this commercial mortgage market. So I am wondering, first, do you believe that this is a very serious issue facing us down the road and might this emerge as our next economic crisis? And regardless of how you might characterize it, which I will wait to hear what you have to say, what do you think we can do? For example, I have been told that this is one in which community banks will face a fair challenge across the spectrum. Is, for example, allowing those banks to amortize losses over 10 years an option so that we do not completely dry up lending and at the same time maybe have a lot of these institutions close as a result of it? I am looking to get ahead of the curve, but that curve is coming--that tidal wave is coming really soon, and so I would like to hear your views on it. " fcic_final_report_full--242 Im p aired Se cu rities Impairment of 2005-2007 vintage mortgage-backed securities (MBS) and CDOs as of year-end 2009, by initial rating. A security is impaired when it is downgraded to C or Ca, or when it suffers a principal loss. IN BILLIONS OF DOLLARS $1,000 N ot impaired 800 600 400 200 0 Impaired A aa A a thru B A aa A a thru B A aa A a thru B A lt- A M BS Su b prime M BS C D Os SOURCE: M oody’s Investors Service, “Special Comment: D efault & Loss Rates of Structured Finance Securities: 1993-2009”; M oody’s SF D RS. Figure . minent or had already been suffered—by the end of  (see figure .). For the lower-rated Baa tranches, . of Alt-A and . of subprime securities were im- paired. In all, by the end of ,  billion worth of subprime and Alt-A tranches had been materially impaired—including . billion originally rated triple-A. The outcome would be far worse for CDO investors, whose fate largely depended on the performance of lower-rated mortgage-backed securities. More than  of Baa CDO bonds and . of Aaa CDO bonds were ultimately impaired.  The housing bust would not be the end of the story. As Chairman Bernanke testi- fied to the FCIC: “What I did not recognize was the extent to which the system had flaws and weaknesses in it that were going to amplify the initial shock from subprime and make it into a much bigger crisis.”  CHRG-111shrg50814--83 Mr. Bernanke," There well could be, yes. Senator Bayh. My second question involves the popular anger at the crisis that we face and some of the steps that have been proposed to deal with it, and it really gets to the dilemma between balancing the risk of contagion versus the risk of moral hazard. It has been said by some that some of the steps that we have taken to contain the damage in the aggregate have had the unintended consequence of absolving some individuals of mistakes that they have made in their individual capacity. This has been expressed by commentators on the financial shows and that sort of thing, and one this last week asked a question or basically made the statement: ``Our policies are rewarding bad behavior.'' A lot of people feel that way who behaved in prudent fashion, who did not extend themselves. They were not working on Wall Street taking these enormous risks. What would you say to them when we seem to absolve the people who created the crisis from bearing its full effects? " 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-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-111shrg61513--10 Mr. Bernanke," Thank you. Chairman Dodd, Ranking Member Shelby, and other members of the Committee, I am pleased to present the Federal Reserve's semiannual Monetary Policy Report to the Congress. I will begin today with some comments on the outlook for the economy and for monetary policy and then touch briefly on several important issues. Although the recession officially began more than 2 years ago, U.S. economic activity contracted particularly sharply following the intensification of the global financial crisis in the fall of 2008. Concerted efforts by the Federal Reserve, the Treasury Department, and other U.S. authorities to stabilize the financial system, together with highly stimulative monetary and fiscal policies, helped arrest the decline and are supporting a nascent economic recovery. Indeed, the U.S. economy expanded at about a 4-percent annual rate during the second half of last year. A significant portion of that growth, however, can be attributed to the progress that firms made in working down unwanted inventories of unsold goods, which left them more willing to increase production. As the impetus provided by the inventory cycle is temporary, and as the fiscal support for economic growth likely will diminish later this year, a sustained recovery will depend on continued growth in private sector final demand for goods and services. Private final demand does seem to be growing at a moderate pace, buoyed in part by a general improvement in financial conditions. In particular, consumer spending has recently picked up, reflecting gains in real disposable income and household wealth and tentative signs of stabilization in the labor market. Business investment in equipment and software has risen significantly. And international trade--supported by a recovery in the economies of many of our trading partners--is rebounding from its deep contraction of a year ago. However, starts of single-family homes, which rose noticeably this past spring, have recently been roughly flat, and commercial construction is declining sharply, reflecting poor fundamentals and continued difficulty in obtaining financing. The job market has been especially hard hit by the recession, as employers reacted to sharp sales declines and concerns about credit availability by deeply cutting their workforces in late 2008 and in 2009. Some recent indicators suggest that the deterioration in the labor market is abating: Job losses have slowed considerably, and the number of full-time jobs in manufacturing rose modestly in January. Initial claims for unemployment insurance have continued to trend lower, and the temporary services industry, often considered a bellwether for the employment outlook, has been expanding steadily since October. Notwithstanding these positive signs, the job market remains quite weak, with the unemployment rate near 10 percent and job openings scarce. Of particular concern, because of its long-term implications for workers' skills and wages, is the increasing incidence of long-term unemployment; indeed, more than 40 percent of the unemployed have been out of work for 6 months or more, nearly double the share of a year ago. Increases in energy prices resulted in a pickup in consumer price inflation in the second half of last year, but oil prices have flattened out over recent months, and most indicators suggest that inflation will likely remain subdued for some time. Slack in labor and product markets has reduced wage and price pressures in most markets, and sharp increases in productivity have further reduced producers' unit labor costs. The cost of shelter, which receives a heavy weight in consumer price indexes, is rising very slowly, reflecting high vacancy rates. In addition, according to most measures, longer-term inflation expectations have remained relatively stable. The improvement in financial markets that began last spring continues. Conditions in short-term funding markets have returned to near pre-crisis levels. Many (mostly larger) firms have been able to issue corporate bonds or new equity and do not seem to be hampered by a lack of credit. In contrast, bank lending continues to contract, reflecting both tightened lending standards and weak demand for credit amid uncertain economic prospects. In conjunction with the January meeting of the FOMC, Board members and Reserve Bank presidents prepared projections for economic growth, unemployment, and inflation for the years 2010 through 2012 and over the longer run. The contours of these forecasts are broadly similar to those I reported to the Congress last July. FOMC participants continue to anticipate a moderate pace of economic recovery, with economic growth of roughly 3 to 3 \1/2\ percent in 2010 and 3 \1/2\ to 4 \1/2\ percent in 2011. Consistent with moderate economic growth, participants expect the unemployment rate to decline only slowly, to a range of roughly 6 \1/2\ to 7 \1/2\ percent by the end of 2012, still well above their estimate of the long-run sustainable rate of about 5 percent. Inflation is expected to remain subdued, with consumer prices rising at rates between 1 and 2 percent in 2010 through 2012. In the longer term, inflation is expected to be between 1 \3/4\ and 2 percent, the range that most FOMC participants judge to be consistent with the Federal Reserve's dual mandate of price stability and maximum employment. Over the past year, the Federal Reserve has employed a wide array of tools to promote economic recovery and preserve price stability. The target for the Federal funds rate has been maintained at a historically low range of 0 to \1/4\ percent since December 2008. The FOMC continues to anticipate that economic conditions--including low rates of resource utilization, subdued inflation trends, and stable inflation expectations--are likely to warrant exceptionally low levels of the Federal funds rate for an extended period. To provide support to mortgage lending and housing markets and to improve overall conditions in private credit markets, the Federal Reserve is in the process of purchasing $1.25 trillion of agency mortgage-backed securities and about $175 billion of agency debt. We have been gradually slowing the pace of these purchases in order to promote a smooth transition in markets and anticipate that these transactions will be completed by the end of March. The FOMC will continue to evaluate its purchases of securities in light of the evolving economic outlook and conditions in financial markets. In response to the substantial improvements in the functioning of most financial markets, the Federal Reserve is winding down the special liquidity facilities it created during the crisis. On February 1, a number of these facilities, including credit facilities for primary dealers, lending programs intended to help stabilize money market mutual funds and the commercial paper market, and temporary liquidity swap lines with foreign central banks, were all allowed to expire. The only remaining lending program for multiple borrowers created under the Federal Reserve's emergency authorities, is the Term Asset-Backed Securities Loan Facility, or TALF, and it is scheduled to close on March 31 for loans backed by all types of collateral except for newly issued commercial mortgage-backed securities, and it will close on June 30 for loans backed by newly issued CMBS. In addition to closing its special facilities, the Federal Reserve is normalizing its lending to commercial banks through the discount window. The final auction of discount window funds to depositories through the Term Auction Facility, which was created in the early stages of the crisis to improve the liquidity of the banking system, will occur on March 8. Last week, we announced the maximum term of discount window loans, which was increased to as much as 90 days during the crisis, would be returned to overnight for most banks, as it was before the crisis erupted in August 2007. To discourage banks from relying on the discount window rather than private funding markets for short-term credit, last week we also increased the discount rate by 25 basis points, raising the spread between the discount rate and the top of the target range for the Federal funds rate to 50 basis points. These changes, like the closure of most of the special lending facilities earlier this month, are in response to the improved functioning of financial markets, which has reduced the need for extraordinary assistance from the Federal Reserve. These adjustments are not expected to lead to tighter financial conditions for households and businesses and should not be interpreted as signaling any change in the outlook for monetary policy, which remains about the same as it was at the time of the January meeting of the FOMC. Although the Federal funds rate is likely to remain exceptionally low for an extended period, as the expansion matures, the Federal Reserve will at some point need to begin to tighten monetary conditions to prevent the development of inflationary pressures. Notwithstanding the substantial increase in the size of its balance sheet associated with its purchases of Treasury and agency securities, we are confident that we have the tools we need to firm the stance of monetary policy at the appropriate time. Most importantly, in October 2008 the Congress gave statutory authority to the Federal Reserve to pay interest on banks' holdings of reserve balances at Federal Reserve banks. By increasing the interest rate on reserves, the Federal Reserve will be able to put significant upward pressure on all short-term interest rates. Actual and prospective increases in short-term interest rates will be reflected in turn in longer-term interest rates and in financial conditions more generally. The Federal Reserve has also been developing a number of additional tools to reduce the large quantity of reserves held by the banking system, which will improve the Federal Reserve's control of financial conditions by leading to a tighter relationship between the interest rate paid on reserves and other short-term interest rates. Notably, our operational capacity for conducting reverse repurchase agreements, a tool that the Federal Reserve has historically used to absorb reserves from the banking system, is being expanded so that such transactions can be used to absorb large quantities of reserves. The Federal Reserve is also currently refining plans for a term deposit facility that could convert a portion of depository institutions' holdings of reserve balances into deposits that are less liquid and could not be used to meet reserve requirements. In addition, the FOMC has the option of redeeming or selling securities as a means of reducing outstanding bank reserves and applying monetary restraint. Of course, the sequencing of steps and the combination of tools that the Federal Reserve uses as it exits from its currently very accommodative policy stance will depend on economic and financial developments. I provided more discussion of these options and possible sequencing in a recent testimony. The Federal Reserve is committed to ensuring that the Congress and the public have all the information needed to understand our decisions and to be assured of the integrity of our operations. Indeed, on matters related to the conduct of monetary policy, the Federal Reserve is already one of the most transparent central banks in the world, providing detailed records and explanations of its decisions. Over the past year, the Federal Reserve also took a number of steps to enhance the transparency of its special credit and liquidity facilities, including the provision of regular, extensive reports to the Congress and the public; and we have worked closely with the GAO, the SIGTARP, the Congress, and private sector auditors on a range of matters relating to these facilities. While the emergency credit and liquidity facilities were important tools for implementing monetary policy during the crisis, we understand that the unusual nature of those facilities creates a special obligation to assure the Congress and the public of the integrity of their operation. Accordingly, we would welcome a review by the GAO of the Federal Reserve's management of all facilities created under emergency authorities. In particular, we would support legislation authorizing the GAO to audit the operational integrity, collateral policies, use of third-party contractors, accounting, financial reporting, and internal controls of these special liquidity and credit facilities. The Federal Reserve will, of course, cooperate fully and actively in all reviews. We are also prepared to support legislation that would require the release of the identities of the firms that participated in each special facility after an appropriate delay. It is important that the release occur after a lag that is sufficiently long that investors will not view an institution's use of one of these facilities as a possible indication of ongoing financial problems, thereby undermining market confidence in the institution or discouraging use of any future facility that might become necessary to protect the U.S. economy. An appropriate delay would also allow firms adequate time to inform investors through annual reports and other public documents of their use of Federal Reserve facilities. Looking ahead, we will continue to work with the Congress in identifying approaches for enhancing the Federal Reserve's transparency that are consistent with our statutory objectives of fostering maximum employment and price stability. In particular, it is vital that the conduct of monetary policy continue to be insulated from short-term political pressures so that the FOMC can make policy decisions in the longer-term economic interests of the American people. Moreover, the confidentiality of discount window lending to individual depository institutions must be maintained so that the Federal Reserve continues to have effective ways to provide liquidity to depository institutions under circumstances where other sources of funding are not available. The Federal Reserve's ability to inject liquidity into the financial system is critical for preserving financial stability and for supporting depositories' key role in meeting the ongoing credit needs of firms and households. Strengthening our financial regulatory system is essential for the long-term economic stability of the Nation. Among the lessons of the crisis are the crucial importance of macroprudential regulation that is, regulation and supervision aimed at addressing risks to the financial system as a whole--and the need for effective consolidated supervision of every financial institution that is so large or interconnected that its failure could threaten the functioning of the entire financial system. The Federal Reserve strongly supports the Congress' ongoing efforts to achieve comprehensive financial reform. In the meantime, to strengthen the Federal Reserve's oversight of banking organizations, we have been conducting an intensive self-examination of our regulatory and supervisory responsibilities and have been actively implementing improvements. For example, the Federal Reserve has been playing a key role in international efforts to toughen capital and liquidity requirements for financial institutions, particularly systemically critical firms, and we have been taking the lead in ensuring that compensation structures at banking organizations provide appropriate incentives without encouraging excessive risk taking. The Federal Reserve is also making fundamental changes in its supervision of large, complex bank holding companies, both to improve the effectiveness of consolidated supervision and to incorporate a macroprudential perspective that goes beyond the traditional focus on safety and soundness of individual institutions. We are overhauling our supervisory framework and procedures to improve coordination within our own supervisory staff and with other supervisory agencies and to facilitate more integrated assessments of risks within each holding company and across groups of companies. Last spring the Federal Reserve led the successful Supervisory Capital Assessment Program, popularly known as the bank stress tests. An important lesson of that program was that combining onsite bank examinations with a suite of quantitative and analytical tools can greatly improve comparability of the results and better identify potential risks. In that spirit, the Federal Reserve is also in the process of developing an enhanced quantitative surveillance program for large bank holding companies. Supervisory information will be combined with firm-level, market-based indicators and aggregate economic data to provide a more complete picture of the risks facing these institutions and the broader financial system. Making use of the Federal Reserve's unparalleled breadth of expertise, this program will apply a multidisciplinary approach that involves economists, specialists in particular financial markets, payments systems experts, and other professionals, as well as bank supervisors. The recent crisis has also underscored the extent to which direct involvement in the oversight of banks and bank holding companies contributes to the Federal Reserve's effectiveness in carrying out its responsibilities as a central bank, including the making of monetary policy and the management of the discount window. But most important, as the crisis has once again demonstrated, the Federal Reserve's ability to identify and address diverse and hard-to-predict threats to financial stability depends critically on the information, expertise, and powers that it has by virtue of being both a bank supervisor and a central bank. The Federal Reserve continues to demonstrate its commitment to strengthening consumer protections in the financial services arena. Since the time of the previous Monetary Policy Report in July, the Federal Reserve has proposed a comprehensive overhaul of the regulations governing consumer mortgage transactions, and we are collaborating with the Department of Housing and Urban Development to assess how we might further increase transparency in the mortgage process. We have issued rules implementing enhanced consumer protections for credit card accounts and private student loans as well as new rules to ensure that consumers have meaningful opportunities to avoid overdraft fees. In addition, the Federal Reserve has implemented an expanded consumer compliance supervision program for nonbank subsidiaries of bank holding companies and foreign banking organizations. More generally, the Federal Reserve is committed to doing all that can be done to ensure that our economy is never again devastated by a financial collapse. We look forward to working with the Congress to develop effective and comprehensive reform of the financial regulatory framework. Thank you. Senator Johnson. [Presiding.] Thank you, Mr. Chairman. Is there an agreement that 5 minutes should be enough on the clock? I do not want to be overly rigid, but so be it. Chairman Bernanke, the weather has been unusually harsh across the country in the past month. This has disrupted business and Government activity and is likely to have an impact on employment. Do you think the effects will be strong enough to show up in the next month's employment statistics? " 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-111hhrg54868--62 The Chairman," Well, it is an appropriate segue to the gentleman from North Carolina, who has been a leading activist here in the subprime crisis, and I am about to recognize him. I would just say to my friend, no one ever said this was the answer to the subprime crisis. The answer to the subprime crisis was the subprime bill that we passed. That is what we thought was the answer to that. This was never meant to be the answer to that. The gentleman may have forgotten that we did pass the subprime bill. The gentleman from North Carolina. Mr. Miller of North Carolina. Thank you, Mr. Chairman. There is a division in the existing law between safety and soundness regulation and consumer protection regulation. Chairwoman Bair said that you had testified or that you had commented as part of the public comment period when the Fed adopted rules that applied to institutions for which you all have principal safety and soundness responsibility--and actually, Comptroller Dugan, you did as well--you commented not for stronger rules, but for weaker rules. You opposed in the public comments many parts of the credit card regulation. Mr. Dugan, I understand that you don't have rulemaking authority. You didn't have rulemaking authority. You do have the authority to bring enforcement actions. The great, great bulk of credit card business was with national banks. It is now like the top 3 banks have 75 percent of the business. It was a little bit less sometime back, but it has always been dominated by national banks. And there were no enforcement actions. Now--yes, sir? Am I missing something? " CHRG-110hhrg44901--56 Mr. Heller," Thank you, Mr. Chairman. I appreciate the opportunity to spend some time here with Chairman Bernanke. I will try to stay on some of the macro issues as you led us earlier in the hearing. I don't think there is a newspaper out there today that is not talking about the bad economic news that is out there--the Washington Post, the New York Times, the Wall Street Journal. You read them and it is talking about yesterday's hearings. I have a copy of USA Today in front of me that talks about the signs of growing crisis, the Dow being down, inflation being up, the U.S. dollar down, foreclosures being up. All of this, I think, was reflected in your testimony as you spoke with us earlier in this hearing. The only good news I am hearing out there is that by December 31st, the year should be over. I guess what I want to do is touch on a concept or a statement that I hear too often, and that is too big to fail and the systemic economic impact of these financial institutions and their ability to survive or not. And we have obviously recent examples--Bear Stearns, the Fed steps in; IndyMac, the Fed steps in; GSEs, the Fed steps in. I receive a lot of calls from constituents who are concerned about their deposits in other banks including Wachovia, Bank of America, and Wells Fargo. I guess the question I have--and I have heard you say in the past, correct me if I am wrong, that some of these financial institutions should be allowed to fail. I guess my question is, what is the threshold between a financial institution that the Fed should step in versus one that should be allowed to fail? " FinancialCrisisInquiry--60 But there are other things you’d like to... MACK: Well, let me just... HOLTZ-EAKIN: And how the traditional system failed. MACK: Well, I’ll just add a couple of things. Our head risk manager sits right by the CEO—our new CEO, James Gorman, on the floor. So there’s a real link with risk management and the most senior person in the firm. The other thing I just want to comment on—and this goes to Commissioner Murren’s question earlier to Mr. Blankfein—I think with the Federal Reserve now as our lead regulator, the amount of focus and scrutiny that we get on risk, not just outright risk but the systems around risk models, how we test the models, even to the point, if we want to make an acquisition or make a major move, they’re involved and ask certain questions that is very new, in my 40 years, with this new regulator. So I would say that I’d give high marks to our regulator in how—I don’t want to use the word “intrusive”—how diligent they are in our risk and how we manage risk. HOLTZ-EAKIN: Thank you. Mr. Moynihan? MOYNIHAN: I think, much like my colleagues, we have an independent risk management function— have had. And if you ask what we thought we missed, I think it would be similar to where Mr. Dimon said, which is if you think about it in a—as we support the broad economy in what we do, so we have—yes, we have the investment banking in a larger one now, but we’ve—the mistakes we made and the most losses we’ve taken have actually been in credit cards and mortgages. And that was just where we kept originating prime—prime assets—too deep into the economy, and we didn’t do the kind of testing you actually do in a trading book saying what if housing goes down 40 percent and test what your thought would be irrespective of the probability of just how you protect your firm. And I think that’s probably the best lesson we’ve learned out of this crisis and will apply. When you actually look on some of the commercial lending side, well felt that in the ‘89, ‘91 -- and so, therefore, we had a practice of that. On the consumer kind, we didn’t have those kinds of practices. And I’d say, above all, that’s what we’ve actually implemented and we’ll continue to make sure we are diligent about. CHRG-110hhrg46594--401 Mr. Sachs," Thank you, Mr. Chairman. This is the 4th financial crisis that I have dealt with, with this committee, over the last 25 years, starting in Latin America, Eastern Europe, East Asia, and now it is our turn. " CHRG-111shrg382--36 Mr. Sobel," So the---- Senator Bayh. I know they were searching for a mission. With the recent crisis, they have been resuscitated. God willing, that is a temporary state of affairs. So I am just wondering what role they might play in all this at the end of the day. " CHRG-111shrg57709--79 Mr. Volcker," A banking institution or a non-bank? Senator Corker. There is not a single bank holding company in this last crisis that had a commercial bank that had issues that were material to failure relating to proprietary trading, not one. " CHRG-110hhrg46596--331 Mr. Kashkari," It proved that the credit crisis intensified deeply in the 2 weeks between when Secretary Paulson first came to the Congress and the Congress acted. I can show you lots of data that substantiates that. And I would be happy to, Congressman. " CHRG-111shrg50814--24 Mr. Bernanke," The banks did have extensive capital coming into this crisis, but, of course, the crisis itself was extraordinary in its size. We could talk at some length about the failures of regulators, including the Federal Reserve, to prevent the credit crisis and prevent the losses that have been affected. Going forward, we need to think about the Basel II regime, on which capital rules are now set. The general principles of the Basel II regime are that capital should be related to the risks of the assets which are being held. But I think we have learned several things. First, that we need to be more aggressive in figuring out what the risks are and make sure that we are stress testing, making sure that we are being conservative in terms of assigning capital to individual kinds of assets. There certainly were some assets that were underweighted in terms of their risk characteristics when the capital was assigned. We need to look at a variety of other things, like off-balance sheet exposures and other things that were not adequately represented in the Basel II framework. And there are other elements which the Basel Committee is looking at. Just to mention two, there probably were improvements in risk management and risk measurement over the period discussed, but they weren't adequate, obviously, and we need to do a lot more work for making sure that bank companies have enterprise-wide comprehensive risk management techniques. In addition, and this is something that the Basel Committee has been focused on, we need to make sure they have adequate liquidity, as well as capital. So there is a lot to be done. You are absolutely right in pointing out the deficiencies and there is a lot of work that we regulators, the international community, has to do to strengthen that capital standard. Senator Shelby. Thank you. My time is up. " FinancialCrisisInquiry--112 I’m here to represent my own views. I’ve submitted almost 200 pages of supporting material. I hope you received that. Two decades ago, I worked down the street at the Federal Reserve. At the time, we were helping banks recover from crisis. We took great meaning from our work. I hope the commission’s efforts lead to a banking system that we don’t have to revisit every two decades to save. This is important. I’ve been covering an industry on steroids. Performance was artificially enhanced, and we’re now paying the price with the biggest bailout of U.S. banks in history. And it’s also resulting in the biggest wealth transfer from future generations to the current generation. My children, 9, 7, and 4, and their generation will have to pay the price. I’m shocked and amazed more changes have not taken place. There seems an unwritten premise that Wall Street, exactly how it exists today, is necessary for the economy to work. That’s not true. The economy worked fine before Wall Street got this large and this complex. Wall Street has done an incredible job at pulling the wool over the eyes of the American people. This may relate to the clout of the banks. The four banks that testified this morning have annual revenues of $300 billion. That’s equal to the GDP of Argentina. My perspective? I’ve analyzed banks since the late 1980’s. I value the independent reputation of COSA. And I’ve been negative on banks since 1999, and I’ve published over 10,000 pages of research to back up my view. I’ve identified 10 causes of the crisis. If you can turn to Slide 3 -- and I’ll go through each cause. Cause One: excessive loan growth. We could not accept the reality that we’re in a slower-growing economy, a more mature market. Loans grew twice as fast as they should have grown, twice as fast as GDP. Cause Two: higher yielding assets. The U.S. banking industry acted like a leverage bond fund. More borrowings with the proceeds invested in more risky assets. Look at Treasury securities. As a percentage of securities, they went down from 32 percent down to 2 percent. That’s the least risky asset. Instead, banks took more risky securities and more risky loans whether it’s home equity or construction loans. Look at construction loans. The percentage of construction loans to total is double the level where it was even in the early ‘90’s. CHRG-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. " 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. 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-111shrg54533--3 STATEMENT OF SENATOR RICHARD C. SHELBY Senator Shelby. Thank you, Mr. Chairman. I have said on a number of occasions that reforming our financial regulatory system may be, as Senator Dodd has indicated, the most significant thing many of us will do while serving in the U.S. Senate. We all know how difficult it can be to shepherd even minor bills through the legislative process, let alone anything as significant as financial regulatory reform. We also know equally well that the opportunity to accomplish something of this magnitude can be fleeting, which presents a bit of a conundrum. We certainly want to strike while the iron is hot, but we also want to make the most of the opportunity that has been presented. The philosopher William James once said, ``He who refuses to embrace a unique opportunity loses the prize as surely as if he has failed.'' I hope that we do not collectively refuse to embrace this unique opportunity because here failure I believe is not an option. The President has put forward his plan. It deserves our careful consideration. That consideration will involve not only an evaluation of his proposed reforms but, more importantly, a close examination of the facts upon which he based his recommendations. The administration's factual predicate can then be compared with the Committee's findings as soon as we complete our examination of the crisis. I have said many times this Committee must first clearly identify what went wrong before we even began to consider a response. It is my hope that we can take advantage of some of the work done by the Secretary and others in the administration. It would be helpful if Secretary Geithner could share with Congress any and all documents and information used in their process in their recommendation. As is the case with all legislative efforts, laws are built around consensus, and consensus is achieved when all parties can agree on either facts or principles. There is one fact upon which I believe we have reached a complete agreement. Our financial regulatory system is antiquated and inadequate. I am not as confident, however, that we have reached agreement on what principles should guide our efforts yet. As we begin evaluating the President's plan, I want to highlight the key considerations that I believe should guide our process as we move forward. First, notwithstanding the great difficulties we have recently experienced, private markets still provide the best means for achieving our full economic potential. Risk taking is an essential ingredient in these markets, and while we should improve our ability to manage risk, we cannot simply eliminate risk taking without sacrificing the foundation of our free market system. We must also remember that risk is a two-way street. Those who take risk must be prepared to suffer the losses as well as enjoy the gains. Any reforms we adopt must reduce expectations that some firms are simply too big to fail. Second, we must establish regulatory mandates that are achievable. This is especially true with respect to the regulation of systemic risk. And while there is wide agreement that we have experienced a systemwide event, we have spent very little time discussing the concept of systemic risk, determining how best to regulate it, or even establish whether it can be regulated at all. Third, I believe that regulators should have clear and manageable responsibilities and be subject to oversight and proper accountability. I am concerned that we already have a number of regulators that do not currently meet these criteria, and the administration is contemplating giving them additional responsibilities. For example, the Federal Reserve already handled monetary policy, bank regulation, holding company regulation, payment systems oversight, international banking regulation, consumer protection, and the lender-of-last-resort function. These responsibilities conflict at times, and some receive more attention than others. I do not believe that we can reasonably expect the Fed or any other agency effectively play so many roles. In addition, the Federal Reserve was provided a unique independent status to assure world markets that monetary policy would be insulated from political influence. The structure of the Federal Reserve involves quasi-public reserve banks that are under the control of boards with members selected by banks regulated by the Fed. By design, the board and the reserve banks are not directly accountable to Congress and are not easily subject to congressional oversight. Recent events have clearly demonstrated that the structure is not appropriate for a Federal banking regulator let alone a systemic regulator. Finally, while we have a responsibility to identify and repair the weaknesses of our current regulatory structure, we also have a duty to position our regulatory system for the future. Since World War I, we have been the world's financial market of choice. That is rapidly changing. We must do everything we can to not only ensure the safety and soundness of our financial system, but also its competitive standing in the world. The President has now added his voice to the debate, and it is now up to us to add ours. As we do, I hope that we will not allow the administration's recommendations to limit the debate that we are about to undertake. While we have a very difficult task before us, I also believe we have a unique opportunity to do something significant. I urge my colleagues to focus on creating a regulatory system for the next century, not one that merely seeks to remedy the mistakes of the last few years. Thank you, Mr. Chairman. " CHRG-111shrg57923--39 Mr. Mendelowitz," Yes, Senator. This discussion about the housing bubble, I think, gives us an insight into what the need for the NIF is. While Steve said back in 2007 he saw it, those of you--but basically 5 years ago, I started predicting a major credit event in the housing sector that was going to push the economy into the worst recession since the Second World War, and it was really just based upon looking at relatively small data sets that went to what was happening to housing prices, what was happening to household income, and what was happening on the delinquency and default rate on mortgages, all of which was readily available data. So it was easy to predict a major credit event in housing and it was easy to predict, because of the widespread nature of home ownership, that this was going to lead to a recession that was going to be driven by falling consumption. That was the easy piece of it. Now we are saying the fact the Fed didn't see it, because they were using the standard monetarist model, and if you can't see something with the monetarist model, you don't see it. But what I didn't see and couldn't see and couldn't understand was how what was happening in the housing sector was going to lead to the collapse in the financial sector. And it is the kind of data that we are talking about the NIF collecting that would provide that insight, and there is no substitute for that. There is no alternative. There is no shortcut. Because at the end of the day, you have to know where the concentrations of risks are and you have to know what the nature of the intertwined network of financial firms and their obligations are, because it is the combination of concentrations of risk and the exposure of the network that can produce a domino effect of multiple failures that creates a systemic risk. And so it is one thing to see a macroeconomic crisis tied to something like housing. It is something entirely different--the data needs are entirely different when it comes to understanding the systemic risk that flows from those concentrations of risk. Senator Reed. I want to thank you all for excellent testimony, thought provoking, and also for your advancing this issue. I think we leave here with, one, we need better data. We need better analysis. And if we don't achieve it in the next several months, the bubbles that might be out there percolating, if that is the right term, will once again catch us by surprise and we shouldn't let that happen. But thank you all very, very much. Thank you. " CHRG-110shrg50417--28 PENNSYLVANIA Ms. Wachter. Thank you. Chairman Dodd and other distinguished Members of the Committee, it is my honor to be here today to provide my perspective on the ongoing mortgage crisis and how and why stabilizing the housing market is essential to stabilizing the broader U.S. economy. The ongoing crisis in our housing and financial markets derives from an expansion of credit through poorly underwritten and risky mortgage lending. Until the 1990s, such lending was insignificant. By 2006, almost half of mortgage originations took the form of risky lending. The unprecedented expansion of poorly underwritten credit induced a U.S. housing asset bubble of similarly unprecedented dimensions and a massive failure of these loans and to today's system breakdown. Today's economic downturn could become ever more severe due to the interaction of financial market stress with declines in housing prices and a worsening economy feeding back in an adverse loop. We have the potential for a true economic disaster. I do not believe we will solve our banking liquidity problems if the housing downturn continues, and the housing market decline shows no signs of abating. Moreover, despite bank recapitalization and rescue efforts, economically rational loan modifications that would help stabilize the market are not occurring. We must directly address the need for these loan modifications in order to halt the downward spiral in mortgage markets and the overall economy. It is critical to bring stability to the housing market. While today prices may not be far from fundamental levels, just as they overinflated going up, there is great danger for overcorrection on the downside. In our current situation, as prices fall, market dynamics give rise to further expectations of price decline, limiting demand, and supply actually increases due to increased foreclosures, causing prices to decline further. A deflationary environment with demand decreases due to expectations of further price decline was in part responsible for Japan's ``lost decade'' of the 1990s. We cannot rely on a price decrease floor at currently market-justified fundamental levels if we rely on market forces alone, even, it appears, if augmented by the interventions so far of the Federal Reserve and Treasury. In fact, home inventories are not declining, and up to half of the inventory of homes are being sold through foreclosures at fire-sale prices in many markets. The Case-Shiller Price Index reflects the massive deterioration of housing wealth so far. Since the peak in 2006, housing values have fallen over 20 percent. While another 5- to 10-percent fall could bring us to market-clearing levels, actual price declines may far exceed this. And as house prices decline, these declines undermine consumer confidence, decrease household wealth, and worsen the system-wide financial stress. While banks have been recapitalized through the Capital Purchase Program--and there is discussion of the use of this funding for acquisitions--as yet, there is little evidence that bank lending has expanded. In order for the overall economy to recover and for conditions not to worsen, prudent lending to creditworthy borrowers needs to occur. Without financing for everyday needs, for education, small business investment and health, American families are at risk. And today the U.S. economy and the global economy are depending on the stabilization of their financial well-being. Moreover, the plans that are already in place do not appear to be leading to the modification of loans at the scale necessary in order to assure a market turnaround at fundamental levels instead of a severe and ongoing overcorrection. Barriers to economically rational loan modifications include conflicting interests, poor incentives, and risks of litigation to modify loans, particularly to modify loans deriving from mortgage-servicing agreements. Given the freefall in housing markets and its implications for credit conditions and the overall economy, there is a need for policies to address these barriers today. It is both necessary and possible to take effective action now. While housing values may not be far from fundamental levels, as housing values continue to fall, resolving the problem will become increasingly difficult and costly. Thus, solutions that are now possible may not be available going forward. Without expeditiously and directly addressing the housing market mortgage crisis, the Nation is at risk. Thank you. " CHRG-111shrg52619--208 RESPONSE TO WRITTEN QUESTIONS OF SENATOR CRAPO FROM JOSEPH A. SMITH, JR.Q.1. The convergence of financial services providers and financial products has increased over the past decade. Financial products and companies may have insurance, banking, securities, and futures components. One example of this convergence is AIG. Is the creation of a systemic risk regulator the best method to fill in the gaps and weaknesses that AIG has exposed, or does Congress need to reevaluate the weaknesses of federal and state functional regulation for large, interconnected, and large firms like AIG?A.1. The current economic crisis has shown that our financial regulatory structure in the United States was incapable of effectively managing and regulating the nation's largest institutions, such as AIG. Institutions, such as AIG, that provide financial services similar to those provided by a bank, should be subject to the same oversight that supervises banks. CSBS believes the solution, however, is not to expand the federal government bureaucracy by creating a new super regulator. Instead, we should enhance coordination and cooperation among federal and state regulators. We believe regulators must pool their resources and expertise to better identify and manage systemic risk. The Federal Financial Institutions Examination Council (FFIEC) provides a vehicle for working toward this goal of seamless federal and state cooperative supervision.Q.2. Recently there have been several proposals to consider for financial services conglomerates. One approach would be to move away from functional regulation to some type of single consolidated regulator like the Financial Services Authority model. Another approach is to follow the Group of 30 Report which attempts to modernize functional regulation and limit activities to address gaps and weaknesses. An in-between approach would be to move to an objectives-based regulation system suggested in the Treasury Blueprint. What are some of the pluses and minuses of these three approaches?A.2. Each of the models discussed would result in further consolidation of the financial industry, and would create institutions that would be inherently too big to fail. If we allowed our financial industry to consolidate to only a handful of institutions, the nation and the global economy would be reliant upon those institutions to remain functioning. CSBS believes all financial institutions must be allowed to fail if they become insolvent. Currently, our system of financial supervision is inadequate to effective supervise the nation's largest institutions and to resolve them in the event of their failure. More importantly, however, consolidation of the industry would destroy the community banking system within the United States. The U.S. has over 8,000 viable insured depository institutions to serve the people of this nation. The diversity of our industry has enabled our economy to continue despite the current recession. Community and regional banks have continued to make credit available to qualified borrowers throughout the recession and have prevented the complete collapse of our economy.Q.3. If there are institutions that are too big to fail, how do we identify that? How do we define the circumstance where a single company is so systemically significant to the rest of our financial circumstances and our economy that we must not allow it to fail?A.3. A specific definition for ``too big to fail'' will be difficult for Congress to establish. Monetary thresholds will eventually become insufficient as the market rebounds and works around any asset-size restrictions, just as institutions have avoided deposit caps for years now. Some characteristics of an institution that is ``too big to fail'' include being so large that the institution's regulator is unable to provide comprehensive supervision of the institution's lines of business or subsidiaries. An institution is also ``too big to fail'' if a sudden collapse of the institution would have a devastating impact upon separate market segments.Q.4. We need to have a better idea of what this notion of too big to fail is--what it means in different aspects of our industry and what our proper response to it should be. How should the federal government approach large, multinational, and systemically significant companies?A.4. The federal government should utilize methods to prevent companies from growing too big to fail, either through incentives and disincentives (such as higher regulatory fees and assessments for higher amounts of assets or engaging in certain lines of business), denying certain business mergers or acquisitions that allow a company to become ``systemic,'' or through establishing anti-trust laws that prevent the creation of financial monopolies. Congress should also grant the Federal Deposit Insurance Corporation (FDIC) resolution authority over all financial firms, regardless of their size or complexity. This authority will help instill market discipline to these systemic institutions by providing a method to close any institution that becomes insolvent. Finally, Congress should consider establishing a bifurcated system of supervision designed to meet the needs not only of the nation's largest and most complex institutions, but also the needs of the smallest community banks.Q.5. What does ``fail'' mean? In the context of AIG, we are talking about whether we should have allowed an orderly Chapter 11 bankruptcy proceeding to proceed. Is that failure?A.5. CSBS believes failures and resolutions take on a variety of forms based upon the type of institution and its impact upon the financial system as a whole. In the context of AIG, an orderly Chapter 11 bankruptcy would have been considered a failure. But it is more important that we do not create an entire system of financial supervision that is tailored only to our nation's largest and most complex institutions. It is our belief the greatest strength of our unique financial structure is the diversity of the financial industry. The U.S. banking system is comprised of thousands of financial institutions of vastly different sizes. Therefore, legislative and regulatory decisions that alter our financial regulatory structure or financial incentives should be carefully considered against how those decisions affect the competitive landscape for institutions of all sizes. ------ CHRG-111hhrg53238--32 Mr. Bartlett," I will comment on four or five of those in my oral testimony. One is the Consumer Financial Protection Agency, no doubt the subject of the largest amount of heat and attention by this committee, as it should be. The Roundtable believes that strengthened consumer protection is an essential component of broader regulatory reform. To that end, we endorse the spirit to ensure sound protections and better disclosures for consumers, but we strongly, strongly oppose the creation of a separate, free-standing Consumer Financial Protection Agency. Rather than create a new agency and bifurcate consumer protection from safety and soundness, we recommend that the Congress enact strong national consumer protection standards for all consumers. We are not here to advocate the status quo; we are here to advocate stronger regulation. In short, we support consumers, we support financial regulatory reform, we support protection, and we oppose the agency. Second, systemic risk regulator and the so-called Tier 1 financial holding companies: An essential part of regulatory reform legislation is the creation of a systemic risk regulator. Today, no single agency has the specific mandate or surveillance purview or the accountability to detect and mitigate the risks of financial stress in future financial crises. We strongly support the designation of the Federal Reserve Board as a systemic risk oversight authority. However, the Board should not be added as an additional super-regulator. Rather, it should work with and through the powers of prudential supervisors in nonemergency situations to achieve their goals. We support a national resolution authority. The recent financial crisis demonstrated the urgent need for that authority. The Roundtable supports and has advocated for the establishment of a resolution regime for insolvent nonbank financial institutions. We recommend that the Treasury Department have the authority to appoint the appropriate prudential regulator for an institution upon determination that authority is necessary. However, we strongly believe that the FDIC and other agencies that are set up for those sectors should be segregated and held off just for the sectors that those funds have been designated for. Insurance: The Administration's proposal recognizes ``our current insurance regulatory system remains highly fragmented, inconsistent and inefficient,'' and ``has led to a lack of uniformity and reduced competition across State and international boundaries, resulting in inefficiency.'' Well, you get the picture. That is from the Administration's statement. So at the Roundtable, we think a logical extension of that should strongly support the adoption of a Federal insurance charter as part of this regulatory reform for national insurers, reinsurers, and producers under the supervision of a single national regulator. We urge the committee to consider H.R. 1880, the National Insurance Consumer Protection Act offered by Congresswoman Bean and Congressman Royce as part of this regulatory structure. Mr. Chairman, the Roundtable supports comprehensive reform now. We recommend a number of practical and important improvements to this legislation to achieve that reform. I yield back. [The prepared statement of Mr. Bartlett can be found on page 56 of the appendix.] " CHRG-111shrg56415--83 PREPARED STATEMENT OF DANIEL K. TARULLO Member, Board of Governors of the Federal Reserve System October 14, 2009 Chairman Johnson, Ranking Member Crapo, and members of the Subcommittee, thank you for your invitation to discuss the condition of the U.S. banking industry. First, I will review the current conditions in financial markets and the overall economy and then turn to the performance of the banking system, highlighting particular challenges in commercial real estate (CRE) and other loan portfolios. Finally, I will address the Federal Reserve's regulatory and supervisory responses to these challenges.Conditions in Financial Markets and the Economy Conditions and sentiment in financial markets have continued to improve in recent months. Pressures in short-term funding markets have eased considerably, broad stock price indexes have increased, risk spreads on corporate bonds have narrowed, and credit default swap spreads for many large bank holding companies, a measure of perceived riskiness, have declined. Despite improvements, stresses remain in financial markets. For example, corporate bond spreads remain quite high by historical standards, as both expected losses and risk premiums remain elevated. Economic growth appears to have moved back into positive territory last quarter, in part reflecting a pickup in consumer spending and a slight increase in residential investment--two components of aggregate demand that had dropped to very low levels earlier in the year. However, the unemployment rate has continued to rise, reaching 9.8 percent in September, and is unlikely to improve materially for some time. Against this backdrop, borrowing by households and businesses has been weak. According to the Federal Reserve's Flow of Funds accounts, household and nonfinancial business debt contracted in the first half of the year and appears to have decreased again in the third quarter. For households, residential mortgage debt and consumer credit fell sharply in the first half; the decline in consumer credit continued in July and August. Nonfinancial business debt also decreased modestly in the first half of the year and appears to have contracted further in the third quarter as net decreases in commercial paper, commercial mortgages, and bank loans more than offset a solid pace of corporate bond issuance. At depository institutions, loans outstanding fell in the second quarter of 2009. In addition, the Federal Reserve's weekly bank credit data suggests that bank loans to households and to nonfinancial businesses contracted sharply in the third quarter. These declines reflect the fact that weak economic growth can both damp demand for credit and lead to tighter credit supply conditions. The results from the Federal Reserve's Senior Loan Officer Opinion Survey on Bank Lending Practices indicate that both the availability and demand for bank loans are well below pre-crisis levels. In July, more banks reported tightening their lending standards on consumer and business loans than reported easing, although the degree of net tightening was well below levels reported last year. Almost all of the banks that tightened standards indicated concerns about a weaker or more uncertain economic outlook, and about one-third of banks surveyed cited concerns about deterioration in their own current or future capital positions. The survey also indicates that demand for consumer and business loans has remained weak. Indeed, decreased loan demand from creditworthy borrowers was the most common explanation given by respondents for the contraction of business loans this year. Taking a longer view of cycles since World War II, changes in debt flows have tended to lag behind changes in economic activity. Thus, it would be unusual to see a return to a robust and sustainable expansion of credit until after the overall economy begins to recover. Credit losses at banking organizations continued to rise through the second quarter of this year, and banks face risks of sizable additional credit losses given the outlook for production and employment. In addition, while the decline in housing prices slowed in the second quarter, continued adjustments in the housing market suggest that foreclosures and mortgage loan loss severities are likely to remain elevated. Moreover, prices for both existing commercial properties and for land, which collateralize commercial and residential development loans, have declined sharply in the first half of this year, suggesting that banks are vulnerable to significant further deterioration in their CRE loans. In sum, banking organizations continue to face significant challenges, and credit markets are far from fully healed.Performance of the Banking System Despite these challenges, the stability of the banking system has improved since last year. Many financial institutions have been able to raise significant amounts of capital and have achieved greater access to funding. Moreover, through the rigorous Supervisory Capital Assessment Program (SCAP) stress test conducted by the banking agencies earlier this year, some institutions demonstrated that they have the capacity to withstand more-adverse macroeconomic conditions than are expected to develop and have repaid the government's Troubled Asset Relief Program (TARP) investments.\1\ Depositors' concerns about the safety of their funds during the immediate crisis last year have also largely abated. As a result, financial institutions have seen their access to core deposit funding improve.--------------------------------------------------------------------------- \1\ For more information about the SCAP, see Ben S. Bernanke (2009), ``The Supervisory Capital Assessment Program,'' speech delivered at the Federal Reserve Bank of Atlanta 2009 Financial Markets Conference, held in Jekyll Island, Ga., May 11, www.Federalreserve.gov/newsevents/speech/bernanke20090511a.htm.--------------------------------------------------------------------------- However, the banking system remains fragile. Nearly 2 years into a substantial recession, loan quality is poor across many asset classes and, as noted earlier, continues to deteriorate as lingering weakness in housing markets affects the performance of residential mortgages and construction loans. Higher loan losses are depleting loan loss reserves at many banking organizations, necessitating large new provisions that are producing net losses or low earnings. In addition, although capital ratios are considerably higher than they were at the start of the crisis for many banking organizations, poor loan quality, subpar earnings, and uncertainty about future conditions raise questions about capital adequacy for some institutions. Diminished loan demand, more-conservative underwriting standards in the wake of the crisis, recessionary economic conditions, and a focus on working out problem loans have also limited the degree to which banks have added high quality loans to their portfolios, an essential step to expanding profitable assets and thus restoring earnings performance. These developments have raised the number of problem banks to the highest level since the early 1990s, and the rate of bank and thrift failures has accelerated throughout the year. Moreover, the estimated loss rates for the deposit insurance fund on bank failures have been very high, generally hovering near 30 percent of assets. This high loss level reflects the rapidity with which loan quality has deteriorated during the crisis and suggests that banking organizations may need to continue their high level of loan loss provisioning for some time. Moreover, some of these institutions, including those with capital above minimum requirements, may need to raise more capital and restrain their dividend payouts for the foreseeable future. Indeed, the buildup in capital ratios at large banking organizations has been essential to reassuring the market of their improving condition. However, we must recognize that capital ratios can be an imperfect indicator of a bank's overall strength, particularly in periods in which credit quality is deteriorating rapidly and loan loss rates are moving higher.Comparative Performance of Banking Institutions by Asset Size Although the broad trends detailed above have affected all financial institutions, there are some differences in how the crisis is affecting large financial institutions and more locally focused community and regional banks. Consider, for example, the 50 largest U.S. bank holding companies, which hold more than three-quarters of bank holding company assets and now include the major investment banks in the United States. While these institutions do engage in traditional lending activities, originating loans and holding them on their balance sheets like their community bank competitors, they also generate considerable revenue from trading and other fee-based activities that are sensitive to conditions in capital markets. These firms reported modest profits during each of the first two quarters of 2009. Second-quarter net income for these companies at $1.6 billion was weaker than that of the first quarter, but was still a great improvement over the $19.8 billion loss reported for the second quarter of last year. Net income was depressed by the payment of a significant share of the Federal Deposit Insurance Corporation's (FDIC) special deposit insurance assessment and a continued high level of loan loss provisioning. Contributing significantly to better performance was the improvement of capital markets activities and increases in related fees and revenues. Community and small regional banks have also benefited from the increased stability in financial markets. However, because they depend largely on revenues from traditional lending activities, as a group they have yet to report any notable improvement in earnings or condition since the crisis took hold. These banks--with assets of $10 billion or less representing almost 7,000 banks and 20 percent of commercial bank assets--reported a $2.7 billion loss in the second quarter. Earnings remained weak at these banks due to a historically narrow net interest margin and high loan loss provisions. More than one in four of these banks reported a net loss. Earnings at these banks were also substantially affected by the FDIC special assessment during the second quarter. Loan quality deteriorated significantly for both large and small institutions during the second quarter. At the largest 50 bank holding companies, nonperforming assets climbed more than 20 percent, raising the ratio of nonperforming assets to 4.3 percent of loans and other real estate owned. Most of the deterioration was concentrated in residential mortgage and construction loans, but commercial, CRE, and credit card loans also experienced rising delinquency rates. Results of the banking agencies' Shared National Credit review, released in September, also document significant deterioration in large syndicated loans, signaling likely further deterioration in commercial loans.\2\ At community and small regional banks, nonperforming assets increased to 4.4 percent of loans at the end of the second quarter, more than six times the level for this ratio at year-end 2006, before the crisis started. Home mortgages and CRE loans accounted for most of the increase, but commercial loans have also shown marked deterioration during recent quarters. Importantly, aggregate equity capital for the top 50 bank holding companies, and thereby for the banking industry, increased for the third consecutive quarter and reached 8.8 percent of consolidated assets as of June 30, 2009. This level was almost 1 percentage point above the year-end 2008 level and exceeded the pre-crisis level of midyear 2007 by more than 2 percentage points. Risk-based capital ratios for the top 50 bank holding companies also remained relatively high: Tier 1 capital ratios were at 10.75 percent, and total risk-based capital ratios were at 14.09 percent. Signaling the recent improvement in financial markets since the crisis began, capital increases during the first half of this year largely reflected common stock issuance, supported also by reductions in dividend payments. However, asset contraction also accounts for part of the improvement in capital ratios. Additionally, of course, the Treasury Capital Purchase Program also contributed to the increase in capital in the time since the crisis emerged.--------------------------------------------------------------------------- \2\ See Board of Governors of the Federal Reserve System, FDIC, Office of the Comptroller of the Currency, and Office of Thrift Supervision (2009), ``Credit Quality Declines in Annual Shared National Credits Review,'' joint press release, September 24, www.Federalreserve.gov/newsevents/press/bcreg/20090924a.htm.--------------------------------------------------------------------------- Despite TARP capital investments in some banks and the ability of others to raise equity capital, weak earnings led to modest declines in the average capital ratios of smaller banks over the past year--from 10.7 percent to 10.4 percent of assets as of June 30 of this year. However, risk-based capital ratios remained relatively high for most of these banks, with 96 percent maintaining risk-based capital ratios consistent with a ``well capitalized'' designation under prompt corrective action standards. Funding for the top 50 bank holding companies has improved markedly over the past year. In addition to benefiting from improvement in interbank markets, these companies increased core deposits from 24 percent of total assets at year-end 2008 to 27 percent as of June 30, 2009. The funding profile for community and small regional banks also improved, as core deposit funding rose to 62 percent of assets and reliance on brokered deposits and Federal Home Loan Bank advances edged down from historically high levels. As already noted, substantial financial challenges remain for both large and small banking institutions. In particular, some large regional and community banking firms that have built up unprecedented concentrations in CRE loans will be particularly affected by emerging conditions in real estate markets. I will now discuss the economic conditions and financial market dislocations affecting CRE markets and the implications for banking organizations.Current Conditions in Commercial Real Estate Markets Prices of existing commercial properties are estimated to have declined 35 to 40 percent since their peak in 2007, and market participants expect further declines. Demand for commercial property has declined as job losses have accelerated, and vacancy rates have increased. The higher vacancy levels and significant decline in the value of existing properties have placed particularly heavy pressure on construction and development projects that generate no income until completion. Developers typically depend on the sales of completed projects to repay their outstanding loans, and with the volume of property sales at especially low levels and with prices depressed, the ability to service existing construction loans has been severely impaired. The negative fundamentals in the CRE property markets have caused a sharp deterioration in the credit performance of loans in banks' portfolios and loans in commercial mortgage-backed securities (CMBS). At the end of the second quarter of 2009, approximately $3.5 trillion of outstanding debt was associated with CRE, including loans for multifamily housing developments. Of this, $1.7 trillion was held on the books of banks and thrifts, and an additional $900 billion represented collateral for CMBS, with other investors holding the remaining balance of $900 billion. Also at the end of the second quarter, about 9 percent of CRE loans on banks' books were considered delinquent, almost double the level of a year earlier.\3\ Loan performance problems were the most striking for construction and development loans, especially for those that finance residential development. More than 16 percent of all construction and development loans were considered delinquent at the end of the second quarter.--------------------------------------------------------------------------- \3\ The CRE loans considered delinquent on banks' books were non-owner occupied CRE loans that were 30 days or more past due.--------------------------------------------------------------------------- Almost $500 billion of CRE loans will mature each year over the next few years. In addition to losses caused by declining property cash-flows and deteriorating conditions for construction loans, losses will also be boosted by the depreciating collateral value underlying those maturing loans. These losses will place continued pressure on banks' earnings, especially those of smaller regional and community banks that have high concentrations of CRE loans. The current fundamental weakness in CRE markets is exacerbated by the fact that the CMBS market, which had financed about 30 percent of originations and completed construction projects, has remained virtually inoperative since the start of the crisis. Essentially no CMBS have been issued since mid-2008. New CMBS issuance came to a halt as risk spreads widened to prohibitively high levels in response to the increase in CRE-specific risk and the general lack of liquidity in structured debt markets. Increases in credit risk have significantly softened demand in the secondary trading markets for all but the most highly rated tranches of these securities. Delinquencies of mortgages backing CMBS have increased markedly in recent months. Market participants anticipate these rates will climb higher by the end of this year, driven not only by negative fundamentals but also by borrowers' difficulty in rolling over maturing debt. In addition, the decline in CMBS prices has generated significant stresses on the balance sheets of financial institutions that must mark these securities to market, further limiting their appetite for taking on new CRE exposure.Federal Reserve Activities to Help Revitalize Credit Markets The Federal Reserve, along with other government agencies, has taken a number of actions to strengthen the financial sector and to promote the availability of credit to businesses and households. In addition to aggressively easing monetary policy, the Federal Reserve has established a number of facilities to improve liquidity in financial markets. One such program is the Term Asset-Backed Securities Loan Facility (TALF), begun in November 2008 to facilitate the extension of credit to households and small businesses. Before the crisis, securitization markets were an important conduit of credit to the household and business sectors; some have referred to these markets as the ``shadow banking system.'' Securitization markets (other than those for mortgages guaranteed by the government) have virtually shut down since the onset of the crisis, eliminating an important source of credit. Under the TALF, eligible investors may borrow to finance purchases of the AAA-rated tranches of certain classes of asset-backed securities. The program originally focused on credit for households and small businesses, including auto loans, credit card loans, student loans, and loans guaranteed by the Small Business Administration. More recently, CMBS were added to the program, with the goal of mitigating a severe refinancing problem in that sector. The TALF has had some success. Rate spreads for asset-backed securities have declined substantially, and there is some new issuance that does not use the facility. By improving credit market functioning and adding liquidity to the system, the TALF and other programs have provided critical support to the financial system and the economy.Availability of Credit The Federal Reserve has long-standing policies in place to support sound bank lending and the credit intermediation process. Guidance issued during the CRE downturn in 1991 instructs examiners to ensure that regulatory policies and actions do not inadvertently curtail the availability of credit to sound borrowers.\4\ This guidance also states that examiners should ensure loans are being reviewed in a consistent, prudent, and balanced fashion to prevent inappropriate downgrades of credits. It is consistent with guidance issued in early 2007 addressing risk management of CRE concentrations, which states that institutions that have experienced losses, hold less capital, and are operating in a more risk-sensitive environment are expected to employ appropriate risk-management practices to ensure their viability.\5\--------------------------------------------------------------------------- \4\ See Board of Governors of the Federal Reserve System, Division of Banking Supervision and Regulation (1991), ``Interagency Examination Guidance on Commercial Real Estate Loans,'' Supervision and Regulation Letter SR 91-24 (November 7), www.Federalreserve.gov/BoardDocs/SRLetters/1991/SR9124.htm; and Office of the Comptroller of the Currency, Federal Deposit Insurance Corporation, Federal Reserve Board, and Office of Thrift Supervision (1991), ``Interagency Policy Statement on the Review and Classification of Commercial Real Estate Loans,'' joint policy statement, November 7, www.Federalreserve.gov/BoardDocs/SRLetters/1991/SR9124a1.pdf. \5\ See Board of Governors of the Federal Reserve System, Division of Banking Supervision and Regulation (2007), ``Interagency Guidance on Concentrations in Commercial Real Estate,'' Supervision and Regulation Letter SR 07 1 (January 4), www.Federalreserve.gov/boarddocs/srletters/2007/SR0701.htm.--------------------------------------------------------------------------- We are currently in the final stages of developing interagency guidance on CRE loan restructurings and workouts. This guidance supports balanced and prudent decisionmaking with respect to loan restructuring, accurate and timely recognition of losses and appropriate loan classification. The guidance will reiterate that classification of a loan should not be based solely on a decline in collateral value, in the absence of other adverse factors, and that loan restructurings are often in the best interest of both the financial institution and the borrower. The expectation is that banks should restructure CRE loans in a prudent manner, recognizing the associated credit risk, and not simply renew a loan in an effort to delay loss recognition. On one hand, banks have raised concerns that our examiners are not always taking a balanced approach to the assessment of CRE loan restructurings. On the other hand, our examiners have observed incidents where banks have been slow to acknowledge declines in CRE project cash-flows and collateral values in their assessment of the potential loan repayment. This new guidance, which should be finalized shortly, is intended to promote prudent CRE loan workouts as banks work with their creditworthy borrowers and to ensure a balanced and consistent supervisory review of banking organizations. Guidance issued in November 2008 by the Federal Reserve and the other Federal banking agencies encouraged banks to meet the needs of creditworthy borrowers, in a manner consistent with safety and soundness, and to take a balanced approach in assessing borrowers' ability to repay and making realistic assessments of collateral valuations.\6\ In addition, the Federal Reserve has directed examiners to be mindful of the effects of excessive credit tightening in the broader economy and we have implemented training for examiners and outreach to the banking industry to underscore these intentions. We are aware that bankers may become overly conservative in an attempt to ameliorate past weaknesses in lending practices, and are working to emphasize that it is in all parties' best interests to continue making loans to creditworthy borrowers.--------------------------------------------------------------------------- \6\ See Board of Governors of the Federal Reserve System, FDIC, Office of the Comptroller of the Currency, and Office of Thrift Supervision (2008), ``Interagency Statement on Meeting the Needs of Creditworthy Borrowers,'' joint press release, November 12, www.Federalreserve.gov/newsevents/press/bcreg/20081112a.htm.---------------------------------------------------------------------------Strengthening the Supervisory Process The recently completed SCAP of the 19 largest U.S. bank holding companies demonstrates the effectiveness of forward-looking horizontal reviews and marked an important evolutionary step in the ability of such reviews to enhance supervision. Clearly, horizontal reviews--reviews of risks, risk-management practices and other issues across multiple financial firms--are very effective vehicles for identifying both common trends and institution-specific weaknesses. The SCAP expanded the scope of horizontal reviews and included the use of a uniform set of stress parameters to apply consistently across firms. An outgrowth of the SCAP was a renewed focus by supervisors on institutions' own ability to assess their capital adequacy--specifically their ability to estimate capital needs and determine available capital resources during very stressful periods. A number of firms have learned hard, but valuable, lessons from the current crisis that they are applying to their internal processes to assess capital adequacy. These lessons include the linkages between liquidity risk and capital adequacy, the dangers of latent risk concentrations, the value of rigorous stress testing, the importance of strong governance over their processes, and the importance of strong fundamental risk identification and risk measurement to the assessment of capital adequacy. Perhaps one of the most important conclusions to be drawn is that all assessments of capital adequacy have elements of uncertainty because of their inherent assumptions, limitations, and shortcomings. Addressing this uncertainty is one among several reasons that firms should retain substantial capital cushions. Currently, we are conducting a horizontal assessment of internal processes that evaluate capital adequacy at the largest U.S. banking organizations, focusing in particular on how shortcomings in fundamental risk management and governance for these processes could impair firms' abilities to estimate capital needs. Using findings from these reviews, we will work with firms over the next year to bring their processes into conformance with supervisory expectations. Supervisors will use the information provided by firms about their processes as a factor--but by no means the only factor--in the supervisory assessment of the firms' overall capital levels. For instance, if a firm cannot demonstrate a strong ability to estimate capital needs, then supervisors will place less credence on the firm's own internal capital results and demand higher capital cushions, among other things. Moreover, we have already required some firms to raise capital given their higher risk profiles. In general, we believe that if firms develop more-rigorous internal processes for assessing capital adequacy that capture all the risks facing those firms--including under stress scenarios--and maintain adequate capital based on those processes, they will be in a better position to weather financial and economic shocks and thereby perform their role in the credit intermediation process. We also are expanding our quantitative surveillance program for large, complex financial organizations to include supervisory information, firm-specific data analysis, and market-based indicators to identify developing strains and imbalances that may affect multiple institutions, as well as emerging risks to specific firms. Periodic scenario analyses across large firms will enhance our understanding of the potential impact of adverse changes in the operating environment on individual firms and on the system as a whole. This work will be performed by a multidisciplinary group composed of our economic and market researchers, supervisors, market operations specialists, and accounting and legal experts. This program will be distinct from the activities of onsite examination teams so as to provide an independent supervisory perspective, as well as to complement the work of those teams. As we adapt our internal organization of supervisory activities to build on lessons learned from the current crisis, we are using all of the information and insight that the analytic abilities the Federal Reserve can bring to bear in financial supervision.Conclusion A year ago, the world financial system was profoundly shaken by the failures and other serious problems at large financial institutions here and abroad. Significant credit and liquidity problems that had been building since early 2007 turned into a full-blown panic with adverse consequences for the real economy. The deterioration in production and employment, in turn, exacerbated problems for the financial sector. It will take time for the banking industry to work through these challenges and to fully recover and serve as a source of strength for the real economy. While there have been some positive signals of late, the financial system remains fragile and key trouble spots remain, such as CRE. We are working with financial institutions to ensure that they improve their risk management and capital planning practices, and we are also improving our own supervisory processes in light of key lessons learned. Of course, we are also committed to working with the other banking agencies and the Congress to ensure a strong and stable financial system. ______ CHRG-111shrg51395--128 PREPARED STATEMENT OF DAMON A. SILVERS Associate General Counsel, AFL-CIO March 10, 2009 Good morning, Chairman Dodd and Senator Shelby. My name is Damon Silvers, I am an Associate General Counsel of the AFL-CIO, and I am the Deputy Chair of the Congressional Oversight Panel created under the Emergency Economic Stabilization Act of 2008 to oversee the TARP. While I will describe the Congressional Oversight Panel's report on regulatory reform, my testimony reflects my views and the views of the AFL-CIO unless otherwise noted, and is not on behalf of the Panel, its staff or its chair, Elizabeth Warren. The vast majority of American investors participate in the markets as a means to secure a comfortable retirement and to send their children to college. Most investors' goals are long term, and most investors rely on others to manage their money. While the boom and bust cycles of the last decade generated fees for Wall Street--in many cases astounding fees--they have turned out to have been a disaster for most investors. The 10-year nominal rate of return on the S&P 500 is now negative, and returns for most other asset classes have turned out to be more correlated with U.S. equity markets than anyone would have imagined a decade ago. While the spectacular frauds like the Madoff ponzi scheme have generated a great deal of publicity, the bigger questions are (1) how did our financial system as a whole become so weak how did our system of corporate governance, securities regulation, and disclosure-based market discipline fail to prevent trillions of dollars from being invested in value-destroying activities--ranging from subprime mortgages and credit cards, to the stocks and bonds of financial institutions, to the credit default swaps pegged to those debt instruments; and (2) what changes must be made to make our financial system a more reasonable place to invest the hard earned savings of America's working families? My testimony today will seek to answer the second question at three levels: 1 How should Congress strengthen the regulatory architecture to better protect investors; 2. How should Congress think about designing regulatory jurisdiction to better protect investors; and 3. What are some specific substantive steps Congress and the regulators should take to shore up our system of investor protections? Finally, I will briefly address how to understand the challenge of investor protection in globalized markets.Regulatory Architecture While there has been much discussion of the need for better systemic risk regulation, the Congressional Oversight Panel, in its Special Report on Regulatory Reform issued on January 29, 2009, observed that addressing issues of systemic risk cannot be a substitute for a robust, comprehensive system of routine financial regulation. \1\ There are broadly three types of routine regulation in the financial markets--(1) safety and soundness regulation for insured institutions like banks and insurance companies; (2) disclosure and fiduciary duty regulation for issuers and money managers in the public securities markets; and (3) substantive consumer protection regulation in areas like mortgages, credit cards, and insurance. These are distinct regulatory missions in significant tension with each other.--------------------------------------------------------------------------- \1\ Congressional Oversight Panel, Special Report on Regulatory Reform, at 3 (Jan. 29, 2009), available at http://cop.senate.gov/documents/cop-012909-report-regulatoryreform.pdf--------------------------------------------------------------------------- Investors, people who seek to put money at risk for the prospect of gains, really are interested in transparency, enforcement of fiduciary duties, and corporate governance. This is the investor protection mission. It is often in tension with the equally legitimate regulatory mission of protecting the safety and soundness of insured financial institutions. A safety and soundness regulator is likely to be much more sympathetic to regulated entities that want to sidestep telling the investing public bad news. At the same time, investor protection is not the same thing as consumer protection--the consumer looking for home insurance or a mortgage is seeking to purchase a financial service with minimal risk, not to take a risk in the hope of a profit. Because these functions should not be combined, investor protection should be the focus of a single agency within the broader regulatory framework. That agency needs to have the stature and independence to protect the principles of full disclosure by market participants and compliance with fiduciary duties among market intermediaries. Any solution to the problem of systemic risk prevention should involve the agency charged with investor protection, and not supersede it. Since the New Deal, the primary body charged with enforcing investor protections has been the Securities and Exchange Commission. Although the Commission has suffered in recent years from diminished jurisdiction and leadership failure, it remains an extraordinary government agency, whose human capital and market expertise needs to be built upon as part of a comprehensive strategy for effective reregulation of the capital markets. While I have a great deal of respect for former Treasury Secretary Paulson, there is no question that his blueprint for financial regulatory reform was profoundly deregulatory in respect to the Securities and Exchange Commission. \2\ He and others, like the self-described Committee on Capital Markets Regulation led by Harvard Professor Hal Scott, sought to dismantle the Commission's culture of arms length, enforcement-oriented regulation and to replace it with something frankly more captive to the businesses it regulated. \3\ While these deregulatory approaches have fortunately yet to be enacted, they contributed to an environment that weakened the Commission politically and demoralized its staff.