[Senate Hearing 111-614]
[From the U.S. Government Printing Office]




                                                        S. Hrg. 111-614

                          FINANCIAL REGULATION

=======================================================================

                                HEARINGS

                               before the

                              COMMITTEE ON
               HOMELAND SECURITY AND GOVERNMENTAL AFFAIRS
                          UNITED STATES SENATE

                                 of the

                     ONE HUNDRED ELEVENTH CONGRESS

                             FIRST SESSION

                               ----------                              

                            JANUARY 21, 2009

  WHERE WERE THE WATCHDOGS? THE FINANCIAL CRISIS AND THE BREAKDOWN OF 
                          FINANCIAL GOVERNANCE

                             MARCH 4, 2009

WHERE WERE THE WATCHDOGS? SYSTEMIC RISK AND THE BREAKDOWN OF FINANCIAL 
                               GOVERANCE

                              MAY 21, 2009

   WHERE WERE THE WATCHDOGS? FINANCIAL REGULATORY LESSONS FROM ABROAD

                               ----------                              

       Available via http://www.gpoaccess.gov/congress/index.html

                       Printed for the use of the
        Committee on Homeland Security and Governmental Affairs







                                                        S. Hrg. 111-614

                          FINANCIAL REGULATION

=======================================================================

                                HEARINGS

                               before the

                              COMMITTEE ON
               HOMELAND SECURITY AND GOVERNMENTAL AFFAIRS
                          UNITED STATES SENATE

                                 of the

                     ONE HUNDRED ELEVENTH CONGRESS

                             FIRST SESSION

                               __________

                            JANUARY 21, 2009

  WHERE WERE THE WATCHDOGS? THE FINANCIAL CRISIS AND THE BREAKDOWN OF 
                          FINANCIAL GOVERNANCE

                             MARCH 4, 2009

WHERE WERE THE WATCHDOGS? SYSTEMIC RISK AND THE BREAKDOWN OF FINANCIAL 
                               GOVERANCE

                              MAY 21, 2009

   WHERE WERE THE WATCHDOGS? FINANCIAL REGULATORY LESSONS FROM ABROAD

                               __________

       Available via http://www.gpoaccess.gov/congress/index.html

                       Printed for the use of the
        Committee on Homeland Security and Governmental Affairs




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        COMMITTEE ON HOMELAND SECURITY AND GOVERNMENTAL AFFAIRS

               JOSEPH I. LIEBERMAN, Connecticut, Chairman
CARL LEVIN, Michigan                 SUSAN M. COLLINS, Maine
DANIEL K. AKAKA, Hawaii              TOM COBURN, Oklahoma
THOMAS R. CARPER, Delaware           JOHN McCAIN, Arizona
MARK L. PRYOR, Arkansas              GEORGE V. VOINOVICH, Ohio
MARY L. LANDRIEU, Louisiana          JOHN ENSIGN, Nevada
CLAIRE McCASKILL, Missouri           LINDSEY GRAHAM, South Carolina
JON TESTER, Montana
ROLAND W. BURRIS, Illinois
MICHAEL F. BENNET, Colorado

                  Michael L. Alexander, Staff Director
                    Beth M. Grossman, Senior Counsel
                      Jonathan M. Kraden, Counsel
 Ryan P. McCormick, Legislative Assistant, Office of Senator Joseph I. 
                               Lieberman
     Brandon L. Milhorn, Minority Staff Director and Chief Counsel
                Asha A. Mathew, Minority Senior Counsel
              Mark B. LeDuc, Minority Legislative Counsel
           Clark T. Irwin, Minority Professional Staff Member
                  Trina Driessnack Tyrer, Chief Clerk
         Patricia R. Hogan, Publications Clerk and GPO Detailee
                    Laura W. Kilbride, Hearing Clerk

















                            C O N T E N T S

                                 ------                                
Opening statements:
                                                                   Page
    Senator Lieberman........................................ 1, 39, 73
    Senator Collins.......................................... 3, 40, 74
    Senator Levin................................................     5
    Senator Tester.............................................. 27, 58
    Senator Burris.............................................. 30, 63
    Senator McCaskill............................................    93
Prepared statements:
    Senator Lieberman.................................... 344, 357, 361
    Senator Collins...................................... 346, 359, 364
    Senator Levin with an attachment.............................   349

                               WITNESSES
                      Wednesday, January 21, 2009

Eugene L. Dodaro, Acting Comptroller General of the United 
  States, U.S. Government Accountability Office, accompanied by 
  Richard J. Hillman, Managing Director, Financial Markets and 
  Community Investment, U.S. Government Accountability Office, 
  and Thomas McCool, Director, Center for Economics, Applied 
  Research and Methods, U.S. Government Accountability Office....     8
Howell E. Jackson, James S. Reid Jr. Professor of Law, Harvard 
  Law School.....................................................    11
Steven M. Davidoff, Professor of Law, University of Connecticut 
  School of Law..................................................    16

                        Wednesday, March 4, 2009

Robert E. Litan, Ph.D., Vice President for Research and Policy, 
  Ewing Marion Kauffman Foundation...............................    42
Damon A. Silvers, Deputy Chair, Congressional Oversight Panel, 
  and Associate General Counsel, AFL-CIO.........................    47
Robert C. Pozen, Chairman, MFS Investment Management.............    51

                         Thursday, May 21, 2009

David W. Green, Former Head of International Policy, Financial 
  Services Authority, United Kingdom.............................    76
Jeffrey Carmichael, Ph.D., Chief Executive Officer, Promontory 
  Financial Group Australasia....................................    78
W. Edmund Clark, Ph.D., President and Chief Executive Officer, TD 
  Bank Financial Group...........................................    81
David G. Nason, Managing Director, Promontory Financial Group, 
  LLC............................................................    84

                     Alphabetical List of Witnesses

Carmichael, Jeffrey, Ph.D.:
    Testimony....................................................    78
    Prepared statement...........................................   318
Clark, W. Edmund, Ph.D.:
    Testimony....................................................    81
    Prepared statement...........................................   326
Davidoff, Steven M.:
    Testimony....................................................    16
    Prepared statement...........................................   143
Dodaro, Eugene L.:
    Testimony....................................................     8
    Prepared statement...........................................   105
Green, David W.:
    Testimony....................................................    76
    Prepared statement...........................................   311
Jackson, Howell E.:
    Testimony....................................................    11
    Prepared statement...........................................   133
Litan, Robert E., Ph.D.:
    Testimony....................................................    42
    Prepared statement...........................................   158
Nason, David G.:
    Testimony....................................................    84
    Prepared statement...........................................   334
Pozen, Robert C.:
    Testimony....................................................    51
    Prepared statement...........................................   304
Silvers, Damon A.:
    Testimony....................................................    47
    Prepared statement with attachments..........................   178

                                APPENDIX

Congressional Oversight Panel, ``Special Report on Regulatory 
  Reform,'' January 2009, submitted by Mr. Silvers...............   190
Responses to post-hearing questions for the Record from:
    Mr. Dodaro...................................................   341
GAO Report titled ``Financial Regulation--A Framework for 
  Crafting and Assessing Proposals to Modernize the Outdated U.S. 
  Financial Regulatory System,'' January 2009, submitted by Mr. 
  Dodaro.........................................................   366

 
                     WHERE WERE THE WATCHDOGS? THE
                   FINANCIAL CRISIS AND THE BREAKDOWN
                        OF FINANCIAL GOVERNANCE

                              ----------                              


                      WEDNESDAY, JANUARY 21, 2009

                                     U.S. Senate,  
                           Committee on Homeland Security  
                                  and Governmental Affairs,
                                                    Washington, DC.
    The Committee met, pursuant to notice, at 2:07 p.m., in 
room SD-342, Dirksen Senate Office Building, Hon. Joseph I. 
Lieberman, Chairman of the Committee, presiding.
    Present: Senators Lieberman, Levin, Tester, Burris, and 
Collins.

            OPENING STATEMENT OF CHAIRMAN LIEBERMAN

    Chairman Lieberman. The hearing will come to order. Good 
afternoon and welcome. As our Nation begins work under our 
brand-new President to recover from the worst financial crisis 
since the Great Depression, we must ask how and why it 
happened. Is the existing U.S. financial regulatory system 
adequately equipped to protect consumers, investors, and our 
economy?
    A new report \1\ by the Government Accountability Office 
(GAO) that is the focus of today's hearing lays out a very 
persuasive case that the answer to that question is ``no.'' 
Over time, as the financial services sector has grown, moved in 
new directions, or suffered from scandals or crises, Congress 
has usually responded in a piecemeal fashion, grafting new 
regulatory agencies on top of one another. As a result, 
responsibilities for overseeing the financial services industry 
are today shared by over 200 different regulatory agencies at 
the Federal and State level, not to mention numerous self-
regulatory organizations, such as the stock exchanges.
---------------------------------------------------------------------------
    \1\ The GAO Report referenced by Chairman Lieberman appears in the 
Appendix on page 366.
---------------------------------------------------------------------------
    GAO's report concludes that our current regulatory 
structure is outdated and unable to meet today's challenges and 
highlights several key changes in financial markets that have 
exposed significant gaps and limitations in our ability to 
protect the public interest. Some of GAO's observations are 
familiar to Members of this Committee. We have heard over the 
years about the careless lending practices that led to the 
current subprime mortgage crisis, the increasing number of 
overleveraged financial institutions that need to be bailed out 
by the government, the failures of credit-reporting agencies to 
provide credible ratings for increasingly complex financial 
products, and the inability of regulators to uncover or in some 
sense respond to the world's largest ever Ponzi scheme.
    It gives this Committee no satisfaction to note that some 
of these shortcomings were highlighted over 6 years ago in our 
investigation both by the full Committee and the Permanent 
Subcommittee on Investigations following the collapse of Enron. 
And there we noted the inadequacies of the credit-rating 
agencies and the failures of regulators to notice the red flags 
that warned of massive financial fraud. Rather than 
contributing to the stability of financial markets, our 
fractured regulatory system seems to encourage financial 
institutions to play regulators against one another. New and 
complex financial products have been created that bypass these 
antiquated regulatory regimes. In some derivatives markets, the 
regulation is absent altogether.
    All in all, these problems surely contributed to the build-
up of systemic risks and the eventual breakdown in credit and 
financial markets in the last year that has put millions of 
people out of work, destroyed so much of the savings and home 
values of the American people, and broken our economic 
confidence in the future.
    We have called this hearing today to take a government-wide 
look at our existing structure of regulation of financial 
services. We have asked today's witnesses--Gene Dodaro, Acting 
Comptroller General of the United States, Professor Howell 
Jackson of the Harvard Law School, and Professor Steven 
Davidoff of the University of Connecticut School of Law--to 
tell us if the current regulatory system adequately protects 
consumers, preserves the integrity of our markets, and protects 
the safety and soundness of our financial institutions.
    Given the scope of the crisis we face today on top of the 
crises that we have gone through over recent years, including--
and I go back a little further here--the savings and loan 
scandals, the dot-com bubble, and the Enron accounting mess 
that I mentioned, we think that now is the time to think, not 
just about regulatory reform, but about regulatory 
reorganization. Personally, I have not concluded if the way to 
fix our current system is to establish a single overarching 
super-regulatory agency, like that which exists in other 
developed countries, if it would be wiser simply to improve the 
ability of the existing regulatory bodies, or if the answer is 
somewhere in between.
    However, what I have concluded is that there are serious 
deficiencies in our current patchwork regulatory system, and 
before Congress can fix them wisely--and in a way that will not 
just respond to the last economic crisis or scandal but prevent 
the next one--I think we have to step back and carefully 
scrutinize how the pieces would best fit together. And that, I 
believe, is what our Committee is well suited to do.
    President Obama has declared that reforming the current 
financial regulatory structure will be one of his top 
priorities in this first year of his presidency, and I think we 
all welcome that. Such legislation will come out of the Senate 
Banking Committee, although it does touch on agencies that are 
regulated by other committees, such as the Finance Committee, 
the Agriculture Committee, and the Commerce Committee. However, 
I believe that this Committee's unique authority concerning 
governmental organization and oversight, as well as the special 
investigative power of our Permanent Subcommittee on 
Investigations, requires us to get involved in this review and 
will enable us to help the Senate reach the right conclusions 
about how we restructure our system of financial governance to 
prevent future financial crises that can cause terrible 
economic pain.
    You may ask, how are we going to do this if the bill is not 
coming out of our Committee? Well, we certainly can do this 
first with a series of hearings and investigations; then 
depending on the interest and will of Committee Members, to 
express our conclusions in a report, which we will forward to 
the Banking Committee; and perhaps, if we are so moved, to 
offer amendments on the floor later this year when the fiscal 
regulation reform proposal reaches the floor.
    In any case, this is a matter of importance and urgency to 
our country, and I do believe that we have something to 
contribute to the Senate discussion and legislation.
    Senator Levin. Senator Burris is here, and I would like to 
welcome him, since it is his first hearing.
    Chairman Lieberman. Senator Levin notes that Senator Burris 
is here. I have to get over a bad habit where I refer to him as 
``General Burris'' because we were both Attorneys General, and 
we love that title. But, Senator Burris, I really welcome you. 
I know of your work, and although you came here, shall we say, 
in uncertain circumstances, I know you well enough to know that 
you are very well qualified to be an outstanding Member of the 
Senate and will contribute greatly to the work of this 
Committee. So I am delighted that you have chosen to be on the 
Committee, and we welcome you here today.
    Senator Burris. Thank you, Mr. Chairman.
    Chairman Lieberman. A pleasure. Senator Collins.

              OPENING STATEMENT OF SENATOR COLLINS

    Senator Collins. Thank you, Mr. Chairman. Let me also add 
my words of welcome to our newest Committee Member. I would 
also inform the Members of this Committee that we will be 
adding Members on the Republican side. I am very pleased that 
Senators McCain, Ensign, and Graham will be joining the 
Committee as well. So, once again, we will have a great 
complement of Members with which to do our work.
    Chairman Lieberman. And with that group, I might add, 
lively hearings and deliberations.
    Senator Collins. This is true, Mr. Chairman.
    Mr. Chairman, let me start by thanking you for holding this 
hearing today. I spent 5 years in State government overseeing 
financial regulation, so I have a great deal of interest in 
this area.
    The spiraling financial crisis has harmed virtually every 
American family. December's job losses were the worst monthly 
decline since 1945 and drove the unemployment rate above 7 
percent. Individual retirement accounts and college savings 
accounts, as well as university endowments and public and 
private pension funds, have suffered huge losses. Consumer 
credit and mortgage availability have become more restricted.
    In the past year, more than one million homes have been 
foreclosed upon, and foreclosure proceedings are targeting two 
million more. Home prices are still falling, and at least 14 
million households owe more on their mortgages than their homes 
are worth. The current crisis has its roots in the financial 
system, where a combination of low interest rates, reckless 
lending, complex new instruments, securitization of assets, 
poor disclosure and understanding of risks, excessive leverage, 
and inadequate regulation poisoned the normal flows of credit 
and commerce.
    The financial system itself has not escaped this carnage. A 
year ago, American capital markets were dominated by five large 
investment firms: Bear Stearns, Lehman Brothers, Merrill Lynch, 
Morgan Stanley, and Goldman Sachs. Now they have either failed, 
been sold to banks, or have converted to bank holding 
companies.
    Tens of thousands of banking and investment jobs have 
disappeared. A year ago, we thought a ``tarp'' was for covering 
your roof after a hurricane. Now the Troubled Asset Relief 
Program (TARP), originally touted as a means for the Treasury 
Department to buy troubled assets from banks, has morphed into 
a mechanism for buying hundreds of billions of dollars in bank 
preferred stock and warrants in order to inject capital into 
those financial institutions. It is not sufficient for Congress 
to continue to infuse new money into the TARP, or simply to 
pass an economic stimulus package. We must also ask how to 
repair our system of financial regulation to minimize the risk 
that another crisis such as this might build up undetected and 
unchallenged.
    As we consider the options for reform, the GAO's new report 
on financial regulation will be a valuable guidebook. It 
describes the structure of the current system, explains the 
system's inability to cope with shifting circumstances, and 
proposes criteria for judging reforms. GAO sums up our 
challenge: ``As the Nation finds itself in the midst of one of 
the worst financial crises ever, it has become apparent that 
the regulatory system is ill-suited to meet the Nation's needs 
in the 21st Century.'' That judgment confirms what this 
Committee has found in our hearings on commodity speculation 
and derivatives trading; that is, there are too many gaps 
between jurisdictions, too many financial entities and 
instruments that can create huge risks but are largely free 
from regulatory requirements, and too little attention paid to 
systemic risk.
    We now understand that everyday activities by mortgage 
brokers, hedge funds, over-the-counter traders, investment 
banks, Freddie Mac and Fannie Mae, and others dealing in 
mortgage-backed securities, credit default swaps, and other 
instruments can create a crisis that affects virtually every 
home and business in America. Yet, of the dozen Federal 
agencies and hundreds of State agencies that are involved in 
financial regulation, it appears that not one is tasked with 
detecting and assessing systemic risks. We have seen the 
consequences of that flaw. The proliferation of unregulated and 
unreported credit default swaps created spider webs of 
commitments so that a few failures rippled into the destruction 
of major investment banks.
    By accident or by design, there are many key players in the 
modern regulatory system who are unregulated or lightly 
regulated, including mortgage brokers, self-regulating 
exchanges and credit-rating agencies, hedge funds, and non-bank 
lenders. Without additional transparency into their operations, 
a new systemic risk monitor would find its mission difficult to 
achieve. These difficulties have become so obvious that it is 
now common to hear government and industry officials, as well 
as academic experts, calling for a new systemic risk agency or 
monitor and for a restructuring of regulatory agencies.
    In November, I introduced a bill to correct two other 
glaring gaps in our regulatory system: The lack of explicit 
regulatory authority over investment bank holding companies, 
and the lack of transparency for credit default swaps. 
Regulatory reform is absolutely essential to restoring public 
confidence in our financial markets. I am convinced we could 
continue to invest billions of dollars in banks, but that if we 
do not put in place a new, strong regulatory system, the 
public's confidence, which is essential to the operation of our 
markets, will not be restored. America's consumers, workers, 
savers, and investors deserve the protection of a new 
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.
    Mr. Chairman, I am going to ask unanimous consent that the 
remainder of my statement be introduced into the record since I 
realize we have only limited time this afternoon, and I could 
go on forever on what is one my favorite issues.\1\ Thank you.
---------------------------------------------------------------------------
    \1\ The prepared statement of Senator Collins appears in the 
Appendix on page 346.
---------------------------------------------------------------------------
    Chairman Lieberman. Needless to say, I would be interested 
in having you go on forever, but without objection, we will 
enter the statement in the record.
    Senator Levin is the Chairman of the Permanent Subcommittee 
on Investigations. He has some thoughts and plans with regard 
to the topic of our inquiry today, and therefore, I would like 
to call on him on this occasion as well for an opening 
statement.

               OPENING STATEMENT OF SENATOR LEVIN

    Senator Levin. Well, thank you, Mr. Chairman. Again, I 
would be happy to have this time deducted from my question 
period.
    Chairman Lieberman. Not at all.
    Senator Levin. Mr. Chairman, I thank you and the Ranking 
Member for holding this hearing. History has proven time and 
again that markets are not self-policing. The Pecora hearings 
before a Senate committee in the 1930s pulled back the curtain 
on the abuses that gave rise to the Great Depression. Hearings 
since then have documented a litany of abuses by financial 
firms trying to take advantage of investors and markets for 
private gain.
    In recent years, for example, Congressional hearings--
including by the Permanent Subcommittee on Investigations 
(PSI), which I chair--showed how Enron cooked its books, 
deliberately distorted energy prices, and cheated on its taxes, 
becoming the seventh largest corporation in the country before 
its collapse. Our Subcommittee hearings also showed how leading 
U.S. financial institutions such as Citigroup, JPMorgan, and 
Merrill Lynch willingly participated in deceptive transactions 
to help Enron inflate its earnings. Some of our other hearings 
of PSI have disclosed that U.S. corporations engaged in 
misleading accounting, offshore tax abuses, excessive stock 
option payments, and other disturbing practices.
    Our hearings in 2007 showed how a single hedge fund named 
Amaranth made massive commodity purchases on both regulated and 
unregulated energy markets to profit from distorted energy 
prices that they helped generate, causing U.S. consumers to pay 
more. Subcommittee hearings last year showed how Lehman 
Brothers, Morgan Stanley, and others helped offshore hedge 
funds dodge payment of U.S. taxes on U.S. stock dividends by 
facilitating complex swap agreements and stock loan 
transactions. Other congressional hearings have shown how 
Countrywide and others sold abusive mortgages, overcharged 
borrowers, and offloaded defective mortgage-based securities 
onto the market.
    Part of the explanation for these recent abuses is a 
history of actions that have gradually weakened our financial 
regulatory system. Here is a chart, which I guess our audience 
can see, but we cannot, so I will quickly read what is on 
it.\1\ The chart lists just a few of those actions over the 
last 10 years. Some of these actions are the following:
---------------------------------------------------------------------------
    \1\ The chart referenced by Senator Levin appears in the Appendix 
on page 356.
---------------------------------------------------------------------------
    Back in October 1998, at the request of the Securities and 
Exchange Commission (SEC), the Treasury Department, and the 
Federal Reserve, Congress blocked funding for the Commodity 
Futures Trading Commission (CFTC) regulation of over-the-
counter derivatives.
    In 1999, the Gramm-Leach-Bliley Act repealed the Glass-
Steagall Act of 1933, which separated banks, broker-dealers, 
and insurers.
    In December 2000, the Commodity Futures Modernization Act 
prohibited swaps regulation, and opened the Enron loophole 
allowing unregulated energy markets for large traders.
    In August 2003, the SEC delayed requiring auditors of 
private broker-dealers to register with Public Company 
Accounting Oversight Board rules.
    In June 2004, the SEC weakened the net capital rule for 
securities firms.
    In June 2006, the Court of Appeals invalidated the SEC 
regulation requiring hedge fund registration. We needed the SEC 
to come back to us and to ask for legislation. That did not 
happen.
    In December 2007, the SEC allowed foreign companies trading 
on U.S. exchanges to use international financial reporting 
standards without a reconciliation to U.S. generally accepted 
accounting principles.
    And these are just a few of the actions which have been 
taken.
    It hasn't been all one way, although it has mostly been one 
way. After the Enron scandal, we were able to enact the 
Sarbanes-Oxley Act that strengthened oversight of the 
accounting profession, required stronger financial controls, 
and made a number of other improvements. Last year, we 
successfully closed the Enron loophole which barred government 
oversight of electronic energy markets for large traders. There 
is still more reform in that area needed. But, overall, 
stronger market regulation has been the exception, not the 
rule, and had to be won despite naysayers claiming that markets 
work best with minimal regulation. The current crisis shows 
that minimal regulation is a recipe for disaster, an overhaul 
of Wall Street regulation is long overdue, and Congress needs 
to act now to fix a broken system.
    As Congress and the new Administration begin the work of 
financial restructuring and our Committee begins to examine 
these issues, I just want to briefly offer a few observations 
about needed financial reforms. The first is that Congress 
needs to put a cop on the beat in every financial market with 
authority to police every type of market participant and 
financial instrument to stop the abuses. We need to eliminate 
the statutory barriers, for example, that prohibit Federal 
regulation of credit default swaps, hedge funds, and derivative 
traders. We need to enact new limits on high-risk activities 
including preventing banks from running their own hedge funds 
and requiring the end of abusive offshore activities. Congress 
also needs to reduce the concentration of risk to the taxpayer 
by preventing any one bank from holding more than 10 percent of 
U.S. financial deposits, and to institute new protections to 
stop financial institutions from profiting from practices that 
abuse investors and consumers. I believe that we need to act on 
the substance of these abuses and to fill these gaps.
    Finally, Mr. Chairman, let me just add one other thought. 
The Chairman and Ranking Member are undertaking a very 
important mission, which is to look at the structure of the 
regulations because that is within the jurisdiction of this 
Committee. And I do not want to, in any way, minimize the 
importance of that effort. But we also need to make sure that 
this effort puts additional pressure on the committees that 
have the substantive jurisdiction to take the steps necessary 
to close the gaps that have been created in this system, the 
regulatory gaps so big that some of the greediest members of 
our society have been able to very easily walk through the 
gaps, making billions of dollars for themselves.
    And so, again, I want to commend you, Mr. Chairman. This is 
the more difficult part of the effort, the structuring part, 
and it is important to try to reach conclusions as to which 
agency is the proper agency to do the regulation. That is the 
who. But I believe the more urgent item, which I hope this 
effort will help support, is not so much the who, as important 
as that is; it is the whether--whether we are going to get a 
cop back on the beat. And this effort of our Chairman and our 
Ranking Member is, I know, aimed at supporting that goal 
because both of them have expressed and through their actions 
on this Committee have indicated the importance of the 
substantive reforms that need to be made to fill the gaps that 
have been created and the holes that have been gone through by 
too many greedy folks. And I want to commend you, Mr. Chairman, 
and our Ranking Member, Senator Collins, for your effort.
    But, again, I just think we have to make sure that our 
effort in some way supports the critical substantive changes 
which both of you have spoken about, introduced legislation on, 
and fully support. I thank you.
    Chairman Lieberman. Thanks, Senator Levin. Your statement 
means a lot to me. I appreciate what you have said. That is 
exactly what we hope to do. Your support obviously will help us 
to do that. I think we can, through these hearings, both learn 
and educate others, and then reach conclusions which can help 
us to be advocates for the most effective regulation of the 
financial sectors of our economy that we are capable of doing.
    I like what Senator Levin says, and if I may again go back 
to our earlier days as attorneys general, Senator Burris, there 
is a role within the chamber for advocacy among our colleagues 
for the most comprehensive and toughest regulation in this 
particular area because so much suffering has resulted from the 
lack of such.
    Thanks, Senator Levin.
    Let us go right to our witnesses now. First we are going to 
hear from Gene Dodaro, who, as I mentioned, is Acting 
Comptroller General. I will say for the record that Mr. Dodaro 
is accompanied by Richard Hillman, Managing Director of the 
Financial Markets and Community Investment Section of GAO; and 
Thomas McCool, Director of the Center for Economics, Applied 
Research, and Methods within GAO.
    Thanks for being here. Thanks for an excellent foundational 
report, which we ask you to testify on now.

