[Senate Hearing 111-109]
[From the U.S. Government Publishing Office]
S. Hrg. 111-109
MODERNIZING BANK SUPERVISION AND REGULATION--PART I
=======================================================================
HEARING
before the
COMMITTEE ON
BANKING,HOUSING,AND URBAN AFFAIRS
UNITED STATES SENATE
ONE HUNDRED ELEVENTH CONGRESS
FIRST SESSION
ON
EXAMINING WAYS TO MODERNIZE AND IMPROVE BANK REGULATION AND
SUPERVISION, TO PROTECT CONSUMERS AND INVESTORS, AND HELP GROW OUR
ECONOMY IN THE FUTURE
----------
MARCH 19, 2009
----------
Printed for the use of the Committee on Banking, Housing, and Urban
Affairs
S. Hrg. 111-109
MODERNIZING BANK SUPERVISION AND REGULATION--PART I
=======================================================================
HEARING
before the
COMMITTEE ON
BANKING,HOUSING,AND URBAN AFFAIRS
UNITED STATES SENATE
ONE HUNDRED ELEVENTH CONGRESS
FIRST SESSION
ON
EXAMINING WAYS TO MODERNIZE AND IMPROVE BANK REGULATION AND
SUPERVISION, TO PROTECT CONSUMERS AND INVESTORS, AND HELP GROW OUR
ECONOMY IN THE FUTURE
__________
MARCH 19, 2009
__________
Printed for the use of the Committee on Banking, Housing, and Urban
Affairs
Available at: http: //www.access.gpo.gov /congress /senate/
senate05sh.html
U.S. GOVERNMENT PRINTING OFFICE
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COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS
CHRISTOPHER J. DODD, Connecticut, Chairman
TIM JOHNSON, South Dakota RICHARD C. SHELBY, Alabama
JACK REED, Rhode Island ROBERT F. BENNETT, Utah
CHARLES E. SCHUMER, New York JIM BUNNING, Kentucky
EVAN BAYH, Indiana MIKE CRAPO, Idaho
ROBERT MENENDEZ, New Jersey MEL MARTINEZ, Florida
DANIEL K. AKAKA, Hawaii BOB CORKER, Tennessee
SHERROD BROWN, Ohio JIM DeMINT, South Carolina
JON TESTER, Montana DAVID VITTER, Louisiana
HERB KOHL, Wisconsin MIKE JOHANNS, Nebraska
MARK R. WARNER, Virginia KAY BAILEY HUTCHISON, Texas
JEFF MERKLEY, Oregon
MICHAEL F. BENNET, Colorado
Colin McGinnis, Acting Staff Director
William D. Duhnke, Republican Staff Director
Amy Friend, Chief Counsel
Aaron Klein, Chief Economist
Jonathan Miller, Professional Staff Member
Deborah Katz, OCC Detailee
Charles Yi, Senior Policy Advisor
Lynsey Graham-Rea, Counsel
Mark Oesterle, Republican Chief Counsel
Hester Peirce, Republican Counsel
Jim Johnson, Republican Counsel
Dawn Ratliff, Chief Clerk
Devin Hartley, Hearing Clerk
Shelvin Simmons, IT Director
Jim Crowell, Editor
(ii)
C O N T E N T S
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THURSDAY, MARCH 19, 2009
Page
Opening statement of Chairman Dodd............................... 1
Opening statements, comments, or prepared statements of:
Senator Shelby............................................... 3
Senator Bunning
Prepared statement....................................... 49
WITNESSES
John C. Dugan, Comptroller of the Currency, Office of the
Comptroller of the Currency.................................... 5
Prepared statement........................................... 49
Response to written questions of:
Senator Shelby........................................... 184
Senator Reed............................................. 196
Senator Crapo............................................ 200
Senator Kohl............................................. 203
Senator Hutchison........................................ 206
Sheila C. Bair, Chairman, Federal Deposit Insurance Corporation.. 7
Prepared statement........................................... 56
Response to written questions of:
Senator Shelby........................................... 207
Senator Reed............................................. 215
Senator Crapo............................................ 220
Senator Kohl............................................. 226
Senator Hutchison........................................ 233
Michael E. Fryzel, Chairman, National Credit Union Administration 8
Prepared statement........................................... 65
Response to written questions of:
Senator Shelby........................................... 237
Senator Reed............................................. 242
Senator Crapo............................................ 245
Senator Kohl............................................. 249
Senator Hutchison........................................ 250
Daniel K. Tarullo, Member, Board of Governors of the Federal
Reserve
System......................................................... 10
Prepared statement........................................... 74
Response to written questions of:
Senator Shelby........................................... 251
Senator Reed............................................. 264
Senator Crapo............................................ 270
Senator Kohl............................................. 274
Senator Hutchison........................................ 279
Scott M. Polakoff, Acting Director, Office of Thrift Supervision. 12
Prepared statement........................................... 85
Response to written questions of:
Senator Shelby........................................... 281
Senator Reed............................................. 290
Senator Crapo............................................ 293
Senator Kohl............................................. 297
Senator Hutchison........................................ 300
(iii)
Joseph A. Smith, Jr., North Carolina Commissioner of Banks, and
Chair-Elect of the Conference of State Bank Supervisors........ 14
Prepared statement........................................... 90
Response to written questions of:
Senator Shelby........................................... 300
Senator Reed............................................. 304
Senator Crapo............................................ 307
Senator Kohl............................................. 309
George Reynolds, Chairman, National Association of State Credit
Union
Supervisors, and Senior Deputy Commissioner, Georgia Department
of Banking and Finance......................................... 15
Prepared statement........................................... 103
Response to written questions of:
Senator Shelby........................................... 311
Senator Reed............................................. 315
Senator Crapo............................................ 318
Senator Kohl............................................. 320
MODERNIZING BANK SUPERVISION AND REGULATION--PART I
----------
THURSDAY, MARCH 19, 2009
U.S. Senate,
Committee on Banking, Housing, and Urban Affairs,
Washington, DC.
The Committee met at 10:37 a.m., in room SD-538, Dirksen
Senate Office Building, Senator Christopher J. Dodd (Chairman
of the Committee) presiding.
OPENING STATEMENT OF CHAIRMAN CHRISTOPHER J. DODD
Chairman Dodd. The Committee will come to order.
Senator Shelby is in his office. He will be along shortly
but asked us to commence the hearing. So we will begin this
morning. Let me welcome my colleagues, welcome our witnesses as
well. We have another long table here this morning of
witnesses, and we are trying to move through this series of
hearings on the modernization of financial regulation. So I am
very grateful to all of you for your testimony.
The testimony is lengthy, I might add. Going through last
evening the comments--there is Senator Shelby. Very, very
helpful, though, and very informative testimony, so we thank
you all for your contribution.
I will open up with some comments. I will turn to Senator
Shelby, and then we will get right to our witnesses. We have
got votes this morning as well, I would notify my colleagues,
coming up so we are going to have to stagger this a bit so we
do not delay the hearing too long, and we will try to, each one
of us, go out and vote and come back so we can continue the
hearing uninterrupted, if that would work out. So I will ask my
colleagues' indulgence in that regard as well.
We are gathering here again this morning to discuss the
modernization of bank supervision and regulation. This hearing
marks yet another in a series of hearings to identify causes of
the financial crisis and specific responses that will guide
this Committee's formulation of a new architecture for the 21st
century financial services regulation.
Today, we are going to explore ways to modernize and
improve bank regulation and supervision, to protect consumers
and investors, and help grow our economy in the decades ahead.
A year ago, this Committee heard from witnesses on two separate
occasions that the banking system was sound and that the vast
majority of banks would be well positioned to weather the
storm.
A year later, taxpayers are forced to pump billions of
dollars into our major banking institutions to keep them
afloat. Meanwhile, every day 20,000 people, we are told, are
losing their jobs in our country, 10,000 families' homes are in
jeopardy from foreclosure, and credit--the lifeblood of our
economy--is frozen solid. People are furious right now, and
they should be. But history will judge whether we make the
right decisions. And as President Obama told the Congress last
month, we cannot afford to govern out of anger or yield to the
politics of the moment as we prepare to make choices that will
shape the future of our country literally for decades and
decades to come.
We must learn from the mistakes and draw upon those lessons
to shape the new framework for financial services regulation,
an integrated, transparent, and comprehensive architecture that
serves the American people well through the 21st century.
Instead of the race to the bottom we saw in the run-up to
the crisis, I want to see a race to the top, with clear lines
of authority, strong checks and balances that build the
confidence in our financial system that is so essential to our
economic growth and stability.
Certainly there is a case to be made for a so-called
systemic risk regulator within that framework, and whether or
not those vast powers will reside in the Fed remains an open
question, although the news this morning would indicate that
maybe a far more open question in light of the balance sheet
responsibilities.
And, Mr. Tarullo, we will be asking you about that question
this morning to some degree as well. This news this morning
adds yet additional labors and burdens on the Fed itself, and
so the question of whether or not, in addition to that job, we
can also take on a systemic risk supervisor capacity is an
issue that I think a lot of us will want to explore.
As Chairman Bernanke recently said, the role of the
systemic risk regulator will entail a great deal of expertise,
analytical sophistication, and the capacity to process large
amounts of disparate information. I agree with Chairman
Bernanke, which is why I wonder whether it would not make more
sense to give authority to resolve failing and systemically
important institutions to the agency with actual experience in
the area--the FDIC.
If the events of this week have taught us anything, it is
that the unwinding of these institutions can sap both public
dollars and public confidence essential to getting our economy
back on track. This underscores the importance of establishing
a mechanism to resolve these failing institutions.
From its failure to protect consumers, to regulate mortgage
lending, to effectively oversee bank holding companies, the
instances in which the Fed has failed to execute its existing
authority are numerous. In a crisis that has taught the
American people many hard learned lessons, perhaps the most
important is that no institution should ever be too big to
fail. And going forward, we should consider how that lesson
applies not only to our financial institutions, but also to the
Government entities charged with regulating them.
Replacing Citibank-size financial institutions with
Citibank-size regulators would be a grave mistake. This crisis
has illustrated all too well the dangers posed to the consumer
and our economy when we consolidate too much power in too few
hands with too little transparency and accountability.
Further, as former Fed Chairman Volcker has suggested,
there may well be an inherent conflict of interest between
prudential supervision--that is, the day-to-day regulation of
our banks--and monetary policy, the Fed's primary mission--and
an essential one, I might add.
One idea that has been suggested that could complement and
support an entity that oversees systemic risk is a consolidated
safety and soundness regulator. The regulatory arbitrage,
duplication, and inefficiency that comes with having multiple
Federal banking regulators was at least as much of a problem in
creating this crisis as the Fed's inability to see the crisis
coming and its failure to protect consumers and investors. And
so systemic risk is important, but no more so than the risk to
consumers and depositors, the engine behind our very banking
system.
Creating that race to the top starts with building from the
bottom up. That is why I am equally interested in what we do to
the prudential supervision level to empower regulators, the
first line of defense for consumers and depositors, and
increase the transparency that is absolutely essential to
checks and balances and to a healthy financial system.