--------------------------------------------------------------------------- \2\ Department of the Treasury, Blueprint for a Modernized Financial Regulatory Structure, at 11-13, 106-126 (Mar. 2008), available at http://www.treas.gov/press/releases/reports/Blueprint.pdf \3\ Committee on Capital Markets Regulation, Interim Report (Nov. 30, 2006), available at http://www.capmktsreg.org/pdfs/11.30Committee_Interim_ReportREV2.pdf; Committee on Capital Markets Regulation, The Competitive Position of the U.S. Public Equity Market (Dec. 4, 2007), available at http://www.capmktsreg.org/pdfs/The_Competitive_Position_of_the_US_Public_Equity_Market.pdf--------------------------------------------------------------------------- While there has been a great deal of attention paid to the Commission's failure to spot the Madoff ponzi scheme, there has been insufficient attention to the Commission's performance in relation to the public debt markets, where the SEC regulates more than $438.3 billion in outstanding securities related to home equity loans and manufactured housing loans, among the riskiest types of mortgages. Similarly, little attention has been paid to the oversight of disclosures by the financial and homebuilding firms investing in and trading in those securities, and perhaps most importantly, the lack of action by the Commission once the financial crisis began. \4\--------------------------------------------------------------------------- \4\ Securities Industry and Financial Markets Association, Market Sector Statistics: Asset Backed Securities--Outstanding By Major Types of Credit.--------------------------------------------------------------------------- But elections have consequences, and one of those consequences should be a renewed commitment by both Congress and the new Administration to revitalizing the Commission and to rebuilding the Commission's historic investor protection oriented culture and mission. The President's budget reflects that type of approach in the funding it seeks for the Commission, and the new Chair of the Commission Mary Schapiro has appeared to be focused on just this task in her recent statements. \5\--------------------------------------------------------------------------- \5\ See, e.g., Speech by SEC Chairman: Address to Practising Law Institute's ``SEC Speaks in 2009'' Program available at http://sec.gov/news/speech/2009/spch020609mls.htm--------------------------------------------------------------------------- A key issue the Commission faces is how to strengthen its staff. Much of what needs to be done is in the hands of the Commission itself, where the Chair and the Commissioners set the tone for better or for worse. When Commissioners place procedural roadblocks in the way of enforcing the law, good people leave the Commission and weak staff are not held accountable. When the Chair sets a tone of vigorous enforcement of the laws and demands a genuine dedication to investor protection, the Commission both attracts and retains quality people. Congress should work with the Commission to determine if changes are needed to personnel rules to enable the Commission to attract and retain key personnel. The Commission should look at more intensive recruiting efforts aimed at more experienced private sector lawyers who may be looking for public service opportunities--perhaps through a special fellows program. On the other hand, Congress should work with the Commission to restrict the revolving door--ideally by adopting the rule that currently applies to senior bank examiners for senior Commission staff--no employment with any firm whose matters the staffer worked on within 12 months.Regulating the Shadow Markets and the Problem of Jurisdiction The financial crisis is directly connected to the degeneration of the New Deal system of comprehensive financial regulation into a Swiss cheese regulatory system, where the holes, the shadow markets, grew to dominate the regulated markets. If we are going to lessen future financial boom and bust cycles, Congress must give the regulators the tools and the jurisdiction to regulate the shadow markets. In our report of January 29, the Congressional Oversight Panel specifically observed that we needed to regulate financial products and institutions, in the words of President Obama, ``for what they do, not what they are.'' \6\ We further noted in that report that shadow market products and institutions are nothing more than new names and new legal structures for very old activities like insurance (read credit default swaps) and money management (read hedge funds and private equity/lbo funds). \7\--------------------------------------------------------------------------- \6\ Senator Barack Obama, Renewing the American Economy, Speech at Cooper Union in New York (Mar. 27, 2008) (transcript available at http://www.nytimes.com/2008/03/27/us/politics/27text-obama.html?pagewanted=all); Congressional Oversight Panel, Special Report on Regulatory Reform, at 29. \7\ Congressional Oversight Panel, Special Report on Regulatory Reform, at 29.--------------------------------------------------------------------------- The Congressional Oversight Panel's report stated that shadow institutions should be regulated by the same regulators who currently have jurisdiction over their regulated counterparts. \8\ So, for example, the SEC should have jurisdiction over derivatives that are written using public debt or equity securities as their underlying asset. The Congressional Oversight Panel stated that at a minimum, hedge funds should also be regulated by the SEC in their roles as money managers by being required to register as investment advisors and being subject to clear fiduciary duties, the substantive jurisdiction of U.S. law, and periodic SEC inspections. \9\ To the extent a hedge fund or anyone else engages in writing insurance contracts or issuing credit, however, it should be regulated by the bodies charged with regulating that type of economic activity.--------------------------------------------------------------------------- \8\ Id. \9\ Id.--------------------------------------------------------------------------- Some have suggested having such shadow market financial products as derivatives and hedge funds simply regulated by a systemic regulator. This would be a terrible mistake. Shadow market products and institutions need to be brought under the same routine regulatory umbrella as other financial actors. To take a specific case, while it is a good idea to have public clearinghouses for derivatives trading, that reform by itself is insufficient without capital requirements for the issuers of derivatives and without disclosure and the application of securities law principles, generally, to derivatives based on public securities regulations. So, for example, the SEC should require the same disclosure of short positions in public equities that it requires of long positions in equities, whether those positions are created through the securities themselves or synthetically through derivatives or futures. The historic distinctions between broker-dealers and investment advisors have been eroding in the markets for years. In 2007, the Federal Appeals Court for the District of Columbia issued an opinion overturning Commission regulations seeking to better define the boundary between the two. \10\ The Commission should look at merging the regulation of the categories while ensuring that the new regulatory framework preserves clear fiduciary duties to investors. As part of a larger examination of the duties owed by both broker-dealers and investment advisors to investors, the Commission ought to examine the fairness and the efficacy of the use of arbitration as a form of dispute resolution by broker-dealers. Finally, part of what must be done in this area is to determine whether the proper regulatory approach will require Congressional action in light of the D.C. Circuit opinion.--------------------------------------------------------------------------- \10\ Fin. Planning Ass'n v. SEC, 482 F.3d 481 (D.C. Cir. 2007).--------------------------------------------------------------------------- But there is a larger point here. Financial reregulation will be utterly ineffective if it turns into a series of rifle shots at the particular mechanisms used to evade regulatory structures in earlier boom and bust cycles. What is needed is a return to the jurisdictional philosophy that was embodied in the founding statutes of federal securities regulation--very broad, flexible jurisdiction that allowed the SEC to follow the activities. By this principle, the SEC should have jurisdiction over anyone over a certain size who manages public securities, and over any contract written that references publicly traded securities. Applying this principle would require at least shifting the CFTC's jurisdiction over financial futures to the SEC, if not merging the two agencies under the SEC's leadership. Much regulatory thinking over the last couple of decades has been shaped by the idea that sophisticated parties should be allowed to act in financial markets without regulatory oversight. Candidly, some investors have been able to participate in a number of relatively lightly regulated markets based on this idea. But this idea is wrong. Big, reckless sophisticated parties have done a lot of damage to our financial system and to our economy. I do not mean to say that sophisticated parties in the business of risk taking should be regulated in the same way as auto insurers selling to the general public. But there has to be a level of transparency, accountability, and mandated risk management across the financial markets. Finally, while it is not technically a shadow market, the underregulation of the credit rating agencies has turned out to have devastating consequences. The Congressional Oversight Panel called particular attention to the dysfunctional nature of the issuer pays model, and recommended a set of options for needed structural change--from the creation of PCAOB-type oversight body to the creation of a public or non-profit NRSRO. \11\--------------------------------------------------------------------------- \11\ Id. at 40-44.---------------------------------------------------------------------------Substantive Reforms Beyond regulating the shadow markets, the Congress and the Securities and Exchange Commission need to act to shape a corporate governance and investor protection regime that is favorable to long term investors and to the channeling of capital to productive purposes. There is no way to look at the wreckage surrounding us today in the financial markets and not conclude we have had a regulatory regime that, intentionally or not, facilitated grotesquely short-term thinking and led to capital flowing in unheard of proportions to pointless or destructive ends. This is a large task, and I will simply point out some of the most important steps that need to be taken in three areas--governance, executive pay, and litigation. First, in the area of governance, once again the weakness of corporate boards, particularly in the financial sector, appears to be a central theme in the financial scandal. The AFL-CIO has interviewed the audit committees of a number of the major banks to better understand what happened. We found in general very weak board oversight of risk--evidenced in audit committee leadership who did not understand their companies' risk profiles, and in boards that tolerated the weakening of internal risk management. Strong boards require meaningful accountability to investors. Short-term, leveraged investors have been the most powerful voices in corporate governance in recent years, with destructive results. The AFL-CIO urges Congress to work with the SEC to ensure that there are meaningful, useable ways for long-term investors to nominate and elect psychologically independent directors to public company boards through access to the corporate proxy. I put the stress here on long-term--there must be meaningful holding time requirements for exercising this right. Recent statements by SEC Chair Mary Schapiro suggest she is focused on this area, and we urge the Congress to support her efforts. \12\--------------------------------------------------------------------------- \12\ Rachelle Younglai, SEC developing proxy access plans: sources, REUTERS, Mar. 6, 2009, at http://www.reuters.com/article/bernardMadoff/idUSTRE52609820090307--------------------------------------------------------------------------- Second, effective investor protection requires a comprehensive approach to reform in the area of executive pay. Proxy access is an important first step in this area, but we should learn from the financial crisis how destructive short-term oriented, asymmetric executive pay can be for long-term investors and for our economy. The focus of the Congressional Oversight Panel's recommendations in the area of executive pay were on ending these practices in financial institutions. \13\ Here Chairman Dodd's leadership has been very helpful in the context of the TARP.--------------------------------------------------------------------------- \13\ Congressional Oversight Panel, Special Report on Regulatory Reform, at 37-40.--------------------------------------------------------------------------- But Congress and the Administration should pursue a comprehensive approach to executive pay reform around two concepts--equity linked pay should be held beyond retirement, and pay packages as a whole should reflect a rough equality of exposure to downside risk as to upside gain. Orienting policy in this direction requires coordination between securities regulation and tax policy. But we could begin to address what has gone wrong in executive pay incentives by (1) developing measurements for both the time horizon and the symmetry of risk and reward of pay packages that could be included in pay disclosure; (2) looking more closely at mutual fund proxy voting behavior to see if it reflects the time horizons of the funds; (3) focusing FINRA inspections of broker dealer pay policies on these two issues; and (4) providing for advisory shareholder votes on pay packages. With respect to say on pay, any procedural approaches that strengthened the hand of long term investors in the process of setting executive compensation would be beneficial. Finally, Congress needs to address the glaring hole in the fabric of investor protection created by the Central Bank of Denver and Stoneridge cases. \14\ These cases effectively granted immunity from civil liability to investors for parties such as investment banks and law firms that are co-conspirators in securities frauds. It appeared for a time after Enron that the courts were going to restore some sanity in this area of the law on their own, by finding a private right of action when service providers were actually not just aiders and abetters of a fraud, but actual co-conspirators. In the Stoneridge decision, with the Enron case looming over them, the Supreme Court made clear Congress would have to act. The issue here of course is not merely fairness to the investors defrauded in a particular case--it is the incentives for financial institutions to police their own conduct. We seem to have had a shortage of such incentives in recent years.--------------------------------------------------------------------------- \14\ Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A., 511 U.S. 164 (1994); Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc., 128 S. Ct. 761 (2008).---------------------------------------------------------------------------The International Context The Bush Administration fundamentally saw the internationalization of financial markets as a pretext for weakening U.S. investor protections. That approach has been discredited. It needs to be replaced by a commitment on the part of the Obama Administration to building a strong global regulatory floor in coordination with the world's other major economies. This effort is vital not only for protecting U.S. investors in global markets, but for protecting our financial sector from the consequences of a global regulatory race to the bottom that will inevitably end in the kind of financially driven economic crisis that we are living through today. Congress can play a part by seeking to strengthen its relationships with its counterpart legislative bodies in the major world markets, and should look for opportunities to coordinate setting regulatory standards on a global basis. The Administration needs to make this effort a priority, and to understand that it needs to extend beyond the narrow confines of systemic risk and the banking system to issues of transparency and investor protection. However, Congress must not allow the need for global coordination to be an impediment or a prerequisite to vigorous action to reregulate U.S. financial markets and institutions. That task is urgent and must be addressed if the U.S. is to recover from the blow this financial crisis has delivered to our private capital markets' reputation as the gold standard for transparency and accountability.Conclusion The task of protecting investors by reregulating our financial system and restoring vitality to our regulators is a large one. This testimony simply sketches the outline of an approach, and notes some key substantive steps Congress and the Administration need to take. This Committee has already taken a leadership role in a number of these areas, but there is much more to be done. Even in areas where the primary responsibility must lie with regulators, there is a much needed role for Congress to oversee, encourage, and support the efforts of the Administration. While I do not speak for the Congressional Oversight Panel, I think I am safe in saying that the Panel is honored to have been asked to assist Congress in this effort, and is prepared to assist this Committee in any manner the Committee finds useful. I can certainly make that offer on behalf of the AFL-CIO. Thank you.SUPPLEMENT--March 10, 2009 The challenge of addressing systemic risk in the future is one, but by no means the only one, of the challenges facing Congress as Congress considers how to reregulate U.S. financial markets following the extraordinary events of the last 18 months. Systemic crises in financial markets harm working people. Damaged credit systems destroy jobs rather than create them. Pension funds with investments in panicked markets see their assets deteriorate. And the resulting instability undermines business' ability to plan and obtain financing for new investments--undermining the long term growth and competitiveness of employers and setting the stage for future job losses. The AFL-CIO has urged Congress since 2006 to act to reregulate shadow financial markets, and the AFL-CIO supports addressing systemic risk, but in a manner that does not substitute for strengthening the ongoing day to day regulatory framework, and that recognizes addressing systemic risk both requires regulatory powers and financial resources that can really only be wielded by a fully public body. The concept of systemic risk is that financial market actors can create risk not just that their institutions or portfolios will fail, but risk that the failure of their enterprises will cause a broader failure of other financial institutions, and that such a chain of broader failures can jeopardize the functioning of financial markets as a whole. The mechanisms by which this broader failure can occur involve a loss of confidence in information, or a loss of confidence in market actors ability to understand the meaning of information, which leads to the withdrawal of liquidity from markets and market institutions. Because the failure of large financial institutions can have these consequence, systemic risk management generally is seen to both be about how to determine what to do when a systemically significant institution faces failure, and about how to regulated such institutions in advance to minimize the chances of systemic crises. Historically, the United States has had three approaches to systemic risk. The first was prior to the founding of the Federal Reserve system, when there was a reluctance at the Federal level to intervene in any respect in the workings of credit markets in particular and financial markets in general. The Federal Reserve system, created after the financial collapse of 1907, ushered in an era where the Federal Government's role in addressing systemic risk largely consisted of sponsoring through the Federal Reserve system, a means of providing liquidity to member banks, and thus hopefully preventing the ultimate liquidity shortage that results from market participants losing confidence in the financial system as a whole. But then, after the Crash of 1929 and the 4 years of Depression that followed, Congress and the Roosevelt Administration adopted a regulatory regime whose purpose was in a variety of ways to substantively regulate financial markets in an ongoing way. This new approach arose out of a sense among policymakers that the systemic financial crisis associated with the Great Depression resulted from the interaction of weakly regulated banks with largely unregulated securities markets, and that exposing depositors to these risks was a systemic problem in and of itself. Such centerpieces of our regulatory landscape as the Securities and Exchange Commission's disclosure based system of securities regulation and the Federal Deposit Insurance Corporation came into being not just as systems for protecting the economic interests of depositors or investors, but as mechanisms for ensuring systemic stability by, respectively, walling off bank depositors from broader market risks, and ensuring investors in securities markets had the information necessary to make it possible for market actors to police firm risk taking and to monitor the risks embedded in particular financial products. In recent years, financial activity has moved away from regulated and transparent markets and institutions and into the so-called shadow markets. Regulatory barriers like the Glass-Steagall Act that once walled off less risky from more risky parts of the financial system have been weakened or dismantled. So we entered the recent period of extreme financial instability with an approach to systemic risk that looked a lot like that of the period following the creation of the Federal Reserve Board but prior to the New Deal era. And so we saw the policy response to the initial phases of the current financial crisis primarily take the form of increasing liquidity into credit markets through interest rate reductions and increasingly liberal provision of credit to banks and then to non-bank financial institutions. However, with the collapse of Lehman Brothers and the Federal rescues of AIG, FNMA, and the FHLMC, the federal response to the perception of systemic risk turned toward much more aggressive interventions in an effort to ensure that after the collapse of Lehman Brothers, there would be no more defaults by large financial institutions. This approach was made somewhat more explicit with the passage of the Emergency Economic Stabilization Act of 2008 and the commencement of the TARP program. The reality was though that the TARP program was the creature of certain very broad passages in the bill, which generally was written with the view that the federal government would be embarking on the purchase of troubled assets, a very different approach than the direct infusions of equity capital that began with the Capital Purchase Program in October of 2008. We can now learn some lessons from this experience for the management of systemic risk in the financial system. First, our government and other governments around the world will step in when major financial institutions face bankruptcy. We do not live in a world of free market discipline when it comes to large financial institutions, and it seems unlikely we ever will. If two administrations as different as the Bush Administration and the Obama Administration agree that the Federal Government must act when major financial institutions fail, it is hard to imagine the administration that would do differently. Since the beginning of 2008, we have used Federal dollars in various ways to rescue either the debt or the equity holders or both at the following companies--Bear Stearns, Indymac, Washington Mutual, AIG, Merrill Lynch, Fannie Mae, Freddie Mac, Citigroup, and Bank of America. But we have no clear governmental entity charged with making the decision over which company to rescue and which to let fail, no clear criteria for how to make such decisions, and no clear set of tools to use in stabilizing those that must be stabilized. Second, we appear to be hopelessly confused as to what it means to stabilize a troubled financial institution to avoid systemic harm. We have a longstanding system of protecting small depositors in FDIC insured banks, and by the way policyholders in insurance companies through the state guarantee funds. The FDIC has a process for dealing with banks that fail--a process that does not always result in 100 percent recoveries for uninsured creditors. Then we have the steps taken by the Treasury Department and the Federal Reserve since Bear Stearns collapsed. At some companies, like Fannie Mae and Freddie Mac, those steps have guaranteed all creditors, but wiped out the equity holders. At other companies, like Bear Stearns, AIG, and Wachovia, while the equity holders survive, they have been massively diluted one way or another. At others, like Citigroup and Bank of America, the equity has been only modestly diluted when looked at on an upside basis. It is hard to understand exactly what has happened with the government's interaction with Morgan Stanley and Goldman Sachs, but again there has been very little equity dilution. And then there is poor Lehman Brothers, apparently the only non-systemic financial institution, where everybody lost. In crafting a systematic approach to systemically significant institutions, we should begin with the understanding that while a given financial institution may be systemically significant, not every layer of its capital structure should be necessarily propped up with taxpayer funds. Third, much regulatory thinking over the last couple of decades has been shaped by the idea that sophisticated parties should be allowed to act in financial markets without regulatory oversight. But this idea is wrong. Big, reckless sophisticated parties have done a lot of damage to our financial system and to our economy. This is not to say that sophisticated parties in the business of risk taking should be regulated in the same way as auto insurers selling to the general public. But there has to be a level of transparency, accountability, and mandated risk management across the financial markets. Fourth, financial markets are global now. Norwegian villages invest in U.S. mortgage backed securities. British bankruptcy laws govern the fate of U.S. clients of Lehman Brothers, an institution that appeared to be a U.S. institution. AIG, our largest insurance company, collapsed because of a London office that employed 300 of AIG's 500,000 employees. Chinese industrial workers riot when U.S. real estate prices fall. We increasingly live in a world where the least common denominator in financial regulation rules. So what lessons should we take away for how to manage systemic risk in our financial system? The Congressional Oversight Panel, in its report to Congress made the following points about addressing systemic risk: 1. There should be a body charged with monitoring sources of systemic risk in the financial system, but it could either be a new body, an existing agency, or a group of existing agencies; 2. The body charged with systemic risk managements should be fully accountable and transparent to the public in a manner that exceeds the general accountability mechanisms present in self- regulatory organizations; 3. We should not identify specific institutions in advance as too big to fail, but rather have a regulatory framework in which institutions have higher capital requirements and pay more on insurance funds on a percentage basis than smaller institutions which are less likely to be rescued as being too systemic to fail. 4. Systemic risk regulation cannot be a substitute for routine disclosure, accountability, safety and soundness, and consumer protection regulation of financial institutions and financial markets. 5. Ironically, effective protection against systemic risk requires that the shadow capital markets--institutions like hedge funds and products like credit derivatives--must not only be subject to systemic risk oriented oversight but must also be brought within a framework of routine capital market regulation by agencies like the Securities and Exchange Commisson. 6. There are some specific problems in the regulation of financial markets, such as the issue of the incentives built into executive compensation plans and the conflict of interest inherent in the credit rating agencies' business model of issuer pays, that need to be addressed to have a larger market environment where systemic risk is well managed. 7. Finally, there will not be effective reregulation of the financial markets without a global regulatory floor. I would like to explain some of these principles and at least the thinking I brought to them. First, on the issue of a systemic risk monitor, while the Panel made no recommendation, I have come to believe that the best approach is a body with its own staff and a board made up of the key regulators, perhaps chaired by the Chairman of the Board of Governors of the Federal Reserve. There are several reasons for this conclusion. First, this body must have as much access as possible to all information extant about the condition of the financial markets--including not just bank credit markets, but securities and commodities, and futures markets, and consumer credit markets. As long as we have the fragmented bank regulatory system we now have, this body would need access to information about the state of all deposit taking institutions. The reality of the interagency environment is that for information to flow freely, all the agencies involved need some level of involvement with the agency seeking the information. Connected with the information sharing issue is expertise. It is unlikely a systemic risk regulator would develop deep enough expertise on its own in all the possible relevant areas of financial activity. To be effective it would need to cooperate in the most serious way possible with all the routine regulators where the relevant expertise would be resident. Second, this coordinating body must be fully public. While many have argued the need for this body to be fully public in the hope that would make for a more effective regulatory culture, the TARP experience highlights a much more bright line problem. An effective systemic risk regulator must have the power to bail out institutions, and the experience of the last year is that liquidity provision is simply not enough in a real crisis. An organization that has the power to expend public funds to rescue private institutions must be a public organization--though it should be insulated from politics much as our other financial regulatory bodies are by independent agency structures. Here is where the question of the role of the Federal Reserve comes in. A number of commentators and Fed officials have pointed out that the Fed has to be involved in any body with rescue powers because any rescue would be mounted with the Fed's money. However, the TARP experience suggests this is a serious oversimplification. While the Fed can offer liquidity, many actual bailouts require equity infusions, which the Fed cannot currently make, nor should it be able to, as long as the Fed continues to seek to exist as a not entirely public institution. In particular, the very bank holding companies the Fed regulates are involved in the governance of the regional Federal Reserve Banks that are responsible for carrying out the regulatory mission of the Fed, and would if the current structure were untouched, be involved in deciding which member banks or bank holding companies would receive taxpayer funds in a crisis. These considerations also point out the tensions that exist between the Board of Governors of the Federal Reserve System's role as central banker, and the great importance of distance from the political process, and the necessity of political accountability and oversight once a body is charged with dispersing the public's money to private companies that are in trouble. That function must be executed publicly, and with clear oversight, or else there will be inevitable suspicions of favoritism that will be harmful to the political underpinnings of any stabilization effort. One benefit of a more collective approach to systemic risk monitoring is that the Federal Reserve Board could participate in such a body while having to do much less restructuring that would likely be problematic in terms of its monetary policy activity. On the issue of whether to identify and separately regulate systemically significant firms, another lesson of the last eighteen months is that the decision as to whether some or all of the investors and creditors of a financial firm must be rescued cannot be made in advance. In markets that are weak or panicked, a firm that was otherwise seen as not presenting a threat of systemic contagion might be seen as doing just that. Conversely, in a calm market environment, it maybe the better course of action to let a troubled firm go bankrupt even if it is fairly large. Identifying firms (ITAL)ex ante as systemically significant also makes the moral hazard problems much more intense. An area the Congressional Oversight Panel did not address explicitly is whether effective systemic risk management in a world of diversified institutions would require some type of universal systemic risk insurance program or tax. Such a program would appear to be necessary to the extent the federal government is accepting it may be in a position of rescuing financial institutions in the future. Such a program would be necessary both to cover the costs of such interventions and to balance the moral hazard issues associated with systemic risk management. However, there are practical problems defining what such a program would look like, who would be covered and how to set premiums. One approach would be to use a financial transactions tax as an approximation. The global labor movement has indicated its interest in such a tax on a global basis, in part to help fund global reregulation of financial markets. More broadly, these issues return us to the question of whether the dismantling of the approach to systemic risk embodied in the Glass-Steagall Act was a mistake. We would appear now to be in a position where we cannot wall off more risky activities from less risky liabilities like demand deposits or commercial paper that we wish to ensure. On the other hand, it seems mistaken to try and make large securities firms behave as if they were commercial banks. Those who want to maintain the current dominance of integrated bank holding companies in the securities business should have some burden of explaining how their securities businesses plan to act now that they have an implicit government guaranty. Finally, the AFL-CIO believes very strongly that the regulation of the shadow markets, and of the capital markets as a whole cannot be shoved into the category labeled ``systemic risk regulation,'' and then have that category be effectively a sort of night watchman effort. The lesson of the failure of the Federal Reserve to use its consumer protection powers to address the rampant abuses in the mortgage industry earlier in this decade is just one of several examples going to the point that without effective routine regulation of financial markets, efforts to minimize the risk of further systemic breakdowns are unlikely to succeed. We even more particularly oppose this type of formulation that then hands responsibility in the area of systemic risk regulation over to self-regulatory bodies. As Congress moves forward to address systemic risk management, one area that we believe deserves careful consideration is how much power to give to a body charged with systemic risk management to intervene in routine regulatory policies and practices. We strongly agree with Professor Coffee's testimony that a systemic risk regulator should not have the power to override investor or consumer protections. However, there are a range of options, ranging from power so broad it would amount to creating a single financial services superregulator, e.g., vesting such power in staff or a board chairman acting in an executive capacity, to arrangements requiring votes or supermajorities, to a system where the systemic risk regulator is more of scout than a real regulator, limited in its power to making recommendations to the larger regulatory community. The AFL-CIO would tend to favor a choice somewhere more in the middle of that continuum, but we think this is an area where further study might help policymakers formulate a well-founded approach. Finally, with respect to the jurisdiction and the reach of a systemic risk regulator, we believe it must not be confined to institutions per se, or products or markets, but must extend to all financial activity. In conclusion, the Congressional Oversight Panel's report lays out some basic principles that as a Panel member I hope will be of use to this Committee and to Congress in thinking through the challenges involved in rebuilding a more comprehensive approach to systemic risk. The AFL-CIO is very concerned that as Congress approaches the issue of systemic risk it does so in a way that bolsters a broader reregulation of our financial markets, and does not become an excuse for not engaging in that needed broader reregulation.AFL-CIO Executive Council Statement--Miami, Florida--March 5, 2009Bank Bailouts There has been a dramatic concentration of banking power since the Gramm-Leach-Bliley Act repealed New Deal bank regulation. More than 43 percent of U.S. bank assets are held by just four institutions: Citigroup, Bank of America, Wells Fargo and JPMorgan Chase. When these institutions are paralyzed, our whole economy suffers. When banks appear on the brink of collapse, as several have repeatedly since September, government steps in. The free market rules that workers live by do not apply to these banks. Since Congress passed financial bailout legislation in October, working people have seen our tax dollars spent in increasingly secretive ways to prop up banks that we are told are healthy, until they need an urgent bailout. In some instances, institutions that were bailed out need another lifeline soon after. The Congressional Oversight Panel, charged with overseeing the bailout, recently found that the Federal Government overpaid by $78 billion in acquiring bank stock. The AFL-CIO believes government must intervene when systemically significant financial institutions are on the brink of collapse. However, government interventions must be structured to protect the public interest, and not merely rescue executives or wealthy investors. This is an issue of both fairness and our national interest. It makes no sense for the public to borrow trillions of dollars to rescue investors who can afford the losses associated with failed banks. The most important goal of government support must be to get banks lending again by ensuring they are properly capitalized. This requires forcing banks to acknowledge their real losses. By feeding the banks public money in fits and starts, and asking little or nothing in the way of sacrifice, we are going down the path Japan took in the 1990s--a path that leads to ``zombie banks'' and long-term economic stagnation. The AFL-CIO calls on the Obama administration to get fair value for any more public money put into the banks. In the case of distressed banks, this means the government will end up with a controlling share of common stock. The government should use that stake to force a cleanup of the banks' balance sheets. The result should be banks that can either be turned over to bondholders in exchange for bondholder concessions or sold back into the public markets. We believe the debate over nationalization is delaying the inevitable bank restructuring, which is something our economy cannot afford. A government conservatorship of the banks has been endorsed by leading economists, including Nouriel Roubini, Joseph Stiglitz, and Paul Krugman. Even Alan Greenspan has stated it will probably be necessary. The consequences of crippled megabanks are extraordinarily serious. The resulting credit paralysis affects every segment of our economy and society and destroys jobs. We urge President Obama and his team to bring the same bold leadership to bear on this problem as they have to the problems of economic stimulus and the mortgage crisis.AFL-CIO Executive Council Statement--Miami, Florida--March 5, 2009Financial Regulation Deregulated financial markets have taken a terrible toll on America's working families. Whether measured in lost jobs and homes, lower earnings, eroding retirement security, or devastated communities, workers have paid the price for Wall Street's greed. But in reality, the cost of deregulation and financial alchemy are far higher. The lasting damage is in missed opportunities and investments not made in the real economy. While money poured into exotic mortgage-backed securities and hedge funds, our pressing need for investments in clean energy, infrastructure, education, and health care went unmet. So the challenge of reregulating our financial markets, like the challenge of restoring workers' rights in the workplace, is central to securing the economic future of our country and the world. In 2006, while the Bush administration was in the midst of plans for further deregulation, the AFL-CIO warned of the dangers of unregulated, leveraged finance. That call went unheeded as the financial catastrophe gathered momentum in 2007 and 2008, and now a different day is upon us. The costs of the deregulation illusion have become clear to all but a handful of unrepentant ideologues, and the public cast its votes in November for candidates who promised to end the era of rampant financial speculation and deregulation. In October, when Congress authorized the $700 billion financial bailout, it also established an Oversight Panel to both monitor the bailout and make recommendations on financial regulatory reform. The panel's report lays the foundation for what Congress and the Obama administration must do. First, we must recognize that financial regulation has three distinct purposes: (1) ensuring the safety and soundness of insured, regulated institutions; (2) promoting transparency in financial markets; and (3) guaranteeing fair dealing in financial markets, so investors and consumers are not exploited. In short, no gambling with public money, no lying and no stealing. To achieve these goals, we need regulatory agencies with focused missions. We must have a revitalized Securities and Exchange Commission (SEC), with the jurisdiction to regulate hedge funds, derivatives, private equity, and any new investment vehicles that are developed. The Commodity Futures Trading Commission should be merged with the SEC to end regulatory arbitrage in investor protection. Second, we must have an agency focused on protecting consumers of financial services, such as mortgages and credit cards. We have paid a terrible price for treating consumer protection as an afterthought in bank regulation. Third, we need to reduce regulatory arbitrage in bank regulation. At a minimum, the Office of Thrift Supervision, the regulator of choice for bankrupt subprime lenders such as Washington Mutual and IndyMac, should be consolidated with other federal bank regulators. Fourth, financial stability must be a critical goal of financial regulation. This is what is meant by creating a systemic risk regulator. Such a regulator must be a fully public agency, and it must be able to draw upon the information and expertise of the entire regulatory system. While the Federal Reserve Board of Governors must be involved in this process, it cannot undertake it on its own. We must have routine regulation of the shadow capital markets. Hedge funds, derivatives, and private equity are nothing new--they are just devices for managing money, selling insurance and securities, and engaging in the credit markets without being subject to regulation. As President Obama said during the campaign, ``We need to regulate institutions for what they do, not what they are.'' Shadow market institutions and products must be subject to transparency and capital requirements and fiduciary duties befitting what they are actually doing. Reform also is required in the incentives governing key market actors around executive pay and credit rating agencies. There must be accountability for this disaster in the form of clawbacks for pay awarded during the bubble. According to Bloomberg, the five largest investment banks handed out $145 billion in bonuses in the 5 years preceding the crash, a larger amount than the GDP of Pakistan and Egypt. Congress and the administration must make real President Obama's commitment to end short-termism and pay without regard to risk in financial institutions. The AFL-CIO recently joined with the Chamber of Commerce and the Business Roundtable in endorsing the Aspen Principles on Long-Term Value Creation that call for executives to hold stock-based pay until after retirement. Those principles must be embodied in the regulation of financial institutions. We strongly support the new SEC chair's effort to address the role played by weak boards and CEO compensation in the financial collapse. With regard to credit rating agencies, Congress must end the model where the issuer pays. Financial reregulation must be global to address the continuing fallout from deregulation. The AFL-CIO urges the Obama administration to make a strong and enforceable global regulatory floor a diplomatic priority, beginning with the G-20 meeting in April. The AFL-CIO has worked closely with the European Trade Union Congress and the International Trade Union Confederation in ensuring that workers are represented in this process. We commend President Obama for convening the President's Economic Recovery Advisory Board, chaired by former Federal Reserve Chair Paul Volcker, author of the G-30 report on global financial regulation, and we look forward to working with Chairman Volcker in this vital area. Reregulation requires statutory change, regulatory change, institutional reconstruction and diplomatic efforts. The challenge is great, but it must be addressed, even as we move forward to restore workers' rights and revive the economy more broadly. ______ CHRG-111hhrg53246--77 Mrs. Maloney," First, I would like to welcome our witnesses--particularly Mary Schapiro, a former constituent, a resident of New York; New Yorkers are very proud of your service and your current appointment--and to Gary Gensler, the Chairman, who was part of the Clinton team that brought us the longest period of economic expansion in our country's history of balanced budgets and surpluses. I am glad that you are back on the economic team. And welcome, it is good to see you again. First of all, I want to say that I truly believe that reforming the financial markets and system is the most important issue before our country. And getting it right will determine our economic growth and expansion for the next--probably 50 years. And I want to go on record in support of the many honest hardworking men and women in the financial services industry. Many people have made mistakes, and they feel like they are unjustly being attacked when they are trying very, very hard to be part of the solution and part of moving our economy forward. I also want to state how important financial services are in terms of our exports. Along with Boeing, it is one of the largest areas that we export goods and services that helps with our trade deficit. So moving forward in a correct way is tremendously important. I for one would like to wait until the report comes back from the Commission that we have put in place that will tell us what was really the problem, so that we can make sure we are addressing what is the thoughtful process of what caused the crisis. I truly believe the best chapter in government since I have been in Congress was the 9/11 Commission report that expertly pointed out what caused the problem, with concrete recommendations of what should be done. And I would like to see what this Commission has to say. But the first road map we saw was AIG. And it clearly showed markets were out of control. No one knew what was going on. At the beginning of the week, they said they didn't need help. By the end of the week, they needed $50 million. By the end of the weekend, they needed another $30 million, and then it just continued. Former Chairman Fuld testified before this committee on the Lehman disaster and crisis and said if he had one recommendation, it would be that there would be one central clearinghouse so that you had control of what your exposure is internationally and nationally so you understood the exposure. I don't think you are going to get that with capital requirements and margin requirements and leverage requirements. And my question, really to Mr. Gensler is, in these clearinghouses are you proposing one central clearinghouse, which is what he suggested, or several clearinghouses? And then what do you determine is going to be over the counter, what is going to be in a clearinghouse? But do we have one area where we are going to be able to track the exposure of investors and the economy of our country? " CHRG-111shrg57709--45 Mr. Volcker," These firms I just listed---- Senator Shelby. Yes, sir. " Mr. Volcker,"----were not commercial banks until they were given a commercial--a bank holding company in the midst of crisis. Senator Shelby. Right. Yes. " CHRG-111shrg55739--90 Mr. Froeba," In 1997, I left the tax group at Skadden, Arps in New York where I had been working in part on structured finance securities to join the CDO group at Moody's and I worked there for just over 10 years, all of that time in the CDO group. Since the beginning of the subprime crisis, there have been many proposals for rating agency reform. Most of them are well intentioned. However, few seem likely to accomplish real reform. Real reform, in my opinion, must achieve two clear policy goals. It must first prevent another rating-related financial crisis like the subprime crisis, and it must also restore investor confidence in the quality and reliability of credit ratings. In my opinion, the rating agency reform provisions of the Investor Protection Act of 2009 are not sufficient in themselves to accomplish either of these goals. However, the Act's rulemaking authority could be used to expand their effectiveness. Why are the reform provisions in themselves, in my opinion, insufficient? First, they are not the product of a complete investigation into what actually happened at the rating agencies. Without a proper investigation of what happened, not conducted on a theoretical level or in discussions with senior managers, but with the analysts who actually assigned the problem ratings in question, we cannot be sure the proposed legislation provides solutions designed to fix the problems. The best way to illustrate my second reason for questioning the sufficiency of this proposal is to ask you a simple question. If the Investor Protection Act of 2009 had been enacted just as it is 5 years ago, do you think it would have prevented the subprime crisis? In my opinion, the answer to this question is no. That does not mean that the proposals are bad, it just means that they do not advance what should be the central policy goal of reform, preventing a future crisis. If these proposals are uncertain to prevent a future crisis and restore confidence in credit ratings, what reforms could achieve these goals? I have, you will not be surprised to hear, six proposals, and I am going to speak really fast or skip some. First, put a firewall around rating analysis. The agencies have already separated their rating and nonrating businesses. This is fine, but not enough. The agencies must also separate the rating business from rating analysis. Investors need to believe that rating analysis generates a pure opinion about credit quality, not one even potentially influenced by business goals, like building market share. Even if business goals have never corrupted a single rating, the potential for corruption demands a complete separation of rating analysis from bottom-line analysis. Investors should see that rating analysis is kept safe from interference by any agenda other than getting the answer right, and the best reform proposal will exclude business managers from involvement in any aspect of rating analysis and critically also from any role in decisions about analyst pay, performance, or promotions. Second, prohibit employee stock ownership and change the way rating analysts are compensated. There is a reason why we don't want judges to have a stake in the matters before them, and it is not just to make sure judges are fair. We do this so litigants have confidence in the system and trust its results. We do this even if some or all judges could decide cases fairly without such a rule. The same should be true for ratings. Even if employee stock ownership has never actually affected a single rating, it provokes doubt that the ratings are disinterested and undermines investor confidence. Investors should have no cause to question whether the interests of rating agency employees align more closely with agency shareholders than investors. Reform should ban all forms of employee stock ownership, direct and indirect, by anyone involved in rating analysis. The same concerns arise with respect to annual bonus compensation and 401(k) contributions. As long as these forms of compensation are allowed to be based upon how well the company performs and are not limited to how well the analyst performs, there will always be doubts about how the rating analyst's interests align. Third, create a remedy for unreasonably bad ratings. Essentially, expand the liability of the agencies. I am going to skip my discussion of that because some of that discussion has already occurred. My fourth proposal is to change the antitrust laws so agencies can cooperate on standards. When rating agencies compete over rating standards, everybody loses. Giving them the capacity to get together to talk about rating standards may expand our ability to prevent the kind of problems that we have had. Imagine how different the world would be today if the agencies could have joined forces 3 years ago to refuse to securitize the worst of the subprime mortgages. My other proposals are to create an independent professional organization for rating analysts, and also to introduce investor-pay incentives into the issuer-pay framework, neither of which I have time to discuss, but they are described in my statement. Thank you. Senator Reed. Thank you very much, Mr. Froeba. Thank you all. This has been a very, I think, informative panel. Let me pose a question to all the panel members. I think I know Dr. White's answer. [Laughter.] Senator Reed. The Investor Working Group chaired by former SEC Chairman Donaldson and Arthur Levitt has recommended that myriad statutes and rules that require a certain investor to hold only securities with specific ratings should be eliminated over time to clarify that reliance on a rating does not satisfy due diligence efforts. I think Secretary Barr suggested that in one of his responses, and this is an issue, frankly, that Senator Bunning has raised directly, which is the reliance on these ratings, and the Secretary suggests that on a case by case, they were going to walk through the statutes. Just your reaction, Mr. Joynt, and down the line. " fcic_final_report_full--436 These are related but different problems. While many involve the word “deriva- tive,” it is a mistake to bundle them together and say, “Derivatives or CDOs caused the crisis.” In each case, we assign responsibility for the failures to the people and in- stitutions rather than to the financial instruments they used. Conclusions: Rather than “derivatives and CDOs caused the financial crisis,” it is more accurate to say: • Securitizers lowered credit quality standards; • Mortgage originators took advantage of this to create junk mortgages; • Credit rating agencies assigned overly optimistic ratings; • Securities investors and others failed to perform sufficient due diligence; • International and domestic regulators encouraged arbitrage toward lower capi- tal standards; • Some investors used these securities to concentrate rather than diversify risk; and • Others used synthetic CDOs to amplify their housing bets. CHRG-111hhrg54868--16 Mr. Dugan," Chairman Frank, Ranking Member Bachus, and members of the committee, I appreciate this opportunity to continue where we left off last time in discussing the Treasury Department's proposal for regulatory reform. As I testified in July, the OCC supports many elements of the proposal, including the establishment of a council of financial regulators to identify and monitor systemic risk and enhanced authority to resolve systemically significant financial firms. We also believe it would be appropriate to extend consolidated supervision to all systemically significant financial firms. The Federal Reserve already plays this role for the largest bank holding companies, but during the financial crisis, the absence of a comparable supervisor for large securities and insurance firms proved to be an enormous problem. The proposal would fill this gap by extending the Federal Reserve's holding company regulation to such firms which we believe would be appropriate. However, one aspect of the proposal goes much too far, which is to grant broad new authority to the Federal Reserve to override the primary banking supervisor on standards, examination, and enforcement applicable to the bank. Such override power would alter our present working relationship with the Federal Reserve that works very well and fundamentally undermine the authority and accountability of the banking supervisor. We also support the imposition of more stringent capital and liquidity standards on systemically significant financial firms. This would help address their heightened risk to the system and mitigate the competitive advantage they could realize from being designated as systemically significant. Similarly, the OCC supports the proposals calling for more forward-looking loan loss provisioning, which is an issue that I have spent a great deal of time on as co-Chairman of the Financial Stability Board's Working Group on Provisioning. Unfortunately, our current system unacceptably discourages banks from building reserves during good times when they can most afford it, and requires them to take larger provisions for loan losses during downturns when it weakens vulnerable banks and inhibits needed lending. And we support the proposal to effectively merge the OTS into the OCC. Finally, we support enhanced consumer financial protection standards and believe that a dedicated consumer protection agency, the CFPA, could help achieve that goal. However, we have significant concerns with the parts of the proposed CFPA that would consolidate all financial consumer protection rulewriting, examination, and enforcement in one agency, which would completely divorce these functions from safety and soundness regulation. It makes sense to consolidate all consumer protection rulewriting in a single agency with the rules applying to all financial providers of a product, both bank and nonbank, but we believe the rules must be uniform, and that banking supervisors must have meaningful input into formulating them, and unfortunately, the proposed CFPA falls short on two counts. First, the rules would not be uniform because the proposal would expressly authorize States to adopt different rules for all financial firms, including national banks, by repealing the Federal preemption that has always allowed national banks to operate under uniform Federal standards. This repeal of the uniform Federal standards option is a radical change that will make it far more difficult and costly for national banks to provide financial services to consumers in different States having different rules, and these costs will ultimately be borne by the consumer. The change will also undermine the national banking charter and the dual banking system that has served us well for nearly 150 years. Second, the rules do not afford meaningful input from banking supervisors, even on real safety and soundness issues, because in the event of any dispute, the proposed CFPA would always win. The new agency needs to have a strong mechanism for ensuring meaningful bank supervisor input into the CFPA rulemaking. Finally, the banking agencies should continue to be responsible for examination and enforcement, not the CFPA. I believe there are real benefits to an integrated approach to consumer compliance and safety and soundness exams, a process that I think has worked well over time. Moreover, moving bank examination and enforcement functions to the CFPA would only distract it from its most important and most daunting implementation challenge, which is establishing an effective enforcement regime for the shadow banking system of the tens of thousands of nonbank providers that are currently unregulated or lightly regulated, like nonbank mortgage brokers and originators. We believe the CFPA's resources should be focused on this fundamental regulatory gap rather than on already regulated depository institutions. Thank you. [The prepared statement of Comptroller Dugan can be found on page 98 of the appendix.] " 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-111shrg56376--59 Mr. Tarullo," Well, I actually think, as Sheila suggested early in the hearing, that what we have learned in this crisis is that there were lots of different models of supervision and regulation around the world, and none of them performed particularly well. And that seemed to me more of a lesson than anything about a particular structure or anything else. None of them performed particularly well. Senator Tester. OK. Go ahead. " FinancialCrisisInquiry--211 So – Do I understand what you’re saying is that the Wall Street banks are now calling for more regulation, which you think are going to redound to the detriment of the community banks who already are adequately regulated. CLOUTIER: Correct. I mean, you know, one example is if they had to live with my capital levels. I had 12 percent capital. When I heard them talk about their capital levels here earlier today, I wondered how in the world they got away with that. Because I guarantee you, if I walked and told my regulator I was going to have 6 percent capital, I’d have a C&D in the morning on my desk. You know, it’s an unfair system. So when they say send more regulation, more regulation only means that’s more stuff that I don’t have to worry about and that’s an easy way to go out the back door. You know, when we had the crisis at Enron, they passed—which by the way, Citicorp and them were deeply involved in. You know, they paid big fines for. It didn’t affect them at all. It was crushing to small business. It was a crushing event. Gramm-Leach-Bliley, when they changed the rules, it didn’t affect them. It affected us. So more regulation usually doesn’t have much effect. My question is, and the question this commission should ask: Why wasn’t the regulations on the books enforced? And then that would be an amazing question to ask. And I think most of the answer is is that they’re a member of the FAC they’re very closely interlinked into the Washington circles. GRAHAM: Ms. Gordon, you made some very strong statements about the fact that there was a preference given to the worst mortgages and actual economic incentives to create harsh conditions and possibly overprice to the consumer mortgages. What is—do you have some evidence to substantiate those charges? 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? " fcic_final_report_full--507 Up to this point, we have seen that HUD’s policy was to reduce underwriting standards in order to make mortgage credit more readily available to low-income borrowers, and that Fannie and Freddie not only took the AH goals seriously but were willing to go to extraordinary lengths to make sure that they met them. Nevertheless, it seems to have become an accepted idea in some quarters— including in the Commission majority’s report—that Fannie and Freddie bought large numbers of subprime and Alt-A loans between 2004 and 2007 in order to recover the market share they had lost to subprime lenders such as Countrywide or Wall Street, or to make profits. Although there is no evidence whatever for this belief—and a great deal of evidence to the contrary—it has become another urban myth, repeated so often in books, blogs and other media that it has attained a kind of reality. 103 The formulations of the idea vary a bit. As noted earlier, HUD has claimed— absurdly, in light of its earlier efforts to reduce mortgage underwriting standards— that the GSEs were “chasing the nonprime market” or “chasing market share and profits,” principally between 2004 and 2007. The inference, all too easily accepted, is that this is another example of private greed doing harm, but it is clear that HUD was simply trying to evade its own culpability for using the AH goals to degrade the GSEs’ mortgage underwriting standards over the 15 year period between 1992 and 2007. The Commission majority also adopted a version of this idea in its report, blaming the GSEs’ loosening of their underwriting standards on a desire to please stock market analysts and investors, as well as to increase management compensation. None of HUD’s statements about its efforts to reduce underwriting standards managed to make it into the Commission majority’s report, which relied entirely on the idea that the GSEs’ underwriting standards were reduced by their desire to “follow Wall Street and other lenders in [the] rush for fool’s gold.” These claims place the blame for Fannie and Freddie’s insolvency—and the huge number of low quality mortgages in the U.S. financial system immediately prior to the financial crisis—on the firms’ managements. They absolve the government, particularly HUD, from responsibility. The GSEs’ managements made plenty of mistakes—and won’t be defended here—but taking risks to compete for market share was not something they actually did. Because of the AH goals, Fannie and 103 See, e.g., Barry Ritholtz, “Get Me ReWrite!” in Bailout Nation, Bailouts, Credit, Real Estate, Really, Really Bad Calls , May 13, 2010, http://www.ritholtz.com/blog/2010/05/rewriting-the-causes-of-the- credit-crisis/print/ ; Dean Baker, “NPR Tells Us that Republicans Believe that Fannie and Freddie Caused the Crash” Beat the Press Blog, Center for Economic and Policy Research http://www.cepr.net/index.php/ blogs/beat-the-press/npr-tells-us-that-republicans-believe-that-fannie-and-freddie-caused-the-crash ; Charles Duhigg, “Roots of the Crisis,” Frontline , Feb 17, 2009, http://www.pbs.org/wgbh/pages/frontline/ meltdown/themes/howwegothere.html . 503 fcic_final_report_full--240 Mark-to-market write-downs were required on many securities even if there were no actual realized losses and in some cases even if the firms did not intend to sell the securities. The charges reflecting unrealized losses were based, in part, on credit rat- ing agencies’ and investors’ expectations that the mortgages would default. But only when those defaults came to pass would holders of the securities actually have real- ized losses. Determining the market value of securities that did not trade was diffi- cult, was subjective, and became a contentious issue during the crisis. Why? Because the write-downs reduced earnings and capital, and triggered collateral calls. These mark-to-market accounting rules received a good deal of criticism in re- cent years, as firms argued that the lower market prices did not reflect market values but rather fire-sale prices driven by forced sales. Joseph Grundfest, when he was a member of the SEC’s Committee on Improvements to Financial Reporting, noted that at times, marking securities at market prices “creates situations where you have to go out and raise physical capital in order to cover losses that as a practical matter were never really there.”  But not valuing assets based on market prices could mean that firms were not recording losses required by the accounting rules and therefore were overstating earnings and capital. As the mortgage market was crashing, some economists and analysts estimated that actual losses, also known as realized losses, on subprime and Alt-A mortgages would total  to  billion;  so far, by , the figure has turned out not to be much more than that. As of year-end , the dollar value of all impaired Alt-A and subprime mortgage–backed securities total about  billion.  Securities are im- paired when they have suffered realized losses or are expected to suffer realized losses imminently. While those numbers are small in relation to the  trillion U.S. economy, the losses had a disproportionate impact. “Subprime mortgages themselves are a pretty small asset class,” Fed Chairman Ben Bernanke told the FCIC, explaining how in  he and Treasury Secretary Henry Paulson had underestimated the repercussions of the emerging housing crisis. “You know, the stock market goes up and down every day more than the entire value of the subprime mortgages in the country. But what created the contagion, or one of the things that created the conta- gion, was that the subprime mortgages were entangled in these huge securitized pools.”  The large drop in market prices of the mortgage securities had large spillover ef- fects to the financial sector, for a number of reasons. For example, as just discussed, when the prices of mortgage-backed securities and CDOs fell, many of the holders of those securities marked down the value of their holdings—before they had experi- enced any actual losses. In addition, rather than spreading the risks of losses among many investors, the securitization market had concentrated them. “Who owns residential credit risk?” two Lehman analysts asked in a September  report. The answer: three-quarters of subprime and Alt-A mortgages had been securitized—and “much of the risk in these securitizations is in the investment-grade securities and has been almost en- tirely transferred to AAA collateralized debt obligation (CDO) holders.”  A set of large, systemically important firms with significant holdings or exposure to these se- curities would be found to be holding very little capital to protect against potential losses. And most of those companies would turn out to be considered by the authori- ties too big to fail in the midst of a financial crisis. FinancialCrisisInquiry--166 WALLISON: The buyers, the customers. GM, for example—GM was saved. Were there externalities if GM had failed? MAYO: I’m the one who said I don’t think the prudent should subsidize the imprudent. WALLISON: Right. Exactly. MAYO: How you define that is not always easy. I feel like we’ve overdone it, though. WALLISON: OK. I want to—I’d like to go into some other things. Mr. Bass, you laid a lot of the losses in the financial crisis on the question of derivatives, presumably, credit-default swaps. How then do you explain why the credit-default swap market continued to function throughout the entire financial crisis without any obvious disruption of any kind even after Lehman failed? BASS: There are three parts to the derivatives market—the OTC derivatives market the way I think about it. There’s the CDS marketplace... CHAIRMAN ANGELIDES: Excuse me, Mr. Bass. Yield the gentleman an additional two minutes. WALLISON: OK. CHRG-110hhrg46595--29 The Chairman," The gentlewoman from Florida for 1\1/2\ minutes. Ms. Brown-Waite. Thank you, Mr. Chairman. Several weeks ago when you were here, we were thinking of Christmas and the three wise men. Your method of transportation proved that you were the three wise guys. I am glad to see that you have turned into the three wise men in choosing your own products as a method of transportation here. You are here to tell us that after a decade of declining sales volume, if it weren't for the financial crisis, consumers would be buying the cars from Detroit over the competition. However, the current crisis facing Detroit is not one created from short-term problems beyond your control, rather the crisis facing you all comes from long-term problems of overcapacity, poor corporate governance, and a lack of foresight. To be fair, Ford did have the foresight to make preparations for the future. General Motors and Chrysler, though, ignored their liquidity problems, probably planning to come to Congress rather than taking an objective look at reality. You all continue to act with negligent disregard toward your duty to plan for future emergencies. As a result, today we have over 3 million jobs at risk. Fortunately, the $34 billion that you are asking for today is obviously more than what you asked for the last time and probably less than what everyone feels you will be coming back for within a reasonable period of time. That is pretty sad. As we learned with AIG, these situations can spiral out of control, and despite the recent lessons, some of my colleagues want to do for Detroit what already has been done for AIG. Mr. Chairman, thank you for holding this hearing. I look forward to hearing from the witnesses. " CHRG-110hhrg46596--495 Mrs. Maloney," The gentleman's time has expired. I would like to be associated with the remarks of my colleague that underscores that, from the beginning, many members of this committee and in the Joint Economic Committee called upon Treasury to recapitalize the financial system, to protect the equity of taxpayers' funds with preferred stock, and that this was an alternative or the goal of many European countries during this crisis. The number-one question that I am asked--and I would like to conclude the hearing with this. I voted for the bailout because the Secretary of the Treasury and the Chairman of the Federal Reserve said that, if we did not vote for this bailout, or this rescue plan, that we would not stabilize our markets, that we confronted a possible failure of our financial institutions, and, really, the alternative was unacceptable, and the pain and suffering of taxpayers, our constituents, and the American public would be far greater. Yet the questions that are raised at this hearing today, that are continually raised by the press, or some of the press, and by the general public is that the rescue plan was not needed. Given the advantage of your position and what you continue to do and the startling fact that one weekend we had four investment banks, at the end of the weekend there were none remaining, and the fact that some of our major and most respected banks have failed or been forced into merger, I would like to ask the most often asked question I receive, whether it is in the grocery store, on the street, or from major media. What would have happened to our great country if this Congress had not supported the President of the United States and the Secretary of the Treasury, who called upon us to react with assistance to our financial institutions? I would like both of you to respond, starting with you, Mr. Kashkari. " CHRG-111shrg52619--204 RESPONSE TO WRITTEN QUESTIONS OF SENATOR KOHL FROM SCOTT M. POLAKOFFQ.1. Two approaches to systemic risk seem to be identified: (1) monitoring institutions and taking steps to reduce the size/activities of institutions that approach a ``too large to fail'' or ``too systemically important to fail'' or (2) impose an additional regulator and additional rules and market discipline on institutions that are considered systemically important. Which approach do you endorse? If you support approach one how you would limit institution size and how would you identify new areas creating systemic importance? If you support approach two how would you identify systemically important institutions and what new regulations and market discipline would you recommend?A.1. OTS endorses the establishment of a systemic risk regulator with broad authority, including regular monitoring, over companies that if, due to the size or interconnected nature of their activities, their actions or their failure would pose a risk to the financial stability of the country. Such a regulator should be able to access funds, which would present options to resolve problems at these institutions. The systemic risk regulator should have the ability and the responsibility for monitoring all data about markets and companies including, but not limited to, companies involved in banking, securities, and insurance. Any systemic regulator should have all of the authority necessary to supervise institutions and companies especially in a crisis situation, but this regulator would be in addition to the functional regulator. The systemic risk regulator would not have supervisory authority over nonsystemically important banks. However, the systemic risk regulator would need access to data regarding the health and activities of these institutions for purposes of monitoring trends and other matters influencing monetary policy. In addition, the systemic risk regulator would be charged with coordination of supervision of conglomerates that have international operations. The safety and soundness standards including capital adequacy and other measurable factors should be as comparable as possible for entities that have multinational businesses. The ability of banks and other entities in the United States to compete in today's global financial services market place is critical. The identification of systemically important entities would be accomplished by looking at those entities whose business is so interconnected with the financial services market that its failure would have a severe impact on the market generally. Any systemic risk regulator would have broad authority to monitor the market and products and services offered by a systemically important entity or that dominate the market. Important additional regulations would include additional requirements for transparency regarding the entity and the products. Further, such a regulator would have the authority to require additional capital commensurate with the risks of the activities of the entity and would monitor liquidity with the risks of the activities of the entity. Finally, such a regulator would have authority to impose a prompt corrective action regime on the entities it regulates.Q.2. Please identify all regulatory or legal barriers to the comprehensive sharing of information among regulators including insurance regulators, banking regulators, and investment banking regulators. Please share the steps that you are taking to improve the flow of communication among regulators within the current legislative environment.A.2. The most significant barrier to disclosure is that if a regulator discloses confidential supervisory information to another regulator, the disclosure could lead to further, unintended disclosure to other persons. Disclosure to another regulator raises two significant risks: the risk that information shared with the other regulator will not be maintained confidential by that regulator, or that legal privileges that apply to the information will be waived by sharing. The regulator in receipt of the information may not maintain confidentiality of the information because the regulator is required by law to disclose the information in certain circumstances or because the regulator determines that it is appropriate to do so. For example, most regulators in the United States or abroad may be required to disclose confidential information that they received from another supervisor in response to a subpoena related to litigation in which the regulator may or may not be a party. While the regulator may seek to protect the confidentiality of the information that it received, the court overseeing the litigation may require disclosure. In addition, the U.S. Congress and other legislative bodies may require a regulator to disclose confidential information received by that regulator from another regulator. Moreover, if a regulator receives information from another regulator that indicates that a crime may have been committed, the regulator in receipt of the information may provide the information to a prosecutor. Other laws may require or permit a regulator in receipt of confidential information to disclose the information, for example, to an authority responsible for enforcement of anti-trust laws. These laws mean that the regulator that provides the information can no longer control disclosure of it because the regulator in receipt of the information cannot guarantee that it will not disclose the information further. With respect to waiver of privileges through disclosure to another regulator, legislation provides only partial protection against the risk that legal privileges that apply to the information will be waived by sharing. When privileged information is shared among covered U.S. federal agencies, privileges are not waived. 12 U.S.C. 1821(t). This statutory protection does not, however, extend to state regulators (i.e., insurance regulators) or foreign regulators. To reduce these risks, OTS has information-sharing arrangements with all but one state insurance regulator, 16 foreign bank regulators, and one foreign insurance regulator. (Some of these foreign bank regulators may also regulate investment banking or insurance.) OTS is in the process of negotiating information-sharing arrangements with approximately 20 additional foreign regulators. OTS also shares information with regulators with which it does not have an information-sharing arrangement on a case-by-case basis, subject to an agreement to maintain confidentiality and compliance with other legal requirements. See 12 U.S.C. 1817(a)(2)(C), 1818(v), 3109(b); 12 C.F.R. 510.5. In terms of practical steps to ensure a robust flow of communication, OTS, as part of its supervisory planning, identifies foreign and functional regulators responsible for major affiliates of its thrifts and maintains regular contact with them. This interaction includes phone and e-mail communication relating to current supervisory matters, as well as exchanging reports of examination and other supervisory documentation as appropriate. With its largest holding companies, OTS sponsors an annual supervisory conference to which U.S. and foreign regulators are invited to discuss group-wide supervisory issues. ------ CHRG-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-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. " FOMC20080625meeting--325 323,CHAIRMAN BERNANKE.," Okay. If there are no other pressing comments, thank you very much for this discussion. I heard general support for the short-term strategy, which means, I hope, that if we do come to ask you for an extension of the TSLF we can do it by notation vote without a videoconference meeting, unless things change. There clearly is a lot of dissatisfaction among all of us about the ad hoc nature of the way we had to deal with the crisis in March. We would all like much more clarity about our authorities, the limit of those authorities, and the match between our responsibilities and our authorities; and, as we go forward, we will try to get clarification on that. At the same time, we also want to take steps to try to increase the resilience of the system and reduce the risk that we will be in the same situation again in the future. I will try to vet my speech. I don't want to overpromise. It has to be done over the Fourth of July weekend, so I expect everyone to be available 24/7 for commentary. [Laughter] But I will generally be talking about things that we are doing. I will talk only in general terms about some of the principles that we have discussed today about the need for clarification about how to resolve a troubled institution, how to set those limits, and so on. But I will try to circulate that, to the extent that it is feasible. Let's see, our next meeting is Tuesday, August 5. You are invited to get lunch and come back to the table to hear Laricke Blanchard's update on congressional matters. If you have any revisions to your economic projections, you have until 5:00 p.m. tomorrow to send those in. And I want to thank--I haven't done this--Art, Scott, Pat, and all of their colleagues, who have been working very hard on these issues, for their presentation and their hard work. The meeting is adjourned. END OF MEETING" 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. ______ FinancialCrisisInquiry--98 I would like to ask your opinion of the role that over-the- counter derivatives played in causing or contributing to the financial crisis. BLANKFEIN: Now, I think people will have—may have different opinions about this, but I would say that the aspects of the over-the- counter derivative market was a very, very big concern and a big worry, so much so that a lot of institutions—all of the institutions here, I believe—were working very, very hard to make sure that the plumbing—that things would settle, that things would clear, and that we started the process of creating these clearinghouses well in advance of this particular crisis and really glad that we do. I mean, this was highly publicized. The Federal Reserve of New York created a program to get people to just make sure that confirms were done well. And that was a very big concern. As it turns out, my belief is that the derivatives market functioned—over-the-counter derivatives market functioned, actually, pretty well under the circumstances. Now, the risks that may have been embedded to the extent that they had credit in them, people made bad credit decisions because of—and so—and some of those credit decisions were taken in derivatives. Some were taken in terms of securities. But the derivatives market itself actually worked better, I think, than we had a right to expect. And if you could call anything lucky in the crisis, I think it was that it worked so well. So for example, Fannie, Freddie, Lehman, WaMu all had big events of default with huge numbers of offsetting but, clearly, people were taking credit risks with each other, offsetting derivatives on those credits. They settled and they cleared. And in the benefit of hindsight, that means people were able to hedge their risk, lay off risks, protect themselves. And it was—it worked very well; better than I would have thought. fcic_final_report_full--457 SUMMARY Although there were many contributing factors, the housing bubble of 1997- 2007 would not have reached its dizzying heights or lasted as long, nor would the financial crisis of 2008 have ensued, but for the role played by the housing policies of the United States government over the course of two administrations. As a result of these policies, by the middle of 2007, there were approximately 27 million subprime and Alt-A mortgages in the U.S. financial system—half of all mortgages outstanding—with an aggregate value of over $4.5 trillion. 4 These were unprecedented numbers, far higher than at any time in the past, and the losses associated with the delinquency and default of these mortgages fully account for the weakness and disruption of the financial system that has become known as the financial crisis. Most subprime and Alt-A mortgages are high risk loans. A subprime mortgage is a loan to a borrower who has blemished credit, usually signified by a FICO credit score lower than 660. 5 Typically, a subprime borrower has failed in 4 Unless otherwise indicated, all estimates for the number of subprime and Alt-A mortgages outstanding, as well as the use of specific terms such as loan to value ratios and delinquency rates, come from research done by Edward Pinto, a resident fellow at the American Enterprise Institute. Pinto is also a consultant to the housing finance industry and a former chief credit offi cer of Fannie Mae. Much of this work is posted on both my and Pinto’s scholar pages at AEI as follows: http://www.aei.org/docLib/Pinto-Sizing- Total-Exposure.pdf , which accounts for all 27 million high risk loans; http://www.aei.org/docLib/ Pinto-Sizing-Total-Federal-Contributions.pdf , which covers the portion of these loans that were held or guaranteed by federal agencies and the four large banks that made these loans under CRA; and http:// www.aei.org/docLib/Pinto-High-LTV-Subprime-Alt-A.pdf , which covers the acquisition of these loans by government agencies from the early 1990s. The information in these memoranda is fully cited to original sources. These memoranda were the data exhibits to a Pinto memorandum submitted to the FCIC in January 2010, and revised and updated in March 2010 (collectively, the “Triggers memo”). 5 One of the confusing elements of any study of the mortgage markets is the fact that the key definitions have never been fully agreed upon. For many years, Fannie Mae treated as subprime loans only those that it purchased from subprime originators. Inside Mortgage Finance , a common source of data on the mortgage market, treated and recorded as subprime only those loans reported as subprime by the originators or by Fannie and Freddie. Other loans were recorded as prime, even if they had credit scores that would have classified them as subprime. However, a FICO credit score of less than 660 is generally regarded as a subprime loan, no matter how originated. That is the standard, for example, used by the Offi ce of the Comptroller of the Currency. In this statement and in Pinto’s work on this issue, loans that are classified as subprime by their originators are called “self-denominated” subprime loans, and loans to borrowers with FICO scores of less than 660 are called subprime by characteristic. Fannie and Freddie reported only a very small percentage of their loans as subprime, so in effect the subprime loans acquired by Fannie and Freddie should be added to the self-denominated subprime loans originated by others in order to derive something closer to the number and principal amount of the subprime loans outstanding in the financial system at any given time. One of the important elements of Edward Pinto’s work was to show that Fannie and Freddie, for many years prior to the financial crisis, were buying loans that should have been classified as subprime because of the borrowers’ credit scores and not simply because they were originated by subprime lenders. Fannie and Freddie did not do this until after they were taken over by the federal government. This lack of disclosure on the part of the GSEs appears to have been a factor in the failure of many market observers to foresee the potential severity of the mortgage defaults when the housing bubble deflated in 2007. 