TESTIMONY OF EUGENE L. DODARO,\1\ ACTING COMPTROLLER GENERAL OF 
   THE UNITED STATES, U.S. GOVERNMENT ACCOUNTABILITY OFFICE, 
ACCOMPANIED BY RICHARD J. HILLMAN, MANAGING DIRECTOR, FINANCIAL 
       MARKETS AND COMMUNITY INVESTMENT, U.S. GOVERNMENT 
ACCOUNTABILITY OFFICE, AND THOMAS MCCOOL, DIRECTOR, CENTER FOR 
   ECONOMICS, APPLIED RESEARCH AND METHODS, U.S. GOVERNMENT 
                     ACCOUNTABILITY OFFICE

    Mr. Dodaro. Thank you very much, Mr. Chairman. Good 
afternoon to you, Ranking Member Senator Collins, and other 
Members of the Committee. We are very pleased to be here today 
to assist your deliberations on the financial regulatory 
system.
---------------------------------------------------------------------------
    \1\ The prepared statement of Mr. Dodaro appears in the Appendix on 
page 105.
---------------------------------------------------------------------------
    As was mentioned, our report was intended to provide a 
foundation for how the system has evolved over the last 150 
years, what changes have occurred in the markets that have 
challenged that regulatory system and caused some of the 
fissures that we have seen, and to put forth a framework for 
helping the Congress craft and evaluate proposals in order to 
modernize the system. Our basic conclusion is the system is 
outdated, it is fragmented, and it is ill suited to meet the 
21st Century challenges.
    Now, there are many reasons why we come to that conclusion 
in the report, but I will highlight three main points right 
now.
    First is that regulators have struggled and often failed to 
address the systemic risk of large financial conglomerates or 
to adequately ensure that those entities manage their own 
risks. Now, over the last two decades, financial conglomerates 
have developed through mergers and acquisitions, and they have 
developed and gotten into banking, securities, insurance, and a 
wide variety of services. And while this has occurred, 
basically our financial regulatory structure has remained 
relatively the same, set up on a functional basis. This has 
caused tremendous coordination problems, which are documented 
in some of our reports, and raises questions about the 
authorities and the tools available to regulators in order to 
address these concerns.
    A vivid example is the difficulty and the ultimate failure 
of the SEC's consolidated supervision program, which failed to 
address the holding company risk of many of the investment 
banks over this period of time. Our reports have also 
documented some of the challenges that the Office of Thrift 
Supervision had in managing such--or regulating holding 
companies activities of the type that AIG had conducted.
    The second major trend is the fact that the financial 
regulators have had to deal with now some of the problems that 
have been created by entities that have been less regulated. 
These include the non-bank mortgage lenders, the hedge funds, 
and the credit-rating agencies.
    For example, just to give you some significance of the size 
of this, in 2006, for the mortgage origination loans for 
subprime and non-prime entities, of those 25 institutions that 
made those loans, which made up about 90 percent of all loans--
it is about $543 billion in loans. Of the 25 entities, only 
four were not non-bank lenders. So you had a lot of activity 
going on that was growing over this period of time that was not 
subject to the same type of regulation that commercial banks 
were experiencing during this period of time.
    The third trend was the emergence of a wide variety of 
complex financial products, as has been referenced here in the 
opening statements: Collateralized debt obligations, credit 
default swaps, over-the-counter derivatives, and mortgage 
products that were innovative and did not have the type of 
disclosures that were needed. All this confused investors and 
others and complicated attempts to have a complete picture of 
this.
    The other conclusion that we come to is there is no one 
central entity that is basically charged with looking at risk 
across the system, and this is a major deficiency in the 
current structure that needs attention.
    Our view is that reform is urgently needed, and unless it 
is approached and dealt with soon, the vulnerabilities that we 
have all talked about this morning are going to continue to 
remain in the system. And that just can't be as we go forward 
as a country and try to stabilize the system and move forward 
in economic development.
    Our framework is intended, though, to say a couple things. 
One, the reform needs to be approached in a comprehensive 
manner so that we do not react as a country, again, in a 
fragmented approach. And our nine characteristics that we set 
out are intended to help in that regard to make sure that all 
critical elements are addressed.
    Those nine characteristics deal with a couple of very 
important topics. I will just highlight a few quickly.
    First, we believe there need to be a clear articulation of 
the goals of the regulatory system set in statute. That would 
provide consistency over time and also enable Congress to hold 
the regulators accountable for achieving those results.
    It has to be appropriately comprehensive, another 
characteristic. We need to close the gaps with some of the 
large entities that are posing risk and many of the products. 
We have to move to both cover the entities as well as the 
complexity of these financial products.
    It has to be systemwide. Somebody needs to be in charge of 
monitoring the system and focusing on the development of risk 
going forward. We all know where the risks are now, but they 
are likely to change over a period of time. So we need to close 
the gaps and put a process in place to monitor this on an 
ongoing basis.
    It needs to be flexible and adaptable. We need innovation 
to allow for capital formation, but somebody has to make 
determinations on what the level of risk is that is acceptable 
with those innovations and make some early decisions and not 
wait until the consequences have become so dire over time.
    We need to have an efficient system. There is a lot of 
overlap right now. The overlap can be dealt with as part of the 
reform.
    There need to be strong consumer protections. It is clear 
from our work and the work of others, as referenced in Senator 
Levin's comments and the opening statements both by the 
Chairman and Ranking Member, disclosures have not been 
adequate.
    There also needs to be greater attention to financial 
literacy efforts. We have looked at the entity that has been 
put in place in the Federal Government to provide that, but it 
has not been resourced properly, and not enough attention has 
been given to that particular area.
    We have to make sure that the regulators are independent, 
resourced properly to preserve that independence, and given the 
necessary authority to move forward.
    And, finally, we need to protect the taxpayers. Any risks 
that occur in the future should be borne by the entities being 
regulated and not by the taxpayer. That needs to be our goal, 
and we need to minimize taxpayer exposure so we do not go 
through again what we are currently going through across the 
country.
    This is a very important initiative. GAO is pleased to 
assist this Committee and stands ready to help this Committee 
and the Congress deal with these very important issues and 
decisions going forward. And my colleagues and I would be happy 
to answer any of your questions at the appropriate time this 
afternoon.
    So thank you very much.
    Chairman Lieberman. Thanks very much, Mr. Dodaro. That is a 
very good beginning for us.
    We are grateful that Professor Howell Jackson from Harvard 
is here, and we are also grateful that President Obama and the 
new Administration are not taking everybody from the Harvard 
Law School faculty. [Laughter.]
    In fact, if I am correct, the President's nomination of 
Dean Elena Kagan to be Solicitor General has moved you now to 
be the Acting Dean of the Law School. Is that right?
    Mr. Jackson. That is true.
    Chairman Lieberman. If so, I congratulate you and wish you 
well. Thanks for your testimony. We will hear it now.

TESTIMONY OF HOWELL E. JACKSON,\1\ JAMES S. REID JR. PROFESSOR 
                   OF LAW, HARVARD LAW SCHOOL

    Mr. Jackson. Thank you very much. It is a pleasure to be 
here, Senator Lieberman and Senator Collins. I am delighted to 
have a chance to participate in this hearing and begin the 
process, I hope, of genuine and serious regulatory reform in 
this country, which is long overdue.
---------------------------------------------------------------------------
    \1\ The prepared statement of Mr. Jackson appears in the Appendix 
on page 133.
---------------------------------------------------------------------------
    Let me begin by just commending Government Accountability 
Office for its fine report. I think it does an excellent job 
both pulling together its prior work on the subject and also 
laying out the major weaknesses in our regulatory structure. 
And I agree with almost everything that is in the report. The 
regulatory gaps that exist have created serious problems for 
our economy. There is a serious mismatch between our regulatory 
structure and the 21st Century financial services industry, 
particularly to the extent that financial conglomerates 
dominate and are able to play off different regulatory agencies 
against each other and find this unregulated space to expand 
products.
    I think that one of the things the report highlights in 
passing that is important to recognize is the world has really 
moved ahead of us in the area of regulatory reform. If you go 
around the major countries and look at the legislation that 
they have been adopting over the past 5 to 10 years, it has all 
been a movement towards consolidated supervision that puts us 
at a serious disadvantage.
    We have the anomalous situation in this country of having 
the world's most expensive regulatory structure in both 
absolute terms and relative terms, but one that has failed to 
provide us the kind of protections that we need. So this 
Committee's agenda is very much in need of setting an agenda 
for the whole Congress.
    What I thought I would do is comment upon five areas in 
which I thought it would be useful to discuss some of the 
ramifications of the GAO study in areas where I think the 
weaknesses are particularly important for this Committee to 
note.
    The first has been touched upon, and I just want to talk 
about it a little bit more, which is the absence of a market 
stability regulator, something that Senator Collins mentioned, 
and it is certainly the case that this is a problem.
    The Federal Reserve Board was set up to be our market 
stability regulator in a time when systemic risks were thought 
to lie solely with depository institutions, with banks, and 
having a lender of last resort function, oversight of bank 
holding companies, and member banks was thought to be an act of 
protection, and I think in the middle of the 20th Century that 
was the case. Since the middle of the 20th Century, the role of 
depository institutions has declined. Other sectors, most 
notably capital market sectors, have expanded dramatically. And 
it is not surprising today that when we look to see where the 
system risks came from, they came from other sectors of the 
economy. They came from the investment banking sector; they 
came from the over-the-counter (OTC) derivatives area; they 
came from innovations in mortgage lending--all things that were 
not contemplated in the past. And so we need to have a 
regulator of market stability that can see all potential 
sources of regulatory risk, including insurance companies and 
other areas of the economy.
    I think that it is appropriate to think of the Federal 
Reserve Board as the candidate for having that expanded power, 
and I know today is not the day to talk about the exact 
structure of regulatory reform. But I would just point out five 
areas of weakness with the current oversight of market 
stability. One is the cramped jurisdiction that the Federal 
Reserve Board has, now limited to a certain number of areas, 
not including insurance companies, not including many other 
areas of importance systemic risk.
    Another problem is the manner in which the lender of last 
resort powers are structured. It has been remarked by many 
people that the Federal Reserve Board had to operate at the 
boundaries of its powers. Now, I think it acted legally, but it 
was constrained in how it provided liquidity in the past 6 
months. I think that is something that needs to be clarified in 
regulatory reform.
    I think, as was just alluded to by Mr. Dodaro, the 
mechanisms for ensuring that the costs of systemic risk are 
borne by the sectors of the industry that generate those 
problems is an important weakness of our current structure. The 
systemic intervention powers of the Federal Deposit Insurance 
Corporation (FDIC) are charged back to the banking sector if 
they are used. The TARP has an aspirational provision for 
recouping some funds, but we need to have a comprehensive 
approach to recouping funds to make sure that the incentives 
are right in the financial services industry, that they will 
bear the cost of systemic risk when they arise.
    I think it is also important to recognize that the Federal 
Reserve Board needs to expand its expertise to go beyond the 
traditional areas of jurisdiction. The crisis with AIG and the 
investment banks show that it needs to have broader expertise 
and greater personnel skills in many areas that are not 
traditionally supervised. Whether you want the Federal Reserve 
to be a comprehensive supervisor I think is a difficult 
question of regulatory design, but I think if it is going to be 
the market stability regulator, it has got to expand its 
knowledge in certain areas.
    There may well be things that the Federal Reserve currently 
does that it does not need to do in the future that should be 
reassigned to other places. But if we are going to have an 
effective market stability regulator, we need to think more 
broadly about the powers of the Federal Reserve.
    Finally, it is important to recognize that many of the 
solutions to systemic risk and market stability need to be done 
on the front end. The regulation of clearing and settlement 
systems, limitations on investments, problems generated by the 
number of investments in Fannie Mae and Freddie Mac 
securities--these are all ordinary supervisory issues, and we 
need to have a mechanism where the market stability regulator 
can speak to the front-line regulators and, in my view, have a 
veto or an override if it thinks those other regulators are not 
addressing market stability issues. It is a weakness in the 
structure that the Federal Reserve comes in after the fact, not 
in front, and it is inevitably more costly to correct things 
after the fact, and that is a weakness.
    Let me go on to just mention a couple of other areas of 
weakness that I think it is worthwhile for this Committee to 
focus on, and the second one that I want to mention is actually 
Congress' role in the current difficulties, or at least the 
statutory structure that Congress has helped create.
    We have a regulatory system that has lots of legalistic 
divisions in regulatory authority, where the boundaries are 
written in very cramped ways, every regulator has its 
jurisdiction, and each regulator is jealously guarding its 
jurisdiction against other regulators. That leads to a 
situation where the industry can play regulators off against 
each other and exploit regulatory loopholes, and the regulators 
are inherently at a disadvantage.
    One of the items on Senator Levin's list was the failure of 
the SEC to oversee hedge funds. That was a decision by the 
Court of Appeals of the District of Columbia based on an 
interpretation of statute. Now, I don't agree with the 
interpretation of the court in that case, but it was a problem 
for the SEC that it had no jurisdictional authority.
    One of the things that we need to do in regulatory reform 
is to create broad jurisdictional mandates so that the 
regulators have the power to go into areas and do what needs to 
be done rather than having cramped constraints.
    The division of regulatory authority is also totally clear 
in the problems of the mortgage banking industry. If you look 
at the regulatory structure that we have created in this 
country, the Department of Housing and Urban Development (HUD) 
had a piece of consumer protection for mortgage loans. The 
Federal Reserve Board was responsible for subprime loans. There 
were at least five Federal agencies in charge of depository 
institutions that were making the loans. The SEC was 
responsible for the securitization process in the credit-rating 
agencies. State regulators had some powers over mortgage 
brokerage transactions. And actually just this last summer, we 
created a new licensing process for mortgage brokers.
    It is no surprise that in a regulatory structure that is so 
fragmented no one saw the homeownership problem arising, and 
that there is no single agency to point to for responsibility 
after the fact.
    Another area that has been alluded to already this 
afternoon but I would like to mention is the problem of 
regulatory expertise and competence. This is, I think, most 
apparent if one looks around the world and sees what happens 
when other regulatory agencies are consolidated together. And 
one of the things that happen is the quality of personnel that 
is willing to work in the regulatory agencies goes up. 
Professionally, it is a broader mandate. There are more 
professional experiences. There are fewer positions that are 
taken by political appointees. It is a more attractive career 
position that attracts higher-quality personnel when we have a 
broader mandate.
    I think it is also the case to recognize that when you have 
a narrow regulatory function, it is hard to have expertise in 
every area. So the failure of Bear Stearns actually is a pretty 
good example of this because when the investment bank was 
getting into trouble, the SEC had to look to the Federal 
Reserve Bank of New York to get the personnel it needed to 
understand the problems. The Federal Reserve Board has a large 
number of economists that study banking issues in great detail, 
but the SEC has never had that kind of expertise, and it has 
lacked the bench strength to address many of the problems 
before it.
    So we have a mismatch of personnel. We have an inability to 
move personnel from one sector to the other, which seriously 
constrains us in terms of risk and is a weakness of our system.
    Another weakness of the fragmented system is the 
vulnerability of specialized regulatory agencies to the problem 
of regulatory capture. If you are an agency and you just 
regulate one sector of the financial services industry or one 
subsector, you are much more likely to identify with the 
success of your constituent institutions. So I would say the 
Comptroller of the Currency and the Office of Thrift 
Supervision, in order to make the national charters more 
attractive, cavalierly preempted State law of consumer 
protection, to the great detriment of the consumers of the 
regulated banks, and also making the task of State regulators 
much more complicated as Federal entities were coming in with 
preemption and State entities were being subject to full 
regulatory structure.
    I think there are many reasons one can explain that, but 
part of the reason was the agencies much too much identified 
with their constituents rather than thinking about what was in 
the best interest of the economy and the general public.
    I think in the area of consumer protection, this has 
already been touched upon, but to the extent this Committee is 
looking at shortcomings of consumer protection, I think the 
fragmented regulatory structure is also a source of concern 
here. There are lots of functionally similar products that are 
regulated in different ways because different regulatory 
agencies have expertise over them. If you are a clever 
attorney, you can make an insurance product look like a 
securities product or a banking product look like an insurance 
product or an insurance product look like a securities product 
and get a different regulatory structure. And there are many 
examples of repositioning to take advantage of marginal 
differences in regulation. That confuses the consumer, and it 
creates inconsistent protections across the financial services 
industry.
    In the area of financial education, which I think is 
tremendously important, in the end we depend on consumers to 
understand the products, and we need to have those consumers be 
educated. There is ample academic evidence that shows that less 
educated consumers make poor choices, take worse mortgages, 
have worse credit card terms. So financial literacy is a major 
goal, but it cannot be done on a piecemeal basis. We cannot 
have 200 different agencies engaging in financial education. It 
needs to be a centralized function. It needs to be a function 
that attacks the problem of financial literacy in a 
comprehensive way. It needs to interact with the educational 
system. That needs to be centralized, and fragmented financial 
education really is no financial education.
    The final point of weakness that I want to mention is also 
covered in the GAO report, but it is just worth noting. We live 
in an increasingly globalized financial market, and a major 
task of financial regulators is to interact globally, to work 
with regulators overseas. And there are a variety of reasons 
for this. Among other things, we need to make sure that 
transactions are not just escaping overseas and obtaining lower 
regulation in other jurisdictions, but there is cooperation 
that needs to be done in terms of enforcement actions, 
memoranda of understanding, and working out consistent 
regulatory systems.
    Our fragmented regulatory system is poorly suited for this 
task, having multiple entities going overseas to interact with 
unified regulators in other countries. When you are overseas, 
it is a common complaint about the United States that you 
cannot talk to one person, you have to talk to a dozen people. 
There are monthly visits by different regulators from the 
United States to London, to Tokyo, to Hong Kong, and it is an 
ineffective and inappropriate system.
    In many areas, such as in the banking area, we have 
multiple regulators representing the United States on the same 
issues. That complicates negotiations, makes it more difficult 
to work with our allies, and is a serious impediment to 
effective regulation. So I think the interactions on the 
international side are a separate area of concern that one 
should look for.
    I should say in this area, since it is in the Committee's 
mandate, there is a lot of expertise internationally on how to 
do regulatory reform. Many other jurisdictions have gone 
through the process, and I think particularly the British model 
is one to look at for some very interesting examples of 
structuring the reform, which very much needs to be done.
    Let me just close by saying the current financial situation 
is a challenge on multiple levels for this country, and for the 
most part our task is regaining our economic strength and 
trying to restore lost value to the people of this country. The 
one silver lining to the current crisis is it gives us an 
opportunity to reform our regulatory structure. That is 
something that has long been overdue. It has been a difficult 
political task to take on. But we finally have the opportunity 
to address a problem of a major sort for the United States, and 
I hope this Committee will take leadership in addressing that 
concern. Thank you very much.
    Chairman Lieberman. Very well said. Thank you.
    Professor Steven Davidoff is on the faculty of the 
University of Connecticut School of Law. I think I overheard 
you say you had been at Michigan before.
    Mr. Davidoff. Wayne State University Law School.
    Chairman Lieberman. Wayne State, so you claim you do not 
have any connection with the State of Maine?
    Mr. Davidoff. No. But I have been there many times, and it 
is a lovely place. [Laughter.]
    Senator Levin. And you apparently still have a place in Ann 
Arbor?
    Mr. Davidoff. Sadly, I have a house in Ann Arbor that I am 
unable to sell. [Laughter.]
    Chairman Lieberman. Senator Levin raised this subject.
    Mr. Davidoff. It is not Senator Levin's fault.
    Senator Levin. I did not know that part or else I would not 
have gotten into it. But Wayne State University Law School, if 
I could say, Mr. Chairman, is the law school where my wife 
graduated. She is a lawyer.
    Chairman Lieberman. Well, that speaks for the quality of 
the law school.
    Mr. Davidoff. It is the true public law school of Michigan.
    Chairman Lieberman. Senator Levin is known for his 
constituent service, and I am sure he will do anything he can 
to help you sell your house in Ann Arbor. [Laughter.]
    Mr. Davidoff. I like my house. Ann Arbor is a lovely place.
    Chairman Lieberman. With all of that, Mr. Davidoff, I am 
proud that our staff search for experts in this happily led us 
to somebody who is now at the University of Connecticut Law 
School. Please proceed.