Each of these issues leads us to a simple conclusion: The
need for broad, comprehensive reform is clear. We cannot afford
to address the future of our financial system piecemeal or ad
hoc without considering the role that every actor at every
level must play in creating a stable banking system that helps
our economy grow for decades to come. That must be our
collective goal.
With that, let me turn to Senator Shelby.
STATEMENT OF SENATOR RICHARD C. SHELBY
Senator Shelby. Thank you, Chairman Dodd.
We are in the midst of an unprecedented financial crisis. I
believe the challenge before us involves three tasks: First, we
must work to stabilize the system. Second, we must understand
the origins of the current crisis. And, third, we must work to
restructure our regulatory regime to meet the demands of a 21st
century financial system.
Today, the Committee will focus primarily on the third
task, rebuilding the regulatory structure. I believe the
success of our effort will depend a great deal on our ability
to determine what led us to this point. Without that knowledge,
we will not know whether we are regulating the right things in
the right way.
We need to determine whether the regulators had sufficient
authority and whether they used the authority they had to the
fullest extent. We need to consider here whether market
developments outpace current regulatory capabilities. We also
need to better understand the impact regulation has on the
private sector's due diligence and risk management practices.
After understanding the nature of the regulatory structure,
I believe we need to come to an understanding as to the
specific cause or causes of the regulatory failure. We then
need to address those failures in such a manner where we create
a durable, flexible, and robust regime that can grow with
markets while still protecting consumers and market stability.
This is a very tall order. It will take an intensive and
extended effort on our behalf, but in the end, getting this
thing done right is more important than getting it done
quickly.
Thank you, Mr. Chairman.
Chairman Dodd. We have a lot of witnesses, but some of my
colleagues may want to make some very brief opening comments on
this. Senator Brown, you are next in line. Do you want to make
a brief opening comment on this at all?
Senator Brown. I will pass.
Chairman Dodd. You will. Senator Bunning.
Senator Bunning. Pass.
Chairman Dodd. As well. Senator Tester.
Senator Tester. I will pass.
Chairman Dodd. As well. Senator Crapo.
Senator Crapo. Pass.
Chairman Dodd. Let me see. Senator Warner.
Senator Warner. I will pass.
Chairman Dodd. We have a trend going here. Senator Bennett?
I was told by my staff that some members wanted to be heard, so
I am just responding to the staff request.
Senator Bennett. I just want to thank you for holding the
hearing and recognize that it is going to be the first in a
series, because there is probably nothing more important that
we will do in this Committee this year than deal with this
problem. The future is a very--there are many demands that we
have to deal with, with respect to the future here.
Chairman Dodd. Thank you.
Senator Schumer.
Senator Schumer. Pass.
Chairman Dodd. All right. Senator Merkley.
Senator Merkley. I will pass.
Chairman Dodd. Senator Bennet.
Senator Bennet. I appreciate the opportunity to make a
lengthy opening statement.
[Laughter.]
Chairman Dodd. Statements will be included in the record.
We will make sure that happens.
We will begin with our witnesses here. We are very
fortunate to have a good, strong group of folks who know these
issues well and have been involved before with this Committee
on numerous occasions. Let me briefly introduce them each.
I will begin with John Dugan. He is currently the
Comptroller of the Currency. We thank you for coming back
before the Committee once again.
Sheila Bair, Chairperson of the Federal Deposit Insurance
Corporation, has been before the Committee on numerous
occasions.
We have next Michael Fryzel, Chairman of the National
Credit Union Administration, and we appreciate your
participation.
Dan Tarullo is with the Federal Reserve. We thank you, Dan.
Congratulations on your recent confirmation as well.
Scott Polakoff currently serves as the Acting Director of
the Office of Thrift Supervision.
Joseph Smith is currently North Carolina Commissioner on
Banks and is appearing on behalf of the State Bank Supervisors,
and we thank you for being here.
And George Reynolds is the Chairman of the National
Association of State Credit Union Supervisors and Senior Deputy
Commissioner of the Georgia Department of Banking and Finance.
And we thank you as well for joining us.
I am going to ask, given the magnitude, the size of our
Committee here this morning--I noticed, for instance, John,
your testimony is about 18 or 20 pages long last night as I
went through it, and I am hopeful you are not going to try and
do all 20 pages here this morning. Dan, yours is about 16 or 17
pages as well. If you could abbreviate this down to about 5 or
6 minutes or so--and it is important we hear what you have to
say, so I do not want to constrain you too much. But I would
like to be able to get through everyone so we can go through
the question period.
We will begin with you.
STATEMENT OF JOHN C. DUGAN, COMPTROLLER OF THE CURRENCY, OFFICE
OF THE COMPTROLLER OF THE CURRENCY
Mr. Dugan. Thank you, Chairman Dodd, Ranking Member Shelby,
and Members of the Committee.
The financial crisis has raised legitimate questions about
whether we need to restructure and reform our financial
regulatory system, and I welcome the opportunity to testify on
this important subject on behalf of the OCC.
Let me summarize the five key recommendations from my
written statement which address issues raised in the
Committee's letter of invitation.
First, we support the establishment of a systemic risk
regulator, which probably should be the Federal Reserve Board.
In many ways, the Board already serves this role with respect
to systemically important banks, but no agency has had similar
authority with respect to systemically important financial
institutions that are not banks, which created real problems in
the last several years as risk increased in many such
institutions. It makes sense to provide one agency with
authority and accountability for identifying and addressing
such risks across the financial system.
This authority should be crafted carefully, however, to
address the very real concerns of the Board taking on too many
functions to do all of them well, while at the same time
concentrating too much authority in a single Government agency.
Second, we support the establishment of a regime to
stabilize resolve and wind down systemically significant firms
that are not banks. The lack of such a regime this past year
proved to be an enormous problem in dealing with distressed and
failing institutions such as Bear Stearns, Lehman Brothers, and
AIG. The new regime should provide tools that are similar to
those the FDIC currently has for resolving banks, as well as
provide a significant funding source, if needed, to facilitate
orderly dispositions, such as a significant line of credit from
the Treasury. In view of the systemic nature of such
resolutions and the likely need for Government funding, the
systemic risk regulator and the Treasury Department should be
responsible for this new authority.
Third, if the Committee decides to move forward with
reducing the number of bank regulators--and that would, of
course, shorten this hearing--we have two general
recommendations. The first may not surprise you. We believe
strongly that you should preserve the role of a dedicated
prudential banking supervisor that has no job other than bank
supervision. Dedicated supervision produces no confusion about
the supervisor's goals or mission, no potential conflict with
competing objectives; responsibility and accountability are
well defined; and the result is a strong culture that fosters
the development of the type of seasoned supervisors that we
need. But my second recommendation here may sound a little
strange coming from the OCC given our normal turf wars.
Congress, I believe, should preserve a supervisory role for the
Federal Reserve Board, given its substantial experience with
respect to capital markets, payment systems, and the discount
window.
Fourth, Congress should establish a system of national
standards that are uniformly implemented for mortgage
regulation. While there were problems with mortgage
underwriting standards at all mortgage providers, including
national banks, they were least pronounced at regulated banks,
whether State or nationally chartered. But they were extremely
severe at the nonbank mortgage companies and mortgage brokers
regulated exclusively by the States, accounting for a
disproportionate share of foreclosures. Let me emphasize that
this was not the result of national bank preemption, which in
no way impeded States from regulating these providers. National
mortgage standards with comparable implementation by Federal
and State regulators would address this regulatory gap and
ensure better mortgages for all consumers.
Finally, the OCC believes the best way to implement
consumer protection regulation of banks, the best way to
protect consumers is to do so through prudential supervision.
Supervisors' continual presence in banks through the
examination process creates especially effective incentives for
consumer protection compliance, as well as allowing examiners
to detect compliance failures much earlier than would otherwise
be the case. They also have strong enforcement powers and
exceptional leverage over bank management to achieve corrective
action. That is, when examiners detect consumer compliance
weaknesses or failures, they have a broad range of corrective
tools from informal comments to formal enforcement action, and
banks have strong incentives to move back into compliance as
expeditiously as possible.
Finally, because examiners are continually exposed to the
practical effects of implementing consumer protection rules for
bank customers, the prudential supervisory agency is in the
best position to formulate and refine consumer protection
regulation for banks.
Proposals to remove consumer protection regulation and
supervision from prudential supervisors, instead consolidating
such authority in a new Federal agency, would lose these very
real benefits, we believe. If Congress believes that the
consumer protection regime needs to be strengthened, the best
answer is not to create a new agency that would have none of
the benefits of the prudential supervisor. Instead, we believe
the better approach is for Congress to reinforce the agency's
consumer protection mission and direct them to toughen the
applicable standards and close any gaps in regulatory coverage.
The OCC and the other prudential bank supervisors will
rigorously apply any new standards, and consumers will be
better protected.
Thank you very much. I would be happy to answer questions.
Chairman Dodd. Thank you very much.
Ms. Bair, thank you for joining us.
STATEMENT OF SHEILA C. BAIR, CHAIRMAN, FEDERAL DEPOSIT
INSURANCE CORPORATION
Ms. Bair. Chairman Dodd, Ranking Member Shelby, and Members
of the Committee, thank you for the opportunity to testify
today.
Our current regulatory system has clearly failed in many
ways to manage risk properly and to provide market stability.
While it is true that there are regulatory gaps which need to
be plugged, U.S. regulators already have broad powers to
supervise financial institutions. We also have the authority to
limit many of the activities that undermined our financial
system. The plain truth is that many of the systemically
significant companies that have needed unprecedented Federal
help were already subject to extensive Federal oversight. Thus,
the failure to use existing authorities by regulators casts
doubt on whether simply entrusting power in a new systemic risk
regulator would be enough.
I believe the way to reduce systemic risk is by addressing
the size, complexity, and concentration of our financial
institutions. In short, we need to end ``too big to fail.'' We
need to create regulatory and economic disincentives for
systemically important financial firms. For example, we need to
impose higher capital requirements on them in recognition of
their systemic importance to make sure they have adequate
capital buffers in times of stress. We need greater market
discipline by creating a clear, legal mechanism for resolving
large institutions in an orderly manner that is similar to the
one for FDIC-insured banks.
The ad hoc response to the current crisis is due in large
part to the lack of a legal framework for taking over an entire
complex financial organization. As we saw with Lehman Brothers,
bankruptcy is a very poor way to resolve large, complex
financial organizations. We need a special process that is
outside bankruptcy, just as we have for commercial banks and
thrifts.
To protect taxpayers, a new resolution regime should be
funded by fees charged to systemically important firms and
would apply to any institution that puts the system at risk.
These fees could be imposed on a sliding scale, so the greater
the risk the higher the fee. In a new regime, rules and
responsibility must be clearly spelled out to prevent conflicts
of interest. For example, Congress gave the FDIC back-up
supervisory authority and the power to self-appoint as receiver
when banks get into trouble. Congress did this to ensure that
the entity resolving a bank has the power to effectively
exercise its authority even if there is disagreement with the
primary supervisor. As Congress has determined for the FDIC,
any new resolution authority should also be independent of any
new systemic risk regulator.
The FDIC's current authority to act as receiver and to set
up a bridge bank to maintain key functions and sell assets is a
good starting point for designing a new resolution regime.