451 the past to meet other financial obligations. Before changes in government policy in the early 1990s, most borrowers with FICO scores below 660 did not qualify as prime borrowers and had diffi culty obtaining mortgage credit other than through the Federal Housing Administration (FHA), the government’s original subprime lender, or through a relatively small number of specialized subprime lenders. An Alt-A mortgage is one that is deficient by its terms. It may have an adjustable rate, lack documentation about the borrower, require payment of interest only, or be made to an investor in rental housing, not a prospective homeowner. Another key deficiency in many Alt-A mortgages is a high loan-to-value ratio—that is, a low downpayment. A low downpayment for a home may signify the borrower’s lack of financial resources, and this lack of “skin in the game” often means a reduced borrower commitment to the home. Until they became subject to HUD’s affordable housing requirements, beginning in the early 1990s, Fannie and Freddie seldom acquired loans with these deficiencies. 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 . FinancialCrisisInquiry--15 Our economy needs financial institutions of all sizes, business models and areas of expertise to promote economic stability, job creation and customer service. America’s largest companies operate around the world and employ millions of people. These firms need banking partners to operate globally, who offer a full range of products and services and provide financing in billions of dollars. But let me be clear. As I’ve said before, no institution, including our own, should be too big to fail. We need a regulatory system that provides for even the largest financial firms to be allowed to fail in a way that did not put taxpayers or the broader economy at risk. Shareholders, management and unsecured creditors should bear the full cost of failure. The great strength of any organization—indeed, our country—lies in our ability to face problems, to learn from our experiences and to make necessary changes. I would like to thank the commission for their contribution to this process and commitment to identifying the causes of the crisis. We stand ready to assist the commission in any way we can. Thank you for the opportunity to testify before you today. CHAIRMAN ANGELIDES: Thank you very much, Mr. Dimon. Mr. Mack? MACK: I’m ready to go. Chairman Angelides, Vice Chairman Thomas, distinguished commissioners, my name is John Mack. I’m the chairman of Morgan Stanley. I also served as Morgan Stanley’s CEO from June of 2005 to ‘09. And I’m pleased to have the opportunity to address you today. CHRG-111hhrg53248--179 Mr. Dugan," Thank you, Mr. Kanjorski, Ranking Member Bachus, and members of the committee. I appreciate this opportunity to discuss the Administration's comprehensive proposal for reforming the regulation of financial services. The OCC supports many elements of the proposal, including the establishment of a Council of Financial Regulators to identify and monitor systemic risk. We believe that having a centralized and formalized mechanism for gathering and sharing systemically significant information and making recommendations to individual regulators makes good sense. We also support enhanced authority to resolve systemically significant financial firms. The FDIC currently has broad authority to resolve systemically significant banks in an orderly manner, but no comparable resolution authority exists for systemically significant holding companies of either banks or non-banks. The proposal would appropriately extend resolution authority like the FDIC's to such companies. We also believe it would be appropriate to designate the Federal Reserve Board as the consolidated supervisor of all systemically significant financial firms. The Board already plays this role with respect to the largest bank holding companies. In the financial crisis of the last 2 years, the absence of a comparable authority with respect to large securities and insurance firms proved to be an enormous problem. The proposal would fill this gap by extending the Federal Reserve's holding company regulation to such firms. However, one aspect of this part of the proposal goes much too far, which is to grant broad new authority to the Federal Reserve to override the banking supervisor on standards, examination, and enforcement applicable to the bank. Such override power would undermine the authority and the accountability of the banking supervisor. We also support the imposition of more stringent capital and liquidity standards on systemically significant firms. This would help address the heightened risk to the system and mitigate the competitive advantage they could realize from being designated as systemically significant. And we support the proposal to effectively merge the OTS into the OCC with a phaseout of the Federal thrift charter. However, it is critical that the resulting agency be independent from the Treasury Department and the Administration to the same extent that the OCC and the OTS are currently independent. Finally, we support enhanced consumer protection standards for financial services providers and believe that an independent agency like the proposed CFPA could achieve that goal. However, we do have significant concerns with some elements of the proposed CFPA stemming from its consolidation of all financial consumer protection, rule writing, examination, and enforcement in one agency, which would completely and inappropriately divorce all these functions from the comparable safety and soundness functions at the Federal banking agencies. I believe it makes sense to consolidate all consumer protection rule writing in a single agency with the rules applying to all financial providers of a product, both bank and non-bank, but we believe the rules must be uniform and that banking supervisors must have meaningful input into formulating these rules. Unfortunately, the proposed CFPA falls short on both counts. First, the rules would not be uniform, because the proposal would expressly authorize States to adopt different rules for all financial firms, including national banks, by repealing the Federal preemption that has always allowed national banks to operate under uniform Federal standards. This repeal of the uniform Federal standards option is a radical change that will make it far more difficult and costly for national banks to provide financial services to consumers in different States having different rules, and these costs will ultimately be borne by the consumer. The change will also undermine the national banking charter and the dual banking system that has served us very well for nearly 150 years in which national banks operate under uniform Federal Rules and States are free to experiment with different rules for the banks they charter. Second, the rules do not afford meaningful input from banking supervisors, even on real safety and soundness issues, because in the event of any disputes, the proposed CFPA would always win. That should be changed by allowing more banking supervisors on the board of the CFPA and by providing a formal mechanism for banking supervisor input into CFPA rulemaking. Finally, the CFPA should not take examination and enforcement responsibilities away from the banking agencies. The current banking regime works well, where the integration of consumer compliance and safety and soundness supervision provides real benefits for both functions. Real life examples attached to my testimony demonstrate how this works. To the extent the banking agencies have been criticized for consumer protection supervision, the fundamental problem has been with the lack of timely and strong rules, which the CFPA would address, and not the enforcement of those rules. Moreover, moving these bank supervisory functions to the CFPA would only distract it from its most important and daunting implementation challenge, establishing an effective examination and enforcement regime for the shadow banking system of the tens of thousands of non-bank providers that are currently unregulated or lightly regulated, like the non-bank mortgage brokers and originators that were at the heart of the subprime mortgage problem. CFPA's resources should be focused on this fundamental regulatory gap, rather than on already-regulated depository institutions. Thank you very much. [The prepared statement of Comptroller Dugan can be found on page 106 of the appendix.] " FinancialCrisisInquiry--560 BASS: Yes. Just with one small caveat. Back pre-crisis, there are two margins. There’s the initial margin, and then there’s the variance margin that you’re required to post if that specific security moves against you. So they are marked to market every day with counter parties. January 13, 2010 So what’s happened post-crisis, there’s still no initial margin to the best of my knowledge. Now, maybe between some dealers, there is. Between the big ones, to the best of my knowledge, there isn’t. They’ve just narrowed the bands of variance margin. The variance margin bands used to be wide enough to drive a truck through, and now they’re much narrower. So you can be on the hook for $5 million or $10 million before they force you to post it. And now, maybe it went from $5 million or $10 million to $1 million, but you’re still not posting any initial collateral. So theoretically, you could take very, very large positions and not be recognized or noticed until it starts moving against you. CHRG-111hhrg46820--121 Mr. Merski," That is a very good question. And the programs--the capital purchase program and the TALF that you were instrumental in jump-starting are going to help, but the banking sector has already written off about $700 billion in real estate value that they will not be paid back on. So if you think about the economics of it, about 60 percent of all small business lending is backed up by some sort of real estate collateral. And, as we pointed out in our testimony, unless you stem this decline in real estate values, whether it is commercial real estate or individual's homes, the financial credit crisis and economic crisis is going to continue to get worse, not better. So as the Congress is looking at fiscal stimulus plans to match what the Federal Reserve has done on cutting interest rates to nearly zero, additional policies have to be put in place to stem the tide of declining real estate values, because that is what the collateral is for many small business loans. And also the fact that, until this real estate is stabilized, banks are going to have a very difficult time of lending more. " CHRG-111hhrg56241--142 Mr. Green," Do you understand that we have Members of Congress who are advocating we should have just let the world go, just left it alone? Can you imagine where we would be if we had done nothing? Is it irresponsible to do just nothing at a time of crisis like this? Ma'am? Ms. Minow. Yes. " FinancialCrisisInquiry--374 BLANKFEIN: I think nobody—looking what happened and the most horrible thing of this crisis, what has happened to consumers, to individuals, in the mortgage market, in other things have taken on debt as a consequence of behavior. And the confluence of behavior and the recession I would say no one would argue that there shouldn’t be more protection and safeguards and regulation of that interaction between finance and the consumer. CHRG-111shrg57322--1186 Mr. Blankfein," No, I think--you can't go by the gross amount because some of these positions don't move. The way you can tell whether you are short and long, really, the best way is, look, if you were short early in the crisis---- Senator Levin. I am just asking you. You said these were small positions. " fcic_final_report_full--486 The Commission majority did not discuss the significance of mark-to- market accounting in its report. This was a serious lapse, given the views of many that accounting policies played an important role in the financial crisis. Many commentators have argued that the resulting impairment charges to balance sheets reduced the GAAP equity of financial institutions and, therefore, their capital positions, making them appear financially weaker than they actually were if viewed on the basis of the cash flows they were receiving. 53 The investor panic that began when unanticipated and unprecedented losses started to appear among NTMs generally and in the PMBS mortgage pools now spread to financial institutions themselves; investors were no longer sure which of these institutions could survive severe mortgage-related losses. This process was succinctly described in an analysis of fair value or mark-to-market accounting in the financial crisis issued by the Institute of International Finance, an organization of the world’s largest banks and financial firms: [O]ften-dramatic write-downs of sound assets required under the current implementation of fair-value accounting adversely affect market sentiment, in turn leading to further write-downs, margin calls and capital impacts in a downward spiral that may lead to large-scale fire-sales of assets, and destabilizing, pro-cyclical feedback effects These damaging feedback effects worsen liquidity problems and contribute to the conversion of liquidity problems into solvency problems. 54 [emphasis in the original] At least one study attempted to assess the effect of this on financial institutions overall. In January 2009, Nouriel Roubini and Elisa Parisi-Capone estimated the mark-to-market losses on MBS backed by both prime loans and NTMs. Their estimate was slightly over $1 trillion, of which U.S. banks and investment banks were estimated to have lost $318 billion on a mark-to-market basis. 55 This would be a dramatic loss if all of it were realized. In 2008, the U.S. banking system had total assets of $10 trillion; the five largest investment banks had 53 54 FCIC Draft Staff Report, “The Role of Accounting During the Financial Crisis,” p.16. Institute of International Finance, “IIF Board of Directors - Discussion Memorandum on Valuation in Illiquid Markets,” April 7, 2008, p.1. 55 Nouriel Roubini and Elisa Parisi-Carbone, “Total $3.6 Trillion Projected Loan and Securities Losses in U.S. $1.8 Trillion of Which Borneby U.S. Banks/Brokers,” RGE Monitor , January 2009, p.8. 481 total assets of $4 trillion. 56 If we assume that the banks had a leverage ratio of about 15-to-1 in 2008 and the investment banks about 30-to-1, that would mean that the equity capital position of the banking industry as a whole would be about $650 billion and the same number for the investment banks would be about $130 billion, for a total of $780 billion. Under these circumstances, the collapse of the PMBS market alone reduced the capital positions of U.S. banks and investment banks by approximately 41 percent on a mark-to-market basis. This does not mean that any actual losses were suffered, only that the assets concerned might have to be written down or could not be sold for the price at which they were previously carried on the firm’s balance sheet. CHRG-111shrg52619--15 Mr. Dugan," Thank you, Chairman Dodd, Ranking Member Shelby, and Members of the Committee. The financial crisis has raised legitimate questions about whether we need to restructure and reform our financial regulatory system, and I welcome the opportunity to testify on this important subject on behalf of the OCC. Let me summarize the five key recommendations from my written statement which address issues raised in the Committee's letter of invitation. First, we support the establishment of a systemic risk regulator, which probably should be the Federal Reserve Board. In many ways, the Board already serves this role with respect to systemically important banks, but no agency has had similar authority with respect to systemically important financial institutions that are not banks, which created real problems in the last several years as risk increased in many such institutions. It makes sense to provide one agency with authority and accountability for identifying and addressing such risks across the financial system. This authority should be crafted carefully, however, to address the very real concerns of the Board taking on too many functions to do all of them well, while at the same time concentrating too much authority in a single Government agency. Second, we support the establishment of a regime to stabilize resolve and wind down systemically significant firms that are not banks. The lack of such a regime this past year proved to be an enormous problem in dealing with distressed and failing institutions such as Bear Stearns, Lehman Brothers, and AIG. The new regime should provide tools that are similar to those the FDIC currently has for resolving banks, as well as provide a significant funding source, if needed, to facilitate orderly dispositions, such as a significant line of credit from the Treasury. In view of the systemic nature of such resolutions and the likely need for Government funding, the systemic risk regulator and the Treasury Department should be responsible for this new authority. Third, if the Committee decides to move forward with reducing the number of bank regulators--and that would, of course, shorten this hearing--we have two general recommendations. The first may not surprise you. We believe strongly that you should preserve the role of a dedicated prudential banking supervisor that has no job other than bank supervision. Dedicated supervision produces no confusion about the supervisor's goals or mission, no potential conflict with competing objectives; responsibility and accountability are well defined; and the result is a strong culture that fosters the development of the type of seasoned supervisors that we need. But my second recommendation here may sound a little strange coming from the OCC given our normal turf wars. Congress, I believe, should preserve a supervisory role for the Federal Reserve Board, given its substantial experience with respect to capital markets, payment systems, and the discount window. Fourth, Congress should establish a system of national standards that are uniformly implemented for mortgage regulation. While there were problems with mortgage underwriting standards at all mortgage providers, including national banks, they were least pronounced at regulated banks, whether State or nationally chartered. But they were extremely severe at the nonbank mortgage companies and mortgage brokers regulated exclusively by the States, accounting for a disproportionate share of foreclosures. Let me emphasize that this was not the result of national bank preemption, which in no way impeded States from regulating these providers. National mortgage standards with comparable implementation by Federal and State regulators would address this regulatory gap and ensure better mortgages for all consumers. Finally, the OCC believes the best way to implement consumer protection regulation of banks, the best way to protect consumers is to do so through prudential supervision. Supervisors' continual presence in banks through the examination process creates especially effective incentives for consumer protection compliance, as well as allowing examiners to detect compliance failures much earlier than would otherwise be the case. They also have strong enforcement powers and exceptional leverage over bank management to achieve corrective action. That is, when examiners detect consumer compliance weaknesses or failures, they have a broad range of corrective tools from informal comments to formal enforcement action, and banks have strong incentives to move back into compliance as expeditiously as possible. Finally, because examiners are continually exposed to the practical effects of implementing consumer protection rules for bank customers, the prudential supervisory agency is in the best position to formulate and refine consumer protection regulation for banks. Proposals to remove consumer protection regulation and supervision from prudential supervisors, instead consolidating such authority in a new Federal agency, would lose these very real benefits, we believe. If Congress believes that the consumer protection regime needs to be strengthened, the best answer is not to create a new agency that would have none of the benefits of the prudential supervisor. Instead, we believe the better approach is for Congress to reinforce the agency's consumer protection mission and direct them to toughen the applicable standards and close any gaps in regulatory coverage. The OCC and the other prudential bank supervisors will rigorously apply any new standards, and consumers will be better protected. Thank you very much. I would be happy to answer questions. " CHRG-110hhrg46595--556 Mr. Sachs," Congressman, I don't think with all due respect that it is really the question for this weekend or before you recess or before the new government comes in. This has to be viewed practically as a two-part process. You have a basic framework that has been put in front of this committee, which I find very valid and very credible and absolutely worth the American people investing in. Then we are going to have a new government that is responsible for helping to answer a lot of these questions. We don't have, with the outgoing Administration, the capacity to do these things right now, but we are going to have a new government. In 6 months' time you will get a lot of answers. And it is important--even in a month-and-a-half's time, you will get a lot of answers that you will not get right now. I think, therefore, pragmatically, because these decisions really are needed in hours--day two, you are leaving town--that putting in the kinds of protections that are in your draft legislation, I think, is appropriate. Assigning oversight responsibility to the Cabinet, ministers of departments of the incoming government are completely--and of the outgoing government, for that matter--are completely appropriate. But fine-tuning, in my opinion, is not commensurate with our macroeconomic reality. Last week, $306 billion was thrown over something without 1/100th of what you are asking for right now in scrutiny because events are moving at trillions of dollars very, very fast. And I think it is important that we understand the macroeconomic crisis that we are in, and that the American people understand the macroeconomic crisis we are in. This is not normal, what is happening. This isn't even normal about a difficult situation for the auto industry. This is a global macroeconomic crisis unprecedented since the Great Depression. And so we have to act with the speed that is imperfect in answering a lot of things, but it is realistic to the circumstances that our country and the world face. " CHRG-110shrg50414--71 Chairman Dodd," Senator Shelby. Senator Shelby. Thank you, Mr. Chairman. I would like to address my first question to Secretary Paulson and Chairman Bernanke. I assume that during your deliberations dealing with this crisis, you must have considered a range of proposals before you decided on the one that you proposed to us. Is that correct? Is that right, you considered other proposals? " FinancialCrisisInquiry--329 BLANKFEIN: I don’t think we should rely on—I think that was lucky. And I think the amount of attention and time that people—regulators, the industry, legislators—are focused on making sure that the instrumentality and the pipes of clearing derivatives are in place is highly justified, notwithstanding, we didn’t specifically have a derivatives crisis. CHRG-111hhrg49968--49 Mr. Bernanke," The Federal Reserve will not monetize the debt. And I think it is important to point out that, notwithstanding our purchases of Treasuries as part of a program to strengthen private credit markets, even when we complete the $300 billion purchase that we have committed to, we will still hold less Treasuries, a smaller volume of Treasuries than we had before the crisis began. " CHRG-111hhrg48867--41 The Chairman," Thank you all. This is all very useful, and I think we are having--I mean, we have a crisis, and the crisis is not conducive to kind of calmness, and I am pleased that we appear to be able to separate that out, and we deal with the crisis under a lot of sturm und drang. We can have rational conversations about where to go forward. I appreciate everybody's approach. A couple of brief points. Ms. Jorde, as you know, if we are able to get through the Senate, and we would then concur an increase in the FDIC's lending authority to deal with potential problems up to the $500 billion mark, the increase in the assessment will be substantially reduced. They are talking now about a 13-cent increase, and it would go down to a 3-cent increase. So that is on the community banks, as you correctly point out, being hit with the assessment that is based on some others. Whether or not that should be risk-based, many of us think it is. If that could be worked out, that is separate. But we are on track, I think it is now 6.3 cents. Instead of going to 20 cents, it would go to 10 cents, which is a very substantial reduction, and we will try to do that. Mr. Wallison, on the insurance issue, an important one, you mentioned the problem with the regulated AIG entities, the insurance companies. Then the money went to an unregulated entity. And you said an optional Federal charter, and that would be very much on the agenda of this committee. There are members who have pushed for it. But what would you do for those who opted not to opt? Would you give some Federal power--and you pointed out a problem here that, with AIG, you had regulated companies but an unregulated entity on the top. If you had an optional Federal charter and the entity became a Federal charter that could be federally regulated, what would you do for situations where the companies did not opt for Federal charter? Would you extend some Federal regulation at that top level? " FinancialCrisisInquiry--188 The only reason for these products to have been mass marketed to consumers was for Wall Street, lenders, and brokers to make a huge profit by selling, flipping, and securitizing large numbers of unsustainable mortgages. And the bank regulators who, as many have talked about today, had ample warning about the dangers posed by these loans, either were asleep at the switch or actively encouraging this high-profit, high-risk lending. The impact of foreclosures has been particularly hard on African American and Latino communities. This crisis has widened the already sizable wealth gap between whites and minorities in this country and has wiped out the asset base of entire neighborhoods. The foreclosure crisis was not caused by greedy or risky borrowers. The average subprime loan amount nationally was just over $200,000 and is much lower if you exclude the highest priced markets such as California. A majority of subprime borrowers had credit scores that would qualify them for prime loans with much better terms, and researchers have found that abusive loan terms such as exploding rates and prepayment penalties created an elevated risk of foreclosure even after controlling for differences in borrowers’ credit scores. It’s also not the case that widespread unemployment is in and of itself the reason for the spread of this crisis to the prime market. For the past 30 years, foreclosure rates remained essentially flat during periods of high unemployment because people who lost their jobs could sell their homes or tap into home equity to tide them over. Unemployment is now triggering an unprecedented number of home losses because loan flipping and the housing bubble have left so many families underwater. Most important, it’s crucial to put to rest any idea that the crisis was caused by efforts to extend home ownership opportunities to traditionally underserved communities. Many financial institutions, our own included, have long lent safely and successfully to these communities without experiencing outsize losses. Legal requirements such as those embodied in the CRA had been in effect for more than two decades with no ill effect before the increase in risky subprime loans, and fully 94 percent of all subprime loans were not covered by the CRA. FinancialCrisisInquiry--20 Finally, today’s financial markets are global and interconnected. Our regulatory regime needs to be as well. The U.S. must work with countries across the globe to coordinate and synchronize risk. At Morgan Stanley, we’re grateful for everything the federal government and the American taxpayer did to support our industry and to help bring stability back to the markets. We recognize our industry has much to do and to regain the trust and confidence of taxpayers, investors, and public officials. Thank you. CHAIRMAN ANGELIDES: Thank you, Mr. Mack. Mr. Moynihan? MOYNIHAN: Thank you, Chairman Angelides, Vice Chairman Thomas, and other members of the commission. I welcome the opportunity to help provide some information on important matters you’re investigating. As you know, I assumed my role of CEO of Bank of America on January 1 st , and prior to that time, I ran the consumer areas of the company. In leading our consumer business, I had a first-hand knowledge and a recognition of the hardships that many hard-working families and small businesses experience across America. Together, the financial services companies, our elected leaders, and regulators must continue to work to understand what occurred in the financial crisis and apply these lessons so that it simply does not happen again. Over the course of the crisis, we, as an industry, caused a lot of damage. Never has it been clearer how poor business judgments we have made have affected Main Street. This commission’s work is important because the lessons are not going to be simple. This crisis had a multitude of causes that are not easily summarized. It is important that we understand the breadth of the causes so we can learn the right lessons and apply the appropriate policy to remedy them for the future. CHRG-110shrg50417--3 STATEMENT OF SENATOR MIKE CRAPO Senator Crapo. Thank you very much, Mr. Chairman, and, again, I appreciate the attention you have given to the need for strong and continuous oversight by this Committee after now seeing the extreme and serious repercussions throughout every aspect of our economy as a result of the credit crisis. According to one study, for every dollar of net losses on loans and securities, there is a multiplier of 10 in the reduction of credit. If we use the most recent number of $1 trillion in writedowns and credit losses and take into consideration the fact that the banks have raised $350 billion in new capital, there would be a $650 billion net loss and, using that formula, a $6.5 trillion loss in credit available in the market. I am not sure whether these are the right numbers or whether we actually know what they are or what the deleveraging is. But it is clear that we are facing a significant credit loss, and it has the potential to become even worse. Secretary Paulson's announcement that Treasury is not planning to buy toxic assets and that there are more effective ways to use the taxpayer dollars that have been provided provides a perfect opportunity to assess the results of the rescue package and to consider other directional changes. As you know, Mr. Chairman, I was not one of those who supported the notion of purchasing these toxic assets and have been very concerned that not only was the taxpayer not adequately protected, but that Treasury's proposal to buy toxic assets created an incentive for investors to stay on the sidelines and watch what the Government would do to then step in at a later date and either buy or purchase or finance purchases from the Government at a discount. I am very interested in what ways our witnesses believe these taxpayer dollars should be used and in what direction we should go. I have always believed that the direct utilization of our resources to increase liquidity with specific actions was a more appropriate direction that we should take, and I am hopeful to hear the witnesses' advice on those matters as well. In addition, Mr. Chairman, I hope that we can get into a strong discussion about some of the broad regulatory, structural reforms that we need to consider. Again, as you know, I have strongly argued for regulatory reform of our financial institutions, and this is an opportunity now for us to evaluate just exactly what is the regulatory structure our Nation should have. This week, the head of the CFTC said that he believes the United States should scrap the current outdated regulatory framework in favor of an objectives-based regulatory system consisting of three primary authorities: a new systemic risk regulator, a new market integrity regulator, and a new investor protection regulator. The risk regulator would police the financial system for hazards that could ratchet across companies to have broad economic consequences. The market integrity regulator would oversee safety and soundness of exchanges and the key financial institutions, effectively acting as a replacement for existing bank regulators and the SEC's function of regulating brokerages. The investor protection regulator would protect investors and business conduct across all firms. This is a similar idea to the outline provided in March by Secretary Henry Paulson of the Treasury, and I for one believe we should evaluate these kinds of proposals. I hope we also evaluate the potential for a single regulator, as has been done in other parts of the world where we have seen some significant effectiveness. But whatever our new regulatory structure is, I think it is important that we move from the outdated regulatory structure that we have now into one that still protects a strong, viable market, but allows for the consumer protections and the other protections against the systemic risks that we are seeing today that the Chairman has described. And I look forward to working with you closely as we evaluate this important part of our regulatory system. Thank you, Mr. Chairman. " fcic_final_report_full--17 The greatest tragedy would be to accept the refrain that no one could have seen this coming and thus nothing could have been done. If we accept this notion, it will happen again. This report should not be viewed as the end of the nation’s examination of this crisis. There is still much to learn, much to investigate, and much to fix. This is our collective responsibility. It falls to us to make different choices if we want different results. CHRG-111hhrg48867--240 Mr. Ellison," Thank you. Mr. Wallison, you know that in 1999, I believe, legislation was passed in our Congress which exempted credit default swaps from regulation. Do you agree that it is the fact that these derivative instruments were not regulated that has created part of the financial crisis we find ourselves in today? " 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-111shrg57923--2 Mr. Tarullo," Thank you, Senator Reed and Senator Corker, and thank you both for your attention to a subject whose importance to financial stability is, as Senator Reed said a moment ago, often overlooked in the broader debates about reform. Good information is crucial to the success of any form of regulation as it is to the success of any form of market activity. But many features of financial activity make the quality and timeliness of information flows even more significant for effective regulation. Most important, perhaps, is the interconnectedness of financial services firms. In few other industries do major players deal so regularly with one another, as a result of which major problems at one firm can quickly spread throughout the system. The financial crisis revealed gaps in the data available to both Government regulators and to private analysts. It also revealed the relatively undeveloped nature of systemic or macroprudential oversight of the financial system. With this experience in mind, I believe there are two goals toward which agency and congressional action to improve data collection and analysis should be directed. First, 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, including containment of systemic risk; And, second, to make sure such data available to other Government agencies, to private analysts, to academics, in appropriately usable form so that the Congress and the public will have the benefit of multiple perspectives on potential threats to financial stability. My written testimony details some of the initiatives at the Federal Reserve to enhance the type and quality of information available to us in support of our exercise of consolidated supervision over the Nation's largest financial holding companies. I would stress also, though, the importance of using that information to regulate more effectively. The Special Capital Assessment we conducted last year of the Nation's 19 largest financial firms demonstrated how quantitative, horizontal methodologies built on consistent data across firms could complement traditional supervision. It also showed the importance of having supervisory needs and knowledge determine data requirements. We are building on that experience and adding a more explicitly macro prudential dimension and developing a quantitative surveillance mechanism as a permanent part of large-firm oversight. While there is much that the Federal Reserve--and other agencies such as the SEC--can do and are doing under existing authority, I do believe we will need congressional action to achieve fully the two goals I stated a moment ago. There are a number of specific areas in which legislative changes would be helpful. Let me briefly mention three. First, it is very important that Government agencies have the authority to collect information from firms not subject to prudential supervision, but which may nonetheless have the potential to contribute to systemic risk. Without this ability, regulators will have a picture of the financial system that is incomplete, perhaps dangerously so. Second, it appears to me that greater standardization of important data streams will only be achieved with a congressional prod. This objective of standardization has for years proved elusive, even though most observers agree that it is critical to identifying risks in the financial system. Third, there will need to be some modifications to some of the constraints on information colleague by Government agencies, such as authority to share that information with foreign regulators or to release it in usable form to the public. Since privacy, proprietary information, intellectual property, reporting burden, and other important interests will be implicated in any such modifications, it is most appropriate that Congress provide guidance as to how these interests should be accommodated in a more effective system of financial data collection. Finally, as you consider possible legislative changes in this area, I would encourage you to consider the relationship between the authorities and responsibilities associated with data collection and the substantive regulatory authorities and responsibilities entrusted to our financial agencies. Generally speaking, regulators have the best perspective on the kind of data that will effectively advance their statutory missions. Indeed, without the authority to shape information requirements, their effectiveness in achieving these missions can be compromised. This is all the more important given the current state of knowledge of systemic risk in which there are as many questions as answers. In these circumstances in particular, the insights gained by supervisors through their ongoing examination of large firms and of markets should be the key, though not the exclusive determinant, of new data collection efforts. This does not mean that agencies should collect only the information they believe they need. The aim of providing independent perspectives on financial stability means that other data may be important to collect for the use of private analysts, academics, and the public. The agencies can certainly be asked to collect other forms of information that are important for independent assessments of financial stability risks. But I think this relationship does counsel considerable symmetry between regulatory responsibility and data collection. Thank you for your attention and, again, for having this hearing. I would be pleased to try to answer any questions you might have. Senator Reed. Well, thank you very much, Governor Tarullo. Let me first ask the question that this need for better information is not exclusive to the United States. Could you comment on how other G-20 countries are trying to deal with this and the need for not just a national approach but an international approach? " 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-111hhrg53021--295 Mr. Hensarling," I don't mean to put words in your mouth, but I now have 30 seconds. I think you said again that some of your critics you said were wanting to maintain the status quo. Many economists believe that the greatest cause that we have for the economic crisis was Fannie and Freddie, and yet your reform proposal does nothing about Fannie and Freddie. " CHRG-111hhrg48873--88 Secretary Geithner," Absolutely, Congressman. I think that the American people are deeply frustrated and concerned and angry and skeptical, frankly, that they understand what is happening and whether taxpayers' moneys are being used wisely to deal with this. I completely understand it, and it is a completely reasonable reaction to the damage caused by this crisis. " CHRG-111hhrg53021Oth--295 Mr. Hensarling," I don't mean to put words in your mouth, but I now have 30 seconds. I think you said again that some of your critics you said were wanting to maintain the status quo. Many economists believe that the greatest cause that we have for the economic crisis was Fannie and Freddie, and yet your reform proposal does nothing about Fannie and Freddie. " CHRG-111hhrg54867--74 Secretary Geithner," Well, that is what people will say. But there is a huge risk that it will just make it harder, because people will say, ``Gee, it seems kind of hard. Let's not take this on. It is difficult. The crisis receded. Things aren't going to be so bad.'' I think that is a huge risk. " fcic_final_report_full--139 Overall, while the mortgages behind the subprime mortgage–backed securities were often issued to borrowers that could help Fannie and Freddie fulfill their goals, the mortgages behind the Alt-A securities were not. Alt-A mortgages were not gener- ally extended to lower-income borrowers, and the regulations prohibited mortgages to borrowers with unstated income levels—a hallmark of Alt-A loans—from count- ing toward affordability goals.  Levin told the FCIC that they believed that the pur- chase of Alt-A securities “did not have a net positive effect on Fannie Mae’s housing goals.”  Instead, they had to be offset with more mortgages for low- and moderate- income borrowers to meet the goals. Fannie and Freddie continued to purchase subprime and Alt-A mortgage–backed securities from  to  and also bought and securitized greater numbers of riskier mortgages. The results would be disastrous for the companies, their share- holders, and American taxpayers. COMMISSION CONCLUSIONS ON CHAPTER 7 The Commission concludes that the monetary policy of the Federal Reserve, along with capital flows from abroad, created conditions in which a housing bub- ble could develop. However, these conditions need not have led to a crisis. The Federal Reserve and other regulators did not take actions necessary to constrain the credit bubble. In addition, the Federal Reserve’s policies and pronouncements encouraged rather than inhibited the growth of mortgage debt and the housing bubble. Lending standards collapsed, and there was a significant failure of accounta- bility and responsibility throughout each level of the lending system. This in- cluded borrowers, mortgage brokers, appraisers, originators, securitizers, credit rating agencies, and investors, and ranged from corporate boardrooms to individ- uals. Loans were often premised on ever-rising home prices and were made re- gardless of ability to pay. The nonprime mortgage securitization process created a pipeline through which risky mortgages were conveyed and sold throughout the financial system. This pipeline was essential to the origination of the burgeoning numbers of high- risk mortgages. The originate-to-distribute model undermined responsibility and accountability for the long-term viability of mortgages and mortgage-related se- curities and contributed to the poor quality of mortgage loans. (continues) (continued) fcic_final_report_full--597 Chapter 11 1. William Dudley, interview by FCIC, October 15, 2010. 2. Inside Mortgage Finance, The 2009 Mortgage Market Statistical Annual, vol. 2, The Secondary Mar- ket (Bethesda, Md.: Inside Mortgage Finance, 2009), p. 13, “Non-Agency MBS Issuance by Type.” 3. FCIC staff estimates based on Moody’s CDO Enhanced Monitoring System (EMS) database. 4. 2009 Mortgage Market Statistical Annual, 2:373, “Commercial MBS Issuance.” 5. Ben S. Bernanke, chairman of the Federal Reserve, letter to Phil Angelides, chairman of the FCIC, December 21, 2010. 6. Mark Zandi, Celia Chen, and Brian Carey, “Housing at the Tipping Point,” Moody’s Economy.com, October 2006, pp. 6–7. 7. CoreLogic Home Price Index, Single-Family Combined (available at www.corelogic.com/ Products/CoreLogic-HPI.aspx), FCIC staff calculations, January to January. 8. CoreLogic Census Bureau Statistical Area (CBSA) Home Price Index, FCIC staff calculations. 9. Data provided by Mark Fleming, chief economist for CoreLogic, in his written testimony for the FCIC, Hearing on the Impact of the Financial Crisis—Sacramento, session 1: Overview of the Sacra- mento Housing and Mortgage Markets and the Impact of the Financial Crisis on the Region, September 9, 2010, figures 4, 5. 10. Mark Fleming, testimony before the FCIC, Hearing on the Impact of the Financial Crisis—Sacra- mento, session 1: Overview of the Sacramento Housing and Mortgage Markets and the Impact of the Fi- nancial Crisis on the Region, September 9, 2010, transcript, p. 14. 11. Mortgage Bankers Association, National Delinquency Survey, data provided to the FCIC. 12. Ibid., with FCIC staff calculations. 13. FCIC staff analysis, “Analysis of housing data,” July 7, 2010. The underlying data come from Core- Logic and Loan Processing Svcs. Tabulations were provided to the FCIC by staff at the Federal Reserve. 14. Subprime and Alt-A mortgages are defined as those included in subprime or Alt-A securitiza- tions, respectively. GSE mortgages included mortgages purchased or guaranteed by Fannie Mae or Fred- die Mac. FHA mortgages included mortgages insured by the FHA or VA. 15. FCIC staff analysis. 16. A recent analysis published by FHFA comes to very similar conclusions. See “Data on the Risk Characteristics and Performance of Single-Family Mortgages Originated from 2001 through 2008 and Financed in the Secondary Market,” September 13, 2010. 17. FCIC staff analysis, “Analysis of housing data and comparison with Ed Pinto’s analysis,” August 9, 2010. In the sample data provided by the Federal Reserve, Fannie Mae and Freddie Mac mortgages with a FICO score below 660 had an average rate of serious delinquency of 6.2% in 2008. In public reports, the GSEs stated that the average serious delinquency rates for loans with FICO scores less than 660 in their guarantee books was 6.3%. Fannie Mae 2008 Credit Supplement, p. 5; Freddie Mac Fourth Quarter 2008 Financial Results Supplement, March 11, 2009, p. 15. 18. In the sample data provided by the Federal Reserve, Fannie Mae and Freddie Mac mortgages with LTVs above 90% had an average rate of serious delinquency of 5.7% in 2008. In public reports, the GSEs stated that the average serious delinquency rates for loans with LTVs above 90% in their guarantee books was 5.8%. Fannie Mae 2008 Credit Supplement, p. 5; CHRG-111hhrg48867--250 Mr. Ellison," Mr. Bartlett, in returning back to you, in a speech that FDIC Chairwoman Bair made recently, she expressed serious concern about the implementation of Basel II internationally, and it might allow for reduction in regulatory capital requirements at the height of a global financial crisis. To address this concern--I think I am all done there, Mr. Chairman. " CHRG-110hhrg44903--3 Mr. Bachus," I thank the chairman for holding this second hearing on systemic risk. And I welcome our two witnesses to the hearing. Chairman Cox and President of the New York Fed Geithner, you have actually been at the center of the government's response to recent turmoil in the financial markets. And I commend you both on the job you are doing. You are both very capable public servants, and I think the country is fortunate to have your expertise. We look forward to your perspectives as we go forward. Nothing I say today should be taken as a criticism of anything you have done, particularly in the Bear Stearns matter, because I realize that sometimes decisions are made, and we don't know at the time whether they are the best, but we do the best we can. I think we were faced with that yesterday on the Floor. We had a difference of opinion. But we make a decision, and then we all come together and hope that decision is right when it is collectively made. I would say this to Chairman Frank, before we begin a serious discussion of greater government involvement in our capital markets, we need to have a clearer understanding of exactly where we are and how we got to where we are. I know the chairman has also said that. We need to know how we arrived at a system in which the issuers of credit default swaps are allowed to provide guarantees that far exceed their capital reserves and that there is virtually no possibility that they can pay in the defaults of the underlying obligations, commit themselves to obligations that they cannot possibly cover in worst-case scenarios. We need a better understanding of why our regulations allow credit default swaps to remain essentially under-regulated when they have such a profound effect and are so intertwined with our larger financial markets and even our economy. And in light of the Bear Stearns episode, and I think we all learned from that, we need to know whether the SEC's current approach to the supervision of investment banks and their holding companies is sufficient to prevent further meltdowns in that sector of our financial services industry. Or even, you know, we need to ask ourselves, can regulators really prevent such meltdowns? What are our obligations? Sometimes, it may be to stand back and allow companies to fail. In this vein, and perhaps most critical of all, we need to know how we ended up with a financial system in which almost every primary dealer, at least on the surface, appears almost too big or too interconnected to fail or whether we have arrived at that point. If we accept that premise, that every primary dealer is too big to fail, then we also have to conclude that our financial markets are no longer capable of self-regulation and that government must exercise greater control, both as a regulator and as a lender, if not a buyer of last resort. As I indicated at our first hearing 2 weeks ago, that is a conclusion I am not prepared to accept. I think a far better approach is one that restores market discipline and discourages moral hazard. Does the Bear Stearns rescue and recent proposals to invest taxpayer dollars in the debt in equity of Fannie Mae and Freddie Mac, does that send a different signal to the market, that taxpayers can be counted on, ultimately, to indemnify risk-taking that reaches levels sufficient to place the entire financial system in jeopardy? What we ultimately need is to ensure that our regulators maintain a framework in which individual firms can fail while the system continues to function. I think it has been referred to as an orderly liquidation. We know that sudden failures like Bear Stearns, if they are not orderly, can definitely have systemic risk. And I think we all appreciate that. We need to ensure that our firms strike the right balance between risk and leverage. Capital and credit must continue to flow where they are most needed, but our financial institutions should not be taking outsized risks that require repeated government interventions to save the system from recurring crisis. Chairman Cox, you have taken significant steps to protect the integrity of our capital markets during these turbulent times. I think your efforts have been underappreciated. One of your most important initiatives has been to help make sure investors have access to accurate and reliable information. In this regard, your credit rating agency reforms, your firm stance against the spreading of false information, and your emergency order to curb abusive short-selling practices in the securities of 17 primary dealers and Fannie and Freddie were welcomed developments. And we have seen now that they have had a positive effect. On July 15th, the SEC also noted that it will undertake a rulemaking to address these issues across the entire market. I look forward to working with the Commission to ensure that a rulemaking recognizes the legitimate role of short selling and does not eliminate liquidity from the capital markets. I think we all appreciate that short selling is a valid, valuable process. It serves a useful purpose. What isn't and what is presently prohibited is the spreading of false information to drive down the price of these stocks by some short sellers, not most, and that, you know, puts and calls, all those, are a valuable part of our market and indicate a sophisticated financial system. Mr. Chairman, I want to conclude by thanking you for holding this hearing. And my thanks to Chairman Cox and Mr. Geithner for being with us today. We look forward to your testimony. " 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-111shrg62643--25 Mr. Bernanke," If the debt continues to accumulate and becomes unsustainable, as the Congressional Budget Office believes our current policies are, then the only way that can end is through a crisis or some other very bad outcome. Senator Shelby. Do you, as Chairman of the Fed, do you believe that our current continuing to have these big deficits adding to our debt is unsustainable? " 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-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. " fcic_final_report_full--582 CDS Portfolio,” provided to the FCIC. 86. Park, interview. 87. AIG, CDS notional balances at year-end, 2000 through 2010 Q1. 88. Alan Frost, interview by FCIC, May 11, 2010. 89. AIG Financial Products Corp. Deferred Compensation Plan, March 18, 2005, p. 2. 90. Joseph Cassano, email to All Users, re: 2007 Special Compensation Plan, December 17, 2007. 91. Joseph Cassano compensation history, provided by AIG to the FCIC. 92. AIG, Form 8-K, filed May 1, 2005. 93. “Fact Sheet on AIGFP,” provided by Hank Greenberg, p. 4. 94. AIG, CDS notional balances at year-end. 95. Gene Park, email to Joseph Cassano, re: “CDO of ABS Approach Going Forward—Message to the Dealer Community,” February 28, 2006. 96. Henry M. Paulson Jr., testimony before the FCIC, Hearing on the Shadow Banking System, day 2, session 1: Perspective on the Shadow Banking System, May 6, 2010, transcript, p. 22. 97. Henry M. Paulson Jr., written testimony for the FCIC, Hearing on the Shadow Banking System, day 2, session 1: Perspective on the Shadow Banking System, May 6, 2010, p. 2. 98. Goldman Sachs, 2005 and 2006 10-K (appendix 5a to Goldman’s March 8, 2010, letter to the FCIC). 99. Appendix 5c to Goldman’s March 8, 2010, letter to the FCIC. 100. Goldman’s March 8, 2010, letter to the FCIC, p. 28 (subprime securities). 101. “Protection Bought by GS,” spreadsheet provided by Goldman Sachs to the FCIC. Specifically, IKB purchased $30 million of Class A notes, $40 million of Class B notes, and $30 million of Class C notes on June 9, 2004. TCW purchased $50 million of Class A notes in January 2005, and Wachovia pur- chased $45 million of Class A notes in March 2005. See ibid., Exhibit 1. 102. FCIC staff calculations based on data provided by Goldman Sachs. 103. “Protection Bought by GS,” spreadsheet. 104. FCIC calculations based on data provided by Goldman Sachs. 105. FCIC staff analysis based on data provided by Goldman Sachs. 106. Sparks, interview. 107. Of course, in theory the net impact on the financial system is not greater, because there is a win- ner for every loser in the derivatives market. 108. Sparks, interview. 109. From Goldman Sachs data provided to the FCIC in a handout titled “Amplification” and quoted at the FCIC’s Hearing on the Role of Derivatives in the Financial Crisis, day 1, session 3: Goldman Sachs Group, Inc. and Derivatives, June 30, 2010. 110. FCIC staff analysis based on data provided by Goldman Sachs. 111. Lloyd Blankfein, chairman of the board and chief executive officer, Goldman Sachs Group, inter- view by FCIC, June 16, 2010; Sparks, interview. 112. Gary Cohn, testimony before the FCIC, Hearing on the Role of Derivatives in the Financial Cri- sis, day 1, session 3: Goldman Sachs Group, Inc. and Derivatives, June 30, 2010, transcript, p. 351. 113. Parkinson, interview. 114. Michael Greenberger, before the FCIC, Hearing on the Role of Derivatives in the Financial Cri- sis, day 1, session 1: Overview of Derivatives, June 30, 2010; oral testimony, transcript, p. 109; written tes- timony, p. 16. 115. Moody’s Investors Service, “Summary of Key Provisions for Cash CDOs as of January 2000– 2010.” 116. Gary Witt, written testimony for the FCIC, Hearing on Credibility of Credit Ratings, the Invest- ment Decisions Made Based on Those Ratings, and the Financial Crisis, day 1, session 1: The Ratings Process, June 2, 2010, pp. 12, 15. 579 117. Ibid., 12. 118. Gary Witt, testimony before the FCIC, Hearing on Credibility of Credit Ratings, the Investment Decisions Made Based on those Ratings, and the Financial Crisis, day 1, session 1: The Ratings Process, June 2, 2010, transcript, pp. 168, 436. 119. Moody’s Investors Service, “Moody’s Approach to Rating Multisector CDOs,” September 15, 2000, p. 5. 120. Gary Witt, interview by FCIC, April 21, 2010. 121. Witt, written testimony for the FCIC, June 2, 2010, p. 17. 122. Gary Witt, follow-up interview by FCIC, May 13, 2010. 123. Witt, interview, April 21, 2010. 124. For example, Moody’s assumed that borrowers with different credit ratings would not default at the same time. The agency split the securities into three subcategories based on the average FICO score of the underlying mortgages: prime (FICO greater than 700), midprime (FICO between 700 and 625), and subprime (FICO under 625). Creating three FICO-based subcategories rather than the traditional two (prime and subprime) resulted in lower correlation assumptions, because mortgage-backed securi- ties in different subcategories were assumed to be less correlated. “Moody’s Revisits Its Assumptions Re- garding Structured Finance Default (and Asset) Correlations for CDOs,” June 27, 2005, pp. 15, 5, 7, 9, 4; Gary Witt, interview by FCIC, May 6, 2010. 125. Hedi Katz, “U.S. Subprime RMBS in CDOs,” Fitch Special Report, April 15, 2005, p. 3; Sten Bergman, “CDO Evaluator Applies Correlation and Monte Carlo Simulation to Determine Portfolio Quality,” Standard & Poor’s Global Credit Portal RatingsDirect, November 13, 2001, p. 8. 126. Ingo Fender and Janet Mitchell, “Structured Finance: Complexity, Risk and the Use of Ratings,” FinancialCrisisInquiry--119 Depository institutions like Citibank were able to parlay their deposits into large levered bets in the derivatives marketplace. In fact, at fiscal year-end 2007, Citigroup was 68- times levered to its tangible common equity, including off balance sheet exposures. Clearly, the composition of these assets is important as well, but I am simply trying to illustrate how levered these companies were at the start of the financial crisis. While AIG’s derivatives book was only 20-times levered to their book equity, $64 billion of these derivatives were related to subprime and subprime credit securities, the majority of which were ultimately worth zero. In some cases, excessive leverage cost the underlying company many years of lost earnings, and in other cases it cost them everything. I’ve put a table labeled “exhibit two” in my presentation. What we’ve done is looked back at the cumulative net income that was lost in financial institutions since the third quarter of 2007. Fannie Mae lost 20 ½ years of its profits in the last 18 months. AIG lost 17 ½ years of its profits in the last 18 months. Freddie Mac lost 11 ½ years of profits in a little bit more than a year. The point I’m trying to make is the ridiculousness of what’s gone on in the leverage that was in the system. The key problem with the system is the leverage and we must regulate that leverage. I’m going to—my third point that I’ll talk about briefly here is Fannie and Freddie. With $5.5 trillion of outstanding debt in mortgaged-backed securities, the quasi-public are now in conservatorship, Fannie and Freddie, have obligations that approach the total amount of government-issued bonds the U.S. currently has outstanding. There are so many things that went wrong or are wrong at these so-called “GSEs” that I don’t even know where to start. First, why are there two for-profit companies with boards, shareholders, charitable foundations, and lobbying arms ever given the implicit backing of the U.S. government? The Chinese won’t buy them anymore because our government won’t give them the explicit backing. The U.S. government cannot give them the explicit backing because the resulting federal debt burden will crash through the congressionally mandated debt ceiling, which was already recently raised to accommodate more deficit spending. CHRG-111hhrg54867--169 Mr. Watt," You are being very kind when you say it is the risk. Actually, the Federal Reserve in a hearing had a witness up here that said that they really never thought of that as being on an equal plain with the mandate that they were given. It was kind of a second class authority that they had, but they never really thought about it until we got to this crisis. That is in testimony that we took before my subcommittee. " CHRG-111hhrg55811--405 Mr. Holmes," Certainly, credit availability and cost has changed since the credit crisis. So it would be very costly. We would have to raise hundreds of millions of dollars and keep cash on our balance sheet to meet margin requirements that instead could be productively employed in building factories and employing people. " CHRG-111hhrg55811--327 Mr. Holmes," Yes. Certainly our major concern through the credit crisis was the health of our counterparties. And it certainly didn't appear that any of the interest rate swaps in which end-users were participants or foreign exchange transactions were the things that created financial difficulties for our counterparties. It was the subprime market, as you indicated. " CHRG-111hhrg48868--574 Mr. Baca," So it was basically under this last Administration. And part of the problem that we have and people are so much upset with this, retention bonuses that were given out right now--isn't retention, doesn't that mean that you stay, and a bonus means that you're getting paid for something you performed that is positive and is turning our economy around and our crisis around? " 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-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-111hhrg54869--135 Mr. Green," I am going to ask one final question, and because my friend and I have different views on this, I am going to stay and give him an opportunity, because he may want to have a follow-up on this question. I think it is only fair to do so. Mr. Volcker, was the CRA the cause of this crisis that you and I just finished discussing? " 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-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. fcic_final_report_full--241 The International Monetary Fund’s Global Financial Stability Report published in October  examined where the declining assets were held and estimated how se- vere the write-downs would be. All told, the IMF calculated that roughly  trillion in mortgage assets were held throughout the financial system. Of these, . trillion were GSE mortgage–backed securities; the IMF expected losses of  billion, but in- vestors holding these securities would lose no money, because of the GSEs’ guaran- tee. Another . trillion in mortgage assets were estimated to be prime and nonprime mortgages held largely by the banks and the GSEs. These were expected to suffer as much as  billion in write-downs due to declines in market value. The remaining . trillion in assets were estimated to be mortgage-backed securities and CDOs. Write-downs on those assets were expected to be  billion. And, even more troubling, more than one-half of these losses were expected to be borne by the investment banks, commercial banks, and thrifts. The rest of the write-downs from non-agency mortgage–backed securities were shared among institutions such as in- surance companies, pension funds, the GSEs, and hedge funds. The October report also expected another  billion in write-downs on commercial mortgage–backed securities, CLOs, leveraged loans, and other loans and securities—with more than half coming from commercial mortgage–backed securities. Again, the commercial banks and thrifts and investment banks were expected to bear much of the brunt.  Furthermore, when the crisis began, uncertainty (suggested by the sizable revi- sions in the IMF estimates) and leverage would promote contagion. Investors would realize they did not know as much as they wanted to know about the mortgage assets that banks, investment banks, and other firms held or to which they were exposed. To an extent not understood by many before the crisis, financial institutions had lever- aged themselves with commercial paper, with derivatives, and in the short-term repo markets, in part by using mortgage-backed securities and CDOs as collateral. Lenders would question the value of the assets that those companies had posted as collateral at the same time that they were questioning the value of those companies’ balance sheets. Even the highest-rated tranches of mortgage-backed securities were downgraded, and large write-downs were recorded on financial institutions’ balance sheets based on declines in market value. However, although this could not be known in , at the end of  most of the triple-A tranches of mortgage-backed securities have avoided actual losses in cash flow through  and may avoid significant realized losses going forward. Overall, for  to  vintage tranches of mortgage-backed securities origi- nally rated triple-A, despite the mass downgrades, only about  of Alt-A and  of subprime securities had been “materially impaired”—meaning that losses were im- CHRG-111hhrg74090--33 Mr. Pitts," Thank you, Mr. Chairman. Thank you for holding this important hearing on the Administration's proposal to create a new agency responsible for consumer protection. I think we all agree that we need strong consumer protection measures. The recent housing and credit crisis our country has faced makes this abundantly clear. We must do this prudently, though, avoiding the mistakes of the past. It seems, however, the proposal we have before us creates yet another divided system of regulation, making room for gaps in oversight. We saw the effects of divided regulation at Fannie Mae and Freddie Mac where two regulators meant less regulation, not more. The proposed new agency would also have the authority to set prices rather than allowing costs to be determined by consumers in the marketplace. Everything from ATM fees, check overdraft fees and late payment fees for credit cards would fall under the purview of this new agency. Instead of adding layers of bureaucracy to financial regulation and intervening in the marketplace, things we have tried in the past, we should work to bring transparency and consumer choice to our markets. Consumer financial protection is a worthy goal. Unfortunately, increasing the layers of bureaucracy in the financial industry has not protected consumers in the past and I see no reason why it will this time around. Again, we all desire effective and efficient enforcement of consumer protection laws. It is my hope that this committee moves forward in a wise and careful manner with increased transparency and consumer choice as their primary goals. I look forward to hearing from our distinguished witnesses. Thank you, and I yield back. " fcic_final_report_full--612 Chapter 16 1. David Wong, interview by FCIC, October 15, 2010. 2. Josh Fineman and Yalman Onaran, “Lehman’s Fuld Says ‘Worst Is Behind Us’ in Crisis (Update3), Bloomberg, April 15, 2008. 3. Henry Paulson, testimony before the FCIC, Hearing on the Shadow Banking System, day 2, session 1: Perspective on the Shadow Banking System, May 6, 2010, transcript, p. 28. 4. Viral V. Acharya and T. Sabri Öncü, “The Dodd-Frank Wall Street Reform and Consumer Protec- tion Act and a Little Known Corner of Wall Street: The Repo Market,” Regulating Wall Street, July 16, 2010. 5. Sandie O’Connor, JP Morgan, interview by FCIC, March 4, 2010. 6. Jamie Dimon, interview by FCIC, October 20, 2010. 7. Adam Copeland, Antoine Martin, Michael Walker, “The Tri-Party Repo Market Before the 2010 Reforms,” FRBNY Staff Report No. 477, November 2010, p. 24. 8. Steven Meier, testimony before the FCIC, Hearing on the Shadow Banking System, day 2, session 3: Institutions Participating in the Shadow Banking System, May 6, 2010, transcript, p. 276. 9. William Dudley, interview by FCIC, October 15, 2010. 10. Darryll Hendricks, interview by FCIC, August 6, 2010. 11. James Cayne, testimony before the FCIC, Hearing on the Shadow Banking System, day 1, session 2: Investment Banks and the Shadow Banking System, May 5, 2010, transcript, p. 168. 12. Seth Carpenter, interview by FCIC, September 20, 2010. 13. Federal Reserve, “Regulatory Reform: Primary Dealer Credit Facility (PCDF),” Usage of Federal Reserve Credit and Liquidity Facilities, data available at www.federalreserve.gov/newsevents/ reform_pdcf.htm. 14. Anton R. Valukas, Report of Examiner, In re Lehman Brothers Holdings Inc., et al., Chapter 11 Case No. 08-13555 (JMP), (Bankr. S.D.N.Y.), March 11, 2010, 4:1396–98; quotation, 1396 (hereafter cited as Valukas; available at http://lehmanreport.jenner.com/). 15. William Dudley, email to Chairman, June 17, 2008. 16. Dimon, interview. 17. Ibid. 18. Hendricks, interview. 19. Lucinda Brickler, email to Patrick Parkinson, July 11, 2008; Lucinda Brickler et al., memorandum to Timothy Geithner, July 11, 2008. 20. The $200 billion figure is noted in Patrick Parkinson, email to Ben Bernanke et al., July 20, 2008. 21. Brickler et al., memorandum, p. 1. 22. Patrick Parkinson, email to Lucinda Brickler, July 11, 2008. 23. Patrick Parkinson, email to Ben Bernanke et al., July 20, 2008. 24. Ibid. 609 25. Based on chart in Federal Reserve Bank of New York, Developing Metrics for the Four Largest Secu- rities Firms, August 2008, p. 5. 26. Ibid. 27. Tobias Adrian, Christopher Burke, and James McAndrews, “The Federal Reserve’s Primary Dealer Credit Facility,” Federal Reserve Bank of New York, Current Issues in Economics and Finance 15, no. 4 (August 2009): 2. 28. Erik Sirri, interview by FCIC, April 9, 2010, p. 3. 29. Fed Chair Ben Bernanke, “Lessons from the Failure of Lehman Brothers,” testimony before the fcic_final_report_full--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. FinancialCrisisReport--260 Subprime lending fueled the overall growth in housing demand and housing price increases that began in the late 1990s and ran through mid-2006. 1008 “Between 2000 and 2007, backers of subprime mortgage - backed securities – primarily Wall Street and European investment banks – underwrote $2.1 trillion worth of [subprime mortgage backed securities] business, according to data from trade publication Inside Mortgage Finance .” 1009 By 2006, subprime lending made up 13.5% of mortgage lending in the United States, a fivefold increase from 2001. 1010 The graph below reflects the unprecedented growth in subprime mortgages between 2003 and 2006. 1011 1008 See 3/2009 U.S. Department of Housing and Urban Development Interim Report to Congress, “Root Causes of the Foreclosure Crisis,” at 36. See also “A Brief History of Credit Rating Agencies: How Financial Regulation Entrenched this Industry’s Role in the Subprime Mortgage Debacle of 2007 – 2008,” Mercatus on Policy (10/2009), at 2. 1009 “The Roots of the Financial Crisis: Who is to Blame?” The Center for Public Integrity (5/6/2009), http://www.publicintegrity.org/investigations/economic_meltdown/articles/entry/1286. 1010 3/2009 U.S. Department of Housing and Urban Development Interim Report to Congress, “Root Causes of the Foreclosure Crisis,” at 7. 1011 1/25/2010, “Mortgage Subprime Origination,” chart prepared by Paulson & Co. Inc., PSI-Paulson&Co-02-0001- 21, at 4. CHRG-111shrg57709--152 Mr. Volcker," Of course, that reaction became extreme in the middle of the crisis a year or more ago, and nobody wanted to move any money anyplace. I hope that is changing some. There is a little evidence from some banker survey that the Federal Reserve made that they may be less tight than they were. But this is partly a matter of the severity of the economic crisis, and a lot of loans went bad and they are cautious. And we want to do what we can to increase confidence and get the money flowing. Senator Reed. Let me ask you if there is another way to approach this concept, which is to say to an institution if your traditional commercial banking activities are less than 75 percent, then you do not have access to the Fed window. I mean, essentially what my colleagues have said time and time again, we do not want to subsidize the risk. We do not want the bailout. Well, the bailout comes, as we have seen, particularly in the context of bank holding companies, when the Federal Reserve walks up and takes whatever collateral they are willing to give them and gives them lots of money. " CHRG-111hhrg55811--331 Mr. Ferreri," Could I add some insight to that, please? As an inter-dealer broker, when we hear stories from end-users, our customers are not end-users as the dealers that they deal with. The interest rate swap market, even during the crisis, the height of the crisis, operated very effectively and very efficiently. The foreign exchange market that our members operate, operated very effectively and very efficiently. The London Clearing House, in a report to the European Commission, made a case that after Lehman failed, $9 trillion in interest rate swaps with Lehman as a counterparty were in the Clearing House, more than 60,000 trades. Those trades settled through the Clearing House without a single dollar lost of member funds. So although there may be underlying problems in a certain aspect or a certain area, the breadth of the marketplace and the ability for the dealers to participate as market makers instinctively for the inter-dealer market was certainly proven to be strong. " FinancialCrisisReport--348 A similar view as to why the CDO business continued to operate despite increasing market risk was expressed by a former executive at the hedge fund Paulson & Co. in a January 2007 email exchange with another investor. The Paulson executive wrote: “It is true that the market is not pricing the subprime RMBS wipeout scenario. In my opinion this situation is due to the fact that rating agencies, CDO managers and underwriters have all the incentives to keep the game going, while ‘real money’ investors have neither the analytic tools nor the institutional framework to take action before the losses that one could anticipate based [on] the ‘news’ available everywhere are actually realized.” 1331 At the end of September 2006, the head of Deutsche Bank’s sales force, Sean Whelan, wrote to Mr. Lippmann expressing concern that some CDO tranches were getting increasingly difficult to sell: “[T]he equity and the AAA were the parts we found difficult to place.” 1332 Mr. Lippmann told the Subcommittee that once firms could not sell an entire CDO to investors, it was a warning that the market was waning, and the investment banks should have stopped structuring new ones. 1333 Instead of getting out of the CDO business, however, he said, a new source of CDO demand was found – when new CDOs started buying old CDO securities to include in their assets. One media report explained how this worked: “As the housing boom began to slow in mid-2006, investors became skittish about the riskier parts of those investments. So the banks created – and ultimately provided most of the money for – new CDOs. Those new CDOs bought the hard-to-sell pieces of the original CDOs. The result was a daisy chain that solved one problem but created another: Each new CDO had its own risky pieces. Banks created yet other CDOs to buy those.” 1334 Research conducted by Thetica Systems, at the request of ProPublica, found that in the last years before the financial crisis, CDOs had become the dominant purchaser of high risk CDO securities, largely replacing real money investors like pension funds, insurance companies, and hedge funds. The CDO market analysis found that, by 2007, 67% of the high risk mezzanine CDO securities had been purchased by other CDOs, up from 36% in 2004. 1335 1331 1/14/2007 email from Paolo Pellegrini at Paulson to Ananth Krishnamurthy at 3a Investors, PAULSON ABACUS 0234459. 1332 9/27/2006 email from Sean Whelan to Greg Lippmann, DBSI_PSI_EMAIL02255361-63. 1333 Subcommittee interview of Greg Lippmann (10/18/2010). Mr. Lippmann told the Subcommittee that he thought Mr. Lamont’s CDO Group at Deutsche Bank had too many CDOs in the pipeline in the spring of 2007, when it could not sell all of its CDO securities. He reported that he told Mr. Lamont that defaults would increase. 1334 “Banks’ Self-Dealing Super Charged Financial Crisis,” ProPublica , (8/26/2010), http://www.propublica.org/article/banks-self-dealing-super-charged-financial-crisis. 1335 Id. ProPublica even found that, from 2006 to 2007, nearly half of all the CDOs sponsored by Merrill Lynch bought significant portions of other Merrill CDOs. FOMC20070918meeting--328 326,MS. YELLEN.," Thank you, Mr. Chairman. I also want to congratulate the staff. This is a very clever and targeted intervention, and it’s a very nicely put together proposal. I’m supportive. I think it’s something that’s good to have available. I’m glad that we’re not planning to put it in place instantly. It does have the potential to address the stigma issues that banks have coming to the discount window. Really, the spike in the spread between term and overnight loans in the interbank market has been quite sizable, and it’s obvious that that has been complicating the difficulties that banks have had in managing liquidity. I have also been concerned, given how many other borrowing rates are linked to LIBOR, that if the spread remains elevated, it has the potential to spill over into the rates that a lot of borrowers pay. I think this has a chance in succeeding and reducing that spread and bringing LIBOR down, but it’s not 100 percent obvious to me that it will succeed. I think it does depend on your interpretation of exactly what that spread represents, whether it’s credit risk or liquidity risk. As I read the proposal, I thought it really didn’t make the case in a powerful way to me that the inability of banks to fund at term was creating systemic risk. It seems to me that, given a proposal of this magnitude that involves coordinating central bank intervention and has a chance of not succeeding, we ought to be doing it to address something that we regard as an important have discussed this, that there could very well be systemic risks here and that we might, if things get worse again, want to put this into place. So I found that discussion very useful. It seemed to me that the case that was actually made in the document in a sense was more a monetary policy case that banks facing these funding pressures would likely raise rates and that would have macroeconomic consequences. That then suggests to me, Well, why don’t we use the federal funds rate more? It is a more general tool to remove those pressures. I share the concern that we will be perceived as bailing out a small set of weak institutions, including Washington Mutual, Countrywide, and others that may be associated with the crisis. Especially if we’re using this overnight index swap rate. It has been sitting here, I guess, around 4.80, 4.76, or something like that, which if we had had this facility in effect would be below the funds rate and would raise questions about why we were lending so cheaply. One way or another, I would certainly be happy to approve a swap agreement with the European Central Bank and the Swiss National Bank to provide them with dollar funding whether we go ahead or not, if that’s desirable." CHRG-111shrg55479--25 Mr. Verret," Chairman Reed, Ranking Member Bunning, and distinguished Members of the Committee, I appreciate the opportunity to testify in this forum today. My name is J.W. Verret. I teach corporate law at George Mason Law School. I am a Senior Scholar with the Mercatus Center Financial Markets Working Group, and I also run the Corporate federalism Initiative, a network of scholars dedicated to studying the intersection of State and Federal authority in corporate governance. I will begin by addressing proxy access and executive compensation rules under consideration, neither of which address the current financial crisis and both of which may result in significant unintended consequences. Then I will close with a list of factors that did contribute to the present financial crisis. I am concerned that some of the corporate governance proposals recently advanced impede shareholder voice in corporate elections. This is because they leave no room for investors to design corporate governance structures appropriate for their particular circumstances and particular companies. Rather than expanding shareholder choice, the proxy reform and ``say-on-pay'' proposals before this committee actually stand in the way of shareholder choice. Most importantly, they do not permit a majority of shareholders to reject the Federal approach. The Director of the United Brotherhood of Carpenters said it best. Quote, ``We think less is more. Fewer votes and less often would allow us to put more resources toward intelligent analysis.'' The Brotherhood of Carpenters opposes the current proposal out of concern about compliance costs. The proposals at issue today ignore their concerns, as well as concerns of many other investors. Consider why one might limit shareholders from considering alternative means of shareholder access. It can only be because a majority of shareholders at many companies might reject the Federal approach if given the opportunity. Not all shareholders share the same goals. Public pension funds run by State elected officials and union pension funds are among the most vocal proponents of the proposals before this committee. There are many examples where they used their power, their existing shareholder power, toward their own special interests. Main Street investors deserve the right to determine whether they want the politics of unions and State pension funds to take place in their 401(k)s. The current proposals also envision more disclosure about compensation consultants. Such a discussion would be incomplete without mentioning conflicts faced by proxy advisory firms like RiskMetrics, an issue the current proposals have failed to address. In addition, I will note that there is no evidence that executive compensation played a role in the current crisis. If executive compensation were to blame for the present crisis, we would see significant difference between compensation policies at those companies that recently returned their TARP money and those needing additional capital. We do not. Many of the current proposals also seek to undermine and take legislative credit for efforts currently underway at the State level and in negotiations between investors and boards. This is true on proxy access, the subject of recent rule making at the State level, and it is true for Federal proposals on staggered boards, majority voting, and independent chairmen. We have run this experiment before. The Sarbanes-Oxley Act passed in 2002 was an unprecedented shift in corporate governance, designed to prevent poor management practices. Between 2002, when Sarbanes-Oxley was passed, and 2008, the managerial decisions that led to the current crisis were in full swing. I won't argue that Sarbanes-Oxley caused the crisis, but this does suggest that corporate governance reform at the Federal level does a poor job of preventing crisis. And yet the financial crisis of 2008 must have a cause. I commend this Committee's determination to undercover it, but challenge whether corporate governance is, in fact, the culprit. Let me suggest six alternative contributing factors for this Committee to investigate. One, the moral hazard problems created by the prospect of Government bailout. Two, the market distortions caused by subsidization of the housing market through Fannie Mae, Freddie Mac, and Federal tax policy. Three, regulatory failure by the banking regulators and the SEC in setting appropriate risk-based capital reserve requirements for investment in commercial banks. Four, short-term thinking on Wall Street, fed by institutional investor fixation on firms making and meeting quarterly earnings predictions. Five, a failure of credit-rating agencies to provide meaningful analysis caused by an oligopoly in the credit-rating market supported by regulation. Six, excessive write-downs in asset values under mark-to-market accounting, demanded by accounting firms who refuse to sign off on balance sheets out of concern about exposure to excessive litigation risk. Corporate governance is the foundation of American capital markets. Shifting that foundation requires deliberation and a respect for the roles of States in corporate governance. Eroding that foundation risks devastating effects for capital markets. Thank you for the opportunity to testify and I look forward to answering your questions. " fcic_final_report_full--480 PMBS rely on a classification and subordination system known as “tranching” to provide some investors in the pool with a degree of assurance that they will not suffer losses because of mortgage defaults. In the tranching system, different classes of securities are issued by the pool. The rights of some classes to receive payments of principal and interest from the mortgages in the pool are subordinated to the rights of other classes, so that the superior classes are more likely to receive payment even if there are some defaults among the mortgages in the pool. Through this mechanism, approximately 90 percent of an issue of PMBS could be rated AAA or AA, even if the underlying mortgages are NTMs that have a higher rate of delinquency than prime loans. In theory, for example, if the historic rates of loss on a pool of NTMs is, say, five percent, then those losses will be absorbed by the ten percent of the securities holders who are in the classes rated lower than AAA or AA. Of course, if the losses are greater than anticipated—exactly what happened as the recent bubble began to deflate—they will reach into the higher classes and substantially reduce their value. 48 It is not clear whether, in 2007 or 2008, mortgage delinquencies and defaults had actually caused cash losses in the AAA tranches of PMBS, but the rate at which delinquencies and defaults among NTMs were occurring throughout the financial system was so high that such losses were a distinct possibility—obviously a matter of great concern to investors. This means that investors in PMBS and government-backed Agency MBS had different experiences when the bubble began to deflate. Those who invested in Agency MBS did not suffer losses (the U.S. government has thus far protected all investors in Agency MBS), while those who invested in PMBS were exposed to losses if the losses on the underlying mortgages were so great that they threatened to invade the AAA and AA classes. Even if no cash losses had actually been suffered, the holders of PMBS would see a sharp decline in the market value of their holdings as investors—shocked by the large number of defaults on mortgages—fled the asset- backed market. So when we look for the direct effect of mortgage failures on the financial condition of various financial institutions in the financial crisis we should look only to the PMBS, not the MBS issued by the Agencies. In addition, the default and delinquency ratios on the loans underlying the PMBS were higher than similar ratios among the loans held or guaranteed by the Agencies. Many of the loans which backed the PMBS were the self-denominated subprime loans (that is, made by subprime lenders explicitly to subprime borrowers) and were classified in the worst-performing categories in Table 3. In part, the better- performing characteristics of the NTMs held or guaranteed by the Agencies was due to the fact that the Agencies were not buying for economic purposes—to make profits—but only to meet government requirements such as the AH goals. They did not want or need the higher-yielding and thus more risky mortgages that backed the PMBS, because they did not need higher yields in order to sell their MBS. In addition, because of their lower cost funding, the Agencies could pay more for the NTMs they bought and thus could acquire the “best of the worst.” 48 A thorough description of the tranching system, and many more details about various methods of protecting senior tranches, is contained in Gary B. Gorton, Slapped By the Invisible Hand: The Panic of 2007, Oxford University Press, 2010, pp. 82-113. 