     TESTIMONY OF STEVEN M. DAVIDOFF,\1\ PROFESSOR OF LAW, 
            UNIVERSITY OF CONNECTICUT SCHOOL OF LAW

    Mr. Davidoff. Thank you. Chairman Lieberman, Ranking 
Minority Member Collins, and other Members of this Senate 
Committee, I want to start by thanking you for providing me an 
opportunity to testify today.
---------------------------------------------------------------------------
    \1\ The prepared statement of Mr. Davidoff appears in the Appendix 
on page 143.
---------------------------------------------------------------------------
    I would like to start by agreeing with the uniform 
sentiment expressed today that today's financial regulatory 
architecture is fractured, archaic, and ill suited to today's 
modern financial world.
    What I would like to do in my testimony is fill out the 
excellent GAO report by providing a short narrative of the 
deficits of the past few years, which aptly illustrates the 
failures of the regulatory system and its current fractured 
nature. I want to start with the root causes of the financial 
crisis.
    The causes of the current financial crisis are still the 
subject of much study and debate, and will remain so long after 
Congress acts on any financial reform. Nonetheless, at this 
point, 18 months into the crisis, we have a rough sketch. In 
summary, historically low interest rates led to excessive 
borrowing by both individuals and financial institutions. The 
consequence was the rapid rise of housing prices. These prices 
were increased by demand from so-called subprime borrowers.
    During the period from 2000 through 2006, the amount of 
outstanding subprime mortgage debt grew an astounding 801 
percent to $732 trillion. These loans were often issued and 
underwritten under the assumption that ``housing prices do not 
fall.'' The assumption proved all too incorrect. And it is now 
all too clear that in many instances borrowers were placed into 
loans that they cannot now afford.
    Theoretically, bankers should have been more concerned with 
whether their loans would be repaid. However, the traditional 
``It's a Wonderful Life'' banking model where lenders and 
borrowers passed each other on the street and lenders 
personally assessed the creditworthiness of their clients has 
long past. Mortgages are now securitized into asset-backed 
facilities called collateralized debt obligations (CDOs), and 
sold into the market. Lenders now serve as intermediaries in 
this ``originate to distribute'' model and are more concerned 
with the ability to sell these loans rather than whether they 
are repaid. Many of these lenders, particularly for subprime 
mortgages, were non-bank lenders subject to differing oversight 
and regulation than their bank counterparts.
    It is now clear that this new securitization process 
allowed for lax lending standards. In 2005, the SEC contributed 
to this by liberalizing the registration process for these 
securities. At that time, the SEC discarded the obligation of 
underwriters of CDOs to perform due diligence on these CDOs to 
confirm adequate loan documentation. In essence, for those CDOs 
that were registered, the SEC relied upon private underwriters 
to uphold standards. Here, the underwriters also procured a 
private ratings agency to rate the CDO's tranches. Notably, 
though, the SEC, due to regulatory restrictions, was only 
responsible for regulating affirmative disclosure in the 
securitization process when the underwriter chose to register 
the securities. In no instances, as Professor Jackson 
highlighted, was the SEC responsible for the mortgage 
origination process or disclosure. In fact, financial 
disclosure, again as Professor Jackson highlighted, is subject 
to multiple regulatory agencies, none of which have the primary 
goal of consumer financial disclosure.
    In addition, under the Credit Rating Agency Reform Act, the 
SEC was affirmatively denied the ability to regulate the 
procedures and methodologies by which any rating agency 
determines credit ratings. In hindsight, the SEC and other 
financial regulatory agencies lacked complete oversight over 
the mortgage securitization market, and it was a market that 
was, at best, subject to overlapping and conflicting 
regulation. This allowed market failure as lenders, rating 
agencies, and borrowers all contributed to lax borrowing 
standards and the taking of excess risk, the consequences of 
which we are now dealing with now.
    During the period from August 2007 through March 2008, 
banks rushed to recapitalize their balance sheets from private 
investors. Nonetheless, the week of March 11, 2008, Bear 
Stearns collapsed. In hindsight, the largely unregulated 
investment banking model was overly susceptible to shock. 
Unlike bank holding companies, investment banks historically 
had a leverage model ranging from 20:1 to 30:1 and relied on 
short-term, highly movable deposits for liquidity. These 
deposits came from hedge funds, for the most part--
sophisticated financial institutions that could quickly move 
their assets in the case of a crisis, and this is what they 
did, leading Bear Stearns to lose liquidity and into a forced 
sale.
    The fall of Lehman Brothers was due to similar factors. At 
the time, there was a significant outcry that the failing of 
Lehman and perhaps Bear Stearns was due to shorting of their 
stock in the market and the crisis in confidence it created. In 
some cases, it has led to cries for regulation of the credit 
default market and a prohibition on shorting. Credit default 
swaps (CDSs), notably, were deliberately legislated to be left 
unregulated by Congress in the inaptly named Commodity Futures 
Modernization Act. The veracity of these claims about shorting 
and CDSs is unknown at this point. But, in fact, due to the 
lack of information about trading in the CDS market, I doubt 
anyone will ever be able to definitively conclude one way or 
the other on this point.
    The full role of derivatives generally in the financial 
crisis still appears uncertain. Certainly in some 
circumstances, derivatives increased risk, heightening the 
impact of the rapid decline of the CDO market. More certainly, 
AIG was brought down because of underwriting of credit default 
swaps out of a London-based subsidiary. AIG was able to 
leverage a regulatory gap. It was regulated by the Office of 
Thrift Supervision as a savings and loan holding company 
because of AIG's control of a thrift, but AIG was not subject 
under this regulation to the same scrutiny or heightened 
requirement it otherwise would have been subject to had it been 
a bank holding company.
    Furthermore, the Inspector General of the SEC issued on 
September 25, 2008, a report on the SEC's now defunct voluntary 
regulation program of the five investment banks, the voluntary 
Consolidated Supervised Entity (CSE) program. The program was 
doomed to fail and understaffed from the start. Three SEC 
employees were assigned to monitor each bank with tens of 
thousands of employees. The SEC never conducted appropriate, 
in-depth inspections as to risk measurement, capital liquidity 
sources, and other disclosure for these investment banks.
    This was true even after Bear Stearns fell. The investment 
banks were able to leverage a regulatory gap to avoid in-depth 
scrutiny of their leveraging and risk processes and be 
regulated to the same level as bank holding companies are.
    I want to spend the next few minutes just talking about the 
government response to the financial crisis and, again, how it 
illustrates the fractured nature of today's regulation and 
regulators.
    Initially deprived of statutory ability to fully address 
the crisis, the government would engage in what Professor David 
Zaring and I call ``regulation by deal'' in order to attempt to 
salvage the financial system. In a series of transactions, the 
government nationalized Fannie Mae and Freddie Mac, bailed out 
AIG, and arranged for the sale of Wachovia and the banking 
deposits of Washington Mutual. Then with the passage of the 
Emergency Economic Stabilization Act and the adoption of the 
TARP program, the Treasury Department agreed to invest--or 
force financial institutions to invest, depending upon who you 
speak to--$125 billion in the country's nine largest financial 
institutions.
    Since that time the government has been administering the 
TARP; along the way the bailout of AIG has been reworked, Citi 
and Bank of America have received a second set of TARP funds--
$90 billion in total--and General Motors (GM) and Chrysler have 
also received TARP funds under the automotive component of 
TARP. Meanwhile, just today Treasury Secretary nominee, Timothy 
Geithner, part of the prior team, announced his desire to 
rework the entire program.
    Each of these deals has been on different terms and 
structured seemingly on an ad hoc basis, without any 
organization or systematic approach. From news reports in the 
Wall Street Journal and other sources, it appears that the 
coordination of the FDIC, Treasury, and Federal Reserve on 
these individual bailouts was sometimes strained by 
disagreement over each of their regulators' role and statutory 
capacity. This may have contributed to the ad hoc nature of the 
government's response. The statutory limitations on these 
agencies, as Professor Jackson alluded to, and the lack of an 
in-place lender of last resort also affected the regulators' 
ability to fully respond to the financial crisis.
    I note that the perceived cure to a panic and general 
credit freeze is to restore confidence in the markets. This has 
at times been sorely lacking among the populace due to the 
regulators' perceived ad hoc response to the financial crisis.
    In conclusion, this brings us to today. I do not have time 
in my testimony to recommend solutions, but Congress will 
clearly hear many, and I offer some in my written testimony. 
Here I want to conclude by answering the question posed by this 
hearing: Where were the watchdogs?
    Well, in part, as you can see from my sad narrative, the 
regulators were hobbled by their deregulatory bent and limited, 
fractured, and overlapping jurisdiction which left wide parts 
of the financial system without oversight or regulation. Thank 
you.
    Chairman Lieberman. Thanks, Professor Davidoff. That was an 
excellent narrative, really an excellent summary of how we got 
to where we are. I must say that insofar as I expressed in my 
opening statement our intention and hope that in these hearings 
we would learn, so we could help to educate, and then advocate 
effectively, I think all three of you have been excellent 
educators of the Committee, and I thank you for it.
    We will have 7-minute rounds of questions. I will begin 
now.
    A clear conclusion that you all share--and it begins with 
the excellent GAO report--is that the current system for 
regulating financial institutions in our country is fractured, 
out of date, and just not able to deal with today's complicated 
and immense global financial networks that do business here in 
the United States.
    I was thinking as you were testifying that we have all 
become over the last year or so familiar with a term that I had 
not heard before, which is that an entity can be ``too big to 
fail.'' Right? And so we end up spending or extending billions 
of dollars either of direct aid or credit.
    From what you are saying, it sounds like it may not be that 
these entities are too big to regulate, but they are certainly 
too big and complicated for our current regulatory system to 
oversee in the public interest. And that is a big part of the 
problem.
    I take it, just to start with the baseline question, that 
it is reasonable to conclude, both from the report and the 
testimony, that none of you thinks that simply fixing some of 
the specific authorities of existing regulatory agencies is 
enough to prevent the next regulatory crisis without a larger, 
comprehensive reform. Mr. Dodaro.
    Mr. Dodaro. Certainly there are some parts of the current 
regulatory structure that you may want to look at.
    Chairman Lieberman. Right. Sure.
    Mr. Dodaro. But we do not think that you can adequately 
address this problem in a comprehensive manner without making 
broader changes.
    Now, on the point that you mentioned about some of the 
sizes of the entities and them being too big to fail, questions 
have to be asked about the extent of whether or not they are 
too big to manage effectively.
    Chairman Lieberman. Right.
    Mr. Dodaro. One of the really important themes, I believe, 
that runs through a lot of this issue is the whole question of 
risk management approaches and models, risk management at the 
individual institution level, at the industry level, at our 
national U.S. level, and at a global level. And I think that 
issue really needs a lot of attention from a regulatory 
standpoint, but also a corporate governance standpoint.
    Chairman Lieberman. I was wondering whether you were 
suggesting that there ought to be some governmental regulatory 
mechanism that may say to a financial entity this next 
acquisition you have in mind or the next product line you are 
putting out is too much. In some sense, it sounds like a 
classic antitrust function. It is a little bit different, of 
course. But what would you say to that?
    Mr. Dodaro. Well, I would say you need some checks and 
balances in the system. Ultimately, the company's management 
and the board of directors are responsible, but there has to be 
a threshold of risk as to whether or not the regulators are 
adequately achieving the goals that would be set up with the 
new system and protecting investors and taxpayers, in 
particular.
    So this whole question of how to achieve the proper balance 
between regulating and allowing innovation, I think, is really 
going to be the tough underlying issue that really needs to be 
addressed, because there is a tendency to overregulate and have 
things roll back over time. Neither one of those is really the 
optimum solution. So, our characteristics are intended to try 
to get to see what can happen with that balance.
    We also point out that there needs to be an adequate 
transition period in terms of whatever change, but also, Mr. 
Chairman, I would say the really other important part of this 
is diligent oversight on a continual basis by the Congress. The 
likelihood that this is going to be solved with one big stroke 
is really----
    Chairman Lieberman. One big move, understood. That is 
always a danger here. We legislate, we reform, and then we walk 
away.
    Mr. Dodaro. Because things change, markets are going to be 
fluid, and there needs to be some built-in oversight on a 
regular basis.
    Chairman Lieberman. Professor Jackson, you made some 
interesting statements about the possibilities of expanding the 
authorities and powers and jurisdiction of the Federal Reserve 
Board. Given your druthers, would that be at the heart of your 
comprehensive reform? And if so, would you blend or have the 
Federal Reserve absorb some of the existing Federal financial 
regulatory agencies?
    Mr. Jackson. Senator, that is a good question, and 
certainly one model that one could think about is to say the 
Federal Reserve is at the heart of the system with the best 
expertise, and we will fold everything in or a lot of things in 
to make a super agency.
    That is not personally what I would favor. I think that the 
amount of centralization of authority is antithetical to a lot 
of American traditions. And, more importantly, I think what you 
want is a focused regulator with specific tasks.
    So I would prefer a model of the Federal Reserve Board 
having broader powers for market stability issues to sort of 
have a roving mandate throughout the system, but another 
counterweight Federal agency with consolidated supervision that 
would be responsible for the front-line authority.
    Chairman Lieberman. So create a new agency that would take 
in some of the existing agencies.
    Mr. Jackson. Yes, consolidated in the new agency. It would 
have front-line supervision, and all the consumer protections 
in day-to-day activities and have the Federal Reserve Board as 
an expanded oversight entity that does the market stability 
functions and with the lender of last resort capacity to come 
in should the need arise.
    Chairman Lieberman. Interesting.
    Mr. Jackson. It is a little bit like the British model, 
except I would envision a more robust role for the Federal 
Reserve than the Bank of England has.
    Chairman Lieberman. Got it. Professor Davidoff, I have 
about a minute left in my time. Why don't you get into this 
discussion. What would be your druthers if you were redesigning 
the system?
    Mr. Davidoff. If I were redesigning the system, I would 
look at it analytically as three lines: One as systemic risk 
regulator; second, a consumer protection agency, which is the 
SEC and CFTC, which would have enhanced regulation over 
financial disclosure, and third, consumer financial disclosure.
    Chairman Lieberman. You would put them together?
    Mr. Davidoff. I would have two separate agencies. I would 
put the CFTC and SEC together.
    Chairman Lieberman. That is what I meant.
    Mr. Davidoff. It creates opportunities for regulatory 
arbitrage. There is really no good reason to have them separate 
anymore. Some people argue they should be competitors, they are 
models, but we have ample models and competitors abroad 
globally that can regulate them.
    I think there is a third type of regulator, which Professor 
Jackson alluded to, which is your capital regulator, which is 
your FDIC or the Office of the Comptroller of the Currancy 
(OCC). And so there are really three lines: Your lender of last 
resort systemic regulator, then capital regulator----
    Chairman Lieberman. Which would be the Federal Reserve.
    Mr. Davidoff. Well, you can place them wherever you want.
    Chairman Lieberman. Yes.
    Mr. Davidoff. And I think Professor Jackson makes a good 
point, which is the Federal Reserve is naturally cited as the 
lender of last resort, but it is a unique independent agency. 
And perhaps the capital requirements should be elsewhere with 
Federal Reserve input because we want congressional oversight. 
And this is why it is good that your Committee is having this 
hearing because it is really a structural issue. Congress 
should not be legislating the nuances, or else you are going to 
get into a battle of the experts in deciding things. You should 
set up a regulatory apparatus and let those regulators fill it 
all in.
    Chairman Lieberman. Great. Thank you. Senator Collins.
    Senator Collins. Thank you, Mr. Chairman. Let me take up 
where you left off.
    As I look at this issue, it is clear that we have a gap 
because there is no one who is responsible for assessing 
systemic risk, what Professor Jackson called the ``market 
stability regulator.'' So that is a problem. And it is 
interesting. A few years ago, the House actually rejected 
regulatory authority over Freddie and Fannie that would have 
allowed regulation for systemic risk. When I look back on that 
with the benefit of hindsight, it is just extraordinary that 
the amendment was defeated so handily in the House.
    But then there is also what I call the safety and soundness 
regulators from my experience at the State level. We would not 
allow a State-chartered bank or credit union to have a leverage 
ratio of 30:1 that Bear Stearns did. That is just 
inconceivable. So you need that safety and soundness regulator 
to be extended so that a large investment bank has to meet the 
same kind of capital requirements and undergoes the same kind 
of audits and reviews as the local credit union--whose failure 
would be far less devastating for the economy.
    And then the third issue to me is who ensures that new, 
exotic financial instruments like credit default swaps do not 
fall through the regulatory gaps. To me, credit default swaps 
are an insurance product, and yet they were not regulated as 
insurance. They also were not regulated as securities.
    So help me sort through who should do what, and I am going 
to start with you, Professor Jackson, because you started down 
that road when you said the Federal Reserve Board should have 
the systemic risk authority.
    Mr. Jackson. Right. Well, I do think this would fall into 
the second heading of my discussions, I think, in terms of 
thinking about how you are defining jurisdiction. This is a 
lawyer's task, writing the jurisdiction of agencies, and it can 
be done in a lot of different ways. We have tended to take a 
narrow focus, so the SEC has authority over securities. It is a 
defined term. The Supreme Court has decided I think maybe 15 
cases at this point about what that term means. There was 
litigation about whether swaps were securities in the 1980s and 
1990s, and they were determined to fall outside of the SEC's 
mandate for the most part, and Congress did not reverse it. It 
sort of validated that decision.
    So I think that whether it is the SEC or a consolidated 
supervisor, one should define the jurisdiction broadly, and so, 
for example, you could define the jurisdiction to be over 
products that are financial in nature. That is a definition we 
use in some areas, which is an open-ended definition that gives 
the agency authority to say if a new product comes along, that 
is financial, and we are going to exert some sort of 
jurisdiction.
    To pick up on a question that Senator Lieberman put 
forward, I do think that the agencies have to have the power, 
if a new product comes along, to say this is financial and you 
just cannot sell it willy-nilly any way you want. You can sell 
it but it has got to be, for example, on an exchange with a 
clearing and settlement system that we can keep track of, so we 
know the transparency, so we know counterparty risk. And that 
does mean saying you cannot just go to London and do it on 
Fleet Street any way you want because we recognize that 
increases risk.
    So I think the regulators have got to have the self-
confidence and the support to say certain products are too 
risky. For too long we have said, well, as long as it is 
institutional investors, we do not need to worry, they can fend 
for themselves. The lesson of the last year is when 
institutional investors get into trouble, sometimes they drag 
the rest of us down, and we need to have just a different 
philosophy that sometimes means saying no.
    Senator Collins. Professor Davidoff.
    Mr. Davidoff. I agree with that sentiment. If you do not 
have regulators with broad jurisdictional authority, you will 
have Ph.D.'s on Wall Street who will structure products to fill 
that black hole. And so you need regulators with broad 
authority, and you need it over the entire financial system. 
Credit default swaps are a perfect example. They are traded 
over the counter. We have no idea who the parties are. They 
should be traded on an exchange, or a regulator should look at 
them to see if they should be traded on an exchange.
    But we have to regulate forward, not backward. We do not 
know what the next crisis is going to be. So we need to have 
regulators that have full jurisdictional scope.
    Senator Collins. Should we have safety and soundness 
regulation for entities like the Bear Stearnses of the world?
    Mr. Davidoff. Absolutely. I mean, the investment banks, the 
only reason the CSE program existed was because the investment 
banks needed a regulator under an EU directive.
    Senator Collins. But that was a voluntary program.
    Mr. Davidoff. Right, it was a voluntary program that they 
were trying to get out of direct oversight from the European 
Union, and they existed in this netherworld of unregulated 
jurisdiction.
    Now, the elephant in the room, which we have alluded to, is 
insurance. It is regulated by the States. It is a big problem, 
how we capture those products, because if we regulate all 
securities, if we have oversight of hedge funds--and here I am 
talking about oversight, not necessarily regulation--the 
regulator should have the power to regulate. But that should be 
done through the regulatory process. But if we leave, for 
example, insurance out of the mix, what do we do then?
    Senator Collins. Mr. Dodaro, who should be the regulator 
for what? Who should be the systemic risk regulator? Should 
safety and soundness regulation by front-line regulators be 
extended to all financial entities that could possibly pose 
hazards to the economy?
    Mr. Dodaro. Our report at this juncture does not make 
specific recommendations, but the points that you are probing 
on go to a couple of the characteristics that we have. One is 
the systemwide risk proponent that would look across the system 
and look for systemic issues. I think also, Senator Collins, 
that ensuring that regulation is comprehensive, is one of the 
characteristics that is meant to close the gaps with entities 
and products.
    Then the third component that we point out has to do with 
flexibility and adaptability, and I completely agree with my 
colleagues at the witness table here that we need a proactive 
approach and not a reactive approach. And I think that is where 
you are headed with your question, and I quite agree with that, 
whoever that person is who is charged.
    But it also goes back to our first objective and 
characteristic in our framework, which is to set clear 
regulatory goals and mandates and charter and give the 
regulators the broad authority, then hold them accountable for 
doing it.
    Senator Collins. Thank you.
    Chairman Lieberman. Thanks very much, Senator Collins. 
Senator Levin.
    Senator Levin. Thank you, Mr. Chairman.
    Let me do something which really is not the direct purpose 
of the hearing, but something that I want to do to take 
advantage of your expertise while you are here. It is obvious 
from your answers that you do have some opinions on not just 
who should do the regulation, but whether certain activities 
ought to be regulated. I do not know whether, Mr. Dodaro, you 
are going to want to or be able to comment, but let me start 
with our other two witnesses.
    First, should hedge funds be regulated? Professor Jackson.
    Mr. Jackson. Yes
    Senator Levin. Professor Davidoff.
    Mr. Davidoff. Yes.
    Senator Levin. Are they currently regulated?
    Mr. Jackson. I would say inadequately. I think this is a 
good example that the SEC had an initiative to bring the 
advisers under their jurisdiction. Whether that is strong 
enough for all aspects of their activities, I am not sure. But 
that was certainly an important first step.
    I think beyond thinking about the hedge funds as entities, 
it is the products--the credit default swaps, the OTC 
products--that need to be brought into what I think would look 
more like a futures regulation standard.
    I would say here that I think this is just an excellent 
area to rethink how we got into the current situation of the 
CFTC and the SEC being in competition for business and trying 
to attract entities by giving exemptions that play to our 
disadvantage over the long run.
    Senator Levin. I will get to the specifics of the hedge 
funds.
    Mr. Davidoff. Can I just add something on the hedge funds?
    Senator Levin. Yes.
    Mr. Davidoff. I think if you ask someone, if you ask a 
regulator what role did hedge funds play in the current 
financial crisis, I think he would look at you like a deer in 
the headlights because we just do not know. And one of the 
things that we need--and even the hedge fund managers who 
testified about a month ago agree--is an oversight process for 
hedge funds, and we need a disclosure process. It may need to 
be confidential. But there are also systemic risks of 
unregulated capital pools that any systemic risk regulator will 
have to look at. Even the Harvard Endowment is in some terms a 
hedge fund, and we need to bring those capital pools under some 
oversight, or else the next systemic risk will rise there. And 
it happened in Long Term Capital Management. It could happen 
again.
    Senator Levin. Let me move to the credit default swaps. We 
have had a lot of discussion about that. The SEC Chairman, 
Christopher Cox, back in October asked for jurisdiction over 
those credit default swaps. Professor Jackson, should they be 
regulated?
    Mr. Jackson. Yes. I think that Mr. Cox's proposal was a 
good one, albeit a piecemeal response, but that would be an 
incremental improvement, his recommendation.
    Senator Levin. Mr. Davidoff.
    Mr. Davidoff. Yes, I think they should be moved to an open 
exchange.
    Senator Levin. Where they would be regulated.
    Mr. Davidoff. Yes, where they would be regulated. That way 
we can see the pricing, and the price discovery mechanism can 
work. And if credit default swaps are going up on an entity, we 
can see it instead of an opaque process.
    Senator Levin. Senator Collins has, I believe--or last 
session, at least--introduced a bill on this, and I fully 
support that effort. But the bottom line is the two of you 
believe that Congress should eliminate the barriers to the 
regulation of credit default swaps.
    Mr. Jackson. Yes.
    Mr. Davidoff. Yes.
    Senator Levin. By the way, Mr. Dodaro, if you have a 
feeling of any of this, if this is within your ambit, just jump 
in anytime.
    Mr. Dodaro. Well, I will get caught up quickly.
    First, on all of these areas, our belief is you definitely 
need more transparency. I agree with my other witnesses that 
whoever the systemic risk regulator is should have some 
jurisdiction over these issues. And, Senator, I would point out 
that we have raised concerns about some of these derivative 
products dating back as far as 1994. GAO encourages that some 
of the regulators have oversight over these derivative 
products.
    Senator Levin. All right. I want to keep going down a rat-
a-tat-tat list here, if I can, because I think this is 
important while we have your expertise here. Now, we were 
talking about credit default swaps. What about Federal 
regulation of all types of swaps, including interest rate, 
equity, and foreign currency swaps? Same answer or different 
answer? Professor Jackson.
    Mr. Jackson. Well, I think that you need to look at some of 
these products on a case-by-case basis, but I think that you 
need to have a single financial authority who is making a 
decision about the best way to approach these instruments. In 
some cases, it may not be necessary to go to exchange-based 
regulation. One may want to do it by regulating the entities 
that engage in the transactions. But I do not think we should 
have an artificial boundary or a competition between agencies 
around these instruments. I think they should be fully within 
the financial sector and an expert agency should have the 
jurisdiction.
    Senator Levin. There ought to be jurisdiction in an agency 
to regulate.
    Mr. Jackson. To regulate.
    Senator Levin. Fair enough. Professor Davidoff.
    Mr. Davidoff. Absolutely you need the ability.
    Senator Levin. All right. And the authority in an agency to 
regulate.
    Mr. Davidoff. Yes.
    Senator Levin. Now, what about over-the-counter market 
derivatives?
    Mr. Jackson. I would give the same answer to that.
    Senator Levin. Same answer, Professor Davidoff, or 
different?
    Mr. Davidoff. The same answer. You need jurisdiction over 
everything.
    Senator Levin. Capital reserve requirements on banks and 
security firms--should Congress require regulators to impose 
stronger capital reserve requirements? Should we just simply 
authorize them to do it?
    Mr. Jackson. I think that Congress needs to be careful not 
to be too specific in its dictates, only that if you are too 
specific the industry will work around it. I think that 
comprehensive capital requirements are important, and it needs 
to be done not just at banks and insurance companies, but it 
needs to be done for conglomerates as well, including the 
entities that we do not have traditional names for.
    So I think one needs to be careful about specifying sector 
regulations as opposed to saying we need to have a 
comprehensive oversight of solvency and liquidity.
    Senator Levin. Authorize an agency to do that.
    Mr. Jackson. Authorize an agency, and then----
    Senator Levin. That is fine. That is in keeping with your 
previous answer, essentially.
    Mr. Jackson. Yes.
    Senator Levin. Professor Davidoff. I know this may sound 
obvious to you, but let me tell you, we have to build up a 
record if we are going to move quickly on this thing. I think 
all of us want to get to the structural issues, and again, I 
commend our Chairman and Ranking Member. This is a tough job to 
do that. It is a harder job in a lot of ways because it is more 
technical. It does not have the glamour of some of these other 
issues, so-called.
    Senator Burris. It does not have the sex appeal.
    Senator Levin. Sex appeal, there you go. It is essential 
that it be done, but we cannot let that effort stop us from 
doing things we have to move very quickly on. So that is why I 
wanted this record to----
    Mr. Davidoff. Can I just add one more thing here----
    Senator Levin. Of course.
    Mr. Davidoff [continuing]. To your very good point, which 
is Congress should use its political capital to set up a 
structure, and they should not get bogged down in the details. 
Sometimes they should, but bank capital requirements is a fight 
that Congress does not need to pick. They can have the 
regulator have the authority and give them the authority to set 
it.
    Senator Levin. But it is clear that we ought to act to give 
the regulators those kinds of authorities?
    Mr. Davidoff. Yes.
    Senator Levin. My time is up. I have some additional 
questions, Mr. Chairman, for the record along the same line, 
and I very much appreciate the patience of our witnesses 
because this is really slightly different than what they were 
called to testify on, which is very valuable testimony. But I 
want to thank you for your testimony.
    Chairman Lieberman. Thanks, Senator Levin. I agree with 
you. To go back to a metaphor you used in your opening 
statement, which is used a lot but it is very relevant here, 
and your last series of questions made the point, which is: 
There are a lot of financial beats in America today that do not 
have a cop on them, and that is part of the reason why we are 
in the mess we are in now.
    The second thing is that the public gets this, and they are 
really infuriated, and it does create a political moment in 
which we can achieve the kind of comprehensive, proactive 
reform in regulation of financial entities for which you have 
all in one way or another called. So, obviously, at some 
political moments you can overreact. This happens to be a 
political moment, I think, where the public wants us to do, in 
fact, what we should do. And you are testifying from a very 
non-political point of view that is exactly the case.
    Senator Levin. If I could just interrupt for one more 
second. We had the SEC months ago asking us for authority to 
regulate credit default swaps.
    Chairman Lieberman. Yes.
    Senator Levin. Now, it should not take much, as far as I am 
concerned, to do that little piece as quickly as we can. We are 
talking--I do not know--$1 trillion?
    Mr. Davidoff. Twenty trillion dollars.
    Senator Levin. Twenty trillion dollars of exposure?
    Chairman Lieberman. Here is an interesting number. From 
June 2006 until June 2008, the market value of outstanding 
credit default swaps increased from $294 billion to $3.1 
trillion. So in just 2 years, it went up tenfold. That is a lot 
of money, even around here. You agree.
    Senator Levin. Thank you.
    Chairman Lieberman. Thank you. Senator Tester is next. For 
Senator Burris' information, we have a rule on this Committee 
that we call on the Senators in the order of arrival, so you 
will be next after Senator Tester.

              OPENING STATEMENT OF SENATOR TESTER

    Senator Tester. Thank you, Mr. Chairman, and I, too, 
appreciate the hearing that you and the Ranking Member have 
lined up here. I do not know how many Members of this Committee 
are also on the Banking Committee. I am one. Senator Carper was 
one also. I do not think he is on it anymore. And I do not mean 
to speak for the chairman of the Banking Committee. You know 
him better than I do. But I would say that any suggestions this 
Committee could give to the Banking Committee would be well 
accepted. This is a very complex issue. And as you pointed out, 
it is an issue that I think the public wants something done 
here to re-establish faith in the marketplace.
    Chairman Lieberman. Thanks, Senator Tester. I forgot that 
you were on the Banking Committee. I did talk to Senator Dodd 
about the hearing, and he was encouraging. And, obviously, we 
defer to you in terms of legislation, but maybe this Committee 
can offer some suggestions about what form that should take.
    Senator Tester. We would be more than happy to take them 
forward and would be more than happy to hear suggestions even 
on a personal basis, because like I said, it is complex.
    I guess the question I would have for all three of you--you 
understand how complex the markets are, and you already talked 
about the holes and the overlaps and the fact that it does not 
work very well right now. How much time do you think, if we 
really got after it, would it take to develop a structure that 
would be comprehensive enough to add consumer confidence to the 
marketplace, but yet not so detailed that we have to fight 
fights we did not have to fight, and not so regulatory that it 
would take away flexibility in the system and deter growth? 
Just give me an idea on how long you think that would take to 
do something that would be thorough.
    Mr. Jackson. Well, I think that is a good question, and the 
way I think about it is on two levels. For Congress and the new 
Administration to come to a consensus about the direction that 
we should go in, whether it should be the two-peak model that I 
was outlining or a three-peak model that Professor Davidoff was 
suggesting, or a more narrow set of consolidations with a 
different agenda, I think that is something that could be 
decided in this session relatively quickly.
    I think that the task of implementing is one that you need 
to give a lot of thought to. Just as an example, in the United 
Kingdom there was a 3 to 4 year process from when the Blair 
government decided it was going to consolidate its 
supervision--it created a shell entity that carried the 
baggage, but the legislation took 3 years to enact. And, 
actually, they created the agency first, and it had the task of 
helping draft its own legislation. So I think the more you go 
to a really comprehensive solution, the more you are going to 
need to draw on expertise for this very technical task.
    One example, something that came up here that we did not 
mention in our testimony, is dealing with financial institution 
failures. Right now one of the problems, one of the reasons 
things are too big to fail is that we do not have a mechanism 
for wrapping up big institutions because we have the banks, the 
securities companies, the insurance companies, and the Federal 
Bankruptcy Code all interacting.
    Well, we should have a consolidated disposition process so 
when Lehman goes bankrupt, we can actually deal with it. And 
then we actually could make it fail because we would have a 
mechanism.
    Senator Tester. So you are saying several years.
    Mr. Jackson. Several years, yes.
    Senator Tester. Mr. Davidoff.
    Mr. Davidoff. I think I agree with that assessment. But I 
think that Congress can pass a bill that does it this session.
    Senator Tester. Mr. Dodaro.
    Mr. Dodaro. I think that part of it depends on a couple 
factors: One, that Congress required the Congressional 
Oversight Panel under TARP to submit a regulatory reform 
proposal; and also required the Secretary of Treasury to have a 
proposal. There have been a couple that have come forward from 
other sources, and to the extent to which there is a consensus 
gathering on some of those issues I think is important. But I 
think it is going to take time to do it right and to do it 
comprehensively.
    Senator Tester. Well, let me ask you this, then: If it 
takes that kind of time, do you think that there is any threat 
that--and I mean that just as it sounds--a regulatory system 
from outside this country could actually become the standard by 
which we live, from the European Union or Pacific Rim?
    Mr. Davidoff. I think the answer to that is no. I mean, 
they are equally as troubled, and capital flows, although they 
can shift rapidly, are staying concentrated in the United 
States due to our----
    Senator Tester. Do you see it the same, all of you? How 
about you, Mr. Jackson? You understand the question?
    Mr. Jackson. No, I do not. Can you just repeat what the 
question is?
    Senator Tester. What I am concerned about is that our 
regulatory system is screwed up right now, to be kind. The 
financial crisis is a worldwide situation, and if our reform is 
not done in a reasonable amount of time, would we have to live 
under the rules of another system--the European Union's 
financial system or the Pacific Rim's or however you want to 
put it? Do you see what I am saying? If ours is inadequate, 
does that mean we have to take theirs? Does that mean the 
companies, the investors, and all of the above adopt theirs?
    Mr. Jackson. Well, I think that, as Professor Davidoff 
says, the companies will stay in the United States because 
there is so much business in the United States, and they are 
going to be here, and they will live with our rules.
    I think that we can learn from other jurisdictions, and I 
think we can have a more effective and cost-effective 
regulatory system if we move to consolidation, which is what is 
done around the world.
    Senator Tester. I would agree with you.
    Mr. Jackson. But we control our regulatory fate.
    Senator Tester. Good. That is all I need to know. Mr. 
Dodaro, do you see it the same way?
    Mr. Dodaro. Basically.
    Senator Tester. Perfect. I have got a question, because it 
has been brought up a few times. My mother brought it up to me 
a while back, and it is something that we bounce off and around 
once in a while. We are 10 years after the Gramm-Leach-Bliley 
Act, which means we are also 10 years after the undoing of the 
Glass-Steagall Act. If the Glass-Steagall Act had still been in 
effect, do you think this same problem would have happened?
    Mr. Jackson. I am fairly confident the same problem would 
have happened. The securitization process was already underway, 
and we did not need Gramm-Leach-Bliley to facilitate that.
    Mr. Davidoff. I think it exacerbated it. The banks and the 
investment banks began competing with each other, and the 
investment banks were not built to compete in that way.
    Senator Tester. So you are saying the Gramm-Leach-Bliley 
Act exacerbated it.
    Mr. Davidoff. Yes.
    Mr. Dodaro. I think the question is more what was not done 
rather than what was done. And I think the necessary 
adjustments were not made to the regulatory structure to follow 
the policy decisions and what was going to occur in the market.
    Senator Tester. Thank you, Mr. Chairman. I, too, would like 
to welcome Senator Burris to the Committee. I am sure that his 
opinions and perspectives will be much valued.
    Chairman Lieberman. Thanks, Senator Tester. Again, I am 
really happy that you are on the Banking Committee, and that 
gives us a good link to the work of that committee.
    Senator Burris, it is really a great honor--having met you 
before you came to the Senate, knowing of your service in 
Illinois, particularly the time as Attorney General, but 
obviously you have done a lot beyond that--to call on you for 
the first time to question the witnesses. Senator Burris of 
Illinois.