There should be a clearly defined priority structure for
settling claims depending on the type of firm. Any resolution
should be required to minimize losses to the public. And the
claims process should follow an established priority list.
Also, no single Government entity should have the power to
deviate from the new regime. It should include checks and
balances that are similar to the systemic risk exception for
the least cost test that now applies to FDIC-insured
institutions.
Finally, the resolution entity should have the kinds of
powers the FDIC has to deal with such things as executive
compensation. When we take over a bank, we have the power to
hire and fire. We typically get rid of the top executives and
the managers who caused the problem. We can terminate
compensation agreements, including bonuses. We do whatever it
takes to hold down costs. These types of authorities should
apply to any institution that gets taken over by the
Government.
Finally, there can no longer be any doubt about the link
between protecting consumers from abusive products and
practices and the safety and soundness of America's financial
system. It is absolutely essential that we set uniform
standards for financial products. It should not matter who the
seller is, be it a bank or nonbank. We also need to make sure
that whichever Federal agency is overseeing consumer
protection, it has the ability to fully leverage the expertise
and resources accumulated by the Federal banking agencies. To
be effective, consumer policy must be closely coordinated and
reflect a deep understanding of financial institutions and the
dynamic nature of the industry as a whole.
The benefits of capitalism can only be recognized if
markets reward the well managed and punish the lax. However,
this fundamental principle is now observed only with regard to
smaller financial institutions. Because of the lack of a legal
mechanism to resolve the so-called systemically important,
regardless of past inefficiency or recklessness, nonviable
institutions survive with the support of taxpayer funds.
History has shown that Government policies should promote, not
hamper, the closing and/or restructuring of weak institutions
into stronger, more efficient ones. The creation of a systemic
risk regulator could be counterproductive if it reinforced the
notion that financial behemoths designated as systemic are, in
fact, too big to fail.
Congress' first priority should be the development of a
framework which creates disincentives to size and complexity
and establishes a resolution mechanism which makes clear that
managers, shareholders, and creditors will bear the
consequences of their actions.
Thank you.
Chairman Dodd. Thank you very much.
Mr. Fryzel.
STATEMENT OF MICHAEL E. FRYZEL, CHAIRMAN, NATIONAL CREDIT UNION
ADMINISTRATION
Mr. Fryzel. Thank you, Chairman Dodd, Ranking Member
Shelby, and Members of the Committee. As Chairman of the
National Credit Union Administration, I appreciate this
opportunity to provide the agency's position on regulatory
modernization.
Federally insured credit unions comprise a small but
important part of the financial institution community, and I
hope NCUA's perspective on this matter will add to the
understanding of the unique characteristics of the credit union
industry and the 90 million members they serve.
The market dislocations underscore the importance of your
review of this subject. I see a need for revisions to the
current regulatory structure in ways that would improve Federal
oversight of not just financial institutions, but the entire
financial services market. My belief is that there is a better
way forward, a way that would enable Federal regulators to more
quickly and effectively identify and deal with developing
problems.
Before I express my views on possible reforms, I want to
briefly update you on the condition of the credit union
industry.
Overall, credit unions maintained reasonable performance in
2008. Aggregate capital level finished the year at 10.92
percent, and while earnings decreased due to the economic
downturn, credit unions still posted a 0.30 percent return on
assets in 2008. I am pleased to report that even in the face of
market difficulties, credit unions were able to increase
lending by just over 7 percent. Loan delinquencies were 1.3
percent, and charge-offs were 0.8 percent, indicating that
credit unions are lending prudently.
Credit unions are fundamentally different in structure and
operation than other types of financial institutions. They are
not-for-profit cooperatives owned and governed by their
members. Our strong belief is that these unique and distinct
institutions require unique and distinct regulation,
accompanied by supervision tailored to their special way of
operating.
Independent NCUA regulation has enabled credit unions to
perform in a safe and sound manner while fulfilling the
cooperative mandate set forth by Congress. One benefit of our
distinct regulatory approach is the 18-percent usury ceiling
for Federal credit unions that enhances their ability to act a
low-cost alternative to predatory lenders. Another is the
existence of a supervisory committee for Federal charters,
unique among all financial institutions. These committees,
comprised of credit union members, have enhanced consumer
protection by giving members peer review of complaints and have
supplemented the ability of NCUA to resolve possible violations
of consumer protection laws.
NCUA administers the National Credit Union Share Insurance
Fund, the Federal insurance fund for both Federal and State-
chartered credit unions. The fund currently has an equity ratio
of 1.28 percent. The unique structure of the fund where credit
unions make a deposit equal to 1 percent of their insured
shares, augmented by premiums as needed, to keep the fund above
a statutory level of 1.20 percent has resulted in a very stable
and well-functioning insurance fund. Even in the face of
significant stress in the corporate credit union part of the
industry, stress that necessitated extraordinary actions by the
NCUA board to stabilize the corporates, the fund has proven
durable.
I want to underscore the benefits of having the fund
administered by NCUA. Working in concert with our partners in
the State regulatory system, NCUA uses close supervision to
control risks. This concept was noted prudently by GAO studies
over the years, as were the benefits of a streamlined oversight
and insurance function under one roof. This consolidated
approach has enabled NCUA to manage risk in an efficient manner
and identify problems in a way that minimizes losses to the
fund.
NCUA considers the totality of our approach for mixed
deposit and premium funding mechanism to unify supervisory and
insurance activities, to be the one that has had significant
public policy benefits, and one worth preserving. Whatever
reorganization Congress contemplates, the National Credit Union
Share Insurance Fund should remain integrated into the Federal
credit union regulator and separate from any other Federal
insurance funds.
Regarding restructuring of the financial regulatory
framework, I suggest creating a single oversight entity whose
responsibilities would include monitoring financial institution
regulators and issuing principles-based regulations and
guidance. The entity would be responsible for establishing
general safety and soundness standards, while the individual
regulators would enforce them in the institutions they
regulated. It would also monitor systemic risks across
institution types.
Again, for this structure to be effective for federally
insured credit unions and the consumers they serve, the
National Credit Union Share Insurance Fund should remain
independent in order to maintain the dual NCUA regulatory and
insurance roles that have been tested and proven to work for
almost 40 years.
I appreciate the opportunity to provide testimony today and
would be pleased to answer any questions.
Chairman Dodd. Thank you very, very much.
Dan Tarullo, thank you very much for being here on behalf
of the Fed.
STATEMENT OF DANIEL K. TARULLO, MEMBER, BOARD OF GOVERNORS OF
THE FEDERAL RESERVE SYSTEM
Mr. Tarullo. Thank you, Mr. Chairman, Senator Shelby, and
Members of the Committee. We are here this morning because of
systemic risk. We have had a systemic crisis. We are still in
the middle of it, and I would endorse wholeheartedly Senator
Shelby's three-part approach to responding to that crisis.
In the weeks that I have been at the Federal Reserve, the
discussions that have taken place internally, both among staff
and among the members, have focused on the issue of systemic
risk and how to prevent it going forward. The important point I
would make as a prelude to our recommendations is that the
source of systemic risk in our financial system has to some
considerable extent migrated from traditional banking
activities to markets over the last 20 or 25 years. If you
think about the problems that led to the Depression, that were
apparent even in the 1970s among some banks, the concern was
that there would be a run on a bank, that depositors would be
worried about the safety and soundness of that bank and that
there would be contagion spreading to other institutions as
depositors were uncertain as to the status of those
institutions.
What has been seen more recently is a systemic problem
starting in the interactions among institutions in markets.
Now, banks are participants in markets, so this can still be
something that affects banks. But we have also seen other kinds
of institutions at the source of the systemic problems we are
undergoing right now.
I think you cannot focus on a single institution or even
just look at institutions as a series of silos, as it were, and
concentrate solely on trying to assure their safety and
soundness. We need to look at the interaction among
institutions. Sometimes that means their actual counterparty
relationships with one another. Sometimes it means the fora in
which they interact with one another, in payment systems and
the like. Sometimes it even means the parallel strategies which
they may be pursuing--when, for example, they are all relying
on the same sources of liquidity if they have to change their
investing strategies. So they may not even know that they are
co-dependent with other actors in the financial markets.
For all of these reasons, our view is that the focus needs
to be on an agenda for financial stability, an agenda for
systemic risk management. I emphasize that because, although
there is rightly talk about a systemic risk regulator, it is
important that we understand each component of an agenda which
is going to be fulfilled by all the financial regulators over
which you have jurisdiction.
So what do we mean by this agenda? Well, I tried in my
testimony to lay out five areas in which we should pay
attention. First, we do need effective consolidated supervision
of any systemically important institution. We need consolidated
supervision and it needs to be effective. There are
institutions that are systemically important, and certainly
were systemically important over the last few years, which were
not subject to consolidated prudential supervision by any
regulator.
But that supervision needs to be effective. I think
everybody is aware, and ought to be aware, of the ways in which
the regulation and supervision of our financial institutions in
recent years has fallen short. And unless, as Senator Shelby
suggests, we all concentrate on it and reflect on it without
defensiveness, we are not going to learn the lessons that need
to be learned.
Second, there is need for a resolution mechanism. I am
happy to talk about that in the back and forth with you, but
Comptroller Dugan and Chairman Bair have laid that out very
well.
Third, there does need to be more oversight of key areas in
which market participants interact in important ways. We have
focused in particular on payments and settlement systems,
because there the Fed's oversight authority derives largely
from the coincidence that some of the key actors happen to be
member banks. But if they weren't, if they had another
corporate form, there is no statutory authority right now for
us to exercise prudential supervision over those markets in
which problems can arise.
Fourth, consumer protection. Now, consumer protection is
not and should not be limited to its relationship with
potential systemic risk. But, as the current crisis
demonstrated, there are times in which good consumer protection
is not just good consumer protection, but it is an important
component of an agenda for containment of systemic risk.
Fifth and finally is the issue of a systemic risk
regulator. This is something that does seem to fit into an
overall agenda. There are gaps in covering systemically
important institutions. There are also gaps in attempting to
monitor what is going on across the system.
I think in the past there have been times at which there
was important information being developed by various regulators
and supervisors which, if aggregated, would have suggested
developing issues and problems. But without a charge to one or
more entities to try to put all that together, one risks
looking at things, as I said, in a more siloed fashion. The
extent of those authorities for a systemic risk regulator is
something that needs to be debated in this Committee and in the
entire Congress. But I do think that it is an important
complement to the other components of this agenda and the
improvements in supervision and regulation under existing
authorities, and thus something that ought to be considered.
I am happy to answer any questions that you may have.
Chairman Dodd. Thank you very much.
There will be three or four consecutive votes that are
going to occur, so regretfully, we are going to have to recess,
and when we get over there, there are going to be, 10-minute
votes, not 15-minute votes. I apologize to our witnesses, but
all of you have been here before in the past when this has
occurred. We will have three or four votes--it may even be two,
it may be a voice on one, so we may get back much more quickly,
and we will pick up with Mr. Polakoff.
The Committee will stand in recess.
[Recess.]
Chairman Dodd. Could I invite all of you to come back in,
and let me tell you how we will proceed. I apologize to our
witnesses. There is going to be another vote, but I thought we
could complete the testimony from our witnesses, and by that
time, the third vote might begin. I have been advised the
members will stay over there for the vote rather than run back
and forth. As I said, we will complete your testimony, and then
we will engage in the questioning for the remainder of the
time.