475 CHRG-111shrg61651--14 Mr. Johnson," Thank you, Senator. I strongly support the Volcker Rules, as everybody is starting to call them, in terms of the principles they put forward. I think there are two main principles. The first is that we should redesign the size cap that does already exist for U.S. banks, the size cap from the 1994 Riegle-Neal Act. We should redesign it to reflect current realities. And second, we should address the issue that has arisen, in particular over the past few years, of U.S. Government backing for very large financial enterprises that have basically an unlimited ability to take risk around the world. I do not, however, think that the exact formulation of the Volcker Rules as put forward is the right way to go. I think, actually, you should consider tightening the restrictions on the largest banks and reducing the size cap, and I would emphasize that our banks are now already much larger as a percent of the--our largest banks as a percent of the economy, a percent of total financial assets, than we have ever seen before in the United States. Our largest six banks have assets worth over 60 percent of GDP. This reflects, in addition to what has happened in the financial crisis and the bailout and the rescue, it reflects the underlying concentration of these financial markets. So the big four banks now have more than half of the mortgage market in this country and two-thirds of the market for credit cards. This is unfair competition. Because these banks are too big to fail, they have lower funding costs, they are able to attract more capital, they make more money over the cycle, and they continue to get larger. And I do not think that we have seen the end of this. If you look at the European situation today, for example, it is much worse than what we have in this country with regard to the size of the largest banks. Just as one example, the Royal Bank of Scotland peaked with total assets at 125 percent of U.K. GDP. That is a seriously troubled bank that is now the responsibility of the U.K. taxpayer. If we allow our biggest banks to continue to build on these unfair market advantages and the lower funding costs, we will head in the same direction. I think I would suggest to you that you consider imposing a size cap on banks relative not to total normal assets or liabilities, which is the Volcker proposal, because that is not bubble-proof. If you have a massive increase in house prices, real estate prices, such as happened in Japan in the 1980s, you will have a big increase in the normal size of bank balance sheets. And when the bubble bursts, you are going to have a big problem. I think the size cap should be redefined as a percent of GDP. And I think that while the science on bank size is, to be sure, incomplete and inexact, there is no evidence that I can find of any kind, and I have spent a lot of time talking to technical people from they financial sector and people at central banks, people in the banking system themselves have impressed various points on me. I cannot find anything--I put this in the written testimony--that supports the idea that societies such as ours should have banks with total assets larger than around $100 billion in today's money. Now, if you were to impose a size cap of, say, 3 or 5 percent of GDP, no bank can be larger than that size, that would return our biggest banks roughly to the position that they had in the early 1990s. Now, our financial system worked very well in the early 1990s. Goldman Sachs, as one example, was one of the world's top investment banks. I don't think anyone questioned the competitive sector. But since the early 1990s, we have developed a lot more system risk focused on the existence of these very big banks. So, as Mr. Corrigan said, the essence of this crisis was lending, but it was lending that at the heart of it was based on the idea you could make nonrecourse loans to people who can walk away from their homes when the house value falls, leaving the bank with huge losses. How do people think this was a good idea? Why did they think that this would survive as a business model? Well, I think it was very much about the size of these banks and very much about the support they expected to receive when they are under duress. So in conclusion, I think the Volcker principles are exactly right. I think they are long overdue. I think you should--I hope that you will take them up and develop them further. I think the degree of unfair market competition, the degree to which the community banks are disadvantaged by the current situation, because they have to pay a lot more money--they pay higher interest for funds, their cost of capital is higher--this is unfair. This dynamic will continue unless you put an effective cap on it. The biggest banks will become even larger and even more dangerous. Thank you very much. " CHRG-110shrg50417--124 Mr. Campbell," Mr. Chairman, I want to start by, again, really confirming that we understand the sensitive nature of this crisis, and it is clearly in all of our best interests to find solutions. Having said that, our view is still that while it may be an important fix right now, what does it do to the longer-term availability of credit to this market? " CHRG-111hhrg52397--299 Mr. Manzullo," Thank you, Mr. Chairman. Let me ask a very basic question. I believe that we would not be in this crisis that we are today if the subprime market had not gone sour and thus tainted the basis of the investments, which grew, the investments grow obviously exponentially through derivatives. Does that statement make sense or am I missing something on it? " CHRG-110hhrg46595--344 Mr. Mulally," Even though we are not requesting a bridge loan, it is so important, this industry so important, that is why we have joined our colleagues. Because if one of us goes in, it has the potential, as we have talked about, to take all of us in. And what that would mean to the economy would be tremendous. Then, instead of being part of the solution to get through the worst economic crisis all of us have been in across this great country, we would be part of the problem. " CHRG-110shrg50418--74 Mr. Mulally," Well, we clearly don't know, but separating out what has happened because of the current financial crisis and economic slowdown has kind of masked that right now. But we are going through vehicle by vehicle, each size, what is the real demand? But I think there is a real possibility that over the long term, it could be a lot less than that 17 million. " CHRG-111shrg61513--2 Chairman Dodd," The Committee will come to order. Let me welcome all who are here this morning for the Committee hearing, the hearing on the semiannual monetary report to Congress by the Chairman of the Federal Reserve, and we welcome you once again, Mr. Chairman, to the Banking Committee. I will make a brief opening statement, turn to Senator Shelby for any comments he may make, and then we will turn right to you for your opening comments and get to some questioning. But we thank you once again for joining us here this morning. Today, as you testify before us, Mr. Chairman, it is worth taking a moment to recognize that our economy is showing signs of emerging from this recession. During the last two quarters, GDP has shown positive growth, as has gross private domestic investment, and financial markets have stabilized enough to allow the Fed to wind down nearly all the liquidity facilities it established in response to this crisis. But that does not mean, of course, that our economy is out of the woods, as we all know. And more importantly, it does not mean that the situation of working families has improved dramatically either. Households and small businesses dependent on banks for financing continue to have trouble getting the loans that they need. Commercial real estate losses continue to mount, and combined with losses on home mortgages, they are making the credit crunch even worse. Outside of securities guaranteed by the Federal Government, the residential and commercial markets for mortgage-backed securities are practically non-existent. Foreclosures continue to plague our communities at greater and greater rates, and the large inventory of foreclosed homes continues to suppress the housing market and discouraging new construction. And worst of all, Mr. Chairman, the job market continues to suffer from the losses incurred during the recession. We have lost 8.4 million jobs since December of 2007. The unemployment rate stands at 9.7 percent, although many of us would argue here that that number is actually vastly in excess of that in many areas of the country. And it is widely expected that it will remain high for several years to come. An astonishing 6.3 million American workers have been out of a job for a half a year or more, and that is a record in our Nation. The state of our economy as a whole may be improving, but if we are talking about the situation of ordinary American families, I think I can sum up this recovery in three words: Not good enough. I think most would agree. The longer we go without resolving these problems, the worse off, of course, we all will be. Unemployed Americans will continue to lose their health insurance and their homes. Their skills will begin to deteriorate, leaving us less competitive in the global economy. Those who do have jobs will see their wages stagnate. Our country will suffer as a result. This Congress has a role to play in putting people back to work, and we have a responsibility to put protections in place to make sure that a crisis like this never threatens our financial system again. Our Committee has made important progress toward that end, and my hope is that we will have a financial reform bill ready in the coming days. Mr. Chairman, you also have a role to play in all of this, as you know, and I have been impressed by your leadership, keeping the American economy from falling into the abyss, and you deserve a great deal of credit, in my view, for having contributed so significantly to that result. But now it is time as well, as I am sure you will agree, for you to show the same kind of leadership in helping us and American families along with those of us on this side of the dais to achieve the same fate, to come out of this abyss and get back on our feet again. So I look forward to working with you in the coming days--I know all of my colleagues will--work on your ideas and how monetary policy can help our constituents emerge from this recession. Now, as many of my colleagues know, having filled in the seat for Ted Kennedy as Chairman of the Health, Education, and Labor Committee, I have another place to be this morning--at the White House--to sit there and resolve health care, which I am confident we are going to do this morning, I would say to my colleagues. I do not see any smiles around the table on hearing that prediction. And so I am going to be leaving shortly, but I want to take--I am going to abuse my chairmanship for a minute. I am going to ask you a question because I will not get a chance in the normal process. In light of what is happening in Greece, Mr. Chairman, I wanted to raise an issue because matters have arisen, and I will raise this and you can either respond quickly to it and I will go right to Senator Shelby. But if I indulge my colleagues by doing this--I have not done this before, but given that I have got the problems this morning where I have to be. The debt crisis, Mr. Chairman, in Greece is shedding light on the role of derivatives in the financial markets. According to news reports this morning and over the last several days, banks and hedge funds are using credit default swaps to bet that Greece will default on its debt. The rising price of these contracts contributes to an atmosphere of crisis, making it even more difficult for the Greek Government, in my opinion, to borrow. Since there is no requirement that purchasers of credit default swaps actually own any of the underlying debt, we have a situation in which major financial institutions are amplifying a public crisis for what would appear to be private gain. I want to ask you here whether or not you think there ought to be limits on the use of credit default swaps to prevent the intentional creation of runs against governments. Do you have any quick comments on that? " CHRG-111shrg54533--66 Secretary Geithner," Senator, at the beginning of this administration, we said that there were five areas where we thought it was going to be appropriate to consider using TARP authority Congress provided, and those were to help address the housing crisis, to make sure banks have capital where they need capital, to help support bringing back the securitization markets, targeted programs for small business lending, and a program to help restart these markets for loans on the balance sheets of banks. Now, we have moved forward to put in place programs in each of those areas, as we said we would do. We are on the verge of putting in place the last of those programs, which is to help create a set of funds to help restart these markets for--you call them ``toxic.'' We call them ``legacy assets.'' These programs are subjected to an enormous amount of carefully designed oversight, not just by the Congressional Oversight Panel you provided, you established under statute, but also by a Special Inspector General at the Treasury and by the GAO. They report monthly on everything we are doing. We have been fully transparent about the specific terms underpinning each of these programs so that everyone can look at exactly what we are doing and measure their impact and their success. We are looking very carefully at every recommendation those oversight bodies make for bringing more transparency and accountability to them, and where we think they make sense and we can do them, we have adapted those recommendations, and we will keep doing that. It is hard to know what might be necessary in the future in terms of using this authority, if any further use will be required, but my sense is that if we need to do more in the future, that anything we do will fall within those core basic framework, which, to reduce them, are about making sure the banking system has capital and making sure these markets are getting going again. Senator Hutchison. So further congressional oversight would not be necessary or prudent, in your view? " CHRG-111hhrg48873--246 Secretary Geithner," I think you are absolutely right to be concerned about this. I share that concern very much. That is why the reform effort we are going to have to work with the Congress on is going to have to address the moral hazard created by these extraordinary interventions. You are absolutely right to be worried about it. We need to dial back this assistance when we get through the crisis, and we have to put in place much stronger restraints on future risk-taking. " CHRG-111hhrg55809--261 Mr. Bernanke," Well, the SEC is looking at that. I think there are interesting questions about whether the market is served by having more transparency about those pools. I don't really have a firm position on that. I am not aware that those dark pools were an important factor in the crisis as a whole. I mean, I may be mistaken, but transparency in general is very important, but again, on this particular area, I know the SEC is looking at it and trying to make some determination. " 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-111shrg52619--211 RESPONSE TO WRITTEN QUESTIONS OF SENATOR REED FROM GEORGE REYNOLDSQ.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. We do not perceive that lack of action is a problem among the state credit union regulators. In fact, the authority given to state regulators by state legislatures allows state regulators to move quickly to mitigate problems and address risk in their state-chartered credit unions. NASCUS \1\ believes that the dual chartering structure which allows for both a strong state and federal regulator is an effective regulatory structure for credit unions.--------------------------------------------------------------------------- \1\ NASCUS is the professional association of state credit union regulatory agencies that charter, examine and supervise the nation's 3,100 state-chartered credit unions. The NASCUS mission is to enhance state credit union supervision and advocate for a safe and sound credit union system.--------------------------------------------------------------------------- State and federal credit union regulators regularly exchange information about the credit unions they supervise; it is a cooperative relationship. The Federal Credit Union Act (FCUA) provides that ``examinations conducted by State regulatory agencies shall be utilized by the Board for such purposes to the maximum extent feasible.'' \2\ Further, Congress has recognized and affirmed the distinct roles played by state and federal regulatory agencies in the FCUA by providing a system of consultation and cooperation between state and federal regulators. \3\ It is important that all statutes and regulations written in the future include provisions that require consultation and cooperation between state and federal credit union regulators to prevent regulatory and legal barriers to the comprehensive information sharing. This cooperation helps regulators identify and act on issues before they become a problem.--------------------------------------------------------------------------- \2\ 12 U.S. Code 1781(b)(1). \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).--------------------------------------------------------------------------- State regulators play an important role in protecting the safety and soundness of the state credit union system. It is imperative that any regulatory structure preserve state regulators role in overseeing and writing regulations for state credit unions. In addition, it is critical that state regulators and National Credit Union Administration (NCUA) have parity and comparable systemic risk authority with the Federal Deposit Insurance Corporation (FDIC).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. To ensure a comprehensive regulatory system, Congress should consider the current dual chartering system as a regulatory model. Dual chartering and the value offered to consumers by the state and federal systems provide the components that make a comprehensive regulatory system. Dual chartering also reduces the likelihood of gaps in financial regulation because there are two interested regulators. Often, states are in the first and best position to identify current trends that need to be regulated and this structure allows the party with the most information to act to curtail a situation before it becomes problematic. Dual chartering should continue. This system provides accountability and the needed structure for effective and aggressive regulatory enforcement. The dual chartering system has provided comprehensive regulation for 140 years. Dual chartering remains viable in the financial marketplace because of the distinct benefits provided by each charter, state and federal. This system allows each financial institution to select the charter that benefits its members or consumers the most. Ideally, for any system, the best elements of each charter should be recognized and enhanced to allow for competition in the marketplace so that everyone benefits. In addition, the dual chartering system allows for the checks and balances between state and federal government necessary for comprehensive regulation. Any regulatory system should recognize the value of the dual chartering system and how it contributes to a comprehensive regulatory structure. Regulators should evaluate products and services based on safety and soundness and consumer protection criterion. This will maintain the public's confidence.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? Is this an issue that can be addressed through regulatory restructure efforts?A.3. The current credit union regulatory structure appropriately provides state credit union regulators rulemaking and enforcement authority. This authority helps state regulators respond to problems and trends at state-chartered credit unions and it places them in a position to help state credit unions manage risks on their balance sheets. It is sometimes difficult, particularly during a period of economic expansion to motivate financial institutions to reduce concentration risk when institutions are strongly capitalized and have robust earnings. This is, nevertheless, the appropriate role of a regulator and it is not really a factor that can be addressed through regulatory restructuring. It can only be impacted by having effective, experienced and well trained examiners that are supported in consistent manner by experienced supervisory management.Q.4. 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.4. The current economic crisis and resulting destabilization of portions of the financial services system has revealed certain gaps and lapses in overall regulatory oversight. Currently, state and federal regulators are assessing those lapses, identifying gaps, and working diligently to address weaknesses in the system. As part of this process, it is also important to recognize regulatory oversight that worked, whether preventing failure, or identifying undue risk in a manner that allowed for an orderly unwinding of a going concern. To the extent that regulators miscalculated a calibration of acceptable risk, as opposed to undue risk, it may be safe to conclude that undue reliance was placed on underlying market assumptions that failed upon severe market dislocation.Q.5. While we know that certain hedge funds, for example, have failed, have any of them contributed to systemic risk?A.5. NASCUS members do not regulate hedge funds. The answers provided by NASCUS focus solely on issues related to our expertise regulating state credit unions and issues concerning the state credit union system.Q.6. 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.6. Given NASCUS members regulatory scope, this question does not apply. The answers provided by NASCUS focus solely on issues related to our expertise regulating state credit unions and issues concerning the state credit union system. NASCUS background: The NASCUS, \4\ mission is to enhance state credit union supervision and advocate for a safe and sound credit union system. NASCUS represents the interests of state agencies before Congress and is the liaison to federal agencies, including the National Credit Union Administration (NCUA). NCUA is the chartering authority for federal credit unions and the administrator of the National Credit Union Share Insurance Fund (NCUSIF), the insurer of most state-chartered credit unions.--------------------------------------------------------------------------- \4\ NASCUS is the professional association of state credit union regulatory agencies that charter, examine and supervise the nation's 3,100 state-chartered credit unions.--------------------------------------------------------------------------- Credit unions in this country are structured in three tiers. The first tier consists of 8,088 natural-person credit unions \5\ that provide services to consumer members. Approximately 3,100 of these institutions are state-chartered credit unions and are regulated by state regulatory agencies. There are 27 \6\ retail corporate credit unions, which provide investment, liquidity and payment system services to credit unions; corporate credit unions do not serve consumers. The final tier of the credit union system is a federal wholesale corporate that acts as a liquidity and payment systems provider to the corporate system and indirectly to the consumer credit unions.--------------------------------------------------------------------------- \5\ Credit Union Report, Year-End 2008, Credit Union National Association. \6\ There are 14 state-chartered retail corporate credit unions and 13 federally chartered corporate credit unions.--------------------------------------------------------------------------- ------ FinancialCrisisInquiry--99 BLANKFEIN: I don’t think we should rely on—I think that was lucky. And I think the amount of attention and time that people—regulators, the industry, legislators—are focused on making sure that the instrumentality and the pipes of clearing derivatives are in place is highly justified, notwithstanding, we didn’t specifically have a derivatives crisis. BORN: Do you think that the failure or near failure of AIG was related to credit swaps? That is, credit-default swaps? And do you think that having clearing would have, in any way, reduced the risks inherent in AIG’s position? BLANKFEIN: I believe that it wouldn’t—it may have helped a bit. I don’t think that was a key thing. AIG was bent on taking a lot of credit risk. They took that credit risk in the derivatives market. They took that business by writing insurance against credit events. They took it by holding securities. It was a failure of risk management of colossal proportion, and there were derivatives in there, but it was really -- those were merely mechanisms of taking credit exposure to get paid for that exposure that they took through multiple kinds of vehicles and could have substituted other vehicles for them. BORN: Do you think—how would having a clearinghouse and having exchange trading of standardized derivatives reduce systemic risk as you say in your testimony? BLANKFEIN: I think that, to the extent that you have a—starting with a clearing house—to the extent that you have a clearing house, the issue we had with an AIG, vis-à-vis margin or fighting over settlements of what mark-to-market should be for the smooth transfer of margin, we would have avoided. We got margin for them, but it was hard to get out of them and it was slow. It lagged what we thought the mark-to-market—in a clearinghouse context, that would be easier to do. So anything that’s liquid enough and could be priced easily to go through a clearinghouse should. CHRG-111hhrg48867--92 The Chairman," The gentlewoman from California is now recognized for 5 minutes. Ms. Waters. Thank you very much, Mr. Chairman. I would like to thank all of our witnesses who have appeared here today. I am particularly pleased about the testimony of Ms. Terry Jorde, president and chief executive officer of CountryBank U.S.A., on behalf of the Independent Community Bankers of America. Let me just say, Ms. Jorde, that I heard your testimony about your bank. The only thing wrong with your bank is it sounds too much like Countrywide, and you ought to be worried about that because, despite all of the testimony about Fannie and Freddie, it was Countrywide who threatened Fannie, that if they didn't take their products, that they would just kind of squeeze them out of the market. And of course, Countrywide was a nonbank that was unregulated by anybody. I am from California. I think we have at least repaired part of the problem where we require the licensing of all these brokers. Countrywide had only had one license, and it had anybody who could breathe to go out and initiate loans. And there is a lot of fraud that was involved in that, and I appreciate the testimony of all of those who understand that it is not simply a systemic regulator, someone who I think, as was indicated, sitting on the top of all of this that is going to make it work. We really do need consumer protection, and if we think we are going to get it from the same people who have been in the system, I don't think so, not because they are evil people, they just don't think that way. All of our regulators think about how to notice the banks, how to warn the banks, how to talk with the banks but they never talk about how to stop them because of the way that they think they absolutely believe that you should let the marketplace work. All of those exotic products that were placed on the market, whether they were, Alt-A loans or adjustable rate, option loans, etc., as long as these kinds of products can be put on the market without any scrutiny, without any real interference by regulators, we are going to have a problem. The mailboxes of citizens are being swamped now with new products because of the foreclosure meltdown. Now, the insurance companies, many of them I guess owned by maybe some of these banks, I don't know, are flooding the mailboxes with mortgage protection. What is it? How does it work? I don't think the regulators have been here to talk about it. And out of this crisis that we have, now we have all of the loan modification companies that have sprang up, and all they need is $3,500 to start to work to help someone get a loan modification. No regulator has said a word about this. And so we sit here and, of course, we think that they know what they are doing, but I am afraid that if we have a systemic regulator they are going to come from Goldman Sachs; and it seems to me Goldman Sachs is everywhere. Not only was it our past Treasurer, it is our now present Treasurer. I understand that Edward Liddy over at AIG worked for Goldman Sachs, and we find that Goldman Sachs was kind of taken care of when they were brought in to snatch up Bear Stearns for pennies on the dollar. And then we find that now Goldman Sachs is taken care of, again, through AIG; and of course we took care of them in our TARP program with the capital purchase program, and I guess they are sitting on top of all of this. Am I to expect that this systemic regulator who will probably come out of the same market that caused this problem is going to cure all of this? We need a consumer protection agency to deal with all of this. Don't forget, it was the activists and the consumers who went before every bank merger attempt and went to the hearings held by the Fed and everybody else, saying, ``Don't do that.'' And they talked about the problems that would be caused. Now, I want to ask again the idea of the consumer protection agency that came from Labor, to please explain what you are. " CHRG-111shrg53176--118 Mr. Ketchum," Chairman Dodd, Ranking Member Shelby, and Members of the Committee, I am Richard Ketchum, Chairman and CEO of the Financial Industry Regulatory Authority, or FINRA. On behalf of FINRA, I would like to thank you for the opportunity to testify, and I commend you, Mr. Chairman, for having today's hearing on the critically important topic of reforming our regulatory structure for financial services. As someone who has spent the great majority of my career as a regulator, dedicated to protecting investors and improving market integrity, I am deeply troubled by our system's recent failures. The credit crisis and scandals of the last year have painfully demonstrated how the gaps in our current fragmented regulatory system can allow significant activity and misconduct to occur outside the view and reach of regulators. FINRA shares this Committee's commitment to identifying these gaps and weaknesses and improving the system for investors. Let me briefly talk about FINRA and our regulatory role. FINRA regulates the practices of nearly 4,900 securities firms and more than 650,000 registered securities representatives. As an independent regulatory organization, FINRA provides the first line of oversight for broker-dealers. FINRA augments and deepens the reach of the Federal securities laws with detailed and enforceable ethical rules and a host of comprehensive regulatory oversight programs. We have a robust and comprehensive examination program with dedicated resources of more than 1,000 employees. FINRA has the ability to bring enforcement actions against firms and their employees who violate the rules. Mr. Chairman, as I said earlier, the topic of today's hearing is critical. The failures that have rocked our financial system have laid bare the regulatory gaps that must be fixed if investors are to have the confidence to re-enter the markets. Our current system of financial regulation leads to an environment where investors are left without consistent and effective protections when dealing with financial professionals. At the very least, our system should require that every person who provides financial advice and sells a financial product be licensed and tested for competence, that advertising for products not be misleading; that every product marketed to an investor is appropriate for that particular investor; and that comprehensive disclosure exists for services and products. I would like to highlight the regulatory gap that, in our view, is among the most glaring examples of what needs to be addressed--the disparity between oversight regimes for broker-dealers and investment advisers. The lack of a comprehensive, investor-level examination program for investment advisers impacts the level of protection for every person that entrusts funds to an adviser. In fact, the Madoff Ponzi scheme highlighted what can happen when a regulator like FINRA has only free rein to see one side of the business. Let me be clear. I mention this example not because FINRA is sanguine with its role in the Madoff tragedy. Any regulator who had any responsibility for oversight for Madoff must accept accountability and search diligently for lessons learned. But the way to identify fraud, just as with sales practice abuse, is not through the fog of jurisdictional restrictions. Fragmented regulation provides opportunities to those who would cynically game the system to do so at great harm to investors, and it must be changed. The regulatory regime for investment advisers should be expanded to include an additional component of oversight by an independent regulatory organization, similar to that which exists for broker-dealers. The SEC and State securities regulators play vital roles in overseeing both broker-dealers and investment advisers, and they should continue to do so. But it is clear that dedicating more resources to regular and vigorous examination and day-to-day oversight of investment advisers could improve investor protection for their customers, just as it has for customers of broker-dealers. Broker-dealers are subject to rules established and enforced by FINRA that pertain to safety of customer cash and assets, advertising, sales practices, limitations on compensation, and financial responsibility. FINRA ensures firms are following the rules with a comprehensive exam and enforcement regime. Simply put, FINRA believes that the kind of additional protections provided to investors through its model are essential. Does that mean FINRA should be given that role for investment advisers? That question must ultimately be answered by Congress and the SEC, but we do believe FINRA is uniquely positioned from a regulatory standpoint to build an oversight program quickly and efficiently. In FINRA's view, the best oversight system for investment advisers would be one that is tailored to fit their services and role in the market, starting with the requirements that are currently in place for advisory activity. Simply exporting in wholesale fashion the broker-dealer rulebook or current governance would not make sense. We stand ready to work with Congress and the SEC to find solutions that fill the gaps in our current regulatory system and create a regulatory environment that works properly for all investors. Thank you, Mr. Chairman. I would be happy to answer any questions. " CHRG-111shrg50814--58 Mr. Bernanke," Senator, if there is one message I would like to leave you, it is that if we are going to have a strong recovery, it has to be on the back of a stabilization of the financial system, and it is basically black and white. If we stabilize the financial system adequately, we will get a reasonable recovery. It might take some time. If we do not stabilize the financial system, we are going to founder for some time. Senator Schumer. Just one final comment. Saying that we will be back moving forward in 2010 is pretty much a V theory, not an L theory, if we stabilize the system. " CHRG-111hhrg48674--362 Mr. Bernanke," Well, by strengthening supervisory oversight over the risk management, making banks responsible for strengthening those controls. I think the system just got carried away by the credit bubble, and the risk management systems didn't succeed in protecting the system from that. There are also a lot of gaps in the regulatory system, places where there is duplicate oversight, places where there is not enough oversight. So we have a lot of work to do. " CHRG-110hhrg45625--155 Mr. Feeney," I want to thank both of you for being here. I know these are difficult times. I actually liked Mr. Ackerman's analogy. But for all too many Americans, this looks like it turns the play on its head. It is Little Orphan Annie who is being taxed to prop up Big Daddy Warbucks. And the average American out there believes very much that is what they are being forced to participate in as part of this proposal. But I want to look at a bigger picture. We have some huge expertise here, and I am going to mention two dirty words, the Great Depression. Virtually every major market crisis in 100-some years in America has been caused by easy credit, a bubble bursting, and then a credit tightening crisis. That is exactly what we are facing now. There were the Roaring Twenties with easy money. And for the last 6 or 8 years, we have had not only very easy money, there is plenty of blame to go around. It has been the United States Congress that passed the Community Reinvestment Act and browbeat every lender they could into making risky loans and then turned around and accused the lenders of being greedy. It is almost amazing, but that is what we do here, unfortunately, almost all too often. Congress also refused to reform Fannie and Freddie, despite the urging of many of us, and Secretary Paulson, for example, you have huge expertise in what happened after the October 29th stock market crash. In this case, we had a subprime lending bubble that started the crisis. But in 1929, the reaction to that was very real, and it wasn't just a failure to provide liquidity. Credit tightened by some 33 percent. The money supply shrank in America. And I know we are trying to fight that. I don't necessarily agree with your proposal. I know what you are trying to do. But simultaneously, Herbert Hoover raised marginal tax rates from 25 percent to 63 percent. This Congress just passed an impending largest tax increase in history. Hoover signed into law the largest anti-free trade act in history, Smoot-Hawley. This Congress has sat on free trade bills, sending a horrible message to our trading partners. There were huge regulatory increases that started in the aftermath of the 1929 market bubble that, in my view, contributed to taking a short-term, 18-month, 2-year recession, and turned it into a 15-year depression before the stock market fully recovered. I believe that the failure to pass an energy bill here is huge. So I would ask you gentlemen, in addition to dealing with the liquidity crisis, as we turn over these enormous regulatory powers and socialize much of the lending industry, even though we have already socialized Fannie and Freddie for all intents and purposes, how do you intend on these other huge issues, tax increases, huge new spending increases which accompanied the aftermath of the 1929 market crash, how do you in the name of fighting demagoguery explain to the average American that what really needs to be done here? This was not, in my view, a huge failure of the marketplace. This was bad policy by the Fed, easy credit, and Congress browbeating people into making terrible loans. Just like investors speculated with other peoples' money in the 1929 market crash, and bet on margin, it is exactly what happened in our subprime crisis. And so my view is that it was horrible government policy, anti-capitalist policy, that largely led to this crisis. I would like you to address as historians and economists, how we can avoid all of these other things, big tax increases, fighting free trade, huge regulatory burdens, socializing much of the market. Back then, it was utilities and other areas. Today, of course, it is the AIG, it is the banking lenders. And I would like you to address the broader picture. How do we avoid taking an 18-month market recession and turning it into a 15-year Great Depression? " 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-110shrg50369--120 Mr. Bernanke," I hope so. But, again, as Senator Schumer suggested, if the accounting industry or the regulators can be of help there, I think we ought to try to be of assistance. Senator Corker. You mentioned that leverage was at all-time lows in other sectors, and, you know, I still am shocked that when we had a credit problem, it was our wisdom to sprinkle money around America in an America that already had an incredibly low savings rate and ask them to spend it as quickly as possible. And I get concerned about actions that we might take here that, in essence--I know you mentioned at the last meeting several times the word ``correction.'' I know Chairman Dodd somewhat chastised me at the end because I was pressing for an answer. But do you still believe that--and he did so in a very amicable way. I appreciate that. But, in fact, do we have a crisis right now in housing, or do we have a correction? The reason I ask, I look at delinquencies over 30 days. Everything is over 30 days, all the way through foreclosure. And even though I know we are having some extreme issues in some of the higher-cost housing, it really is not very much different than it has been over the last 30 years, only about a percent and a half different as far as delinquencies go. Is this a correction or is this a crisis as it relates to housing itself? " CHRG-111shrg51290--5 STATEMENT OF SENATOR AKAKA Senator Akaka. Thank you very much, Mr. Chairman. I want you to know that I appreciate your conducting this hearing and also appreciate your advocacy on behalf of consumers, Mr. Chairman and Ranking Member, Senator Shelby. I also want to welcome our witnesses this morning to this hearing. Well before the current economic crisis, our financial regulatory system was failing to adequately protect working families, home buyers, individuals from predatory practices and exploitations. Prospective home buyers were steered into mortgage products with risks and costs that they could not afford. Working families were being exploited by high-cost fringe financial service providers, such as payday lenders and check cashers. Low-income taxpayers had their Earned Income Tax Credit benefits unnecessarily diminished by refund anticipation loans. Individuals trying to cope with their debt burdens were pushed into inappropriate debt management plans by disreputable credit counselors. We must increase consumer education so that individuals are able to make better informed decisions. However, although it is essential, education is not enough. We must also restrict predatory policies, ensure that consumers' interests are better represented in the regulatory process, and increase effective oversight of financial services. Mr. Chairman, you mentioned this in your opening statement and I will certainly work with you on these measures. I appreciate the witnesses today and I look forward with all of you to educate, protect, and empower consumers. Thank you very much, Mr. Chairman. " CHRG-111hhrg67816--92 Mr. Radanovich," And you have to balance this idea of dealing with the bad actors and there may be more of them out there, you know, during this financial crisis or not. I don't know how you measure how many bad actors are out there, but the other side of over enforcement is higher compliance costs, and where do you find the balance to where you are regulating so much that, you know, we have higher cost of goods out there as a result of it? " CHRG-110shrg50415--39 Mr. Ludwig," They have been really beat on in the last 8 years as orphans that do not need to exist, and that may or may not be true, but we have not had an architecture of how they really fit. My own belief is that they are very important props and should have been key factors in solving the current crisis. But they frankly were so constrained earlier in the decade that they were not in a position to be able to help. " CHRG-111hhrg48873--237 Mr. Ackerman," We are in a crisis mode right now. You know, if we discover that an airplane has a faulty flycam, whatever that might be, you know, they usually ground the whole fleet that has them, because of obvious reasons. Are we looking at doing that, these other companies with credit default swaps, to a large extent to see if we can ground them until we fix the mechanism? " CHRG-111hhrg53234--2 Chairman Watt," Unfortunately, we have been notified that we will have a series of votes, four or five votes pretty soon, so we are going to try to get as far as we can into the process. I am going to go ahead and get started. Let me call this hearing of the Subcommittee on Domestic Monetary Policy and Technology to order. Without objection, all members' opening statements will be made a part of the record, and I will recognize myself for an opening statement, which I will try to get in before we get called for votes, and maybe we can get the opening statements in before we get the call to the Floor. This hearing is entitled, ``Regulatory Restructuring: Balancing the Independence of the Federal Reserve in Monetary Policy With Systemic Risk Regulation.'' Our current regulatory system, created largely as a response to the Great Depression in the 1930's, has proven ineffective and outdated at preventing and addressing the financial crisis we are currently experiencing. Recognizing this, the President recently put forth a proposal for comprehensive financial regulatory reform. This hearing will examine one aspect of that proposal, the part that proposes to delegate to the Federal Reserve Board new powers, including the power to serve as the systemic risk regulator for all large, interconnected financial firms. As the systemic risk regulator, the Federal Reserve would be empowered to structure and implement a more robust supervisory regime for firms with a combination of size, leverage, and interconnectedness that could pose a threat to financial stability. This hearing will examine whether and how the Fed could perform and balance the proposed new authority as systemic risk regulator with its current critical role as the independent authority on monetary policy. While recent events have caused many to reevaluate and question the role and the extent of independence accorded to the Federal Reserve, the Fed's independence from political influence by the Legislative and Executive Branches of Government has long been viewed as necessary to allow the Fed to meet the long-term monetary policy goals of low inflation, price stability, maximum sustainable employment, and economic growth. Most central banks around the world, including the Federal Reserve, the Bank of England, the Bank of Japan, and the European Central Bank, have had a strong tradition of independence in executing monetary policy. Many scholars and commentators agree that an independent central bank that is free from short-term political influence and exhibits the indicia of independence, such as staggered terms for board members, exemption from the appropriations process, and no requirement to directly underwrite government debt, can better execute the long-term goals of monetary policy. The important question that our hearing today is focused upon is whether the Fed can maintain its current role as the independent authority on monetary policy, and take on a new role, a significantly new role, as the systemic risk regulator. Some scholars and commentators argue that the Fed is uniquely positioned to become the systemic regulator because it already supervises bank holding companies, and through its monetary policy function, helps manage microeconomic policy. Others argue that the Fed is already stretched too thin, and has strayed from its core monetary policy function, particularly by using its powers under section 13(3) of the Federal Reserve Act to purchase securities in distressed industries under existing emergency circumstances. As Congress and the President work to enact financial regulatory reform, it is critical for us to examine carefully the extent to which proposed new rules may conflict with existing roles and whether the Fed can effectively juggle all of these roles while performing its vital function as the Nation's independent authority on monetary policy. For our economy to function effectively, the Fed's monetary activities, such as open market operations, discount window lending, and setting bank reserve requirements must be independent and free from political influence. We need to get a clear handle on the extent to which the Administration's proposals could compromise or interfere with what the Fed already is charged to do. I look forward to learning more about how and whether the Fed can effectively carry out additional regulatory responsibilities while maintaining its current role as the independent authority on monetary policy. I now recognize the ranking member of the full committee for 4 minutes, Mr. Bachus from Alabama. " CHRG-111hhrg54867--218 Secretary Geithner," Partly that. But partly we had a system where parts of the system and people were crawling over these institutions yet didn't prevent excessive risk-taking; parts of the system, where there was nobody looking at it. It is not a sensible way to run a system. So I would--it is not as elegant as the phrase they used. I would say we just screwed up the regulatory system. " CHRG-111hhrg58044--128 Chairman Gutierrez," The time of the gentleman has expired. Mr. Moore is recognized for 5 minutes. Mr. Moore of Kansas. Thank you, Mr. Chairman. Our Oversight and Investigations Subcommittee held the first in a series of hearings last week on the topic of the end of excess, a broad look at lessons learned from the crisis. I believe that one lesson from the financial crisis is we need to go back to living within our means and that is true for our government, for financial firms, for businesses, families, and individuals. Mr. Snyder, I agree with the point you make in your testimony that we need to increase financial literacy, which will be the focus of one of our subcommittee hearings in our lessons learned series. We need to teach personal finance to our students in high school and college, ensuring that our young people are fully empowered to make sound financial decisions. Mr. Snyder, as we think about credit scores, how can we encourage individuals to regularly review their credit report, correct any misinformation, and learn how to build their credit scores? " CHRG-111hhrg48674--125 Mr. Bernanke," There was a confusion in the sense that there was an honest representation of the goals of the program to focus on taking assets off of balance sheets, which I believe was an appropriate objective and we are now returning to it. But shortly after the bill was passed, the global financial crisis erupted. The purchase of assets was not fast enough to address it, and so capital infusion was the only method that would save the situation. " FinancialCrisisInquiry--169 I don’t have time to finish this. Just let me finish this question, Mr. Chairman. And that is would you just submit in writing a connection between your argument about credit- default swaps and the financial crisis? Why that occurred? BASS: Sure. WALLISON: I don’t have time to talk about it now. BASS: Sure. CHAIRMAN ANGELIDES: Great. Thank you very much. Ms. Born? BORN: Thank you. And I would like to actually follow up a little bit. You say in your written testimony that the over-the-counter derivatives market affords OTC derivatives dealers nearly infinite leverage, I assume, because they do not post collateral as a regular matter. There isn’t marking to market of the derivatives. There isn’t the kind of margin requirements and payments that you would have in a futures exchange. Is that right? BASS: Yes. Just with one small caveat. Back pre-crisis, there are two margins. There’s the initial margin, and then there’s the variance margin that you’re required to post if that specific security moves against you. So they are marked to market every day with counter parties. 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. FOMC20081029meeting--263 261,CHAIRMAN BERNANKE.," Okay. Thank you. Let me try to summarize all that I heard today and yesterday, and then I'll try to add some new comments to that. The outlook for economic growth appears to have deteriorated quite significantly since the last meeting. Data on consumer spending, production, and employment had weakened more than expected even before the recent intensification of the financial crisis. Over the past six weeks or so, however, financial conditions have greatly worsened, and risk aversion has increased, despite actions here and abroad to stabilize the banking system. Equity values have declined sharply amid conditions of low liquidity and extraordinary volatility. Credit market conditions have improved modestly since the global actions to recapitalize banks and guarantee their deposits, assisted also by additional central bank liquidity actions. However, in almost all credit markets, spreads remain much wider, maturities shorter, and availability more constrained than was the case before the intensification of the crisis. Firms face continued funding risk and rollover risk. Banks have probably not reserved sufficiently for the credit losses to come, and hedge funds will be hitting their net asset value triggers in greater numbers, forcing them to liquidate assets. The duration of future financial turmoil is hard to judge, but it could be lengthy. The worst thing is that financial conditions appear already to have had a significant and remarkably quick effect on activity and consumer and business expectations and plans. Most Committee participants see us in or entering a recession and have marked down significantly their expectations for near-term growth or for the pace of the recovery. The difficulty of predicting the course of the crisis or its effects on the economy has also increased forecast uncertainty. In particular, the ultimate effects of some major policy actions, such as the creation of the TARP and the bank guarantee, are not yet known. Uncertainty about future policy actions, as well as uncertainty about the economy, has affected behavior in markets and the broader economy. Consumer spending has weakened considerably and probably fell sharply in the third quarter, reflecting in part a recessionary psychology. Consumer durables, such as automobiles and discretionary expenditures, have been particularly hard hit. This weakness reflects the same set of negative influences on consumption that we have been seeing for a while, now compounded by losses of equity wealth and confidence effects on prices, although lower oil prices may provide some relief. The labor market continues to decline, with many firms reporting that they are cutting back workers. The housing sector has not been noticeably worse than expected, and reports are somewhat mixed. But on a national basis, the contraction is continuing, and recent developments in the economy and credit markets are likely to have adverse effects. Inventories of unsold new homes remain high, putting pressure on prices. Nonresidential construction continues at a moderate pace; but backlogs are falling, and the sector is looking increasingly vulnerable to weakening fundamentals and tighter credit conditions. Whether a new fiscal stimulus package will be passed and to what extent such a package would be helpful remain open questions. Manufacturing production has weakened significantly as have expectations of demand, including export demand. Credit is becoming more of a problem for many firms and their customers. Spending on equipment and software appears to have slowed, reflecting greater pessimism and uncertainty. Falling commodity prices may reduce mining activity and cool the boom in agriculture. On the plus side, firms are reporting fewer cost pressures, and inventories do not appear excessive. Deterioration in global growth expectations has been marked. Industrial economies had already shown signs of slowing, and they have been hit hard by recent financial developments. Emerging market economies, until recently evidently not much affected by the U.S. slowdown, have in recent weeks also been hit hard by the spreading financial crisis. Together with the stronger dollar, these developments are likely to restrain future growth of U.S. exports. Inflation risks have declined materially, reflecting the fall in the prices of energy and other commodities, the stronger dollar, and the prospect of considerable economic slack. Firms report much reduced pricing power and lower markups. Inflation expectations have come down, both in the surveys and in the TIPS market, though it wasn't noted--but I will note--that the TIPS market is distorted by illiquidity and other problems there. Most participants see both overall and core inflation moderating in the coming quarters toward levels consistent with price stability, with some seeing a risk of undesirably low rates of inflation. Some note, however, that financial dislocations affect aggregate supply as well as aggregate demand and may reduce the extent to which slower growth damps inflation. So that's just my sense. Any comments? Additions? Let me make just a few additional comments, none of which will be radically different from what we have already discussed. I do think it is overwhelmingly clear that we are now in a recession and that it is going to be a severe one. To give some sense of perspective, the postwar record for duration is 16 months. If the NBER sets this experience as having begun early this year, I think we have a reasonable chance to break that record. The largest increase from peak to trough in unemployment rate was in 1981. It was 3.6 percentage points. Starting from 4.4 percent, I think we have a chance to come close to that number. Yesterday's drop in consumer confidence in one month from 61 to 38 shattered the previous low of 43 in December 1975. So I think we are talking about an episode here that could easily be among the largest postwar recessions. We don't know how things would have evolved without the developments in September, but obviously we have to deal with that reality. It was just a few weeks ago that we were dealing with what might have been a true systemic crisis, in the week leading up to the G-7 and IMF meeting. I think it has been very fortunate that Europe, the United States, and other countries have adopted vigorous responses to that, including bank capitalization, bank guarantees, and other measures. That has been very important in calming the situation somewhat and reducing the systemic aspects of investor concerns. That being said, concern about counterparties remains very strong. Risk aversion is intense, spreads remain high, and I think that this has now become really pervasive. It isn't just a question of junk bonds and weak borrowers or weak credit histories. The spreads on GSE debt, on high-grade corporate debt, and other areas have also widened, leading to a very broad based tightening in credit conditions. So I think that, overall, any reasonable reading of financial conditions suggests that the tightening of credit or financial conditions in the last six weeks or so has been quite substantial and overwhelms the effects of our coordinated rate cut. Now, normally you would expect to see a tightening of credit conditions affect the economy with some lag. It takes time for people to borrow money and to use the money they borrow to make expenditures. But compared with that prediction, we have instead seen a sudden stop--a remarkable and very rapid effect on economic activity. It is possible this is due less to the direct effects of credit availability and more to the psychological impact of these events. One possible analogy is the 1980 Carter credit controls, when the government announced what seemed to be a tightening of credit. There was a very sharp response in economic activity, probably based more on expectations than on actual credit availability. Unfortunately, the credit controls could be removed by government fiat; we are not able to do that today. One interesting development is that the labor market has not yet shown as much weakness as one would expect. Unemployment insurance claims and other indicators do not yet show a marked deterioration. I expect that we will see more deterioration of the labor market. Besides the intensification of the financial crisis that has markedly increased the restrictiveness of financial conditions, I think the other very important development since our last meeting has been the internationalization of the crisis. We had already seen weakening in Europe before the most recent intensification, but it has become much more severe. There is little doubt that the United Kingdom and Europe are in or about to enter recession. My sense is that their monetary policy responses will be stronger than what the Greenbook anticipates. I believe they will be very aggressive in responding to that. A new and particularly worrying development is the fact that the crisis has now spread beyond the industrial countries to the emerging markets. The G-7 weekend was quite an interesting one. It was a striking experience. I heard over and over again from the Indians, from the Brazilians, and from all over the world that, until the middle of September we were fine, we were not being much affected, we didn't see much effect on our trade flows, and suddenly everything changed; and now we are under severe stress. We are seeing tremendous outflows. Our currencies are plummeting. Commodity price declines are hurting many countries. I think that is going to be a very significant development as we go forward. Just to give some data, in just a few weeks the EMBI spread, the emerging market sovereign debt spread, went from 280 basis points to 850 basis points; and the emerging market equity index has fallen about 40 percent since the last meeting. It is not obvious that these changes were justified by economic fundamentals. Many of these countries are very well run and had shown a lot of progress in their domestic policies and their domestic economies. Instead, I think they are suffering contagion from us mostly. Unfortunately, the implications of this will be not only the usual trade and commodity price type of implications but also, and even more important, financial implications. We are now seeing that the adverse feedback loop, which we've been talking about for a long time in the United States, is becoming a global phenomenon. In particular, European banks are very heavily exposed to emerging market debt. So we are going to see yet more of this interaction between the financial markets and the broader economy, except at a global rather than a national level. These developments, obviously, are very disturbing and don't bode well for U.S. growth or now for global growth. Somewhat ironically, all of this deterioration in the global outlook has led the dollar to appreciate very sharply, which is interesting to say the least. For us that obviously also has important implications for inflation, and as Governor Kohn mentioned, it means that we will be less a recipient of foreign strength and more a supporter of foreign weakness than we have been until now. On inflation, I know there is some discomfort in talking about a 1 percent policy rate and promising to keep it low for a protracted period--and all those things. We have seen this movie before, and I think we all have to recognize the importance of watching the implications of that for our economy and for asset prices and to take quite seriously the responsibility for removing accommodation in a timely fashion once the crisis has begun to moderate. That being said, I don't think that there is really any case in the near term to be worrying very much about inflation--or, perhaps even less so, the dollar--as we look at our policy. Pricing power is evaporating. And given what is happening in the global economy, I don't see a commodity price boom any time soon, although I think as the economies do begin to recover in the next year or so that we might see some recovery in commodity prices. So I think that, as everyone has indicated, this is a very worrisome situation. I don't think we have control of it. I don't think we know what the bottom is, so we have to remain very flexible and very open to new initiatives as they become necessary. There has been some comparison of this to the Japanese situation. I'm beginning to wonder if that might not be a good outcome. The advantage of the Japanese was, first of all, that they were isolated. The rest of the world was doing okay, and they were able to draw strength from their exports and the rest of the global economy. Although they had very slow growth, they never really had a deep recession or big increases in unemployment. I think we are looking at perhaps a much sharper episode, and our challenge will be to make sure that it doesn't persist longer. I do think that one lesson of both Japan and the 1930s as well as other experiences is that passivity is not a good answer. We do have to continue to be aggressive. We have to continue to look for solutions. Some of them are not going to work. Some of them are going to add to uncertainty. I recognize that critique. I realize it's a valid critique. But I don't think that this is going to be a self-correcting thing anytime soon. I think we are going to have to continue to provide support of all kinds to the economy. Let me stop there and, unless there is any question or comment, ask Brian to introduce the policy round. " CHRG-111shrg56415--244 PREPARED STATEMENT OF JOSEPH A. SMITH, JR. North Carolina Commissioner of Banks, on behalf of the Conference of State Bank Supervisors October 14, 2009INTRODUCTION Good afternoon, Chairman Johnson, Ranking Member Crapo, and distinguished members of the Subcommittee. My name is Joseph A. Smith, Jr. I am the North Carolina Commissioner of Banks and the Chairman of the Conference of State Bank Supervisors (CSBS). Thank you for the opportunity to testify today on the condition of the banking industry. In the midst of a great deal of discussion about reform and recovery, it is very important to pause to assess the health of the industry and the factors affecting it, for good and ill. My testimony today will present the views of state bank supervisors on the health of the banking industry generally and the banks we oversee in particular--the overwhelming majority of which are independent community banks. The states charter and regulate 73 percent of the nation's banks (Exhibit A). These banks not only compete with the nation's largest banks in the metropolitan areas, but many are the sole providers of credit to less populated and rural areas (Exhibit B). We must remember 91 percent of this country's banks have less than $1 billion in assets but share most of the same regulatory burdens and economic challenges of the largest banks which receive the greatest amount of attention from the Federal Government. Community and regional banks are a critical part of our economic fabric, providing an important channel for credit for consumers, farmers, and small businesses. I will address: the key challenges that state-chartered banks face, regulatory policies that we are pursuing to improve supervision and the health of the industry, and recommendations to improve the regulation of our banks and ultimately the health of the industry.CONDITION OF THE BANKING INDUSTRY While the economy has begun to show signs of improvement, there are still many areas of concern. Consumer confidence and spending remains low, deficit spending has soared, and unemployment rates continue to slowly tick upward. The capital markets crisis, distress in the residential and commercial real estate markets, and the ensuing recession have greatly weakened our nation's banking industry. And despite recent positive developments, the banking industry continues to operate under very difficult conditions. While there are pockets of strength in parts of the state bank system, the majority of my fellow state regulators have categorized general banking conditions in their states as ``gradually declining.'' Not surprisingly, the health of banks is directly affected by the economic conditions in which they operate. Times of economic growth will usually be fueled by a banking industry with sufficient levels of capital, a robust and increasing volume of performing loans, ample liquidity, and a number of new market entrants, in the form of de novo institutions. Conversely, this recession is characterized by a banking industry marred by evaporating capital levels, deteriorating and increasingly delinquent loans, liquidity crunches, and a steady stream of bank failures. The Federal Deposit Insurance Corporation (FDIC) reports in its most recent Quarterly Banking Profile that the banking industry suffered an aggregate net loss of $3.7 billion in the second quarter of 2009. These losses were largely caused by the increased contributions institutions made to their loan-loss provisions to counter the rising number of non-performing loans in their portfolios and realized losses. Further, additional writedowns in the asset-backed commercial paper portfolios and higher deposit insurance assessments impacted banks' earnings significantly.\1\--------------------------------------------------------------------------- \1\ FDIC Quarterly Banking Profile, Second Quarter 2009: http://www2.fdic.gov/qbp/2009jun/qbp.pdf.--------------------------------------------------------------------------- Across the country, my colleagues are experiencing deteriorating credit quality in their banks, which is straining earnings and putting extreme pressure on capital. Deterioration in credit quality is requiring greater examination resources as regulators evaluate a higher volume of loans. Concentrations in commercial real estate (CRE) loans in general, and acquisition, development, and construction (ADC) loans in particular, are posing the greatest challenge for a significant portion of the industry. This is an important line of business for community and regional banks. Banks with less than $10 billion in assets comprise 23 percent of total bank assets, but originate and hold 52 percent of CRE loans and 49 percent of ADC loans by volume. Reducing the concentrations that many of our institutions have in CRE lending is an important factor in restoring them to health; however, it is our view that this reduction needs to be done in a way that does not remove so much credit from the real estate market that it inhibits economic recovery. Striking an appropriate balance should be our goal. Deteriorating credit quality has a direct and destructive effect on bank capital. Reduction in capital, in turn, has a direct and destructive effect on a bank's liquidity, drying up its sources of funding from secondary sources, including capital markets, brokered deposits, home loan and bankers' banks and the Federal Reserve. This drying up of liquidity has been a significant challenge for a substantial number of the failures.CAPITAL IS KING As we entered the financial crisis, we touted the overall strong capital base of the industry, especially compared to previous periods of economic stress. While this was true, banks are highly leveraged operations, and when losses materialize, capital erodes quickly. While this is true for all institutions, it is more pronounced in our largest banks. According to the FDIC, as of December 31, 2007, banks over $10 billion in assets had an average leverage capital ratio of 7.41 percent. This was 200 basis points (b.p.) less than banks with assets between $1 billion and $10 billion; 256 b.p. less than banks with assets between $100 million and $1 billion; and an astonishing 610 b.p. less than banks with assets less than $100 million. As the financial crisis was unfolding and the serious economic recession began, these numbers show our largest institutions were poorly positioned, leading to the extraordinary assistance by the Federal Government to protect the financial system. Even with this assistance, this differential continues today with the largest institutions holding considerably less capital than the overwhelming majority of the industry. Last year, the Federal Government took unprecedented steps to protect the financial system by providing capital investments and liquidity facilities to our largest institutions. Financial holding company status was conferred on a number of major investment banks and other financial concerns with an alacrity that was jaw-dropping. We trust the officials responsible took the action they believed necessary at that critical time. However, Federal policy has not treated the rest of the industry with the same expediency, creativity, or fundamental fairness. Over the last year, we have seen nearly 300 community banks fail or be merged out of existence, while our largest institutions, largely considered too big to fail, have only gotten bigger. State officials expect this trend to continue, with an estimated 125 additional unassisted, privately negotiated mergers due to poor banking conditions. Additional capital, both public and private, must be the building block for success for community and regional banks. While TARP has provided a source of capital for some of these institutions, the process has been cumbersome and expensive for the community and regional banks, whether they actually received the investment of funds or not. There has been a lack of transparency associated with denial of a TARP application, which comes in the form of an institution being asked to withdraw. This should of deep concern to Congress. If TARP is to be an effective tool to strengthen community and regional banks, the Treasury must change the viability standard. We should provide capital to institutions which are viable after the TARP investment. Expanded and appropriate access to TARP capital will go a long way to saving the FDIC and the rest of the banking industry a lot of money. To date, this has been a lost opportunity for the Federal Government to support community and regional banks and provide economic stimulus. There are positive signs private capital may be flowing into the system. For the 6 months ending June 30, 2009, over 2,200 banks have injected $96 billion in capital. While capital injections were achieved for all sizes of institutions, banks with assets under $1 billion in assets had the smallest percentage of banks raising capital at 25 percent. There has been and, to our knowledge, there still is a concern among our Federal colleagues with regard to strategic investments in and acquisitions of banks, both through the FDIC resolution process and in negotiated transactions. While these concerns are understandable, we believe they must be measured against the consequence of denying our banks this source of capital. It is our view that Federal policy should not unnecessarily discourage private capital from coming off the sidelines to support this industry and in turn, the broader economy.SUPERVISION DURING THE CRISIS There are very serious challenges facing the industry and us as financial regulators. State regulators have increased their outreach with the industry to develop a common understanding of these challenges. Banks are a core financial intermediary, providing a safe haven for depositors' money while providing the necessary fuel for economic growth and opportunity. While some banks will create-and have created-their own problems by miscalculating their risks, it is no surprise that there are widespread problems in banks when the national economy goes through a serious economic recession. We will never be able, nor should we desire, to eliminate all problems in banks; that is, to have risk-free banking. While they are regulated and hold the public trust, financial firms are largely private enterprises. As such, they should be allowed to take risks, generate a return for shareholders, and suffer the consequences when they miscalculate. Over the last year, we have watched a steady stream of bank failures. While unfortunate and expensive, this does provide a dose of reality to the market and should increase the industry's self-discipline and the regulators' focus on key risk issues. In contrast to institutions deemed too big to fail, market discipline and enhanced supervisory oversight can result in community and regional banks that are restructured and strengthened.Recognizing the Challenges The current environment, while providing terrific challenges with credit quality and capital adequacy, has also brought an opportunity for us to reassess the financial regulatory process to best benefit our local and national economies. To achieve this objective, it is vital to step back and make an honest assessment of our regulated institutions, their lines of business, management ability, and capacity to deal with economic challenges. This assessment provides the basis for focusing resources to address the many challenges we face. With regard to financial institutions, as regulators we must do a horizontal review and engage in a process of ``triage'' that divides our supervised entities into three categories: I. Strong II. Tarnished III. Weak Strong institutions have the balance sheets and management capacity to survive, and even thrive, through the current crisis. These institutions will maintain stability and provide continued access to credit for consumers. Further, these institutions will be well-positioned to purchase failing institutions, which is an outcome that is better for all stakeholders than outright bank failure. We need to ensure these institutions maintain their positions of strength. Tarnished institutions are under stress, but are capable of surviving the current crisis. These institutions are where our efforts as regulators can make the biggest difference. Accordingly, these institutions will require the lion's share of regulatory resources. A regulator's primary objective with these institutions should be to fully and accurately identify their risks, require generous reserves for losses, and develop the management capacity to work through their problems. We have found that strong and early intervention by regulators, coupled with strong action by management, has resulted in the strengthening of our banks and the prevention of further decline or failure. By coordinating their efforts, state and Federal regulators can give these banks a good chance to survive by setting appropriate standards of performance and avoiding our understandable tendencies to over-regulate during a crisis. Weak institutions are likely headed for failure or sale. While this outcome may not be imminent, our experience has shown that the sooner we identify these institutions, the more options we will have to seek a resolution which does not involve closing the bank. It simply is not in our collective best interest to allow an institution to exhaust its capital and to be resolved through an FDIC receivership, if such an action can be avoided. Institutions we believe are headed toward almost certain failure deserve our immediate attention. This is not the same as bailing out, or propping up failing institutions with government subsidies. Instead, as regulators our goal is an early sale of the bank, or at least a ``soft landing'' with minimal economic disruption to the local communities they serve and minimal loss to the Deposit Insurance Fund.AREAS REQUIRING ATTENTION This is the time for us to be looking forward, not backwards. We need to be working to proactively resolve the problems in the banking industry. To do this, we need to ensure our supervisory approach is fair and balanced and gives those banks which deserve it the chance to improve their financial positions and results of operations. The industry and regulators must work together to fully identify the scope of the problems. However, I believe we need to consider the response which follows the identification. We should be tough and demanding, but the response does not need to send so many banks toward receivership. A responsive, yet reasonable approach, will take a great deal of time and effort, but it will result in less cost to the Deposit Insurance Fund and benefit communities and the broader economy in the long-run. I would like to highlight a few areas where I have concerns.Increase Access to Capital First, as discussed earlier, we need to allow capital to flow into the system. There is a significant amount of capital which is seeking opportunities in this market. We need to encourage this inflow through direct investments in existing institutions and the formation of new banks. To the extent that private investors do not themselves have bank operating experience or intend to dismantle institutions without consideration of the social and economic consequences, such shortcomings can and should be addressed by denial of holding company or bank applications or through operating restrictions in charters or regulatory orders. Where private equity groups have employed seasoned management teams and proposed acceptable business plans, such groups should be granted the necessary regulatory approvals to invest or acquire. While we cannot directly fix the capital problem, we should ensure the regulatory environment does not discourage private capital.Expedite Mergers Second, we need to allow for banks to merge, especially if it allows us to resolve a problem institution. Unfortunately, we have experienced too many roadblocks in the approval process. We need more transparency and certainty from the Federal Reserve on the process and parameters for approving mergers. To be clear, I am not talking about a merger of two failing institutions. Facilitating the timely merger of a weak institution with a stronger one is good for the system, good for local communities, and is absolutely the least cost resolution for the FDIC.Brokered Deposits Third, over the last several years the industry has explored more diversified funding, including the use of brokered deposits. Following the last banking crisis, there are restrictions for banks using brokered deposits when they fall below ``well capitalized.'' I appreciate the efforts of FDIC Chairman Bair in working to provide more consistency and clarity in the application of this rule. However, I am afraid the current approach is unnecessarily leading banks to fail. We allowed these banks to increase their reliance on this funding in the first place, and I believe we have a responsibility to assist them in gradually unwinding their dependency as they work to clean up their balance sheet. My colleagues have numerous institutions that could have benefited from a brokered deposit waiver granted by the FDIC. As noted above, many of the recent failures of community and regional banks have been the result of a sudden and precipitous loss of liquidity.Open Bank Assistance Fourth, the FDIC is seriously constrained in providing any institution with open bank assistance. We are concerned that this may be being too strictly interpreted. We believe there are opportunities to provide this assistance which do not benefit the existing shareholders and allows for the removal of bank management. This is a much less disruptive approach and I believe will prove to be much less costly for the FDIC. The approach we suggest was essentially provided to Citibank and Bank of America through loan guarantees without removing management or eliminating the stockholders. As discussed previously, we believe that the Capital Purchase Program under TARP can be a source of capital for transactions that restructure banks or assist in mergers to the same effect. We are not suggesting that such support be without conditions necessary to cause the banks to return to health.Prompt Corrective Action Finally, Congress should also investigate the effectiveness of the Prompt Corrective Action (PCA) provisions of the Federal Deposit Insurance Corporation Improvement Act in dealing with problem banks. We believe there is sufficient evidence that the requirements of PCA have caused unnecessary failures and more costly resolutions and that allowing regulators some discretion in dealing with problem banks can assist an orderly restructuring of the industry.LOOKING FORWARD There will be numerous legacy items which will emerge from this crisis designed to address both real and perceived risks to the financial system. They deserve our deliberate thought to ensure a balanced and reasoned approach which provides a solid foundation for economic growth and stability. The discussions around regulatory reform are well underway. We would do well to remember the instability of certain firms a year ago which put the U.S. financial system and economy at the cliff's edge. We must not let the bank failures we are seeing today cloud the real and substantial risk facing our financial system--firms which are too big to fail, requiring extraordinary government assistance when they miscalculate their risk. We need to consider the optimal economic model for community banks, one that embraces their proximity to communities and their ability to engage in high-touch lending. However, we must ensure lower concentrations, better risk diversification, and improved risk management. We need to find a way to ensure banks are viable competitors for consumer finance and ensure they are positioned to lead in establishing high standards for consumer protection and financial literacy. We must develop better tools for offsite monitoring. The banking industry has a well established and robust system of quarterly data reporting through the Federal Financial Institutions Examination Council's Report of Condition and Income (Call Report). This provides excellent data for use by all regulators and the public. We need to explore greater standardization and enhanced technology to improve the timeliness of the data, especially during times of economic stress. Over the last several years, the industry has attracted more diversified sources of funding. This diversification has improved interest rate risk and liquidity management. Unfortunately, secured borrowings and brokered deposits increase the cost of resolution to the FDIC and create significant conflicts as an institution reaches a troubled condition. We need to encourage diversified sources of funding, but ensure it is compatible with a deposit insurance regime. We need to consider how the Deposit Insurance Fund can help to provide a countercyclical approach to supervision. We believe Congress should authorize the FDIC to assess premiums based on an institution's total assets, which is a more accurate measure of the total risk to the system. Congress should revisit the cap on the Fund and require the FDIC to build the Fund during strong economic times and reduce assessments during period of economic stress. This type of structure will help the entire industry when it is most needed.CONCLUSION The banking industry continues to face tremendous challenges caused by the poor economic conditions in the United States. To move through this crisis and achieve economic stability and growth, Members of Congress, state and Federal regulators, and members of the industry must coordinate efforts to maintain effective supervision, while exercising the flexibility and ingenuity necessary to guide our industry to recovery. Thank you for the opportunity to testify today, and I look forward to any questions you may have. ______ CHRG-111shrg56376--210 Mr. Baily," Can I throw in a comment? I think Gene is absolutely right and you are right. We don't want to have institutions that are too big to fail. We want to be able to have a mechanism by which they can go bankrupt when they make bad decisions. Otherwise, this is not a good system at all. But realistically, I mean, if an airline goes into bankruptcy, you can still have the planes fly, or if a railroad goes into bankruptcy, you can still have the trains go on the tracks. The trouble with a financial institution is that it may get to a certain point where it really can't function without some kind of funding or some kind of support to keep it going. Now, to some extent, that was the justification for giving money to General Motors. You needed money for the suppliers, and I don't want to get into that case which I don't know the ins and outs of. But clearly, we need a mechanism, whether it is a bankruptcy or a resolution mechanism, that has a certain amount of money available to make sure that you don't just close the doors and people can't get at their money. Now, what is in the Treasury proposal is a sort of open-ended checkbook that somebody can write a check for any amount to prop up an institution. So I think that is--I don't agree with that. I think that Treasury proposal is too open-ended, and I think the House and the Senate need to make sure taxpayers are protected and that they have a control over the purse. But I don't think we can, at the same time, just say, no, we are never going to put taxpayer money in again, because the fact of the matter is we will come into another financial crisis and we will end up putting in a lot of money, and it is better to have a resolution mechanism or a special bankruptcy court that has the resources to let this thing down gently, although letting it down. " FinancialCrisisReport--259 C. Mass Credit Rating Downgrades In the years leading up to the financial crisis, Moody’s and S&P together issued investment grade ratings for tens of thousands of RMBS and CDO securities, earning substantial sums for issuing these ratings. In mid-2007, however, both credit rating agencies suddenly reversed course and began downgrading hundreds, then thousands of RMBS and CDO ratings. These mass downgrades shocked the financial markets, contributed to the collapse of the subprime RMBS and CDO secondary markets, triggered sales of assets that had lost investment grade status, and damaged holdings of financial firms worldwide. Perhaps more than any other single event, the sudden mass downgrades of RMBS and CDO ratings were the immediate trigger for the financial crisis. To understand why the credit rating agencies suddenly reversed course and how their RMBS and CDO ratings downgrades impacted the financial markets, it is useful to review trends in the housing and mortgage backed security markets in the years leading up to the crisis. (1) Increasing High Risk Loans and Unaffordable Housing The years prior to the financial crisis saw increasing numbers of borrowers buying not only more homes than usual, but higher priced homes, requiring larger and more frequent loans that were constantly refinanced. By 2005, about 69% of Americans had purchased homes, the largest percentage in American history. 