              OPENING STATEMENT OF SENATOR BURRIS

    Senator Burris. Thank you, Mr. Chairman. By the way, Mr. 
Chairman, I am also an old banker. I started out my career as 
the first black in this Nation to be a bank examiner for the 
Comptroller of the Currency, and I am sitting here just taking 
all this in.
    Chairman Lieberman. That is great.
    Senator Burris. And I have a couple of questions I would 
like to ask.
    One, have we really listed the various agencies? We have 
the FDIC. We have the SEC. How many agencies are involved that 
would be impacted by any type of regulations? And would we have 
to then seek to come up with some type of blanket or overall 
package that would impact each one of these agencies that has 
these piecemeal jurisdictions over all of these various 
entities? How many are there? You also try to get the 
Comptroller of the----
    Mr. Davidoff. In the GAO report, they have nine, I believe, 
primary agencies. Which would be 10 if you included the 
Treasury. But I would ask that they confirm that.
    Mr. Dodaro. Yes, there would be 10 with the Treasury, and I 
think your question is appropriate, both in designing the 
reform that would be put in place, but also making the 
transition as----
    Senator Burris. As to try to tie all those together and get 
all of those different interests that are going to be 
protecting their turf and all the other types of situations 
that could cause a problem. Professor Jackson.
    Mr. Jackson. I think that there actually are some that the 
GAO report may not have included. I would include the 
Department of Labor with respect to Employee Retirement Income 
Security Act (ERISA) issues. I would include HUD with respect 
to mortgage lending. You could say that the most important 
financial agency for most people is the Social Security 
Administration with its retirement savings program.
    So there are a host of little pockets around government in 
addition to the primary agencies that one should think about 
collectively. But it is a large number.
    Mr. Davidoff. I would add that I do not expect that 
everything will be cleaned up into a neat package. I would 
recommend you build dominant regulators, whether you adopt a 
twin-peaks model, the three-peaks model, and have them over 
time--have their primary goal so they can absorb these 
functions.
    Senator Burris. And one other point that may seem a little 
bit farfetched, but I have to take my mind to the ultimate of 
all this, and that is the consumer and how would that consumer 
get impacted by this overall change in regulations. It was the 
consumer that ended up getting all caught up in these various 
different piecemeal approaches as the subprime lending, and 
then not only subprime but prime, got caught up in these equity 
loans and dropping house values. So that also impacted what 
happened in our financial markets because there are a lot of 
individuals who are not subprime who were just underwater. 
Their mortgages exceed the overall value of the property that 
they are living in, and that constant pressure of equity, take 
out the equity because it is not going to go down, and we found 
ourselves in serious trouble.
    The consumer has to be taken into consideration of how 
these regulations are going to impact them, and I just hope 
that we would give some thought to just how that person would 
ultimately be impacted by that.
    Mr. Jackson. Senator, one of the problems, as I see it, is 
that each of our agencies has a consumer protection division or 
a division of consumer affairs, but it takes a second seat to 
other functions at the Federal Reserve or at the OCC or the 
other agencies. And what we need to do is increase the salience 
and the importance of the consumer protection function, and 
that can be done with an accountability standard. It can be 
done in a consolidated agency by having a division of consumer 
affairs, perhaps with a political appointee and Senate 
confirmation to elevate the status. Or it could be done with a 
specialized market conduct regulator that has consumer 
protection as a mandate.
    But I think it starts with Congress saying that this is a 
major goal and setting up a structure that someone has that as 
their main mission, not as a secondary or tertiary mission, 
which tends to be what is going on nowadays.
    Senator Burris. Thank you very much.
    Mr. Dodaro. Senator, I completely agree with that, and that 
is one of the main characteristics that we point out that 
should be in the framework of crafting and evaluating proposals 
to reform the structure. Also, the States play a very important 
role here, as I am sure you are aware, based on your past 
position.
    Senator Burris. I am a former State Comptroller.
    Mr. Dodaro. And I do think that whatever is done ought to 
be to preserve and to build on that check and balance at the 
State level.
    Mr. Davidoff. And, again, I would just add a small point, 
which is it should have broad jurisdiction. So it is not just 
mortgage disclosure. It is credit card disclosure. It is 
financial protection for consumer financial products.
    Senator Burris. Thank you, Mr. Chairman.
    Chairman Lieberman. Thank you very much, Senator Burris. I 
appreciate that. Your question was an interesting one, and if 
you add on the State agencies that really do get involved, you 
could get pretty rapidly up to about 200 separate oversight--we 
have some ability, but we do not want to overdo it to deal with 
the State agencies as well and allocate authority. But it 
really is a fragmented system, and it does leave a lot of gaps, 
which give people room to play games in between.
    Senator Burris. Mr. Chairman, they mentioned one industry 
that really needs to be looked at, and that is the insurance 
industry.
    Chairman Lieberman. Yes, sir.
    Senator Burris. We really have to check out the insurance 
industry.
    Chairman Lieberman. Thank you. I look forward to working 
with you on the Committee.
    We will do a second round for any of the Senators who want 
to ask additional questions.
    Professor Davidoff, I want to ask you one thing briefly, 
which is, in your testimony, interestingly, you mentioned that 
the lack of coordination between some of the existing 
regulatory agencies--in the case you particularly mentioned the 
FDIC, the Treasury, and the Federal Reserve--may actually have 
contributed to the ad hoc and ultimately inadequate nature of 
the government's response to the current fiscal crisis. So the 
fragmentation in the system may not only create gaps that allow 
for the problems, but it also creates a problem in responding 
to a crisis or a scandal. Correct?
    Mr. Davidoff. Correct. Obviously, I was not in the 
discussions, but from news reports it is clear that the 
regulators conflicted over what to do at certain times, and 
they lacked the full authority to address the crisis. And these 
bailouts, one reason why they are so haphazard is because they 
were structured within narrower limits of the law than they 
were subject to.
    Chairman Lieberman. I believe Mr. Dodaro first and then 
others mentioned the ideal or the goal that we may, as part of 
our reform, want to create a system in which the financial 
entities are asked to bear the cost of the risk. Just 
conceptually--the canvas is empty now and we are thinking about 
how to paint on it--what kind of system would that involve? 
Would it be fees up front?
    Mr. Dodaro. Well, basically you would have to have some 
kind of fee structure. It would basically take the Bank 
Insurance Fund concept that is in place and replicate that or 
adapt it--is probably a better word--to the other types of 
services and products. This goes, too, to how the regulators 
should be funded to preserve their independence. So I think it 
is both a system that needs to be put in place modeled after 
the Bank Insurance Fund, conceptually, that would require that 
some fees be paid into a centralized fund that could then 
provide for the industry that is in need of it, but also have 
it be funded in a way where the regulators have clear 
independence. Right now they are funded in different schemes, 
which contribute to some of this difficulty in deciding how to 
hold people accountable.
    Chairman Lieberman. We have been reminded in the Bernie 
Madoff case that there is a fund there that can be drawn on to 
a limited degree to try to compensate people who were cheated 
by Mr. Madoff. But I presume that there are large areas of 
financial transactions where there is no such fund and, 
therefore, there is no coverage for loss. Correct, Professor 
Jackson?
    Mr. Jackson. There is a complicated system of specific 
guarantees. It is limited given the losses in the Madoff case, 
but it is available for fraud of the sort that he engaged in 
apparently. And there is the FDIC fund for banks, there are 
State guarantee funds operated at the State level for insurance 
companies to protect individuals when institutions fail.
    I think the model for a systemic recovery would be the FDIC 
Improvements Act of 1991 (FDICIA), which basically says that if 
the FDIC saves a bank that is too big to fail and takes on 
extra costs, those extra costs are then charged back to the 
whole banking sector over some period of time. And TARP has 
that characteristic, too. There is a provision that says if 
TARP loses money--which it seems like it will--then in 5 years, 
the Treasury has to make a recommendation for a charge-back. So 
that is the kind of mechanism on the systemic risk side.
    I think for ordinary failures, the pre-funding model, which 
Mr. Dodaro referred to, is the sensible one. The FDIC fund is 
kept at a certain percentage of deposits, so that handles 
routine failures. But then when there is a special failure, you 
need to have some special mechanism. And it should be 
consistent throughout the financial services industry, and it 
is not right now. If the Federal Reserve loses money on some of 
its interventions, there is no mechanism to get recovery and 
there is no general system for charge-backs that I think would 
be important to put in place.
    Chairman Lieberman. Would you like to add anything to this 
discussion?
    Mr. Davidoff. No. I think it has been adequately addressed.
    Chairman Lieberman. Good enough. Let me, since we are 
painting on a big canvas that is, obviously I would like to 
think, not filled now--as we reconsider where we are--we are 
dealing here in so many cases with an extraordinarily different 
international financial system where enormous sums of money 
travel with incredible rapidity, and one of you mentioned, 
using it for another point, how frustrated European regulators, 
or the British, are sometimes when they come here because they 
have to shop around or figure out who to talk to.
    This may be reaching a bit beyond, but in response to the 
current crisis--last year I remember reading that there was a 
town in Norway that was going under financially because it had 
put its money in mortgage-backed securities that were failing.
    Senator Burris. And Iceland.
    Chairman Lieberman. And Iceland, exactly. So should the 
United States be initiating some round of international 
discussions now to create either new international entities for 
financial regulation or institutionalizing or regularizing some 
kind of interaction between national regulators?
    Mr. Jackson. Well, I mentioned the international 
connections, and I do think it is increasingly important for us 
to have coordination and cooperation, particularly with our 
leading economic allies. I think the tenor of today's 
discussion of having more regulation, tightening the 
regulation, is entirely appropriate. But it means that the 
pressure to move offshore is going to be strong.
    Chairman Lieberman. Right.
    Mr. Jackson. And there are two places people can move 
offshore. They are to the developed countries--Europe, Asia, 
and major markets--where we can and should have good 
coordination. I think the task of absolute harmonization is not 
an appropriate aspiration because their systems are different, 
their traditions are different. But we need to have convergence 
and coordination with these major entities. Then we need to 
collectively deal with the second group of entities, which are 
the offshore centers that we can only deal with collectively. 
And we have had some good experience internationally 
cooperating on that, but we need to be working with our allies 
to protect all of us against the offshore centers. So that is a 
priority.
    Chairman Lieberman. Mr. Dodaro or Mr. Davidoff, any 
response to our international responsibilities?
    Mr. Dodaro. Well, I think there are two things at a 
minimum. One is there have been some international bodies of 
individuals from the different countries that have had some 
dialogues, and I know this was mentioned to me when I was in 
the United Kingdom talking to one of their treasury officials. 
And so there are proposals both to perhaps more 
institutionalize this, expand this type of regular discussion 
and dialogue on issues. Second, there should be some 
discussions looking at international organizations, like the 
International Monetary Fund and others, that could perhaps play 
an enhanced role in this.
    I am not positing any particular outcomes, but I do think 
international dialogue is very important as part of the 
equation in this particular issue.
    Mr. Davidoff. I would just add that I think there is 
already an extraordinary amount of dialogue between regulators, 
and the Federal Reserve, in fact, entered into a dollar loan 
program with the other banks in Europe because of their 
difficulties.
    I think that the issue is that although dialogue is good, 
we have to take a stand on some regulation and say this is 
where we will go, and because someone else does it differently 
does not mean that we have to set it there.
    Now, that should be done with the regulatory process, and 
we need to keep the preeminence of the U.S. capital markets, 
and the best way to do that is through treaties and cooperation 
but also by saying you are not going to be able to come into 
our system, which is the largest system, if you don't play by 
our rules.
    Chairman Lieberman. Excellent. Thanks. Senator Collins.
    Senator Collins. Thank you, Mr. Chairman.
    Professor Davidoff, I want to talk further with you about 
the ``too big to fail'' issue, which the Chairman raised at one 
point. It concerns me that we are creating a classic moral 
hazard. If we send the signal--and, indeed, we are sending the 
signal--that if you are big enough so that there are 
consequences to the economy in terms of job losses or other 
cascading effects that we are not going to allow you to fail, 
we take away any incentive to carefully manage risk.
    In addition, we encourage companies to become bigger and 
bigger or to enter into financial arrangements where there are 
more complex and interlocking transactions to make these 
institutions' failure too consequential for our economy.
    How do we prevent that? I know that is not an easy 
question, but I am really concerned that we are sending a 
message to just become bigger and bigger, riskier and riskier, 
and don't worry, Uncle Sam will bail you out?
    Mr. Davidoff. This is a hard one. Let me give you just a 
quick anecdote. When Lehman failed, it defaulted on its 
commercial paper, which was held by the money market funds, 
including Prime Reserve, which broke the buck. In the space of 
48 hours, over $200 billion was taken out of money market 
funds. Money market funds, if they do not have money, can't buy 
commercial paper. Most of industrial America finances its 
operations through commercial paper. Literally, the cash 
machines almost shut down. Because Lehman defaulted on its 
commercial paper, the money market funds were losing all their 
funds and couldn't fund the commercial paper market. Companies 
couldn't get their commercial paper, and they were unable in 
that market to get their financing. And that just shows how 
tightly interconnected the world is today.
    I think what you do--and I look forward to a vigorous 
debate and the other experts offering their opinions--is two 
things. First, ironically we have been building big 
institutions through this process. You need to manage those 
institutions. And, second, I think this has been such an 
extreme event that the moral hazard effects may be reduced. But 
we need to put in incentives for the people who are trading and 
running these institutions that they will be penalized.
    I hate to jump into the executive compensation arena--and 
we certainly shouldn't, in doing regulatory reform--but you 
need incentives that people will be punished. They can't leave 
with a $1 million exit package. If their institutions fail, 
they should leave with nothing, including without their country 
club membership.
    Senator Collins. Professor Jackson, I would like you to 
address this as well, but I also want you to address a related 
issue. When I look at the financial markets--and it is related 
to the problem I have just outlined--an issue at risk is 
divorced from responsibility at every step along the way. It 
used to be that your community bank made the loan, kept the 
loan, so if the loan went bad, that institution bore the 
consequences. Now, the mortgage broker may make the loan and 
take his fee. He does not care what happens to the loan after 
that. Then it goes on to the financial institution, which takes 
its fee. Then it is sold on the secondary market. Everybody is 
getting a cut along the way. Then when the mortgage is sliced 
and diced and securitized, it means that nobody is really 
bearing the risk of the decisions that were made. And yet 
everybody is taking a cut and getting paid along the way.
    Mr. Jackson. Right.
    Senator Collins. And I don't know what we do about this.
    Mr. Jackson. Well, this has definitely been a problem. You 
describe the nature of the huge moral hazard agency problem 
that the mortgage financing system has generated.
    One thing that I will say going forward is if we look at 
the system backwards and we think of that pension fund up in 
Norway that ended up holding mortgage paper, it is going to be 
a lot more careful the next time it buys American securities, 
if it ever does.
    So I think we can expect some pretty severe market 
corrections, and one of the ironies is we are living in a 
market over-reaction. No one wants to finance mortgages 
anymore, which is part of our problem that we are currently in.
    So some of the correction is going to come from people who 
have been burnt who are going to be more careful. We clearly 
need to look at these relationships and decide when there is 
not enough skin in the game and whether we want to have a 
mortgage brokerage industry operating the way it has in the 
past. I am quite dubious anyone will ever buy mortgages from 
the old mortgage broker system. But we need to look at those 
conflicts very carefully.
    On too big to fail, one thing I would just like to say is 
it is important for groups like GAO to think hard about why 
institutions are too big to fail. And sometimes the reason is 
we have allowed them to enter into such complicated 
transactions and complicated networks that we can't unwind 
them. So I think AIG, Lehman, and Bear Stearns have this 
characteristic. The solution is make a better swap system with 
clearinghouses, and then if we had a good clearing system, we 
can let them fail.
    So you can prevent ``too big to fail'' by not having 
complex payment systems or complex clearing systems. So that is 
a prospective solution.
    In the case of Fannie Mae and Freddie Mac, they are too big 
to fail because they had too large a share of the mortgage 
business, and we also let every bank in the country buy as much 
stock or bonds of Fannie and Freddie as they wanted. Now, that 
is a recipe for too big to fail.
    If we are going to have government-sponsored enterprises 
(GSEs) in the future, which is an open question, we should make 
them smaller. We should not let their financial significance be 
so big so that if one of them needs to shut down we can't just 
shut it down.
    So we can correct some aspects of too big to fail going 
forward. If we have a disposition mechanism that can handle 
liquidation in a sensible way, that will also give us more 
latitude.
    So smart regulation can allow us to enforce market 
discipline, and I think that is an important lesson going 
forward.
    Senator Collins. Thank you.
    Mr. Chairman, I am going to have to leave, and I apologize 
that I will not hear the Senator's final round of questions, if 
he has some--he is done? Well. Could I just read for the record 
from Warren Buffett?
    Chairman Lieberman. Go right ahead.
    Senator Collins. In 2002--he is not called ``The Oracle'' 
for nothing--he wrote to his shareholders, and he said, ``We at 
Berkshire Hathaway try to be alert to any sort of mega-
catastrophe risk, and that posture makes us unduly appreciative 
about the burgeoning quantities of long-term derivative 
contracts and the massive amount of uncollateralized 
receivables that are growing alongside.''
    Listen to this statement: ``In our view, however, 
derivatives are financial weapons of mass destruction, carrying 
dangers that, while now latent, are potentially lethal.''
    How sad it is that when Warren Buffett said this in 2002 
that the regulators apparently weren't listening.
    Chairman Lieberman. Amen. Thanks, Senator Collins.
    Senator Burris, no further questions?
    Senator Burris. No.
    Chairman Lieberman. Thanks so much. I appreciate it.
    The three of you have been excellent witnesses and, again, 
I thank you, Mr. Dodaro, for the GAO report. You have really 
gotten us off to a good start here. We are quite serious about 
this. Actually, I think in talking to the Members, you have 
engaged our interest.
    I wonder if I could presume on your service to the 
Committee thus far--this is a pleasure that a Senator gets in 
giving two law professors a homework assignment, so to speak, 
which is, I am really intrigued by the two-peak/three-peak 
model. I am not asking for a law journal article because I know 
you are very busy, but if you would for the benefit of the 
Committee, in writing, over the next couple of weeks just 
outline, with what we have now, how would you bring agencies 
together? How would you change things? I think it would be very 
helpful to us and to the Congress overall.
    Mr. Dodaro, to the extent that you are able to do that 
within your mandate, we would, of course, really welcome the 
same from you. And we are glad to talk to you more about the 
best way we can do that.
    Mr. Dodaro. Yes, I would like to give that some thought, 
and we could have some follow-up dialogue.
    Chairman Lieberman. Good.
    Mr. Dodaro. And I would also like to recognize the fine 
efforts of the GAO team that put the report together.
    Chairman Lieberman. It is another excellent piece of work 
to assist Congress and in the public interest by GAO. I 
appreciate it.
    We will keep the record of this hearing open for 15 days in 
case any of you want to submit additional testimony or any of 
the Members want to submit testimony or questions to you. But I 
can't thank you enough for bringing forth your expertise to 
help us prevent another crisis such as the one we are going 
through now.
    With that, the hearing is adjourned.
    [Whereupon, at 4:09 p.m., the Committee was adjourned.]


                       WHERE WERE THE WATCHDOGS?
                    SYSTEMIC RISK AND THE BREAKDOWN
                        OF FINANCIAL GOVERNANCE

                              ----------                              


                        WEDNESDAY, MARCH 4, 2009

                                     U.S. Senate,  
                           Committee on Homeland Security  
                                  and Governmental Affairs,
                                                    Washington, DC.
    The Committee met, pursuant to notice, at 9:02 a.m., in 
room SD-342, Dirksen Senate Office Building, Hon. Joseph I. 
Lieberman, Chairman of the Committee, presiding.
    Present: Senators Lieberman, Tester, Burris, and Collins.

            OPENING STATEMENT OF CHAIRMAN LIEBERMAN

    Chairman Lieberman. Good morning and welcome.
    Thanks for coming a bit early. As you know, we moved the 
hearing up so that we might attend the joint session to hear 
British Prime Minister Gordon Brown.
    This is the second in our series of hearings examining the 
structure of our Nation's financial regulatory system in the 
aftermath of its obvious failure to protect us from the 
economic crisis that we are suffering through now. We are 
undertaking this series of hearings pursuant to Senate rules 
that give our Committee the responsibility for ``the 
organization and reorganization of the Executive Branch of the 
government'' as well as for the study of ``the efficiency, 
economy and effectiveness of all agencies and departments of 
the government.''
    By examining what changes should be made to improve and 
modernize the organization of the Federal regulatory system, we 
are not only fulfilling these responsibilities, but we hope to 
be preparing ourselves to make recommendations to our 
colleagues on the Senate Banking Committee about reforms that 
they may be considering reporting out to deal with gaps in our 
financial regulatory system.
    In other words, we see our unique role here as reaching a 
judgment about the structures through which we are regulating 
financial institutions, and not so much about the day to day 
regulations. This is particularly important based on what we 
heard at our first hearing from the witnesses, which was that 
our Nation's outdated and fragmented system of financial 
regulation is unable to handle risks that occur across many 
different types of institutions, markets, and activities.
    Today's hearing will examine the pros and cons of creating 
a systemic risk regulator for the financial services industry.
    The first obvious question is what is a systemic risk 
regulator?
    I gather that it means a risk that a failed institution, a 
risky activity, or a particular event could broadly affect the 
financial system rather than just one institution or activity. 
And, frankly, I want our witnesses to help educate me about the 
difference between that systemic risk regulating function and 
the other problem that we heard about at the last hearing, 
which is that there are, today, gaps in our regulatory system 
that leave trillions of dollars of economic activity 
unregulated.
    The fact is that there is no one government agency or 
market participant responsible for monitoring systemic risks to 
the integrity of our entire financial system, and that is a 
significant fact.
    Many experts believe that the gap should be bridged by 
creation of what we are calling a systemic risk regulator who 
would supervise or which would supervise the financial system 
holistically. Federal Reserve Chairman Ben Bernanke has given 
us another title to chew over. He has referred to such an 
entity as a macro-prudential regulator. And I will wait for the 
three of you to help me understand that.
    Part of the reason our current watch dogs failed, we 
learned at the last hearing, is because each has just a piece 
of the system to oversee. That, as I said a moment ago, leaves 
gaps.
    For as long as there have been markets, obviously, there 
have been speculative bubbles and resulting financial crises. 
But through sensible regulation, I believe we can improve the 
ability of our financial system to prevent and withstand such 
shocks, reduce vulnerability to extreme crises and limit the 
damage to our economy when a crisis occurs.
    And so, we come to this hearing with a series of questions 
and an excellent group of witnesses, questions like: Can the 
role of monitoring and responding to systemic risks be 
accomplished by expanding the authority of one or more existing 
regulatory institutions or should Congress create a totally new 
entity to act as a systemic risk regulator?
    What would be the responsibilities of that body?
    What tools would it need to meet those responsibilities?
    And what would its relationship be with other regulators?
    We have an excellent panel of witnesses before us today, 
and I look forward to their testimony.
    Senator Collins.

              OPENING STATEMENT OF SENATOR COLLINS

    Senator Collins. Thank you, Mr. Chairman.
    Today, as the Chairman has indicated, our Committee is 
examining the need to establish a systemic risk monitor that 
might have helped to prevent the financial crisis that our 
Nation now confronts, and I will stick with the term systemic 
risk monitor rather than macro-prudential regulator.
    America's financial crisis has spread from Wall Street to 
Main Street, affecting the livelihoods of people all across the 
country. The American people deserve the protection of a new 
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.
    Our financial regulators should have had the ability to see 
the current collapse coming and to act quickly to prevent or 
mitigate its impacts. Unfortunately, oversight gaps in our 
existing system, risky financial instruments with little or no 
regulatory oversight and a lack of attention to systemic risk 
undermined our financial markets. When the entire financial 
sector gambled on the rise of the housing market, no single 
regulator could see that everyone from mortgage brokers to 
credit default swap traders was betting on a bubble that was 
about to burst. Instead, each agency viewed its regulated 
market through a narrow tunnel, missing the total risk that 
permeated our financial markets.
    When the housing market collapsed, the impact set off a 
wave of consequences. Borrowers could no longer refinance their 
mortgages. Credit markets were frozen. Consumer demand 
plummeted. Businesses were unable to make payments or to meet 
payrolls. And workers were laid off, making it even more 
difficult for families to pay their mortgages.
    In Maine, the unemployment rate has reached a 16-year high 
of 7 percent at the end of 2008. There were also more than 
2,800 foreclosures in my State, not that many compared to other 
States but nearly a 900 percent increase from the previous 
year.
    This financial crisis has harmed virtually every American 
family. Taxpayers have financed bailout after bailout of huge 
financial institutions at the cost of trillions of dollars. 
These drastic and expensive rescues might not have occurred had 
there been a regulator evaluating risk to the financial system 
as a whole. Such a regulator could have recognized the house of 
cards being constructed in our financial markets.
    While there are certainly many regulators at both the 
Federal and State levels, not one of them had the ability to 
evaluate risk across the entire financial system. For example, 
the Federal Reserve could clearly see the large number of 
securitized mortgages of banks within its jurisdiction, but it 
had virtually no visibility into the full extent of 
securitization at non-federally regulated banks or financial 
institutions under the purview of the Securities and Exchange 
Commission (SEC).
    What was needed then and is needed now is the systemic risk 
regulator. The Government Accountability Office (GAO) and other 
government and industry officials as well as academic experts 
have called for the creation of such a monitor.
    But, as the Chairman indicated, the creation of a systemic 
risk monitor raises many new questions about its structure and 
authority. Should it be an existing regulator such as the 
Federal Reserve that is charged with monitoring systemic risk 
or should an entirely new entity be tasked with that 
responsibility?
    My belief is that we should establish a council composed of 
the heads of our Nation's financial regulatory agencies that 
could be an interagency task force.
    We must also consider what should occur when systemic risk 
is detected. Should a systemic risk entity be empowered to 
issue its own regulations to review and approve new financial 
instruments and to fill the regulatory black holes that result 
from overlapping or narrow agency jurisdictions or should the 
monitor be required to work through existing regulators?
    In designing a better regulatory framework, we must take 
care not to create a moral hazard by implying that this entity 
exists to make failure impossible. We must also take care not 
to stifle the creation of innovative, useful new products nor 
to prevent beneficial risk-sharing. The challenge is to ease 
the turmoil caused by failing of important institutions without 
setting off a cascade of trouble for otherwise healthy 
entities.
    In other words, we need a better system to prevent the 
development of catastrophic concentrations of risk at firms 
like Bear Stearns, AIG, and better systems to mitigate the 
collateral damage if they do fail.
    Our goals must combine several vital objectives: Stability 
for the financial system, safety and soundness regulation for 
institutions, protections for investors and consumers, 
transparency and accountability for transactions, and increased 
financial literacy for the public. Significant regulatory 
reforms are required to restore public confidence and to ensure 
that a lack of regulation does not allow such a crisis to occur 
in the future.
    In fact, I would contend that one reason why we have not 
seen a stabilization of our markets is because the public 
continues to lack confidence. One step that we can take that 
would make a real difference is the creation of a stronger, 
more effective regulatory system to help restore that 
confidence, and that is why this set of hearings that the 
Chairman has initiated are so important.
    Thank you, Mr. Chairman. I look forward to hearing our 
witnesses.
    Chairman Lieberman. Thanks very much, Senator Collins. I 
agree with you totally on that last point.
    I know people within the Administration and our colleagues 
on the Banking Committee are working on this. It is very 
important because, obviously, the troubles in the markets, 
notwithstanding what we and the Administration have been trying 
to do, reflect a lack of confidence, and one part of that 
clearly is in the ability of the government to protect 
investors and consumers.
    Let's go right to the witnesses with thanks that you are 
here. First is Dr. Robert Litan, Vice President for Research 
and Policy at the Kauffman Foundation.
    Thanks for being here.

  STATEMENT OF ROBERT E. LITAN, PH.D.,\1\ VICE PRESIDENT FOR 
     RESEARCH AND POLICY, EWING MARION KAUFFMAN FOUNDATION

    Mr. Litan. Thank you very much, Mr. Chairman and Senator 
Collins for inviting me to appear on this very distinguished 
panel.
---------------------------------------------------------------------------
    \1\ The prepared statement of Mr. Litan appears in the Appendix on 
page 158.
---------------------------------------------------------------------------
    We are here, of course, because we are all in the midst of 
the worst financial crisis of our lives and because of our 
ardent desire to never see something like this again. To 
realize this objective, we must reduce and contain systemic 
financial risk, the subject of this hearing.
    Your staff has asked me to provide a few scene-setting 
remarks before addressing the questions you posed.
    Our financial system has long rested on two pillars: Market 
discipline and sound regulation and supervision of key 
financial institutions and markets. Both pillars failed us.
    Shareholders and creditors of now failed financial 
institutions did not prevent what happened, but also we did not 
have policies in place to assure that market discipline would 
work effectively.
    Mortgage documents and the securities backed by mortgages 
were not transparent. With too many borrowers, the institutions 
that securitized their loans and the institutions that bought 
these securities also did not have enough money at risk to 
ensure prudent behavior.
    Likewise, we all thought that regulators were on top of the 
risk and the capital levels at our financial institutions. We 
were wrong.
    Reforms are needed to fix these errors. We are here today, 
however, to do more than that, specifically, how to address 
systemic risk which, as you, Mr. Chairman, accurately 
described, is the transmission of losses at one or more failed 
financial institutions simultaneously or at near time 
coincidence with each other throughout the rest of the 
financial system.
    I also agree with you that we cannot expect to prevent all 
future asset bubbles like the housing bubble, but the public 
does have a right to expect reform to reduce the size of those 
future bubbles and, obviously, to reduce the economic costs 
when they pop.
    The place to begin is to establish an effective system of 
regulating the solvency and improving the transparency of 
systemically important financial institutions (SIFIs).
    In my view, this oversight is best carried out by a single 
agency, not a collection of agencies, with due apologies to 
Senator Collins. President Truman had a famous sign on his 
desk: The buck stops here.
    Well, the buck stops here dictum, if we apply it here, and 
I think we should, means that one agency, not many agencies, 
should have clear responsibility over SIFIs. Among the 
alternatives that I survey in my written remarks, I believe 
that the ideal solution, if I could play God, is to consolidate 
all the Federal financial regulation into two bodies, one for 
solvency and the Treasury under former Secretary Henry Paulson.
    Chairman Lieberman. Just go into that a little bit. When 
you say all, just give us a little more detail of what agencies 
we are talking about.
    Mr. Litan. On the banking side, I am talking about all the 
banking agencies. I think we ought to have Federal regulation 
of large systemically important insurers which we, of course, 
now do not have at all.
    Chairman Lieberman. So when you are saying all the banking 
regulators, you are talking about the Office of the Comptroller 
of the Currency (OCC).
    Mr. Litan. OCC and the Federal Deposit Insurance 
Corporation (FDIC).
    Chairman Lieberman. Right.
    Mr. Litan. And the Federal Reserve functions of solvency. 
And you have large insurers. I would put them there too.
    You would have the solvency of broker dealers. Essentially, 
an agency charged with solvency. Then you would have an agency 
charged with consumer protection which would consolidate all 
the consumer protection arms of each of these agencies. Plus, I 
would add the consumer protection power of the of the Federal 
Trade Commission (FTC), and we ought to have a financial 
consumer protection agency.
    I mean those are the two functions that we are worried 
about, and in an ideal world I would consolidate them.
    Chairman Lieberman. Then the SEC and the Commodity Futures 
Trading Commission (CFTC)?
    Mr. Litan. I would combine those and make them part of the 
consumer protection agency.
    Chairman Lieberman. OK.
    Mr. Litan. And the Paulson Treasury plan had--I am 
departing now from my prepared remarks here. But they also 
suggested that the Federal Reserve would be a free safety, 
roaming out there to pick and choose what it wanted to do.
    In my written remarks, I am worried about the free safety 
model because it is just a recipe for regulatory overlap, 
especially with vague and ambiguous powers that you would give 
the Federal Reserve.
    So, to go back to what I was saying, that is my ideal 
world.
    We do not live in an ideal world, and I do not expect 
something like this to happen. I would be glad if it did. So, 
as a fallback, I urge that the Federal Reserve be the logical 
systemic risk regulator.
    My third choice would be to create a new regulator and 
leave everything else intact. I am not wild about this 
alternative because we already have enough cooks in the 
kitchen. This would just add another one, and it would be a 
recipe, I think, for overlap, jurisdictional fights, and 
fingerpointing after the fact and so forth.
    And, finally, we come to the last suggestion which is the 
so-called college of supervisors. I am not wild about this 
either because it preserves too many cooks in the kitchen. I 
think, again, as I said, it violates the buck stops here 
principle. So that is my least favorite alternative.
    Now there are a lot of details of how systemic risk 
regulation would have to be carried out, and so I think the 
Congress, if I were writing legislation, should provide very 
broad language and leave the details to the agency and then 
have Congress oversee the agency rather closely.
    Let me just give you an example of a few of the issues that 
would have to be addressed:
    First, there has to be a clear process for identifying the 
SIFIs and to allow an institution that is designated as a SIFI 
to remove itself if the situation warrants.
    Factors such as size, leverage and the degree of 
interconnection with the financial system, as the Group of 
Thirty has suggested, would be, I think, obvious ways to define 
the SIFIs. Clearly, large banks, large insurers and, 
conceivably, some hedge funds and some private equity funds 
could meet the SIFI test. So would the major clearinghouses, 
the exchanges, including the new exchanges or clearinghouses 
that are now contemplated for credit default swaps.
    Footnote: There is a recent report by the Geneva Reports on 
the World Economy--an excellent report, by the way--that has 
come out. It also recommends something like this, but it 
suggests in an ideal world that the list of SIFIs would be kept 
private. You would not publicize the names of them to address 
the moral hazard concern that, Senator Collins, you rightly 
point to.
    I do not think that is feasible because the reality is you 
would have to disclose, if you were a public company, what 
special rules you are subject to, if you have higher capital 
and liquidity rules. And the markets would be able to interpret 
very clearly, if you have these higher standards, that you are 
a SIFI. So I think you cannot keep the list quiet. That is just 
my view.
    Second, SIFIs should be subject to tougher regulation, 
specifically capital and liquidity, than other financial 
institutions precisely in order to address the moral hazard 
concern. Capital standards should be countercyclical but only 
if the minimum capital standard is raised over time and--and 
this is very important--the required ratios for good times and 
bad are publicized in advance so that everybody knows what the 
rules are. If you do not have clear rules what will happen is 
that you will relax the rules in bad times, but you will not 
raise them in good times. So the capital rules have to be super 
clear at the outset.
    Third, the systemic risk regulator should not rely solely 
on supervisors to watch over SIFIs because we know that 
supervisors and regulators are not perfect. Trust me. I have 
been hearing an earful from the public about this.
    So I think we need to harness what I call stable market 
discipline to supplement regulators, and the best source of 
stable discipline is long-term uninsured, unsecured, and 
subordinated debt. SIFIs should be required to back a certain 
portion of their assets with this long-term debt, or the long-
term money which cannot run. Such debt is not like short-term 
deposits. Because the long-term money is stuck, the holders of 
such debt have tremendous incentives to monitor the institution 
to insure that it is not taking excessive risk, and that is 
another way to address the moral hazard concern.
    Fourth, and this is critically important, SIFIs should be 
required to submit and gain approval for early closure and 
loss-sharing plans in the event they get into trouble. These 
plans could limit, though possibly not eliminate, losses from 
their failure. I was going to address some of the critics of 
the SIFI approach, but I think we have addressed the moral 
hazard concern, and I will not go into great detail on that 
issue. I have a number of responses to the other criticisms in 
my written testimony.
    I have a couple final points. One is that you cannot put 
all your eggs in a systemic regulator basket. There have to be 
other tools to address systemic risk, and so I address two of 
them in my testimony.
    First, my colleague, Alice Rivlin at Brookings, has 
suggested that the systemic risk regulator provide an annual or 
perhaps more frequent report to Congress on systemic risk 
regulation. Highlight the areas, for example, of rapid asset 
growth or areas where there may be particular vulnerabilities 
so that the system, you and the public are alert to the 
dangers. And, if there are needed recommendations, the 
regulator would provide them.
    Second, regulators should encourage financial institutions 
to tie their pay to long-term performance, not to short-term 
results.
    Finally, I want to say just a few words about the global 
nature of the problems we are facing and what we should do 
about them globally.
    Clearly, we are all witnessing the fact that the troubles 
in the United States have now reverberated around the world. 
So, naturally, the rest of the world wants us to participate in 
some kind of global macro solution to the current problems. 
That is why President Obama is going to the April 2, 2009, 
meeting in London. That is why President Bush agreed to the G-
20 meeting in November.
    I have a couple words of caution, not that I am against 
global coordination. I am all for that. We need to learn from 
other countries. But for those who say that we ought to 
harmonize all our rules with the rest of the world before we 
act, I strongly disagree, and I will give you a prime example 
why.
    We have something called the Basel II Capital Accords. I 
have written for years about how I think these things were 
horribly mistaken. As it turns out, the biggest mistake is they 
took 10 years to develop, and by the time they went into effect 
we had a full blown banking crisis. And so, I hate to repeat 
that episode.
    By the way, the substance of the Basel rules turned out to 
be bad. They ignored liquidity. They were 400 pages of 
complexity that only risk modelers could love. They delegated 
authority to credit rating agencies, and now we learned how 
that was a mistake. There were complicated formulas that tried 
to measure risk that did not do it well.
    The bottom line is let's not spend our time trying to 
negotiate with the rest of the world what our rules should be. 
We know enough to fix our own problems, and we should do that.
    And the final point I would like to make goes to the issue 
of a global financial regulator. I do not think any of the 
countries in the G-20 are ready to cede financial regulation to 
an uncreated, untested global regulator. We have plenty of work 
to do at home, and I think we should do it.
    That will conclude my formal remarks. Thank you.
    Chairman Lieberman. Thanks very much, Dr. Litan. Very 
helpful. Very interesting.
    I gather that at 11 a.m., according to the previews, Prime 
Minister Brown may be talking about an international global 
financial New Deal. Though I must say I heard him respond to a 
question about that on the radio yesterday, and his answer was 
quite vague which meant either that he was holding the details 
for this morning or there are no details, and we will see as 
time goes on.
    Senator Collins. Mr. Chairman, I just want to explain to 
our witnesses that I have a conflict that I need to leave for. 
I have read all of their testimony, and I am very interested. 
If humanly possible, I will try to get back, but I do look 
forward to talking further with the experts that you have 
brought together today.
    Chairman Lieberman. Thanks very much, Senator Collins, and 
I understand why you have to go. And thank you for being in 
this, as in most everything else, such a supportive partner. 
Thank you very much.
    Next, we are going to hear from Damon Silvers who is 
Associate Counsel at the AFL-CIO and a member of the Troubled 
Asset Relief Program (TARP) Congressional Oversight Panel.
    We probably could hold a separate hearing on that, but for 
now we welcome you on the question before us this morning, Mr. 
Silvers.