Mr. Polakoff, we welcome you. Thank you.
STATEMENT OF SCOTT M. POLAKOFF, ACTING DIRECTOR, OFFICE OF
THRIFT SUPERVISION
Mr. Polakoff. Good morning, Chairman Dodd. Thank you for
inviting me to testify on behalf of OTS on ``Modernizing Bank
Supervision and Regulation.''
As you know, our current system of financial supervision is
a patchwork with pieces that date back to the Civil War. If we
were to start from scratch, no one would advocate establishing
a system like the one we have, cobbled together over the last
century and a half. The complexity of our financial markets has
in some cases reached mind-boggling proportions. To effectively
address the risks in today's financial marketplace, we need a
modern, sophisticated system of regulation and supervision that
applies evenly across the financial services landscape.
Our current economic crisis enforces the message that the
time is right for an in-depth, careful review and meaningful,
fundamental change. Any restructuring should take into account
the lessons learned from this crisis. At the same time, the OTS
recommendations that I am presenting here today do not
represent a realignment of the current regulatory structure.
Rather, they represent a fresh start using a clean slate. They
represent the OTS vision for the way financial services
regulation in this country should be. In short, we are
proposing fundamental changes that would affect virtually all
of the current financial regulators.
It is important to note that these are high-level
recommendations. Before adoption and implementation, many
details would need to be worked out and many questions would
need to be answered.
The OTS proposal for modernization has two basic elements.
First, a set of guiding principles, and second, recommendations
for Federal bank regulation, holding company supervision, and
systemic risk regulation. So what I would like to do is offer
the five guiding principles.
Number one, a dual banking system with Federal and State
charters for banks.
Number two, a dual insurance system with Federal and State
charters for insurance companies.
Number three, the institution's operating strategy and
business model would determine its charter and identify its
responsible regulatory agency. Institutions would not simply
pick their regulator.
Number four, organizational and ownership options would
continue, including mutual ownership, public and private stock
entities, and Subchapter S corporations.
And number five, ensure that all entities offering
financial products are subject to the consistent laws,
regulations, and rigor of regulatory oversight.
Regarding our recommendations on regulatory structure, the
OTS strongly supports the creation of a systemic risk regulator
with authority and resources to accomplish the following three
functions.
Number one, to examine the entire conglomerate.
Number two, to provide temporary liquidity in a crisis.
And number three, to process a receivership if failure is
unavoidable.
For Federal bank regulation, the OTS proposes two charters,
one for banks predominately focused on consumer and community
banking products, including lending, and the other for banks
primarily focused on commercial products and services. The
business models of the commercial bank and the consumer and
community bank are fundamentally different enough to warrant
two distinct Federal banking charters. These regulators would
each be the primary Federal supervisor for State chartered
banks with the relevant business models.
A consumer and community bank regulator would close the
gaps in regulatory oversight that led to a shadow banking
system of uneven regulated mortgage companies, brokers, and
consumer lenders that were significant causes of the current
crisis. This regulator would also be responsible for developing
and implementing all consumer protection requirements and
regulations.
Regarding holding companies, the functional regulator of
the largest entity within a diversified financial company would
be the holding company regulator.
I realize I have provided a lot of information and I look
forward to answering your questions, Mr. Chairman.
Chairman Dodd. Thank you very, very much.
Mr. Smith, welcome to the Committee.
STATEMENT OF JOSEPH A. SMITH, JR., NORTH CAROLINA COMMISSIONER
OF BANKS, AND CHAIR-ELECT OF THE
CONFERENCE OF STATE BANK SUPERVISORS
Mr. Smith. Thank you, Mr. Chairman. I am Joe Smith. I am
North Carolina Commissioner of Banks and Chair-Elect of the
Conference of State Bank Supervisors, on whose behalf I am
testifying. I very much appreciate this opportunity.
My colleagues and I have submitted to you written
testimony. I will not read it to you today.
Chairman Dodd. Thank you.
Mr. Smith. I would like to emphasize a few points that are
contained in it.
The first of these points is that proximity, or closeness
to the consumers, businesses, and communities that deal with
our banks is important. We acknowledge that a modern financial
regulatory structure must deal with systemic risks presented by
complex global institutions. While this is necessary, sir, we
would argue that it is not itself sufficient.
A modern financial regulatory structure should also
include, and as more than an afterthought, the community and
regional institutions that are not systemically significant in
terms of risk but that are crucial to effectively serving the
diverse needs of our very diverse country. These institutions
were organized to meet local needs and have grown as they have
met such needs, both in our metropolitan markets and in rural
and exurban markets, as well.
We would further suggest that the proximity of State
regulators and attorneys general to the marketplace is a
valuable asset in our efforts to protect consumers from fraud,
predatory conduct, and other abuses. State officials are the
first responders in the area of consumer protection because
they are the nearest to the action and see the problems first.
It is our hope that a modernized regulatory system will make
use of the valuable market information that the States can
provide in setting standards of conduct and will enhance the
role of States in enforcing such standards.
To allow for this system to properly function, we strongly
believe that Congress should overturn or roll back the OTS and
OCC preemption of State consumer protection laws and State
enforcement.
A second and related point that we hope you will consider
is that the diversity of our banking and regulatory systems is
a strength of each. One size does not fit all, either with
regard to the size, scope, and business methods of our banks or
the regulatory regime applicable to them.
We are particularly concerned that in addressing the
problems of complex global institutions, a modernized financial
system may inadvertently weaken community and regional banks by
under-support for the larger institutions and by burdening
smaller institutions with the costs of regulation that are
appropriate for the large institutions, but not for the smaller
regional ones.
We hope you agree with us that community and regional banks
provide needed competition in our metropolitan markets and
crucial financial services in our smaller and more isolated
markets. A corollary of this view is that the type of
regulatory regime that is appropriate for complex global
organizations is not appropriate for community and regional
banks. In our view, the time has come for supervision and
regulation that is tailored to the size, scope, and complexity
of a regulated enterprise. One size should not and cannot be
made to fit all.
I would like to make it clear that my colleagues and I are
not arguing for preservation of the status quo. Rather, we are
suggesting that a modernized regulatory system should include a
cooperative federalism that incorporates both national
standards for all market participants and shared responsibility
for the development and enforcement of such standards. We would
submit that the shared responsibility for supervising State
charter banks is one example, current example, of cooperative
federalism and that the developing partnership between State
and Federal regulators under the Secure and Fair Enforcement
for mortgage licensing, or SAFE Act, is another.
Chairman Dodd, my colleagues and I support this Committee's
efforts to modernize our Nation's financial regulatory system.
As always, sir, it is an honor to appear before you. I hope
that our testimony is of assistance to the Committee and would
be happy to answer any questions you may have. Thank you very,
very much.
Chairman Dodd. Thank you very much, Mr. Smith.
We don't say this often enough in the Committee. The
tendency today is to use the word ``bank,'' and I am worried
about it becoming pejorative. There are 8,000 banks and I think
there are 20--Governor Tarullo can correct me on this--that
control about 70 to 80 percent of all the deposits in the
country. The remaining 7,000-plus are regional or community
banks. They do a terrific job and have been doing a great job.
And the tendency to talk about lending institutions in broad
terms is not fair to a lot of those institutions which have
been very prudent in their behavior over the last number of
years and it is important we recognize that from this side of
the dais. And so your comments are appreciated.
Mr. Reynolds.
STATEMENT OF GEORGE REYNOLDS, CHAIRMAN, NATIONAL ASSOCIATION OF
STATE CREDIT UNION SUPERVISORS, AND SENIOR DEPUTY COMMISSIONER,
GEORGIA DEPARTMENT OF BANKING AND FINANCE
Mr. Reynolds. Chairman Dodd, I appear today on behalf of
NASCUS, the professional association of State Credit Union
Regulators. My comments focus solely on the credit union
regulatory structure and four distinct principles vital to the
future growth and safety and soundness of State chartered
credit unions.
NASCUS believes regulatory reform must preserve charter
choice and dual chartering, preserve the States' role in
financial regulation, modernize the capital system for credit
unions, and maintain strong consumer protections.
First, preserving charter choice is crucial to any
regulatory reform proposal. Charter choice is maintained by an
active system of federalism that allows for clear
communications and coordination between State and Federal
regulators. Congress must continue to recognize and affirm the
distinct roles played by State and Federal regulatory agencies.
The Nation's regulatory structure must enable State credit
union regulators to retain their regulatory authority over
State-chartered credit unions. Further, it is important that
new polices do not squelch the innovation and enhanced
regulatory structure provided by the dual chartering system.
The second principle I will highlight is preserving the
State's role in financial regulation. The dual chartering
system is predicated on the rights of States to authorize
varying powers for their credit unions. NASCUS supports State
authority to empower credit unions to engage in activities
under State-specific rules. States should continue to have the
authority to create and to maintain appropriate credit union
powers in any new regulatory reform structure. Preemption of
State laws and the push for more uniform regulatory systems
will negatively impact our Nation's financial services industry
and ultimately consumers.
The third principle is the need to modernize the capital
system of credit unions. We encourage Congress to include
capital reform as part of the regulatory modernization process.
State credit union regulators are committed to protecting
credit union safety and soundness. Allowing credit unions to
access supplemental capital would protect the credit union
system and provide a tool for regulators if a credit union
faces declining network or liquidity needs. Further, it will
provide an additional layer of protection to the National
Credit Union Share Insurance Fund, the NCUSIF, thereby
maintaining credit unions' independence from the Federal
Government and taxpayers.
A simple fix to the definition of ``net worth'' in the
Federal Credit Union Act would authorize regulators the
discretion, when appropriate, to allow credit unions to use
supplemental capital.
The final principle I will discuss is the valuable role
States play in consumer protection. Many consumer protection
programs were designed by State legislators and State
regulators to protect citizens in their States. The success of
State programs have been recognized at the Federal level when
like programs have been introduced. It is crucial that State
legislatures have the primary role to enact consumer protection
statutes for their residents and to promulgate and enforce
State regulations.
I would also mention that both State and Federal credit
unions have access to the NCUSIF. federally insured credit
unions capitalize this fund by depositing 1 percent of their
shares into the fund. This concept is unique to credit unions
and it minimizes exposure to the taxpayers. Any modernized
regulatory system should recognize the NCUSIF. NASCUS and
others are concerned about any proposal to consolidate
regulators and eliminate State and Federal credit union
charters.
As Congress examines a regulatory reform system for credit
unions, the following should be considered. Enhancing consumer
choice provides a stronger financial regulatory system.
Therefore, charter choice and dual chartering must be
preserved. Preservation of the State's role in financial
regulation is vital. Modernization of the capital system for
credit unions is critical for safety and soundness. And strong
consumer protection should be maintained, and these should be
protected against Federal preemption.
NASCUS appreciates the opportunity to testify and share our
priorities. We urge the Committee to be watchful of Federal
preemption and to remember the importance of dual chartering
and charter choice in regulatory modernization. Thank you.