1005 In the five-year period running up to 2006, the median home price, adjusted for inflation, increased 50 percent. 1006 The pace of home price appreciation was on an unsustainable trajectory, as is illustrated by the chart below. 1007 1003 4/27/2007 email from Yuri Yoshizawa to Noel Kirnon, PSI-MOODYS-RFN-000044 (Attachment, PSI- MOODYS-RFN-000045). 1004 See S&P’s “Global Compensation Guidelines 2007/2008,” S&P-SEC 067708, 067733, 067740, and 067747. 1005 See 3/1/2006 “Housing Vacancies and Homeownership Annual Statistics: 2005,” U.S. Census Bureau. 1006 “Housing Bubble Trouble,” The Weekly Standard (4/10/2006). 1007 1/25/2010, “Estimation of Housing Bubble: Comparison of Recent Appreciation vs. Historical Trends,” chart prepared by Paulson & Co. Inc., Hearing Exhibit 4/23-1j. CHRG-111hhrg48867--202 Mr. Bartlett," Congressman, I suppose I understand why the discussion keeps, sort of, trending over towards identifying specific firms, but let me try to offer some clarity. That is not the goal. It is a set of practices and activities across the markets, it is the system that we should focus on. There is no--at least we don't have a proposal to identify, ``systemically significant firms.'' That should not be done. It should not be size-mattered. It should be related to whether their system or the practices create systemic risk. Now, let me give you a real-life example of one that we just went through. Hundreds of thousands of mortgage brokers, not big companies but hundreds of thousands, had a practice of selling mortgage products not related to whether they were good mortgages or not, without the ability to repay. Thousands of lenders--42 percent were regulated banks; 58 percent were unregulated by anyone--had a practice of originating those loans, even though they were systemically a major risk, as it turned out, and then selling them to mortgage-backed securities on Wall Street, who then put them into pools, who then had them insured, that were regulated by 50 State insurance commissioners. So the system itself was the systemic failure. It wasn't any one of those firms. And so the goal here, I think, is to create a regulatory system that can identify those patterns or practices that then can result in a systemic collapse before it happens. " CHRG-110hhrg46595--388 Mr. Sachs," I think the chances of GM and Ford remaining self-standing, successful companies is over 90 percent. Very, very high probability. Chrysler, obviously, the chance that it gets merged with some other company is more likely. But these are major global enterprises. Unless in the middle of this crisis they are driven to disaster, they will survive and they will recover. " CHRG-111shrg57322--912 Mr. Blankfein," Sorry. Senator Levin [continuing]. That you have any concern about that kind of a situation. Senator McCain. Senator McCain. Thank you for being here, Mr. Blankfein. Would you agree that the financial crisis that brought on the greatest recession since the Great Depression was due to a collapse of the housing market? " FOMC20080625meeting--214 212,MR. LACKER.," I mention that because it sounds as though it would be worthwhile knowing if it's important. Since we've asked the Congress twice now for permission to pay interest and they've declined, and if this was a factor in the recent crisis, we might want to point that out to them as part of our legislative dialogue with them over the next couple of months to try to get them to do something. " FOMC20080310confcall--23 21,MR. FISHER.," The only thing I would caution about is the sentence in the paper that said ""conservative relative to pre-crisis levels."" Those were fantastically low spreads that were out of touch with reality, which we now know. Obviously, you are going to be prudent about this, but it seems to me that 8 percent is not much more than what we have on the TAF now. Is it 7 percent that we apply as a discount? " CHRG-111hhrg54867--41 Secretary Geithner," But let's make sure people understand what the choice is. Remember, what we are proposing to do is to take a regime that was set up, a process that was set up for small banks and thrifts that existed for more than 20 years, set up in the wake of the S&L crisis, to make sure the government has the ability to come in and act to help restructure-- " CHRG-111hhrg56766--181 The Chairman," I recognize the gentleman from Kansas and ask for 10 seconds to say that the amendment to the House bill embodies precisely the approach that the Chairman just recommended with regard to proprietary trading, and it is in our bill. The gentleman from Kansas. Mr. Moore of Kansas. Thank you, Mr. Chairman. And Mr. Chairman, the economist Mark Zandi testified yesterday that policy uncertainty is playing a role in the business community's lack of confidence. It will be 2 years next month since the financial crisis started in full with the failure of Bear Stearns, and Republicans and Democrats have been in agreement of the key principles of financial reg reform, including increased consumer and investor protections, strong oversight of derivatives and executive compensation, new dissolution of authority to safely unwind the next AIG while protecting tax payers, stricter capital and leverage standards, and a financial reg structure that monitors systemic risk. The House recently passed a strong bill that accomplished all of these principles, in my judgment, that the Senate is now considering. And we need to eventually reform housing finance after considering the best ideas and the ways to do that. Mr. Chairman, will uncertainty increase or decrease in the business community if Congress delays these important reforms, or should Congress enact these reforms into law this year, now, so businesses know what the rules of the road will be? Won't that encourage investment and hiring in your judgment? " fcic_final_report_full--52 During a hearing on the rescue of Continental Illinois, Comptroller of the Cur- rency C. Todd Conover stated that federal regulators would not allow the  largest “money center banks” to fail.  This was a new regulatory principle, and within mo- ments it had a catchy name. Representative Stewart McKinney of Connecticut re- sponded, “We have a new kind of bank. It is called ‘too big to fail’—TBTF—and it is a wonderful bank.”  In , during this era of federal rescues of large commercial banks, Drexel Burnham Lambert—once the country’s fifth-largest investment bank—failed. Crip- pled by legal troubles and losses in its junk bond portfolio, the firm was forced into the largest bankruptcy in the securities industry to date when lenders shunned it in the commercial paper and repo markets. While creditors, including other investment banks, were rattled and absorbed heavy losses, the government did not step in, and Drexel’s failure did not cause a crisis. So far, it seemed that among financial firms, only commercial banks were deemed too big to fail. In , Congress tried to limit this “too big to fail” principle, passing the Federal Deposit Insurance Corporation Improvement Act (FDICIA), which sought to curb the use of taxpayer funds to rescue failing depository institutions. FDICIA mandated that federal regulators must intervene early when a bank or thrift got into trouble. In addition, if an institution did fail, the FDIC had to resolve the failed institution in a manner that produced the least cost to the FDIC’s deposit insurance fund. However, the legislation contained two important loopholes. One exempted the FDIC from the least-cost constraints if it, the Treasury, and the Federal Reserve determined that the failure of an institution posed a “systemic risk” to markets. The other loophole ad- dressed a concern raised by some Wall Street investment banks, Goldman Sachs in particular: the reluctance of commercial banks to help securities firms during previ- ous market disruptions, such as Drexel’s failure. Wall Street firms successfully lobbied for an amendment to FDICIA to authorize the Fed to act as lender of last resort to in- vestment banks by extending loans collateralized by the investment banks’ securities.  In the end, the  legislation sent financial institutions a mixed message: you are not too big to fail—until and unless you are too big to fail. So the possibility of bailouts for the biggest, most centrally placed institutions—in the commercial and shadow banking industries—remained an open question until the next crisis,  years later. CHRG-111shrg54533--93 RESPONSES TO WRITTEN QUESTIONS OF SENATOR SHELBY FROM TIMOTHY GEITHNERQ.1. Role of the Fed--Secretary Geithner, the Administration proposes to expand the Fed's powers by giving it authority to regulate systemically significant nonbank financial institutions. This would mean that the Chairman of the Fed would not only have to be an expert in monetary policy and banking regulation, but also would have to be an expert in systemic risk regulation. Is it reasonable to expect that any one person can possibly acquire the expertise in so many highly technical fields? Do you think that one person could possibly oversee a complex institution like Citigroup and still have time to be fully prepared to make decisions on monetary policy?A.1. As the supervisor of bank holding companies and financial holding companies, the Federal Reserve already supervises all large U.S. commercial and investment banking firms. As stated elsewhere in my responses to these questions for the record, we propose modestly expanding the Federal Reserve's regulatory authority over the largest and most interconnected financial institutions in large part because we believe that the Federal Reserve is the only agency with the depth of expertise in financial institutions and markets that such regulation would require. The role of banking supervision is closely tied to the Federal Reserve's role in promoting financial stability. To do this, it needs deep and direct knowledge of the financial system through direct supervision of financial firms. Moreover, our proposals would also remove responsibility for consumer protection supervision and regulation from the Federal Reserve because we believe that this mission is better conducted by one agency with market wide coverage and a central mission of consumer protection. This mission is not closely related to the core responsibilities of the Nation's central bank. This step should make it easier for the Chairman and the Board to focus on core responsibilities.Q.2. Consumer Protection and Safety and Soundness--In making the case for a separate consumer protection agency the administration's white paper states ``banking regulators at the State and Federal level had a potentially conflicting mission to promote safe and sound banking practices, while other agencies had a clear mission, but limited tools and jurisdiction.'' Secretary Geithner, please articulate the ``potentially conflicting mission'' between safety and soundness and consumer protection. It seems clear that a prudently underwritten loan will ensure that a consumer is protected, while also ensuring that a bank operates in a safe and sound manner.A.2. While in rare cases there may be conflicts between prudential regulation and consumer protection, we agree that strong consumer protection supports safety and soundness. We reject the notion that profits based on unfair and deceptive practices can ever be considered sound. Requiring all financial institutions to act fairly and transparently will improve the safety and soundness of banks while also providing consumers with the protection they need to make sound financial decisions. For the Consumer Financial Protection Agency (CFPA), protecting consumers will be its sole mission, whereas it is a secondary mission at the existing prudential regulators. Under the current system, consumer protection has always taken a back seat to safety and soundness concerns within the prudential regulators. In the lead-up to the current crisis, safety and soundness regulators failed to protect consumers from exploding subprime and exotic mortgages and unfair credit card features, and were far too slow in issuing rules to address these problems. The CFPA would have the responsibility and authority to act more quickly to protect consumers when they face undue risk of harm from changing products or practices. Our proposals are designed so that the CFPA prescribes regulations that are consistent with maintaining the safety and soundness of banks. The CFPA would be required by statute to consult with each of the prudential supervisors before issuing a new regulation. In addition, we propose that the National Bank Supervisor would be one of the five members of the CFPA board. These measures provide further assurance that the CFPA will consider safety and soundness interests when adopting regulations. Finally, in the very rare instance that conflicts do arise, we propose that the legislation incorporate reasonable dispute resolution mechanisms to force the CFPA and the prudential regulator to resolve any conflicts that they cannot work out on their own.Q.3. Role for Congress--Secretary Geithner, the Administration's Proposal grants the Fed and several other agencies vast new powers. It also gives the Treasury authority over the use of the Fed's 13(3) loan window. It also gives the Treasury, the FDIC, and the Fed authority to decide whether the Federal Government will bailout a troubled financial institution. Nowhere in the Proposal, however, does it consider granting Congress more authority over our regulatory system. There is not even a reporting requirement to Congress. Do you think that Congress should have a decision-making role in our financial regulatory system? Do you think that it is consistent with our republican form of government to concentrate so much power in independent agencies, such as the Fed? Would you support requiring Congressional approval before the Federal Government could bail out financial institutions?A.3. I believe that Congress has a strong role to play in reforming the financial regulatory system. Critically, it is Congress that will consider and enact the legislation that will form the framework for our new financial regulatory system. Of equal importance will be Congress' ongoing oversight role, which will be enhanced by many of our proposals. For example, the Financial Services Oversight Council will have the critical responsibility of identifying emerging threats and coordinating a response--because we know that threats to our economy can emerge from any corner of the financial system. The Council is required to report to Congress each year on these risks and threats and to coordinate action by individual regulators to address them. The Consumer Financial Protection Agency (CFPA) will have reporting requirements related to its rulemaking, supervisory and enforcement activity, and regarding consumer complaints. In addition, the Director of the Office of National Insurance will be required to submit an annual report to Congress on the insurance market. In formulating our proposals we were careful to include appropriate checks and balances to avoid concentrating authority in any single agency. For example, although our proposals provide for a modest enhancement of the Federal Reserve's powers, our proposals also move consumer protection authority from the Federal Reserve to a dedicated agency with a single mission and market-wide coverage. Moreover, our proposed resolution regime, which is modeled on the existing resolution regime for insured depository institutions, requires the consent of three separate agencies; Treasury must consult with the President, and it must receive the written recommendation of two-thirds of the members of the boards of both the Federal Reserve Board and the FDIC (or the SEC, if the SEC is the institution's primary supervisor). Moreover, even after the decision to use the resolution authority is made, the choice of the appropriate resolution method is not left to one agency. Under our proposals, the agency responsible for managing the resolution and Treasury must agree on the appropriate method. We expect this process will allow for timely decision making during a crisis while ensuring that there are appropriate perspectives included and that this new authority is exercised only under extraordinary circumstances. Anytime that this authority is exercised, the Treasury Secretary must submit a report to Congress regarding the determination, and each determination is also reviewed by the Government Accountability Office.Q.4. Hedge Funds--Secretary Geithner, you favor the mandatory registration of advisors to hedge funds, venture capital funds, and private equity funds with the SEC. As the Madoff and Stanford cases painfully illustrate, being registered with the SEC does not guarantee that a firm will be closely monitored. The administration white paper cites hedge fund de-leveraging as a contributor to the crisis. How will the registration of hedge fund advisors prevent them from de-leveraging in future crises?A.4. As noted in the Treasury's report to Congress, at various points in the financial crisis, de-leveraging by hedge funds contributed to the strain on financial markets. Because these funds were not required to register with regulators, the government lacked reliable, comprehensive data with which to assess this market activity and its potential systemic implications. Requiring registration of hedge fund advisors would allow data to be collected that would permit an informed assessment by the government of the market positions of such funds, how such funds are changing over time and whether any such funds or fund families have become so large, leveraged, or interconnected that they require additional oversight for financial stability purposes. Among other requirements, all registered hedge fund advisors would be subject to recordkeeping and reporting requirements, including the following information for each private fund advised by the adviser: amount of assets under management, borrowings, off-balance sheet exposures, trading and investment positions, and other information necessary or appropriate for the protection of investors or for the assessment of systemic risk. Information would be shared with the Federal Reserve, which would determine whether such a firm meets the Tier 1 Financial Holding Company (Tier 1 FHC) criteria. Designation as a Tier 1 FHC would subject the firm to robust and consolidated supervision and regulation as Tier 1 FHCs. The prudential standards for Tier 1 FHCs would include capital, liquidity, and risk management standards that are stricter and more conservative than those applicable to other firms to account for the risks that their potential failure would impose on the financial system.Q.5. What other problems did hedge funds, private equity funds, and venture capital funds cause and how will SEC registration of advisors to those funds address the problems caused by each of these types of funds?A.5. Although these funds do not appear to have been at the center of the current crisis, de-leveraging contributed to the strain on financial markets and the lack of transparency contributed to market uncertainty and instability. New advisor registration, recordkeeping, and disclosure requirements will give regulators access to important information concerning funds in order to address opacity concerns. Information about the characteristics of a hedge fund, including asset size, borrowings, off-balance sheet exposure, and other matters will help regulators to protect the financial system from systemic risk and help regulators to protect investors from fraud and abuse. In addition, this information will allow regulators to make an assessment of whether a firm is so large, leveraged, or interconnected that it poses a threat to financial stability, and thus require regulation as Tier 1 FHC.Q.6. How should the SEC allocate its examination resources between advisors to private pools of capital, on the one hand, and advisors to mutual funds and other advisors that serve the less affluent in our society, on the other?A.6. We defer to the SEC to address how resources should be allocated. In testimony on July 14, SEC Chairman Mary Schapiro addressed strengthening SEC examination and oversight and improving investor protection. The Chairman noted that the SEC is working towards improving its risk-based oversight, including extending that oversight to investment advisers. The SEC is recruiting additional professionals with specialized expertise, creating new positions in its examination program, and making use of automated systems to assist in determining which firms or practices raise red flags and require greater scrutiny.Q.7. Credit Rating Agencies--Secretary Geithner, the Administration's proposal calls for reduced regulatory reliance on credit ratings, but seems focused only on reducing reliance on ratings of structured products. Will you be recommending a legislative mandate to the SEC and other regulatory agencies to find ways to reduce their reliance on ratings of all types, not just ratings on structured products?A.7. It is clear that over-reliance on ratings from credit rating agencies contributed to the fragility of the system in the current crisis--especially as the systematic underestimation of risk in structured securities became clear. While the regulatory reliance on ratings covers both structured and unstructured products, we believe that the problems in the markets for structured products were particularly acute. Our legislative proposal includes a requirement that rating agencies distinguish the symbols used to rate structured products from those used for unstructured products. This will not directly reduce the use of ratings, but it will require that regulators and investors reassess their approaches to ratings--in regulations, contracts, and investment guidelines. In addition, we are working with the SEC and through the President's Working Group to identify other areas in Federal regulations where there is a need to reassess the use of ratings, with respect to both structured and unstructured products. For instance, as part of a comprehensive set of money market fund reform proposals, the SEC requested public comment on whether to eliminate references to ratings in the regulation governing money market mutual funds.Q.8. Fed Study of Itself--In the Administration's proposal, after giving the Fed extensive new regulatory power, you would ask the Fed to review ``ways in which the structure and governance of the Federal Reserve System affect its ability to accomplish its existing and proposed functions.'' Why should we give the Fed these additional responsibilities prior to knowing if they are able to administer them? Why do you have the Fed study itself'? Were other entities considered as alternatives for the purposes of conducting the study?A.8. As the supervisor of bank holding companies and financial holding companies, the Federal Reserve already supervises all large U.S. commercial and investment banking firms. As stated elsewhere in the responses to these questions for the record, we propose modestly expanding the Federal Reserve's regulatory authority over the largest and most interconnected financial institutions in large part because we believe that the Federal Reserve is the only agency with the depth of expertise in financial institutions and markets that such regulation would require. The role of banking supervision is closely tied to the Federal Reserve's role in promoting financial stability. To do this, it needs deep and direct knowledge of the financial system through direct supervision of financial firms. The proposed role for the Fed in supervising nondepository financial firms will require the Federal Reserve to acquire additional expertise in some areas of financial activity. But the potential extension of its consolidated supervision authority to some nonbanking financial institutions represents an evolution rather than a revolution in the Federal Reserve's role in the financial markets. At the same time, the structure and governance of the Federal Reserve System should be reviewed to determine whether and, if so, how it can be improved to facilitate accomplishment of the agency's current and proposed responsibilities. Every agency has the responsibility to review itself periodically to ensure that it is organized in a manner that best promotes its mission.Q.9. Congress Needs To Do Its Homework--Secretary Geithner, the Administration's Proposal defers making decisions on how to address the GSEs, improve banking supervision, modernize capital requirements, update insurance regulation, improve accounting standards, coordinate SEC and CFTC regulation, and even how to define systemic risk. The Administration has said that it will study these topics before proceeding. Should not Congress wait to pass reform legislation until after it has had the benefit of the Administration's studies on these topics? Would not that help ensure that Congress acts in an informed manner and that the final legislation is based on the best available information?A.9. The reform proposals for which we have submitted draft legislation in June and July do not depend on completion of the studies. It is important that Congress move forward to enact legislation to reform our financial regulatory system, while regulators, at the same time, move forward to find ways to improve the nuts and bolts of supervising U.S. financial firms.Q.10. Fed v. Systemic Risk Regulator--Secretary Geithner, despite strong opposition in Congress to expanding the powers of the Fed, the Administration has proposed doing just that. Do you recognize that this will create significant hurdles for passing regulatory reform? Is it more important to you that some entity be charged with regulating systemic risk, or must the Fed be the systemic risk regulator?A.10. We chose not to make one agency the ``systemic risk regulator'' or ``super regulator'' because our system should not depend on the foresight of a single institution or a single person to identify and mitigate systemic risks. This is why we have proposed that the critical role of monitoring for emerging risks and coordinating policy be vested in a Financial Services Oversight Council rather than the Federal Reserve or any other single agency. Each Federal supervisor will contribute to the systemic analysis of the Council through the institution-focused work of their examiners. We did propose an evolution in the Federal Reserve's authority to include the supervision and regulation of the largest and most interconnected financial firms. The Federal Reserve is the appropriate agency because of its depth of expertise, its existing mandate to promote financial stability, and its existing role as the supervisor for all large commercial and investment banking firms, including bank and financial holding companies.Q.11. Basel Capital Accords--Secretary Geithner, in the Obama Administration's white paper, you state that the administration will recommend various actions to the Basel Committee on Banking Supervision (BCBS). Previously, the BCBS has approved capital plans that were deemed inadequate by many in Congress, as well as the bank regulators. What will you do if the BCBS returns with measures and definitions that raise concerns along the same lines as Basel II? For the record, will you seek alterations to their standards as was done with Basel II, if the new standards are considered inadequate?A.11. The U.S. banking regulators have always played a significant role in the Basel Committee's policy development process and we strongly believe that they will be highly influential in the next phase of capital proposals in ways that will address flaws in the Basel II framework that have been made manifest by the current economic crisis. The U.S. regulatory community considers the Basel Committee to be a useful and receptive forum in which international supervisors can set consistent international supervisory standards. U.S. supervisors have and will continue to push for improvements to those standards. For example, the Basel Committee just released in mid-July significant enhancements to the Basel II framework that increase risk weights for the trading book, certain securitizations, and off-balance sheet activities, as supported by the President and myself at the G20 Leaders Summit in April.Q.12. Basel Leverage Measurement--Mr. Secretary, in the white paper, you clearly state that the Obama Administration will, ``urge the BCBS to develop a simple, transparent, nonmodel based measure of leverage, as recommended by the G20 leaders.'' Please expand on this statement and what manner of measuring leverage you envision, including what criteria will be used and how you arrived at these answers?A.12. As we explained in the Treasury Department's September 3, 2009, ``Principles for Reforming the U.S. and International Regulatory Capital Framework for Banking Firms,'' risk-based capital rules are a critical component of a regulatory capital regime; however, it is impossible to construct risk-based capital rules that perfectly capture all the risk exposures of banking firms. Inevitably, there will be gaps and weak spots in any risk-based capital framework and regulatory arbitrage activity by firms will tilt asset portfolios and risk taking toward those gaps and weak spots. A simple leverage constraint would make the regulatory system more robust by limiting the degree to which such gaps and weak spots in the risk-based capital framework can be exploited. A simple leverage constraint also can help reduce the threats to financial stability from categorical misjudgments about risk by market participants and the official sector. In addition, imposing a leverage constraint on banking firms would have macroprudential benefits. The balance sheets of financial firms and the intermediation chains between and among financial firms tend to grow fastest during good economic times but become subject to rapid reversal when economic conditions worsen. Supervisors generally have failed to exercise discretion to constrain leverage leading into a boom. A simple leverage ratio acts as a hard-wired dampener in the financial system that can be helpful to mitigate systemic risk. It is important to recognize that the leverage ratio is a blunt instrument that, viewed in isolation, can create its own set of regulatory arbitrage opportunities and perverse incentive structures for banking firms. The existing U.S. leverage ratio is calculated as the ratio of Tier 1 capital to total balance sheet assets. To mitigate potential adverse effects from an overly simplistic leverage constraint, the constraint going forward should at a minimum incorporate off-balance sheet items. It is also important to view the leverage constraint as a complement to a well designed risk-based capital requirement. Although it may be possible for banking firms to either arbitrage any free-standing risk-based capital requirement or any free-standing simple leverage constraint, it is much more difficult to arbitrage both frameworks at the same time.Q.13. Supervisory Colleges--Mr. Secretary, in the white paper, you state that, ``supervisors have established `supervisory colleges' for the 30 most significant global financial institutions. The supervisory colleges for all 30 firms have met at least once.'' Will information from these meetings be made public; will there be publication of any agendas, minutes, plans, membership, etc.? If this information will not be made public, will there be the opportunity for Congressional staff to receive reports and briefings of the conduct and actions of these colleges? Will the firms that are being examined have any opportunity to receive any information about these meetings?A.13. Supervisory colleges are confidential meetings, held by regulators from multiple countries, which function as an information-sharing mechanism with regards to large cross-border financial institutions. The information shared in these meetings is governed by information sharing agreements signed by the participating regulatory organizations. Supervisory colleges are not themselves decision-making regulatory bodies. The information shared within a supervised institution's college is used to assist regulators in conducting their supervisory responsibilities over that institution. A particular firm may be invited to brief regulators on specific topics. However, any resulting regulatory actions are conducted by the respective regulatory agencies. The Federal Reserve Board of Governors, the Office of the Comptroller of the Currency, and the Securities and Exchange Commission participate in the supervisory colleges and can be contacted for further information.Q.14. Implications of Resolution Regime--Mr. Secretary, in the white paper, you state that the proposed resolution regime would provide authority to avoid disorderly resolution of any systemically critical firm. You also write that national authorities are inclined to protect assets with their own jurisdictions. I would hope that our regulators would continue to have this mind-set, to spare the U.S. taxpayer from additional costs. It seems that this paper takes a negative view of this mind-set. Can you explain your statement further? Also, please explain to the Committee why protecting assets, which protects the taxpayer, should not be the focus of our national regulators?A.14. Our proposal presents a new resolution regime, beyond what the U.S. already has, only where the failure of certain bank holding companies or nonbank financial firms threatens the stability of the entire financial system. The authority to invoke resolution procedures for these large entities would be used only for extraordinary circumstances and would be subject to strict governance and control procedures. Furthermore, the purpose of the expanded resolution regime would be to unwind, dismantle, restructure, or liquidate the firm in an orderly way to minimize costs to taxpayers and the financial system; all costs to exercise this authority would be recouped through assessments and liquidation of any acquired assets, therefore sparing the taxpayer. The global nature of the current crisis has also shown that in the failure of globally active financial firms, there needs to be improved coordination between national authorities representing jurisdictions that are affected. No common procedure exists among countries with respect to the failure of a large financial firm. The aim of this cross-border coordination should be to establish fair and orderly procedures to resolve a firm according to a system of laws and rules that investors can rely on as well as to protect the interests of U.S. taxpayers in globally active financial firms. The absence of predictability in cross-border procedures was a contributing factor to the contagion in our financial markets in the fall of 2008.Q.15. Federal Reserve Supervision of Foreign Tier 1 Financial Holding Companies--Secretary Geithner, you ``propose to change the Financial Holding Company eligibility requirements . . . but do not propose to dictate the manner in which those requirements are applied to foreign financial firms with U.S. operations.'' Please clarify this statement. Do you foresee the Federal Reserve getting information from other national supervisors or do you see the Federal Reserve conducting examinations of foreign Financial-Holding Companies overseas? What criteria would you recommend the Federal Reserve use when they evaluate foreign parent banks? Many financial products differ in other parts of the world, how should the Federal Reserve evaluate those products' safety and soundness for the parent company balance sheet?A.15. Treasury intends to work with the Financial Services Oversight Council and the Federal Reserve Board to create a regulatory framework for foreign companies operating in the United States that are deemed to be Tier 1 Financial Holding Companies (FHCs). That framework will be comparable to the standards applied to domestic Tier 1 FHCs, giving due regard to the principle of national treatment and equality of competitive opportunity. In determining today whether a foreign bank is well capitalized and well managed in accordance with FHC standards, the Board, relying on the existing Bank Holding Company Act, may take into account the foreign bank's risk-based capital ratios, composition of capital, leverage ratio, accounting standards, long-term debt ratings, reliance on government support to meet capital requirements, the anti-money laundering procedures, whether the foreign bank is subject to comprehensive supervision or regulation on a consolidated basis, and other factors that may affect analysis of capital and management. While not conducting examinations of foreign banks in a foreign country, the Federal Reserve Board consults with the home country supervisor for foreign banks as appropriate. Treasury intends to work with the Federal Reserve Board to determine what modifications to the existing FHC framework are needed for new foreign Tier 1 financial holding companies.Q.16. New Financial Stability Board (FSB)--Mr. Secretary, in the white paper, you ``recommend that the FSB complete its restructuring and institutionalize its new mandate to promote global financial stability by September 2009.'' To whom will the FSB be accountable and from where will it receive its funding? Will the FSB make their reports and conclusions public? Will the Congress be able to have access to FSB documents and decisions?A.16. The G20 Leaders in April 2009 agreed that the Financial Stability Forum should be reestablished as the Financial Stability Board (FSB) and be given a stronger mandate. Its membership was expanded to include all G20 member countries. The FSB is composed of finance ministries, central banks, regulatory authorities, international standard-setting bodies, and international institutions. It is supported by a small secretariat provided by the Bank for International Settlements. The FSB provides public statements following its meetings and may issue papers on important issues from time to time. It regularly posts information to its Web site (www.financialstabilityboard.org), which is available to Congress and the general public. The FSB can provide coordination and issue recommendations and principles (e.g., on crisis management; principles on compensation; protocols for supervisory colleges). The FSB operates as a consensus organization and it is up to each country whether and how to implement the recommendations of the FSB. The point of accountability for decisions and responses lies with each national regulator. The U.S. will work through the FSB as an effective body to coordinate and align international standards with those that we will set at home.Q.17. Adequacy of the Proposal--Secretary Geithner, the Administration's Proposal aims to address the causes of the financial crisis by closing regulatory gaps. I would like to know more about which gaps in our financial supervisory system the Administration believes contributed to the crisis. What are two cases where supervisory authority existed to address a problem but where regulators nevertheless failed act? What are two cases where supervisory authority did not exist to address a problem and regulators were unable to act? Does the Administration's Proposal address all of the cases you cited in your answers?A.17. There were a number of cases in which supervisory authority existed but supervisors did not act in a timely and forceful fashion. It was clear, at least by the early to mid-2000s, that banks and nonbanks were making subprime and nontraditional mortgage loans without properly assessing that the borrowers could afford the loans once scheduled payment increases occurred. Yet supervisors did not issue guidance requiring banks to qualify borrowers at the fully indexed interest rate and fully amortizing payment until 2006 and 2007. By consolidating consumer protection authority into a single agency with a focused mission, the CFPA will be able to recognize when borrowers are receiving loans provided in an unfair or deceptive manner earlier, and it will act more quickly and effectively through guidance or regulation to address such problems. In the securitization markets, regulatory authority existed to address the problems that emerged in the current crisis but the regulatory actions were not taken. For instance, regulators had the ability to address the treatment of off-balance sheet risks that many institutions retained when they originated new financial products such as structured investment vehicles and collateralized debt obligations, but supervisors did not fully grasp these risks and did not require sufficient capital to be held. Our proposals would increase capital charges for off-balance sheet risks to account more fully for those risks. In addition, in many instances, regulators simply lacked the authority to take the actions necessary to address problems that existed. For example, independent mortgage companies and brokers were major players in the market for nontraditional and sub-prime mortgages at the heart of the foreclosure crisis and operated without Federal supervision. Under our proposals, they would have been subject to supervision and regulation by the proposed CFPA. Similarly, AIG took advantage of loopholes in the SHC act and was not adequately supervised on a consolidated basis. Under our proposals, AIG would have been subject to supervision and regulation by the Federal Reserve for safety and soundness, with an explicit mandate to look across the risks to the enterprise as a whole, not simply to protect the depository institution subsidiary. As discussed above, the Administration's proposals create a comprehensive framework that would have addressed each of these failures.Q.18. Fed as Consolidated Supervisor--Secretary Geithner, I find it interesting that, under your proposal, the entire financial industry would be within the Federal Reserve's regulatory reach. While you have created a shadow consolidated regulator, you have not bothered to get rid of the other regulators. If you are intent on creating a single financial regulator, why not move everything into an agency with political accountability and eliminate the other regulatory agencies?A.18. The entire financial industry would not be within the Federal Reserve's regulatory reach and we are not intending to create a single financial regulator. The Financial Services Oversight Council will have the authority and responsibility to identify emerging risks to the financial system and will help facilitate a coordinated response. In critical markets, like those for securities and derivatives, the SEC and CFTC will play leading roles. We are also proposing to retain and enhance crucial roles for the National Bank Supervisor and the FDIC on prudential regulation, and resolution of banks. The Federal Reserve would be the consolidated regulator of Tier 1 FHCs and would be responsible, as it is today, for prudential matters in the basic plumbing of the system--payment, settlement, and clearance systems. In formulating our proposals we were careful to include appropriate checks and balances to avoid concentrating authority in any single agency. For example, although our proposals provide for a modest enhancement of the Federal Reserve's powers, our proposals also strip power from the Federal Reserve in the consumer protection area.Q.19. Regulatory Overlap--Secretary Geithner, the Administration's proposal states that jurisdictional boundaries among agencies should be drawn clearly to avoid mission overlap and afford agencies exclusive regulatory authority. How do you reconcile that principle with the proposal to expand the Fed's regulatory authority into so many different areas, many of which already have primary regulators?A.19. In Treasury's report to Congress, we articulate a principle that agencies should be held accountable for critical missions such as promoting financial stability and protecting consumers of financial products. The consolidated supervisor of the holding company and the functional supervisor of the subsidiary each have critical roles to play.Q.20. Over-the-Counter Derivatives--Secretary Geithner, the Administration does not appear to have made much headway in fleshing out the details of last month's outline for regulating over-the-counter derivatives. How will you encourage standardization of derivatives without preventing companies from being able to buy derivatives to meet their unique hedging needs?A.20. As you know, we have now sent up detailed legislative language to implement our proposal. Any regulatory reform of magnitude requires deciding how to strike the right balance between financial innovation and efficiency on the one hand, and stability and protection on the other. We failed to get this balance right in the past. If we do not achieve sufficient reform, we will leave ourselves weaker as a Nation and more vulnerable to future crises. Our proposals have been carefully designed to provide a comprehensive approach. That means strong regulation and transparency for all OTC derivatives, regardless of the reference asset, and regardless of whether the derivative is customized or standardized. In addition, our plan will provide for strong supervision and regulation of all OTC derivative dealers and all other major participants in the OTC derivative markets. We recognize, however, that standardized products will not meet all of the legitimate business needs of all companies. That is why our proposals do not--as some have suggested--ban customized OTC derivatives. Instead, we propose to encourage substantially greater use of standardized OTC derivatives primarily through higher capital charges and margin requirements on customized derivatives, and thereby facilitate a more substantial migration of these OTC derivatives on to central clearinghouses and exchanges.Q.21. Systemically Significant Firms--Secretary Geithner, systemically significant firms, or Tier 1 Financial Holding Companies, will be required to make enhanced public disclosures ``to support market evaluation.'' Don't you believe that giving these firms a special label, a special oversight regime, and special disclosure will simply send a signal to the market that these firms are too big to fail and therefore do not need to be monitored?A.21. Identification as a Tier 1 Financial Holding Company (Tier 1 FHC) does not come with any commitment of government support nor does it provide certain protection against failure. Instead our proposals would apply stricter prudential standards and more stringent supervision. For example, higher capital charges for Tier 1 FHCs would be used to account for the greater risk to financial stability that these firms could pose if they failed. It is designed to internalize the externalities that their failure might pose, to reduce incentives to excessive risk-taking at the taxpayer's expense, and to create a large buffer in the event of failure. In addition, in the event of failure, our proposals provide for a special resolution regime that would avoid the disruption that disorderly failure can cause to the financial system and the economy. That regime, however, would be triggered only in extraordinary circumstances when financial stability is at risk, and bankruptcy would remain the dominant tool for handling the failure of a financial company. Moreover, the purpose of the special resolution regime is to provide the government with the option of an orderly resolution, in which creditors and counterparties may share in the losses, without threatening the stability of the financial system.Q.22. Federal Reserve and Systemically Important Firms--Secretary Geithner, under your proposal, the Federal Reserve would identify and regulate firms the failure of which, could pose a threat to financial stability due to their combination of size, leverage, and interconnectedness. It is unclear just what types of companies might fall into this new category of so-called Tier 1 Financial Holding Companies, because it will be up to the Fed to identify them. Could Starbucks--which offers a credit card and would certainly affect numerous sectors of the economy if it failed--be classified as a Tier 1 Financial Holding Company and be subjected to Fed oversight?A.22. Starbucks is not a financial firm and therefore would not qualify as a Tier 1 FHC. Starbucks currently offers a credit card through an independent financial institution.Q.23. Financial Services Oversight Council--Secretary Geithner, the Administration recommends replacing the President's Working Group on financial Markets with a Financial Services Oversight Council. Aside from having slightly enlarged membership and a dedicated staff, how will this Council differ from the PWG? Is this anything more than a cosmetic change?A.23. There are important differences between the President's Working Group (PWG) and the Financial Services Oversight Council (FSOC or Council). As an initial matter, the PWG was created by executive order and the Council would have permanent statutory status. In addition, the Council would have a substantially expanded mandate to facilitate information sharing and coordination, identify emerging risks, advise the Federal Reserve on the identification of Tier 1 FHCs and systemically important payment, clearing, and settlement activities, and provide a forum in which supervisors can discuss issues of mutual interest and settle jurisdictional disputes. It would also enjoy the benefit of a dedicated staff that will enable it to undertake its missions in a unified way and to effectively conduct analysis on emerging risks. In addition, unlike the PWG, the Council will have authority to gather information from market participants and will report to Congress annually on financial market developments and emerging systemic risks.Q.24. Identifying Systemic Risk--Secretary Geithner, your proposal gives the Federal Reserve the authority to identify and regulate financial firms that pose a systemic risk due to their combination of size, leverage, and interconnectedness. Because neither ``systemic risk'' nor ``financial firm'' is defined, it is unclear what types of firms will fall within the Tier 1 Financial Holding Company designation. Theoretically, the term could include large investment advisers, mutual funds, broker-dealers, insurance companies, private equity funds, pension funds, and sovereign wealth funds, to name a few possibilities. What further specificity will you be providing about your intentions with respect to the reach of the Fed's new powers?A.24. In the draft legislation sent to Congress in July, we proposed the specific factors that the Federal Reserve must consider when determining whether an individual financial firm is a Tier 1 FHC. Our proposed legislation defines a Tier 1 FHC as a financial firm whose material financial distress could pose a threat to financial stability or the economy during times of economic stress. Our proposed legislation requires the Fed to designate U.S. financial firms as Tier 1 FHCs based on an analysis of the following factors: the amount and nature of the company's financial assets; the amount and types of the company's liabilities, including the degree of reliance on short-term funding; the extent of the company's off-balance sheet exposures; the extent of the company's transactions and relationships with other major financial companies; the company's importance as a source of credit for households, businesses, and State and local governments and as a source of liquidity for the financial system; the recommendation, if any, of the Financial Services Oversight Council.Q.25. Expertise of the Fed--Secretary Geithner, the Administration's Proposal chooses to grant the Fed authority to regulate systemic risk because it ``has the most experience'' to regulate systemically significant institutions. I believe this represents a grossly inflated view of the Fed's expertise. Presently, the Fed regulates primarily bank holding companies and State banks. As a systemic risk regulator, the Fed would likely have to regulate insurance companies, hedge funds, asset managers, mutual funds and a variety of other financial institutions that it has never supervised before. Since the Fed lacks much of the expertise it needs to be an effective systemic regulator, why could not the responsibility for regulating systemic risk just as easily be given to another or a newly created entity?A.25. We are not proposing that the Federal Reserve act as a systemic risk regulator. In critical markets, like those for securities and derivatives, the SEC and CFTC will play lead roles. The bank regulators all play crucial roles as prudential supervisors of banks. The Financial Services Oversight Council will have the authority and responsibility to identify emerging risks to the financial system and will help facilitate a coordinated response. We have proposed that the Federal Reserve act as the consolidated supervisor of the largest and most interconnected financial firms. The Federal Reserve has broad expertise in supervising financial institutions involved in diverse financial markets through the exercise of its current responsibilities as the supervisor of bank and financial holding companies. We are confident that it can acquire expertise where needed to oversee the supervision of Tier 1 Financial Holding Companies that do not own a depository institution. As noted above, the potential extension of its consolidated supervision authority to some nonbanking financial institutions represents an evolution in the Federal Reserve's responsibilities.Q.26. Skin-in-the-Game--Secretary Geithner, your proposal would require that mortgage originators maintain an unhedged 5 percent stake in securitized loans. Will the administration adopt the same position with respect to government programs that assist borrowers in obtaining mortgages and require increased down payment requirements and other such measures to increase ``skin-in-the-game?''A.26. One of the key problems that the financial system experienced in the buildup to the current crisis, was a breakdown in loan underwriting standards--especially in cases where the ability to sell loans in a secondary market allowed originators and securitizers to avoid any long-term economic interest in the credit risk of the original loans. We are proposing that securitizers or originators retain up to a 10 percent stake in securitized loans to align their interests with those of the ultimate investor in those loans. This directly addresses the incentives of originators and securitizers to consider the performance of the underlying loans after asset-backed securities were issued. A family buying a home is in a different position from a loan originator or securitizer. The household faces substantial tangible and intangible costs if it is forced to move. Our proposal would not require home owners to increase their down payment. Also our proposal specifically gives regulators authority to exempt government-guaranteed loans from the skin-in-the-game requirement.Q.27. Insurance Regulation--Secretary Geithner, the Proposal states that the Administration will support measures to modernize insurance regulation, but fails to offer a specific plan. While we all recognize the difficulties involved in modernizing insurance regulation, the problems with AIG's insurance subsidiaries and the fact that several insurers needed TARP money demonstrates that we need to reconsider how we regulate insurance companies. Will systemically significant insurance companies be regulated by the Fed? If so, will this effectively require the Fed to act as a Federal insurance regulator so that it can properly supervise the company? Does the Fed have the necessary expertise in insurance to regulate an insurance company? Would it be more efficient to establish a Federal insurance regulator that can specialize in regulating large insurance companies?A.27. Under the Administration's proposals, all firms designated as Tier 1 Financial Holding Companies (Tier 1 FHCs) will be subject to robust, consolidated supervision and regulation. Tier 1 FHCs will be regulated and supervised by the Board of Governors of the Federal Reserve System (Board). Consolidated supervision of a Tier 1 FHC will extend to the parent company and to all of its subsidiaries--regulated and unregulated, U.S. and foreign. This could include an insurance company, if it or its parent were designated as a Tier 1 FHC. For all Tier 1 FHCs, functionally regulated subsidiaries like insurance companies will continue to be supervised and regulated by their current regulator. However, the Federal Reserve will have a strong oversight role, including authority to require reports from and conduct examinations of a Tier 1 FHC and all its subsidiaries, including insurance companies. We believe that the current insurance regulatory system is inefficient and that there is a need for a Federal center for expertise and information on the insurance industry. The Administration has proposed creating an Office on National Insurance (ONI) to develop expertise, coordinate policy on prudential aspects of international insurance matters, and consult with the States regarding insurance matters of national and international importance, among other duties. The ONI will receive and collect data and information on and from the insurance industry and insurers, enter into information-sharing agreements, and analyze and disseminate data and information, and issue reports for all lines of insurance except health insurance. This will allow the ONI to identify the emergence of problems within the insurance industry that could affect the economy as a whole. In addition, our proposal lays out core principles to consider proposals for additional reforms to insurance regulation: Increased consistency in the regulatory treatment of insurance, including strong capital standards and consumer protections, would enhance financial stability, result in real improvements for consumers and also increase economic efficiency in the insurance industry. One of our core principles for insurance regulation is to increase national uniformity of insurance regulation through either a Federal charter or effective action by the States. We look forward to working with you and others in the Congress on this important issue.Q.28. Resolution Plans--Secretary Geithner, under your proposal, systemically significant firms would be required to devise their own plans for rapidly resolving themselves in times of financial distress. Will firms be able to incorporate into their death plans the expectation of taxpayer money to cover wind-down expenses?A.28. No. That is the opposite of what we have in mind. We propose that the Federal Reserve should require each Tier 1 FHC to prepare and periodically update a credible plan for the rapid resolution of the firm in the event of severe financial distress. Such a requirement would create incentives for the firm to better monitor and simplify its organizational structure and would better prepare the government, as well as the firm's investors, creditors, and counterparties, in the event that the firm collapsed. The Federal Reserve should review the adequacy of each firm's plan on a regular basis. It would not be appropriate for firms to incorporate in such a plan the expectation of taxpayer money to cover wind-down expenses. As I have stated elsewhere in my responses to these questions for the record, identification as a Tier 1 FHC does not come with any commitment of government support. Moreover, any government support through our proposed special resolution regime would be available only in extraordinary circumstances when financial stability is at risk and only upon the agreement of three different government agencies. In most circumstances, bankruptcy would remain the dominant tool for handling the failure of a financial company.Q.29. Citigroup--Secretary Geithner, you mentioned AIG and Lehman as being examples of untenable options for firms nearing failure during a financial crisis. I would add Citigroup to that list of untenable options. As you surveyed the landscape to understand the types of scenarios that might have to be handled by the new resolution authority that you propose, are there any entities that would still require ad hoc solutions as Lehman, AIG, and Citigroup did?A.29. Our proposals are designed to provide a comprehensive set of tools to address the potential disorderly failure of any bank holding company, including Tier 1 FHCs, when the stability of the financial system is at risk. It is important to note that after the TARP purchase authority expires this year, the government will lack the effective legal tools that it would need to adequately address a similar situation to that which we have seen in the past 2 years. We believe that our comprehensive regulatory reform proposals would provide the government with the tools necessary to wind down any large, interconnected highly leveraged financial firm if such a failure would threaten financial stability.Q.30. Accounting Standards--Secretary Geithner, among the changes recommended by your proposal are changes in accounting standards. What is the appropriate role of the administration in directing the substantive determinations of an independent accounting standard setter?A.30. It is critical that the FASB be fully independent in carrying out its mission to establish accounting and financial reporting standards for public and private companies. The health and soundness of capital markets depend critically on the provision of honest and neutral accounting and financial reporting, not skewed to favor any particular company, industry, or type of transaction or purposefully biased in favor of regulatory, social, or economic objectives other than sound reporting to investors and the capital markets. Governmental entities with knowledge and responsibility for the health of capital markets have an interest and expertise in maintaining the health of America's capital markets. These entities include the SEC, which has specific oversight of disclosure for publicly held firms, the Public Company Accounting Oversight Board, which is tasked with overseeing the auditors of public companies, and other financial regulators, which have oversight over the soundness of the entities they regulate.Q.31. SEC-CFTC Merger--Secretary Geithner, the proposal acknowledges the need for harmonization between the SEC and CFTC, but stops short of merging the two agencies. Instead, you direct the agencies to work their differences out among themselves and report back in September. Given the tortured history of compromise between the SEC and CFTC, why do you anticipate that the two agencies can come to agreement in a matter of months? Wouldn't a merger of the agencies be a better way to force them to work out their differences?A.31. In the last few months, the SEC and the CFTC have made great progress towards eliminating their differences. Treasury worked closely with the SEC and CFTC to propose a comprehensive framework for regulation of derivatives that is consistent across both SEC and CFTC jurisdiction. In addition, the SEC and CFTC held joint public hearings in early September to identify issues in the process of harmonization and to collect public comment on the process. The SEC and CFTC have produced a joint report on reducing differences in their two frameworks for regulation. We considered whether to merge the SEC and CFTC. At bottom, however, we are focused on the substance of regulation, not the boxes and the lines. In terms of substance, the most necessary reform is to harmonize futures and securities regulation between these entities, and the SEC and CFTC have begun a process to accomplish that.Q.32. Broker-Dealers and Investment Advisors--Secretary Geithner, the Administration's proposal recommends applying a fiduciary standard to broker-dealers that offer investment advice. How will this change affect the way FINRA regulates broker-dealer activities? Do you anticipate recommending a self-regulatory organization for investment advisors or eliminating FINRA as an SRO for broker-dealers?A.32. Treasury's report to Congress advocates a fiduciary standard for investment advisers and broker-dealers offering investment advice. We have not taken a position with respect to the role of SROs.Q.33. Barriers to Entry--Secretary Geithner, in many ways the Administration's proposal rewards failure. The Fed, which fumbled the responsibilities it had, will get more responsibility. The SEC, which failed to properly oversee the advisors registered with it, will have more registered advisors. And some of the biggest financial firms, the ones that made so many miscalculations with respect to risk management, stand to benefit from the additional layers of regulatory red-tape that your system creates. Yet in your statement, you state that the changes you are proposing reward innovation, often the product of smaller firms. What specific changes in your proposal make the environment more conducive to small, innovative firms?A.33. Under existing law, financial instruments with similar characteristics may be designed or forced to trade on different exchanges that are subject to different regulatory regimes. Harmonizing the regulatory regimes would remove such distinctions and permit a broader range of instruments to trade on any regulated exchange. For example, we propose the harmonization of futures and securities regulation. By eliminating jurisdictional uncertainties and ensuring that economically equivalent instruments are regulated in the same manner, regardless of which agency has jurisdiction, our proposals will foster innovation resulting from competition rather than the ability to evade regulation. Permitting direct competition between exchanges also would help ensure that plans to bring OTC derivatives trading onto regulated exchanges or regulated transparent electronic trading systems would promote rather than hinder competition. Greater competition would make these markets more efficient and create an environment more conducive to the most innovative participants. Innovation is advanced by promoting competition among firms and between financial products. By eliminating arbitrary jurisdictional differences and creating a regulatory regime that is stable and promotes transparency, fairness, accountability, and access, our proposals will increase competition and reward innovation.Q.34. Bank of America-Merrill--Secretary Geithner, last year, Bank of America contemplated not going forward with a merger with Merrill Lynch, but was strongly exhorted by the Fed and Treasury to proceed with the merger. Did you play a role in deliberations about how to handle the Bank of America-Merrill merger? If the Administration's proposed changes were in place, would the Fed and Treasury have had any additional tools in their arsenal to deal with the potential fallout of the failed merger that would have made it unnecessary to exercise a heavy hand behind the scenes to force the merger to close?A.34. After President Obama advised me that I would be his nominee for Treasury Secretary, I no longer participated in policy decisions regarding the Merrill-Lynch situation, including a possible merger with Bank of America. I was, however, kept apprised of developments involving the merger in my role as President of the NYFED. Consequently, I was not involved in policy decisions regarding Bank of America potentially exercising the materially adverse change clause and not going forward with the merger. While I will not comment on the specifics of the Bank of America-Merrill Lynch merger, it is clear that the government lacked the tools it needed during this crisis to provide for an orderly resolution of a large, nonbank financial firm whose failure could threaten financial stability. That is why we have proposed a special resolution regime for extraordinary circumstances and subject to high procedural and substantive hurdles to fill this gap. Under our proposal, the government would have the ability to establish a receivership for a failing firm. The regime also would provide for the ability to stabilize the financial system as a result of a failing institution going into receivership. In addition, the receiver of the firm would have broad powers to take action with respect to the financial firm. For example, it would have the authority to take control of the operations of the firm or to sell or transfer all or any part of the assets of the firm in receivership to a bridge institution or other entity. That would include the authority to transfer the firm's derivatives contracts to a bridge institution and thereby avoid termination of the contracts by the firm's counterparties (notwithstanding any contractual rights of counterparties to terminate the contracts if a receiver is appointed).Q.35. Multiple Banking Regulators--The administration outline states ``similar financial institutions should face the same supervisory and regulatory standards, with no gaps, loopholes, or opportunities for arbitrage.'' Your plan envisions a national banking regulator that combines or eliminates many of the various types of banking charters such as thrifts, ILCs, and credit card banks. Your plan, however, seeks to eliminate only one regulator, the Office of Thrift Supervision, while adding one more Federal regulator solely for consumer protection. Thus the total number of bank regulators remains the same. Why did you decide to leave the Federal Reserve and the FDIC as the primary supervisor of some commercial banks? If the desire is to achieve more accountability from our regulatory system why not consolidate the commercial banking regulatory structure into one Federal and one State Charter?A.35. Our proposals for structural reform of our regulatory system are focused on eliminating opportunities for regulatory arbitrage. Most importantly, we address the central source of arbitrage in the bank regulatory environment by proposing the creation of a new National Bank Supervisor through the merger of the Office of Thrift Supervision and the Office of the Comptroller of the Currency. These agencies granted Federal banking charters whereas the FDIC and Federal Reserve have oversight regarding charters granted by the States. As such, we are reducing the potential for arbitrage regarding Federal charters. In addition, by recommending closing the loopholes in the legal definition of a ``bank,'' we also make sure that no company that owns a depository institution escapes firm-wide supervision. Moreover, our proposals on preemption and examination fee equalization would substantially reduce arbitrage opportunities between national and State charters.Q.36. Resolution Regime--Secretary Geithner, if Lehman had been resolved under your proposed resolution regime, how would Lehman's foreign broker-dealer have been handled?A.36. The financial regulatory reform initiative that we are proposing is comprehensive. Under the plan, all subsidiaries of Tier 1 FHCs, including foreign entities, will be subject to consolidated supervision. The focus of this supervision is on activities of the firm as a whole and the risks the firm might pose to the financial system. First, United States Tier 1 FHCs will be required to maintain and update a credible rapid resolution plan, to be used to facilitate the resolution of an institution and all of its subsidiaries (U.S. and foreign) in the event of severe financial distress. This requirement will provide incentives for better monitoring and simplification of organizational structures, including foreign subsidiaries, so that the government and the entity's customers, investors, and counterparties may be better prepared in the event of firm collapse. Second, in the event that the Tier 1 FHC is resolved through the proposed special resolution regime, the appointed receiver would coordinate with foreign authorities involved in the resolution of subsidiaries of the firm established in a foreign jurisdiction. This is the same process the FDIC would use for failing banks with foreign subsidiaries.Q.37. Would U.S. taxpayer funds have been used to satisfy foreign customer liabilities?A.37. The resolution regime that we are proposing is not designed to replace or augment existing customer protections, either domestically or internationally. We would expect existing programs to protect insured depositors, customers of broker-dealers, and insurance policyholders to continue. The resolution regime would allow the receiver to create a bridge institution in order to more effectively unwind the firm while protecting financial stability and it is possible that liabilities held by foreign counterparties could be put into the bridge institution. However, the purpose of the special resolution regime would be to unwind, dismantle, restructure, or liquidate the firm in an orderly way to minimize costs to taxpayers and the financial system. All holders of Tier 1 and Tier 2 regulatory capital would be forced to absorb losses, and management responsible for the failure would be fired. If there are any losses to the government in connection with the resolution regime, these will be recouped from large financial institutions in proportion to their size.Q.38. Over-the-Counter Derivatives--Secretary Geithner, the Administration's plan does not provide much detail about the Administration's views as to the proper allocation of responsibility with respect to over-the-counter derivatives between the Securities and Exchange Commission and the Commodity Futures Trading Commission. As you devise your recommendations for allocating regulatory responsibility over derivatives, how are you taking into account the importance of interest rate swaps and currency swaps to the debt securities markets.A.38. As a general matter, our plan allocates responsibility for over-the-counter derivatives (swaps) between the SEC and CFTC consistent with how existing law allocates responsibility over futures. More specifically, we provide the SEC with authority to regulate swaps based on a single security or a narrow-based securities index; we provide the CFTC with authority to regulate swaps based on broad-based securities indices and other commodities (including interest rates, currencies, and nonfinancial commodities). Given the functional similarities between swaps and futures, we believed that it was important to have the swaps regulatory jurisdictions parallel those of the futures markets. In addition, to ensure that all classes of swaps face similar constraints, we have required the SEC and CFTC to issue joint rules on the regulation of swaps, swap dealers, and major swap participants. In designing our swaps framework, we took into account the importance of interest rate swaps and currency swaps to the debt markets. We believe that our proposals will enhance the transparency and stability of those markets. Although our proposals require central clearing of standardized derivatives, we have preserved the ability of businesses to hedge their interest rate and currency risks through customized derivatives in appropriate cases. ------ CHRG-111hhrg48868--922 Mr. Liddy," I do not think it is a bad deal. I think the Federal Reserve and Treasury made an appropriate decision back in September, particularly on the heels of Lehman Brothers and the banking crisis and credit crisis that was in place. As I mentioned earlier, the amount of money we owe the American taxpayer right now, at the end of December, was $78- to $79 billion. We have sufficient assets that we should be able to repay that in full. The market is a pretty difficult place right now. There are not people with money who can afford to buy assets. So we are attempting to put up a structure which will isolate these assets, break the business up into component parts, and isolate those that are particularly healthy. I would like to wind this whole thing down and be the first company that is able to make a meaningful repayment to the American taxpayer. I think we have the potential to do that, but it is somewhat out of our control because it very much depends upon what happens with the worldwide capital markets, not just the stock market but liquidity and capital flows. I think the American taxpayer has a better chance of getting paid from AIG than perhaps many of the other companies that have received TARP dollars. I would like nothing better than to prove that statement to you. " CHRG-111hhrg56241--73 Mr. Stiglitz," Can I make a general point, which is that corporations are a creation of the State. We write the laws that define a corporation. What I think Mr. Bebchuk and Ms. Minow have been emphasizing is that we want to think about how we write those laws to make sure that our whole corporate sector works more efficiently, which has to do with the systems of corporate governance. But what are those systems? I think that is really the debate here. There is going to be one system or another, so the question is, can we create a system that is better than the current system? " FinancialCrisisInquiry--335 MACK: Happy to. But, as Mr. Blankfein said, it really would alleviate some of the issues of settling up with your counter parties. So not to be redundant, but it would be very helpful—you’d have better discovery, you would shrink, I think, some of the notional amounts by being able to do that. So I think it would go a long way in helping us, especially in times of crisis. But away that, it makes sense to do, and if you go back not too many years ago when we were able to put swaps business into that clearinghouse, that’s helped us on swaps. 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-111hhrg52400--135 Mr. McRaith," Thank you, Congressman. First of all, I think it's important to appreciate the strengths of our current system, as you clearly understand. We are a nationally-coordinated system of States. We have multiple sets of eyes, multiple sets of experts looking at one company, so that it's not a single regulator, it is multiple regulators working together in a coordinated fashion with a national system of solvency regulation, a national system for people like Mr. Nutter and others in his constituency and internationally. There is that national system that can be recognized. In terms of systemic risk, as I mentioned earlier, there needs to be--there must be--a primary role for the functional regulators. In our case, of course, it's the expertise that we have, the information we have, and the experience that we have in relation to State insurance regulation. Systemic regulation can integrate. It is inherently--State regulation is inherently compatible with systemic regulation. We need to formalize regulatory cooperation, reduce barriers, enhance communication. The systemic risk management--as I alluded to earlier, as regulators of the insurance industry, we require extensive exhaustive risk management for any insurance enterprise. We need that at the holding company level, and of course at systemically significant institutions, that is even more true. And then limit the circumstances in which the functional regulator can be preempted--must be extremely narrow and extremely limited. Only if there is an actual possibility of not just risk, but disruption to the system. And those circumstances are very narrow, indeed. The primary function and purpose and service that a systemic regulator will provide is to enhance the communication. And using AIG as the poster child, there was not sufficient interaction and communication among the functional regulators. We support systemic regulation, Congressman. " CHRG-111shrg61513--124 PREPARED STATEMENT OF BEN S. BERNANKE Chairman, Board of Governors of the Federal Reserve System February 25, 2010 Chairman Dodd, Ranking Member Shelby, and other members of the Committee, I am pleased to present the Federal Reserve's semiannual Monetary Policy Report to the Congress. I will begin today with some comments on the outlook for the economy and for monetary policy, then touch briefly on several other important issues.The Economic Outlook Although the recession officially began more than 2 years ago, U.S. economic activity contracted particularly sharply following the intensification of the global financial crisis in the fall of 2008. Concerted efforts by the Federal Reserve, the Treasury Department, and other U.S. authorities to stabilize the financial system, together with highly stimulative monetary and fiscal policies, helped arrest the decline and are supporting a nascent economic recovery. Indeed, the U.S. economy expanded at about a 4 percent annual rate during the second half of last year. A significant portion of that growth, however, can be attributed to the progress firms made in working down unwanted inventories of unsold goods, which left them more willing to increase production. As the impetus provided by the inventory cycle is temporary, and as the fiscal support for economic growth likely will diminish later this year, a sustained recovery will depend on continued growth in private-sector final demand for goods and services. Private final demand does seem to be growing at a moderate pace, buoyed in part by a general improvement in financial conditions. In particular, consumer spending has recently picked up, reflecting gains in real disposable income and household wealth and tentative signs of stabilization in the labor market. Business investment in equipment and software has risen significantly. And international trade--supported by a recovery in the economies of many of our trading partners--is rebounding from its deep contraction of a year ago. However, starts of single-family homes, which rose noticeably this past spring, have recently been roughly flat, and commercial construction is declining sharply, reflecting poor fundamentals and continued difficulty in obtaining financing. The job market has been hit especially hard by the recession, as employers reacted to sharp sales declines and concerns about credit availability by deeply cutting their workforces in late 2008 and in 2009. Some recent indicators suggest the deterioration in the labor market is abating: Job losses have slowed considerably, and the number of full-time jobs in manufacturing rose modestly in January. Initial claims for unemployment insurance have continued to trend lower, and the temporary services industry, often considered a bellwether for the employment outlook, has been expanding steadily since October. Notwithstanding these positive signs, the job market remains quite weak, with the unemployment rate near 10 percent and job openings scarce. Of particular concern, because of its long-term implications for workers' skills and wages, is the increasing incidence of long-term unemployment; indeed, more than 40 percent of the unemployed have been out of work 6 months or more, nearly double the share of a year ago. Increases in energy prices resulted in a pickup in consumer price inflation in the second half of last year, but oil prices have flattened out over recent months, and most indicators suggest that inflation likely will be subdued for some time. Slack in labor and product markets has reduced wage and price pressures in most markets, and sharp increases in productivity have further reduced producers' unit labor costs. The cost of shelter, which receives a heavy weight in consumer price indexes, is rising very slowly, reflecting high vacancy rates. In addition, according to most measures, longer-term inflation expectations have remained relatively stable. The improvement in financial markets that began last spring continues. Conditions in short-term funding markets have returned to near pre-crisis levels. Many (mostly larger) firms have been able to issue corporate bonds or new equity and do not seem to be hampered by a lack of credit. In contrast, bank lending continues to contract, reflecting both tightened lending standards and weak demand for credit amid uncertain economic prospects. In conjunction with the January meeting of the Federal Open Market Committee (FOMC), Board members and Reserve Bank presidents prepared projections for economic growth, unemployment, and inflation for the years 2010 through 2012 and over the longer run. The contours of these forecasts are broadly similar to those I reported to the Congress last July. FOMC participants continue to anticipate a moderate pace of economic recovery, with economic growth of roughly 3 to 3 \1/2\ percent in 2010 and 3 \1/2\ to 4 \1/2\ percent in 2011. Consistent with moderate economic growth, participants expect the unemployment rate to decline only slowly, to a range of roughly 6 \1/2\ to 7 \1/2\ percent by the end of 2012, still well above their estimate of the long-run sustainable rate of about 5 percent. Inflation is expected to remain subdued, with consumer prices rising at rates between 1 and 2 percent in 2010 through 2012. In the longer term, inflation is expected to be between 1 \3/4\ and 2 percent, the range that most FOMC participants judge to be consistent with the Federal Reserve's dual mandate of price stability and maximum employment.Monetary Policy Over the past year, the Federal Reserve has employed a wide array of tools to promote economic recovery and preserve price stability. The target for the Federal funds rate has been maintained at a historically low range of 0 to \1/4\ percent since December 2008. The FOMC continues to anticipate that economic conditions--including low rates of resource utilization, subdued inflation trends, and stable inflation expectations--are likely to warrant exceptionally low levels of the Federal funds rate for an extended period. To provide support to mortgage lending and housing markets and to improve overall conditions in private credit markets, the Federal Reserve is in the process of purchasing $1.25 trillion of agency mortgage-backed securities and about $175 billion of agency debt. We have been gradually slowing the pace of these purchases in order to promote a smooth transition in markets and anticipate that these transactions will be completed by the end of March. The FOMC will continue to evaluate its purchases of securities in light of the evolving economic outlook and conditions in financial markets. In response to the substantial improvements in the functioning of most financial markets, the Federal Reserve is winding down the special liquidity facilities it created during the crisis. On February 1, a number of these facilities, including credit facilities for primary dealers, lending programs intended to help stabilize money market mutual funds and the commercial paper market, and temporary liquidity swap lines with foreign central banks, were allowed to expire.\1\ The only remaining lending program for multiple borrowers created under the Federal Reserve's emergency authorities, the Term Asset-Backed Securities Loan Facility, is scheduled to close on March 31 for loans backed by all types of collateral except newly issued commercial mortgage-backed securities (CMBS) and on June 30 for loans backed by newly issued CMBS.--------------------------------------------------------------------------- \1\ Primary dealers are broker-dealers that act as counterparties to the Federal Reserve Bank of New York in its conduct of open market operations.--------------------------------------------------------------------------- In addition to closing its special facilities, the Federal Reserve is normalizing its lending to commercial banks through the discount window. The final auction of discount-window funds to depositories through the Term Auction Facility, which was created in the early stages of the crisis to improve the liquidity of the banking system, will occur on March 8. Last week we announced that the maximum term of discount window loans, which was increased to as much as 90 days during the crisis, would be returned to overnight for most banks, as it was before the crisis erupted in August 2007. To discourage banks from relying on the discount window rather than private funding markets for short-term credit, last week we also increased the discount rate by 25 basis points, raising the spread between the discount rate and the top of the target range for the Federal funds rate to 50 basis points. These changes, like the closure of most of the special lending facilities earlier this month, are in response to the improved functioning of financial markets, which has reduced the need for extraordinary assistance from the Federal Reserve. These adjustments are not expected to lead to tighter financial conditions for households and businesses and should not be interpreted as signaling any change in the outlook for monetary policy, which remains about the same as it was at the time of the January meeting of the FOMC. Although the Federal funds rate is likely to remain exceptionally low for an extended period, as the expansion matures, the Federal Reserve will at some point need to begin to tighten monetary conditions to prevent the development of inflationary pressures. Notwithstanding the substantial increase in the size of its balance sheet associated with its purchases of Treasury and agency securities, we are confident that we have the tools we need to firm the stance of monetary policy at the appropriate time.\2\--------------------------------------------------------------------------- \2\ For further details on these tools and the Federal Reserve's exit strategy, see Ben S. Bernanke (2010), ``Federal Reserve's Exit Strategy,'' statement before the Committee on Financial Services, U.S. House of Representatives, February 10, www.federalreserve.gov/newsevents/testimony/bernanke20100210a.htm.--------------------------------------------------------------------------- Most importantly, in October 2008 the Congress gave statutory authority to the Federal Reserve to pay interest on banks' holdings of reserve balances at Federal Reserve Banks. By increasing the interest rate on reserves, the Federal Reserve will be able to put significant upward pressure on all short-term interest rates. Actual and prospective increases in short-term interest rates will be reflected in turn in longer-term interest rates and in financial conditions more generally. The Federal Reserve has also been developing a number of additional tools to reduce the large quantity of reserves held by the banking system, which will improve the Federal Reserve's control of financial conditions by leading to a tighter relationship between the interest rate paid on reserves and other short-term interest rates. Notably, our operational capacity for conducting reverse repurchase agreements, a tool that the Federal Reserve has historically used to absorb reserves from the banking system, is being expanded so that such transactions can be used to absorb large quantities of reserves.