 STATEMENT OF DAMON A. SILVERS,\1\ DEPUTY CHAIR, CONGRESSIONAL 
    OVERSIGHT PANEL, AND ASSOCIATE GENERAL COUNSEL, AFL-CIO

    Mr. Silvers. Thank you, Mr. Chairman, and thank you for the 
honor of inviting me here today.
---------------------------------------------------------------------------
    \1\ The prepared statement of Mr. Silvers appears in the Appendix 
on page 178.
---------------------------------------------------------------------------
    As you know, I am Associate General Counsel of the AFL-CIO, 
and I am a member and Deputy Chair of the Congressional 
Oversight Panel.
    My testimony today will include a discussion of the 
Congressional Oversight Panel's report on regulatory reform 
mandated by the Emergency Economic Stabilization Act of 
2008.\2\ However, my testimony reflects my views and does not 
necessarily reflect the views of the panel, its chair, 
Elizabeth Warren, or its staff.
---------------------------------------------------------------------------
    \2\ The report submitted by Mr. Silvers appears in the Appendix on 
page 190.
---------------------------------------------------------------------------
    We have inherited a financial regulatory landscape designed 
in part to address issues of systemic risk. The SEC's 
disclosure-based system of securities regulation and the FDIC's 
system of deposit insurance came into being not just to protect 
the economic interests of depositors or investors but as 
mechanisms for insuring systemic stability, respectively, by 
walling off bank depositors from broader market risks and 
ensuring that investors in securities markets had the 
information necessary to police firm risk-taking and to monitor 
the risks embedded in particular financial products.
    But, as both the Chairman and Senator Collins have noted, 
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. 
And we have seen a significant concentration in banking 
activity in the hands of very large financial institutions.
    So we entered the recent period of extreme financial 
instability with an approach to systemic risk that looked a lot 
like that applied during the period following the creation of 
the Federal Reserve Board but before the New Deal.
    But with the collapse of Lehman Brothers and the Federal 
rescues of AIG and Fannie Mae and Freddie Mac, the Federal 
response turned toward a much more aggressive set of 
interventions in an effort to ensure that after the collapse of 
Lehman Brothers there would be no more defaults by large 
financial institutions. Of course, this kind of approach was 
made much more explicit by the Emergency Economic Stabilization 
Act and the TARP program.
    It has become very clear that 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 that we ever will. 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.
    And I would submit to you that, unfortunately, the Act 
passed last fall did not really fix these problems.
    In addition, we appear to be hopelessly confused as to what 
it means to stabilize a troubled financial institution to avoid 
systemic harm. 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 necessarily be propped up with taxpayer funds.
    In response to these circumstances, the Congressional 
Oversight Panel, in its report to Congress mandated by the 
Emergency Economic Stabilization Act, made the following points 
about addressing systemic risk:
    First, we agreed with both you and Senator Collins and the 
prior witness that there should be a body charged with 
monitoring sources of systemic risk in the financial system, 
and we left open the options that it could be a new agency, an 
existing agency, or a group of existing agencies.
    Second, the body charged with systemic risk management 
needs to be fully accountable and transparent to the public in 
a manner that exceeds the general accountability mechanisms 
present today either in the Federal Reserve Board or in other 
self-regulatory organizations. If the Congress and the 
President were to look to the Federal Reserve, the panel 
recommended that there would have to be governance changes.
    Third, contrary to Mr. Litan's testimony, we should not 
identify specific institutions in advance as too big to fail, 
but, rather, we should have a regulatory framework in which, in 
a graduated fashion, institutions have higher capital 
requirements and pay more in insurance funds on a percentage 
basis than smaller institutions which are less likely to need 
to be rescued as being too systemic to fail.
    Fourth, we do, here, very much agree with Mr. Litan that 
systemic risk regulation cannot be a substitute for routine 
disclosure, accountability, safety and soundness, and consumer 
protection regulation of financial institutions and financial 
markets.
    Fifth, effective protection against systemic risk requires 
that shadow 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 Commission.
    Sixth, and here again I echo the testimony of the prior 
witness, we found that there are some specific problems in the 
regulation of financial markets--such as issues of incentives 
built into executive compensation plans and the conflicts 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.
    And, finally, the panel found that there will not be 
effective re-regulation of the financial markets in general, 
and including in the area of systemic risk, without a global 
regulatory floor. However, I think it is very clear that our 
recommendations agree with Mr. Litan that this should not and 
cannot be an excuse for inaction here in the United States now.
    As to who exactly should be the systemic risk monitor, 
well, the panel made no recommendation.
    I have come to believe that the best approach is a body 
made up of the key regulators much as Senator Collins 
described. There are several reasons for my conclusion.
    First, such a body must have as much access as possible to 
regulatory agency expertise and to all the information extant 
about the condition of the financial markets, including not 
just banks and bank holding companies but securities, 
commodities, and futures and consumer credit markets, more 
broadly.
    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, 
and I do not believe it is practical or wise to try to 
duplicate or centralize all capital markets information in one 
new agency or one existing agency.
    Second, as I noted earlier, the panel concluded 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 which you alluded to, 
Mr. Chairman, highlights a much more bright-line problem. An 
effective systemic risk regulator must have the power to bail 
out institutions. 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. 
Here, the distinction really is between lending money and 
investing in equity much as we have done in the TARP program, 
though such a body should be insulated from politics--much as 
our other financial regulatory bodies are--to some degree by 
independent agency structures.
    As to the Federal Reserve, while the Federal Reserve can 
offer liquidity, many actual bailouts, as I said, require 
equity infusions which the Federal Reserve currently cannot 
make nor should it be able to make as long as the Federal 
Reserve continues to exist as a not entirely public 
institution. In particular, the very bank holding companies the 
Federal Reserve regulates today are involved in the governance 
of the regional Federal Reserve banks that are responsible for 
carrying out the Federal Reserve's regulatory mission on a 
daily basis 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 as to the Federal Reserve's role 
as central banker and the great importance of distance from the 
political process in that function and the necessity of 
political accountability and oversight once a body is 
discharged with disbursing 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, and I 
think we have seen some of that in recent months.
    One benefit of a more collective approach to systemic risk 
monitoring, as Senator Collins suggested, is that the Federal 
Reserve Board could participate in such a body, and I believe 
that is essential. You cannot do this function, I think, 
without the Federal Reserve's involvement while having to do 
much less restructuring of the Federal Reserve's governance 
that would likely be problematic in terms of the Federal 
Reserve's monetary policy role.
    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 insure. On 
the other hand, it seems mistaken to try and make large 
securities firms behave as if they were commercial banks.
    Finally, as I said earlier, 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 effectively become a kind 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 not likely to succeed.
    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 key, though, in the end is to make sure that as 
Congress approaches the issue of systemic risk, it does so in a 
way that bolsters a broader re-regulation of our financial 
markets, closing in a day-to-day way the profound gaps in our 
system that both you and Senator Collins alluded to, and that 
systemic risk regulation, while it is important that it be 
done, does not become an excuse for not engaging in that 
broader re-regulation.
    Thank you very much.
    Chairman Lieberman. Thanks, Mr. Silvers. Excellent 
statement. I will have some questions for you.
    Our last witness is Bob Pozen. It is good to see you again.
    Mr. Pozen. Glad to see you, Senator.
    Chairman Lieberman. We go back some distance to our halcyon 
student days.
    Mr. Pozen. Yes, those were the days.
    Chairman Lieberman. Those were the days, my friend. That is 
the end of our discussion of that subject.
    But, Mr. Pozen has gone on to be a leader in the financial 
services business over the years. He comes to us today from MFS 
Investment Management and has really been a creative thinker on 
a lot of public finance questions over the years, to the 
benefit of Congress and previous presidents.
    So, it is great to have you here today to help us 
understand this question and hopefully to do something 
constructive about it. Thank you.

   STATEMENT OF ROBERT C. POZEN,\1\ CHAIRMAN, MFS INVESTMENT 
                           MANAGEMENT

    Mr. Pozen. Thank you, Senator, and thank you and your 
Committee for inviting me to speak.
---------------------------------------------------------------------------
    \1\ The prepared statement of Mr. Pozen appears in the Appendix on 
page 304.
---------------------------------------------------------------------------
    Instead of giving a long presentation, let me try to really 
focus in on a few of the issues.
    Are we likely to have more or less systemic risk failures?
    There was a study done on how many financial crises we have 
had in the 20th Century. This study was done by Professor 
Eichengreen from Berkeley. From 1945 to 1971, there were 38 
financial crises across the world. Between 1973 and 1997, there 
were 139 financial crises of which 44 took place in high income 
countries. In the last decade, besides this one, we have seen 
the Asian financial crisis and the dot.com crisis.
    So I think it is fair to say that the trend line for crises 
is definitely rising.
    Now you ask a good question about what is systemic risk, 
and I do agree that it is a term that is loosely thrown around 
a lot. To me, one of the more useful exercises is to think 
about what historically have been the leading indicators that 
have come before financial crises if you look at them as a 
group. There are five indicators that we can say that tend to 
occur, though not always, before a financial crisis.
    The first is that when a country has a very much above 
trend line set of real estate prices. This is not just true in 
the United States but was true in Japan, and also was true in 
Australia and other countries.
    A country must be way above trend line, which is what we 
were, and financed by a credit boom. You need both--not just 
real estate prices above trend line, but also financed by a 
credit boom of easy money. That combination is often associated 
with a crash at the end.
    The second leading indicator is very high leverage ratios. 
For example, if we look at all the things that happened in 
2004, the SEC agreed to essentially allow the five investment 
banks to triple their leverage ratios from about 10 to 1 to 30 
to 1.
    Such a high leverage does lead to a potential for systemic 
risk because then all you need is a small loss, and you are in 
trouble. At that point, you would like to raise capital, but 
you cannot. And so, you start selling assets, which depresses 
the price of assets held by others. In this manner, you start a 
downward spiral.
    The third leading indicator is when you have gaps in the 
regulatory system. Here, probably the most obvious was for 
credit default swaps (CDS). But these gaps for CDS were not 
hidden. People knew them. People saw them. People had a chance 
to make a decision on them, and they chose not to act. Then in 
this regulatory vacuum, credit default swaps increased quickly 
to the $50 to $60 trillion level of nominal value.
    The fourth leading indicator is having an asset class that 
experiences explosive growth. That is what we saw in the 
collateralized debt obligation (CDO) market, for instance. When 
you see a product that goes from small to very large, you ought 
to beware. Similarly, we went from $250 billion in hedge funds 
assets to $2 trillion in about 10 years. Either hedge fund 
managers are absolute geniuses or there is something that does 
not quite make sense there. So this type of growth spurt is 
very much worth looking at.
    The fifth leading indicator is the mismatch between long-
term assets and liabilities. This, obviously, was 
characteristic of the savings and loan crisis where you had 
long-term mortgages and short-term deposits.
    What is less known is that many issuers of securitized 
assets recreated this mismatch problem. So you would have long-
term mortgages bought by a special purpose entity, which would 
be financed by 60-day or 180-day commercial paper. Such a 
mismatch has the potential to create a liquidity crisis.
    So those are five areas that we really ought to look at 
closely. It may be more useful, rather than talk theoretically 
about systemic risk, to focus on those five types of 
situations.
    What should we do to prevent systemic risks from 
materializing? Let's start with efforts to close the regulatory 
gaps. We had a chance to regulate hedge funds as well as credit 
default swaps. But we chose not to in both cases--one a 
product, the other an institution.
    So there were regulatory gaps which were discussed but not 
closed, not for lack of knowledge, but for lack of political 
will.
    Second, we gave various regulators only partial 
jurisdiction over their own turf. The most important example is 
that the SEC did not have jurisdiction over the holding company 
of investment banks. In fact, if you look at the whole Lehman 
complex--let's say there were 200 subsidiaries--the SEC 
probably had jurisdiction over less than 10.
    So you need a consolidated regulator for each institution 
because we know people can play games with affiliates and 
parents and these sorts of things. That is really a crucial 
objective.
    Third, as Mr. Litan mentioned, we should not try to have 
all institutional monitoring done by Federal officials. We need 
help from the market, and the best helpers in the market are 
the debt holders. Unfortunately, we have now undertaken a 
program where the FDIC is guaranteeing 100 percent of almost 
all debt for 10 years--not only of banks and thrifts, but also 
of their holding companies. Please note that thrift holding 
companies include General Motors and General Electric.
    By these broad guarantees, we have created a moral hazard. 
We have eliminated the people in the market who are most likely 
to help us police these institutions--the large debt holders of 
these institutions.
    Last, I think we do want to make sure that we are looking 
at institutions across the board and not just ones that have 
Federal charters. One category of institution with potential 
systemic risk is very large insurance companies which are 
regulated by the States. We also have the very large mortgage 
lenders, which under last summer's act are licensed by the 
States. Those are two areas where we should think about whether 
a few very large institutions might come under a Federal 
regulator.
    My last point is that we should not try to form a new 
Bretton Woods, whatever that means. We have a hard enough time, 
as you know, getting everyone in the Senate to agree on 
legislation. Since the chance of getting all major countries to 
agree on a new international institution is remote, we should 
not spend a long time waiting for this to happen.
    What should we do here in the United States?
    I am personally quite skeptical about the consolidation of 
all financial agencies into one. We did not see a lot of 
benefit from the Financial Services Authority (FSA) in the 
United Kingdom, a consolidated regulator, in terms of 
preventing a financial crisis. These consolidations of agencies 
have as many problems as they do benefits.
    As Mr. Litan pointed out, you do not want too many cooks. 
You want one person or agency with responsibility for each 
financial service. Also, you want an agency that is pretty 
nimble. If it is a big bureaucracy with lots of different 
divisions, it is hard to move quickly.
    I tend to think that the Federal Reserve is the right 
agency to be the monitor of systemic risks. It has a lot of 
experience in keeping tabs on macroeconomic trends.
    I also agree with Mr. Litan's point that the Federal 
Reserve has been acting as a consumer protection agency in the 
mortgage disclosure area. It is not a function that fits in 
very well with what the Federal Reserve does. Quite frankly, 
the Federal Reserve did not do a very good job in that area, so 
I would tend to move that function to another agency.
    According to Federal Reserve officials, their jurisdiction 
over banks and bank holding companies helps them understand 
risk and other financial issues. So I would leave that 
jurisdiction with the Federal Reserve.
    My model, which I outline in my written testimony, is that 
the Federal Reserve would be the central risk regulator. The 
buck stops there. But it would not be the primary regulator of 
all large financial institutions. We would leave that to the 
functional regulators for several reasons.
    First, I do not want to identify these systemically risky 
institutions because then everybody will want to become one. 
This could pose an antitrust problem. Institutions will want to 
merge so that they can become too big to fail. If you are 
systemically monitored and you are labelled that way, then 
everyone will feel you will never be allowed to fail and act 
accordingly.
    Second, I think the functional regulators know a lot more 
about their areas than the Federal Reserve does. For instance, 
in my view, large hedge funds should be registered with the 
SEC, which should inspect their books and have them file 
reports. But the SEC should funnel information to the Federal 
Reserve that relates to macro risks.
    And so I see us as having a lot of functional regulators 
feeding information to the Federal Reserve, and the Federal 
Reserve with the job of putting it all together. I would not 
start a new agency just to monitor systemic risk. To start a 
new bureaucracy takes a lot of time and effort.
    I think the Federal Reserve, if it lost its mortgage 
disclosure function, is the appropriate agency to monitor 
systemic risks. It would have to develop more expertise in 
capital markets, but it would be sent information by all the 
functional agencies with their experts.
    Then, if the Federal Reserve decided action needed to be 
taken to reduce the potential for a systemic failure, it would 
not just act itself. It would go back and consult with the 
primary regulator, the SEC, the insurance regulator, or the 
FDIC, so we would get a combined effort. You really would not 
want the Federal Reserve acting alone on systemic risk without 
the knowledge or expertise of the relevant functional agency.
    So that is my recommended approach. I guess my approach is 
roughly between those of the prior two speakers. It is making 
the buck stop with the Federal Reserve, but setting up a system 
by which it relies on inputs from all the functional 
regulators. This approach would produce some of the benefits of 
coordination that Mr. Silbers was advocating.
    Chairman Lieberman. Thanks. It is very interesting, and 
very helpful. We will have 7-minute rounds of questions.
    I find your term, central risk regulator, to be more 
comfortable than the systemic risk regulator. You have said, 
Mr. Pozen, in your ideal vision of what should happen here, the 
Federal Reserve would be the central risk regulator, and Mr. 
Silvers and Dr. Litan have also spoken about the value of a 
central risk regulator whether it is a new agency or a college 
of regulators.
    I want to understand what this central risk regulator does 
in your vision of the Federal Reserve playing that role. To go 
back to my earlier observation, it is different, is it not, 
from filling the gaps that exist in current regulation?
    Mr. Pozen. Absolutely.
    Chairman Lieberman. In other words, if credit default swaps 
in the trillions of dollars or hedge funds in the trillions of 
dollars are operating essentially unregulated, the systemic 
regulator or central risk regulator may keep an eye on that, 
but we need to give somebody else the authority to regulate 
them.
    Mr. Pozen. I agree with that. Under my approach, there 
would always be someone else as the primary regulator except 
for Federal Reserve banks and bank holding companies.
    Chairman Lieberman. What would the Federal Reserve, as a 
central risk regulator, do?
    Mr. Pozen. I think the Federal Reserve would focus on the 
five historic indicators of financial crises outlined in my 
testimony.
    Chairman Lieberman. So they would watch out for those.
    Mr. Pozen. Yes, they would look to see which products or 
which institutions were growing very rapidly.
    Chairman Lieberman. Right.
    Mr. Pozen. They would look to see what financial firms had 
very high leverage ratios. They would look to see whether any 
sort of financing bubbles are being created. And I am sure if 
they look carefully at the history of financial crises, they 
would wind up with 10 more concrete indicators of what factors 
are likely to cause a financial crisis. Those are the areas 
where they ought to focus.
    Further, it seems to me, it would be part of the Federal 
Reserve's job to point out where gaps exist and to request that 
gaps be filled in the regulatory structure.
    Chairman Lieberman. OK.
    Mr. Pozen. They would not be the ones to fill them, but 
they would say: OK, we have this new product. It is a credit 
default swap. The New York State Insurance Department has 
declared it is not an insurance contract, but it is growing 
very quickly.
    It is very important. It really should not be regulated by 
the States. It should be regulated by some Federal agency. We 
call on Congress to fill this gap.
    Chairman Lieberman. Yes.
    Mr. Pozen. And that would be a second important function.
    Chairman Lieberman. So, right now, the Federal Reserve is 
not carrying out that kind of central risk regulation oversight 
function, not asking the kinds of questions that you and the 
others think should be asked as what might be called early 
warnings of coming broad-scale failure.
    Mr. Pozen. Yes. I think, unfortunately, the Federal Reserve 
tends to get involved when the failure is upon us.
    Mr. Silvers. When the horse is out of the barn.
    Chairman Lieberman. Right. Does it have the authority now 
in statute to perform that central risk regulation?
    Mr. Pozen. I do not think it really does.
    Chairman Lieberman. So that would be something we would 
need to do.
    Mr. Pozen. It has broad authority relative to bank holding 
companies.
    Chairman Lieberman. Right.
    Mr. Pozen. But it really does not have authority as a 
general risk monitor. It can cooperate with the other agencies, 
but they are not under an obligation to give the Federal 
Reserve information on a regular basis.
    Chairman Lieberman. Of course, if the Federal Reserve is 
not performing that central risk regulating role, no other 
institution is either.
    Mr. Pozen. That is true, and I think that the Federal 
Reserve probably would need to broaden its capabilities. There 
are certain areas where the Federal Reserve is very strong, 
say, in macroeconomic analysis. Becoming a general monitor of 
systemic risks would require that the Federal Reserve become 
more sophisticated in capital markets.
    Chairman Lieberman. Right.
    Mr. Pozen. As I say, while the Federal Reserve has acted in 
part as a consumer protection agency, this seems out of sync 
with its core functions.
    Chairman Lieberman. I agree.
    Mr. Pozen. So we ought to think carefully. There may be 
other functions that should be taken out of the Federal 
Reserve's mandate.
    Chairman Lieberman. Taken away, yes.
    Mr. Pozen. And so, the Federal Reserve ought to be a bank 
regulator and a central risk monitor.
    Chairman Lieberman. Yes. In a way, you are answering the 
concern that some like former Treasury Secretary Paul Volcker 
have expressed, that if we put this function--central risk 
regulator, early warning, etc.--on the Federal Reserve, we may 
be overloading it. But you are saying, take some of what it is 
doing now away from it because it is less urgent.
    Mr. Pozen. I think it is not only less urgent, it is a 
consumer protection function. As I am sure Mr. Silvers would 
agree, consumer protection should be the main focus of an 
agency.
    If you tell an agency, you have to be a prudential 
regulator and you have to also look after consumer protection, 
consumer protection tends to get subordinated and solvency 
takes precedence.
    Whether it is the SEC, the FTC, or some other agency, 
investor protection and consumer protection need to be placed 
with an agency where that is their main mandate.
    Chairman Lieberman. Mr. Silvers and Dr. Litan, is there 
general agreement on what the systemic or central risk 
regulator should be doing?
    I know there is disagreement on who should do it among you. 
But do you agree that it is to ask the kinds of early warning 
questions that Mr. Pozen has described?
    Mr. Silvers. Mr. Chairman, I would sort of unpack that a 
little bit more, I would guess.
    Chairman Lieberman. Go ahead.
    Mr. Silvers. Well, two points. One is that I think our 
history of our existing regulatory bodies, including the 
Federal Reserve and particularly the Federal Reserve, at 
performing that early warning function has not been very good.
    In our report, we recommend essentially a body of 
nongovernmental experts, academics, people like my colleagues 
on this panel not embedded in the daily to and fro, who would 
play that kind of reconnaissance function. That recommendation 
from the Congressional Oversight Panel, I think is in large 
part based on the actual track record of the Federal Reserve 
and, to a lesser degree, the other agencies.
    Chairman Lieberman. That is very interesting. And that is 
different from the college of regulators?
    Mr. Silvers. Yes. That is a different panel. It is not 
something with significant staff. Its sole purpose is to have a 
check outside the regulatory processes and the political 
processes, intellectually.
    Mr. Pozen. I think it is an interesting idea. It is like an 
advisory commission to the Pentagon, as we now have in defense.
    Mr. Silvers. Well, precisely.
    Mr. Pozen. I think it is very consistent with having the 
Federal Reserve as the central risk monitor. This would be a 
group that would act as an idea generator and would keep the 
Federal Reserve on its toes. It seems like a good proposal.
    Mr. Silvers. In particular, it would issue a mandated 
report, in our view, to Congress on what is coming over the 
horizon.
    Second, Mr. Chairman, this, I am afraid, is influenced by 
my experience and our experience with respect to TARP, that we 
looked at the systemic risk regulator as, in part, having this 
advance warning function but also necessarily being the body 
that acts when a systemic crisis occurs.
    And it turns out, of course, we have experienced it when a 
systemic crisis does occur, that the range of action often 
turns out to be much more extensive and much more involving 
public money than we might have thought in advance.
    Chairman Lieberman. Right. I am over my time. But, Dr. 
Litan, why don't you get into this a moment?
    Mr. Litan. Yes. So, I have a couple of points.
    One, the idea of an outside body doing the warning is an 
interesting idea. It is not mutually exclusive. You can have 
them and the Federal Reserve do this. So I think that is point 
one.
    Point two, in an ideal world, you would like to keep the 
list of the SIFIs private.
    As a practical matter, however, the markets will interpret 
any large institution that, for example, may have larger 
capital requirements or different liquidity requirements as 
being a SIFI. It will take the markets about five seconds to 
figure out that the regulators are treating these institutions 
differently, and, as a practical matter, the secret will be 
out.
    And the last point is the issue that Mr. Pozen has raised 
and, actually, Mr. Chairman, you raised. Do we agree on exactly 
what this regulator should do? We all agree that early warning, 
probably supplemented with some outside advice, but I think 
there is some disagreement about how much the systemic 
regulator needs to get into the weeds.
    So, under one model, let's say Mr. Pozen's model, they 
delegate, but they are overseeing and they are issuing 
thunderbolts, if you will.
    In my model, I am actually having them on the front lines 
and being involved in the direct supervision of the 
systemically important institutions. They have the expertise 
already from supervising large bank holding companies. They 
would need more staff, I admit. I think you would probably 
borrow them from the Comptroller and other agencies.
    But the thing that worries me about the sort of delegation 
model is that it violates the ``buck stops here'' principle. I 
worry that the Federal Reserve Chairman will call up the OCC 
and say, look, you ought to watch Citigroup and certain other 
large institutions more carefully. And the Comptroller says, I 
do not agree. And then they argue.
    That is what happens in the real world. Now not all the 
time, and it is true that the Federal Reserve Chairman does 
have a lot of influence. But I have been in government before, 
at least in the Executive Branch. People have different views 
about these things.
    Ultimately, at the end of the day, let's take the Federal 
Reserve if they are going to be the agency. If they are the 
ones shelling out the bucks, it seems to me they ought to have 
the final say on what is going on underneath with the 
institutions.
    Mr. Silvers. But they are not shelling out the bucks. That 
is the problem.
    Chairman Lieberman. I will give you a quick response, and 
we will go to Senator Tester.
    Mr. Pozen. Thanks. First, that would require the Federal 
Reserve to have deep expertise in six or seven different areas. 
That is not likely.
    Second, I think the buck still stops at the Federal 
Reserve. It just gets information from these other agencies.
    And, third of all, we do have the President's working group 
to resolve disputes among financial agencies.
    Mr. Silvers. Senator Lieberman, just one sentence about 
this: The Federal Reserve is not ultimately shelling out the 
bucks. The taxpayer is, meaning that when we move to a real 
systemic crisis, as we have learned through TARP, it is the 
taxpayer shelling out the bucks. And that is why. That 
underlies my view that it needs to be a public body.
    Chairman Lieberman. So the question is not only where the 
buck stops but who is shelling out the bucks.
    Mr. Silvers. Right.
    Chairman Lieberman. OK.
    Senator Tester, you may have heard a term being used by Dr. 
Litan, SIFIs. I want to assure you that you arrived at the 
right hearing, that we are not exploring the world of Dr. 
Spock. SIFIs, as I have learned this morning, are systemically 
important financial institutions.
    With that, it is all yours.