Chairman Dodd. Thank you very much, Mr. Reynolds, and
again, my appreciation to all of you here this morning. We are
going to have an ongoing conversation with you as I know all of
my colleagues are interested--deeply interested--in the subject
matter of modernization of financial regulation. We are going
to want to have as many conversations as we can with you as we
move forward on how to develop these ideas. We all understand
the critical importance of this and all of you can play a very
critical role in helping us.
Let me begin, if I can, with the issue of regulatory
arbitrage, because all of you in your testimony addressed this
issue as forum shopping. In 1994, when this Committee
considered legislation to comprehensively reform of the
financial regulatory system, then-Treasury Secretary Lloyd
Bentsen appeared before the Committee, and let me quote him for
you on that day, some 15 years ago. He said, ``What we are
seeing is a situation that enables banks to shop for the most
lenient Federal regulator.''
In those very same hearings on that very same proposal, the
Chairman of the Federal Reserve, at the time Alan Greenspan,
said the following, and I am quoting him, ``Every bank should
have a choice of Federal regulator.''
So let me ask the panel here very quickly, beginning with
you, Mr. Dugan, with whom do you agree? Should financial
institutions be allowed to choose their regulators, leading to
a potential race to the bottom, or should we attempt to end the
regulatory arbitrage that is going on?
Mr. Dugan. Well, I guess what I would say is this.
Institutions should not be able to, when they have a problem
with that one regulator, to leave that regulator to go to
another regulator where they think they are not going to have
the problem.
I will say from the point of view of the OCC, we don't have
any ability to stop someone from leaving, but we have ample
authority to stop them from coming in and we exercise it. And
so we will not allow someone to transfer in and become a
national bank unless they have resolved their problems with
their own institution and we make that clear, and we have had
during my tenure as Comptroller several instances of companies
wanting to come in and deciding not to when they realize that
that would be the case. It is not a good situation to have
people try to leave one problem to go to another.
I am not sure you have to have only one charter to solve
that problem. I think there are other ways to solve it where it
does occur and I think there can be some benefits that some
charters offer over others that are not what I just spoke
about, and in those cases, I think that is a good thing. But it
has to be clear. To go to the competition at the bottom, I
think is a bad thing.
Chairman Dodd. Yes. Chairman Bair.
Ms. Bair. Yes. I think the problems with regulatory
arbitrage have been more severe regarding banks than nonbanks,
especially on capital constraints--leverage constraints--
certainly with regard to investment banks versus commercial
banks, and bank mortgage lenders versus nonbank mortgage
lenders with regard to lending standards. So I think there
needs to be some baseline standards that apply to all types of
financial institutions, especially with consumer protection and
basic prudential requirements, such as capital standards.
I think there are still some problems within the category
of banks. We have four different primary regulators now and I
think there have been some issues. There have been issues we
have seen with banks converting charters because they fear
perhaps the regulatory approach by one regulator. We have seen
banks convert charters in order to get preemption, which is not
always a good thing.
So I think there is more work to be done here. Part of that
may be Congress's call in terms of whether they want to
establish basic consumer protections that cannot be preempted--
whether you want Federal protection to be a floor or a ceiling
for consumer protection. I think among us as regulators, we
could do more to formalize agreements among ourselves that we
will respect each other's CAMELS ratings and enforcement
actions even if a charter is converted to remove the bad
incentives for charter conversion.
So I think there are some steps to be taken, but I do agree
with what Joe said, we need both State and Federal charters.
There is a long history of the dual banking system in the
United States and I think that should be preserved.
Chairman Dodd. You mentioned the four bank regulators, and
I think Mr. Dugan made the point earlier that this could be a
briefer hearing----
[Laughter.]
Chairman Dodd. ----given the fact that we have the four
regulators involved in all of this. Is this making any sense at
all? And I am not jumping to one, but maybe the question ought
to be what do we need out there to provide the safety and
soundness and consumer protection. And I am not interested in
just moving boxes around--take four and make it one--as
attractive as that may seem to people, because that may defeat
the very purpose of why we gather and talk about this issue.
But the question is a basic one. Do we have too many
regulators here and has that contributed, in your view, Sheila,
to some of the issues we are confronting?
Ms. Bair. I think that you probably could have fewer bank
regulators. I do think you need at least a national and a State
charter. I think you should preserve the dual structure. But I
also think in terms of the immediate crisis, the bigger
problems are with the bank versus nonbank arbitrage, not
arbitrage within the banking system.
Chairman Dodd. Yes, Mr. Fryzel.
Mr. Fryzel. Thank you, Senator. I agree with my colleagues
that there should be the dual chartering system between State
and Federal banks as well as credit unions. Chairman Bair says
that there probably are too many bank regulators. Well,
fortunately, we only have one credit union regulator, so I
think that is something we should maintain.
But again, I think we need to look at where are the
problems? Which regulator perhaps hasn't done the job that they
should have done, and maybe that is where the correction should
be. I think the majority of regulators have done the best they
possibly can considering what the circumstances are. I think
they have taken the right types of moves to correct the
situation that is out there with the economy the way it is.
But for restructuring, I think we need to see where is the
problem. Is it with the banks? Is it with the insurance
companies? Is it with other types of financial institutions,
and address that. And then making that improvement, determine
whether or not we need the systemic risk regulator above these
other institutions.
Chairman Dodd. Governor.
Mr. Tarullo. Thank you, Mr. Chairman. I agree with my
colleagues that we should not undermine the dual banking system
in the United States, and so you are going to have at least two
kinds of charters. It does seem to me, though, that the
question is not so much one of can an institution choose, but
what constraints are placed upon that choice.
So, for example, under current law, with the improvements
that were made to the Federal Deposit Insurance Act following
the savings and loan crisis, there are now requirements on
every federally insured institution that apply whether you are
a State or a Federal bank. I think that Chairman Bair was
alluding to some areas in which she might like to see more
constraints within the capacity to choose, so that a bank
cannot escape certain kinds of rules and regulations by moving
from one charter to another.
Chairman Dodd. Well, to make a distinction here, I do not
know that anyone is really going to argue about the idea of
having State-chartered and nationally chartered institutions,
but are you suggesting having separate regulators, or could we
talk about a common regulator and dual charters?
Mr. Dugan. I think you have choices. Basically, of the four
regulators of banks, you have two for Federal charters, two for
State charters, and the question is: Does that make sense? You
could have a single one for Federals; you could have a single
one for States; you could have a single that cuts across all of
them and still have two charters.
There are complexities and issues with respect to each of
those, and I should not leave out you have 12 Federal Reserve
banks.
Chairman Dodd. No. I know.
Mr. Dugan. Which is another set of people at the table.
Chairman Dodd. Right.
Mr. Dugan. My own view, I think there are too many. I agree
with Chairman Bair. I do not think that was a substantial cause
of the problems that we have seen, but if you are looking at
creating more efficiency and providing a system that is more
flexible and works better, I think you do not need--we do not
have four FDAs.
Chairman Dodd. Would you agree with that, Sheila, that you
can have a common regulator and dual charters?
Ms. Bair. Well, I think it is tricky with the State charter
we should not leave out the 50 State regulators. The Fed and
the FDIC partner with the State regulators in our examination
activities. So I think you could certainly consolidate all the
Federal oversight with one Federal regulator. We would still, I
assume, if you preserve a State charter, have shared
responsibilities with the State regulator. And so there has
been historical competition between national and State charters
that----
Chairman Dodd. Doesn't that lend itself to shopping again
here? The point that Mr. Dugan raised here, that the FDA does
not have a national regulator and a State regulator when it
comes to food and drug safety. Why not financial products? Why
shouldn't they be as safe?
Ms. Bair. I think for the smaller banks, for the community
banks, they like having the state option.
Chairman Dodd. Yes.
Ms. Bair. They like having the State option. They like
having the regulator that is a little closer, more local to
them, more accessible to them. So I think there are some
benefits and I strongly support continuation of the community
banking sector here, and I think maintaining the State charter
is essential to that.
Chairman Dodd. Let me jump----
Mr. Polakoff. Mr. Chairman, if I could offer--in our
written testimony--and I tried to synopsize it in my oral--we
believe the dual banking system, State and Federal, makes
sense. But we believe that the business model and the strategy
of the organization should then dictate what regulatory agency
oversees it.
So from our perspective, there is a clear distinction
between a commercial bank and a community and consumer bank.
And it does not make a difference whether it is a Federal
charter or State charter. Under our approach, we would submit
to you that you have a Federal regulator and a Federal charter
for commercial banks. And you have the same for community and
consumer banks. And then if it is a State-chartered entity that
fits one of those two business strategies, the relevant Federal
regulator works with it.
So it retains the dual banking system. It prevents the
ability of the individual institution to select a regulator.
Instead, this schematic would suggest that the business
strategy determines the regulator.
Chairman Dodd. That is a good point. Let me finish up, and
I apologize to my colleagues. I will just get the comments and
then go quickly to the----
Mr. Smith. I would say that as a State charterer who has
good experience with both of our Federal colleagues, we need to
say that the current State system involves what we have called
constructive or cooperative federalism now, and State-chartered
banks are not exempt or are not free from federally enforced
standards.
Chairman Dodd. Right.
Mr. Smith. And to be frank, we are grateful we have been
included in the FFIC because in that case we work with our
Federal colleagues to establish standards that we understand
have to apply across the board. As I say in my testimony, we
understand we have got to raise our game. In other words, we
understand that going forward, working with our Federal
colleagues, we would like to have a place in setting national
standards and in enforcing them. But I think actually even in
light of the current problems we have, the system has, the
State system, in partnership with the Fed and the FDIC, is
holding up so far. We have got our issues, but we are holding
up pretty well. So I think there is a question in the future
about our continuing to work more cooperatively with our
Federal partners, and I think that can help.
Chairman Dodd. Mr. Reynolds.
Mr. Reynolds. Well, my observation, as a regulator that has
been involved in financial institution regulation for over 30
years, is that we do not have any tolerance for forum shopping;
we do not have any tolerance for trying to arbitrage safety and
soundness. And it has been my experience in dealing with other
State regulators that that same approach applies.
I think the State system does provide choice, but I do not
believe there is any tolerance for that type of behavior in a
State system.
Chairman Dodd. Thanks very much.
Senator Corker.
Senator Corker. Thank you, Mr. Chairman, and I thank all of
you for your testimony and your service.
Ms. Bair, Chairman Bair, let me ask you this: Do you think
that not having an entity that can do the overall resolution
for complex entities is affecting the policies that we have in
place right now as it relates to supporting them?
Ms. Bair. It absolutely is. There is really no practical
alternative to the course that has been set right now, because
there is no flexibility for resolution.
Senator Corker. So much of the actions that we are taking
as a Congress and as an administration to support some of these
entities have to do with the fact that we really do not have
any way to unwind them in a logical way. Is that correct?
Ms. Bair. I do agree with that.
Senator Corker. I know the Chairman mentioned the potential
of FDIC being the systemic regulator. What would be the things
that the FDIC would need to do to move beyond bank resolution
but into other complex entities like AIG, Lehman Brothers, and
others?
Ms. Bair. Right. Well, we think that if we had resolution
authority, we actually should be separate from where we have
the requirements for prudential supervision of systemic
institutions. Those responsibilities are actually separated
now, and I think it is a good check and balance to have the
resolution authority with some back-up supervisory authority
working in conjunction with the primary regulator who has
responsibility for prudential supervision.