\3\ The Federal Reserve is also currently refining plans for a term deposit facility that could convert a portion of depository institutions' holdings of reserve balances into deposits that are less liquid and could not be used to meet reserve requirements.\4\ In addition, the FOMC has the option of redeeming or selling securities as a means of reducing outstanding bank reserves and applying monetary restraint. Of course, the sequencing of steps and the combination of tools that the Federal Reserve uses as it exits from its currently very accommodative policy stance will depend on economic and financial developments. I provided more discussion of these options and possible sequencing in a recent testimony.\5\--------------------------------------------------------------------------- \3\ The Federal Reserve has recently developed the ability to engage in reverse repurchase agreements in the triparty market for repurchase agreements, with primary dealers as counterparties and using Treasury and agency debt securities as collateral, and it is developing the capacity to carry out these transactions with a wider set of counterparties (such as money market mutual funds and the mortgage-related government-sponsored enterprises) and using agency mortgage-backed securities as collateral. \4\ In December the Federal Reserve published a proposal describing a term deposit facility in the Federal Register (see Board of Governors of the Federal Reserve System (2009), ``Federal Reserve Board Proposes Amendments to Regulation D That Would Enable the Establishment of a Term Deposit Facility,'' press release, December 28, www.federalreserve.gov/newsevents/press/monetary/20091228a.htm) We are now in the process of analyzing the public comments that have been received. A revised proposal will be reviewed by the Federal Reserve Board, and test transactions could commence during the second quarter. \5\ See Bernanke, ``Federal Reserve's Exit Strategy,'' in note 2.---------------------------------------------------------------------------Federal Reserve Transparency The Federal Reserve is committed to ensuring that the Congress and the public have all the information needed to understand our decisions and to be assured of the integrity of our operations. Indeed, on matters related to the conduct of monetary policy, the Federal Reserve is already one of the most transparent central banks in the world, providing detailed records and explanations of its decisions. Over the past year, the Federal Reserve also took a number of steps to enhance the transparency of its special credit and liquidity facilities, including the provision of regular, extensive reports to the Congress and the public; and we have worked closely with the Government Accountability Office (GAO), the Office of the Special Inspector General for the Troubled Asset Relief Program, the Congress, and private-sector auditors on a range of matters relating to these facilities. While the emergency credit and liquidity facilities were important tools for implementing monetary policy during the crisis, we understand that the unusual nature of those facilities creates a special obligation to assure the Congress and the public of the integrity of their operation. Accordingly, we would welcome a review by the GAO of the Federal Reserve's management of all facilities created under emergency authorities.\6\ In particular, we would support legislation authorizing the GAO to audit the operational integrity, collateral policies, use of third-party contractors, accounting, financial reporting, and internal controls of these special credit and liquidity facilities. The Federal Reserve will, of course, cooperate fully and actively in all reviews. We are also prepared to support legislation that would require the release of the identities of the firms that participated in each special facility after an appropriate delay. It is important that the release occur after a lag that is sufficiently long that investors will not view an institution's use of one of the facilities as a possible indication of ongoing financial problems, thereby undermining market confidence in the institution or discouraging use of any future facility that might become necessary to protect the U.S. economy. An appropriate delay would also allow firms adequate time to inform investors through annual reports and other public documents of their use of Federal Reserve facilities.--------------------------------------------------------------------------- \6\ Last month the Federal Reserve said that it would welcome a full review by the GAO of all aspects of the Federal Reserve's involvement in the extension of credit to the American International Group, Inc. (see Ben S. Bernanke (2010), letter to Gene L. Dodaro, January 19, www.federalreserve.gov/monetarypolicy/files/letter_aig_20100119.pdf). The Federal Reserve would support legislation authorizing a review by the GAO of the Federal Reserve's operations of its facilities created under emergency authorities: the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility, the Commercial Paper Funding Facility, the Money Market Investor Funding Facility, the Primary Dealer Credit Facility, the Term Asset-Backed Securities Loan Facility, and the Term Securities Lending Facility.--------------------------------------------------------------------------- Looking ahead, we will continue to work with the Congress in identifying approaches for enhancing the Federal Reserve's transparency that are consistent with our statutory objectives of fostering maximum employment and price stability. In particular, it is vital that the conduct of monetary policy continue to be insulated from short-term political pressures so that the FOMC can make policy decisions in the longer-term economic interests of the American people. Moreover, the confidentiality of discount window lending to individual depository institutions must be maintained so that the Federal Reserve continues to have effective ways to provide liquidity to depository institutions under circumstances where other sources of funding are not available. The Federal Reserve's ability to inject liquidity into the financial system is critical for preserving financial stability and for supporting depositories' key role in meeting the ongoing credit needs of firms and households.Regulatory Reform Strengthening our financial regulatory system is essential for the long-term economic stability of the nation. Among the lessons of the crisis are the crucial importance of macroprudential regulation--that is, regulation and supervision aimed at addressing risks to the financial system as a whole--and the need for effective consolidated supervision of every financial institution that is so large or interconnected that its failure could threaten the functioning of the entire financial system. The Federal Reserve strongly supports the Congress's ongoing efforts to achieve comprehensive financial reform. In the meantime, to strengthen the Federal Reserve's oversight of banking organizations, we have been conducting an intensive self-examination of our regulatory and supervisory responsibilities and have been actively implementing improvements. For example, the Federal Reserve has been playing a key role in international efforts to toughen capital and liquidity requirements for financial institutions, particularly systemically critical firms, and we have been taking the lead in ensuring that compensation structures at banking organizations provide appropriate incentives without encouraging excessive risk-taking.\7\--------------------------------------------------------------------------- \7\ For further information, see Board of Governors of the Federal Reserve System (2009), ``Federal Reserve Issues Proposed Guidance on Incentive Compensation,'' press release, October 22, www.federalreserve.gov/newsevents/press/bcreg/20091022a.htm.--------------------------------------------------------------------------- The Federal Reserve is also making fundamental changes in its supervision of large, complex bank holding companies, both to improve the effectiveness of consolidated supervision and to incorporate a macroprudential perspective that goes beyond the traditional focus on safety and soundness of individual institutions. We are overhauling our supervisory framework and procedures to improve coordination within our own supervisory staff and with other supervisory agencies and to facilitate more-integrated assessments of risks within each holding company and across groups of companies. Last spring the Federal Reserve led the successful Supervisory Capital Assessment Program, popularly known as the bank stress tests. An important lesson of that program was that combining onsite bank examinations with a suite of quantitative and analytical tools can greatly improve comparability of the results and better identify potential risks. In that spirit, the Federal Reserve is also in the process of developing an enhanced quantitative surveillance program for large bank holding companies. Supervisory information will be combined with firm-level, market-based indicators and aggregate economic data to provide a more complete picture of the risks facing these institutions and the broader financial system. Making use of the Federal Reserve's unparalleled breadth of expertise, this program will apply a multidisciplinary approach that involves economists, specialists in particular financial markets, payments systems experts, and other professionals, as well as bank supervisors. The recent crisis has also underscored the extent to which direct involvement in the oversight of banks and bank holding companies contributes to the Federal Reserve's effectiveness in carrying out its responsibilities as a central bank, including the making of monetary policy and the management of the discount window. Most important, as the crisis has once again demonstrated, the Federal Reserve's ability to identify and address diverse and hard-to-predict threats to financial stability depends critically on the information, expertise, and powers that it has by virtue of being both a bank supervisor and a central bank. The Federal Reserve continues to demonstrate its commitment to strengthening consumer protections in the financial services arena. Since the time of the previous Monetary Policy Report in July, the Federal Reserve has proposed a comprehensive overhaul of the regulations governing consumer mortgage transactions, and we are collaborating with the Department of Housing and Urban Development to assess how we might further increase transparency in the mortgage process.\8\ We have issued rules implementing enhanced consumer protections for credit card accounts and private student loans as well as new rules to ensure that consumers have meaningful opportunities to avoid overdraft fees.\9\ In addition, the Federal Reserve has implemented an expanded consumer compliance supervision program for nonbank subsidiaries of bank holding companies and foreign banking organizations.\10\--------------------------------------------------------------------------- \8\ For further information, see Board of Governors of the Federal Reserve System (2009), ``Federal Reserve Proposes Significant Changes to Regulation Z (Truth in Lending) Intended to Improve the Disclosures Consumers Receive in Connection with Closed-End Mortgages and Home-Equity Lines of Credit,'' press release, July 23, www.federalreserve.gov/newsevents/press/bcreg/20090723a.htm. \9\ For more information, see Board of Governors of the Federal Reserve System (2009), ``Federal Reserve Approves Final Amendments to Regulation Z That Revise Disclosure Requirements for Private Education Loans,'' press release, July 30, www.federalreserve.gov/newsevents/press/bcreg/20090730a.htm; Board of Governors of the Federal Reserve System (2009), ``Federal Reserve Announces Final Rules Prohibiting Institutions from Charging Fees for Overdrafts on ATM and One-Time Debit Card Transactions,'' press release, November 12, www.federalreserve.gov/newsevents/press/bcreg/20091112a.htm; and Board of Governors of the Federal Reserve System (2010), ``Federal Reserve Approves Final Rules to Protect Credit Card Users from a Number of Costly Practices,'' press release, January 12, www.federalreserve.gov/newsevents/press/bcreg/20100112a.htm. \10\ For further information, see Board of Governors of the Federal Reserve System (2009), ``Federal Reserve to Implement Consumer Compliance Supervision Program of Nonbank Subsidiaries of Bank Holding Companies and Foreign Banking Organizations,'' press release, September 15, www.federalreserve.gov/newsevents/press/bcreg/20090915a.htm.--------------------------------------------------------------------------- More generally, the Federal Reserve is committed to doing all that can be done to ensure that our economy is never again devastated by a financial collapse. We look forward to working with the Congress to develop effective and comprehensive reform of the financial regulatory framework. RESPONSE TO WRITTEN QUESTIONS OF SENATOR SHELBY FROM BEN S. BERNANKEEmergency Lending Under Section 13(3)Q.1.a. Charles Plosser, President of the Federal Reserve Bank of Philadelphia, stated in a recent speech his belief that the Fed's emergency 13(3) lending authority should be either eliminated or severely curtailed (``The Federal Reserve System: Balancing Independence and Accountability,'' presented February 17, 2010 by President Plosser to the World Affairs Council of Philadelphia). He stated: I believe that the Fed's 13(3) lending authority should be either eliminated or severely curtailed. Such lending should be done by the fiscal authorities only in emergencies and, if the Fed is involved, only upon the written request of the Treasury. Any non-Treasury securities or collateral acquired by the Fed under such lending should be promptly swapped for Treasury securities so that it is clear that the responsibility and accountability for such lending rests explicitly with the fiscal authorities, not the Federal Reserve. To codify this arrangement, I believe we should establish a new Fed-Treasury Accord. This would eliminate the ability of the Fed to engage in `bailouts' of individual firms or sectors and place such responsibility with the Treasury and Congress, squarely where it belongs.Do you agree with President Plosser?A.1.a Since the fall of 2008, I have advocated that Congress establish a statutory resolution regime that provides a workable alternative to Government bailouts and disorderly bankruptcies. With enactment of a workable resolution regime for systemically important firms, I have also called for removal of the Federal Reserve's authority under section 13(3) to extend credit to troubled nonbanking entities. However, I believe that it would be appropriate for the Federal Reserve to retain the authority to lend to establish broad market-based credit facilities in unusual and exigent circumstances. In exceptional circumstances the preservation of financial stability may require that the Federal Reserve have the authority to provide liquidity to restart or encourage markets to operate, thereby providing liquidity needed to allow households, small businesses, depositors and others access to working liquid markets. The need for such authority was fully evident during the financial crisis, when preventing a financial catastrophe required that the Federal Reserve provide liquidity to money market mutual funds, primary dealers, the commercial paper market, and the market for student loans, credit card loans, small business loans and the commercial real estate market.Q.1.b. Do you believe that modifications to Section 13(3) of the Federal Reserve Act would be useful in clarifying emergency responses of various branches of government to financial crises? If so, what modifications do you believe would be most useful?A.1.b. Apart from a possible elimination of the authority to lend to single firms (as discussed above), I do not believe that significant modifications to section 13(3) are necessary or appropriate. The Federal Reserve has historically been extremely cautious in using the section 13(3) authority. Prior to the recent financial crisis, the Federal Reserve had authorized the extension of credit under section 13(3) in only one circumstance since the Great Depression and had not in fact extended credit under this section since the 1930s. During this financial crisis, the Federal Reserve worked closely with the Department of the Treasury before exercising authority under section 13(3). We believe this consultation is important and appropriate and would not object to a statutory provision requiring consultation with or approval by the Secretary of the Treasury prior to authorizing an extension of credit under section 13(3).Q.1.c. Do you favor the establishment of a new Fed-Treasury Accord to provide greater distinction between fiscal policy actions and lender-of-last resort actions taken by the Federal Reserve in an emergency?A.1.c. The Federal Reserve and the Treasury have an accord that sets forth the principles applied by each in addressing the current crisis. We would favor a legislative provision allowing the Federal Reserve to transfer to the Treasury obligations that, while acquired in the course of Federal Reserve action as the lender of last resort, become fiscal obligations more appropriately managed by the Treasury Department. We would be happy to work with you on developing this type of approach.Interest on ReservesQ.2. Congress provided the authority to pay interest on reserves to the Board of Governors of the Federal Reserve, and not the Federal Open Market Committee (FOMC). Similarly, the Board of Governors, and not the FOMC, has authority over setting the discount rate and reserve requirements. According to minutes of the January 26-27, 2010, FOMC meeting, the interest rate paid on excess reserve balances (the IOER rate) is one of the tools available to support a gradual return to a more normal monetary policy stance. Quoting from the minutes: Participants expressed a range of views about the tools and strategy for removing policy accommodation when that step becomes appropriate. All agreed that raising the IOER rate and the target for the Federal funds rate would be a key element of a move to less accommodative monetary policy. LAre there any possible future conflicts or difficulties that you could imagine might arise from having the Federal Reserve's target for the Federal funds rate determined by the FOMC while the IOER and discount rate are determined by the Board of Governors? LAs it moves toward a more normal monetary policy stance, the Federal Reserve may use the IOER rate to help manage reserve balances. If the IOER rate, rather than a target for a market rate, becomes an indicator of the stance of monetary policy for a time, will the balance of power over monetary policy between the FOMC and the Federal Reserve Board change?A.2. As you know, the Congress has assigned to the Board the responsibility for determining the rate paid on reserves. Although the Federal Open Market Committee (FOMC) by law is responsible for directing open market operations, the Congress has also assigned to the Board the responsibility for determining certain other important terms that are relevant for the conduct of monetary policy--for example, the Board ``reviews and determines'' the discount rates that are established by the Federal Reserve Banks; the Federal Open Market Committee has no statutory role in setting the discount rate. Similarly, the Board sets reserve requirements subject to the constraints established by the Congress; the Federal Open Market Committee has no statutory role in setting reserve requirements. For many years, the Board and the FOMC have worked collegially and cooperatively in setting the discount rate, the Federal funds target rate, and other instruments of monetary policy. I am convinced that the Board and the FOMC will continue to work cooperatively in the future in adjusting all of the instruments of monetary policy.Monetary Policy and Fiscal Policy DistinctionQ.3.a. Several regional Federal Reserve bank presidents have expressed concern that actions taken by the Fed, many under Section 13(3) authority, were actions to channel credit to specific firms or specific segments of financial markets and the economy. The concern is that some actions amounted to fiscal, and not lender of last resort, policies. Moreover, in a March 23, 2009 joint press release, the Fed and the Treasury stated the following: The Federal Reserve to avoid credit risk and credit allocation The Federal Reserve's lender-of-last-resort responsibilities involve lending against collateral, secured to the satisfaction of the responsible Federal Reserve Bank. Actions taken by the Federal Reserve should also aim to improve financial or credit conditions broadly, not to allocate credit to narrowly defined sectors or classes of borrowers. Government decisions to influence the allocation of credit are the province of the fiscal authorities. In accord with the joint statement, should the Fed's stock of agency debt and mortgage-backed securities along with its Maiden Lane holdings be swapped for Treasury securities, thereby transparently placing the channeling of credit support to the housing sector firmly in the hands of fiscal authorities?A.3.a. The Federal Reserve's purchases of agency debt and mortgage-backed securities, and the credit it has extended to the Maiden Lane entities, arose for different reasons and deserve different treatment. The primary purpose of the Federal Reserve's purchases of securities issued or guaranteed by Federal agencies was a monetary policy response intended to support the overall economy by providing support to the mortgage and housing sectors. The Federal Reserve believes that in routine circumstances the modes of government support for the housing sector should be determined by the Congress and carried out through agencies other than the Federal Reserve. For that reason, the Federal Reserve in recent decades minimized its participation in the agency securities markets. However, the highly strained financial market conditions of the past few years prevented the Federal Reserve's monetary policy actions to lower interest rates from being fully transmitted to housing markets, as would have happened in more normal times, and the Federal Reserve's ability to lower short-term interest rates further was constrained after short-term rates were lowered to essentially zero. In the circumstances, the Federal Reserve initiated a program to purchase agency debt and mortgage-backed securities. The credit extensions to AIG and the Maiden Lane entities represent exercise of the Federal Reserve's authority as lender of last resort. The Treasury Department is better suited to make the policy and management decisions that attend the longer term relationship with a nonbanking firm that requires government assistance. Accordingly, the Federal Reserve would support a transfer to the Treasury of its AIG and Maiden Lane credits. The issues regarding a possible swap of agency debt and MBS securities for Treasury securities are somewhat more complex and would require careful study.Q.3.b. The Fed has purchased over $1 trillion of agency mortgage-backed-securities and intends to complete purchases of $1.25 trillion of those securities by the end of March. To help finance those purchases, the Fed uses supplemental borrowing from the Treasury and issues interest-bearing reserve balances. In effect, the Fed is borrowing from the public, including banks, with promises to repay the borrowed sums plus interest. The Fed will continue that borrowing in order to hold on to its mortgage-backed securities until those assets gradually decline as they mature or are prepaid or sold. When the Fed effectively finances an enormous portfolio holding of a specific class of assets using interest bearing debt issued to the public, how is that not a fiscal policy exercise?A.3.b. Monetary policy and fiscal policy are different tools that both can be used to stimulate the economy. The purpose of the Federal Reserve's large-scale asset purchases was primarily to apply macroeconomic stimulus by lowering longer-term interest rates and by improving financial market functioning; fiscal policy applies stimulus by adjusting overall government spending or revenues. Because the Federal Reserve's large-scale asset purchases involved changes in the central bank's balance sheet--and, in particular, the creation of a large volume of reserves, it is clear that the purchases were a monetary policy action. Moreover, the Federal Reserve's decision to purchase a large volume of longer-term assets in the crisis was consistent with its statutory mandate to promote maximum employment and price stability, and it was clearly supported by its statutory authorities. These transactions can and will be unwound in a manner consistent with these same mandates.Systemic Risk RegulationQ.4.a. Your February 25, 2010, testimony identifies that the Fed is making fundamental changes in its supervision of bank holding companies to, in your words, ``incorporate a macroprudential perspective that goes beyond the traditional focus on safety and soundness of individual institutions.'' Could you precisely define what you mean by a ``macroprudential perspective,'' and what metrics guide that perspective?A.4.a. Our supervisory approach should better reflect our mission, as a central bank, to promote financial stability. As was evident in the financial crisis, complex, global financial firms can be profoundly interconnected in ways that can threaten the viability of individual firms, the functioning of key financial markets, and the stability of the broader economy. A macroprudential perspective requires a more system-wide approach to the supervision of systemically critical firms that considers the interdependencies among firms and markets that have the potential to undermine the stability of the financial system. To that end, we have supported the creation of a council of regulators that would gather information from across the financial system, identify and assess potential risks to the financial system, and work with member agencies to address those risks. In our own supervisory efforts, we are reorienting our approach to some of the largest holding companies to better anticipate and mitigate systemic risks. For example, we expect to increase the use of horizontal reviews, which focus on particular risks or activities across a group of banking organizations. In doing so, we have drawn on our experience with the Supervisory Capital Assessment Program (SCAP), in which the Federal Reserve led a coordinated effort by the bank supervisors to evaluate on a consistent basis the capital needs of the largest banking institutions in an adverse economic scenario. Because the SCAP involved the simultaneous evaluation of potential credit exposures across all of the included firms, we were better able to consider the systemic implications of financial stress under an adverse economic scenario, in addition to the impact of an adverse scenario on individual firms. The SCAP also showed the benefits of drawing on the work of a wide range of staff--including supervisors, economists, and market and payments system experts--to comprehensively evaluate the risks facing financial firms. Going forward, the Federal Reserve is instituting a data-driven, quantitative surveillance mechanism that will draw on a similar range of staff expertise to provide an independent view of the risks facing large banking firms. As part of that effort, we are developing quantitative tools to help identify vulnerabilities at both the firm level and for the aggregate financial sector. We anticipate that these tools will incorporate macroeconomic forecasts, including spillover and feedback effects. We also expect to develop indicators of interconnectedness, which could encompass common credit, market, and funding exposures. The development of specific metrics will also depend, in part, on the availability of timely and comparable data from systemically important firms.Q.4.b. Does the Fed intend to redefine what regulators should regard as ``safety and soundness?''A.4.b. Ensuring the safety and soundness of institutions has been a cornerstone of the Federal Reserve's supervision program. The recent crisis has shown that large, interconnected firms can be buffeted by a market-driven crisis, magnifying weaknesses in risk management practices, and revealing capital and liquidity buffers calibrated to withstand institution-specific stress events to be insufficient. For this reason, leading supervisors in the United States and abroad are reviewing the prudential standards needed to ensure safety and soundness for individual firms and the financial system as a whole. The Federal Reserve is participating in a range of joint efforts to ensure that large, systemically critical financial institutions hold more and higher quality capital, improve their risk-management practices, have more robust liquidity management, employ compensation structures that provide appropriate performance and risk-taking incentives, and deal fairly with consumers. We are working with our domestic and international counterparts to develop capital and prudential requirements that take account of the systemic importance of large, complex firms whose failure would pose a significant threat to overall financial stability. Options under consideration include assessing a capital surcharge on these institutions or requiring that a greater share of their capital be in the form of common equity. For additional protection, systemically important institutions could be required to issue contingent capital, such as debt-like securities that convert to common equity in times of macroeconomic stress or when losses erode the institution's capital base. U.S. supervisory agencies have already increased capital requirements for trading activities and securitization exposures, two of the areas in which losses were especially high. Liquidity requirements should also be strengthened for systemically critical firms, as even solvent financial institutions can be brought down by liquidity problems. The bank regulatory agencies are implementing strengthened guidance on liquidity risk management and weighing proposals for quantitatively based requirements. In addition to insufficient capital and inadequate liquidity risk management, flawed compensation practices at financial institutions also contributed to the crisis. Compensation should appropriately link pay to performance and provide sound incentives. The Federal Reserve has issued proposed guidance that would require banking organizations to review their compensation practices to ensure they do not encourage excessive risk-taking, are subject to effective controls and risk management, and are supported by strong corporate governance including board-level oversight.Federal Reserve's Asset HoldingsQ.5. Charles Plosser, President of the Federal Reserve Bank of Philadelphia, stated in a recent speech that . . . the Fed could help preserve its independence by limiting the scope of its ability to engage in activities that blur the boundary lines between monetary and fiscal policy. Thus, as the economic recovery gains strength and monetary policy begins to normalize, I would favor our beginning to sell some of the agency mortgage-backed securities from our portfolio rather than relying only on redemptions of these assets. Doing so would help extricate the Fed from the realm of fiscal policy and housing finance.Do you agree with President Plosser?A.5. I provided my views on asset sales in my March 25, 2010, testimony before the House Committee on Financial Services. The relevant passage is reproduced below. When these tools [reverse repurchase agreements and term deposits] are used to drain reserves from the banking system, they do so by replacing bank reserves with other liabilities; the asset side and the overall of the Federal Reserve's balance sheet remain unchanged. If necessary, as a means of applying monetary restraint, the Federal Reserve also has the option of redeeming or selling securities. The redemption or sale of securities would have the effect of reducing the size of the Federal Reserve's balance sheet as well as further reducing the quantity of reserves in the banking system. Restoring the size and composition of the balance sheet to a more normal configuration is a longer-term objective of our policies. In any case, the sequencing of steps and the combination of tools that the Federal Reserve uses as it exits from its currently very accommodative policy stance will depend on economic and financial developments and on our best judgments about how to meet the Federal Reserve's dual mandate of maximum employment and price stability.Treasury Financing Account at the FedQ.6. On February 23, 2010, the Treasury announced, rather suddenly and surprisingly, and without much explanation, that it anticipates increasing its Supplementary Financing Account at the Fed by around $200 billion over the next 2 months. This means, essentially, that the Treasury will borrow on behalf of the Fed and simply hold the funds in the Treasury's account at the Fed. I understand that the Treasury's Supplementary Financing Program helps the Fed absorb reserves from the banking system and manage its balance sheet. I wonder, however, about the lack of information concerning why the Treasury suddenly decided to increase its balance at the Fed. LWas the Treasury's February 23 announcement planned in advance and coordinated with the Fed, or was it a surprise to the Fed? LWhat are the future plans for the size of the Treasury's Supplemental Financing Account? LWho will decide what will be the future balances in the Supplemental Financing Account?A.6. The Treasury and the Federal Reserve consulted closely on the Treasury's February 23 announcement regarding the Supplementary Financing Program. However, the Treasury makes all decisions on balances to be held in the Supplementary Financing Account.Efforts to Toughen Capital and Liquidity RequirementsQ.7.a. Your testimony on February 25, 2010 identifies that . . . the Federal Reserve has been playing a key international role in international efforts to toughen capital and liquidity requirements for financial institutions, particularly systemically critical firms . . .Could you describe what those efforts have been?A.7.a. The Federal Reserve has an active leadership role within the Finance Stability Board, the Basel Committee for Banking Supervision, and various other international supervisory fora. Through these fora, especially the Basel Committee, the Federal Reserve has worked diligently with supervisors from around the world to develop a comprehensive series of reforms to address the lessons that we have learned from the recent global financial crisis. The goal of the Basel Committee's reform package is to improve the international banking sector's ability to deal with future economic and financial stress, thus reducing the contagion risk from the financial sector to the real economy. The Federal Reserve co-chairs three Basel Committee working groups that are focusing on reforms especially pertinent to systemically important institutions. These groups are developing: a) revisions to the capital regulations for trading book activities, designed to enhance risk measurement and to significantly increase the capital requirement associated with various financial instruments that contributed to losses at systemically important institutions during the crisis; b) enhanced and higher capital charges for counterparty credit risk, including a new charge for credit valuation allowances (CVA), which were a significant source of loss during the crisis; and c) new liquidity standards, which directly address a major challenge during the global turmoil. With regard to the latter, the proposed standards draw heavily from conceptual design work contributed by Federal Reserve staff. In addition, Federal Reserve staff made significant contributions to the Basel Committee's Principles for Sound Liquidity Risk Management and supervision issued in September 2008. In many cases, the international principles articulated drew heavily from established Federal Reserve guidance. Moreover, Federal Reserve economists and supervisors have been heavily involved in work conducted by the Basel Committee and by the Committee of Global Financial Stability to develop forward-looking measures of systemic liquidity risks and in assessing the current state of funding and liquidity risk management at internationally active financial institutions. Federal Reserve staff also are key players in the Basel Committee's working groups developing a new international leverage ratio standard, which is largely inspired by the U.S. leverage standard, and a new definition of regulatory capital for banking organizations, which is an area where the Federal Reserve provides insightful experience since almost all banking capital issuance in the U.S. is executed at the bank holding company level.\1\ Moreover, the Federal Reserve has also played an active role in the Basel Committee's working group that recently issued recommendations to strengthen the resolution of systemically significant cross-border banks.\2\--------------------------------------------------------------------------- \1\ See ``Strengthening the resilience of the banking sector-consultative document'' (December 2009), available at www.bis.org/publ/bcbs164.htm. \2\ See ``Report and recommendations of the Cross-border Bank Resolution Group-final paper'' (March 2009), available at www.bis.org/publ/bcbs169.htm.---------------------------------------------------------------------------Q.7.b. Could you define a ``systemically critical'' firm and identify how many such firms currently operate in the United States?A.7.b. A ``systemically critical'' firm is one whose failure would have significant adverse effects on financial markets or the economy. At any point in time, the systemic importance of an individual firm depends on a wide range of factors including whether the firm has extensive on- and off-balance sheet activities, whether the firm is interconnected--either receiving funding from, or providing funding to other systemically important firms--whether the firm plays a major role in key financial markets, and/or whether the firm provides crucial services to its customers that cannot easily or quickly be provided by other financial institutions. That said, the identification of systemic importance requires considerable judgment because each stress event is different, because market structure, business practices, financial products, technologies, supervisory practices and regulatory environments evolve over time. This evolution, of course, changes the interconnections between firms, their relative sizes, their functions and services, and the extent to which services can be obtained from other firms or in financial markets. As a practical matter, it is likely that the number of firms that are considered systemically critical will be less than 50. For example, only about 35 U.S. financial firms, with publicly traded stock outstanding, have total assets over $100 billion as of 2008:Q4. ------ RESPONSE TO WRITTEN QUESTIONS OF SENATOR BROWN FROM BEN S. BERNANKEBank LendingQ.1. I have heard from Ohio banks that banking regulators are preventing them from expanding commercial lending by requiring them to maintain greater capital reserves. I agree that we need to ensure that our banks are well capitalized, but at some point we've got to get lending going again, particularly to businesses that will use their money to hire workers. How can banks strike a balance between being well capitalized and still lending like they are supposed to?A.1. The loss absorbing characteristics of capital provide the economic bedrock that supports prudent bank lending and, as such, it is not inconsistent for banks to remain well capitalized and concomitantly engage in healthy lending practices. However, during the financial crisis, many banks recorded significant financial losses that eroded their capital base and as a result, some banks may be operating with reduced capital bases to support lending activities. In other instances, well capitalized banks may be reluctant to lend if their outlook on economic conditions lead them to believe that additional losses are likely in the near term, which would further erode their current capital position. The Federal Reserve believes that, in cases where banks are concerned about potential additional losses, a prudent response would be for those banks to increase their capital position in order to address this concern and to take advantage of any demand in commercial lending. Likewise, we believe that an improving economic outlook should help banks to bolster their capital levels and contribute to increased willingness of banks to lend.Q.2. Have you considered taking any specific steps, like lowering the Fed's interest payments on excess bank reserves, or perhaps even imposing a penalty on hoarding money, to promote greater lending?A.2. The Federal Reserve's payment of interest on excess reserves is unlikely to be a significant factor in banks' current reluctance to lend. The Federal Reserve is currently paying interest at a rate of only one quarter of 1 percent on banks' reserve balances. By contrast, the prime rate is currently at 3 \1/4\ percent, and many bank lending rates are considerably higher than the prime rate. Given the large difference between the interest rate paid on excess reserves and the interest rates on banks, the ability to earn interest on excess reserves is unlikely to be an important reason for the tightening of banks' lending standards and terms over the past few years. Indeed, survey results suggest that the major reason that banks have tightened lending terms and standards over the past 2 years or so was their concern about the economic outlook. As you know, the Federal Reserve has acted aggressively from the outset of the financial crisis to stabilize financial market conditions and promote sustainable economic growth. An improving economic outlook should contribute to increased willingness of banks to lend.Bank ConcentrationQ.3. Banks are borrowing at record low interest rates--particularly those banks that are viewed as ``too big to fail.'' According to the Center for Economic and Policy Research, the 18 biggest banks are getting what amounts to a $34.1 billion a year subsidy because of their implicit government guarantee. More recent data from the FDIC shows that big banks are turning a profit, but small banks are not. Data from 1999 shows that large banks' fees for overdrafts are 41 percent higher than at small banks and bounced check fees are 43 percent higher. Now borrowers are having their lines of credit slashed and their bank fees are still increasing. So it appears that consumers and small banks are suffering, while the big banks thrive. And the market is only getting more concentrated: 319 banks were forced to merge or fail in 2009. What steps are the Fed taking to ensure that there is not excessive concentration in the banking industry, and that consumers are being well served through meaningful competition?A.3. The Riegle-Neal Interstate Banking and Branching Efficiency Act (IBBEA) of 1994 provides prudential protection against excessive concentration in the banking industry by prohibiting the Federal Reserve from approving a bank acquisition that would result in a bank holding company exceeding a nationwide deposit concentration limitation of more than 10 percent of the total amount of deposits of insured depository institutions in the United States. Notwithstanding that protection, there are many other potential methods to address the subsidies that may arise because of perceptions that large financial firms are ``too-big-to-fail.'' For example, firms that might reasonably be considered ``too-big-to-fail'' may be subject to higher capital (and liquidity) requirements, more highly tailored resolution mechanisms, tighter deposit share caps, required issuance of contingent capital instruments and/or subordinated debt instruments, limitations on, or a ban of, certain activities (e.g., hedge funds or private equity funds), and taxes on non-deposit balance-sheet liabilities. As the financial crisis winds down, many of these types of proposals to reduce the subsidies that arise from implicit guarantees are under consideration in the United States and abroad. In fact, Federal Reserve staff are participating on many international working groups that are considering the potential effects, including unintended consequences, that may arise from implementing such proposals either singularly, or in combination. A key factor in such analyses is the impact on competition here in the United States and internationally across borders. Research on whether consumers benefit from ``too-big-to-fail'' subsidies is scant. It is plausible that large financial institutions might pass along some of their subsidies to consumers to fuel their own growth at the expense of smaller peers. Some evidence, however, suggests otherwise. For example, Passmore, Burgess, Hancock, Lehnert, and Sherlund (in a presentation at the Federal Reserve Bank of Chicago Bank Structure Conference, May 18, 2006) estimate that just 5 percent of the Fannie Mae and Freddie Mac's borrowing advantage flowed through to mortgage rates, resulting in just a few basis points reduction in conforming mortgage loan rates. Even if financial firms do not pass along their ``too-big-to-fail'' subsidies to consumers, it does not necessarily imply that they cannot pass along the higher costs that would result from the reduction of such subsidies. Indeed, larger firms may set the market prices for some financial products because of other cost advantages associated with their size. In such circumstances, consumers may end up paying higher prices when ``too-big-to-fail'' subsidies are reduced (or eliminated) even though they did not previously much benefit from such subsidies. That said, all consumers benefit from a more stable financial system with less systemic risk and this is the goal of reducing or eliminating ``too-big-to-fail'' subsidies.Resolution of Failed BanksQ.4. You have previously said that you favor ``establishing a process that would allow a failing, systemically important non-bank financial institution to be wound down in any orderly fashion, without jeopardizing financial stability.'' There's been a lot of talk about whether this job should be done by banking regulators or a bankruptcy court. Do you have an opinion about this, particularly whether the FDIC is doing a good job with its resolution authority?A.4. In most cases, the Federal bankruptcy laws provide an appropriate framework for the resolution of nonbank financial institutions. However, the bankruptcy code does not sufficiently protect the public's strong interest in ensuring the orderly resolution of a nonbank financial firm whose failure would pose substantial risks to the financial system and to the economy. A new resolution regime for systemically important nonbank financial firms, analogous to the regime currently used by the Federal Deposit Insurance Corporation for banks, would provide the government the tools to restructure or wind down such a firm in a way that mitigates the risks to financial stability and the economy and thus protects the public interest. It also would provide the government a mechanism for imposing losses on the shareholders and creditors of the firm. Establishing credible processes for imposing such losses is essential to restoring a meaningful degree of market discipline and addressing the ``too-big-to-fail'' problem. It would be appropriate to establish a high standard for invocation of this new resolution regime and to create checks and balances on its potential use, similar to the provisions governing use of the systemic risk exception to least-cost resolution in the Federal Deposit Insurance Act (FDI Act). The Federal Reserve's participation in this decisionmaking process would be an extension of our long-standing role in protecting financial stability, involvement in the current process for invoking the systemic risk exception under the FDI Act, and status as consolidated supervisor for large banking organizations. The Federal Reserve, however, is not well suited, nor do we seek, to serve as the resolution agency for systemically important institutions under a new framework. Because the suitability of an entity to serve as the resolution agency for any particular firm may depend on the firm's structure and activities, the Treasury Department should be given flexibility to appoint a receiver that has the requisite expertise to address the issues presented by a wind down of that firm.Banks Trading Commodities Futures DerivativesQ.5. You gave an address at Harvard in 2008 in which you talked about out-of-control crude oil prices. You said that ``demand growth and constrained supplies'' were responsible for ``intense pressure on [gas] prices.'' Senator Carl Levin investigated the crude oil market and found that speculation ``appears to have altered the historical relationship between [crude oil] price and inventory.'' In 2003, at the request of Citigroup and UBS, the Fed authorized bank holding companies to trade energy futures, both on exchanges and over-the-counter. Given that commodity prices affect the Consumer Price Index, which affects inflation, have you investigated what effect the rule change, and the resulting investments in commodities futures and other commodities-related derivatives, have had on oil prices?Q.6. If not, how can you conclude that rises in gasoline prices are due solely to simple changes in supply and demand?Q.7. If presented with evidence that energy speculation was driving up prices or affecting inflation, would you consider revoking the banks' authority to trade energy futures?A5.-7. The broad movements in oil and other commodity prices have been in line with developments in the global economy. They rose when global growth was strong and supply was constrained. and they collapsed with the onset of the global recession. As the global economy began to recover and financial conditions began to normalize, commodity prices rebounded. Nonetheless, the extreme price swings, particularly in the case of oil, have been surprising. Some have argued that speculative activities on the part of financial investors have been responsible for these outsized price movements. Notwithstanding considerable study, however, conclusive evidence of the role of speculators and financial investors remains elusive. The fundamentals of supply and demand, along with expectations for how these fundamentals will evolve in the future, remain the best explanation for the movements in commodity prices. That said, we must remain open to other possibilities, and if conclusive evidence emerged that commodity markets were not performing their price discovery and allocative role effectively, then changes in regulatory policies may be appropriate.Fed Purchases of Foreign Currency DerivativesQ.8. In the wake of the Greek debt crisis, I'm concerned about governments' use of foreign currency exchanges--that other governments might be using foreign currency swaps to mask their debt, or for other purposes. We know that the Federal Reserve entered into swaps with Foreign Central Banks and then those Foreign Central Banks bailed out their own banking systems. For example, the Federal Reserve worked with the Swiss central bank on the rescue effort for UBS, securing dollars through a swap agreement for francs. As of December 31, 2008, the United States had entered into $550 billion in liquidity swaps with foreign central banks. How are these arrangements between the Federal Reserve and the other central banks structured?A.8. The dollar liquidity swap arrangements that the Federal Reserve entered into with foreign central banks were fundamentally different from the currency swaps that have been discussed in the Greek context. According to reports, the Greek cross-currency swaps were highly structured arrangements initiated 8 or 9 years ago between the government of Greece and a private sector financial institution. These swaps apparently entailed payment obligations over a period of 15 to 20 years with large balloon payments at maturity, and they allowed the Greek government to exchange into euros the proceeds of borrowing it had done in Japanese yen and U.S. dollars at off-market rates of exchange. The dollar liquidity swaps, the volume of which is now zero following the termination of the arrangements in February, were more straightforward, shorter-term arrangements with foreign central banks of the highest credit standing. In each dollar liquidity swap transaction, the Federal Reserve provided U.S. dollars to a foreign central bank in exchange for an equivalent amount of funds in the currency of the foreign central bank, based on the market exchange rate at the time of the transaction. The parties agreed to swap back these quantities of their two currencies at a specified date in the future, which was at most 3 months ahead, using the same exchange rate as in the initial exchange. The Federal Reserve also received interest corresponding to the maturity of the swap drawing. Because the terms of each swap transaction were set in advance, fluctuations in exchange rates following the initial exchange did not alter the eventual payments. Accordingly, these swap operations carried no exchange rate or other market risks. In addition, we judged our swap line exposures to be of the highest quality and safety. The foreign currency held by the Federal Reserve during the term of the swap provided an important safeguard. Furthermore, our exposures were not to the institutions ultimately receiving the dollar liquidity in the foreign countries but to the foreign central banks. We have had long and close relationships with these central banks, many of which hold substantial quantities of U.S. dollar reserves in accounts at the Federal Reserve Bank ofNew York, and these dealings provided a track record that justified a high degree of trust and cooperation. The short tenor of the swaps, which ranged from overnight to 3 months at most, also offered some protection, in that positions could be wound down relatively quickly were it judged appropriate to do so.Q.9. Are these swaps being used in any way to mask U.S. Government debt?A.9. No. These swaps were limited to the exchange of U.S. dollar liquidity for foreign-currency liquidity and were not used in any way to mask U.S. Government debt.Q.10. Does the Federal Reserve keep track of which foreign banks ultimately receive U.S. money from foreign central banks? If so, what banks have gotten U.S. money, and how much has each gotten?A.10. The Federal Reserve's contractual relationships were with the foreign central banks and not with the financial institutions ultimately obtaining the dollar funding provided by these operations. Accordingly, the Federal Reserve did not track the names of the institutions receiving the dollar liquidity from the foreign central banks but instead left to the foreign central banks the responsibility for managing the distribution of the dollar funding. This responsibility included determining the eligibility of institutions that could participate in the dollar lending operations, assessing the acceptability of the collateral offered, and bearing any residual credit risk that might have arisen as a result of the lending operations.Q.11. Is the U.S. Treasury issuing Treasury bonds which the Fed is then buying through the U.K. or other foreign governments?A.11. No. ------ RESPONSE TO WRITTEN QUESTIONS OF SENATOR MERKLEY FROM BEN S. BERNANKEQ.1. The homeownership rate in Canada is almost identical to that of the United States. Yet the percentage of U.S. mortgages in arrears is fast approaching 10 percent while the percentage of Canadian mortgages in arrears has been relatively stable for the past two decades at less than 1 percent. What characteristics of the mortgage market in Canada do you believe have helped that country avoid a similar foreclosure crisis?A.1. A number of characteristics of the Canadian mortgage market helped Canada avoid a foreclosure crisis. Canadian homeowners typically maintain greater equity in their homes, in part because mortgage insurance, which is required when loan-to-value ratios exceed 80 percent, is more costly than in the United States. Moreover, Canadian mortgages are subject to substantial pre-payment penalties, reducing the incentives of households to regularly refinance their mortgages. While in general this limits households' ability to take advantage of falling interest rates, it also reduces the number of ``cash out'' refinancings, increasing the average equity held by households. In addition, a greater fraction of Canadian mortgages are prime mortgages, which default at lower rates than sub-prime mortgages. One reason the sub-prime market was slower to grow in Canada is because of the incentives, noted above, for borrowers to make higher down payments. Another reason is that a smaller fraction of mortgages in Canada are securitized, because even mortgages that have been securitized and resold carry a capital charge, giving Canadian banks less incentive to securitize mortgages. A mortgage lender that plans to hold a mortgage to maturity likely employs higher underwriting standards than a mortgage lender that plans to securitize the loan. Finally, Canada has experienced a comparatively milder labor-market downturn than the United States and only a modest decline in house prices. These factors, too, have helped reduce the incidence of default.Q.2. All of the six major banks in Canada own investment banking and insurance subsidiaries. All five of the major banks in Canada would probably be considered ``too-big-to-fail.'' However, the Canadian banking regulators have prudently enforced more stringent capital requirements including a 7 percent minimum of Tier 1 capital and 10 percent minimum of total capital. Additionally, there is an Assets-to-Capital Multiple maximum of 20 (or leverage ratio). What lessons have you learned from observing the actions that Canadian regulators have taken regarding the use of more stringent capital requirements than those required under Basel II?A.2. At present, the U.S. regulatory capital rules result in a requirement for banking organizations to hold capital at levels that are equal to, or exceed, Canadian peers; notwithstanding that the stated required minimum Tier 1 risk-based capital ratio is 6 percent for ``well capitalized'' banks under PCA.\1\ Because of statutorily required responses to the breeching of a PCA capital threshold, market forces generally necessitate banks and bank holding companies to hold substantially more capital than the ``well capitalized'' ratio requirements to ensure that significant losses can be absorbed before a ``well capitalized'' ratio is breached. The following table outlines the Tier I, Total and Leverage ratios of the top six U.S. bank holding companies and provides our estimate of their respective Assets-to-Capital Multiple as computed under the Canadian regulatory capital regime. As shown below, each of the top six U.S. bank holding companies would easily exceed the Canadian standards outlined above.--------------------------------------------------------------------------- \1\ To be considered ``well capitalized'' under the U.S. Prompt Corrective Action (PCA) requirements, a bank must have a Tier 1 Leverage ratio of no less than 5 percent, a Tier I risk-based capital ratio of no less than 6 percent, a Total risk-based capital ratio of no less than 10 percent. Selected Capital Ratios Six Largest U.S. Bank Holding Companies (as of December 31, 2009)---------------------------------------------------------------------------------------------------------------- Assets-to- Tier 1 Capital Assets-to- Tier 1 Risk- Total Risk- Tier 1 Multiple Capital Based Based Leverage (Inverse of Multiple Capital Capital Ratio U.S. (Canadian Leverage Definition) Ratio)----------------------------------------------------------------------------------------------------------------Bank of America................................ 10.41% 14.67% 6.91% 14.5 11.6JP Morgan Chase................................ 11.10% 14.78% 6.88% 14.5 13.7Citigroup...................................... 11.67% 15.25% 6.89% 14.5 12.7Wells Fargo.................................... 9.25% 13.26% 7.87% 12.7 9.6Goldman Sachs.................................. 14.97% 18.17% 7.55% 13.2 12.3Morgan Stanley................................. 15.30% 16.38% 5.80% 17.2 17.1---------------------------------------------------------------------------------------------------------------- The Federal Reserve believes that, going forward, capital requirements will need to be recalibrated to directly address the inappropriate incentives that were the underlying causes of the financial crisis. We are engaged in a significant effort both here in the United States and abroad to achieve this objective.Q.3. Canada has an independent consumer protection agency, called the Consumer Financial Agency of Canada. Do you believe that this agency's mission and independence has helped the Canadian financial markets remain stable and well capitalized, even under the current economic conditions?A.3. Consumer protection laws are very important for maintaining a well-functioning financial system. The Financial Consumer Agency of Canada (FCAC) is responsible for ensuring compliance with consumer protection laws and regulations; monitoring financial institutions' compliance with voluntary codes of conduct; and informing consumers of their rights and responsibilities as well as providing general information on financial products. Ensuring compliance with consumer protection laws is an important defense against future financial problems, and informed consumers are undoubtedly less likely to enter unfavorable mortgage agreements. It is difficult to gauge, however, the extent to which the quality of consumer information and extent of consumer protection help explain why Canada had relatively few of the exotic, hard-to-understand sub-prime mortgages that have had such high default rates in the United States. As noted in the answer to the preceding question, other factors--the structure of the mortgage market and bank capital regulation in Canada--appear to represent more tangible reasons why the sub-prime market was slow to develop in Canada.Q.4. Throughout the past year, many witnesses before the Senate Banking Committee have argued that the widespread practice of securitizing mortgages helped propagate bad underwriting practices and contributed to the toxic nature of many, if not all, investments in subprime mortgages. The Canadian mortgage market only has approximately 5 percent of outstanding mortgages categorized as ``subprime.'' Additionally, according to the Bank of Canada, 68 percent of mortgages remain on the balance sheet of the lender and most residential mortgage financing is funded through deposits. Do you think that banks who keep major portions of their residential real estate lending ``on the books'' are less likely to engage in the financing of, ``subprime'' mortgage lending?A.4. It is unlikely that a requirement to keep mortgage exposures on balance sheet would make banking organizations less likely to underwrite ``subprime'' exposures. For instance, prior to the financial crisis, many banking organizations entered into ``subprime'' mortgage securitizations and retained the ``first loss'' positions ``on the books,'' reflecting a high risk tolerance for exposure to the ``subprime'' mortgage market. Additionally, many other banking organizations provided recourse on ``subprime'' mortgage exposures that they sold to securitization structures; again, a reflections of a high risk tolerance ``subprime'' mortgage exposures. If banking organizations were no longer allowed to place ``subprime'' mortgages into securitization vehicles, it could be reasonably posited that banking organizations would continue to underwrite ``subprime'' mortgages given the higher yield earned from these exposures and the fact that the current risk-based capital framework levies an identical capital requirement for a ``subprime'' exposure as it does for a ``prime'' exposure. There are several distinct differences between the U.S. and Canadian mortgage markets that raise difficulty in using the Canadian experience as a comparator. For example, the Canada Mortgage and Housing Corporation (CMHC), which serves a similar function as Freddie and Fannie, is guaranteed by the full faith and credit of Canada, in the same manner as GNMA is guaranteed by the United States. As a result, banking organizations that invest in securitization structures through the CMHC are required to hold no regulatory capital against their investment (0 percent risk-weight exposure), versus in the United States where banking organizations must risk-weight exposures to Freddie or Fannie at 20 percent. In addition, Canadian banking organizations are required to obtain private mortgage insurance (PMI) for all mortgages with a loan-to-value ratio over 80 percent and they must maintain the PMI for the life of the loan, regardless of any subsequent reduction in a mortgage's LTV that may result from loan repayment or house appreciation. However, banks that rely on private mortgage insurers receive a government guarantee against losses that exceed 10 percent of the original mortgage in the event of an insurer failure. As a result, Canadian banking organizations are required to hold relatively little capital against mortgage exposures that are held on balance sheet--either through on-balance sheet mortgage portfolios or through investments in CMHC securitizations. The market for ``subprime'' mortgages was all but ended for Canadian banking organizations in 2008 when the CMHC decided to no longer insure ``subprime'' mortgages. This provided a significant regulatory capital disincentive for Canadian banking organizations to underwrite ``subprime'' mortgages. ------ RESPONSE TO WRITTEN QUESTIONS OF SENATOR BUNNING FROM BEN S. BERNANKEQ.1. Treasury recently announced they were starting up the Supplemental Financing Program again. Under that Program, Treasury issues debt and deposits the cash with the Fed. That is effectively the same thing as the Fed issuing its own debt, which is not allowed. What are the legal grounds the Fed and Treasury use to justify that program? And did anyone in the Fed or Treasury raise objections when the program was created?A.1. Section 15 of the Federal Reserve Act requires the Federal Reserve to act as fiscal agent for the United States and authorizes the Treasury to deposit money held in the general fund of the Treasury in the Federal Reserve Banks. Balances held by the Reserve Banks in the Treasury's Supplementary Financing Account (SFA) are deposited and held under this authority. Although the Treasury and the Federal Reserve have consulted closely on matters regarding the Supplemental Financing Program (SFP), the Treasury makes all decisions on balances to be held in the SFA. I am not aware of any staff member or policymaker raising legal objections to the creation of the SFP. However, at least one Federal Reserve policymaker has publicly expressed policy concerns with the SFP. See Real Time Economics, WSJ Blogs, ``Q&A: Philly Fed's Plosser Takes on `Extended Period' Language,'' March 1, 2010.Q.2. Given what you learned during the AIG crisis and bailout, do you think Congress should be doing something to address insurance regulation or the commercial paper market?A.2. The financial crisis has made clear that all financial institutions that are so large and interconnected their failure could threaten the stability of the financial system and the economy must be subject to consolidated supervision. Lack of strong consolidated supervision of systemically critical firms not organized as bank holding companies, such as AIG, proved to be a serious regulatory gap. The Federal Reserve strongly supports ongoing efforts in the Congress to reform financial regulation and close existing gaps in the regulatory framework. An effective framework for financial supervision and regulation also must address macroprudential risks--that is, risks to the financial system as a whole. The disruptions in the commercial paper market following the failure of Lehman Brothers on September 15, 2008 and the breaking of the buck by a large money fund the following day are examples of such macroprudential risks. Legislative proposals in both the House and Senate would also improve the exchange of information and the cross-fertilization of ideas by creating an oversight council composed of representatives of the agencies and departments involved in the oversight of the financial sector that would be responsible for monitoring and identifying emerging systemic risks across the full range of financial institutions and markets. The council would have the ability to coordinate responses by member agencies to mitigate identified threats to financial stability and, importantly, would have the authority to recommend that its member agencies, either individually or collectively, adopt heightened prudential standards for the firms under the agencies' supervision in order to mitigate potential systemic risks.Q.3.a. When did you know that AIG's swaps partners were going to be paid off at effectively par value in the Maiden Lane 3 transaction?Q.3.b. Did you or the Board approve the payments?A.3.a.-b. I was not directly involved in the negotiations with the counterparties that sold multi-sector collateralized debt obligations (``CDOs'') to Maiden Lane III LLC (``ML III'') in return for termination of credit default swaps AIG had written on those CDOs. These negotiations were handled by the staff of the Federal Reserve Bank of New York (``FRBNY''). I participated in and support the final action of the Board to authorize lending by the FRBNY to ML III for the purpose of purchasing the CDOs in order to remove an enormous obstacle to AIG's financial stability and thereby help prevent a disorderly failure of AIG during troubled economic times. As explained in the testimony of Thomas Baxter, Executive Vice President and General Counsel, FRBNY, before the Committee on Oversight and Government Reform on January 27, 2010, the Federal Reserve loan to ML III was used by ML III to purchase the multi-sector CDOs underlying AIG's CDS at their current market value (approximately $29 billion), which represented a significant discount to their par value ($62 billion). Collateral already posted by AIG (not ML III) under the terms of the CDS contracts was also relinquished by AIG in return for tearing-up the contracts and freeing AIG of further obligations under the CDS contracts. Before agreeing to the transaction, the Federal Reserve consulted independent financial advisors to assess the value of the underlying CDOs and the expectation that the value of the CDOs would be recovered. The advisors believed that the cash flow and returns on the CDOs would be sufficient, even under highly stressed conditions, to fully repay the Federal Reserve's loan to ML III. Under the terms of the agreement negotiated with AIG, the Federal Reserve will also receive two-thirds of any profits received on the CDOs after the Federal Reserve's loan and AIG's subordinated equity position are repaid in full.Q.3.c. When did you find out about the cover-up of the amount of the payments?Q.3.d. Did you approve of the efforts to cover up the amount of the payments?Q.3.e. If you did not approve of the cover-up at the time, do you believe that it was the right decision?A.3.c.-e. The amount of the payments to the CDS counterparties was fully disclosed by AIG. Moreover, the Federal Reserve fully disclosed the amount of its loan to ML III and the fair value of the assets that serve as collateral for that loan in both the weekly balance sheet of the Federal Reserve (available on the Board's website) and in the Board's reports to Congress as required by law. AIG was at all times responsible for complying with the disclosure requirements of the various securities laws. I was not involved in the discussions between the Federal Reserve and AIG related to AIG's securities law filings. I fully supported AIG's decision to release publicly in March 2009 the identities of these counterparties.Q.4. The Fed has been out in the press talking about how they are going to make money on their AIG loans, making it sound like a good deal for the taxpayers. However, that is not the whole story because Treasury has committed some $70 billion to the AIG bailout. So the taxpayers are still exposed to AIG, and in fact are likely to take losses. Do you agree that the Fed's exposure to AIG is not the whole story and the taxpayers are likely to face losses from the AIG bailout?A.4. As you know, the Federal Reserve provided liquidity to AIG through direct line of credit and through loans provided to two Maiden Lane facilities that funded certain assets of AIG. Extensive information about each of these credits is available on the Board's website and in reports and testimony provided by the Federal Reserve to Congress. Based on analysis of the collateral supporting these loans by experienced third-party advisors and the FRBNY, the Federal Reserve expects to be fully repaid on each of these credits, with no loss to the taxpayers. The Treasury Department has provided equity to AIG. Like the liquidity provided by the Federal Reserve, this equity was provided in order to prevent the disorderly collapse of AIG during a period of extreme financial stress that could have caused significant economic distress for policy holders, municipalities, and small and large businesses, and led to even greater financial chaos and a far deeper economic slump than the very severe one we have experienced.Q.5. Did you or the Board approve of then New York, Fed President Geithner staying on at the New York Fed while working for the Obama transition team? If yes, why did you think that was a good idea?A.5. Timothy Geithner was appointed President of the Federal Reserve Bank of New York for a 5-year term that extended until February 28, 2011. When President Geithner was asked by the President-elect of the United States to serve as Secretary of the Treasury, President Geithner withdrew from the Bank's day-to-day management pending his confirmation by the Senate. He also relinquished his Federal Open Market Committee (FOMC) responsibilities which were assumed by Christine Cumming, the Reserve Bank's alternate representative elected in accordance with the Federal Reserve Act. President Geithner did not attend the December 2008 FOMC meeting. Ms. Cumming served as a voting member of the FOMC until President Geithner's successor took office. It was expected that President Geithner would continue to serve as President of the Reserve Bank at least through the end of his term if he did not become Secretary of the Treasury.Q.6. Is the Fed now, or has the Fed in recent years, purchased Greek Government or bank debt?A.6. The Federal Reserve has not purchased debt of the government of Greece nor has the Federal Reserve purchased the debt of any Greek financial institution. Detailed information on the Federal Reserve's foreign exchange holdings, both currency and investments, is available in the quarterly Treasury and Federal Reserve Foreign Exchange Operations report published by the Federal Reserve Bank of New York. See http://www.newyorkfed.org/markets/quar_reports.html.Q.7. Unemployment numbers continue to bounce up and down every week. As this year goes on, the Census is going to be hiring 700,000 to 800,000 workers on a temporary basis. Are you worried those numbers will distort the true jobs picture, and that economic forecasts that use those jobs numbers will be wrong?A.7. As you suggest, hiring of temporary workers by the U.S. Bureau of the Census in support of the decennial census will elevate the total payroll employment counts reported by the Bureau of Labor Statistics (BLS) each month because these temporary workers are included in Federal Government employment in the Current Employment Statistics (CES) survey. However, I do not think that Census hiring will make it much more difficult than usual to interpret the monthly employment reports. The BLS is publishing information each month on the number of temporary census workers in the CES data, and thus it will be straightforward to adjust the data to calculate the monthly changes in payroll employment excluding the effects of Census hiring; moreover, Census hiring will not distort the BLS estimates of employment change in the private sector. In addition, the Bureau of the Census has made available its hiring plans for coming months, which economic forecasters can use in making their projections of employment changes for the remainder of this year. Although these plans are subject to change, based on this information, the Department of Commerce expects the effect on the level of payroll employment reported by the BLS to peak at about 635,000 jobs in May 2010 and to fall back to roughly 25,000 jobs by September. The extent to which Census hiring reduces the measured unemployment rate is more difficult to estimate because that effect depends on the prior labor force status of the temporary Census workers. However, based on the employment estimates, the peak effect on the unemployment rate in May would probably be between \1/4\ and \1/2\ percentage point.Q.8. Please explain how term deposits and reverse repo transactions are not the economic equivalent of the Fed issuing debt.A.8. There are a number of similarities and differences between term deposits, reverse repurchase agreements and agency debt obligations. In principle, each could be used to drain reserves from the financial system in order to reduce the potential for inflation and thereby maintain price stability. Indeed, various central banks use instruments similar to these to help manage interest rates and maintain price stability. In the United States, Congress has specifically authorized the Federal Reserve to accept deposits from depository institutions. (See 12 USC 342). Congress has also specifically authorized the Federal Open Market Committee to direct Reserve Banks to purchase and sell in the open market obligations of, or obligations guaranteed as to principal and interest by, the United States or its agencies. (See 12 USC 263 and 355). Reverse repurchase agreements represent the sale and purchase of obligations of, or obligations guaranteed as to principal and interest by, the United States or its agencies. Congress has not specifically authorized the Federal Reserve to issue its own agency debt obligations. Unlike deposits and reverse repurchase agreements, agency obligations are freely transferable. Term deposits may only be accepted from depository institutions and are not transferable. Reverse repurchase agreements also are not transferable and occur only with counterparties that are interested in purchasing qualifying government or agency securities.Q.9. Given that you have signaled that the Fed will be using the interest on reserves rate as a policy tool in the near future, do you believe that rate should be set by the Federal Open Market Committee rather than the Board of Governors?A.9. As you know, the Congress has assigned to the Board the responsibility for determining the rate paid on reserves. Although the Federal Open Market Committee (FOMC) by law is responsible for directing open market operations, the Congress has also assigned to the Board the responsibility for determining certain other important terms that are relevant for the conduct of monetary policy--for example, the Board ``reviews and determines'' the discount rates that are established by the Federal Reserve Banks; the FOMC has no statutory role in setting the discount rate. Similarly, the Board sets reserve requirements subject to the constraints established by the Congress; the FOMC has no statutory role in setting reserve requirements. For many years, the Board and the FOMC have worked collegially and cooperatively in setting the discount rate, the Federal funds target rate, and other instruments of monetary policy. I am convinced that the Board and the FOMC will continue to work cooperatively in the future in adjusting all of the instruments of monetary policy." FinancialCrisisReport--163 Washington Mutual. 595 In connection with the hearing, the Subcommittee released a joint memorandum from Chairman Levin and Ranking Member Coburn summarizing the investigation to date into the role of the regulators overseeing WaMu. That memorandum stated: “Federal bank regulators are supposed to ensure the safety and soundness of individual U.S. financial institutions and, by extension, the U.S. banking system. Washington Mutual was just one of many financial institutions that federal banking regulators allowed to engage in such high risk home loan lending practices that they resulted in bank failure and damage to financial markets. The ineffective role of bank regulators was a major contributor to the 2008 financial crisis that continues to afflict the U.S. and world economy today.” On March 16, 2011, the FDIC sued the three top former executives of Washington Mutual for pursuing a high risk lending strategy without sufficient risk management practices and despite their knowledge of a weakening housing market. 596 The FDIC complaint stated: “Chief Executive Officer Kerry K. Killinger (“Killinger”), Chief Operating Officer Stephen J. Rotella (“Rotella”), and Home Loans President David C. Schneider (“Schneider”) caused Washington Mutual Bank (“WaMu” or “the Bank”) to take extreme and historically unprecedented risks with WaMu’s held-for-investment home loans portfolio. They focused on short term gains to increase their own compensation, with reckless disregard for WaMu’s longer term safety and soundness. Their negligence, gross negligence and breaches of fiduciary duty caused WaMu to lose billions of dollars. The FDIC brings this Complaint to hold these three highly paid senior executives, who were chiefly responsible for WaMu’s higher risk home lending program, accountable for the resulting losses.” 595 See “Wall Street and the Financial Crisis: Role of the Regulators,” before the U.S. Senate Permanent Subcommittee on Investigations, S.Hrg. 111-672 (April 16, 2010) (hereinafter “April 16, 2010 Subcommittee Hearing”). 596 The Federal Deposit Insurance Corporation v. Kerry K. Killinger, Stephen J. Rotella, David C. Schneider , et al., Case No. 2:11-CV-00459 (W.D. Wash.), Complaint (March 16, 2011), at http://graphics8.nytimes.com/packages/pdf/business/conformedcomplaint.pdf (hereinafter “FDIC Complaint Against WaMu Executives”). 