              OPENING STATEMENT OF SENATOR TESTER

    Senator Tester. That is good to know, Mr. Chairman. I 
appreciate that because I was thinking maybe I did not do 
enough reading last night.
    I, first of all, apologize for not being here for the 
beginning of the testimony. I appreciate you being here as 
always, and I appreciate the Chairman for calling this hearing.
    As you folks well know, how we get consumer confidence back 
in the system is going to be critically important and how we do 
it and do it right is not going to be, at least from my 
perspective, easy.
    Let's just talk about the Federal Reserve for a second and 
follow up on some of the things the Chairman was talking about. 
If it becomes the major central systemic regulator, is there 
fear of too much power in one agency?
    Mr. Pozen. Senator Tester, it is a good question. I would 
answer that in two ways:
    First, we were talking--and I am not sure exactly when you 
came in--about taking some functions away from the Federal 
Reserve such as consumer protection in the area of mortgage 
disclosure. This is not central to the Federal Reserve's 
mission, and perhaps it has not done as good a job as it should 
have.
    Second, at least under my model, the Federal Reserve would 
not be the primary regulator of, say, an investment bank or an 
insurance company. That would still stay with the functional 
regulators, who would work closely with the Federal Reserve. 
Information relating to systemic risk would be channeled to the 
Federal Reserve from the SEC, the Comptroller of the Currency, 
etc., and the Federal Reserve would have the ability to get 
more information from these agencies.
    By contrast, if we ask the Federal Reserve to be the 
primary regulator of, say, the 20 largest financial 
institutions, then it would have a lot of power, and it would 
have to develop a lot of different kinds of expertise.
    In my view, you solve the problem of having the Federal 
Reserve becoming too powerful by following a decentralized 
approach. I would call it a specialized expertise model. For 
example, the SEC would spend most of its time on investor 
protection; it is not focused on systemic risks. But the SEC 
would pass on risk-related information to the Federal Reserve, 
which would aggregate it with other data in analyzing systemic 
risks. The SEC is an investor protection agency, and that is 
what it does best.
    Mr. Silvers. Senator, I think your concern is well founded, 
and I think that it is well founded for the following reason: 
If you ask the Federal Reserve to play this role, you are then 
asking the Federal Reserve either to take on real power, as I 
think Mr. Litan would like it to do, or the question becomes 
what real abilities is this process going to have to achieve 
the purpose, to actually constrain systemic risk and to act in 
a crisis.
    If we give the Federal Reserve real power, then the concern 
outlined in my testimony comes to the fore, which is that the 
Federal Reserve is not a fully public body. In particular, the 
operational arm of the Federal Reserve and the arms of the 
Federal Reserve in the financial markets, the regional Feds, 
are both capitalized and governed in part by the very 
institutions that they regulate. The result of the Federal 
Reserve not being a completely public institution is that the 
Federal Reserve is neither fully accountable or transparent to 
the public.
    That is not an appropriate structure in which to vest 
either the kind of broad regulatory powers that are being 
envisioned here by some of my colleagues on the panel nor is it 
an appropriate structure to hand over the power to disburse 
taxpayer funds which is a necessary component of systemic risk 
regulation when a crisis hits. For that reason, if one wished 
to vest the Federal Reserve with this type of power, you would 
have to change its governance pretty significantly, and it is 
not clear that is a good idea in relation to the Federal 
Reserve's actual core mission which is monetary policy.
    Furthermore, I am very influenced by two issues of 
expertise and information sharing. My colleague, Mr. Pozen, 
thinks it will be easily handled, but I think it will not. I 
think if systemic risk management is not collective among the 
agencies, that information will not be shared in an appropriate 
way. I think that is just human nature and the nature of 
matters in Washington.
    And, second, I think that the expertise in the broader 
capital markets that Mr. Pozen is convinced can be easily 
acquired by the Federal Reserve is not actually that easily 
acquired and, second, would be completely duplicative of 
expertise resident in the SEC and the CFTC today.
    Mr. Pozen is correct that the SEC's culture is not a risk 
management culture. It is a disclosure and fiduciary duty-
related culture. But that is why you want to bring these 
agencies together to conduct this function.
    The punch line, I would say, though, is that we cannot turn 
over this type of responsibility, either in terms of power to 
regulate or in responsibility to regulate and in terms of the 
ability to expend the taxpayer dollars to an institution that 
in its ultimate functioning is self-regulatory and not 
completely publicly accountable. It would be irresponsible to 
do so.
    Mr. Litan. We do not live in a perfect world. We have all 
kinds of tradeoffs with these considerations.
    So, to the point about their governance structure, I think 
if you give more power to the Federal Reserve you may have to 
change its structure. For example, if you told the Federal 
Reserve that it has regulatory responsibility, you could say 
that part of their activity is subject to the appropriations 
process and is under congressional oversight.
    You can leave monetary policy the way it is, where the 
Federal Reserve gives the money back at the end of the day, 
assuming it has any these days. But, in any event, you could 
change the way the Federal Reserve's regulatory activities are 
conducted. That is point one.
    Point two, you could rebalance the concentration of power--
for example, by transferring the mortgage or the consumer 
protection part of the Federal Reserve to other agencies.
    At the end of the day, and I do not want to exaggerate 
here, we have had the financial equivalent of a nuclear 
meltdown. That is what it is. This is a horrific set of 
circumstances. Frankly, it blows my mind. I would have never 
expected this 2 years ago if somebody had told me this was 
going to happen. And God forbid anything like this should 
happen again.
    So, at the end of the day, if that is the image that you 
have in your mind, do you want a committee making the decisions 
about this or do you want some one agency in charge?
    I would feel more comfortable if someone was in charge, so 
at the end of the day, after it all happened, we do not have 
fingerpointing again, where the Federal Reserve Chairman comes 
before you and says, I recommended X, Y, and Z to the CFTC and 
the SEC and the Comptroller, but they did not listen to me. And 
the Comptroller says, no, we have a difference in views. And 
then we have fingerpointing.
    At the end of the day, you, in Congress, want somebody to 
be held responsible. So, if the magnitude of the problem 
warrants it, you concentrate the power, and then you subject it 
to oversight to solve the transparency problem. That is my 
view.
    Senator Tester. Can I keep going?
    Chairman Lieberman. Go right ahead.
    Senator Tester. All right.
    The thought occurred to me as each of the three of you were 
speaking that we have a Committee here of 17 members, and the 
Banking Committee has the same kind of committee, and I 
wondered if you three could get together and could come up with 
a program that would work because it is going to be five times 
more difficult for us, plus with a lot less expertise.
    Consumer protection versus systemic regulation, are they 
exclusive to one another?
    For instance, good central systemic regulation, is that 
good for consumers? Is that good for consumer protection? Does 
one fit the other's needs and vice versa?
    Mr. Silvers. Senator, I think there are many ironies built 
into the answer to your question.
    The first irony is that I think it is hard to read the 
record of the Federal Reserve's oversight of the mortgage 
markets and not conclude that the Federal Reserve felt that 
consumer protection was an afterthought, and it turned out that 
without effective consumer protection there was no effective 
systemic risk management. Things ran exactly the opposite to 
what the assumption was.
    I think the lesson from this--I think Mr. Pozen talked 
about this a few moments ago, and I absolutely agree with him--
is that there is a tension between not so much systemic risk 
management properly construed but what it often turns into, 
which is the desire to protect the safety and soundness of 
particular institutions. There is a tension between that and 
consumer protection in real life.
    I think everyone who has been in this area knows that 
typically bank regulators are safety and soundness focused, as 
they should be. The safety and soundness mission is quite 
important.
    But the result when you put those two missions together is 
that you get neither. You get neither effective consumer 
protection nor effective safety and soundness regulation. For 
that reason among others, the Congressional Oversight Panel 
recommended a separate consumer protection regulator.
    Now there are several options built into the report. I 
would make clear my view is that consumer protection in the 
financial markets needs to be separated from the safety and 
soundness mission entirely.
    Then the question is where does it go? It could be a 
distinct agency. It could be the Federal Trade Commission which 
has consumer protection responsibilities. It could be the SEC.
    There is a caveat to the SEC. I am an extremely strong 
supporter of that institution and believe it needs to be 
revived and strengthened. However, its conception of its 
mission is heavily oriented toward disclosure and toward 
fiduciary duties. It is not a substantive regulator of the 
fairness of the markets it regulates.
    Consumer financial services--mortgages, insurance, insured 
bank accounts, credit cards--are areas that I think pretty 
obviously need substantive oversight. It is not clear that the 
culture needed matches the SEC's culture and mission.
    But the larger point that consumer protection and investor 
protection need agencies focused on those missions is exactly 
right, and I hope if we learn one lesson from this meltdown 
that Mr. Litan described it is that if you do not get that 
mission right, you are very likely to get these larger systemic 
missions wrong as well.
    Mr. Pozen. I think the short answer is that they are 
related and that the breakdown of one can lead to a breakdown 
of the other. However, as a matter of regulatory strategy, I 
strongly agree with Mr. Silvers that we probably want to take 
the consumer protection functions out of the Federal Reserve, 
put them in an agency where that is the main focus, and then 
the Federal Reserve will concentrate on solvency and other 
aspects of systemic risk. That seems to be the way to go.
    Mr. Litan. And I agree entirely with what Mr. Silvers said. 
In an ideal world, or even less than an ideal world, I would 
consolidate the SEC with something like a FTC to melt down 
these cultures.
    I just want to make one additional point. In my 
professional life, I am sort of bicoastal. I live in Kansas 
City, but I am also affiliated with the Brookings Institution. 
So I am here on the East Coast a lot. Aside from the 
disadvantage of traveling on airplanes, the advantage of being 
bicoastal is that I get to live in the Heartland and hear real 
people most of the week, and it has been good.
    I will tell you one of the things I have heard from 
traveling around the country, and I am sure that you too, when 
you go back to your home districts, hear this. The public is 
not only furious, the public has no confidence in our 
regulatory system. When I talk to groups about how to try to 
fix this and reorganize the government, at the end of the day, 
I want to tell you that I think we have an unbelievably 
skeptical public about the ability of regulation to fix the 
financial system. So that whatever we do, wherever we lodge the 
power, we have a huge uphill road to climb with the public.
    And what really has sent people over the edge is the Bernie 
Madoff affair. People all over America are asking: How could 
something like this happen in the United States?
    And so, in addition to your point about the culture of the 
SEC being different from the others and how we have to change 
the culture there, we also have to convince a very skeptical 
public right now that there is a fix out there that will work.
    Senator Tester. I will just tell you I hear the same exact 
thing, and I, quite frankly, am just as frustrated and just as 
furious as they are. Whether you are talking about Mr. Madoff 
or whether you are talking about how some of those TARP funds 
were used. We will just leave it at the fact that things are 
not running smoothly at this point in time.
    I think they will be fixed. I think it is just a matter of 
time and getting some common-sense regulation. But what is good 
for consumer protection, I heard you guys say, is also good for 
systemic regulation, and that is important.
    I do have some other questions, but I will wait for another 
round. Thanks, Mr. Chairman.
    Chairman Lieberman. Thanks, Senator Tester.
    Senator Tester is one of, I think, two Members of this 
Committee who is also on the Banking Committee. So that is an 
important overlap.
    I agree with you. I hear the same thing at home. Even 
though the Madoff scandal is not, at its heart, relevant to or 
the same as the housing bubble, the credit default swaps, etc., 
it does connect to the critical point of whether there was a 
fiscal cop on the beat. How could this guy get away with this 
Ponzi scheme particularly when we now have this gentleman who 
seemed to have been trying to get the SEC to investigate for 
years?
    So this work is urgent. I know that the President hopes to 
at least have an outline of a proposal before he goes to London 
in early April. But it is critical now in terms of the 
confidence without which the economy will not recover.
    Senator Burris, thanks for being here. We turn to you now.

              OPENING STATEMENT OF SENATOR BURRIS

    Senator Burris. Thank you, Mr. Chairman.
    I certainly have gone through the testimony of the 
witnesses even though I was not here to listen to them.
    Being an old banker and a part of some of that system 
during my younger days, I am just wondering, where did we lose 
control of this situation?
    You have the FDIC, the Comptroller of the Currency, the 
SEC, all of these regulators. Was it turf that started some of 
this or nobody ending up with complete oversight and authority 
for something like this to happen?
    When we got rid of Glass-Steagall, the banks started using 
all types of different instruments and insurance and all these 
other things. Where did we lose control for the systemic 
problem to come in?
    Mr. Silvers. Senator, there are probably as many answers as 
there are hours in the day to that question, but let me give 
you a couple of thoughts that you may be surprised by.
    One thing that is quite striking right now as we look at 
the crisis of our mega-institutions is how few actual bankers 
you find running them. When you start asking, well, who is in 
charge here? Where are the people who know about underwriting 
loans? The sort of old-fashioned bankers?
    Senator Burris. Which I was, an old-fashioned banker.
    Mr. Silvers. They are hard to find, and that, I think, 
tells us something fairly deep.
    I will take it one step further. We moved very dramatically 
over the last 30 years, and you can see it in all kinds of 
statistics about where financial assets are, away from banking 
and institutions and toward markets, toward derivatives 
markets, toward securitization markets and so forth.
    There are a number of advantages to having done that, but 
it is hard not to look at what has happened and also see that 
there have been some profound disadvantages to that, including, 
and I think the Chairman referred to this in his opening 
remarks, the lack of skin in the game, in securitizations, for 
example.
    There is a deep belief among many academics that markets 
are extraordinarily good at capturing information and making 
decisions about things like risk. It is a little unclear to me, 
looking at this landscape and this history, as to whether that 
is really true in relationship to the old-fashioned kind of 
banking activity that you were just describing.
    Second, with respect to regulators and where did we lose 
control on a regulatory basis, I think several big bad ideas 
got going. One big bad idea that I refer to in my written 
testimony goes back into the 1970s, which is the notion that 
financial regulation is about protecting the weak, so that 
basically we look very heavily at how essentially poor people 
are treated and consumers are treated, but we do not look very 
much at large, sophisticated actors because we figure they can 
take care of themselves.
    That idea, and I am not in any way at all against consumer 
protection or against measures for the weak, but the idea that 
we let the strong do whatever they want turns out to be exactly 
what produces a systemic catastrophe. It also fed this notion 
of regulatory loopholes, regulatory holes in our system.
    Then, finally, I would just observe that it is very clear 
that the place where the breakthrough really took off, the 
moment in time when we really let our credit systems run loose 
was in the very early part of this decade. It is what I would 
call essentially idiot Keynesism. Policy decisions were made to 
stimulate our economy through individual borrowing rather than 
intelligent Keynesism which is what I think Congress and the 
President are engaged in today.
    That is an unsustainable move, idiot Keynesism. You cannot 
stimulate an economy through lending money to people who cannot 
pay it back.
    I would finally note, and I think this will not surprise 
you now, coming from an employee of the labor movement, that 
ultimately the decision to try to have a high consumption, low 
wage society was a prelude to disaster and that we tried to 
make up the gap through credit, and it is not a sustainable 
strategy.
    Mr. Pozen. Let me just take up one aspect of what Mr. 
Silvers said because it has not been focused on that much.
    Senator Burris. Sure.
    Mr. Pozen. I personally was recruited to serve as an 
outside director of two large banking institutions, and I was 
shocked by how little expertise there was on those boards. In 
the end, regulators can only do so much. The day to day, month 
to month work must be done by boards. But if you look at a lot 
of bank boards, you really have to question whether they have 
enough financial expertise to deal with these very complex 
institutions.
    You can argue that if somebody does not really know much 
about banking, then they may be very independent. But is that 
the type of director we want for large banks? In the end, I 
could not be a permanent member of those boards because I had a 
potential conflict of interest.
    So we have a lot of very distinguished people on bank 
boards, who spend one day every other month for a total of 6 
days a year. They are not banking experts, and these are very 
complex institutions. They do not seem to have known very much 
about the significant risks taken by these institutions.
    I would suggest that there is a different model of a board 
of directors, which you see in companies that are owned by 
private equity funds. These boards have five or six directors, 
not 12 or 14. Almost all those directors are retired executives 
from the relevant industries, and they spend 3 to 4 days a 
month at the company.
    Also, their compensation is structured differently--low 
base salaries with significant stock options. Those directors 
really care about what happens to that institution. They have 
the time, the expertise, and the financial incentive.
    So, in my view, we should consider a different model for 
corporate governance. I cannot address all types of companies, 
but for large and complex financial institutions, you really 
need a different board structure. This is one of the subjects 
that has not been focused on yet.
    Look at the Citigroup board, filled with distinguished 
people. But where was the audit committee when all these risky 
deals and practices were happening?
    The directors followed all the rules in the Sarbanes-Oxley 
Act. They were all independent. So there are limits to a 
procedural approach to governance.
    But the directors of Citigroup, as opposed to a private 
equity board, were not experts on financial institutions. They 
did not spend a lot of time on company business, and they did 
not have sufficient financial incentives aligned with the 
shareholders.
    We do not have to ask whether a chief executive officer 
(CEO) from a company controlled by private equity received a 
golden parachute when he or she was fired for doing a poor job. 
It has never happened, and it probably never will happen. If we 
had the right board of directors, it would not have happened at 
these financial institutions.
    Mr. Litan. Senator, just a few extra things because we 
could go on, as Mr. Silvers said, forever.
    You know lawyers frequently describe what are called but-
for-causes of accidents. But for X, Y, or Z, it would not have 
happened. In all the tomes that are going to be written about 
this financial crisis, there are lots of but-for-causes, and we 
have heard just some examples. I am going to give you my top 
three. All right?
    If you look at the subprime numbers, they went off the 
charts in 2004, 2005, and 2006.
    Chairman Lieberman. What do you mean by subprime numbers? 
You mean the number of subprime mortgages?
    Mr. Litan. The number and the volume of securitizations, 
they went through the roof in those years.
    If we could have replayed history and notwithstanding that 
we have State mortgage brokers--if we had minimum standards for 
mortgage origination that would have prevented no documentation 
loans, no income loans, and loans to people without any down 
payment, a huge amount of the subprime explosion would have 
never happened. That is point one.
    Second, there was gasoline all over the floor of the 
financial system in the form of excessive leverage. That was 
what I think both Mr. Silvers and Mr. Pozen have talked about. 
So that when the mortgages blew up, they ignited the fire, and 
the fire was fed by the leverage.
    Part of it was the SEC liberalized the rules on the 
securities companies and, in particular, allowed them to fund 
their assets with too much short-term money, which proved to be 
highly destabilizing. The government-sponsored enterprises 
(GSEs) also were way under-capitalized, and now we saw what 
happened to them. So the second thing is that our key financial 
institutions did not have enough skin in the game.
    And the final point relates to credit default swaps. Part 
of the reason investors thought subprime securities were safe 
is that they were backed by bond insurance or you could buy a 
credit default swap to cover risk of default.
    As it turned out, however, the bond insurers were asleep. 
The ratings agencies also were asleep because they all had 
their models based on a few years, not on any long historical 
period. And the credit default swap market is basically an 
insurance market that was unregulated, and we allowed dealers 
to write contracts with not enough money in the till to pay it 
back when the bills came due. Now we, the taxpayers, are paying 
all those bills.
    I honestly believe even with all the other problems that 
Mr. Pozen and Mr. Silvers have talked about I think we would 
have escaped a good portion of this disaster if we had 
addressed these three items.
    Senator Burris. Mr. Chairman, we have to leave shortly. So 
I have a lot more questions, but I will yield at this point, 
and hopefully we can continue this at some other time.
    Chairman Lieberman. Thanks, Senator.
    This has been a great panel, both in your individual ideas 
and in the back and forth between you. Maybe we will see if we 
can do a final round if the three of us want to stay at 5 
minutes each, and we will get out of here hopefully in time to 
get to Prime Minister Brown.
    You have all convinced me that we do need a systemic risk 
regulator or a central risk regulator in some sense. Depending 
on your model, it may not be a regulator. It is a kind of 
financial system overseer in the sense of advance warning.
    We are holding this hearing pursuant to the traditional 
Governmental Affairs jurisdiction of this Committee. In the 
last 5 years, we received a new jurisdiction, Homeland 
Security.
    And I go back to, Dr. Litan, your reference to what we are 
experiencing now as a financial meltdown comparable to a 
nuclear meltdown.
    There are, to me, as I listen to your testimony, stunning 
comparisons to the work we did after September 11, 2001, which 
led to the creation of the Department of Homeland Security 
(DHS) and, an even better example, the Director of National 
Intelligence (DNI). Because what were we saying after September 
11, 2001?
    There was nowhere where the dots could be connected. If 
this agency of the Federal Government had shared what it knew 
with this agency and that agency, I tell you in the end I 
concluded from all I have seen that we could have prevented 
September 11, 2001. But they were not.
    So, in a way, it is that, but it is also putting somebody 
up on top, looking out over the horizon, constantly asking the 
question: Are we seeing something here that is really 
troublesome that could lead to a major economic crisis or 
system failure?
    You have convinced me of that, but there remain important 
questions for all of us. Who does it? What are the kinds of 
authorities that group has?
    But now I come to the other part of this, and let's just go 
to the final part of your last answer, Dr. Litan. We know that 
there were certain kinds of economic activity that were 
extremely consequential that were simply not regulated. Credit 
default swaps are one. Hedge funds are another.
    So I want to ask you for a quick answer. I have spoken too 
long now.
    A central risk regulator is not enough of a reform to avoid 
a repeat of this mess we are in here. I presume we need to 
regulate some of the activity, like the credit default swaps, 
that brought the house down. And I want to ask you quickly if I 
am right and just quickly, if so, who should do this? Who 
should oversee credit default swaps or hedge funds or anything 
else you think contributed to this?
    Mr. Litan. So, shortly, I talk about credit default swaps 
in my testimony.
    Chairman Lieberman. Right.
    Mr. Litan. As much as I want the Federal Reserve to be on 
the front lines of the so-called SIFIs, I am not confident that 
they are the best regulator of credit default swaps or any 
derivatives market. I still see a role for the SEC or the CFTC 
directly overseeing that.
    People are talking about clearinghouses now being formed 
which will reduce the risk, but you have to regulate the 
clearinghouse. You have to make sure it is solvent.
    Chairman Lieberman. Yes.
    Mr. Litan. And then you have all these customized contracts 
which will not be cleared. What do you do about them?
    I think maybe one way to do this, and I am not necessarily 
advocating it, is to have the Federal Reserve overseeing all 
this, getting the relevant information from the agencies. But 
to satisfy my desire that there be some teeth, you could give 
the Federal Reserve the authority so that if it walked in and 
said, look, Citigroup is not doing the right thing or there is 
a section of the market that needs to be looked at or whatever, 
the Federal Reserve could at least do something on its own 
initiative and not just be stuck with calling on the phone and 
saying, please will you do this? That worries me.
    Mr. Silvers. Mr. Chairman.
    Chairman Lieberman. Yes, I was going to ask the two of you, 
quickly. What about derivatives markets that are unregulated, 
hedge funds, etc.? Is that the SEC or the CFTC that we should 
give that to by statute?
    Mr. Silvers. Senator, my view is that what President Obama 
said at Cooper Union during the campaign is the right answer, 
conceptually. Things should be regulated for what they are, not 
what they are called.
    Those derivatives that are based on securities, where the 
underlying instrument is a security, need to be under the 
jurisdiction of the SEC or a merged SEC and CFTC.
    Those derivatives that are effectively insurance need to be 
regulated like insurance. It does not mean that they need to be 
regulated exactly the same as an insurance policy but the same 
capital requirements notions and the same review as to whether 
they do what they say they do needs to be done.
    With respect to hedge funds, it is clearly something that 
ought to be under the SEC. A hedge fund is nothing but a money 
manager, and it needs to be there. If the hedge fund is engaged 
in activity that substantively is insurance, for example, by 
selling a credit default swap, then it needs to be regulated as 
if it is selling insurance--again, not exactly like an 
insurance company but with those principles in mind.
    And I think that is Mr. Pozen's point about somebody has to 
be watching the safety and soundness of whoever is doing this.
    Chairman Lieberman. That is helpful. Mr. Pozen, a last 
word?
    Mr. Pozen. I agree that the SEC should regulate hedge 
funds, and the merged SEC and CFTC, which I agree should 
happen, should regulate hedge funds and credit default swaps.
    I just add one more point. One of the great accomplishments 
of the 1975 Securities Act amendment was to merge the back 
offices of all the securities exchanges into the Depository 
Trust Company (DTC) and one clearing corporation. There was a 
complicated tradeoff between antitrust considerations and 
operating efficiencies in the public interest.
    We have lots of groups now who want to be the central 
clearing agency for credit default swaps, so many that there is 
a lot of in-fighting. In my view, it would be great to have one 
clearing agency for the whole world of swaps; or at least, one 
for the United States and one for Europe. If we have a lot 
more, we are losing a lot of the benefits of a clearing 
corporation.
    We should look at the national market legislation of 1975 
and see whether we can pass a similar bill creating one central 
clearing house for CDS. We do not really want people competing 
on the back office.
    Chairman Lieberman. Good. Thank you. Senator Tester.
    Senator Tester. Thank you, Mr. Chairman.
    The comments about the subprime and the no documentation 
and the low documentation loans are something that is 
interesting to me because I cannot imagine people lending money 
with no documentation unless you can sell it to somebody who 
does not know there is no documentation there, which is exactly 
what happened.
    Are there any provisions? You will have to be concise with 
your answers because we just have a limited amount of time.
    Are there any provisions with Gramm-Leach-Bliley that we 
need to revisit? And if you can be as concise as possible, it 
would be great.
    Mr. Litan. I do not think so and this is where I disagree 
with Mr. Silvers. I do not think Gramm-Leach-Bliley contributed 
to this, Senator Tester.
    And the very simple point that we had commercial banks and 
investment banks that were not affiliated with each other that 
went over the edge by themselves. It was not the fact that they 
got merged together that allowed this. I think it would have 
happened anyhow.
    Senator Tester. We will get to that in another question 
later.
    Mr. Silvers. As my written testimony suggests, I think 
there is a basic problem with the world Gramm-Leach-Bliley 
created, which is that you have institutions that have large 
regulated, insured businesses and large unregulated, uninsured 
businesses, and they interact with each other unavoidably. That 
is an unsustainable situation.
    Senator Tester. So Gramm-Leach-Bliley needs to be changed 
in that particular area?
    Mr. Silvers. I think that we need to decide whether we wish 
to basically really rein in our investment banks in a pretty 
heavy way, recognizing that under Gramm-Leach-Bliley they have 
all become bank holding companies, or that we want to have them 
run pretty aggressively and separately from insured deposits.
    Senator Tester. OK.
    Mr. Pozen. I think that is a separate complex issue. To 
eliminate no documentation loans sold to the secondary market, 
Congress should amend the law that was passed last summer for 
the registration of mortgage lenders. They are still left 
mainly to the oversight of the States. We need a stronger 
Federal presence in mortgage lending.
    And we need a very simple rule: You cannot sell more than 
90 percent of any loan into the secondary market.
    Senator Tester. OK.
    Mr. Pozen. If sellers were required to hold on to 10 
percent of the loan, they would care more about the soundness 
of that loan. Not just the documents; they would care whether 
actually the borrower could pay.
    Mr. Litan. All three of us agree on that issue.
    Senator Tester. We have a situation right now where we 
have--I do not know--I think there are 17 banks that are too 
big to fail. Maybe more than that?
    Mr. Pozen. Who knows?
    Senator Tester. The question for me becomes if they are too 
big to fail and at some point in time the money is going to run 
out, what do we do about that, long-term?
    Mr. Silvers. Senator, do you mean what do we do about the 
fact that there are banks that are too big to fail or what do 
we do about the fact that some of them are unstable right now?
    Senator Tester. Well, both. I mean because I think anytime 
you have a situation where you are too big to fail that means 
you cannot fail. That means that is an inherent problem. If you 
are too big to fail, you have a problem.
    Mr. Silvers. Senator, in the Congressional Oversight 
Panel's report, one of the reasons we recommended that you not 
identify who is too big to fail and who is not is so that you 
can have a continuous ratchet process around your capital 
requirements and your insurance costs that make it more and 
more expensive to be too big to fail. The result would be to 
encourage less too big to fail institutions.
    The question of what do we do with the ones that are sick 
right now is that we need to take whatever steps are necessary 
to get them back to life in a way that is responsible with the 
taxpayers' money because we have a situation now where the four 
largest banks have more than 50 percent of the lending ability 
and they are paralyzed.
    Senator Tester. Yes.
    Mr. Litan. So I agree with Mr. Silvers that there ought to 
be higher capital charges progressively for larger 
institutions. Ditto for liquidity. That would introduce a 
penalty, if you will, for getting too large, and is it 
appropriately so because they visit costs on the rest of the 
system so that they ought to pay for it.
    The only area where I disagree, and I have said this 
before, is that once you introduce that system, given the 
disclosure requirements we have, everyone will know who these 
institutions are and you will not be able to keep it secret.
    Senator Tester. OK.
    Mr. Pozen. Can I just add one more thing?
    Senator Tester. Yes.
    Mr. Pozen. You should realize that our merger and 
acquisition policy now is creating more institutions that are 
too big to fail. We have been encouraging mergers and 
acquisitions among banks. Although Bank of America was too big 
before, we have now made it even bigger with Merrill Lynch. If 
Bank of America was too big to fail before, it is now much too 
big to fail.
    We are also guaranteeing the debt of most banks.
    Senator Tester. Trust me. That is the whole problem. But 
what do we need to do to stop it?
    Mr. Pozen. I think the first thing we should do is start 
guaranteeing only 90 percent of the debt of all these banks and 
related institutions; investors should hang on to a little 
risk. We want the big bond-holders at these banks, thrifts, and 
holding companies to help us police the financial situation and 
managerial quality of these institutions.
    We tell any bank, you issue a billion dollars of debt and 
whoever owns it, it is 100 percent insured by the Federal 
Government, then the bond holders will not care who is running 
the bank or how it is being run.
    Mr. Litan. I just want to be clear on the debt. I think Mr. 
Pozen and I agree on this, that it is really the long-term debt 
where we want people to be on the hook. I think it is 
impractical in my own view to say that for deposits.
    Mr. Pozen. Yes, I agree.
    Mr. Litan. So we are talking about long-term.
    Mr. Pozen. We are now out to 10 years.
    Senator Tester. I understand that.
    Mr. Silvers. Senator, there is one final point about this, 
though. If you say here are five banks or here are 20 banks, 
and they are the systemically significant ones, what happens 
when the one right outside the list fails?
    In a situation like we have today, in a crisis, it will 
turn out that somebody you thought was actually not 
systemically significant is systemically significant. Witness 
Bear Stearns and Lehman Brothers. You want to have a system 
that everybody is in, where that bright line does not become so 
important.
    And, second, if you follow the logic of what my two co-
panelists said about who in the capital structure needs to be 
held responsible when things go wrong, the clear implication of 
that is that we obviously are insuring depositors. We have 
effectively insured commercial paper and the money markets that 
commercial paper backs up, but there are very powerful reasons 
why we should not be insuring long-term debt holders and 
particularly not equity holders. And there is absolutely no way 
to square that with how we have actually treated the 
stockholders and long-term bond holders of Citibank, Bank of 
America, and others.
    Senator Tester. Well, thank you all for being here. We 
could have this discussion well into the evening. So, thank you 
very much.
    Chairman Lieberman. Thank you, Senator Tester. Great 
questions.
    You have been a wonderful panel. I am just thinking, going 
to Prime Minister Brown now, you have basically said that it is 
not time for another Bretton Woods series of agreements and we 
cannot wait here in the United States. We have to take action 
ourselves. There is too much at risk for us, for our economy, 
and the truth is if we right ourselves it will help to right 
the rest of the world.
    Sometime we will have you back when we have more time to 
ask what, if anything, you think the United States should be 
doing to connect to the rest of the world since obviously part 
of the reality we are living in is a remarkably global 
financial system. But no time for that today.
    In terms of time, we are going to keep the record of the 
hearing open for 15 days if you want to supplement your 
testimony in any way or if Members of the Committee who were 
here or not here want to submit questions to you to be answered 
for the record.
    I thank you a lot. You have really helped, I say for 
myself, educate me and clarify some questions. In the end, 
Senator Collins and my hope is that we will make a 
recommendation to our colleagues on the Banking Committee, 
essentially a recommended reorganizational chart with some 
descriptions underneath about what powers we think different 
elements of the financial regulatory system need to have to 
prevent a recurrence of what we are going through now.
    With that, I thank you all very much, and the hearing is 
adjourned.
    [Whereupon, at 10:45 a.m., the Committee was adjourned.]