In terms of resolution authority, I think that the current
system--that we would like--if we were given it, is a good one.
We can set up bridge banks, or conservatorships to provide for
the orderly unwinding of institutions. There is a clear set of
priorities, so investors and creditors know in advance what the
imposition of loss will be. We do have the flexibility to
deviate from that, but it is an extraordinary process that
includes a super majority of the FDIC Board, the Federal
Reserve Board, the concurrence of the Secretary of the Treasury
and the President. So it is a very extraordinary procedure to
deviate from the baseline requirement to minimize cost.
So I think the model we have now is a good one and could be
applied more broadly to complex financial organizations.
Senator Corker. It sounds like in your opinion in a fairly
easy way.
Ms. Bair. Well, I think one easy step would be just to give
us authority to resolve bank and thrift holding companies. I
think that would be--I think there are going to be larger, more
complex issues in terms of going beyond that category, what is
systemic when you talk about insurance companies, hedge funds,
other types of financial institutions. But, yes, I think that
would be a relatively simple step that would give us all some
additional flexibility, yes.
Senator Corker. Thank you
Mr. Dugan, you know, we talk about capital requirements and
institutions, but regardless of the capital that any particular
institution has, if they make really bad loans or make really
bad decisions, it really does not matter how much they have, as
we have seen, right? Are we focusing enough on minimum lending
standards as we think about the overall regulation of financial
institutions?
Mr. Dugan. I think that is a very good question. I think
capital is not enough by itself. I think you are right. And as
I mentioned in my testimony, in the area of mortgages, I think
if we had had or if we would have in the future some sort of
more national standard in the area of--and if I think of two
areas going back that I wish we had over again 10 years ago, it
is in the area of stated income or no-documentation loans, and
it is in the area of loan-to-value ratios or the requirement
for a significant downpayment. Those are underwriting
standards. They are our loan standards, and I think if we had
more of a national minimum, as, for example, they have had in
Canada and as we had in the GSE statutes for GSE conforming
loans, I think we would have had far fewer problems. Now, fewer
people would have gotten mortgages, and there would have been
fewer people that would have been able to purchase homes, and
there would be pressure on affordability. But it would have
been a more prudent, sound, underwriting standard that would
have protected us from a lot of problems.
Senator Corker. I hope as we move forward with this you
will continue to talk about that, because I think that is a
very important component that may be left by the wayside. And I
hope that all of us will look at a cause-neutral solution going
forward. Right now we are focused on home mortgages and credit
default swaps. But we do not know what the next cause might be.
Mr. Tarullo, you mentioned something about credit default
swaps, and I am not advocating this, but I am just asking the
question. In light of the fact that it looks like as you go
down the chain, I mean, we end up having far more credit
default swap mechanisms in place than we have actual loans or
collateral that is being insured, right? I mean, it is
multiplied over and over and over. And it looks like that the
person that is at the very end of the chain is kind of the
greater fool, OK, because everybody keeps laying off.
Is there any thought about the fact that credit default
swaps may be OK, but the only people who should enter into
those arrangements ought to be people that actually have an
interest in the actual collateral itself and that you do not,
in essence, put in place this off-racetrack-betting mechanism
that has nothing whatsoever to do with the collateral that is
being insured itself? Have there been any thoughts about that?
Mr. Tarullo. Senator, I think that issue has been
investigated and discussed by a number of people, in and out of
the Government. Here, I think, are the issues.
There is a group of market actors who have a reason why
they want to hedge a particular exposure or instrument, and the
most efficient way for them to do that is to have a credit
default swap associated with a particular institution or
product, even when they do not own the underlying product
because there is a relationship.
The difficulty, as a lot of people have pointed out, would
come in trying to craft a rule which would allow that to occur
while ending the kind of practice that I think you are worried
about, which is much less tethered to a hedging strategy.
I do think when it comes to credit default swaps, we can
make a couple of observations, though. One, they do underscore,
again, the importance of monitoring and overseeing the arenas
in which big market actors come together. Making sure that
there is a central counterparty, for example, helps to contain
some of the risks associated with the use of credit default
swaps.
And, second, the problems with credit default swaps that we
associate with this crisis did not come from institutions that
were being regulated by Mr. Dugan, for example, or bank holding
companies being regulated by the Fed. What does that tell you?
It tells us that although looking at the interaction of
entities is important, you still should do good, solid
supervision of particular institutions. And if they have
capital requirements and liquidity requirements and good risk
management practices, then whatever use a particular trade an
entity is putting a credit default swap to, we will not allow
them to acquire too much exposure.
Senator Corker. Mr. Chairman, my time is up. Thank you.
Chairman Dodd. Senator Warner. And let me just say what I
am going to do, this vote has started. I am going to go over
and make the vote and come right back. So if you finish up,
Senator Merkley, you may have time for questions as well, and I
will try and get right back with other members as well.
Senator Warner.
Senator Warner. Well, Thank you, Mr. Chairman, and thank
you for holding this hearing and for your leadership in the
reform efforts that are going forward.
I know the subject today is how do we reform on a
prospective basis, but in the interim, as we have seen with the
public and congressional outrage over AIG and with certain
other actions by a number of our institutions, until we get
this new regulatory structure in place, what I think we keep
hearing is, well, we do not really have any tools to stop these
actions.
One area that I have had some folks talk to me about--and I
would like to get your opinion--is that under the Federal
Deposit Insurance Act--which obviously all of the Federal
regulators have the ability to enforce, not only the FDIC but
the OCC, OTS, and the Fed--my understanding is regulators do
have at least the statutory ability to issue cease and desist
orders to institutions or individuals if somebody has engaged
in unsafe or unsound practices, if somebody has engaged in a
breach of their fiduciary duty, or if somebody has received
financial gain or other benefits that show willful disregard
for the safety and soundness of the institution.
And I understand that, you know, the case law is fairly
narrow here, but my understanding of the remedies you have got
is you can ban somebody from banking, you can get restitution,
you can impose a series of other penalties. But, boy, oh, boy,
with narrow case law, it sure does seem that some of the
actions that have taken place--and, again, case in point being
AIG, and I know the fact that it was offshore, off balance
sheet, in the London derivatives entity, but it sure seems like
this tool could be used or could be pushed because there sure
has been a whole lot of activities that have led to either
financial enrichment or unsound practices, at least in
retrospect now. And I just question, you know, have you thought
through this tool. Have you investigated it? Have you not used
it because you felt that there would be--the case law would not
allow it? And why not take a little bit of risk in pushing the
edge, particularly with the amount of abuse and the amount of
public outrage that we see today?
Mr. Polakoff, do you want to start? And I would love to
hear from all of the regulators.
Mr. Polakoff. Senator, if I could offer some thoughts
regarding AIG, as you know, September 15, 2008, with the
Government's action, caused AIG to no longer be a savings and
loan holding company. So 6 months have passed since that time.
I can assure that if AIG was still a savings and loan
holding company, we would have taken enforcement action under
safety and soundness to say those bonuses were an unsafe and
unsound practice and would not have allowed it. But it is not a
savings and loan holding company.
Senator Warner. I know the Government owns it, but even
though the fact that there is a Treasury-owned trust, you say
that--I know you testified here a week ago that, yes, you had
oversight over AIG and maybe you have missed a bit. And now you
are saying you have no regulatory ability to take any of these
actions?
Mr. Polakoff. Once the Government took ownership, by
statute it is no longer a savings and loan holding company.
Senator Warner. But the Government--again, I know you would
know the law better than I, but I thought the Government has
not taken full ownership, that there is still a trust in which
the Treasury and others help put members. But you are saying--
even though the trust is an independent trust, it is not owned
entirely and controlled entirely by the Government. As an
independent trust, wouldn't you still have regulatory----
Mr. Polakoff. No. Our legal analysis says that the control
is with the Government. I mean, we would be thrilled if we
could get to the legal status that it is still a savings and
loan holding company. It would allow us to take action.
Senator Warner. Let me hear from the regulators on the
panel whether beyond just the AIG specific example, whether
this tool--whether you have thought through using this tool as
we have seen other actions, AIG being the most egregious, but
there are other institutions that I think fall into that
category. Ms. Bair?
Ms. Bair. Well, I would say the FDI Act applies to
depository institutions, and obviously AIG had a small thrift,
a depository institution regulated by OTS, and OTS was their
holding company regulator.
Senator Warner. Right.
Ms. Bair. But our authority as back-up supervisor and
primary Federal regulator of nonmember State-chartered banks is
only to the depository institution.
When we take a bank over as receiver or conservator, we
have separate authorities to repudiate all employment
contracts. Typically, the boards are gone, obviously. The
senior management is generally let go. And those who were
responsible for the bank's problems are typically let go as
well.
We very aggressively pick and choose who we want to keep
and who we think needs to leave when an institution fails and
we become receiver or conservator. So we do use it in that
context.
Again, that is just for a bank, the depository institution
part, and AIG certainly was a much larger entity.
Senator Warner. But since the Fed and the OCC also, I
believe, enforce this act, have you thought through using this
tool for actions that you may find to be unsafe or where
individuals might have received financial benefit with willful
disregard to the safety and soundness of the underlying
institution?
Mr. Tarullo. I think, Senator, your question raises two
questions: one about where we are now, but an important one
about going forward as well.
As to where we are now in respect to the compensation
issues, by and large, as you know, those have been for TARP
recipient institutions; those have been things that are either
congressionally mandated or put in place by the Treasury
Department. And so far as I am aware, with respect to
institutions over which the Fed has regulatory authority, there
has not been thought of going beyond the congressional and
Treasury policies on compensation.
I think, though, that the larger question you raise is one,
again, of regulatory gaps. As Chairman Bair said, in order to
be able to exercise any authority, you have got to have the
basic supervisory structure in place. And so, thinking about
where problems which anticipate today are going to arise
underscores the importance of making sure that each of these
systemically important institutions is, in fact, subject to the
kinds of rules that you are talking about.
Senator Warner. Mr. Dugan, I know our time has about
expired, but I just----
Mr. Dugan. Yes, well, we have a range of tools, of course,
both informal and formal, for a number of different things. But
in the compensation area, to find willful disregard that causes
a safety and soundness problem is, in fact, a quite high
standard to meet. There is separate authority under Part 30 of
the Federal Deposit Insurance Act that the so-called safety and
soundness standards that were adopted in FDICIA, also a
somewhat lower standard but still tied to the safety and
soundness of the institution, that possibly you could make a
connection to. And we do look at these, but as I said, to make
that connection to the safety and soundness is not an easy
thing to do.
Senator Warner. My only sense--and I would love to pursue
this a bit more--is that we all understand we have got to fix
this problem on a prospective basis. But there is still an
interim time between now and when Congress would act and these
new rules and regulations would be in place. I would just urge
you to perhaps revisit with your legal staffs this tool
because, as we have seen, it is not healthy for the public's
confidence in the overall financial system when we see the kind
of excesses and everybody saying we do not have any tools to go
after this, when it appears there may be at least partial tools
still here.
Ms. Bair. And I just wanted to re-emphasize what I had
indicated earlier about our lack of resolution authority that
applies to the entire organization.