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-110shrg50415--4 Chairman Dodd," Thank you very much. And, by the way, let me thank all of the Members of this Committee. Obviously, not all are here for all the obvious reasons. I mentioned that when I became Chairman of the Committee in January of 2007, the very first hearing we had were on the foreclosure crisis--in this very room, in fact, and Members will recall, because they participated in it, that we filled this room with stakeholders on the foreclosure crisis and asked them what they were going to do to have a plan of workouts for people facing foreclosure. Senator Crapo has been a leader for years here on regulatory reform, and he deserves a lot of credit for thinking about it. In 2006, in fact, when our friends in the minority today were in the majority, it was Senator Bunning and Senator Allard that had some of the very first hearings on the foreclosure crisis, and the record ought to reflect that as well. And I also want to thank Senator Shelby, the former Chairman of this Committee and now the Ranking Republican on the Committee. We never would have been able to pass that very important housing bill in July of this year without the cooperation of every Member of this Committee. We came out of this Committee on a vote of 19-2 on a matter that people did not think you could come together on, including GSE reform as well as modernization of FHA and a variety of other points. And so I thank all Members of the Committee, and obviously the rescue package, Senator Bennett and Senator Corker particularly on this Committee were invaluable in helping put together that plan as Republican Members, not to in any way detract from the tremendous work being done by the majority Members of this Committee as well on that effort. So I would like the 73 hearings that this Committee held over the last 21 months, almost a hearing a week, over a third of them on this subject matter alone that brings us here today, as well as the legislative work of the Committee. But I wanted the Members to know how much I appreciate the efforts this Committee has made over the last 21 months. " CHRG-111shrg54589--124 PREPARED STATEMENT OF GARY GENSLER Chairman, Commodity Futures Trading Commission June 22, 2009 Good morning Chairman Reed, Ranking Member Bunning, and Members of the Committee. I am here today testifying on behalf of the Commission. The topic of today's hearing, how to best modernize oversight of the over-the-counter derivatives markets, is of utmost importance during this crucial time for our economy. As President Obama laid out last week, we must urgently enact broad reforms in our financial regulatory structure in order to rebuild and restore confidence in our overall financial system. Such reforms must comprehensively regulate both derivative dealers and the markets in which derivatives trade. I look forward to working with the Congress to ensure that the OTC derivatives markets are transparent and free from fraud, manipulation and other abuses. This effort will require close coordination between the SEC and the CFTC to ensure the most appropriate regulation. I'm fortunate to have as a partner in this effort, SEC Chair Mary Schapiro. She brings invaluable expertise in both the security and commodity futures area, which gives me great confidence that we will be able to provide the Congress with a sound recommendation for comprehensive oversight of the OTC derivatives market. We also will work collaboratively on recommendations on how to best harmonize regulatory efforts between agencies as requested by President Obama.Comprehensive Regulatory Framework A comprehensive regulatory framework governing OTC derivative dealers and OTC derivative markets should apply to all dealers and all derivatives, no matter what type of derivative is traded or marketed. It should include interest rate swaps, currency swaps, commodity swaps, credit default swaps, and equity swaps. Further, it should apply to the dealers and derivatives no matter what type of swaps or other derivatives may be invented in the future. This framework should apply regardless of whether the derivatives are standardized or customized. A new regulatory framework for OTC derivatives markets should be designed to achieve four key objectives: Lower systemic risks; Promote the transparency and efficiency of markets; Promote market integrity by preventing fraud, manipulation, and other market abuses, and by setting position limits; and Protect the public from improper marketing practices. To best achieve these objectives, two complementary regulatory regimes must be implemented: one focused on the dealers that make the markets in derivatives and one focused on the markets themselves--including regulated exchanges, electronic trading systems and clearinghouses. Only with these two complementary regimes will we ensure that Federal regulators have full authority to bring transparency to the OTC derivatives world and to prevent fraud, manipulation, and other types of market abuses. These two regimes should apply no matter which type of firm, method of trading or type of derivative or swap is involved.Regulating Derivatives Dealers I believe that institutions that deal in derivatives must be explicitly regulated. In addition, regulations should cover any other firms whose activities in these markets can create large exposures to counterparties. The current financial crisis has taught us that the derivatives trading activities of a single firm can threaten the entire financial system and that all such firms should be subject to robust Federal regulation. The AIG subsidiary that dealt in derivatives--AIG Financial Products--for example, was not subject to any effective regulation. The derivatives dealers affiliated with Lehman Brothers, Bear Stearns, and other investment banks were not subject to mandatory regulation either. By fully regulating the institutions that trade or hold themselves out to the public as derivative dealers we can oversee and regulate the entire derivatives market. I believe that the our laws should be amended to provide for the registration and regulation of all derivative dealers. The full, mandatory regulation of all derivatives dealers would represent a dramatic change from the current system in which some dealers can operate with limited or no effective oversight. Specifically, all derivative dealers should be subject to capital requirements, initial margining requirements, business conduct rules and reporting and record keeping requirements. Standards that already apply to some dealers, such as banking entities, should be strengthened and made consistent, regardless of the legal entity where the trading takes place. Capital and Margin Requirements. The Congress should explicitly require regulators to promulgate capital requirements for all derivatives dealers. Imposing prudent and conservative capital requirements, and initial margin requirements, on all transactions by these dealers will help prevent the types of systemic risks that AIG created. No longer would derivatives dealers or counterparties be able to amass large or highly leveraged risks outside the oversight and prudential safeguards of regulators. Business Conduct and Transparency Requirements. Business conduct standards should include measures to both protect the integrity of the market and lower the risk (both counterparty and operating) from OTC derivatives transactions. To promote market integrity, the business conduct standards should include prohibitions on fraud, manipulation and other abusive practices. For OTC derivatives that come under CFTC jurisdiction, these standards should require adherence to position limits when they perform or affect a significant price discovery function with respect to regulated markets. Business conduct standards should ensure the timely and accurate confirmation, processing, netting, documentation, and valuation of all transactions. These standards for ``back office'' functions will help reduce risks by ensuring derivative dealers, their trading counterparties and regulators have complete, accurate and current knowledge of their outstanding risks. Derivatives dealers also should be subject to record keeping and reporting requirements for all of their OTC derivatives positions and transactions. These requirements should include retaining a complete audit trail and mandated reporting of any trades that are not centrally cleared to a regulated trade repository. Trade repositories complement central clearing by providing a location where trades that are not centrally cleared can be recorded in a manner that allows the positions, transactions, and risks associated with those trades to be reported to regulators. To provide transparency of the entire OTC derivatives market, this information should be available to all relevant Federal financial regulators. Additionally, there should be clear authority for regulating and setting standards for trade repositories and clearinghouses to ensure that the information recorded meets regulatory needs and that the repositories have strong business conduct practices. The application of these business conduct standards and the transparency requirements will enable regulators to have timely and accurate knowledge of the risks and positions created by the dealers. It will provide authorities with the information and evidentiary record needed to take any appropriate action to address such risks and to protect and police market integrity. In this regard, the CFTC and SEC should have clear, unimpeded oversight and enforcement authority to prevent and punish fraud, manipulation and other market abuses. Market transparency should be further enhanced by requiring that aggregated information on positions and trades be made available to the public. No longer should the public be in the dark about the extensive positions and trading in these markets. This public information will improve the price discovery process and market efficiency.Regulating Derivatives Markets In addition to the significant benefits to be gained from broad regulation of derivatives dealers, I believe that additional safety and transparency must be afforded by regulating the derivative market functions as well. All derivatives that can be moved into central clearing should be required to be cleared through regulated central clearinghouses and brought onto regulated exchanges or regulated transparent electronic trading systems. Requiring clearing and trading on exchanges or through regulated electronic trading systems will promote transparency and market integrity and lower systemic risks. To fully achieve these objectives, both of these complementary regimes must be enacted. Regulating both the traders and the trades will ensure that both the actors and the actions that may create significant risks are covered. Exchange-trading and central clearing are the two key and related components of well-functioning markets. Ever since President Roosevelt called for the regulation of the commodities and securities markets in the early 1930s, the CFTC (and its predecessor) and the SEC have each regulated the clearing functions for the exchanges under their respective jurisdiction. The practice of having the agency which regulates an exchange or trade execution facility also regulate the clearinghouses for that market has worked well and should continue as we extend regulations to cover the OTC derivatives market. Central Clearing. Central clearing should help reduce systemic risks in addition to the benefits derived from comprehensive regulation of derivatives dealers. Clearing reduces risks by facilitating the netting of transactions and by mutualizing credit risks. Currently, most of the contracts entered into in the OTC derivatives market are not cleared, and remain as bilateral contracts between individual buyers and sellers. In contrast, when a contract between a buyer and seller is submitted to a clearinghouse for clearing, the contract is ``novated'' to the clearinghouse. This means that the clearinghouse is substituted as the counterparty to the contract and then stands between the buyer and the seller. Clearinghouses then guarantee the performance of each trade that is submitted for clearing. Clearinghouses use a variety of risk management practices to assure the fulfillment of this guarantee function. Foremost, derivatives clearinghouses would lower risk through the daily discipline of marking to market the value of each transaction. They also require the daily posting of margin to cover the daily changes in the value of positions and collect initial margin as extra protection against potential market changes that are not covered by the daily mark-to-market. The regulations applicable to clearing should require that clearinghouses establish and maintain robust margin standards and other necessary risk controls and measures. It is important that we incorporate the lessons from the current crisis as well as the best practices reflected in international standards. Working with Congress, we should consider possible amendments to the CEA to expand and deepen the core principles that registered derivatives clearing organizations must meet to achieve these goals to both strengthen these systems and to reduce the possibility of regulatory arbitrage. Clearinghouses should have transparent governance arrangements that incorporate a broad range of viewpoints from members and other market participants. Central counterparties should also be required to have fair and open access criteria that allow any firm that meets objective, prudent standards to participate regardless of whether it is a dealer or a trading firm. Additionally, central clearinghouses should implement rules that allow indirect participation in central clearing. By novating contracts to a central clearinghouse coupled with effective risk management practices, the failure of a single trader, like AIG, would no longer jeopardize all of the counterparties to its trades. One of the lessons that emerged from this recent crisis was that institutions were not just ``too big to fail,'' but rather too interconnected as well. By mandating the use of central clearinghouses, institutions would become much less interconnected, mitigating risk and increasing transparency. Throughout this entire financial crisis, trades that were carried out through regulated exchanges and clearinghouses continued to be cleared and settled. In implementing these responsibilities, it will be appropriate to consider possible additional oversight requirements that may be imposed by any systemic risk regulator that Congress may establish. Under the Administration's approach, the systemic regulator, would be charged with ensuring consistent and robust standards for all systemically important clearing, settlement and payment systems. For clearinghouses overseen comprehensively by the CFTC and SEC, the CFTC or SEC would remain the primary regulatory, but the systemic regulator would be able to request information from the primary regulator, participate in examinations led by the primary regulator, make recommendations on strengthening standards to the primary regulator and ultimately, after consulting with the primary regulator and the new Financial Services Oversight Council, use emergency authority to compel a clearinghouse to take actions to address financial risks. Exchange-Trading. Beyond the significant transparency afforded the regulators and the public through the record keeping and reporting requirements of derivatives dealers, market transparency and efficiency would be further improved by moving the standardized part of the OTC markets onto regulated exchanges and regulated transparent electronic trading systems. I believe that this should be required of all standardized contracts. Furthermore, a system for the timely reporting of trades and prompt dissemination of prices and other trade information to the public should be required. Both regulated exchanges and regulated transparent trading systems should allow market participants to see all of the bids and offers. A complete audit trail of all transactions on the exchanges or trade execution systems should be available to the regulators. Through a trade reporting system there should be timely public posting of the price, volume and key terms of completed transactions. The Trade Reporting and Compliance Engine (TRACE) system currently required for timely reporting in the OTC corporate bond market may provide a model. The CFTC and SEC also should have authority to impose record keeping and reporting requirements and to police the operations of all exchanges and electronic trading systems to prevent fraud, manipulation and other abuses. In contrast to long established on-exchange futures and securities markets, there is a need to encourage the further development of exchanges and electronic trading systems for OTC derivatives. In order to promote this goal and achieve market efficiency through competition, there should be sufficient product standardization so OTC derivative trades and open positions are fungible and can be transferred between one exchange or electronic trading system to another. Position Limits. Position limits must be applied consistently across all markets, across all trading platforms, and exemptions to them must be limited and well defined. The CFTC should have the ability to impose position limits, including aggregate limits, on all persons trading OTC derivatives that perform or affect a significant price discovery function with respect to regulated markets that the CFTC oversees. Such position limit authority should clearly empower the CFTC to establish aggregate position limits across markets in order to ensure that traders are not able to avoid position limits in a market by moving to a related exchange or market, including international markets.Standardized and Customized Derivatives It is important that tailored or customized swaps that are not able to be cleared or traded on an exchange be sufficiently regulated. Regulations should also ensure that customized derivatives are not used solely as a means to avoid the clearing and exchange requirements. This could be accomplished in two ways. First, regulators should be given full authority to prevent fraud, manipulation and other abuses and to impose record keeping and transparency requirements with respect to the trading of all swaps, including customized swaps. Second, we must ensure that dealers and traders cannot change just a few minor terms of a standardized swap to avoid clearing and the added transparency of exchanges and electronic trading systems. One way to ensure this would be to establish objective criteria for regulators to determine whether, in fact, a swap is standardized. For example, there should be a presumption that if an instrument is accepted for clearing by a fully regulated clearinghouse, then it should be required to be cleared. Additional potential criteria for consideration in determining whether a contract should be considered to be a standardized swap contract could include: The volume of transactions in the contract; The similarity of the terms in the contract to terms in standardized contracts; Whether any differences in terms from a standardized contract are of economic significance; and The extent to which any of the terms in the contract, including price, are disseminated to third parties.Criteria such as these could be helpful in ensuring that parties are not able to avoid the requirements applicable to standardized contracts by tweaking the terms of such contracts and then labeling them ``customized.'' Regardless of whether an instrument is standardized or customized, or traded on an exchange or on a transparent electronic trade execution system, regulators should have clear, unimpeded authority to impose record keeping and reporting requirements, impose margin requirements, and prevent and punish fraud, manipulation and other market abuses. No matter how the instrument is traded, the CFTC and SEC as appropriate also should have clear, unimpeded authority to impose position limits, including aggregate limits, to prevent excessive speculation. A full audit trail should be available to the CFTC, SEC and other Federal regulators.Authority To achieve these goals, the Commodity Exchange Act and security laws should be amended to provide the CFTC and SEC with clear authority to regulate OTC derivatives. The term ``OTC derivative'' should be defined, and clear authority should be given over all such instruments regardless of the regulatory agency. To the extent that specific types of OTC derivatives might overlap agencies' existing jurisdiction, care must be taken to avoid unnecessary duplication. As we enact new laws and regulations, we should be careful not to call into question the enforceability of existing OTC derivatives contracts. New legislation and regulations should not provide excuses for traders to avoid performance under preexisting, valid agreements or to nullify preexisting contractual obligations.Achieving the Four Key Objectives Overall, I believe the complimentary regimes of dealer and market regulation would best achieve the four objectives outlined earlier. As a summary, let me review how this would accomplish the measures applied to both the derivative dealers and the derivative markets. Lower Systemic Risk. This dual regime would lower systemic risk through the following four measures: Setting capital requirements for derivative dealers; Creating initial margin requirements for derivative dealers (whether dealing in standardized or customized swaps); Requiring centralized clearing of standardized swaps; and Requiring business conduct standards for dealers. Promote Market Transparency and Efficiency. This complementary regime would promote market transparency and efficiency by: Requiring that all OTC transactions, both standardized and customized, be reported to a regulated trade repository or central clearinghouses; Requiring clearinghouses and trade repositories to make aggregate data on open positions and trading volumes available to the public; Requiring clearinghouses and trade repositories to make data on any individual counterparty's trades and positions available on a confidential basis to regulators; Requiring centralized clearing of standardized swaps; Moving standardized products onto regulated exchanges and regulated, transparent trade execution systems; and Requiring the timely reporting of trades and prompt dissemination of prices and other trade information; Promote Market Integrity. It would promote market integrity by: Providing regulators with clear, unimpeded authority to impose reporting requirements and to prevent fraud, manipulation and other types of market abuses; Providing regulators with authority to set position limits, including aggregate position limits; Moving standardized products onto regulated exchanges and regulated, transparent trade execution systems; and Requiring business conduct standards for dealers. Protect Against Improper Marketing Practices. It would ensure protection of the public from improper marketing practices by: Business conduct standards applied to derivatives dealers regardless of the type of instrument involved; and Amending the limitations on participating in the OTC derivatives market in current law to tighten them or to impose additional disclosure requirements, or standards of care (e.g., suitability or know your customer requirements) with respect to marketing of derivatives to institutions that infrequently trade in derivatives, such as small municipalities.Conclusion The need for reform of our financial system today has many similarities to the situation facing the country in the 1930s. In 1934, President Roosevelt boldly proposed to the Congress ``the enactment of legislation providing for the regulation by the Federal Government of the operation of exchanges dealing in securities and commodities for the protection of investors, for the safeguarding of values, and so far as it may be possible, for the elimination of unnecessary, unwise, and destructive speculation.'' The Congress swiftly responded to the clear need for reform by enacting the Securities Exchange Act of 1934. Two years later it passed the Commodity Exchange Act of 1936. It is clear that we need the same type of comprehensive regulatory reform today. Today's regulatory reform package should cover all types of OTC derivatives dealers and markets. It should provide regulators with full authority regarding OTC derivatives to lower risk; promote transparency, efficiency, and market integrity and to protect the American public. Today's complex financial markets are global and irreversibly interlinked. We must work with our partners in regulating markets around the world to promote consistent rigor in enforcing standards that we demand of our markets to prevent regulatory arbitrage. These policies are consistent with what I laid out to this Committee in February and the Administration's objectives. I look forward to working with this Committee, and others in Congress, to accomplish these goals. Mr. Chairman, thank you for the opportunity to appear before the Committee today. I look forward to answering any of your questions. ______ fcic_final_report_full--635 Perez, No. 50 2008 CA040805XXXX MB (Fla. Cir. Ct. Dec. 10, 2009), pp. 7, 10. 30. See, for example, Dwayne Ransom Davis and Melisa Davis v. Countrywide Home Loans, Inc.; Bank of America, N.A.; BAC GP LLC; and BAC Home Loans Servicing, LP, 1:10-cv-01303-JMS-DML (S.D. Ind. October 19, 2010). 31. Congressional Oversight Panel, “November Oversight Report: Examining the Consequences of Mortgage Irregularities for Financial Stability and Foreclosure Mitigation,” November 16, 2010, p. 20. 32. See, e.g., Mortg. Elec. Registry Sys. v. Johnston, No. 420-6-09 Rdcv (Rutland Co. Vt. Super. Ct. Oct. 28, 2009), holding that MERS did not have standing to initiate foreclosure because the note and mortgage had been separated. 33. The Honorable F. Dana Winslow, written testimony before the House Committee on the Judiciary, Foreclosed Justice: Causes and Effects of the Foreclosure Crisis, 111th Cong., 2nd sess., December 2, 2010, pp. 2, 4. 34. Order, Objection to Claims of Citibank, N.A. 4-6-10, (Bankr. E.D. Cal. May 20, 2010), p. 3. The or- der cites In re Foreclosure Cases, 521 F. Supp. 2d 650 (S.D. Oh. 2007); In re Vargas, 396 B.R. 511, 520 (Bankr. C.D. Cal. 2008); Landmark Nat’l Bank v. Kesler, 216 P.3d 158 (Kan. 2009); LaSalle Bank v. Lamy, 824 N.Y.S.2d 769 (N.Y. Sup. Ct. 2006). 35. Winslow, written testimony before the House Committee on the Judiciary, pp. 2–3. 36. See John T. Kemp v. Countrywide Home Loans, Inc., Case No. 08-18700-JHW (D. N.J.), pp. 7–8. 37. Grais, interview. 38. Adam J. Levitin, associate professor of law, Georgetown University Law Center, testimony to Sen- ate Committee on Banking, Housing, and Urban Affairs, Problems in Mortgage Servicing from Modifica- tion to Foreclosure, 111th Cong., 2nd sess., November 16, 2010, p. 20. 39. Congressional Oversight Panel, “November Oversight Report,” pp. 5, 7. 40. Katherine Porter, professor of law, University of Iowa College of Law, written testimony before the Congressional Oversight Panel for the Troubled Asset Relief Program (TARP), COP Hearing on TARP Foreclosure Mitigation Programs, October 27, 2010, p. 8. 41. Levitin, written testimony before the Senate Committee on Banking, Housing, and Urban Affairs, p. 20. 42. Erika Poethig, written testimony for the House Subcommittee on Housing and Community Op- portunity, Impact of the Foreclosure Crisis on Public and Affordable Housing in the Twin Cities, 111th Cong., 2nd sess., January 23, 2010, p. 5. 633 43. National Association for the Education of Homeless Children and Youth (NAEHCY) and First Fo- cus, “A Critical Moment: Child and Youth Homelessness in Our Nation’s Schools,” July 2010, p. 2. In early 2010, NAEHCY and First Focus conducted a survey of 2,200 school districts. When they were asked the reasons for the increased enrollment of students experiencing homelessness, 62% cited the economic downturn, 40% attributed it to greater school and community awareness of homelessness, and 38% cited problems stemming from the foreclosure crisis. 44. Dr. Heath Morrison, testimony before the FCIC, Hearing on the Impact of the Financial Crisis— State of Nevada, session 4: The Impact of the Financial Crisis on Nevada Public and Community Services, September 8, 2010, transcript, pp. 261–64. 45. Gail Burks, testimony before the FCIC, Hearing on the Impact of the Financial Crisis—State of Nevada, session 3: The Impact of the Financial Crisis on Nevada Real Estate, September 8, 2010, tran- script, pp. 230–31. 46. Karen Mann, president and chief appraiser, Mann and Associates Real Estate Appraisers & Con- sultants, written testimony for the FCIC, Hearing on the Impact of the Financial Crisis—Sacramento, session 2: Mortgage Origination, Mortgage Fraud and Predatory Lending in the Sacramento Region, Sep- tember 23, 2010, p. 12; oral testimony, p. 66. 47. Dawn Hunt, homeowner in Cape Coral, FL, interview by FCIC, December 20, 2010. 48. Zip code 33991, default, foreclosures and REO, S&P Global Data Solutions RMBS database, July 2010. 49. Hunt, interview. CHRG-111hhrg56778--57 Mr. Royce," Any other commentary there? Ms. Frohman. I guess in terms of where we have been with securities lending, we have in the lessons learned imposed a risk capital charge. We have also enhanced our disclosures, and prior to the credit crisis, we were well aware of the issue and the insurance regulators had required a reduction I think by 50 percent in the securities lending activity. " CHRG-110shrg50420--213 Chairman Dodd," How about these other points here, what did I say, 40 or 48 models, dealerships--I mean, Mr. Fleming told me that in Connecticut we have lost--I forget how many you told me last week. We are losing dealerships anyway, and I wonder if these numbers reflect just the attrition that is occurring as a result of the economic crisis. " CHRG-111hhrg54867--253 Secretary Geithner," Exactly. How you are funded is as important to how much risk you take. In fact, they are totally and completely related. And it is this mismatch between very short-term liabilities that can run and long-term assets that are liquid that allow the risk in them that creates the inherent vulnerability to crisis. So you need to both constrain leverage and make sure there is more conservative funding. " CHRG-111hhrg53021--262 Secretary Geithner," We want to avoid that, but again there is a lot of duplication of effort in our system. Our system is characterized by a, frankly, difficult to defend mix of parts of the system with incredible overlapping authority and parts of the system where nobody had good authority. So it is not a system we would have designed if we were starting from scratch today. We are going to try to get clearer accountability, more focused accountability, less overlap but better safeguards where they didn't exist. " CHRG-111hhrg53021Oth--262 Secretary Geithner," We want to avoid that, but again there is a lot of duplication of effort in our system. Our system is characterized by a, frankly, difficult to defend mix of parts of the system with incredible overlapping authority and parts of the system where nobody had good authority. So it is not a system we would have designed if we were starting from scratch today. We are going to try to get clearer accountability, more focused accountability, less overlap but better safeguards where they didn't exist. " fcic_final_report_full--530 December 3, 2008, 151 in which he said in pertinent part: Only 6 percent of all the higher-priced loans [those that were considered CRA loans because they bore high interest rates associated with their riskier character] were extended by CRA-covered lenders to lower-income borrowers or neighborhoods in their assessment areas , the local geographies that are the primary focus for CRA evaluation purposes. This result undermines the assertion by critics of the potential for a substantial role for the CRA in the subprime crisis. [emphasis supplied] There are two points in this statement that require elaboration. First, it assumes that all CRA loans are high-priced loans. This is incorrect. Many banks, in order to be sure of obtaining the necessary number of loans to attain a satisfactory CRA rating, subsidized the loans by making them at lower interest rates than their risk characteristics would warrant. This is true, in part, because CRA loans are generally loans to low income individuals; as such, they are more likely than loans to middle income borrowers to be subprime and Alt-A loans and thus sought after by FHA, Fannie and Freddie and subprime lenders such as Countrywide; this competition is another reason why their rates are likely to be lower than their risk characteristics. Second, while bank lending under CRA in their assessment areas has probably not had a major effect on the overall presence of subprime loans in the U.S. financial system, it is not the element about CRA that raises the concerns about how CRA operated to increase the presence of NTMs in the housing bubble and in the U.S. financial system generally. There is another route through which CRA’s role in the financial crisis likely to be considerably more significant. In 1994, the Riegle-Neal Interstate Banking and Branching Effi ciency Act for the first time allowed banks to merge across state lines under federal law (as distinct from interstate compacts). Under these circumstances, the enforcement provisions of the CRA, which required regulators to withhold approvals of applications for banks that did not have satisfactory CRA ratings, became particularly relevant for large banks that applied to federal bank regulators for merger approvals. In a 2007 speech, Fed Chairman Ben Bernanke stated that after the enactment of the Riegle-Neal legislation, “As public scrutiny of bank merger and acquisition activity escalated, advocacy groups increasingly used the public comment process to protest bank applications on CRA grounds. In instances of highly contested applications, the Federal Reserve Board and other agencies held public meetings to allow the public and the applicants to comment on the lending records of the banks in question. In response to these new pressures, banks began to devote more resources to their CRA programs.” 152 This modest description, although accurate as far as it goes, does not fully describe the effect of the law and the application process on bank lending practices. In 2007, the umbrella organization for many low-income or community “advocacy groups,” the National Community Reinvestment Coalition, published a report entitled “CRA Commitments” which recounted the substantial success of its members in using the leverage provided by the bank application process to obtain trillions of dollars in CRA lending commitments from banks that had applied to 151 152 Randall Kroszner, Speech at the Confronting Concentrated Poverty Forum, December 3, 2008. Ben S. Bernanke, “The Community Reinvestment Act: Its Evolution and New Challenges,” March 30, 2007, p2. federal regulators for merger approvals. The opening section of the report states (bolded language in the original): 153 CHRG-111shrg56376--23 Chairman Dodd," Senator Shelby. Senator Shelby. Mr. Chairman, just for the record, just my observation, I would think that if you look at the record here of the failure of the regulatory bodies, that all roads seem to lead to the Federal Reserve. They don't lead to the FDIC. They don't lead to the Comptroller. They don't lead to the Community Bank Supervisor. But just about all of them lead to the Fed, and let us be honest about it. I want to get into something else. Chairman Bernanke has testified before this Committee that this crisis has revealed that our Nation's ``too-big-to-fail'' problem is much worse than many thought. After the bailouts of Bear Stearns, AIG, Chrysler, and GM, our markets now have good reason to expect that the Federal Government will bail out any prominent company that gets into financial trouble, perhaps. My question to you is, what steps need to be taken to restore market discipline and minimize the moral hazard created by the bailouts over the past year? Is this a problem that will not be solved until the Federal Government actually allows several prominent institutions to fail? In other words, we are going down a road, a dead-end road on the ``too-big-to-fail'' thing. Sheila. Ms. Bair. Well, we very much agree with you, Senator, and that is why when I have testified before this Committee previously our priority focus has been on resolution authority. We need a mechanism that can resolve very large financial organizations in a way that is orderly, that protects the rest from any systemic implications, but makes sure that their creditors and shareholders take losses. We don't have that right now and I don't think we are going to get that restored market discipline until Congress puts something like that in place. Senator Shelby. John. " CHRG-111hhrg48868--117 Mr. Ario," Thank you for that question. I certainly agree with you that there hasn't been a failure of the State system here. In fact, we are the success story within this overall story and that the insurance companies continue to remain strong, stable, well-capitalized companies. And they are the most likely route that the taxpayer will get paid back here is the value in those insurance companies. There are on an ongoing basis many modernization initiatives that we're involved in. The world changes fast these days, and so we're updating our financial regulation, taking into account some of the issues on securities lending. I do agree with my colleague here, Mr. Polakoff, that it's the same thing on securities lending. It was liquidity issues that caused the problem, not losses in the underlying value. But we're looking at that issue. We're looking at modernizing our product approval and market conduct systems, our producer licensing systems, and so forth. But there is nothing in a systemic nature, I think, that we have to do other than be partners as part of a national systemic risk system that protects the functional regulators within an overall collaborative system. " CHRG-111shrg54533--60 Secretary Geithner," I agree with some of what you said, and I particularly agree that the Fed, I think, in being able to move as quickly as it did played a decisive role in avoiding a much more catastrophic outcome for the financial system and the economy and I think we need to preserve that authority. Now, what 13(3) does is to give the Fed the ability to lend to institutions it does not supervise, as I said. We are trying to fix that basic imbalance between institutions that play a critical role in markets and those that come under the Fed's basic supervision. By changing the authorities of that authority, we will reduce the risk in the future, particularly if you give us resolution authority. It will reduce the risk the Fed has to use 13(3) in the future to lend to institutions outside that basic framework of protection. But as I said, even in this crisis, where the Fed acted, I think, very swiftly and effectively to help contain the damage, where it used 13(3) in particular cases with individual institutions, it did ask for the explicit concurrence of the Secretary of the Treasury in recognition again of the potential losses to the taxpayer that were inherent in those judgments, and I think that was appropriate for the Fed to do. As you know, I was closely involved in that decision and I think that those decisions--and I think that would be appropriate to put in place in the future. And I do not believe, but I think this is an important concern, that that would constrain the Fed's ability in the future. Now, it is necessary, though, to tighten up the responsibility and authority the Fed has now for those core institutions, for payment systems because of the risk they present, and for capital. I think in those three areas, the Fed's authority is too qualified now. It has got responsibility without clear authority and accountability and I think that is worth fixing, basic pragmatic case for fixing that. Senator Johnson. The Secretary must leave at noon, so I remind Members to abide by the 5-minute rule. Senator Reed. Senator Reed. Thank you very much, Mr. Chairman. Thank you, Mr. Secretary. Senator Warner also brought up the issue of the warrants and the guidance, and another issue which is on your long, long list to do is private equity involvement in resolutions of failed institutions, and any guidance, we would appreciate it at your earliest convenience. Let me raise the issue which is going to be debated substantively for a long time, which is the Federal Reserve role, et cetera. You have suggested, I think, in an earlier answer, that the Fed would by October essentially report back to us about the changes that they have to make to accommodate these new responsibilities. So what are we doing between now and October in terms of moving this debate along, if we have to wait for the Fed to sort of say, well, this is how we are going to do it? " FinancialServicesCommittee--59 Mr. B ACHUS . All right. Mr. Leibowitz, what you said I agree with, that the markets and exchanges handled volatility quite well during the financial crisis in 2008. They didn’t react quite as well to the volatility last Thurs- day. What do you see is the difference? Mr. L EIBOWITZ . It is interesting because we actually discussed this at considerable length. And I think it has to do with things happening at a certain point in the day. A lot of the news on the financial crisis came out overnight, where markets had a chance to absorb that news. This is something that happened during the day. And, as Mr. Noll was saying, it was almost, like, set up. The market was in a jittery situation. The VIX was rising. There was nervousness about Europe. And then there was the speculation through the day and the announcement of what was going on in Greece. And it really just happened at a bad time. Had that news come out overnight, my guess is we would not have seen nearly the sort of swing that we saw during the day. Mr. B ACHUS . All right. Thank you. Mr. S COTT . [presiding] Let me follow up on that. Let me ask this question on the circuit breaker concept. Right now, we are in a situation where we have computers which are using very difficult mathematical formulas to trade millions of shares of stock in milliseconds. And our solution to this, as I hear you say, and Chairmen Schapiro and Gensler, is to institute stock- by-stock circuit breakers marketwide in a centralized way. I saw a movie about a couple of weeks ago, and it is a fun movie if you want to see it. It is called ‘‘Eagle Eye.’’ I don’t know if you saw that movie, but if you get a chance, it is very interesting. It just simply points out what happens in concentrating and putting so much control into a computer. So what I want to ask each of you—because, apparently, as I hear your testimony, particularly the New York Stock Exchange, have said that you have circuit breakers. The complaint was that maybe that moved too slow. So, as we debate this issue of circuit breakers, I want each of you to tell us, are there any downsides? Is there anything we have to fear here? Is there an element of freedom that takes out of the free enterprise system the freedom of the market exchange? Let us be very clear. Is there anything we have to fear if this is the solution of putting this much control in a stock-by-stock, marketwide, one central location of a circuit breaker? Mr. N OLL . If I could address that in two parts, Mr. Chairman. I think the issue for us is that technology, in and of itself, is a tool. It is a tool used by market participants and, I think, used very ef- fectively by market participants. We view the functioning of our market and its continuous operation as one of the envies of the world. And, generally, with the exception of that 17-minute period on May 6th, it functions extraordinarily well. And I would argue, even during that period of time, our tech- nology functioned well, but the market participants that were on our market experienced an absence of liquidity. So what we are really concerned about here is when our markets become dysfunc- tional. CHRG-111hhrg48674--359 Mr. Perlmutter," It has been a difficult time for all of us, but you have definitely been on the front line. So here are my questions to you: We have been in triage, we have been in the emergency room. We have systemic risk here and systemic risk here, and automakers, Fannie Mae, banks, investment banks and insurance companies. Is there something wrong with the system--not all these little things; is there something wrong with the system? And if you could go back in time, would you change one thing; Glass-Steagall, branch banking, securitizing loans? If you could go back in time, what would it be? " CHRG-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-111shrg57923--3 Mr. Tarullo," Certainly, Senator. A number of other regulators and overseers around the world have already begun to address the issue of information, among them the various organs of the European Union and the United Kingdom, the Bank of England. The G-20 itself has issued a couple of recommendations that are particularly salient to this question on developing a template for reporting of information of the large internationally active financial firms. Now, this is, of course, not an easy undertaking for any one nation much less for the world as a whole, but it is something which the Financial Stability Board has taken on as a task. There have been some preliminary discussions on how to organize the work of trying to see if we can come to agreement on a template for reporting of the largest, most globally active financial institutions. It is far too early to report progress there, Senator, but I can say that the effort has been launched. Senator Reed. Well, thank you, Governor. As you know, as we are proceeding down, and I think appropriately so, a legislative path which we hope will incorporate this systemic collection of information, I have got legislation in--and, in fact, I want to thank Dr. Mendelowitz and Professor Liechty for their assistance and help. But this is going to have to be an effort that goes beyond the United States to understand that, but I think it is important that we begin here. Another aspect of this international question is the issue of sovereign behavior. The Greek Government now is in a very serious crisis which is rattling the markets. There also is some indication that another one of our favorite topics, derivatives and credit default swaps, have come into it. Apparently, there are reports that investment banking firms have helped them legally avoid treaty obligations under Maastricht, et cetera. But the long and the short of it is, do we also have to include sort of sovereign entities in terms of data collection? " 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-111hhrg54867--69 Secretary Geithner," It is central. Without that, nothing will work. Again, I think in many of the concerns you have expressed on this side of the aisle, but also on your side of the aisle, are concerns about the threat of moral hazard. The question is how best to prevent that. I think what we learned from this crisis is you can't expect the market to constrain excess leverage and you can't fix a problem by hoping it will burn itself out. " FOMC20080310confcall--86 84,CHAIRMAN BERNANKE.," Thank you. So, there are different ways to look at this. We're crossing certain lines. We're doing things we haven't done before. On the other hand, this financial crisis is now in its eighth month, and the economic outlook has worsened quite significantly. We are coming to the limits of our monetary policy capability. The Congress has passed a fiscal program. I do not know how much political capacity there is to do additional things, although I assure you that we will be thinking hard about it and I hope you will be, too. So I view this really as incremental, and I think we need to be flexible and creative in the face of what are really extraordinary challenges. This is a combination of circumstances--a deep and abiding financial crisis, a serious slowdown, and inflation pressures. This combination is really a very challenging and an almost unprecedented combination. I think we need to be flexible, creative, and thoughtful in going forward. I think this is a very creative idea. It's well put together. We will have to do our very best to report regularly to the FOMC for your governance and your oversight of this process. It's not without risks, but I do feel that this is the next step. Whether we will have to take additional steps, we'll come back to you if we think we do or if you think we do. But right now I agree with Vice Chairman Geithner that this is probably the best option that we have, and it comes at a critical time in terms of where the markets are. If there are no other comments, I'd like to ask Scott to tell us what is required of us to move forward. " CHRG-111hhrg51592--21 Mr. Sherman," Thank you. Most entities will eventually work in their own interest. Patriotic speeches and appeals to patriotism only go so far. This is an industry that gave AAA to Alt-A, and is as responsible for where we are now as anyone else playing on Wall Street. Two things create this self-interest. The industry is picked by the issuer, and believes it cannot be sued by the investor. One of those two needs to change. Now, the public accounting forms are picked by the issuer, but they're subject to lawsuits. The auditing firm that audited WorldCom doesn't exist anymore. And in the old days, they were general partnerships, so 100 percent of all the partners' personal equity would be gone. That provided even more incentive to provide for a good audit. If we're not going to force the firms to renounce any First Amendment arguments as a condition for doing business on Wall Street, then we need to end the system where they're picked by the issuer. Otherwise, there will be a race to satisfy the issuer by providing the highest ratings to the issuer and we'll get AAA on Alt-A. It won't be mortgages next time, it'll be some other kind of bond. And we'll be back here in another economic crisis. We don't allow the pitchers to pick the umpires. If we did, the strike zone would go from the ground to well above the head. We cannot allow the issuers to pick the bond-rating agencies or the credit rating agencies unless we're going to then bring in trial lawyers with instant replay cameras. That would assure that the umpires wouldn't cater to the pitchers, if they were subject to lawsuits and instant replay. But one of those two things needs to change, or the fear of God will prevent us from being in this situation with mortgages for a few years, but we'll be back here in another semi-depression with some other kind of credit instrument. I yield back. " 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. FinancialCrisisInquiry--113 Cause Three: too many eggs in one basket. Look at data for loan growth last decade and look at the fastest area of loan growth. First, mortgages; second, mortgages; construction loans, commercial real estate, multi-family real estate. One element in common: real estate. Cause Four: high balance sheet leverage. Shortly before the crisis, the U.S. banking industry had the highest leverage in 25 years. And then take a look at the securities industry. In the ‘80’s, 20 time levered, in the ‘90’s, 30 times levered. And right before the crisis, almost 40 times levered. Cause Five: more exotic products. Some of these were so exotic that I don’t think the directors, the CEOs, and in some cases, even the auditors fully understood the risks. And I think of this like cheap sangria. A lot of cheap ingredients are bad—or bad sangria, I should say. A lot of cheap ingredients repackaged to sell at a premium. It might taste good for a while, but then you get headaches later and you have no idea what’s really inside. Cause Six: consumers went along. There’s some personal responsibility here. Consumer debt-to-GDP is at the highest level in history. Japan didn’t have that. We didn’t have that during the Great Depression. There is a false illusion of prosperity through this additional borrowing. It’s no secret that everybody from kids to pets to dead people got loan solicitations, but a lot of people took these loans voluntarily. Cause Seven: accountants. The SEC, in 1998 made some rules or some decisions that encouraged banks to take less reserves for their problem assets. And look what happened next. Reserves to loans at U.S. banks declined from 1.8 percent down to 1.2 percent right before the crisis. That was a wrong move. It should change now. And the bank regulators should be back in control in helping us set reserves for problem loans. That was not a close call for many of us in the industry. CHRG-111hhrg52261--136 Mr. Hampel," Well, Madam Chair, speaking for credit unions, my understanding of systemic risk is such that if even the largest 10 credit unions were all to get into extreme difficulty at same time, it would not spread to the rest of the financial system. So I don't think that credit unions could ever be the source of systemic risk, just by the nature of their size. However, credit unions, because they are connected and users of the rest of the financial system, can be victims of the systemic risk of other institutions; and that is why we are interested in the issue. " CHRG-110shrg50414--142 Mr. Cox," Senator, I think that there are several issues here. One is the infrastructure issue that the SEC is working on with the Fed, and the Treasury, of course, and the President's Working Group are very aware of this, and this has been a leadership effort for some time. It is important to have an OTC derivatives clearance and settlement infrastructure that works much better. It is important to have a central counterparty. It is also important to note that legislation has expressly excluded CDS from regulation even of the most modest kind, such as disclosure. And the lack of disclosure, the lack of transparency around this market is one of the reasons that we as a law enforcement agency but also market participants are very, very concerned about this. We have seen what happens with these regulatory holes. We have got a big regulatory hole around investment banking supervision. We now have right in focus--and we can see how this works--a bit regulatory hole around CDS. Holding a credit default swap is ordinarily effectively taking a short position in the underlying. But CDS buyers do not have to own the underlying. They do not have to own the bond or the debt instrument upon which the credit default swap is based. So they can effectively naked short it. This is a problem that we have been dealing with with our international regulatory counterparts around the world with straight equities, and it is a big problem in a market that has no transparency and people do not know where the risk lies. The opportunity, therefore, for fraud and manipulation in this market can lead to market distortions, market disruption, and damage to the companies themselves. And it is just vitally important, as we consider reform of the financial system in the current crisis, that we regulate this so that we can have disclosure, so that we can have transparency in this market. Senator Dole. Thank you, Mr. Chairman. My time has expired. " FinancialCrisisInquiry--567 BORN: Simon Johnson has written comparing the situation that we’re facing today with examples he saw as the chief economist of the IMF of crony capitalism in developing countries. If we’re facing that kind of situation and that played a role in the current financial crisis, I’m concerned about how we deal with that going forward. Any ideas, Mr. Solomon? CHRG-111shrg50564--33 Mr. Volcker," The report takes a traditional view of the functions of the Federal Reserve. Senator Shelby. Dr. Volcker, recently Stanford economist and, somebody you know, a former Under Secretary of the Treasury, John Taylor, argued that excessively loose monetary policy during the first part of this decade caused the financial crisis. " CHRG-111hhrg48867--58 Mr. Plunkett," Yes. We would support additional risk-retention requirements for securitization. And Mr. Chairman, on the question of an optional Federal charter, it just seems like a valuable lesson of the current crisis. If we have learned anything, it is that giving the regulated party their choice of regulator will lead to downward pressure on bank quality. " CHRG-111hhrg52261--32 Chairwoman Velazquez," Mr. Hirschmann, Mr. Harris, the financial crisis wreaked havoc on consumers. We all know that. And to that end, several Members of the House, including Representative Minnick, are proposing an alternative consumer protection council, one that will coordinate regulatory actions across several State jurisdictions. What is your take on this idea? " CHRG-111hhrg52261--160 Chairwoman Velazquez," Thank you. Mr. MacPhee, I would like to ask my last question to you. It is regarding securitization that has been billed as one of the chief culprits in the financial crisis. At the same time it has been credited with increasing the availability of capital for small firms. To what degree does your bank take advantage of loan securitization, and do you believe it should be constrained going forward? " FinancialCrisisInquiry--718 GORDON: We don’t see CRA as a contributor to the—the crisis that occurred. CRA had been working for several decades to get some more lending to people who were qualified for the loans that they were getting. CRA was not intended to put unqualified people into home loans. It was intended to get lending to otherwise qualified people who weren’t being serviced by the financial institutions. CHRG-111hhrg53244--38 Mr. Bernanke," It would be a special regime that would be invoked only under circumstances of financial stress and would be analogous to the laws we currently have for resolving failing banks, which allow the regulators to intervene before the actual bankruptcy occurs to avoid the negative impact of a disorderly bankruptcy on the market. So, yes, it could be in the broader bankruptcy regime, but it would be a special category of bankruptcy that would be invoked only during financial crisis. " CHRG-111hhrg53240--55 Mr. Ellison," Right. As I went through here, I looked for people who were bankers. There are some nonprofits. But if you look on--just from my look at what was printed on the Board's Web site the Consumer Advisory Council, it is at last half representation by the banking industry or credit score agency or real estate. That is not a critique of you, Governor, it is just an observation. And I think it is something we need to look at when we talk about issues of governances. Issues around this have already been raised. Let me kind of paint a scenario for you. Let's just say that banks are reaping a lot of their profits from, say, overdraft fees, and we have a safety and soundness regulator who says, great, you are making money, you have an income stream. And then you have a consumer regulator who says, that is a problem, this person had a 35-cent overdraft and has a $35 fee. Now under the present system, that problem will be resolved. Somebody will, someone will make a decision and say the prudential matters are of greater importance than the consumer. Or it could happen the other way, although I doubt it. Isn't that true? Somebody right now is resolving these conflicts that could arise between the prudential regulation and consumer regulation. That is happening now; isn't that right? Ms. Duke. Well, if I could come back to, in particular, overdrafts. What we have found, again, particularly in the most recent crisis, the important thing--we talk a lot about the conflict, but there is also the benefit of having the consumer regulation inform safety and soundness and say this may be a short-term source of profitability, but it may not be a reliable long-term source of profitability, and to sound a warning on the prudential side that products that are not well understood and not used well by consumers can actually, as we have seen, come back and endanger the very institution itself. " 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-110hhrg46593--38 Mr. Kanjorski," Thank you, Mr. Chairman. Mr. Secretary, I heard you use the comment in a response to a question just a little while ago, ``turning the corner.'' It is a quotable phrase, I think. It reminds me of another famous phrase, ``return to normalcy.'' And it sort of scares me if you look at the context of when ``return to normalcy'' was used. I think there is a crisis of confidence that is in the general public and within this body of the Congress. We are trying to figure out, those of us who extended ourselves on the vote for the bailout and the 180-degree change that you made in policy from buying bad assets to injecting investments of equity in banking institutions. I do not fault you for it. It just was an extreme change and rather shocking. And it wasn't your idea. It was the idea of the drafters of the legislation that you set up in the form of a 3\1/2\ page draft and we converted after several weeks to 400 pages. And part of those 400 pages gave you the authority to make that 180-degree change. Now, my problem is, that has happened once. And now suddenly I see other things occurring where you make 180-degree changes in policy. One example is this thing we are struggling with this week, the potential bankruptcy or collapse of our auto industry in the country. And it seems that there is a dual idea, either at Treasury or at the White House, that if you take the $25 billion out of certain qualified funds, then it is necessary and should be used and obviously would avoid systemic risk. The underlying principle: We shouldn't do it unless there is systemic risk. But if you were to use money from the TARP fund, that is unacceptable to the White House and Treasury and should not be done. Now it seems to me, when you are treating the disease, you don't decide where the disease came from. You decide, what is the prognosis, the likely prognosis, and then you take action. So there is a lack of confidence it seems to me, both in this body and in the general population. They want to get some idea, do we have a plan? Where are we going? To say ``turning the corner'' really is not terribly significant. It is no different than what Herbert Hoover said, ``return to normalcy.'' And it is causing fright to the people. Why can this Treasury and this White House not lay out a plan that takes into consideration all the contingencies that will happen or may happen and what our potential response will be, knowing full well mistakes will be made, money will be unreasonably or foolishly expended, but we all tend to agree that if, in fact, we are on the precipice of a disaster or a meltdown, we are willing to take those opportunities. But we do not want to walk into a room of darkness. We really want you to shed as much light in that room before we take the leap over the threshold. So I am sort of calling upon you, can you now give us some indication, do you consider the loss of the American auto industry a significant and systemic risk? Or do you not? If we lose 3 million jobs, what would it cost to make it up? What would be the loss of revenue? And would it be worth spending $25 billion initially to stop that from occurring? And if we do not do that, what is our backup plan, and what do we tend to do? It seems to me that if we are going to build confidence among our constituents, the American people, and confidence within this institution to respond to your requests and the White House's requests just over the next 60 days and then the next Administration, it seems to me we have to be a little more forthcoming. " CHRG-111hhrg56766--97 Mrs. Maloney," Thank you. Thank you so much, Mr. Chairman. Thank you very much, Mr. Chairman, and congratulations on your renomination, and I believe we have been very fortunate to have at the helm during this financial crisis a scholar, a professor who has dedicated his life work primarily to studying the Great Depression, writing about it, and I believe the Fed came forward with many creative unconventional responses to help us move out of this crisis. I also want to thank you for your leadership on many consumer issues that are important to this committee and to this Congress. The CARD Act, the Credit Cardholders' Rule that helps consumers, will put billions back into consumers' hands and the rule that came from the Fed was incredibly helpful in putting a clear logic forward and helping us win passage in this House, also the rule on overdraft is very welcomed and very important to consumers. In the Credit Card Bill of Rights, one of the items that will be enacted in August 22nd is the Federal Reserve's reaction and analysis about charges that may be too onerous and how you would make them fair, and could you comment on what your work is in that area, when you intend to have that ready for us to see, and how you intend to approach this challenge? " 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-111shrg61513--67 Mr. Bernanke," That is a concern that we have, and the problem is that if banks think they are going to be--that their names are going to be publicized, then they will not come even if they are under attack by the market, even if there is a panic or a run on the firm. So it is a very delicate issue. I think we will have further discussions, I am sure, but we are quite nervous about essentially shutting down the viability of this critical tool, which proved to be very valuable during the crisis. So that is something that we are concerned about, even, you know, with a delay. Senator Vitter. So even with a delay. " CHRG-111shrg57322--264 Mr. Sparks," We had clients who lost money, and that is not good. That is not good for us. That is not good for our clients. We dealt with institutional investors. But when you look at the overall economy, there were a lot of individuals out there who were harmed because of the financial crisis, and although we did not deal directly with them, I know that I do, and I think my colleagues do or my former colleagues do, have sympathy for them. With respect to regrets, which I think may be what you are asking---- Senator Pryor. I did not ask about regret. I noticed, though, from the record that---- " 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-111hhrg48674--168 Mr. Capuano," Well, I would much prefer you do, and the reason is, obviously, I believe all you have said thus far. I have read all of the documents. I believe that the decisions you have made are relatively safe. I feel confident where we are. We all know that the Treasury, again, not this Treasurer or the past Treasury, didn't do such a good job valuing assets. And I have a really hard time trusting the private market, who actually valued, I assume it is not new people who came in in the last 5 months, it is going to be the exact same people who got us into the mess in the first place valuing these assets. So their professionalism I think is subject to question based on the current economic crisis we have. They created the economic crisis, number one. Number two is their motivation. Your motivation is to save this economy, because that is your job. That is who pays you. Their motivation is make money. God bless them, it is the American way. It is not a problem. But I am not interested in private investors making money on the backs of taxpayers. I would rather have you do it. You have the motivation I trust. You have the professionalism I trust. You have the professionalism that, up until this point, has proven more accurate than those, and I would strongly suggest it is your money they are going to use. Don't write those checks unless you are comfortable with those values, because otherwise, I don't mean to be disrespectful, but you will be back on the hot seat along with them. " fcic_final_report_full--555 Wally Murray, President and Chief Executive Officer, Greater Nevada Credit Union Philip G. Satre, Chairman, International Gaming Technology (IGT); Chairman, NV Energy, Inc. Session : The Impact of the Financial Crisis on Nevada Real Estate Daniel G. Bogden, United States Attorney, State of Nevada Gail Burks, President and Chief Executive Officer, Nevada Fair Housing Center Brian Gordon, Principal, Applied Analysis Jay Jeffries, Former Southwest Regional Sales Manager, Fremont Investment & Loan Session : The Impact of the Financial Crisis on Nevada Public and Community Services Andrew Clinger, Director of the Department of Administration, Chief of the Budget Division, State of Nevada Jeffrey Fontaine, Executive Director, Nevada Association of Counties David Fraser, Executive Director, Nevada League of Cities Dr. Heath Morrison, Superintendent, Washoe County School District Session : Forum for Public Comment Public Hearing on the Impact of the Financial Crisis—Miami, Florida, Florida Inter- national University, Modesto A. Madique Campus, Miami, FL, September ,  Session : Overview of Mortgage Fraud William K. Black, Associate Professor of Economics and Law, University of Missouri–Kansas City Ann Fulmer, Vice President of Business Relations, Interthinx; Co-founder, Georgia Real Estate Fraud Prevention and Awareness Coalition Henry N. Pontell, Professor of Criminology, Law & Society and Sociology, University of Cali- fornia, Irvine Session : Uncovering Mortgage Fraud in Miami Dennis J. Black, President, D. J. Black & Company Edward Gallagher, Executive Officer, Economic Crimes Bureau, Mortgage Fraud Task Force, Miami-Dade Police Department Jack Rubin, Senior Vice President, JPMorgan Chase Bank Ellen Wilcox, Special Agent, Florida Department of Law Enforcement Session : The Regulation, Oversight, and Prosecution of Mortgage Fraud in Miami J. Thomas Cardwell, Commissioner, Office of Financial Regulation, State of Florida Wilfredo A. Ferrer, United States Attorney, Southern District of Florida R. Scott Palmer, Special Counsel and Chief of the Mortgage Fraud Task Force, Office of the At- torney General, State of Florida Public Hearing on the Impact of the Financial Crisis—Sacramento, California De- partment of Education, Sacramento, CA, September ,  Session : Overview of the Sacramento Housing and Mortgage Markets and the Impact of the Financial Crisis on the Region Mark Fleming, Chief Economist, CoreLogic Session : Mortgage Origination, Mortgage Fraud and Predatory Lending in the Sacra- mento Region Karen J. Mann, President and Chief Appraiser, Mann and Associates Real Estate Appraisers & Consultants Thomas C. Putnam, President, Putnam Housing Finance Consulting 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. " CHRG-111shrg57923--8 Mr. Tarullo," So that varies considerably, Senator, from data stream to data stream, and I think the subject--let me be clear just that when some people say ``realtime,'' some people mean ``immediate'' by that; that as a trade happens, the data, the information about the trade is immediately available to regulators and possibly the public. For most of our supervisory purposes, that kind of literally realtime data is not critical to achieving those supervisory purposes. And, of course, as you all know, true realtime data is a very expensive thing to put together. But timely, meaning in many instances daily or end-of-the-day trading, is very important for making an assessment on a regular basis as to the stability of a firm that may be under stress. One of the things that became clear, I think, during the crisis--and for me became particularly evident during the stress tests last spring--was the substantial divergence in the capacities of firms to amass, to get a hold of their own data, to know what their own trades were, to know what their own counterparty risk exposures were. So one of the things that we have actually been doing in the wake of the Special Capital Assessment Program is placing particular emphasis on the management information systems of the firms, requiring that they themselves be able to get a hold of the data on trades or counterparty exposures or certain kinds of instrument--certain kinds of involvement with certain kinds of instruments, because if they can get a hold of it for their own internal purposes, we will be able to get a hold of it pretty quickly. So right now it is actually not so much a question of our telling them, ``Send us something you have on a daily basis.'' It is in many instances as much a matter of making sure they have the capacity to derive that information from their raw computer records and then to send it to us. Senator Corker. May I ask another question, Mr. Chairman? Senator Reed. Yes, sure. Senator Corker. You know, of course, we all tend to try to find a solution that is unique and maybe alleviates a lot of just the daily work it takes to be good regulators, right? And a lot of what happened this last time could have been prevented with the tools we had if we just maybe had been a little more effective in regulating the way that we should have and Congress overseeing the way that it should have. But there were certainly lots of issues that caused this last crisis, if you will, to unfold. So we have had this wonderful presentation that we are going to hear next, and, you know, we envision having all this, at the end of the day, realtime type of data so we know positions throughout our country, so that regulators have the ability to know if something that is putting our country in systemic risk is occurring. What should we be concerned about there from the standpoint of having this thing that sounds really neat and costs money, how do we prevent it from being something that really is not that useful but is collecting a lot of data that I imagine takes place throughout this city that is not utilized? And then, second, I would imagine that data like that collected in one place could be used for pretty nefarious purposes if it got into the wrong hands. If we actually have it and collect it, what should be our concerns in that regard? " Mr. Tarullo," OK, so with respect to your first question, I mean, I do think that the efforts of the group of academics and others who have been promoting the NIF and certainly the efforts of the National Academy of Sciences in convening that workshop have been very valuable in drawing attention to and moving the debate forward on the data needs that we really do have. And I think, Senator, just to underscore something I said earlier, the absence of data from the shadow banking system was certainly problematic in retrospect. I think that the degree to which the tightly wound, very rapid shadow banking system was channeling liquidity around the financial system and, thus, the rapidity with which it came to a screeching halt once things began to break down, is something that was at least underappreciated by even those who foresaw problems ahead. So I do think that there is--and I do not think it is a coincidence, by the way, that some of the names I saw on the list of participants in that workshop that the NAS held were the names of scholars who have written, quite insightfully, I think, on the substantive causes of the crisis and of the way in which adverse feedback loops began when things moved into reverse. So I do think we need additional data sources. Now, how to make sure that every dollar of governmental funds spent on this are spent most wisely and how to make sure that we do not demand a lot of private expenditures that are not going to useful purposes is the kind of question that I think we all confront all the time in any Government regulatory or data collection effort. And I guess I would say that that is where some of the principles that we suggested in my written testimony I hope will be of some help. Keeping the regulator and supervisory agencies closely involved and, I would hope, the prime movers of these data collection efforts I think will help because whether it is the SEC or us or the CFTC, we are going to be most concerned in the first instance with achieving our statutory missions. And so for us that would be the consolidated supervision of the largest financial holding companies and also, obviously, our monetary policy and financial stability functions. That I think is one way to do it. I think a second way would be to make sure that there is some thought about new requirements coming forward. This is why OMB has the rules they have. And as you know, we think maybe some of the Paperwork Reduction Act features need to be changed around the edges. But there is a good reason why that act exists because you do want to put the brakes on people just willy nilly saying we would like new data sources. I think actually the council, if a council of regulators were created or the President's working group could formalize such an effort, I think it would be useful to have different agencies actually thinking about what new data sources may be important and having a debate precisely to guard against any one maybe going a bit too far afield from its own regulatory mission. On the protection issue, obviously there are, as I mentioned, these important interests, proprietary interests, IP interests in some cases where vendors are involved, privacy interests where individuals are involved, a little bit less, obviously, with some of the things we are talking about. We ought to continue to have those protections. But it is also the case that our country I think wants to be protected from financial instability, and my conclusion at least is that the efforts to identify potential sources of financial stress and risk throughout the economy is not something that one or even a whole group of Government agencies should be the sole actors in. I think we do need to enable analysts, private analysts, finance professors, people who have expertise but are not in the Government, to look at what is going on in the economy to offer their views to you, to us, to the American people, and let us all filter through how much of that may be well grounded and where we might disagree. If we are going to do that, we have to figure out how to get this data into a sufficiently aggregated form so as to protect proprietary information, but to make sure that it is really useful to somebody out there who is trying to do an analysis and have some insight into what is going on in the subprime mortgage market or over-the-counter derivatives or anywhere else. Senator Reed. Well, thank you, Governor Tarullo, and you have reminded me, I have to thank also the National Academy of Sciences because we asked them to convene that meeting and I am pleased that it produced positive results in your view and other people's view, but thank you very much. Senator Corker. I thought maybe you were going to ask another round. If I could just ask one more question---- Senator Reed. Yes, and I might have one, but go ahead. You go first. Senator Corker. No, go ahead. Absolutely. Senator Reed. Well, it sort of--no, why don't you go, because this is not Abbott and Costello, but you are ready. Senator Corker. So a number of us have been looking at speed bumps, ways for us not to be faced with resolution. We obviously, if we have resolution, want to ensure that this whole notion of too big to fail is not part of the American vocabulary. But we have had numbers of entities in recently--today, yesterday, the day before--talking about contingent capital and the ability to take unsecured debt in an institution that is moving into problem areas and converting that immediately to common equity. I know that is a little bit off topic, but there is a lot happening. We are going on recess next week. I just wondered if you might have some comments regarding that. It is something that I think is gaining more and more attention. " CHRG-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-111hhrg48867--205 Mr. Ryan," Just as to the role, as we see the role here, it is really early and prompt warning, prompt corrective action. The systemic regulator needs a total picture of all of the interconnected risks. As I have said, this regulator needs to be empowered with information to look over the horizon. We do not do that job well as regulators right now. And it also needs the power to be the tiebreaker, because there are differences of opinion between primary regulators, and if there is a systemic issue, we need someone to make that determination. Just one last comment here. We were talking about failure of institutions. As Ed Yingling said, we already have a system set up for banks in this country under the FDIC. We had no such system for securities firms, we have no such system for large insurance companies, and we have no such system for other, what I would call, potentially systemically important entities. And we need to address that. Thank you. " FinancialCrisisInquiry--417 BASS: I think I would respectfully disagree with Mr. Mayo on this. I think we need to determine—if an institution is systemically important to the United States and to our system, we need to determine what appropriate level of leverage are, and we need to force those companies to live within those leverage bounds. You know, today, as I mentioned, it’s somewhere between 16 and 25. And I will just assert to you that that is— that’s too high. So what we need to determine is—to Mr. Solomon’s point—if you’re going to be a proprietary trading firm and you want to engage in risk and it is the U.S. way and it’s capitalism, go do it. But there will be no safety net for you if you fail. All right. Don’t become systemically important. January 13, 2010 So you can make that happen. You can separate those two. And it goes back to the Glass- Steagall argument. But I think, of the institutions—we have four banks in the United States that owns 45 percent of the assets. We have 8,300 others that own the balance. Our whole system is very top-heavy here, and the reason that they’re systemically important is they’re that big. So I think, more holistically, we need to figure out what the structure of the system needs to look like, and we need to set what the leverage ratios are of those systemically important institutions. That’s my opinion. CHRG-111hhrg55811--313 Mr. Holmes," I believe so. You have to understand the counterparties that you are dealing with. We deal with the large commercial and investment banks that we have had relationships with for on average 30 years. Some of those relationships go back 100 years. Having said that, we still have credit limits that we place on our exposures with those counterparties. And when we approach those limits, we curtail our activity. Certainly during the credit crisis we were concerned about some of those counterparties, but the failure of any one of them would not have been a major financial problem. " 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-111hhrg55814--127 Secretary Geithner," But if you--again, I don't think this is complicated. Look what happened to Lehman, in the wake of Lehman. Bankruptcy Code was the only option available in that context. It caused catastrophic damage. That's why in the wake of the S&L crisis--and actually well before that--Congress recognized that for banks, and they operate like banks, they need to have a special set of protections to allow for the equivalent of bankruptcy. " FOMC20080310confcall--22 20,MR. DUDLEY.," That is the working assumption for the time being. We are going to have conversations with our primary dealers, and that is where we are going to really fine-tune what the appropriate haircut is. But I think the general operating principle here is to have haircuts that are considerably higher than the market during normal times but lower than the market during times of crisis, which we would argue that we are in or are close to being in right now. " FinancialCrisisInquiry--387 MAYO: Chairman Angelides, Vice Chairman Thomas, members of the commission, thank you for inviting me to testify today. I work at Calyon Securities and in affiliation with COSA, but January 13, 2010 I’m here to represent my own views. I’ve submitted almost 200 pages of supporting material. I hope you received that. Two decades ago, I worked down the street at the Federal Reserve. At the time, we were helping banks recover from crisis. We took great meaning from our work. I hope the commission’s efforts lead to a banking system that we don’t have to revisit every two decades to save. This is important. I’ve been covering an industry on steroids. Performance was artificially enhanced, and we’re now paying the price with the biggest bailout of U.S. banks in history. And it’s also resulting in the biggest wealth transfer from future generations to the current generation. My children, 9, 7, and 4, and their generation will have to pay the price. I’m shocked and amazed more changes have not taken place. There seems an unwritten premise that Wall Street, exactly how it exists today, is necessary for the economy to work. That’s not true. The economy worked fine before Wall Street got this large and this complex. Wall Street has done an incredible job at pulling the wool over the eyes of the American people. This may relate to the clout of the banks. The four banks that testified this morning have annual revenues of $300 billion. That’s equal to the GDP of Argentina. My perspective? I’ve analyzed banks since the late 1980’s. I value the independent reputation of COSA. And I’ve been negative on banks since 1999, and I’ve published over 10,000 pages of research to back up my view. I’ve identified 10 causes of the crisis. If you can turn to Slide 3 -- and I’ll go through each cause. Cause One: excessive loan growth. We could not accept the reality that we’re in a slower-growing economy, a more mature market. Loans grew twice as fast as they should have grown, twice as fast as GDP. Cause Two: higher yielding assets. The U.S. banking industry acted like a leverage bond fund. More borrowings with the proceeds invested in more risky assets. Look at Treasury securities. As a percentage of securities, they went January 13, 2010 down from 32 percent down to 2 percent. That’s the least risky asset. Instead, banks took more risky securities and more risky loans whether it’s home equity or construction loans. Look at construction loans. The percentage of construction loans to total is double the level where it was even in the early ‘90’s. Cause Three: too many eggs in one basket. Look at data for loan growth last decade and look at the fastest area of loan growth. First, mortgages; second, mortgages; construction loans, commercial real estate, multi-family real estate. One element in common: real estate. Cause Four: high balance sheet leverage. Shortly before the crisis, the U.S. banking industry had the highest leverage in 25 years. And then take a look at the securities industry. In the ‘80’s, 20 time levered, in the ‘90’s, 30 times levered. And right before the crisis, almost 40 times levered. Cause Five: more exotic products. Some of these were so exotic that I don’t think the directors, the CEOs, and in some cases, even the auditors fully understood the risks. And I think of this like cheap sangria. A lot of cheap ingredients are bad—or bad sangria, I should say. A lot of cheap ingredients repackaged to sell at a premium. It might taste good for a while, but then you get headaches later and you have no idea what’s really inside. Cause Six: consumers went along. There’s some personal responsibility here. Consumer debt-to-GDP is at the highest level in history. Japan didn’t have that. We didn’t have that during the Great Depression. There is a false illusion of prosperity through this additional borrowing. It’s no secret that everybody from kids to pets to dead people got loan solicitations, but a lot of people took these loans voluntarily. Cause Seven: accountants. The SEC, in 1998 made some rules or some decisions that encouraged banks to take less reserves for their problem assets. And look what happened next. Reserves to loans at U.S. banks declined from 1.8 percent down to 1.2 percent right January 13, 2010 before the crisis. That was a wrong move. It should change now. And the bank regulators should be back in control in helping us set reserves for problem loans. That was not a close call for many of us in the industry. Cause Eight: I know Jamie Dimon said regulators were not at fault. No, that’s not true. Regulators share some blame here, too. Banks—U.S. banks always paid insurance premiums for their deposit insurance. Ever since the FDIC was created after the Great Depression they always paid deposit insurance until 1996. For a decade banks paid no premiums for their deposit insurance. OK. Well, maybe—somebody else might be upset about this, too. OK? It’s a sign that banks for a decade not paying any deposit insurance premiums is ridiculous. And tomorrow when Sheila Bair testifies, that would be a great question to ask her. Why did they not pay deposit insurance for a decade? That’s analogous to getting car insurance and not—not paying premiums until you have an accident or getting life insurance and not paying premiums until you die. It just doesn’t work for an insurance scheme. Cause Nine: Government—government facilitated allocation of capital to the housing market, so government’s involved here, too. And Cause 10: Incentives. I think if there’s one word—after you spent all these months going through this, one word’s going to come up as being a key cause. And that one word is incentives. People do what they’re incented to do. And if you look at the banking industry compensation, what the industry pays out is pretty constant as a percentage of revenues. But guess what? That doesn’t reflect for the risk of those revenues. So if you hold a lot of treasury securities or if you make construction loans of if you own CDOs, it makes a big difference in terms of the degree of risk you’re taking. January 13, 2010 So in summary, I consider this an industry on steroids. Performance was enhanced by excessive loan growth, excessive securities risk, securities yields, bank leverage. Excesses were condoned. Yes, they were conducted by bankers, but they were also conducted by accountants, regulators, government and consumers. The side effects were ignored, and there was little financial incentive to do anything about it. So we ignored the long-term risks. And I say we collectively. The solution, I say, is partly a function of A, B, C. A is for accounting. Let’s have greater transparency and more consistency. The B is for bankruptcy. We should allow firms to fail. The prudent should not have to subsidize the imprudent. And a terrible precedent for the decade was saving long-term capital in 1998. And the C is for both capital and capitalism. During the crisis we all realized that banks are as vital as our most precious utility. Imagine walking into the kitchen in the morning, turning on the faucet and not getting water. We were close to that in the banking industry. That can never happen again. So we need to have enough capital for the banks. The other part of the C is capitalism. And capitalism is about having good information to make decisions. It’s about allowing firms to fail. It’s about having markets over government allocate capital with prudent oversight and regulation. To me the crisis was not caused by capitalism. It was caused by a lack of capitalism. And one more point on capitalism—capitalism is about money, but it’s also about meaning. And for this I look no further than my cousin Andy, who is a captain in the Army. Andy is going from the Army in Iraq to business school in the fall. And here’s what he wrote to me. He said that he hopes that we as the world leader in capital markets can make sound investments that help less fortunate people provide for their family. To him he’ll continue his pursuit of peace and prosperity as he goes into business. And to cousin Andy, Captain Andy, as I would like to call him—he gave a reminder the larger purpose of financial services. And that is to improve people’s lives by helping to allocate scarce resources to where they can best be used. January 13, 2010 I would like to hear the CEOs remind people of this ultimate purpose more often. And I appreciate the commission’s efforts to find out the root cause of this crisis, to bring greater awareness to this mission and to facilitate its execution. I look forward to your questions when they’re done. CHRG-111hhrg53244--73 Mr. Baca," Okay. In the second paragraph, you state that, ``These actions have softened the economic impact of the financial crisis. They have also improved the functioning of key credits, including the market for interbank lending, commercial papers, consumer, small lot, business credit, residential mortgages.'' How does that impact, then, those whoe in foreclosure right now? " CHRG-111hhrg56241--81 Mr. Hensarling," Thank you, Mr. Chairman. Before I make my comments, I would ask unanimous consent to enter two studies into the record relative to the subject: one is entitled, ``Compensation in the Financial Industry'' by the Center on Executive Compensation; and the other is entitled, ``Bank CEO Incentives and the Credit Crisis'' from the Fisher College of Business from Ohio State University. " CHRG-111hhrg48873--87 Mr. Kanjorski," Thank you very much, Mr. Chairman. Mr. Geithner, it is interesting to note, just in the questioning of the gentleman from Alabama, how we are not sure of what happened, when, and under what circumstances. Have you understood yet that the American people's reaction last week to a large extent was due to the fact that they feel that they are boxed out of knowing what is really going on in this economic crisis, and they are not well-informed? " FinancialCrisisInquiry--13 I would like to describe some of the regular business practices that we believe protected us leading up to and during the crisis. If we weren’t doing these things right going into the crisis, it would have been too late to start once the crisis began. J.P. Morgan Chase did not unduly leverage our capital or rely on low-quality capital. We’ve always used conservative accounting and vigilant risk management, built up strong loan loss reserves, and maintained a high level of liquidity. We always believed in maintaining a fortress balance sheet. We continually stress test our capital liquidity to ensure that we can withstand a wide range of highly unlikely but still possible negative scenarios. We did not build up our structured finance business. While we were large participants in the asset-backed securities market, we deliberately avoided large risky positions like structured CDOs. We avoided short-term funding of liquid assets and did not rely heavily on wholesale funding. In addition we essentially stayed away from sponsoring SIVs and minimized our financing of them. Even before 2005 we recognized that the credit losses were extremely low, and we decided not to offer higher risk, less tested loan products. In particular, we did not write payment option ARMs. As I said before, we did make mistakes. There are a number of things we could have done better. First, we should have been more diligent when negotiating and structuring commitment letters for leverage to indicate loan transactions. In response we have tightened our lending standards as well as our oversight of loan commitments we make. Second, the underwriting standards of our mortgage business should have been higher. We have substantially enhanced our mortgage underwriting standards, essentially returning to traditional 80 percent loan to value ratios and requiring borrowers to document their income. We’ve also closed down most—almost all of the business originated by mortgage brokers where credit losses have generally been over two times worse than the business we originate ourselves. CHRG-111shrg52619--206 RESPONSE TO WRITTEN QUESTIONS OF SENATOR SHELBY FROM JOSEPH A. SMITH, JR.Q.1. Consumer Protection Regulation--Some have advocated that consumer protection and prudential supervision should be divorced, and that a separate consumer protection regulation regime should be created. They state that one source of the financial crisis emanated from the lack of consumer protection in the underwriting of loans in the originate-to-distribute space. What are the merits of maintaining it in the same agency? Alternatively, what is the best argument each of you can make for a new consumer protection agency?A.1. CSBS believes safety and soundness and consumer protection should be maintained for the benefit of the system. While CSBS recognizes there is a tension between consumer protection and safety and soundness supervision, we believe these two forms of supervision strengthen the other. Consumer protection is integral to the safety and soundness of consumer protections. The health of a financial institution ultimately is connected to the health of its customers. If consumers lack confidence in their institution or are unable to maintain their economic responsibilities, the institution will undoubtedly suffer. Similarly, safety and soundness of our institutions is vital to consumer protection. Consumers are protected if the institutions upon which they rely are operated in a safe and sound manner. Consumer complaints have often spurred investigations or even enforcement actions against institutions or financial service providers operating in an unsafe and unsound manner. States have observed that federal regulators, without the checks and balances of more locally responsive state regulators or state law enforcement, do not always give fair weight to consumer issues or lack the local perspective to understand consumer issues fully. CSBS considers this a weakness of the current system that would be exacerbated by creating a consumer protection agency. Further, federal preemption of state law and state law enforcement by the OCC and the OTS has resulted in less responsive consumer protections and institutions that are much less responsive to the needs of consumers in our states. CSBS is currently reviewing and developing robust policy positions upon the administration's proposed financial regulatory reform plan. Our initial thoughts, however, are pleased the administration has recognized the vital role