                       WHERE WERE THE WATCHDOGS?
                      FINANCIAL REGULATORY LESSONS
                              FROM ABROAD

                              ----------                              


                         THURSDAY, MAY 21, 2009

                                     U.S. Senate,  
                       Committee on Homeland Security and  
                                      Governmental Affairs,
                                                    Washington, DC.
    The Committee met, pursuant to notice, at 2:03 p.m., in 
room SD-342, Dirksen Senate Office Building, Hon. Joseph I. 
Lieberman, Chairman of the Committee, presiding.
    Present: Senators Lieberman, McCaskill, and Collins.

            OPENING STATEMENT OF CHAIRMAN LIEBERMAN

    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.

              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.
    Chairman Lieberman. Thank you, Senator Collins. Thanks for 
that thoughtful statement.
    Let us go to the witnesses now. First we welcome David 
Green, who was Head of International Policy at the United 
Kingdom's Financial Services Authority (FSA) after having 
previously spent three decades at the Bank of England. Mr. 
Green currently works for England's Financial Reporting 
Council. It is an honor to have you here, and we would invite 
your testimony now.

 TESTIMONY OF DAVID W. GREEN,\1\ FORMER HEAD OF INTERNATIONAL 
      POLICY, FINANCIAL SERVICES AUTHORITY, UNITED KINGDOM

    Mr. Green. Thank you, Chairman. I give testimony, of 
course, as a private individual, having worked in those 
institutions you described. I also give testimony as a co-
author with Sir Howard Davies of a book on global financial 
regulation which discusses a lot of the issues that are before 
the Committee today. The views expressed here are entirely my 
own, of course, and not those of any of the organizations I 
have been associated with.
---------------------------------------------------------------------------
    \1\ The prepared statement of Mr. Green appears in the Appendix on 
page 311.
---------------------------------------------------------------------------
    There is remarkable biodiversity in arrangements for 
financial regulation at a global level. There are essentially 
four main types of structure to be found, with multiple 
variants. There is the sectoral type, with separate regimes for 
banking, securities, and insurance, which can be found in 
France, Italy, or Spain. There is the so-called ``twin peaks'' 
type to be found in Australia or, in alternative versions, in 
Canada and the Netherlands; the integrated type, which can be 
found in Germany, Japan, Scandinavia, and, indeed, in the 
United Kingdom. Then there is perhaps another fourth type, 
where the United States might fit, with extraordinary 
diversity.
    When I was in the FSA, we thought we probably had over a 
hundred counterpart regulatory bodies in the United States.
    Then there is the role of the central bank, which may or 
may not have responsibility for some, many, or, indeed, all 
aspects of supervision, as it does in Singapore, for instance.
    Probably the most advanced form of the integrated regulator 
can be found in the FSA, where it was created remarkably 
rapidly when the incoming Labour Government simply decided in 
1997, without real debate, that at the same time as giving the 
Bank of England independence in the implementation of monetary 
policy, it would also create a single regulator for financial 
services. That was set in train and eventually subsumed 11 
prior agencies, and a single new piece of legislation was 
drafted completely de novo with new objectives for regulation 
and with a set of principles drafted to guide the regulators.
    Not all of integrated regulators have that single piece of 
legislation, and they carry on with sectoral legislation. That 
is obviously an issue to be thought about when the Committee 
addresses the legislative structure that is put in place.
    The bodies were merged in a way which enabled prior 
existing bodies simply not to be visible anymore. There was 
full integration. You cannot find within the regulator the 
bodies that were there before, and that was quite deliberate so 
that no impression should be created of one of the prior 
entities somehow taking over the others.
    The rationale for integrated regulation was set out by the 
FSA, and in my written testimony, I set out the main arguments, 
but the core ones, as you know, are that financial 
conglomerates, in particular, undertake a range of banking, 
insurance, and investment business. The markets themselves have 
instruments which mingle features of all those. And it was 
difficult to carry on regulating on a purely functional basis 
when that no longer matched the structures of either firms or 
markets.
    Integration makes it possible to align the regulatory 
structure with the way the firms manage themselves so that this 
should help with the proper understanding of the overall 
business model and of overall risks. It also means that a 
regulated firm only needs to deal with one agency for all its 
regulatory business, ideally through relationship managers on 
both sides.
    An integrated regulator ought to be able to manage the 
conflicts which inevitably arise between the different 
objectives of regulation, and we will no doubt discuss that 
later. The concept underlying a single regulator is that these 
conflicts exist but need to be managed in one place or another, 
and there have been in the United Kingdom adverse experiences 
in the management of those conflicts in the past, which is one 
of the reasons why the intention was to put them together.
    As regards the role of the central bank, there are a number 
of issues about the possible conflict of interest which might 
take place with the independent conduct of monetary policy. 
Monetary policy might be tempted to look more after the 
regulated community than the wider interest. And those 
arguments are a little bit more difficult to be certain about.
    How has the model stood up? Previously, the model was very 
widely praised. Since the crisis, like of regulators in many 
places, there has been very wide criticism. But much of the 
criticism can be pinned down to failures, if you like, at the 
global level with the international capital rules regarded as 
having fallen short. Markets were inadequately understood. The 
way securitization would work and how markets would behave was 
very widely misunderstood. That has been a common problem. The 
FSA also made mistakes in not doing what it was supposed to do, 
simple internal management mistakes.
    There has been a lot of work done to go over the lessons of 
the crisis. Both the FSA and the Bank of England have 
undertaken work to see whether the structure of regulation has 
identified any patterns of superior models as a result of the 
crisis, and no patterns have been found. The Bank of England 
did do some work--which I think I can make available to the 
Committee--which finds no pattern at all as between integrated, 
prudential, twin peaks regulator, and sectoral regulator. I 
think the conclusion has been that the model itself is not 
really seen to have been implicated in the way the crisis 
unfolded, and, indeed, the fact that banking, securities, and 
insurance were all interlinked in the crisis in some people's 
minds has reinforced the underlying concept.
    Obviously, I would be very happy to answer further 
questions as the hearing proceeds. Thank you, Mr. Chairman.
    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.
    Mr. Green. That appears to be the case. You can find a 
number of examples, if you take them in isolation, which 
reinforce a particular argument. But if you look across the 
board, you do not find a pattern. The Bank of England work that 
I referred to, which I am sorry I do not have available here, 
looked at, I think, about 40 or 50 different jurisdictions and 
could find no pattern related to structure.
    Chairman Lieberman. Yes.
    Mr. Green. And the FSA work has shown that there have been 
problems when supervision was inside the central bank and when 
it was outside, and, again, no clear pattern can be found.
    Chairman Lieberman. That is interesting. I normally would 
hold the questions until after everyone testifies and then I 
come back. That does not mean that there are not preferences 
for one over the other form of regulation.
    I also wanted to thank you for your graciousness in 
describing the American system as ``diversified.'' That was 
nicely done. [Laughter.]
    Second we have Dr. Jeffrey Carmichael, the inaugural 
chairman of the Australian Prudential Regulation Authority, 
with responsibility for regulating and supervising banks, 
insurance companies, and pension funds. Dr. Carmichael 
currently works in Singapore as the Chief Executive Officer 
(CEO) of Promontory Financial Group Australasia.
    Thank you for being here.

  TESTIMONY OF JEFFREY CARMICHAEL, PH.D.,\1\ CHIEF EXECUTIVE 
        OFFICER, PROMONTORY FINANCIAL GROUP AUSTRALASIA

    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.
    Chairman Lieberman. Thank you very much. Well said. I have 
many concerns, but one clearly is that the result of this 
crisis will be that we will change some regulations, some law, 
but we will not change the regulatory structure very much 
because of the resistance of those in the financial communities 
but also, frankly, here in Congress to changing the status quo. 
So your words are very much on target. I thank you.
    Our third witness is Dr. Edmund Clark, President and CEO of 
the TD Bank Financial Group in Canada. Mr. Clark has had a long 
and distinguished career in both the Canadian Government and 
private industry, and we are very grateful that you are here 
today. Please proceed.

  TESTIMONY OF W. EDMUND CLARK, PH.D.,\1\ PRESIDENT AND CHIEF 
           EXECUTIVE OFFICER, TD BANK FINANCIAL GROUP

    Mr. Clark. Thank you, Mr. Chairman and Ranking Member 
Collins, for inviting me, and thank you to the other Members. I 
am obviously not here as a regulatory expert, but we have a 
wonderful panel.
---------------------------------------------------------------------------
    \1\ The prepared statement of Mr. Clark appears in the Appendix on 
page 326.
---------------------------------------------------------------------------
     I am going to speak much more as a CEO who operates under 
the regulatory regimes. We are a little unusual in the sense 
that we operate on both sides of the border in Canada and the 
United States. We have over 1,000 branches in the United States 
from Maine to Florida, and we are a bank in the United States 
that is continuing to lend, and lend aggressively. So we have 
double-digit lending growth, and we are one of the few AAA-
rated banks left in the world. We exited the structured 
products area in 2005, the source of most of the problems.
    I thought I would comment on a couple of things, and one 
was the actual management of the crisis from the beginning of 
August 2007 until now, and I think what certainly distinguished 
the Canadian system, which may not be duplicable in larger 
countries, is that the six banks plus the Bank of Canada, the 
Office of the Superintendent of Financial Institutions (OSFI), 
and the Department of Finance essentially worked almost 
continuously together and have a shared objective. There was a 
very strong feeling among us that if any one of our banks ran 
into trouble, we would all run into trouble. So there was no 
attempt by one bank to, in a sense, game the system, and there 
was also fairly quickly a view that we should try to have a 
private sector solution to this problem, not a public sector 
solution; and to the extent we involved the public sector, it 
should be a profitable involvement on behalf of the taxpayers, 
not a subsidy, and we were able to successfully do that.
    In terms of the structure of the industry, I think it is 
well known that there are some important differences. All the 
major dealers are owned by the Canadian banks, and we did, in 
fact, absorb $18 billion (CAD) of write-offs by these dealers. 
TD Bank did not have any significant write-offs, but $18 
billion (CAD) is a significant amount in the size of Canada, 
but they were able to absorb that because they were tied to 
large entities with very stable retail earnings.
    Second, the mortgage market is completely different in 
Canada. It is concentrated in the top banks, and we originate 
mortgages to hold them. And so we have resisted attempts--
frankly, political attempts--to have us loosen standards 
because we are going to bear the risks of those loosened 
standards. So you did not get the development in Canada of what 
you did in the United States.
    Third, in terms of the capital requirements, our capital 
requirements have always been above world standards, with a 
particular emphasis on common equity. But it has also been 
reinforced by the insistence of our regulation that we have our 
own self-assessment of how much capital we need, and that in 
all cases, it caused Canadian banks to hold more than 
regulatory minimums, not at regulatory minimums.
    I think the other difference would be that our regime's 
binding constraint is risk-weighted assets, and that is a key 
feature why we hold our mortgages rather than sell them. Where 
you have total asset tests, you, in fact, encourage banks to 
sell low-risk assets, and where we have a total asset test is 
not the binding constraint.
    In terms of the nature of the regulatory regime, it is a 
principles regime, not a rule-based regime--it is rather light 
in terms of the actual number of people employed in the 
regulatory regime. There is a high focus on ensuring that 
management and the board know and understand the risks that the 
institution is taking and that, in fact, they are building the 
infrastructure to monitor and manage that risk.
    The way I put it internally in my organization is I am 
actually on the side of the regulator, not on the side of the 
bank. We have the same interest in ensuring that the bank does 
not run into trouble, and do you have less of this conflict 
situation because I see the regulator as helping me manage the 
bank.
    I think another important element that Canada moved to in 
terms of compensation some time ago was to have low cash 
bonuses. So in my case, 70 percent of my pay would be in the 
form of equity which I hold. I am required to hold my economic 
interests in the bank for 2 years after I retire, so I cannot 
cut and run. And all my executives, whether in the wholesale 
side of the bank or the retail side of the bank, are paid on 
the whole bank's performance, including its ability to deliver 
great customer satisfaction. We also have separation of the 
chairman from the CEO, and all board and committee meetings 
have meetings without management present to ensure that 
independence.
    Clearly, the issue, I think, you are addressing is the 
issue of systemic risk, and I think it is the toughest issue to 
deal with here. I think I would have to be in the camp to say 
all the systemic risk issues were well known and well talked 
about. It is not as if there was this mystery out there that 
the U.S. mortgage system was, in fact, going way up the risk 
curve and doing what most bankers would have regarded as crazy 
lending. It is not as if there was not meeting after meeting 
among bankers around the world about the risks that are 
inherent in structured products. And I would say the under-
saving feature of the U.S. economy was a well-known fact. And 
so I think you do have to sit back and say, well, if these 
risks were well known, why were there no, in a sense, forces 
against that?
    I can comment on our own experience. As I indicated, we did 
actually exit these products. We exited them because they were 
hard to understand. They embedded tail risk and added a lot of 
complexity to the organization. We also refused to, in fact, 
distribute the asset-backed paper program that blew up in 
Canada on the basis that if I would not sell it to my mother-
in-law, I should not sell it to my clients.
    But the real issue is that in doing that, that was a very 
unpopular thing to do. It was unpopular within my bank. It was 
unpopular among my investors. It is very hard to run against 
these tides, and so I think when you are talking about systemic 
risk, you have to recognize that there is this odd confluence 
of political, economic, and profit force actually always 
propelling it. It is like a lot of the literature, what creates 
boom. You have the same thing behind any forces of systemic 
risk.
    So what is my conclusion as a practicer in the field? Well, 
I do not think there is one answer because, as I have said, 
banks have failed under most regulatory regimes. But I do think 
a strong regulator is important, and you certainly should not 
allow regulatory shopping. I think that is obviously a very bad 
thing.
    And while rules are important, I actually think principles 
do matter. It was clear throughout the industry that people 
were in the process of using regulatory capital arbitrage, and 
if you sat there from a principle point of view, I think you 
might have stopped it.
    Leadership matters enormously. I think boards should be 
held accountable to ensure that they actually have a CEO with 
the right value system. His job is to preserve the institution. 
And I think it is clear to say while all regulatory regimes may 
have known about systemic risk, they did not focus on systemic 
risk. And I think we are lacking mechanisms where, if you did 
come upon a view that existed, how would you, in fact, 
coordinate action to bring it to an end?
    I do think going forward, though, there is also a risk that 
we could overreact, and one of the things I would plead is that 
many elements of the regulatory reforms could drive 
institutions to take more risk rather than less risk. And I 
think you have to be careful in your rules to make sure that 
low-risk strategies, such as the TD Bank one, are not, in fact, 
negatively impacted by some of the rule changes. Thank you very 
much.
    Chairman Lieberman. Thank you very much. Refreshing. I must 
say, I did not know how different the regulatory system and 
some of the rules of behavior were, and it is striking that one 
of the reasons that Canada did not get into some of the same 
mortgage problems as we did was really because of regulation, 
some of the things you were prohibited from doing.
    Mr. Clark. Right. There was an element of regulation that 
prohibited us, but also we had a capital regime that said we 
could hold low-risk assets and not have large amounts of 
capital. And that is a critical feature to the originate-and-
hold model.
    Chairman Lieberman. Thank you.
    Our final witness this morning is from closer to home. 
David Nason was at the Treasury Department during March 2008 
and before and was very active in the construction of the 
Treasury Department's March 2008 ``Blueprint for a Modernized 
Financial Regulatory Structure,'' previously known as ``the 
Paulson plan.'' Mr. Nason is now the Managing Director for 
Promontory Financial Group here in Washington, DC. We have two 
of the four witnesses from the Promontory Group. That speaks 
well for the group.
    Mr. Nason, we welcome your testimony.

 TESTIMONY OF DAVID G. NASON,\1\ MANAGING DIRECTOR, PROMONTORY 
                      FINANCIAL GROUP, LLC

    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.
    Chairman Lieberman. Thanks, Mr. Nason. Very helpful.
    A vote just went off, but I think we are going to try to do 
a kind of tag team here, so Senator Collins will go over now, 
and I will ask questions, and then we will go on from there. 
The testimony has been very interesting.
    While your testimony is in my mind, Mr. Nason, just take a 
moment, and if we went to the twin peaks here--although as Dr. 
Carmichael said, there are actually four in Australia--what 
would be under the two peaks?
    Mr. Nason. Well, I said the twin peaks model, but 
essentially we would be asking for three peaks.
    Chairman Lieberman. Three, really.
    Mr. Nason. Three peaks in the United States.
    Chairman Lieberman. One being the Federal Reserve.
    Mr. Nason. One would be market stability regulation, which 
we recommend in the Blueprint would be housed at the Federal 
Reserve.
    Chairman Lieberman. Right.
    Mr. Nason. One would be prudential regulation of 
institutions that require prudential regulation for your banks 
and your insurance companies. And then business conduct 
regulation, which is the type of consumer protection regulation 
that we historically see in the consumer aspects of the Federal 
Reserve and the banking agencies and most of what the 
Securities and Exchange Commission does.
    Chairman Lieberman. So you would split up some of the 
existing regulatory agencies' functions, so it is not as simple 
as asking which agencies would go under which, because you 
would take pieces of each.
    Mr. Nason. Yes, the model in the United States, it is a 
difficult way to think about it, but if you take the consumer 
elements of the banking agencies, put them under the business 
conduct regulator, take the bulk of the responsibilities of the 
SEC, put them under the business conduct regulator, and leave 
the prudential or financial regulation in a separate regulatory 
body, those are the two peaks. And then I think there is an 
important role that is not demonstrated in those two peaks: 
Someone taking the ownership of systemwide risks, and that is 
the important role that we give to the Federal Reserve in our 
Blueprint.
    Chairman Lieberman. Incidentally, I like the Paulson plan's 
use of the words ``market stability regulator'' because I think 
it is more clear than systemic regulator, which always confuses 
me at least.
    Mr. Nason. We spent an enormous amount of time debating 
that, and I am glad you noticed it. The one reason we called it 
``market stability'' is to indicate to everyone that you are 
going to have bouts of instability, and the goal is to try to 
keep the markets as stable as possible. But you cannot prevent 
it.
    Chairman Lieberman. Right. Let me ask Mr. Green, Dr. 
Carmichael, and Dr. Clark, from outside the United States 
looking in--acknowledging that we have heard some mixed 
testimony here on the question I am about to ask--and based on 
your experience, obviously, what role do you think the 
fragmented nature of our current structure played in the extent 
of the current economic crisis here in the United States? Can 
you make a judgment on that, Mr. Green?
    Mr. Green. I think the most striking example--and there are 
several--was the AIG affair, where, of course, there was no 
Federal jurisdiction, as you know, which meant that although 
there was a lead regulator in the New York State Insurance 
Commission, nevertheless, that jurisdiction was shared with a 
lot of other regulators. And the Office of Thrift Supervision 
(OTS) also had a role, and I think it is fairly clear and 
widely acknowledged that this meant there were gaps in terms of 
looking at the whole picture for a global firm.
    Chairman Lieberman. Right.
    Mr. Green. The other example I think relates to the U.S. 
investment banks, which almost uniquely at the global level 
were not regulated along with the rest of the banking system. 
And that led to gaps or inconsistencies. They were not--
although they did business that was very similar----
    Chairman Lieberman. To banks.
    Mr. Green [continuing]. To banks and, indeed, in the rest 
of the world was done in banks. Nevertheless, they had a quite 
different capital regime, and, indeed, curiously, their 
consolidated capital regime was voluntary. That, of course, 
came to an end very abruptly over a weekend. This was a risk 
that a lot of people knew was waiting to be crystallized. But 
those are two big examples, if you like.
    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.
    Mr. Carmichael. I do not have a lot to add to that because 
I think it is spot on. If one had to put rough percentages on 
it--and this has got no science--I would say it was enabled 70 
percent by the structure and 30 percent by bad regulation. So I 
think the structure actually had more to do with the problem.
    I will add one example to what Mr. Green said. I was 
interested in one regulatory response to AIG--regulated, of 
course, by the State regulator. The State regulator said, ``We 
now want to regulate credit default swaps as an insurance 
product,'' and immediately the impossibility of that became 
apparent in that, unless the other 49 States agreed to do it, 
the business would just move over the border. And this is not a 
national border. It is just moving across the Hudson River, for 
example.
    So the insurance regulatory structure enables arbitrage, 
enables gravitation to the lowest common denominator. Like Mr. 
Green, we were amazed when we found that AIG was regulated by 
OTS as a conglomerate. That just seems ludicrous. So I agree 
entirely.
    Chairman Lieberman. Thanks. Dr. Clark.
    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.
    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?
    Mr. Green. Certainly for regulators in the rest of the 
world--and Mr. Carmichael will have a view on this as well. 
Leave aside this AIG problem, even in the banking field there 
was no single voice in the United States. Although a case can 
be made for regulatory competition in this kind of area, it is 
not very clear where the advantages came from regulatory 
competition, and certainly in international discussions, it is 
very difficult to have a completely coherent discussion when 
there are three or four counterparties in some discussions even 
about capital. And the SEC, if it was not there, should have 
been there.
    Chairman Lieberman. Right.
    Mr. Green. It makes it very difficult to come to 
international consensus.
    Chairman Lieberman. Yes, and obviously we are in--to say 
the obvious--a global economy, and there are times when we want 
to have interactions globally that are not facilitated by the 
way in which we are organized. So I take your point.
    I am going to have to go in a minute, but, Mr. Nason, from 
the U.S. perspective, are there any negative effects for 
American business in a global economy that result--or even 
domestically, but particularly globally--from this fractured 
system we have now?
    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.
    Chairman Lieberman. Thank you.
    I am going to ask that we stand in recess. As soon as 
Senator Collins comes back, I will ask the staff to please 
encourage her to begin her questioning.
    The hearing is recessed.
    [Recess.]
    Senator Collins [presiding]. The hearing will come back to 
order. Senator Lieberman has graciously allowed me to 
temporarily assume the role of Chairman and reconvene the 
hearing so that we can keep proceeding through this vote.
    I want to thank each of you for your very interesting 
testimony and bring up several issues in the hopes that I am 
not repeating too much of what the Chairman may have already 
asked you.
    Mr. Carmichael, you talked about the four peaks, as you 
described it, and that some of the advantages were that each 
focuses on one aspect. You avoid conflict. You have essentially 
a functional regulatory approach. And then you said there is 
also a council of regulators. Does that council of regulators 
have responsibility for identifying systemic risk?
    Mr. Carmichael. In a short answer, yes. But, more 
importantly, their role is to communicate and coordinate 
between the agencies and to make sure that there is a regular 
testing of issues. Sometimes the central bank, if it is 
concerned about a systemic issue, has the power to send some of 
its staff with the prudential people going on inspections, for 
example, to learn more about what some of those issues might 
be. The involvement of the Treasury is there for exactly the 
systemic type reason.
    So while it does not have any direct authority--there is no 
charter that gives it the power to do anything--through 
coordination they are able to focus the issues and decide, for 
example, do we need more information about a particular area? 
Do we need one of the agencies to collect that on behalf of the 
systemic regulator?
    Senator Collins. Mr. Nason, I know you were very involved 
in the Paulson Blueprint for reform, and I very much 
appreciated your insights. As I understand it, the Blueprint 
that Secretary Paulson put out did call for a systemic risk 
regulator, but it would be vested in, I believe, the Federal 
Reserve. Is that correct?
    Mr. Nason. Yes.
    Senator Collins. When you were involved in drafting the 
Blueprint, was consideration given to the council approach?
    Mr. Nason. It was not labeled the ``council approach,'' but 
one thing we did consider was providing more authority to the 
President's Working Group on Financial Markets, which is very 
similar to the council approach. We thought about it very 
seriously because there is a lot of elements of attractiveness 
to having a council because you are bringing a lot of different 
sets of expertise to bear.
    One of the things we got tripped up on is providing the 
right amount of authority, and we were worried about clarity of 
purpose and clarity of mission among a council. But it is 
certainly something that we considered seriously.
    Senator Collins. Mr. Clark, is there a system for 
identifying systemic risk in Canada?
    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?
    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?
    Mr. Nason. I think there is a lot to like about what you 
are trying to achieve in your legislative proposal. I think 
that identifying the fact that credit default swap (CDS) and 
over-the-counter (OTC) derivative contracts are a source or a 
potential source of systemic risk is very important, and I am 
really happy to see you have identified it here and the 
Administration is thinking about ideas like putting them on 
exchanges and things like that, because OTC derivatives were 
typically not regulated because they were viewed as bilateral 
contracts between sophisticated parties. But they grew so big 
and they are so significant in the U.S. system that they proved 
to be two things: One, a source of great opaqueness in 
financial institutions where you could not get a sense of how 
important the derivative book was to a particular institution; 
and, two, a real channel for the too-interconnected-to-fail 
problem.
    So I think that you are certainly right to identify them as 
something that needs to be looked at carefully. I think that 
they are certainly something that should be under the 
supervision, oversight, and jurisdiction of a council or a 
systemic risk regulator. And I think that I am happy that 
things are moving along in that way.
    Senator Collins. Mr. Clark, I admire your foresight in 
deciding that some of these derivative products were simply not 
well understood and were too high risk in getting out of that 
market. In Canada, however, was there regulation of credit 
default swaps and those kinds of exotic derivatives? Or did the 
regulation only come about through safety and soundness 
regulations? If you understand what I am saying.
    Mr. Clark. I think so. In a sense, it was safety and 
soundness, and I think it is fair to say as we were exiting the 
business, Canadian banks were going into the business. So it 
was not as if our regulator was saying do not do this.
    Senator Collins. That is what I was wondering.
    Mr. Clark. And as I pointed out earlier, Canadian banks 
collectively took $18 billion (CAD) in writedowns. So in U.S. 
terms, that is $180 billion, given the size of the country, so 
it is not an insignificant amount. So we cannot stand here and 
say there are no problems in Canada. I think that would be a 
misnomer.
    I think this is a very difficult area because I think the 
reality is that people were aware of this and they were aware 
that the products were getting bigger and more complex. But as 
we were talking during the break, the reality is that people 
were making a lot of money on it, and it looked like it was 
very profitable. And I would say in its initial evolution, 
credit derivatives were actually a positive factor, and so for 
us as a bank, we were able to lay off a significant amount of 
our risk by buying credit protection, and in that sense we saw 
it as a good thing, not a bad thing. And it is only as a later 
evolution that in a sense it ended up causing, I think, some of 
the problems.
    I think it underscores the capability issue, the one we 
talked earlier about AIG, that in this war, if you will, or 
race for knowledge, you have a very profitable and highly 
sophisticated industry in the banking system around the world. 
I think it does mean that you cannot afford to have three or 
four regulators trying to go up the scale of knowledge. You do 
have to have a concentrated knowledge in order to attract the 
people to try to have a counter-push to these ideas.
    Senator Collins. Mr. Carmichael, any thoughts on how to 
prevent regulatory black holes as new products emerge?
    Mr. Carmichael. Two things I would add to the comments made 
so far. First of all, having banking and insurance under the 
one regulator, as is the case in Canada, Australia, and the 
United Kingdom, gives your regulator a much better chance to 
pick up where those risks are being laid off. And you look at 
the United States where you have 50 State insurance regulators, 
picking that up as a problem for AIG was much more difficult 
than it would have been under the other architectures.
    The other side of it that I would add is that in a 
structure where you have a clear conduct regulator and that 
regulator has a responsibility for markets, that is where the 
primary responsibility for new markets, which is where new 
products tend to spring up. Regardless of how the market is 
conducted, whether bilateral or on an organized exchange, 
conduct should be the responsibility of that particular 
regulator, provided they have the mandate and the skills to 
pick that up and do with it what they need to. That is where 
you would get the primary regulation, the disclosures, the 
aggregation of information, and so on for those markets.
    Senator Collins. Thank you. Senator McCaskill.