Senator Warner. Absolutely. Very valid----
Ms. Bair. The FDIC has very broad authority to repudiate
these contracts at the discretion of the receiver/conservator.
I think AIG is a good example. If the bank regulators had
resolution authority of the entire organization, probably this
problem would not----
Senator Warner. Very, very valid point. But, again, we
still have some interim period that may be a long period of
months, and if the public has lost all confidence in the
fairness and soundness of the actions of some actors in the
financial community, it is going to make our challenge and task
in terms of striking that appropriate balance between the free
market system and appropriate regulatory oversight even more
difficult going forward. So thank you very much.
Senator Reed [presiding]. Senator Merkley.
Senator Merkley. Thank you very much, Mr. Chair.
Very quick responses, because I understand it is 4 minutes
until the closing of the vote. Chairman Bair, you noted the
need to address the issue of ``too big to fail,'' and I believe
talked in your testimony about increasing financial obligations
as the size of organizations creates greater risk and perhaps
regulating the public funds available to very large financial
institutions.
Do we need to also explore the issue of how mergers and
acquisitions affect the growth of individual institutions? Is
there any point in the process of a firm growing through
mergers or acquisitions that this issue needs to be addressed?
And I would open that up to any of you, and please speak
quickly.
Ms. Bair. Right, and I will speak quickly and turn it over
to Dan because the Fed reviews merger and acquisition activity.
But, yes, I think that is part of it. I think compensation tied
to successful mergers and acquisitions, executive compensation
tied to growth for the sake of growth is another area that I
think has fed into this current problem we have.
Senator Merkley. Did I catch you right that executive
compensation as it is tied into growth?
Ms. Bair. As it is tied into merger activity and growth,
yes, I think that help feeds the beast. I do.
Senator Merkley. Thank you.
Mr. Tarullo. Certainly, Senator, with respect to mergers
under the Bank Holding Company Act, there ought to be and is
scrutiny under the anti-trust laws to determine whether there
are going to be anti-competitive consequences to the merger.
But you should understand that the competition analysis as it
is put forth in the statute does not in itself directly feed
into the issues of size and systemic risk. And so there does
need to be an independent focus on systemic risk beyond the
traditional anti-trust question of whether a merger would
reduce competition in a particular market.
Senator Merkley. Does anyone else want to add to that?
Mr. Polakoff. Senator, I would just say real quick that for
thrifts or savings and loan holding companies where there is a
merger, there is absolutely an assessment of what the
consolidated risk profile looks like and the competency of
management. And I think all the regulators go through that
analysis with a merger.
Senator Merkley. So you feel like this--in your case, you
are saying it has really been addressed in the past, we have
done a great job, and no need to change any particular approach
to that issue?
Mr. Polakoff. When it comes to mergers, I think the
regulators have the right powers to assess the consolidated
risk profile of the company in deciding whether to approve it
or not, yes, sir.
Senator Merkley. They have those powers. Have they
exercised those powers?
Mr. Polakoff. Yes, sir.
Senator Merkley. Anyone else?
[No response.]
Senator Merkley. OK. I want to turn to the issue of
consumer protection and how this feeds into the risk, kind of
the retail issues. Certainly it is my view that the current
crisis is an example of how failure to provide for adequate
consumer protection compromises the safe and sound operation of
financial institutions. What is your view of the role of
consumer protection in supervision and regulation? And how
effective do you think your particular agencies have been in
addressing the consumer protection side? Whoever would like to
jump into that.
Mr. Polakoff. I will jump in. I think, first of all, there
is a keen connection between consumer protection and safety and
soundness. That is one of the reasons that I believe all the
regulatory agencies, as part of any safety and soundness
examination, look at all of the consumer complaints. They keep
a file. They look at them. They work through them, because
there is a keen connection when consumers are complaining, they
have some potential safety and soundness-related issues.
I think all of us--certainly OTS has a robust system for
addressing consumer complaints. We have made a number of
referrals, actually a large number of referrals to Justice for
fair lending issues. And I think it is a trend that many of the
agencies are seeing.
Mr. Tarullo. Senator, I would say that consumer protection
is related both to safety and soundness and, as I suggested in
my prepared remarks, to systemic risk.
With respect to how consumer protection is done recently, I
have to say in the interest of full disclosure, as you know I
have only been at the Fed for 6 weeks, and before that was an
academic who was critical of the failure of our bank regulatory
agencies to give as much attention to consumer protection as
they ought to.
I do think in the last couple of years there has been
renewed attention to it and that things have moved in a better
direction. But I think it is something that everybody is going
to need to continue to pay attention to.
Mr. Smith. Senator, if I could respond to that briefly?
Senator Merkley. Please, Mr. Smith.
Mr. Smith. On behalf of the States, I will say that with
regard to the mortgage issue, for example, the State response
to the mortgage issue may have been imperfect, and it may not
have been complete. In North Carolina, we started addressing
predatory lending in 1999. I would say that I think that the
actions of State AGs and State regulators should have been and
ought to be in the future, market information in assessing
systemic risk ought to be taken into account. And I think this
has not been done in the past.
Again, I do not claim that we are perfect. I do claim that
we are closer to the market as a rule than our colleagues in
the Federal Government. And I think we have something to add if
we are allowed to add it. So I hope as we go forward, sir, the
State role in consumer protection will be acknowledged and it
will be given a chance to do more.
Senator Merkley. OK. Well, let me just close with this
comment since my time is up. The comment that this issue has
had robust attention--I believe, Mr. Polakoff, you made that--
WAMU was a thrift. Countrywide was a thrift. On the ground, it
does not look like anything close to robust regulation of
consumer issues.
I will say I really want to applaud the Fed for the actions
they took over subprime lending, their action regarding escrow
for taxes and insurance, their addressing of abusive prepayment
penalties, the ending of liar loans in subprime. But I also
want to say that from the perspective of many folks on the
ground, one of the key elements was booted down the road, and
that was the yield spread premiums.
Just to capture this, when Americans go to a real estate
agent, they have all kinds of protection about conflict of
interest. But when they go to a broker, it is a lamb to the
slaughter. That broker is being paid, unbeknownst to the
customer is being paid proportionally to how bad a loan that
consumer gets. And that conflict of interest, that failure to
address it, the fact that essentially kickbacks are involved,
results in a large number of our citizens, on the most
important financial transaction of their life, ending up with a
subprime loan rather than a prime loan. That is an outrage.
And I really want to encourage you, sir, in your new
capacity to carry this conversation. The Fed has powers that it
has not fully utilized. I do applaud the steps it has taken.
And I just want to leave with this comment: that the foundation
of so many families financially is their homes, and that we
need to provide superb protections designed to strengthen our
families, not deregulation or loose regulations designed for
short-term profits.
Thank you.
Senator Reed. Senator Johanns.
Senator Johanns. Thank you very much.
I am not even exactly certain who I direct this to, so I am
hoping that you all have just enough courage to jump in and
offer some thoughts about what I want to talk about today. As I
was sitting here and listening to the great questioning from my
colleague, the response to one of the questions was that we do
make a risk assessment when there is a merger. We make an
assessment as to the risk that is being taken on by this
merger. And I sit here, I have to tell you, and I think to
myself, well, if it is working that well, how did we end up
where we are at today?
So that leads me to these questions. The first one is, who
has the authority, or does the authority exist for somebody to
say that the sheer size of what we end up with poses a risk to
our overall national, if not international economy, because you
have got so many eggs in one basket that if your judgment is
wrong about the risk assessment, you are not only wrong a
little bit, you are wrong in a very magnificent sort of way. So
who has that authority? Does that authority exist, and if it
doesn't, should it exist?
Mr. Tarullo. Senator, subject to correction or
qualification by my colleagues, I can say that at present,
there is no existing authority to take that kind of top-down
look at the entire system and to make a judgment as to whether
there is systemic risk arising--again, not out of individual
actions, but out of what is happening collectively.
Now, there is one point I should have made in my
introductory remarks, and I will take your question as an
opportunity to make it. We all need to be--I hope you are, and
we certainly will be--we all need to be realistic about what we
can achieve collectively, that is, everybody sitting here on
the panel and all of you, in addressing this systemic risk
issue. Because I don't think anybody should be under the
illusion that simply by saying, oh, yes, systemic risk is
important and everybody ought to pay more attention to it, that
we are going to solve a lot of the really difficult analytic
problems.
Now, we all remember what happened 4 or 5 years ago when
some people, with great prescience, raised issues about whether
risks were being created by what was going on in the subprime
market. And at the same time, many other people came back and
said, don't kill this market. So what in retrospect appears to
everybody to be a clear case of over-leveraging and bad
underwriting and a bubble and all the rest, in at least some
cases in real time produces a big debate over whether you are
killing the market or you are regulating in the interest of the
system.
So that is not, I know, directly responsive to your
question, but I do hope that everybody understands that this is
going to be a challenge for us all going forward, to make sure
that constraints are being placed where they ought to be, but
to recognize that nobody wants to kill the process of credit
allocation in the United States.
Senator Johanns. Could we agree, and I appreciate you
offering that. I appreciate the candor of your testimony. Could
we agree, members of the panel, that if we really wanted today
to make an assessment, again, getting back to this, it just
gets so big and there are so few left that we are putting the
whole economy at risk if one of them fails, that there really
isn't anybody who can step in and say, time out. We can't do
that merger or whatever based upon that premise. Or is that a
false assumption on my part? Yes, sir?
Mr. Dugan. I would just make two points. One is, we do have
on the banking side a Congressional limit on the amount, the
share of deposits that you can have in the United States----
Senator Johanns. Right.
Mr. Dugan. and that is an effective limit of a kind on
growth. It doesn't prevent very large institutions, but it
prevents--we still have, by worldwide standards, a quite deep
consolidated U.S., or lack of concentrated U.S. industry. And,
of course, you have the anti-trust limits. But there is nothing
in the law that I am aware of that says just because you get
large, other than what I just spoke about, that there is a
limit on it.
And I would also say that there are large American
companies that need large banks, and so you have to be careful
if you put some other kind of limit on it that you wouldn't
have large European or Asian institutions come and make large
loans. So we have to----
Senator Johanns. Take the business away.
Mr. Dugan. ----keep a balance here. There is a balance.
Senator Johanns. Yes. The second thought I want to throw
out, and I am very close to being out of time here, and these
are very complicated issues, but I would like a quick thought
if the Chairman will indulge me.
Chairman Dodd [presiding]. Certainly.
Senator Johanns. Let us say that you do have an
institution. You have made your risk assessment. A merger has
occurred. And all of a sudden you are looking at it and saying,
boy, there were some things here that, if I had to do it over
again, I would do it differently. Maybe they have gone a step,
two, or three or four further than you anticipated they were
going to, and now you can see the risk is growing and growing
and growing to a dangerous level. Do we have in our system the
cord we can pull that is the safety valve that says, again, in
effect, time out. We are at a level where the risk is not
acceptable for our economy.
Mr. Tarullo. Senator, I think with respect to a regulated
institution, which I believe is the premise of your question,
the answer is yes. If the institution is regulated, then
somebody sitting at this table is going to have the authority
to say, you are assuming too many risks and you need to reduce
your exposures in a particular area, you need to increase your
capital, you need to do better liquidity management, whatever
the proper guidance might be.