states play in preserving consumer protection. We agree that federal standards should be applicable to all financial entities, and must be a floor, allowing state authorities to impose more stringent statutes or regulations if necessary to protect the citizens of our states. CSBS is also pleased the administration's plan would allow for state authorities to enforce all applicable law--state and federal--on those financial entities operating within our state, regardless of charter type.Q.2. Regulatory Gaps or Omissions--During a recent hearing, the Committee has heard about massive regulatory gaps in the system. These gaps allowed unscrupulous actors like AIG to exploit the lack of regulatory oversight. Some of the counterparties that AIG did business with were institutions under your supervision. Why didn't your risk management oversight of the AIG counterparties trigger further regulatory scrutiny? Was there a flawed assumption that AIG was adequately regulated, and therefore no further scrutiny was necessary? Was there dialogue between the banking regulators and the state insurance regulators? What about the SEC? If the credit default swap contracts at the heart of this problem had been traded on an exchange or cleared through a clearinghouse, with requirement for collateral and margin payments, what additional information would have been available? How would you have used it?A.2. CSBS believes this is a question best answered by the Federal Reserve and the OCC. However, we believe this provides an example of why consolidated supervision would greatly weaken our system of financial oversight. Institutions have become so complex in size and scope, that no single regulator is capable of supervising their activities. It would be imprudent to lessen the number of supervisors. Instead, Congress should devise a system which draws upon the strength, expertise, and knowledge of all financial regulators.Q.3. Liquidity Management--A problem confronting many financial institutions currently experiencing distress is the need to roll-over short-term sources of funding. Essentially these banks are facing a shortage of liquidity. I believe this difficulty is inherent in any system that funds long-term assets, such as mortgages, with short-term funds. Basically the harm from a decline in liquidity is amplified by a bank's level of ``maturity-mismatch.'' I would like to ask each of the witnesses, should regulators try to minimize the level of a bank's maturity-mismatch? And if so, what tools would a bank regulator use to do so?A.3. While banks tend to have an inherent maturity-mismatch, greater access to diversified funding has mitigated this risk. Beyond traditional retail deposits, banks can access brokered deposits, public entity deposits, and secured borrowings from the FHLB. Since a bank essentially bids or negotiates for these funds, they can structure the term of the funding to meet their asset and liability management objectives. In the current environment, the FDIC's strict interpretation of the brokered deposit rule has unnecessarily led banks to face a liquidity challenge. Under the FDIC's rules, when a bank falls below ``well capitalized'' they must apply for a waiver from the FDIC to continue to accept brokered deposits. The FDIC has been overly conservative in granting these waivers or allowing institutions to reduce their dependency on brokered deposits over time, denying an institution access to this market. Our December 2008 letter to the FDIC on this topic is attached.Q.4. Regulatory Conflict of Interest--Federal Reserve Banks which conduct bank supervision are run by bank presidents that are chosen in part by bankers that they regulate. Mr. Tarullo, do you see the potential for any conflicts of interest in the structural characteristics of the Fed's bank supervisory authorities? Mr. Dugan and Mr. Polakoff does the fact that your agencies' funding stream is affected by how many institutions you are able to keep under your charters affect your ability to conduct supervision?A.4. I believe these questions are best answered by the Federal Reserve, the OCC, and the OTS.Q.5. Too-Big-To-Fail--Chairman Bair stated in her written testimony that ``the most important challenge is to find ways to impose greater market discipline on systemically important institutions. The solution must involve, first and foremost, a legal mechanism for the orderly resolution of those institutions similar to that which exists for FDIC-insured banks. In short we need to end too big to fail.'' I would agree that we need to address the too-big-to-fail issue, both for banks and other financial institutions. Could each of you tell us whether putting a new resolution regime in place would address this issue? How would we be able to convince the market that these systemically important institutions would not be protected by taxpayer resources as they had been in the past?A.5. CSBS strongly agrees with Chairman Bair that we must end ``too big to fail.'' Our current crisis has shown that our regulatory structure was incapable of effectively managing and regulating the nation's largest institutions and their affiliates. Further, CSBS believes a regulatory system should have adequate safeguards that allow financial institution failures to occur while limiting taxpayers' exposure to financial risk. The federal government, perhaps through the FDIC, must have regulatory tools in place to manage the orderly failure of the largest financial institutions regardless of their size and complexity. The FDIC's testimony effectively outlines the checks and balances provided by a regulator with resolution authority and capability. Part of this process must be to prevent institutions from becoming ``too big to fail'' in the first place. Some methods to limit the size of institutions would be to charge institutions additional assessments based on size and complexity, which would be, in practice, a ``too big to fail'' premium. In a February 2009 article published in Financial Times, Nassim Nicholas Taleb, author of The Black Swan, discusses a few options we should avoid. Basically, Taleb argues we should no longer provide incentives without disincentives. The nation's largest institutions were incentivized to take risks and engage in complex financial transactions. But once the economy collapsed, these institutions were not held accountable for their failure. Instead, the U.S. taxpayers have further rewarded these institutions by propping them up and preventing their failure. Accountability must become a fundamental part of the American financial system, regardless of an institution's size.Q.6. Pro-Cyclicality--I have some concerns about the pro-cyclical nature of our present system of accounting and bank capital regulation. Some commentators have endorsed a concept requiring banks to hold more capital when good conditions prevail, and then allow banks to temporarily hold less capital in order not to restrict access to credit during a downturn. Advocates of this system believe that counter-cyclical policies could reduce imbalances within financial markets and smooth the credit cycle itself. What do you see as the costs and benefits of adopting a more counter-cyclical system of regulation? Do you see any circumstances under which your agencies would take a position on the merits of counter-cyclical regulatory policy?A.6. Our legislative and regulatory efforts should be counter-cyclical. In order to have an effective counter-cyclical regulatory regime, we must have the will and political support to demand higher capital standards and reduce risk-taking when the economy is strong and companies are reporting record profits. We must also address accounting rules and their impact on the depository institutions, recognizing that we need these firms to originate and hold longer-term, illiquid assets. We must also permit and encourage these institutions to build reserves for losses over time. Similarly, the FDIC must be given the mandate to build upon their reserves over time and not be subject to a cap. This will allow the FDIC to reduce deposit insurance premiums in times of economic stress. A successful financial system is one that survives market booms and busts without collapsing. The key to ensuring our system can survive these normal market cycles is to maintain and strengthen the diversity of our industry and our system of supervision. Diversity provides strength, stability, and necessary checks-and-balances to regulatory power. Consolidation of the industry or financial supervision could ultimately produce a financial system of only mega-banks, or the behemoth institutions that are now being propped up and sustained by taxpayer bailouts. An industry of only these types of institutions would not be resilient. Therefore, Congress must ensure this consolidation does not take place by strengthening our current system and preventing supervisory consolidation.Q.7. G20 Summit and International Coordination--Many foreign officials and analysts have said that they believe the upcoming G20 summit will endorse a set of principles agreed to by both the Financial Stability Forum and the Basel Committee, in addition to other government entities. There have also been calls from some countries to heavily re-regulate the financial sector, pool national sovereignty in key economic areas, and create powerful supranational regulatory institutions. (Examples are national bank resolution regimes, bank capital levels, and deposit insurance.) Your agencies are active participants in these international efforts. What do you anticipate will be the result of the G20 summit? Do you see any examples or areas where supranational regulation of financial services would be effective? How far do you see your agencies pushing for or against such supranational initiatives?A.7. This question is obviously targeted to the federal financial agencies. However, while our supervisory structure will continue to evolve, CSBS does not believe international influences or the global marketplace should solely determine the design of regulatory initiatives in the United States. CSBS believes it is because of our unique dual banking system, not in spite of it, that the United States boasts some of the most successful institutions in the world. U.S. banks are required to hold high capital standards compared to their international counterparts. U.S. banks maintain the highest tier 1 leverage capital ratios but still generate the highest average return on equity. The capital levels of U.S. institutions have resulted in high safety and soundness standards. In turn, these standards have attracted capital investments worldwide because investors are confident in the strength of the U.S. system. Viability of the global marketplace and the international competitiveness of our financial institutions are important goals. However, our first priority as regulators must be the competitiveness between and among domestic banks operating within the United States. It is vital that regulatory restructuring does not adversely affect the financial system in the U.S. by putting banks at a competitive disadvantage with larger, more complex institutions. The diversity of financial institutions in the U.S. banking system has greatly contributed to our economic success. CSBS believes our supervisory structure should continue to evolve as necessary and prudent to accommodate our institutions that operate globally as well as domestically. ------ fcic_final_report_full--15 We conclude that these two entities contributed to the crisis, but were not a pri- mary cause. Importantly, GSE mortgage securities essentially maintained their value throughout the crisis and did not contribute to the significant financial firm losses that were central to the financial crisis. The GSEs participated in the expansion of subprime and other risky mortgages, but they followed rather than led Wall Street and other lenders in the rush for fool’s gold. They purchased the highest rated non-GSE mortgage-backed securities and their participation in this market added helium to the housing balloon, but their pur- chases never represented a majority of the market. Those purchases represented . of non-GSE subprime mortgage-backed securities in , with the share rising to  in , and falling back to  by . They relaxed their underwriting stan- dards to purchase or guarantee riskier loans and related securities in order to meet stock market analysts’ and investors’ expectations for growth, to regain market share, and to ensure generous compensation for their executives and employees—justifying their activities on the broad and sustained public policy support for homeownership. The Commission also probed the performance of the loans purchased or guaran- teed by Fannie and Freddie. While they generated substantial losses, delinquency rates for GSE loans were substantially lower than loans securitized by other financial firms. For example, data compiled by the Commission for a subset of borrowers with similar credit scores—scores below —show that by the end of , GSE mort- gages were far less likely to be seriously delinquent than were non-GSE securitized mortgages: . versus .. We also studied at length how the Department of Housing and Urban Develop- ment’s (HUD’s) affordable housing goals for the GSEs affected their investment in risky mortgages. Based on the evidence and interviews with dozens of individuals in- volved in this subject area, we determined these goals only contributed marginally to Fannie’s and Freddie’s participation in those mortgages. CHRG-111shrg61651--17 Mr. Reed," Mr. Chairman, thank you very much for your kind welcome. Senator Shelby and everybody, I appreciate the opportunity to be with you. I had never anticipated as a retired citizen that I would find myself here, but I really am here to voice support for Mr. Volcker's suggestion, the Volcker Rule. I do think that while details have to be worked out and so forth, I think that it is a good suggestion and one that is worthy of consideration by this Committee and the Congress in general. I don't say this because I think the absence of that rule was central to the difficulties that we have just come through. I don't think that is the case. But I do say it from the point of view that if we were take a blank piece of paper and we were to say to ourselves, how can we design a financial system that would both serve the public and also be relatively safe and relatively unlikely to have a repeat of what we had, you would start out certainly with capital, which needs to be augmented. You would certainly look at the structure of the regulatory framework, which I believe this Committee is doing. But I would argue that you would also look to maybe compartmentalize the industry, not deny any function to the industry in general, but compartmentalize it so as to limit economic spillover. But as somebody who has run a large company in this industry for a long time, because of the impact that it has on the culture and the makeup of the various firms, dealing with the capital markets, proprietary trading, proprietary investing, hedge fund market, so forth and so on, each of these bring with them their own culture. These are cultures that have to exist for the particular purpose, but they have their own particular characteristics and there is no question in my mind but these cultures have an impact on the institution within which they are embedded. And if I were asked to design a system, I would not allow these kind of cultures and activities to be a part of large depository and traditional lending institutions. It is not that I feel these functions shouldn't exist. I would simply separate them from institutions that are the deposit takers and basically the traditional lenders for much of the economy. And I do this because I think the culture from the capital markets that rubs off has to do with risk taking. It certainly has to do with compensation, and it has to do with the nature of the human fabric of the various entities that we are talking about. So I believe as a part of a comprehensive reform that Mr. Volcker's idea with regard to separation of some of these functions makes a lot of sense, not because I am concerned about the economics, but because I am concerned of the nature of the impact that these various activities have on the players and the financial markets. With regard to size, I would differ a little bit with Professor Johnson. I think the antitrust laws are quite capable of dealing with size in the marketplace. The place where size is the problem has to do with the intra-industry transactions, the so-called ``counterparty risk.'' This is where the ``too big to fail'' comes into play. It isn't the balance sheet of the bank that is the problem on ``too big to fail.'' It is the interconnectedness of one financial institution with virtually all other financial institutions. And so this is where I believe we must be concerned about size. You could deal with size by having capital requirements that relate to the size of intra-industry activity, and obviously increasing capital as intra-industry activity goes up. You also, and this has been proposed and I think it is a good idea, can ask that certain instruments be traded through exchanges. This acts as a circuit breaker, the exchanges. It acts as a circuit breaker in the transmission of difficulties. And you could deal with size by simply putting limitations on counterparty risk, on the degree of leverage that can exist with regard to intra-industry trading. So the issue of size, I think, is also relevant, and so I think the two keys to Mr. Volcker's suggestion, that of segregation of function within the industry and particularly the protection of the large deposit-taking institutions and the idea of being concerned about size, have merit and deserve the consideration of this Committee. A final comment, if I could. I believe that one of the reasons that JPMorgan Chase did better than many others during this recent crisis is they did not have embedded in that institution a real money market activity, a trading house. JPMorgan Chase was the amalgam of about five commercial banks, but none of them had a big investment banking trading activity in it, and the absence of that kind of function turned out in the crisis to give them a relative strengthened position. Thank you, Mr. Chairman. " FOMC20080916meeting--140 138,MR. HOENIG.," Mr. Chairman, I have thought about this considerably because I think we have come to a time in our history when we have institutions that clearly ought to be and may in fact be too big to fail. I think we tend to react ad hoc during the crisis, and we have no choice at this point. But as you look at the situation, we ought, instead of having a decade of denying too big to fail, to acknowledge it and have a receivership and intervention program that extends some of the concepts of the FDIC but goes beyond that. That is, if you are insolvent, it is not a central bank issue--we are a liquidity provider--and therefore the government comes in. But unlike the GSEs, everyone has to take some hit--the equity holders, certainly the preferred stockholders, also the subordinated-debt holders, and perhaps the senior ones--by assuming a certain amount of loss. They would have immediate access to--pick a number--80 percent. The research would help us pick that number, and they can have access, but the rest becomes a subordinate-subordinate position after the liquidation so that you have still a sense of market discipline in play and you don't get the system gaming it in that, if you know there's a bailout coming, you buy the debt and sell the equity short to make a bundle. I think therein lie the distortions that are absolutely detrimental to the longrun health of the economy. Regarding how we go forward, I think we are going to have many lessons from this. Part of the problem has been very lax lending and, obviously now, weaknesses in some of the oversight. Also a history of our reacting from a monetary policy point of view to ease quickly to try to take care of the problem and, therefore, to create a sense in the market of our support has raised some real moral hazard issues that we now need to begin to remedy as we look forward in dealing with future receiverships. We are in a world of too big to fail, and as things have become more concentrated in this episode, it will become even more so. " CHRG-111hhrg52400--265 Mr. McRaith," Yes. I think you are asking the multi-billion-dollar question. But I think the Chicago Mercantile Exchange--if I can be a little bit parochial--had an excellent proposal, and that is to have an electronic trading platform and a clearing function, so that there is pricing transparency and counterparty certainty. And those two things, in conjunction, would have prohibited or limited the impact of the crisis we have seen and are suffering through now. " CHRG-111hhrg55811--201 Mr. Green," Exactly. Now, let me say this: One of the reasons why--there may be a multiplicity, but one of the reasons we are so concerned about this is because of the systemic risk that developed with AIG, and other companies as well, and it is really the systemic risk that we are trying to deal with. We, generally speaking, wouldn't be in this position, wouldn't be here today, if we had not had some systemic risk problems we had to deal with, and taxpayer dollars ultimately had to help us maintain the financial system. So this is why we are here. Now, with reference to products that create a risk that can be deemed systemic by virtue of being pervasive and by virtue of being so risky that they just don't fit well in a regulated market, are there any products at all that you can think of that would be so abusive or so systemically risky that you would not have them in this market? " fcic_final_report_full--565 DC: Peterson Institute for International Economics, 2008), p. 58. 47. Final Rule—Amendment to Regulations H and Y,” Federal Reserve Bulletin 75, no. 3 (March 1989), 164–66. 48. Tarullo, Banking on Basel , pp. 61–64. 49. For more on derivatives, see FCIC, “Preliminary Staff Report: Overview on Derivatives,” June 29, 2010. 50. Warren Buffett, testimony before the FCIC, Hearing on the Credibility of Credit Ratings, the In- vestment Decisions Made Based on Those Ratings, and the Financial Crisis, session 2: Credit Ratings and the Financial Crisis, June 2, 2010, transcript, pp. 312, 326, 325. 51. Eric R. Dinallo, former superintendant, New York State Insurance Department, written testimony for the FCIC, Hearing on the Role of Derivatives in the Financial Crisis, session 2, Derivatives: Supervi- sors and Regulators, July 1, 2010, p. 7; Rochelle Katz, State of New York Insurance Department, letter to Bertil Lundqvist, Skadden, Arps, Slate, Meagher & Flom, LLP, June 16, 2000. 52. Data provided by AIG to the FCIC, CDS notional balances at year-end. 53. Bank for International Settlements, semiannual OTC derivatives statistics. 54. Dinallo testified that the market in CDS in September 2008 was estimated to be $62 trillion at a time when there was about $16 trillion of private-sector debt (written testimony for the FDIC, July 1, 2010, p. 9). 55. “AIGFP also participates as a dealer in a wide variety of financial derivatives transactions” (AIG, 2007 Form 10-K, p. 83). AIG’s notional derivatives outstanding were $2.1 trillion at the end of 2007, in- cluding $1.2 trillion of interest rate swaps, $0.6 trillion of credit derivatives, $0.2 trillion of currency swaps, and $0.2 trillion of other derivatives (p. 163). 56. FCIC staff calculations using data from Office of the Comptroller of the Currency; call reports. 57. Data provided to the FCIC by Goldman Sachs. Chapter 4 1. 103 Public Law 103-328, September 29, 1994. Before the 1994 legislation, some states had voluntar- ily opened themselves up to out-of-state banks. FDIC, History of the Eighties: Lessons for the Future , vol. 1, An Examination of the Banking Crises of the 1980s and Early 1990s (Washington, DC: FDIC, 1997), p. 130. 2. These were the largest banks as of 2007. See FCIC, “Preliminary Staff Report: Too-Big-to-Fail Fi- nancial Institutions,” August 31, 2010, p. 14. 3. Data from SNL Financial (www.snl.com/). 4. Public Law 104-208, sec. 2222, codified as 12 U.S.C. § 3311; law in effect as of January 3, 2007. 5. Arthur Levitt, interview by FCIC, October 1, 2010. 6. John D. Hawke and John Dugan, testimony before the FCIC, Hearing on Subprime Lending and Securitization and Government-Sponsored Enterprises (GSEs), day 2, session 2: Office of the Comptrol- ler of the Currency, April 8, 2010, transcript, pp. 169, 175. 7. Fed Vice Chairman Roger W. Ferguson Jr., “The Future of Financial Services—Revisited,” remarks at the Future of Financial Services Conference, University of Massachusetts, Boston, October 8, 2003. 8. Fed Chairman Alan Greenspan, “Government Regulation and Derivative Contracts,” speech at the Financial Markets Conference of the Federal Reserve Bank of Atlanta, Coral Gables, Florida, February 21, 1997. 9. Richard Spillenkothen, “Notes on the performance of prudential supervision in the years preceding the financial crisis by a former director of banking supervision and regulation at the Federal Reserve Board (1991 to 2006),” May 31, 2010, p. 28. 10. See U.S. Department of the Treasury, Modernizing the Financial System (February 1991), pp. XIX- 5, XIX-6, 67–69: “the existence of fewer agencies would concentrate regulatory power in the remaining ones, raising the danger of arbitrary or inflexible behavior. . . . Agency pluralism, on the other hand, may be useful, since it can bring to bear on general bank supervision the different perspectives and experi- ences of each regulator, and it subjects each one, where consultation and coordination are required, to the checks and balances of the others’ opinion.” 11. Fed Chairman Alan Greenspan, statement before the Senate Committee on Banking, Housing, and Urban Affairs, 103rd Cong., 2nd sess., March 2, 1994, reprinted in the Federal Reserve Bulletin, May 1, 1994, p. 382. 12. Securities Industry Association v. Board of Governors of the Federal Reserve System, 627 F.Supp. 695 (D.D.C. 1986); Kathleen Day, “Reinventing the Bank; With Depression-Era Law about to Be Rewrit- ten, the Future Remains Unclear,” Washington Post, October 31, 1999. 13. Edward Yingling, quoted in “The Making of a Law,” ABA Banking Journal , December 1999. 14. The two-year exemption is contained in section 4(a)(2) of the Bank Holding Company Act. The CHRG-111hhrg48867--69 Mr. Bartlett," No, Congressman, I don't; other than what we now have, which is no analysis of systemic risk, no oversight of systemic risk, no one to notice systemic risk and the unlimited Federal Reserve dollars. So none of the systemic risk regulator proposals propose any additional authority on the solution problem. What we have proposed is the Federal Reserve as a systemic risk oversight, but then followed by a coherent, comprehensive resolution authority to resolve the failures in a coherent, consistent manner that does not now exist. " CHRG-110hhrg34673--44 Mrs. Maloney," Thank you, Mr. Chairman. And welcome back, Chairman Bernanke. Many of my colleagues have been quoting ``American Banker.'' I would like to show you ``The Hill.'' There you are on the cover. It says your testimony sparked a stock price rally, and the Dow is up 87 percent, and there is great optimism for our economy, and I hope you are right. I hope the stock market is right. But regrettably, some of my constituents are not feeling optimistic. They feel that the economic expansion has not ended up in their take-home pay, and some are very concerned about losing their homes, and I share that concern. They are concerned about the rising rate of mortgage defaults and home foreclosures. In my district employment is high and stable, yet I am being told that foreclosures are at rates that are up by an order of magnitude--they have jumped up dramatically from what they were last year. Some of my colleagues tell me that they are experiencing the same thing in their districts around the country, and they are being told that homeowners are losing their homes in very stable neighborhoods, and some say that this is due to various causes such as unemployment. Yet in my district and others where employment is high, and in some other areas, it is due to the decline in the housing market. But many also ask whether certain mortgage products, particularly in the subprime market, have contributed to this foreclosure crisis or challenge. In particular, many point to the so-called 2/28 ARM's, and some have described them--and I quote--as an inherent predatory product. And as you have told me and others, these 2/28 ARM's are 80 percent of the subprime market. Recently the Fed wrote back to Senator Dodd, taking the position that in its recent guidance on nontraditional mortgages, they did not extend to 2/28 for similar projects. And since these are what many people think is the problem, my question is why is the Fed not addressing the 2/28's and issuing guidance for what many people feel is the main problem in the foreclosure rates and the loss of homes of many people? You eloquently have said many times that homeownership leads to participation in our economy and increased wealth for Americans, yet if you are losing your home, it is leading you to a personal crisis, and if it continues, we will be facing a tremendous crisis in our economy and in our districts. And now for your comments on whether or not the Fed plans to extend guidance to the 2/28 subprime project, products. " CHRG-111hhrg53245--77 Mr. Kanjorski," Thank you, Mr. Chairman. Ms. Rivlin, in your testimony, I am not sure I understood whether or not you were indicating that the Federal Reserve should not be designated as the systemic risk regulator or that it was in fact well qualified to be the gatherer of information and data for the systemic risk regulator. Ms. Rivlin. I was trying to distinguish two concepts of systemic risk agencies. One is monitor and gatherer of information for which I think the Fed is very well qualified and should be doing it anyway and it is coordinate with its responsibilities on the economy. I would put that responsibility there. I do not think that it should be the systemic risk regulator in the sense of regulator of systemically important institutions, regulator supervisor of systemically important institutions, because (a) I do not think there should be such a designated responsibility for the reasons we have been talking about. I do not think you should have a list. Second, if you did do that, I sure would not put it at the Fed. I think it would dilute their monetary policy responsibilities and they would not be very good at it. " fcic_final_report_full--617 Chapter 18 1. Joseph Sommer, counsel, Federal Reserve Bank of New York, email to Patrick M. Parkinson, deputy research director, Board of Governors of the Federal Reserve System, et al., “Re: another option we should present re triparty?” July 13, 2008. 2. James Dimon, interview by FCIC, October 20, 2010. 3. Barry Zubrow, testimony before the FCIC, Hearing on Too Big to Fail: Expectations and Impact of Extraordinary Government Intervention and the Role of Systemic Risk in the Financial Crisis, day 1, ses- sion 2: Lehman Brothers, September 1, 2010, p. 212. 4. Richard S. Fuld Jr., testimony before the FCIC, Hearing on Too Big to Fail: Expectations and Impact of Extraordinary Government Intervention and the Role of Systemic Risk in the Financial Crisis, day 1, session 2: Lehman Brothers, September 1, 2010, p. 148. See also Fuld’s written testimony at same hearing, p. 6. 5. Ben Bernanke, testimony before the FCIC, Hearing on Too Big to Fail: Expectations and Impact of Extraordinary Government Intervention and the Role of Systemic Risk in the Financial Crisis, day 2, ses- sion 1: The Federal Reserve, September 2, 2010, transcript, pp. 26, 89. 6. Kenneth D. Lewis, interview by FCIC, October 22, 2010. 7. Bernanke, testimony before the FCIC, September 2, 2010, p. 22. 8. Bernanke told the examiner that the Federal Reserve, the SEC, and “markets in general” viewed Lehman as the next most vulnerable investment bank because of its funding model. Anton R. Valukas, Report of Examiner, In re Lehman Brothers Holdings Inc., et al., Debtors, Chapter 11 Case No. 08-13555 (JMP), (Bankr. S.D.N.Y.), March 11, 2010, 2:631 (hereafter cited as Valukas); see also 1:5 and n. 16, 2:609 and nn. 2133–34, 4:1417 and n. 5441, 4:1482 and n. 5728, 4:1494, and 5:1663 and n. 6269. Paulson, 2:632. Geithner told the examiner that following Bear Stearns’s near collapse, he considered Lehman to be the “most exposed” investment bank, 2:631; see also 1:5 and n. 16, 2:609, 4:1417 and n. 5441, 4:1482 and n. 5728, 4:1491 and n. 5769, and 5:1663 and n. 6269. Cox reported that after Bear Stearns collapsed, Lehman was the SEC’s “number one focus”; 1:5 and n. 16, and p. 1491 and n. 5769; see also 2:609, 631. 9. Timothy Geithner, quoted in Valukas, 1:8 and n. 30, 4:1496. 10. Donald L. Kohn, email to Bernanke, “Re: Lehman,” June 13, 2008. Valukas, 2:615; 2:609 and n. 2134. 11. Harvey R. Miller, bankruptcy counsel for Lehman Brothers, interview by FCIC, August 5, 2010; Lehman board minutes, September 14, 2008, p. 34. 12. Erik R. Sirri, interview by FCIC, April 1, 2010. 13. Paolo R. Tonucci, interview by FCIC, August 6, 2010. 14. Specifically, Lehman drew $1.6 billion on March 18; $2.3 billion on March 19 and 20; $2.7 billion on March 24; $2.1 billion on March 25 and 26; and $2 billion on April 16. Lehman Brothers, “Presenta- tion to the Federal Reserve: Update on Capital, Leverage & Liquidity,” May 28, 2008, p. 15. See also Robert Azerad, vice president, Lehman Brothers, “2008 Q2—Liquidity Position (June 6, 2008),” p. 3. Af- ter its bankruptcy, Lehman drew $28 billion, $19.7 billion, and $20.4 billion, on September 15, 16, and 17, until Barclays replaced the Fed in providing financing. Valukas, 4:1399. See also David Weisbrod, senior vice president, Treasury and Securities Services–Risk Management, JPMorgan Chase & Co., email to James Dimon et al., “Re: TriParty Close,” September 15, 2008. 15. Thomas A. Russo, former vice chairman and chief legal officer, Lehman Brothers, email to Richard S. Fuld Jr., forwarding article by John Brinsley (originally sent to Russo by Robert Steel), “Paul- son Says Investment Banks Making Progress in Raising Funds,” Bloomberg, June 13, 2008 (quoting Robert Steel), June 13, 2008. 16. Richard S. Fuld Jr., interview by FCIC, April 28, 2010. 17. Valukas, 2:713 and nn. 2764–65, 2:715 and n. 2774. See also Russo, email to Fuld, “Fw: Rumors of hedge fund putting together a group to have another run at Lehman,” March 20, 2008 (forwarding dis- cussions with SEC regarding short sellers). 18. Dan Chaudoin, Bruce Karpati, and Stephanie Shuler, Division of Enforcement, SEC, interview by FCIC, April 6, 2010; Mary L. Schapiro, chairman, SEC, written responses to written questions—specifically, response to question 13—from FCIC, asked after the hearing on January 14, 2010. 19. Jesse Eisinger, “The Debt Shuffle: Wall Street Cheered Lehman’s Earnings, but There Are Ques- tions about Its Balance Sheet,” Portfolio.com, March 20, 2008. 20. David Einhorn, Greenlight Capital, “Private Profits and Socialized Risk,” speech at Grant’s Spring Investment Conference, April 8, 2008, p. 9. See also David Einhorn, “Accounting Ingenuity,” speech at Ira W. Sohn Investment Research Conference, May 21, 2008, pp. 3–4. 21. Nell Minow, interview by FCIC, September 13, 2010. 22. Nell Minow, testimony before the House Committee on Oversight and Government Reform, CHRG-110hhrg41184--139 Mr. Hinojosa," The last question I would ask is, in today's newspaper, the Washington Post talks about the, I think they're called appraisers who are forced by someone to falsely increase their appraisal value of properties, and what that is doing of course is causing the homeowner to pay such high taxes and also to, in my opinion, contribute to the current crisis in housing market. What are your recommendations for us to stop that and to get to what are realistic appraisals instead of what I just described? " FOMC20080310confcall--19 17,MR. DUDLEY.," Well, the first thing I would say, President Fisher, is that we are doing this collateral swap for a fee and for one that is higher than the normal fee in normal markets. So in no way is it free. In terms of the prudential regulation, I think there will be a lot of lessons learned from this crisis that will be addressed in the fullness of time, and this is one lesson that we are going to have to remember when we look at what we have learned from this experience. " CHRG-111shrg55739--151 PREPARED STATEMENT OF MARK FROEBA, J.D. Principal, PF2 Securities Evaluations, Inc. August 5, 2009 Chairman Dodd, Senator Shelby, and Members of the Committee: My name is Mark Froeba and I am a lawyer based in New York City. I am pleased to be here today and it is an honor to testify before you on the important topic of rating agency reform. Thank you for giving me this opportunity. \1\--------------------------------------------------------------------------- \1\ The opinions and views expressed in this document are those of Mark Froeba, who is appearing before the Committee on his own behalf and as a private citizen, and are not intended to represent the views or opinions of any organization.--------------------------------------------------------------------------- Let me give you a brief summary of my background. I am a 1990 graduate of the Harvard Law School. In 1997, I left the tax group at Skadden, Arps in New York, where I had been working in part on structured finance securities, to join the CDO group at Moody's. I worked at Moody's for just over 10 years, all of that time in the CDO group. I left Moody's in 2007 as a Senior Vice President. At that time, I was Team Leader of the CLO team, cochair of most CLO rating committees and jointly responsible for evaluating all new CLO rating guidelines. Since the beginning of the subprime crisis, there have been many proposals for rating agency reform. Most of these proposals are well-intentioned and would probably do little harm. However, few seem likely to accomplish real reform. Real reform must achieve two clear policy goals: PREVENT another rating-related financial crisis like the subprime crisis; RESTORE investor confidence in the quality and reliability of credit ratings.In my opinion, the rating agency reform provisions of the Investor Protection Act of 2009 are not sufficient--in themselves--to accomplish either of these goals. However, the Act's rule-making authority could be used to expand their effectiveness. Why are the reform provisions in themselves insufficient? First, they are not the product of a complete investigation into what actually happened at the rating agencies. If you repair damage to a ceiling caused by a leaky roof but don't repair the roof, the damage will just keep coming back. In this case, as long as we do not have a precise understanding of how things went so wrong, we cannot really be confident the reform proposals will do what is needed to prevent things from going wrong again. (Of course, this cuts both ways. Just as we do not know without an investigation whether the reform proposals go far enough, we also do not know whether they go too far.) It is true that some work has been done to discover what actually happened at each of the rating agencies, but much could still be learned, especially from the analysts who assigned the problem ratings. Any thorough investigation must include confidential interviews with as many of these analysts as possible from each of the major rating agencies. By these interviews, investigators will gain an intimate knowledge of how each rating agency actually worked, not how it was supposed to work on paper. More importantly, they will uncover exactly what the people closest to the process think caused so many ratings to be so significantly wrong. What questions should be asked? Who is responsible for what happened and why? Was there ever any pressure exerted upon you or your colleagues, direct or indirect, to subordinate rating analysis to business considerations? If so, how was the pressure exerted?Even if these questions seem to insinuate malfeasance, they are questions the rating agencies will welcome because the answers they expect will do much to restore confidence in their integrity. In summary, without a proper investigation of what happened--not conducted on a theoretical level, or in discussions with senior managers but with the analysts who actually assigned the ratings in question--we cannot be sure the proposed legislation provides solutions designed to fix the real problems. The best way to illustrate my second reason for questioning the sufficiency of this proposal is to ask you a simple question. If Investor Protection Act of 2009 had been enacted, just as it is, 5 years ago, do you think it would have prevented the subprime crisis? In my view, the answer to this question is very clearly ``No.'' That does not mean that these proposals are bad. It just means that they do not advance what should be one of the central policy goals of rating agency reform: preventing a future crisis in the financial system triggered at least in part by problem credit ratings. If these reform proposals are uncertain to prevent a future crisis and to restore confidence in the credit ratings, what reforms could achieve these goals? To answer this question, we should first consider the regulatory context in which the rating agencies found themselves just before the subprime crisis. First, they enjoyed an effective monopoly on the sale of credit opinions. Second, and more importantly, they enjoyed the benefit of very substantial Government-sanctioned demand for their monopoly product. (A buggy whip monopoly is a lot more valuable if Government safety regulations require one in every new car). Third, the agencies enjoyed nearly complete immunity from liability for injuries caused by their monopoly product. Fourth, worried about the monopoly power created by the regulations of one branch of Government, another branch encouraged vigorous competition among the rating agencies. This mix of regulatory ``carrots'' and ``sticks'' in the period leading up to the subprime meltdown may have contributed to making it worse than it might have been. Thus, a third goal of rating agency reform should be to untangle these conflicting regulatory incentives. Here are some proposals that I believe will help with all three reform goals. First, put a ``fire wall'' around ratings analysis. The agencies have already separated their rating and nonrating businesses. This is fine but not enough. The agencies must also separate the rating business from rating analysis. Investors need to believe that rating analysis generates a pure opinion about credit quality, not one even potentially influenced by business goals (like building market share). Even if business goals have never corrupted a single rating, the potential for corruption demands a complete separation of rating analysis from bottom-line analysis. Investors should see that rating analysis is virtually barricaded into an ``ivory tower,'' and kept safe from interference by any agenda other than getting the answer right. The best reform proposal must exclude business managers from involvement in any aspect of rating analysis and, critically also, from any role in decisions about analyst pay, performance, and promotions. Second, prohibit employee stock ownership and change the way rating analysts are compensated. There's a reason why we don't want judges to have a stake in the matters before them and it's not just to make sure judges are fair. We do this so that litigants have confidence in the system and trust its results. We do this even if some or all judges could decide cases fairly without the rule. The same should be true for ratings. Even if employee stock ownership has never actually affected a single rating, it provokes doubt that ratings are disinterested and undermines investor confidence. Investors should have no cause to question whether the interests of rating agency employees align more closely with agency shareholders than investors. Reform should ban all forms of employee stock ownership (direct and indirect) by anyone involved in rating analysis. These same concerns arise with respect to annual bonus compensation and 401(K) contributions. As long as these forms of compensation are allowed to be based upon how well the company performs (and are not limited to how well the analyst performs), there will always be doubts about how the rating analysts' interests align. Third, create a remedy for unreasonably bad ratings. As noted above, the rating agencies have long understood (based upon decisions of the courts) that they will not be held liable for injuries caused by ``bad'' ratings. Investors know this. Why change the law to create a remedy if bad ratings arguably cause huge losses? The goal is not to give aggrieved investors a cash ``windfall.'' The goal is to restore confidence--especially in sophisticated investors--that the agencies cannot assign bad ratings with impunity. The current system allows the cost of bad ratings to be shifted to parties other than the agencies (ultimately to taxpayers). Reform must shift the cost of unreasonably bad ratings back to the agencies and their shareholders. If investors believe that the agencies fear the cost of assigning unreasonably bad ratings, then they will trust self interest (even if not integrity) to produce ratings that are reasonably good. My former Moody's colleague, Dr. Gary Witt of Temple University, believes that a special system of penalties might also be useful for certain types of rated instruments. Where a governmental body relies upon ratings for regulatory risk assessment of financial institutions--e.g., the SEC (broker-dealers and money funds), the Federal Reserve (banks), the NAIC (insurance companies) and other regulatory organizations within and outside the U.S.--the Government has a compelling interest and an affirmative duty to regulate the performance of such ratings. Even if other types of ratings might be protected from lawsuits by the first amendment, these ratings are published specifically for use by the Government in assessing risk of regulated financial institutions and should be subject to special oversight, including the measurement of rating accuracy and the imposition of financial penalties for poor performance. Fourth, change the antitrust laws so agencies can cooperate on standards. When rating agencies compete over rating standards, everybody loses (even them). Eight years ago, one rating agency was compelled to plead guilty to felony obstruction of justice. The criminal conduct at issue there related back to practices (assigning unsolicited ratings) actually worth reconsidering today. Once viewed as anticompetitive, this and other practices, if properly regulated, might help the agencies resist competition over rating standards. Indeed, the rating problems that arose in the subprime crisis are almost inconceivable in an environment where antitrust rules do not interfere with rating agency cooperation over standards. Imagine how different the world would be today if the agencies could have joined forces 3 years ago to refuse to securitize the worst of the subprime mortgages. Of course, cooperation over rating analysis would not apply to business management which should remain fully subject to all antitrust limitations. Fifth, create an independent professional organization for rating analysts. Every rating agency employs ``rating analysts'' but there are no independent standards governing this ``profession'': there are no minimum educational requirements, there is no common code of ethical conduct, and there is no continuing education obligation. Even where each agency has its own standards for these things, the standards differ widely from agency to agency. One agency may assign a senior analyst with a Ph.D. in statistics to rate a complex transaction; another might assign a junior analyst with a BA in international relations to the same transaction. The staffing decision might appear to investors as yet another tool to manipulate the rating outcome. Creating one independent professional organization to which rating analysts from all rating agencies must belong will ensure uniform standards--especially ethical standards--across all the rating agencies. It would also provide a forum external to the agencies where rating analysts might bring confidential complaints about ethical concerns. An independent organization could track and report the nature and number of these complaints and alert regulators if there are patterns in the complaints, problems at particular agencies, and even whether there are problems with particular managers at one rating agency. Finally, such an organization should have the power to discipline analysts for unethical behavior. Sixth, introduce ``investor-pay'' incentives into an ``issuer-pay'' framework. Students of the history of rating agencies know that, at one point, rating agencies were paid by investors not by issuers of the securities rated by the agency. Investors subscribed to periodic rating reports and these subscription fees paid for the ratings. By the late 1960s this business model was not working and the agencies gradually shifted away from an investor-pay model to an issuer-pay model. In this model, the party or entity applying for a rating pays for the rating. Critics fault this model because it shifts the attention (and allegedly, the allegiance) of the rating agencies not only away from the ultimate consumer of the rating, the investor, but also toward the party whose interests may strongly conflict with the investor, the issuer. According to this view of the process, the power of the issuer to take the rating business to a competitor became the tool by which the rating agencies were induced to compete with each other on rating standards. For example, an issuer tells rating agency (X) that its competitor (Y) has lowered its subordination levels for some structured security, e.g., from 4.5 percent to 4.3 percent. The issuer urges X to change its standards or lose the issuer's business. Of course, at the same time, the issuer is telling Y that X has lowered subordination levels and urging Y to adopt the lower standards. It isn't hard to see how a spiral of declining rating standards could be triggered under this model. There are those who believe that real rating agency reform requires a return to an investor-pay model. But there may be a third way, a business model that preserves the issuer-pay ``delivery system'' (the issuer still gets the bill for the rating) but incorporates the incentives of the investor-pay model. How would this work? First, issuers seeking a credit rating would be required to provide the same information to every rating agency that has ``registered'' to rate a particular type of security or transaction. Thus, if there are five rating agencies registered to rate CDOs, all five would receive exactly the same information about a new CDO from the issuer. Second, the potential investors in the new security or transaction would decide which agencies get paid to rate the security. During the marketing phase of the transaction, investors would compare the ratings proposed by all of the rating agencies and the investors would then select the agencies to rate the transaction. It would be at this point that the rating agencies would once again be competing with each other for the interest of the investors. The issuers' power to corrupt the process by selecting the rating agency would be eliminated. Finally, every rating agency would be free to publish ratings of the transaction, regardless of whether it was selected to be paid for the rating by investors. It would also be possible to use such a system to create demand for ratings from new rating agencies. To do so, investors (or issuers if they are still making the selection) would be required to pick two agencies for every transaction: (1) only one from the list of agencies with more than 50 percent market share for the asset type in question and (2) one or more from the list of agencies with less than 50 percent market share for the asset type in question. In this way, newer agencies would have an easier time breaking into a business with extremely high barriers to entry. These and other reforms are necessary not only to restore investor confidence in ratings (without regard to whether they actually redress past malfeasance) but also to prevent future ratings-related financial crises. CHRG-110hhrg46594--114 Mr. Ackerman," Thank you, Mr. Chairman. There is a delicious irony in seeing private luxury jets flying in to Washington, D.C., and people coming off of them with tin cups in their hand saying that they are going to be trimming down and streamlining their businesses. It is almost like seeing a guy show up at the soup kitchen in high hat and tuxedo. It kind of makes you a little bit suspicious as to whether or not, as Mr. Mulally said, we have seen the future and causes at least some of us to think have we seen the future. I mean, there is a message there. Couldn't you all have downgraded to first class or jetpooled or something to get here? That would have at least sent a message that you do get it. If you are going to streamline your company, where does it start? And it would seem to me if, as the chief executive officer of those companies, you can't set the standard of what that future is going to look like, that you are really going to be competitive, that you are going to trim the fat, that you don't need all the luxuries and bells and whistles, it causes us to wonder. You know, I don't have a dealership. I have driven a car for a long time. Around here, as my colleagues know, I drive the same 1966 Plymouth Valiant that I have always had. I can't seem to kill it. I strut my stuff in New York a little bit, and I drive a Cadillac. And I just bought a new one. I bought it because of the finance companies that are in the financing of the car business. I bought this car a couple of weeks ago, and I had some problems with it, and I couldn't get in touch with anybody. Because the dealership--which is a great dealership, by the way--couldn't tell me that they had the phone number of somebody at Cadillac to call to fix this GPS system that I had trouble with in the previous car. That is systemically built in with a software problem that I can describe, but nobody can listen. And if you are going to sell cars that customers want, you have to find out what the problems are; and you are not doing that. I wanted a loaded car in blue. I had to reach out to five States to find one in blue. I said, ``Can't you tell them they should be making more blue cars this year?'' He said, ``We have no mechanism to get back to the company to tell them that.'' Well, lucky for me, you guys are in a crisis, and they reached out and called me because you all said to your dealers, call your Congressman if you know who they are. And I got a call, and I actually had somebody call me. And in this discussion, I said, ``Hey, part of the problem is you are not listening to your customers. You have a problem with this, that and the other thing and this GPS system, etc., and I have nobody to talk to.'' And the answer was, ``Well, I think there is an 800-number in the manual somewhere.'' Now when my wife has a problem with the foreign car that she drives, they bend over backwards to try to listen to her and figure out what is going on, what the colors are, what the bells and whistles customers like. And you all are not listening. If you are going to sell cars that customers want, you have to find a way to talk to your customers or better listen to your customers. You have no mechanism. There is an arrogance in that. We will all be out of business in 2 years. We have a time limit also. So maybe you can tell us what you are actually going to do to sell cars people want and how are you going to do that in real short order because otherwise, you know, there is triage. Somebody heard that we were giving out free money in Washington, and they are showing up from all over the place. And we have to figure out where to put it. And you know, you don't want to put your last tourniquet on a dead guy. So tell us, what is going to be different 3 months from now? Anybody? " CHRG-111hhrg48873--288 Secretary Geithner," The best thing we can do for New York and the U.S. financial system is create a much stronger system, a more stable system for the future. But to do that, we need to make sure we bring the world with us, and the world as a whole, all those other financial centers, London, Asia, continental Europe, also put in place higher standards for protection, because without that, there is a risk that capital will move, business will shift from the United States, and we will end up with a weaker system overall, as we have seen. So the best defense for us is to make our system stronger, not to wait for the world; make our system stronger, but try to encourage them to move with us to put in place higher standards, and that is what the President has committed to do. " fcic_final_report_full--532 In its report, the NCRC listed all 446 commitments and includes the following summary list of year-by-year commitments: Table 13. Year Annual Dollars ($ millions) Total Dollars ($ millions) 2007 12, 500 4,566,480 2006 258,000 4,553,980 2005 100,276 4,298,980 2004 1,631,140 4,195,704 2003 711,669 2,564,564 2002 152,859 1,852,895 2001 414,184 1,700,036 2000 13,681 1,285,852 1999 103,036 1,272,171 1998 812,160 1,169,135 1997 221,345 356,975 1996 49,678 135,630 1995 26,590 85,952 1994 6,128 59,362 1993 10,716 53,234 1992 33,708 42,518 1991 2,443 8,811 1990 1,614 6,378 1989 2,260 4,764 1988 1,248 2,504 1987 357 1,256 1986 516 899 1985 73 382 1984 219 309 1983 1 90 1982 6 89 1981 5 83 1980 13 78 1979 15 65 1978 0 50 1977 50 50 The size of these commitments, which far outstrip the CRA loans made in assessment areas, suggests the potential significance of the CRA as a cause of the financial crisis. It is noteworthy that the Commission majority was not willing even to consider the significance of the NCRC’s numbers. In connection with its only hearing on the housing issue, and before any research had been done on the NCRC statements, the Commission published a report absolving CRA of any responsibility for the financial crisis. 154 154 FCIC, “The Community Reinvestment Act and the Mortgage Crisis.” Preliminary Staff Report , http:// www.fcic.gov/reports/pdfs/2010-0407-Preliminary_Staff_Report_-_CRA_and_the_Mortgage_Crisis. pdf. CHRG-111shrg57322--276 Mr. Swenson," I think the reservation here is on the contributed part versus what caused, and we did not cause the financial crisis specifically to the mortgage desk, which is what I am here to speak about. You have two panels in subsequent meetings to speak about Goldman Sachs and our businesses. I do not think that we did anything wrong. There are things that we wish we could have done better in hindsight, but at the times that we made the decisions, I did not think we did anything wrong. Senator Pryor. Mr. Tourre. " CHRG-111shrg56376--196 Mr. Baily," I think you must have a system that is countercyclical, while our current system is procyclical, and one that doesn't penalize the best community banks, which the current system does, and pay for the sins of the bad ones. So the system of assessments that funds this agency has to be one that takes into account not increasing the assessment for community banks and certainly not increasing the assessment for any banks in the storm, and I think that is achievable in terms of the way the institution is funded. " CHRG-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-111hhrg48867--303 Mr. Green," All right. And if you realize that AIG is a cause of or may be a cause of systemic risk, would you not want to prevent AIG from being a systemic risk, creating a systemic risk? " CHRG-110shrg50418--61 Chairman Dodd," And may I ask you, Mr. Nardelli, this is talking about systemic risk. We were told here that we had to provide $150 billion to AIG because of the systemic risk issues here. Tell me if you agree by what has been said by Mr. Wagoner, the additional points. Is there systemic risk? I realize there is financial risk, but is there systemic risk with the failures we have been talking about? " CHRG-111shrg55739--125 Mr. Froeba," In some ways, the most important would be the hardest to implement, and that is the idea that you separate the analytical function from the management function. Just as in the court system or at a university, you want your professors, you want your judges to be independent of the people who are sort of managing the process. At the rating agency, you want the analysis to be independent of the business decisions. And I think that is probably the key, also the most difficult. Another really important one is affecting the way analysts are paid. I think analysts should not be--their pay, their compensation, their reward should not have anything to do with how the company does, because the best answer from the analysts may impact company revenue negatively. You want to encourage them to give that negative answer despite the impact it may have to their own financial situation. So those two are important. I think expanding liability is key. And, finally, the one that is probably, forgive me for saying it so informally--the weirdest proposal is that the rating agencies be allowed to cooperate. If the rating agencies had gotten together 5 years ago and said we are not going to allow for the securitization of liar loans, if they had been able to get together and agree that they were all going to do that and they would not feel undercut by the competitors, I think we would have seen much of this subprime crisis averted. Senator Reed. Thank you. Professor Coffee, I just wanted to follow up on Senator Bunning's line of questioning about liability. As you pointed out, the standard for liability under the securities laws is essentially recklessness, it is a very---- " Mr. Coffee," ``Extreme recklessness.'' Senator Reed. ``Extreme recklessness.'' It is a very high threshold, as it should be. The proposal I have made is not to change that liability standard but to change explicitly the pleading standard. And I wanted you to--if that is your understanding since you have looked at the legislation, if that is the case. And, also, the rationale is that until you get to discovery, it is awful hard to understand what was done on a factual basis, and just your comments on that. " FinancialCrisisInquiry--23 Before closing let me say a few words about compensation. At Bank of America, our compensation guidelines are set by a board of directors. The goal of any compensation program and the program at Bank of America is to attract and retain the talent we need to make the businesses profitable. In 2008, our company actually earned more than $4 billion. But that was far short of what we believed we should have done for our shareholders. Neither my predecessor as CEO nor any of the top leaders in the company, myself included, received a bonus for 2008. For the executives at the next level down, our bonuses were cut more than 80 percent. Our 2009 compensation pools have not been finalized. We anticipate that the compensation levels will be higher than they were in 2008, but certainly not back to the pre-crisis levels. We have implemented many different programs, including claw backs and greater deferrals that you’ve seen referenced in the press and other places. And all of our activities comply with the work that we’ve done through the various regimes, the TARP regime and the paymaster, Feinberg, and others. We understand the anger felt by many citizens because institutions that received federal investments 15 months ago are now recovering and pay their employees reflect this recovery, especially in investment banking and trading areas. And in response to that criticism I’d make a few points. First, at Bank of America we are grateful for the taxpayer assistance we have received. I am pleased to report that we’ve paid back 100 percent of those funds, $45 billion, along with nearly $3 billion in dividends and other payments to taxpayers. Second, the vast majority of our employees played no role in the economic crisis or losses. They have worked hard during this crisis to help their customers and clients and extend more than three- quarters of a trillion dollars in the four quarters leading up to the third quarter of ‘09. Third, while some employees were asked to leave the company over the past couple of years, we believe our 300,000 employees are a valuable part of our future. And we need to pay them competitively to ensure that we can keep them so they can help our clients. CHRG-110shrg50417--8 STATEMENT OF SENATOR MEL MARTINEZ Senator Martinez. Mr. Chairman, thank you very much for calling this timely hearing, and thank you also for your very passionate remarks, and I tend to agree with much of what you had to say. Let me begin by just saying that over the last several days I have had the opportunity to travel around the State of Florida, and the news on the ground is really not good. Talking to bankers, real estate developers, and others in the home industry, it is clear to me that until we change the dynamics of what is occurring today where foreclosures continue to pile up, where we continue to see banks--and I am talking now about local banks, I am talking about community banks, I am talking about Main Street banks that are being told by regulators that even though they have performing loans that are on their books, because they are real estate loans, perhaps they should call them in. And all of a sudden we have now builders that are in the toughest of times but able to maintain that business going and keep people on the job, being told that their lines of credit are being canceled or not extended because the banks simply are being squeezed by regulators. This is a real problem. It also relates to the problem that they are facing at the level of not also being sure what is going to occur with TARP. You know, one set of rules was first put out. They were going to try to work under that set of rules, and now changes have been made to how the Treasury is handling the whole TARP matter. I think some clear guidelines so that bankers and others in the lending business know exactly what the rules of the game are going to be are essential, and I think the sooner we do that, the better that it is going to be. Florida has the third highest foreclosure rate in the Nation, and it is clear to me that Florida's entire economy--and I think the Nation's--is impacted by the homeownership crisis. And in my view, until we stem the tide of foreclosures, until we begin to find effective ways of--and I commend some of the banks that are here today for what they are doing. Some of them have been at some events that we have tried to sponsor to help families stay in their homes. To keep those loans as performing loans and active loans, as opposed to foreclosures, is something I think we need to work toward. Until we get to the bottom of this, until we get to the foreclosure crisis, I do not think any of these other problems are going to ameliorate. I think this crisis began with homeownership problems, and I think it is going to end when we get a handle on that side of the equation. And I believe that your comments are precisely on point. I think we need to ask that as these infusions of capital are being made to the large financial banks, that capital then move downstream and is out there to help local businesses who cannot get credit, to help borrowers who would buy a house if they could just get a loan, and maybe not with 20 percent down but with something different than that. The bottom line is that until we turn the tide of where we are today in terms of the housing crisis and the foreclosure crisis, I believe that our entire economy continues to be at risk. And I look forward to hearing the testimony from the witnesses today. I very much support the efforts by FDIC Chairman Sheila Bair to put a more aggressive approach to loan modifications. I think she is on the right track, and I believe that it is time that we get this done and we get aggressive about it. We have done a number of things, the administration has done a number of things, all well intended and, I think, designed to do some good to the problem. But they have all been timid and they have been late. I think we need to get aggressive and get ahead of the problem once and for all. You are right. We heard a couple of years ago about 2 million foreclosures, and we wish that that was the end of the story. And if we do not get ahead of this, if downward spiraling prices of homes does not get stemmed, if we don't get a floor on the housing economy, I think we are going to see this problem only continue to escalate. Thank you. " CHRG-111shrg56376--8 Mr. Dugan," Thank you very much, Mr. Chairman. Chairman Dodd, Ranking Member Shelby, and Members of the Committee, I appreciate this opportunity to discuss the Administration's proposal for regulatory reform. The OCC supports many elements of the proposal, including the establishment of a council of financial regulators to identify and monitor systemic risk and enhanced authority to resolve systemically significant financial firms. We also believe it would be appropriate to establish a consolidated supervisor of all systemically significant financial firms. The Federal Reserve already plays this role for the largest bank holding companies, but during the financial crisis, the absence of a comparable supervisor for large securities and insurance firms proved to be an enormous problem. The proposal would fill this gap by extending the Federal Reserve's holding company regulation to such firms, which we believe would be appropriate. However, one aspect of the proposal goes much too far, which is to grant broad new authority to the Federal Reserve to override the primary banking supervisor on standards, examination, and enforcement applicable to the bank. Such override power would fundamentally undermine the authority and accountability of the banking supervisor. We also support the proposal to effectively merge the OTS into the OCC with a phase-out of the Federal Thrift Charter. My written testimony responds in detail to the Chairman's questions about options for additional banking agency consolidation by: first, establishing either the Federal Reserve or the FDIC as the single Federal agency responsible for regulating State-chartered banks; second, establishing a single prudential supervisor to supervise all national and State banks; and, third, transferring all holding company regulation from the Federal Reserve to the prudential supervisor. While there are significant potential benefits to be gained from all three proposals, there are also potential costs, especially with removing the Federal Reserve altogether from the holding company regulation of systemically important companies. Finally, we support enhanced consumer financial protection standards and believe that a dedicated consumer protection agency could help to achieve that goal. However, we have significant concerns with the parts of the proposed CFPA that would consolidate all financial consumer protection rulewriting, examination, and enforcement in a single agency which would completely divorce these functions from safety and soundness regulation. It makes sense to consolidate all consumer protection rulewriting in a single agency with the rules applying to all financial providers of a product, both bank and nonbank. But we believe the rules must be uniform and that banking supervisors must have meaningful input into formulating them. Unfortunately, the proposed CFPA falls short on both counts. First, the rules would not be uniform because the proposal would expressly authorize States to adopt different rules for all financial firms, including national banks, by repealing the Federal preemption that has always allowed national banks to operate under uniform Federal standards. This repeal of a uniform Federal standards option is a radical change that will make it far more difficult and costly for national banks to provide financial services to consumers in different States having different rules, and these costs will ultimately be borne by the consumer. The change will also undermine the national banking charter and the dual banking system that have served us well for nearly 150 years. Second, the rules do not afford meaningful input from banking supervisors, even on real safety and soundness issues, because in the event of any disputes, the proposed CFPA would always win. The new agency needs to have a strong mechanism for ensuring meaningful bank supervisor input into CFPA rulemaking. Finally, the CFPA should not take examination and enforcement responsibilities away from the banking agencies. The current bank supervisory process works well where the integration of consumer compliance and safety and soundness supervision provides real benefits for both functions. Moreover, moving bank examination and enforcement functions to the CFPA would only distract it from its most important and daunting implementation challenge--that is, establishing an effective enforcement regime for the shadow banking system of the literally tens of thousands of nonbank providers that are currently unregulated or lightly regulated, like mortgage brokers and originators. The CFPA's resources should be focused on this fundamental regulatory gap rather than on already regulated depository institutions. Thank you very much. " CHRG-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-111hhrg53242--21 Mr. Snook," Thank you, Mr. Chairman, and members of the committee. We appreciate the opportunity to testify at this important hearing. We appreciate your continued leadership on regulatory reform. SIFMA supports efforts to make the regulatory reform changes necessary to restore confidence in the financial markets and meet the challenges of the 21st Century marketplace and to protect consumers and investors. The financial system is critical to the Nation's competitiveness, and reform must provide a durable platform for steady economic growth, employment, and investment. I would like to now highlight elements from our written testimony. Systemic risk has been at the heart of the financial crisis. We have testified before as to the need for a financial markets stability regulator as a first step in addressing the challenges facing financial regulatory reform. Generally, we support Treasury's recommendations for a single accountable systemic risk regulator, balanced with the newly created Financial Services Oversight Council, as it would improve upon the current system. We think this construct should effectively assess threats to financial stability and ensure appropriate action is taken promptly. A Federal resolution authority for certain systemically important financial institutions should be established. Being systemically important in our judgment does not mean too-big-to-fail, but does require an orderly resolution plan should it be needed. The FDIC has broad powers to act as conservator or receiver of a failed or severely troubled bank, but does not have the experience with the operations of other types of systemically important financial institutions. We welcome Treasury's proposal to establish this authority for other institutions, and urge that it draw upon the experience of regulators familiar with the entity being resolved. We support proposals for increased regulation, reporting, and transparency in the derivatives markets. Clearing is a useful tool in the comprehensive risk management framework, and we support clearing of standardized OTC derivative transactions by financial firms whenever possible, but strongly believe there is a role for the continued use of customized contracts, which are employed by thousands of manufacturing and other companies across America every day to manage various kinds of risks. We believe that the transparency needed can readily be achieved without mandating exchange trading of OTC derivative products. SIFMA supports Treasury's proposal to harmonize the regulation of securities and futures. The key concern in this area is that the law should expressly delegate the regulation of financial products such as broad market indices, currencies, and interest rate swaps to the SEC, and nonfinancial products such as commodities to the CFTC. We agree that targeted reforms are needed in order to restore confidence and functionality to the securitization market, one of the keys to a better functioning market broadly, and the industry is working aggressively to make improvements in this area. We support efforts to find appropriate ways to have skin in the game, for securitization market participants to have skin in the game. One mechanism that can promote this goal is the required retention of a meaningful economic interest in securitized exposures, helping to align the incentives of originators and transaction sponsors with those of investors. SIFMA supports strengthening consumer protection regulation, including the creation of national standards governing consumer credit products and lending practices. There are concerns that creating a new agency for these purposes might result in mixed messages and conflicting directives, and therefore may fail to deliver the hoped-for benefits that underlie the suggestion of a new agency. More critical is the balancing of functions of any new consumer protection entity with other regulators. The CFPA as proposed could inadvertently encroach on the jurisdiction of the SEC and the CFTC. And we understand it was not intended to supersede the broad investor protection mandate of these two agencies, but suggest the clarity of a full exclusion for investment products and services regulated by the SEC and CFTC. SIFMA has long advocated the modernization and harmonization of disparate regulatory regimes for brokers, dealers, investment advisers, and other financial intermediaries. Individual investors deserve, and SIFMA supports, the Administration's recent proposal to create a new Federal fiduciary standard of care that supersedes and improves upon existing fiduciary standards, which have been unevenly developed and applied over the years, and which are susceptible to multiple and differing definitions and interpretations under existing Federal and State law. The new Federal standards should function as a standard that is uniformly applied to both advisers and broker-dealers when they provide personalized investment advice to individual investors. When broker-dealers and advisers engage in identical service, they should be held to the same standard of care. Finally, the global nature of financial markets calls for a global approach to regulatory reform. Unless common regulatory standards are applied and enforced across global markets, opportunities for regulatory arbitrage will arise. And so importantly, close cooperation among policymakers on an international basis is essential if we are to effectively address the challenges facing the financial system. We thank you for your time and look forward to your questions. [The prepared statement of Mr. Snook can be found on page 90 of the appendix.] " CHRG-109hhrg31539--205 Mr. Baca," Thank you very much, Mr. Chairman, and Ranking Member Frank, for having this hearing. And thank you, Mr. Bernanke, for being here as well. First, I want to start on the housing crisis. As the housing crisis market slows, areas like California, the Inland Empire where I have quite a few people moving in from L.A., Orange County, into the area, have been heavily dependent on real-estate-related employment will suffer the most. If prices start to drop in San Bernardino County, and homes stay on the market for 5 months instead of the 5 days, it hurts more than just the sellers. It also leads to less work for people, and I state less work for people who build new homes and those who help sell, finance, or insure them. Thousands of people's jobs are at stake, including home construction, real estate agents, mortgage brokers, inspectors, and more. Question number one is what industries of the economy have enough strength to pick up the slack as the housing market continues to cool? And question number two is what will the cooling housing market mean for job growth and unemployment numbers? " CHRG-111hhrg53234--74 Mr. Kohn," We would work closely with them. We already do work with the other banking regulators on FFIEC. We would be part of this council that the Treasury has looking at systemic risk and identifying systemic activities, systemic problems. We have close working relationships with the SEC, and I see that continuing. We basically rely on them for supervision of the individual institutions. But I think this would give us some authority to make sure not only that the individual institution is safe, but that the system is safe, too. " FinancialCrisisInquiry--22 The final crisis and perhaps the most daunting is that we have a severe economic recession going on. While some would say that the financial crisis caused the recession, the experts will analyze that for the coming years to establish the exact causal relationship. But one thing is clear. The U.S. economic growth in the first decade of this century was funded in part by home price appreciation and the ability of homeowners to access the equity in their homes to use for spending. In addition, home mortgage and home equity financing helped drive residential construction activities, which contributed to the economic expansion. The history of past economic cycles and this cycle shows that an economic expansion built on excessive debt or leverage will end in a recession, no matter what triggers it. And this one surely did. This crisis has taught us some very valuable lessons. And let me highlight a few of those that are in my written testimony. First, this credit starts and ends with sound underwriting, a clear assessment of the borrower’s ability to repay the loan. Rating agencies or credit bureaus are no substitute for diligent and independent risk analysis. Second, capital is important. And the leverage of investment banks and other market participants was untenable. While the leverage requirements for a bank holding company may have been better, banks and others should, and undoubtedly will, hold more capital going forward. Third, liquidity is the key. Liquidity allows an institution to meet marginal calls, fund redemptions or pay depositors without having to sell illiquid assets at discounts, which could lead to further losses. And fourth, current accounting rules need to be reviewed. Current rules require banks to reduce reserves against loan losses in good times and build them in bad times. In addition, mark-to-market accounting can become disjointed when there’s no real market for many products. FOMC20080916meeting--73 71,MR. DUDLEY., I think that remains to be discussed with our counterparties. I think we need to have discussions about what would be most effective. Would a big size that's fixed in quantity be most effective? Would an open limit be most effective? I think we have to have those discussions. I think the important thing here--and what we're going for--is credibility. In a crisis you need enough force--more force than the market thinks is necessary to solve the problem--and we're going to have to have discussions to determine how much is enough force. CHRG-111hhrg54867--232 Secretary Geithner," Can I say it slightly differently? Because of the force of the actions that the Congress authorized we took, we did pull the system back from the edge of the abyss, and we are able to wind down some of the emergency authorities necessary to rescue the system. But we still have a very damaged system. There is a lot of challenge ahead for the economy. As many of you observed, we are only just now seeing the economy start to grow again. And it is too early for anyone to declare victory, say this is behind us. And I think anybody who lives in this world would say that there is still a lot of pressure the system is going through. So, it is important that we not declare victory too soon, walk this stuff back prematurely. " CHRG-110hhrg46594--47 Mr. Wagoner," No, sir. I think it is completely due to the credit crisis. And I just give you as an example, sir, that all of us were well on the way with our turnaround which was reflected by stock price improvement and earnings; and, frankly, what happened is the lack of availability of credit at a time when our balance sheets are weakened. This has really hurt not only our ability to fund ourselves but also our consumers' ability to buy cars. " FinancialServicesCommittee--12 Frequently, when we have extreme market volatility, the cry goes out, somewhere quick, ‘‘Let’s shoot the computers.’’ I have never really agreed with that particular position, although I do have an open mind that perhaps some reprogramming may be in order. Specifically, I do believe that we at least need to look and examine the desirability of having stock-specific circuit breakers across all of our markets, and certainly, there is an open question on the impact of canceling trades. How many folks ended up with unintended short positions while arguably adding needed liquidity in a sinking market? But at the end of the day, I think we should tread very, very carefully in this space. Improved technology, rule MNS, have brought great benefits to trading: more competitive markets; cheap- er trades; and really a democratization of investment opportunities. But more importantly, I believe that we need to look beyond simply the mechanics of the panic and look to its likely underlying cause, that being the international debt crisis that is first manifesting itself in Greece. A number of media outlets have spoken to this. We had a CBS–AP report, ‘‘Greek Debt, Trader Error Eyed in Market Selloff,’’ on May 6th: ‘‘Traders were not comforted by the fact that Greece seemed to be working towards a resolution of its debt problems. Instead, they focused on the possibility that other European countries would also run into trouble.’’ Wall Street Journal: ‘‘Many traders worried about the economic situation in Europe. The Dow had already been moving lower as television screens displayed scenes of rioting on Greek streets.’’ Fox Business quoted a managing director of Nye Capital Part- ners: ‘‘The tone and tenor of the global debt crisis has taken over the market. Everything else has taken a back seat.’’ So there is an open question among many in our investing public whether or not we are on the road to becoming Greece ourselves, given that the deficit has increased tenfold in just 2 years, and the President has put forth a budget that will triple the national debt in 10 years. There is fear that Greece is the preview of coming at- tractions to the United States, and no matter how many well-de- signed exits you have, no matter how many well-trained ushers you have, no matter how well-designed your exit plan, if people in the theater sense that something is smoldering, you cannot ultimately remove the conditions of panic. Thank you, Mr. Chairman. I yield back. Chairman K ANJORSKI . Thank you, Mr. Hensarling. We will now hear from the gentleman from Georgia, Mr. Scott, for 1 minute. Mr. S COTT . Thank you, Mr. Chairman. I think what we have here is a clear example of how we as a society have become more the servants of the machine that was created to serve us. Our tech- nology has now far surpassed our human ability to keep up with it. I think we have to move with caution, to make sure we get the right causes of this problem, to understand that our foremost obli- gation at this point is to make sure we have investor confidence, that the American people have confidence in our system. CHRG-110hhrg46595--14 Mr. Watt," Thank you, Mr. Chairman, and thank you for convening the hearing. I have been conducting my own market research for the last 2 weeks, actually, in dealerships, talking to people like Ernel Simpson and George Duran and Reggie Hubbard and Anthony Wilder, who are salespeople and owners of local dealerships. And there is a serious problem exemplified most prominently by Ernel's statement to me that he didn't sell a single car in October of this year. We know there is a crisis. People are not buying. And if people are not buying, there is not going to be any working capital or turnover of money. I also went this morning and looked at the next generation of cars that are out in front of the Botanical Gardens. And I want to encourage my colleagues, if they have an opportunity today, to do that. All of them are in the development stage. But if these manufacturers go into bankruptcy, they will never get out of the development stage and into the implementation stage, which is what is necessary to maintain the manufacturing base here in the United States. So this is important. I am trying to keep an open mind, learning as much as I can about the crisis and what we can reasonably do to bridge this gap. I think we need to do something, and I am hopeful that we will come up with a solution. I appreciate the witnesses being here, and I yield back the balance of my time. " CHRG-111hhrg54869--102 Mr. Volcker," I said people had begun working on the credit default swap problem in terms of the clearance and settlement procedures, even before the crisis, on a voluntary basis, with some success and some great effort. Now the crisis has exposed it and the government stepped in and made proposals. I don't know how many of them require legislation. At some point, it will require some legislation. But now there is a lot of progress in forcing this trading into clearinghouses or organized exchanges with the whole panoply of rules that implies, collateral requirements, protection against default and so forth. So that is a big step forward. You might not have had the AIG problem which has loomed so large, had all those arrangements been in place before, because there were no agreed--well, there was an appropriate basis in that respect, some agreed conventions, but AIG did not sufficiently collateralize and protect against risk, given what happened. They thought they had no risk because they were so big and strong. Well, when they weren't so big and strong, you had a problem. That is a big problem, and it is one of the areas in which I am sure that big progress is going to be made and is being made. Mr. Miller of North Carolina. Do you think that the margin requirements to the collateral requirement is sufficient with respect to-- "