             OPENING STATEMENT OF SENATOR MCCASKILL

    Senator McCaskill. Thank you.
    I do not know if you can help, Mr. Nason, but I have had a 
hard time figuring out how we missed all this. And you were at 
the Treasury Department for the 3 years prior to when we came 
this close to a global meltdown as it relates to our credit 
markets. And, I guess I am curious as to why you think no one 
at Treasury--I mean, I was in a room with Secretary Paulson, 
and I do not want to say that they were panicked, but there is 
a reason why there was such bipartisan support 40 days before 
our political election. If there was ever a time in this 
building that the two sides cannot get along, it would be 40 
days before our national presidential elections. And when you 
had both major candidates for President voting in favor from 
both ends of the political spectrum, that was because we all 
had been given very detailed and accurate information about how 
close we were to completely falling off the table as it related 
to our credit markets.
    I cannot get comfortable with how we are going to identify 
risk going forward if the best and the brightest in our 
country, supposedly the best financial minds in the world, did 
not see this coming. Can you help me?
    Mr. Nason. I can try to help you. I do not have the 
answers, and we will be debating this for decades as to what 
actually happened. But I think there were a couple things that 
happened.
    People saw individual things that they were worried about. 
The regulators knew that underwriting criteria had gone down 
for home mortgages. People had seen there was a very frothy 
housing market. People had seen that the covenants in debt were 
going down to a level that they were concerned with.
    But I think what really was very surprising and what caught 
people off guard was the severity with which things went from 
being very frothy--people were not paying adequate attention to 
risk, so the pendulum was nobody cared about risk at all, 
people were just worried about making money--to people who were 
not willing to take risk at all. So there was just a complete 
and utter contraction of credit in the economy that caused an 
enormous contraction.
    The speed with which that happened was something that 
people were not expecting. You got to a point where money 
center banks would not lend to each other for 20 days or for 10 
days without paying exorbitant interest rates. So you had a 
complete breakdown in confidence. And I cannot give you comfort 
that we are going to find it again. I can give you comfort that 
this is that 1-in-100-year event. And you can try to manage it 
better, you can try to prepare yourself better, but this is one 
of those things where I do not think you can predict it. You 
can just put yourself in a better position to try to deal with 
it.
    Senator McCaskill. Which of the three parts of your plan 
would be responsible for identifying what happened?
    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?
    Mr. Nason. Well, we researched and wrote it the year going 
up to March, and we released it right after Bear Stearns 
failed, but it was not in response to those types of events.
    Senator McCaskill. Right.
    Mr. Nason. So the plan is not a lookback plan. But I think 
generally speaking, you would have coordination among the three 
parties to describe how to better position ourselves to deal 
with this better.
    Senator McCaskill. Let us assume that instead of your plan 
being announced in March 2008--obviously, this is a fantasy--
that Congress passed it whole cloth and it was in existence. 
Which is the body that you would expect under the plan that has 
been drawn up would be the one to say things are nuts, people 
are overleveraging, they have no idea what they are buying and 
selling, they are chasing a number, and it is all about greed?
    Mr. Nason. Sure. I would tell you that each of the three 
would have a role, and here is what they would do. On the 
prudential side, there would be tightened standards for capital 
for financial institutions and more regulation on liquidity 
management. On the conduct side, there would be stronger 
regulations for mortgages and things like that. And on the 
market stability side, there would be more focus on the 
interconnectedness of these two institutions and also of things 
like the derivatives markets. Those would be three ways that 
each of the three pillars of the Paulson plan would respond to 
this.
    Senator McCaskill. Is it possible that the three pillars of 
the Paulson plan, that each one of those pillars would have 
said it was their job?
    Mr. Nason. No. That is actually one of the premises of the 
Paulson plan, is clarity of mission and clarity of objective. 
See, one of the problems that we dealt with was that there was 
a lot of finger pointing. There were battles between the State 
regulators versus the Federal regulators on who was in charge 
of mortgage origination. So there were concerns about who was 
in charge of the holding company of Lehman Brothers. Was it the 
OTS or the SEC?
    So there is much less chance for finger pointing under an 
objectives-based criteria like the Dutch and the Australians 
have.
    Senator McCaskill. Mr. Clark, I heard you say that you 
originate mortgages to hold them, and I keep explaining that 
one of my concerns about reverse mortgages that we are now 
ramping up in this country is that they are very similar to 
subprimes in that the people who are closing loans have no skin 
in the game. Now, the scary thing about reverse mortgages is 
that all of the skin is taxpayer skin. If those assets are sold 
at term and they are not sufficient to cover the loan, the 
Federal Government has to cover the loan. But in the subprime, 
it was all of these exotic sliced and diced derivatives that 
were spread out all over that we are trying, like Humpty-
Dumpty, to put back together again now.
    I assume that in Canada the people who are holding the 
mortgage are the same ones who made them and, therefore, they 
continue to have skin in the game.
    Mr. Clark. Absolutely. We originate all the mortgages. We 
do not buy mortgages. We originate our own mortgages. And, 
therefore, we are very concerned about the underwriting 
standards because we are going to take the risks.
    I do believe that the system of holding the mortgages does 
a couple of things for you. One, it means you have the banking 
system trying to make sure you have conservative risk, not wild 
risk. But, second, it actually gives us an asset. The way I 
always describe our bank is we are not an income statement that 
generates a balance sheet. We are a balance sheet that 
generates an income statement. And that means we have a 
solidity of earnings that is there because we are not 
originating mortgages, then selling them off, and then saying, 
well, where am I getting next year's income if we originate 
more and sell them off. We are actually holding them.
    And so I think it produces tremendous stability in the 
system, but it does require a regulatory regime that does not 
penalize you for capital if, in fact, you hold a low-risk asset 
like that.
    Senator McCaskill. Do you think we should have regulations 
that require people who close mortgages to assume some of the 
risk?
    Mr. Clark. I think some system where the people who 
originate have skin in the game is quite important.
    Senator McCaskill. Mr. Nason, what do you think?
    Mr. Nason. I think that what we have seen is that our 
securitization markets certainly got overheated, and there is 
certainly some merit----
    Senator McCaskill. I think a bonfire is more like it.
    Mr. Nason. I am not going to quibble with that. I think a 
bonfire is just fine. I do want to suggest, though, that the 
securitization market, it is a bad word right now and it is an 
ugly word, but it has a lot of value. It provides a lot of 
credit to the economy. A lot of markets depend on it. It is 
important to rebuild that market so we can get more credit in 
the economy. Today, the auto industry relies on it; a lot of 
industries rely on it. So it is important. Whether or not it 
overheated like a bonfire, I think that is a fair 
characterization.
    Senator McCaskill. Would you mind if I ask one more 
question?
    Chairman Lieberman [presiding]. Go right ahead, Senator.
    Senator McCaskill. I am a little uneasy about BlackRock. I 
know that BlackRock was called in to manage at the New York 
Federal Reserve in terms of some of the valuation of the 
assets, and I know that there is some valuation of assets and 
then there is going around to the other window and 
participating--and I keep hearing that BlackRock is the only 
game in town, and that is why they are getting all these 
contracts. Their name came up again yesterday in connection 
with the Pension Benefit Guaranty Corporation (PBGC), the 
guaranty fund for pensions in this country. I keep hearing that 
BlackRock is the only company that has the model and it is 
proprietary, and therefore, they are the only game in town, and 
we keep going back to BlackRock. In fact, I had somebody tell 
me that the Secretary of the Treasury talked more often to the 
head of BlackRock than probably a lot of other folks. And I do 
not know if that is true or not, but it worries me because of 
the--too big to fail aspect. Can I get you, without threat of 
torture, to give me your take on why BlackRock is all of a 
sudden everywhere and is involved in everything as it relates 
to sorting out our financial mess?
    Mr. Nason. A couple of things. I cannot imagine that the 
comment that either Secretary of the Treasury spent more time 
talking to BlackRock than anyone else is accurate.
    Senator McCaskill. Hyperbole.
    Mr. Nason. Hyperbole. That is one thing.
    The second thing is the determination of hiring BlackRock 
to manage the assets in the Maiden Lane/Bear Stearns situation, 
I think that was a decision made by the Federal Reserve, so 
that is not something I can speak about.
    I think generally speaking what you are dealing with is a 
large risk transfer of assets from financial institutions to a 
variety of structures. And what the government is trying to do 
is to protect the U.S. taxpayers' interest, hire someone who 
has some experience in managing those particular assets. 
BlackRock, Western Asset Management Company (WAMCO), and the 
Pacific Investment Management Company (PIMCO)--there are a 
couple of people who are very experienced in that.
    I do not know the specifics of that particular situation, 
but the only thing I can say is that there is a lot of 
oversight and regulation for this process. There are the 
procurement rules. There is the GAO and the TARP Inspector 
General that are making sure that policies and procedures are 
followed. So I think you can take comfort in the process 
surrounding how these asset managers are retained and the 
solicitations being made for them. That should give you 
comfort. I think there is a lot of transparency in that as 
well.
    Senator McCaskill. Thank you, Mr. Chairman.
    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?
    Mr. Green. Everyone is under one roof and, indeed, it was, 
I think, always under one roof before the great merger into the 
FSA.
    Chairman Lieberman. Right.
    Mr. Green. There was no real distinction between the 
primary markets and the derivative markets. And I must say--and 
I stand to be corrected by my colleagues here--I am not aware 
of any other country where there is such a distinction.
    Chairman Lieberman. Interesting. Correct, as far as you 
know, Mr. Carmichael?
    Mr. Carmichael. Yes, certainly in Australia, it has always 
been under the one roof. What changed after we restructured was 
that we also had brought it into one law. Prior to that, there 
had been a separate law for derivatives and for securities, and 
there were two separate exchanges. Once the law was merged, the 
two exchanges also merged, and it was just simply a recognition 
that there is no fundamental distinction there at all.
    Chairman Lieberman. Right. How about Canada?
    Mr. Clark. Well, unfortunately, we are the worst of all. We 
have multiple security regulators in Canada.
    Chairman Lieberman. Worse than the United States.
    Mr. Clark. Worse than the United States in this----
    Chairman Lieberman. That is very interesting.
    Mr. Clark [continuing]. One respect, I would have to say. 
So I think we are trying to get a national regulator.
    Chairman Lieberman. So is it----
    Mr. Clark. State level, essentially, and so this has been 
an industry for 40 years to try to get this problem solved. I 
think the current government is working very hard to see 
whether they can get this reformed and have a national 
regulator. But it has faced enormous political disagreement on 
it because of state rights, essentially. And so I would say 
that is, if we were looking for black holes in Canada, the fact 
that we do not have a national regulator. And if you take a 
look at the one major crisis Canada did have around asset-
backed paper, certainly a contributing factor was that there 
was no federal regulation of this. This was all done at the 
provincial level and so escaped--so it was--I think it 
represents a black hole example.
    Chairman Lieberman. Mr. Nason, I take it that historically 
the reason we had both the SEC and the CFTC is that the CFTC 
grew up from the trading in agricultural commodities and they 
did not want to be mixed with the Wall Street regulators.
    Mr. Nason. Historically, that is the genesis of the CFTC's 
creation in the 1970s. But, interestingly enough, when the CFTC 
was being created, Members of Congress and their staffs asked 
the SEC if they wanted the jurisdiction for agricultural 
commodities, and they declined because it was a specialized 
market.
    Chairman Lieberman. Right.
    Mr. Nason. But now I think the volume of financial futures 
on the futures exchanges is well over 90 percent; whereas, in 
the 1970s it was significantly bifurcated between financial and 
agriculture.
    Chairman Lieberman. Yes. I think this has a lot of logic, 
but it is going to be, for those historical reasons, difficult 
here. And we can already see not just the regulated entities 
but the Members of Congress fighting for the status quo; that 
is, the Agriculture Committee fighting to keep a separate CFTC. 
Of course, Senator Collins and I think that is why this 
Committee has a unique role to play, because we have no vested 
interest on either side--at least not in this matter. We may in 
other matters.
    Let me go on to ask Mr. Green, Dr. Carmichael, and Mr. 
Clark about what I would call transition challenges. As we are 
heading toward a time of reform, both regulatory and 
structural, I wonder if you could give us any counsel about 
transition problems that your countries faced, particularly the 
two of you, during the transition to a more consolidated 
regulatory system and any warnings you would give us as a 
result.
    Mr. Green. We had a Big Bang in the United Kingdom under 
very unusual circumstances. It was not prepared by a great deal 
of discussion, but it was accepted almost without subsequent 
debate because so many parties thought that it solved a lot of 
prior problems. So there was, if you like, a consensus that the 
previous arrangements were unsatisfactory, and there were a lot 
of attractions in what was being done then.
    There was a big advantage, though, in that because there 
was almost no warning, and the government was able to decide, 
using its parliamentary majority, that this would happen. The 
people just had to get on with it, and the organizations were 
thrown together and told they had to come up with a solution. 
There was not any alternative. You are not in that position in 
the United States.
    I suppose the lesson that one would draw from it is that if 
it is at all possible to start with a structure that, rather as 
I said in my earlier remarks, does not have one organization 
clearly in the lead, but you are building a true merger and a 
new structure out of that, there may be a greater chance of 
success. But the historical circumstances were quite unusual in 
that respect.
    Chairman Lieberman. Dr. Carmichael, in addition to 
responding to that, I wonder if you would talk just a little 
bit about what the opinion is in Australia now about whether 
this was a good move to go to the so-called twin peaks, in the 
government, amongst the public, and I suppose in the regulated 
community.
    Mr. Carmichael. Anytime you have change, you are going to 
have some difficulty, and I have been through this not only 
twice in Australia with regulatory amalgamation, but in about 
half a dozen countries where I have worked as well. So I have 
seen some of the problems that can arise firsthand.
    Two of the biggest ones are fear--and that is mainly among 
staff--fear for jobs, and fear for where they will end up in 
the new structure.
    Chairman Lieberman. Right.
    Mr. Carmichael. And the second is distraction. Regulators 
have a job to do, a day job, which is regulation, but they are 
distracted because of the reorganization and the rebuilding. So 
those are two very big considerations that you have to deal 
with in any change.
    Chairman Lieberman. Did previous agencies disappear, as I 
take it they did, in the United Kingdom?
    Mr. Carmichael. Some did.
    Chairman Lieberman. But some continued.
    Mr. Carmichael. Yes.
    Chairman Lieberman. They were just put into one of the 
peaks.
    Mr. Carmichael. We plucked parts of the central bank and 
parts of some of the State regulators and put them together 
into a national regulator. We only had one major institutional 
rebuild. The others were sort of tinkered with at the edges. If 
reform happened here it would be a much more extensive 
rebuilding than that because of the sheer number of agencies 
that you have.
    But there are two things that in my experience have been 
absolutely critical to getting to the end without falling over. 
First is leadership--we have found that if you identify the 
people who are going to be the leaders of the new 
organizations, you have to do that early and you have to put 
them in place to drive the changes because there are always 
people who will resist the change and undermine the process. 
You do not want them anywhere around when you are doing it. So 
there is a need to make the big decisions early on and then to 
get on with it.
    The second one is communication--so that people understand 
what is happening, and they get involved with it. The more you 
can involve staff in the new structure, the more they will feel 
ownership for it and be a part of it.
    I should mention two other things. Mr. Green mentioned Big 
Bang. In the United Kingdom, they did a Big Bang in terms of 
making the decision very quickly. In terms of moving to a new 
internal structure, the FSA moved in gradual steps over quite a 
long period of time. We used a very different approach. We just 
kept the agencies separate for a year. We brought them together 
in name but people kept doing their old jobs for that year. We 
redesigned how we wanted the agency to look at the end of that. 
And at the end of the first year, we basically sacked everyone 
and invited them to apply for new jobs in the new agency. And 
for 2 weeks I did not sleep, not knowing whether we would 
actually have an agency at the end of the process. I would not 
recommend that approach. It worked, but I would not recommend 
it for anyone else.
    The last point I would make before getting to your comment 
about whether it was a success is about legal elements, and I 
speak here as a non-lawyer, but I have learned to respect law 
much more over the last 10 or 15 years than I ever did. It was 
a mistake in Australia to create the agency just with a piece 
of enabling legislation that set it up, said what its powers 
were, but left it to operate under each of the individual 
industry acts that were already in place. So we still had a 
banking act and a general insurance act and so on.
    What we have done in a couple of other countries is take 
each of those pieces of legislation and, before creating the 
agency, take all of the regulatory powers out of those and move 
them up into the agency's act. The power of that is just 
incredible.
    For example, when we first wanted to create a new 
governance standard for all of our industries, my lawyers said, 
``I am sorry, Chairman. You cannot do that. You have to issue 
it under each of the different pieces of legislation, and some 
of them do not even give you the power to do that.''
    So the ability to create a harmonized approach in Australia 
was severely handicapped by the law.
    Now, the United Kingdom went about it another way--they 
created an omnibus act. It was very painful, but the outcome 
was very strong.
    So legal elements are important. I would encourage you, if 
you go this route, to get the legislation running ahead of the 
agency, if you can. Get the legal side sorted out so that the 
agency has the powers to do what it needs to do.
    You asked whether it was a good move. The answer is 
undoubtedly, yes. Our Prime Minister in Australia and our 
Treasurer are out around the world crowing about how great our 
system has been. If you wound the clock back 2 years ago, they 
were still grumbling that the system belonged to their 
predecessors, who were of a different party. The story has 
changed enormously.
    Chairman Lieberman. That is powerful testimony. Thank you. 
Senator Collins.
    Senator Collins. Thank you, Mr. Chairman.
    Mr. Carmichael, let me take up where the Chairman left off. 
Your four peaks or twin peaks approach has a lot of appeal to 
me, but I am wondering, as someone who spent 5 years overseeing 
financial regulation in the State of Maine, how it works for 
the regulatory community. If you have separate regulators, do 
you also have separate compliance audits? In other words, in 
Maine, when we would send out our bank auditors to review the 
State-chartered banks for compliance, they did the entire audit 
because it was only that one agency plus there was a Federal 
agency involved as well. But if you have separate regulators 
for prudential regulation competition, are you having multiple 
audits?
    Mr. Carmichael. The answer is yes, but ``multiple'' is a 
very small number in that our prudential regulator has the 
primary responsibility for on-site inspections. And I should 
say we are much more of a principles-based than a rules-based 
country, so we do not do anything like as many audits and on-
site inspections as would be common under the U.S. approach.
    Our conduct regulator, which is the pillar that looks at 
mis-selling and mis-pricing of products, works on the basis of 
responding to complaints. So they are not out there auditing 
complaints as such. They will hear a complaint, and they are 
really looking for misconduct of a type. Then they will do an 
investigation. So it is very targeted. It is not a regular on-
site audit of that style.
    So in the sense of overlap, it is really quite minimal.
    Senator Collins. I also recall when I was head of the 
Financial Department that we would have regulated entities say, 
well, we are going to consider becoming federally chartered 
unless you do X. So there is a real problem in our country with 
shopping for the easiest regulator and playing the States off 
against the Federal regulators and vice versa. And because that 
is an income stream to the regulator, those threats matter to 
State governments, particularly State governments that are 
strapped for funds. So I think that is an issue as well.
    Mr. Nason, in the United States we now recognize that a 
large shadow banking sector can threaten the entire financial 
sector, and I, for one, believe that it is not enough to 
monitor just the safety and soundness of traditional banks, but 
we need to extend safety and soundness regulation to investment 
banks, for example, to subsidiaries of companies like AIG.
    Bear Stearns, I am told, had an astonishing leverage ratio 
of 30:1 when it failed. Do you think that we should be 
extending some system of capital requirements across the 
financial sector?
    Mr. Nason. That is a great and very difficult question. If 
you go back to Bear Stearns, Bear Stearns was under a 
consolidated supervisory system that was administered by the 
SEC, so they did have liquidity and capital requirements that 
were different than the banking system, but they were under 
some type of conglomerate supervision.
    I think generally if you are a systemically important 
institution, it is hard to argue that you should not be under 
some type of systemic supervision to prevent hurting the 
general economy.
    What gets harder is where do you draw the line between 
which types of institutions gets safety and soundness 
supervision and which do not? For example, a very easy case is 
some hedge funds, you can make an argument that they are 
systemically important because of their size or concentration 
in particular markets. They could probably be subjected to some 
type of supervision. Should all hedge funds be subjected to 
that type of supervision? The case is harder the smaller they 
become.
    So the way that we cut it in the Blueprint is that 
institutions would all need to be licensed, chartered, and 
under the supervision of our systemic regulator. But that type 
of systemic regulation was different than traditional 
prudential safety and soundness regulation.
    Senator Collins. It, of course, gets very complicated very 
quickly because if you designate certain financial institutions 
as systemically important and, thus, make them subject to 
safety and soundness regulation, you are also sending a message 
that they are too big to fail--a very bad message to send 
because then you are creating moral hazard.
    This is so complicated to figure out the right answer here, 
but I do think it is significant that the Canadian banks, with 
their higher capital requirements and the ability to hold 
lower-return assets, lower-risk assets, and lower leverage 
ratios compared to American banks, were healthier. They did not 
fail. So, clearly, there has got to be a lesson for us there.
    Mr. Clark, I know we are running out of time, but I do want 
to talk to you further about the lending practices. I 
completely agree with my colleague from Missouri that part of 
the problem with the American mortgage system was that risk and 
responsibility were divorced, so you had a mortgage broker who 
was making the loan, gets his or her cut, then sells it to the 
bank, which gets its cut, which then sells it to the secondary 
market. Everyone is getting a financial reward, but ultimately 
no one is responsible for the mortgage if it goes bad. There is 
no skin in the game, which I think is a big problem, although 
difficult to solve because of the liquidity issues that Mr. 
Nason raised.
    But there are other key differences as well that you talked 
to me about when we were in my office, and they had to do with 
downpayment levels, mortgage insurance, and deductibility of 
interest. Could you discuss some of the differences between 
Canadian and American mortgage lending?
    Mr. Clark. Maybe I should just mention one other feature 
that I have not underscored but we found a tremendous 
difference on the two sides of the border. In Canada, because 
we hold all the mortgages, modifying the mortgages is easy to 
do. We do not have to ask anyone's permission to modify the 
mortgage. And it is not the government coming to us and saying, 
``Would you start? Here is our modification program.'' We just 
were instantly modifying the mortgages.
    Last year, we represented about 20 percent of the mortgage 
market in Canada. We only foreclosed on 1,000 homes in a whole 
year, to give you an order of magnitude. And every one of those 
thousand we regarded as a failure. And so the last thing we 
would ever want to do is actually foreclose on a good customer. 
And so we go out of our way to modify the mortgages, and that 
is just natural practice for us because I do not have to ask 
permission of some investor whether or not I want to do this or 
can do it or what rules are governing it.
    So I do think that has turned out in this crisis to be a 
second feature that, frankly, none of us would have thought 
about until the current crisis.
    In terms of our specifics, we are required, if we, in fact, 
lend more than 80 percent loan-to-value, to actually insure the 
mortgage so that represents a constraint. It would not have 
represented a constraint to the kind of no documentation 
lending that was done in the United States because the actual 
underwriting we are doing. But then again, because we actually 
would be holding the mortgages, we insisted on full 
documentation.
    There is not interest deductibility. I think there is no 
question that the feature of having interest deductibility in 
the United States is a major factor for leveraging up. And 
despite the fact that it is justified on the basis that it 
encourages homeownership, historically homeownership has 
actually been higher in Canada than it has been in the United 
States. So there is no evidence that the two are linked at all. 
All it does is inflate housing prices because, in fact, people 
look at the after-tax cost in computing the value on which they 
are to bid for the houses.
    So I would say those are the main features. We do have 
mortgage brokers, but they are originating mortgages which we 
then hold. We do not sell them on. And I think that is the core 
feature.
    Senator Collins. And just to clarify, in most cases the 
homebuyer is putting down 20 percent. Is that correct?
    Mr. Clark. Yes. Although when I started my first house, I 
bought the insurance and put down less than 20 percent. But you 
can do it. But, again, we would not lend to that person unless 
we were sure they were going to pay us back because we are 
responsible for the collections, we are responsible for 
managing that, and it is really our customer relationship, 
which is how we regard it.
    Senator Collins. I think it is fascinating that 
homeownership levels are actually higher in Canada than in the 
United States, because the justification for all these policies 
that encouraged the subprime mortgage market was to increase 
homeownership. And, in fact, it has caused a lot of people to 
lose homes that they could not afford in the first place, and 
the Canadian experience is very instructive.
    Mr. Green, last question to you. In the United Kingdom, 
what are the lending policies? Are they more similar to the 
Canadian practices or to the American practices?
    Mr. Green. A mixture. There is also no interest 
deductibility in the United Kingdom, though that has not 
stopped a boom in house prices. There has been no regulation of 
the terms of lending, and one of the issues that has arisen in 
the review that the FSA has undertaken of what went wrong and 
what might need to change--which I commend to you, it is a very 
detailed review covering many of the issues we have talked 
about today--is whether there should be some kind of mandatory 
loan-to-value ratios or loan-to-income ratios. So they were not 
in place, but that is seriously being considered.
    What has now been agreed at the European level is that 
there will be skin in the game and that the originator in 
securitization will have to maintain 5 percent. And I think I 
am right in saying that has now been legislated across the 
European Union because of a rather widespread perception that 
this was a problem that needed fixing. You may say 5 percent is 
only symbolic, but, of course, it will concentrate the minds of 
the management to all the issues that Dr. Clark has mentioned.
    Senator Collins. Thank you. Thank you, Mr. Chairman.
    Chairman Lieberman. Thanks very much, Senator Collins.
    Thanks to our four witnesses. Thanks for the trouble you 
took to come here, for the time you spent with us, and, most of 
all, for sharing your experiences and opinions. I found this to 
be a very helpful hearing. Even you, Mr. Nason, who did not 
come that far. [Laughter.]
    We appreciate your testimony. And at the risk of 
simplifying it, I think in various ways your testimony has 
shown us that structure matters, obviously regulation does, 
too, that you need a healthy combination of both, and that none 
is a cure-all. You cannot assume that a good regulatory 
structure will solve all the problems. But it will solve some 
of them, and it will prevent others from occurring or make it 
harder for others to occur. I think you have helped clarify 
opinions up here, so we thank you very much.
    It is our normal course to keep the record of the hearing 
open for 15 days for any additional questions or statements. If 
you have any second thoughts you want to add to the printed 
record--all your prepared statements, which were excellent, 
will be printed in the record in full. It may be that some 
Members of the Committee, those who were here and those who 
were not, would file some questions with you, and if you have 
the chance, it would be appreciated if you would answer them 
for the record. But, really, our thanks, and I hope you will 
both watch with interest as we proceed to attempt to reform and 
say a prayer for us as well.
    The hearing is adjourned. Thank you.
    [Whereupon, at 4:01 p.m., the Committee was adjourned.]




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