The one footnote I place there again is that in order to
get to that point, we need to make sure that people are aware
of the risks, and sometimes just looking at it from the
standpoint of the institution is completely adequate. It is
always necessary. But there are these circumstances, and I
think we have seen some of them in the last couple of years,
where you do need to have a bit more of a system-wide
perspective in order to know that something is a risk.
Senator Johanns. I will just wrap up with this thought,
because I am out of time, and I will try to do so quickly. I
think it is a real frustration for us here to be faced with
these issues of, well, Mike, this is just way too big to allow
it to fail, and, Mike, it is going to take taxpayers' money to
unravel the risk that they have gotten themselves into and a
lot of money. These are big institutions. It is going to take
big money.
And so you can see from my questions what I am trying to do
is if we are going to think about this in a global way--I
certainly don't want to stall growth in this Nation. I mean,
gosh, we are the greatest Nation on earth. But on the other
hand, I would like to think whatever we are doing, we are going
to give some policymakers the ability and some regulators the
ability to, in effect, say, time out.
Mr. Tarullo. Mr. Chairman, could I answer briefly?
Chairman Dodd. Certainly.
Mr. Tarullo. Senator, I not only understand but sympathize
with your perspective, and with respect to your closing
remarks, here is what I would suggest back to you: A number of
the instruments--I would say, if I can over-generalize, a lot
of what is in the prepared, the long prepared testimony of
people at this table today is a rehearsing of some of the
instruments which are available to you. And I am sure you and
your staff and your colleagues, after you go through them all,
you are going to want to tweak some. You may not be in favor of
others at all. But I think this is the opportunity that we all
have, which is to take this moment, not only to do an internal
self-examination, but also to say, OK, how are we going to
revamp this system to put in place structures that avoid
exactly the kind of situation you are talking about?
So just to use two, because I don't want to take up too
much time, the resolution mechanism about which you have heard
so much from Mr. Dugan, Ms. Bair, and me is really very
important here precisely because of its association with a
``too big to fail'' institution. Making sure that systemically
important institutions are regulated in a way that takes that
systemic importance into account in the first instance, with
the capital and liquidity requirements they have, will be steps
along that road.
Chairman Dodd. Thank you very much, and I totally agree
with that. I think that is very, very important.
Senator Reed.
Senator Reed. Well, thank you, Mr. Chairman.
I want to thank the witnesses. I have great respect for
your efforts and your colleagues' efforts to enforce the laws
and to provide the kind of stability and regulation necessary
for a thriving financial system. I think I have seen Mr.
Polakoff at least three times this week, so I know you put in a
lot of hours in here as well as back in the office, so thank
you for that.
Yesterday, we had a hearing based on a GAO report about the
risk assessment capacities and capabilities of financial
institutions, but one of the things that struck me is that
perhaps either inadvertently or advertently, we have given you
conflicting tasks. One is to maintain confidence in the
financial system of the United States, but at the same time
giving you the responsibility to expose those faults in the
financial system to the public, to the markets, and also to
Congress.
And I think in reflecting back over the last several years
or months, what has seemed to trump a lot of decisions by all
these agencies has been the need or the perceived need to
maintain confidence in the system when, in fact, many
regulators had grave doubts about the ability of the system to
perform, the risks that were being assembled, the strategies
that were being pursued. And I think if we don't at least
confront that conflict or conundrum directly, we could reassign
responsibilities without making a significant change in
anything we do.
And so in that respect, I wonder if you have any kind of
thoughts about this tradeoff between your role as cheerleaders
for the banking system and your role as referees for the
banking system. Mr. Dugan?
Mr. Dugan. Well, I am not sure I would describe it as the
cheerleader----
Senator Reed. I think in some cases, we heard the cheers
echoing through the halls.
Mr. Dugan. I guess what I would say, Senator, is there is a
tension with financial institutions that depend so heavily on
confidence, particularly because of the run risk that was
described earlier. And I am not just talking about depositors
getting in line. I am talking about funding. That has always
informed and is very deeply embedded in our whole system of
financial regulation. There is much about what we do and how we
do it that is by design confidential supervisory information
and we do have to be careful in everything we do and how we
talk about it, about not creating or making a situation worse.
And at the same time, the tension you quite rightly talk
about is knowing that there are problems that need to be
addressed and finding ways to address them in public forums
without running afoul of that earlier problem, and it gets
harder when we have bigger problems in a financial crisis like
the one we have and we all have to work hard to get through
that and to try to work with that tension, and I think we can
do that by the kinds of hearings that you have had. I think we
have to avoid commenting about specific open institutions, but
there are many things we can talk about and get at and I think
that is what we need to do.
Senator Reed. Ms. Bair, and I will try to get around
briefly because of the time limit. Ms. Bair?
Ms. Bair. Well, I hope we are cheerleaders for depositors.
I think we are all about stability and public confidence, so I
think it is important to keep perspective, though, for all bank
regulators, that what we do should always be tied to the
broader public interest. It is not our job to protect banks. It
is our job to protect the economy and the system, and to the
extent our regulatory functions relate to that, that is how
they should be focused.
I do think that the market is confused now because
different situations have been handled in different ways, and I
hate to sound like a Johnny-one-note, but I think a lot of it
does come back to this inability to have a legal structure for
resolving institutions once they get into trouble. I think
whatever that structure might eventually look like, just
clarity for the market--for investors and creditors--about how
they will be treated and the consistency of the treatment,
would go a long way to promoting financial stability and
confidence.
Senator Reed. Mr. Fryzel.
Mr. Fryzel. Thank you, Senator. Paramount to NCUA is the
safety and soundness of the funds of all our 90 million members
in credit unions across this country, and in an effort to
maintain their confidence is not an easy task, and we have made
every effort to do so by public awareness campaigns. Certainly
the action by Congress in raising the $250,000 limit has been
fantastic in regards to the safety and their ability to think
that their funds, or to know that their funds are safe. We
tried to draw the fine line in letting them know that, yes,
there are problems in our financial structure, but we are
dealing with them and we are going to use the tools that we
have to make sure that things get better. And when this economy
turns around, financial institutions are again going to be in
the position where they are going to be able to serve these
consumers in the way they have in the past.
So yes, Senator, it is a fine line, but I think it is one
that we have to keep talking about. We cannot let anyone think
that there are not problems out there. We have to tell them we
are in a great country. This economy does come back and
everything is going to be better in the future.
Senator Reed. Mr. Tarullo.
Mr. Tarullo. Senator, I may have misunderstood. I
understood you to be asking not about regulatory actions in the
midst of the crisis, but in the period preceding it, when
supervision is supposed to be ongoing. And I think there is a
lot to the question that you asked, not so much because, I
would say, of the conflict of interests as such between
different roles, but because everybody tends to fall into a
notion of what operating principles are for whatever period we
may be in. And so people come to accept things. Bankers do,
supervisors do, maybe even Members of Congress do--something
that is ongoing, is precisely because it has been ongoing,
thought to be an acceptable situation.
So I think from both our perspective and your perspective
the challenge here is to figure out what kinds of mechanisms we
put in place within agencies, between the Hill and agencies in
legislation which force consideration of the kinds of emerging
issues that we can't predict now because we don't know what the
next crisis might look like, but which are going to be noticed
by somebody along the way.
And while I really don't want to overstate the potential
utility of a systemic risk regulator for the reasons I said
earlier, I would say that in an environment in which an overall
assessment of the system is an explicit part of the mandate of
one or more entities in the U.S. Government, you at least
increase the chances that that kind of disparate information
gets pulled together and somebody has to focus on it. Now, what
you do with it, that is another set of questions, but I think
that gets you at least a little bit down the road.
Senator Reed. Mr. Polakoff, and my time is expiring, so
your brevity is appreciated.
Mr. Polakoff. I will be as short as possible, Senator.
Thank you. We are not in the current situation we are in today
because of actions over the last six to 12 months by the
regulators, or in a lot of cases the bankers. It is from 3, 4,
5 years ago.
I think the notion of counter-cyclical regulation needs to
be discussed at some point. When the economy is strong is when
we should be our strongest in being aggressive, and when the
economy is struggling, I think is when we need to be sure that
we are not being too strong.
Any of us at this table can prevent a bank from failing. We
can prevent banks from failing. But what will happen is people
who deserve credit will not get credit because they will be on
the bubble. The thing I love about bank supervision is it is
part art and it is part science, and I think what we are doing
today is going to address the situation today. We have got to
be careful we are doing the right thing for tomorrow and next
year, as well.
Senator Reed. Mr. Smith, and then Mr. Reynolds.
Mr. Smith. Thank you, Senator. I agree with my friend, the
Comptroller, that the two concepts of supervisory authority, on
the one hand, and consumer protection, on the other, are
intertwined. They should not be drawn apart.
I will say that in the State system, sir, we have the
advantage of having a partner with friends in the Federal
Government. We have cooperative federalism. That is a good
thing, because our Federal friends help us and sometimes tell
us things we don't want to know, particularly about consumer
compliance, that makes our system of regulation stronger.
I would suggest, sir, that some of the actions the States
have taken in consumer protection in the past, if they had been
listened to, would have helped in terms of determining the
systemic--understanding what the systemic risk of some
activities in the marketplace were, and so I believe that as a
part, as we say in our testimony, as part of an ongoing system
of supervision, I would argue, and I will agree with, I
believe, with Governor Tarullo, that you need--the fact that
you have multiple regulators focusing on an issue can, in the
proper circumstance, if there is cooperation, result in better
regulation. The idea of a single regulator, I think, is
inherently flawed.
Senator Reed. Mr. Reynolds.
Mr. Reynolds. My comment would be that it is appropriate
that we take a measured response. I agree with Mr. Polakoff's
observation that regulators have the ability to tighten down on
regulation to the point where we make credit availability an
issue. On the other side, it is important that our role as
safety and soundness regulators be the primary role that we
play and that we are not in the business of being cheerleaders
for the industry. I am certain that my bankers and my credit
union managers in the State of Georgia don't regard me as a
cheerleader.
Senator Reed. My time has expired. Thank you.
Chairman Dodd. Well, thank you, Senator, very much.
I should have taken note, and I apologize for not doing so,
Senator Reed had a very good subcommittee hearing yesterday,
and this is the seventh hearing we have had just this year on
the subject matter of modernization of Federal regulations. We
had dozens last year going back and examining the crisis as
well as beginning to explore ideas on how to go forward. And so
I am very grateful to Jack and the other subcommittee chairs
who are meeting, as well. We have four hearings this week alone
just on the subject matter, so it is very, very helpful and I
thank Senator Reed for that.
Senator Reed. Thank you, Mr. Chairman.
Chairman Dodd. I am going to turn to Senator Menendez, but
I want to come back to this notion about a supervisory capacity
and consumer protection, because too often, the safety and
soundness dominates the consumer protection debate and we have
got to figure out a new direction--that can't go on, in my
view. There has got to be a better way of dealing with this.
But let me turn to Senator Menendez.
Senator Menendez. Thank you, Mr. Chairman, and Mr.
Chairman, I have a statement for the record, so I hope that can
be included.
Chairman Dodd. It will be included.
Senator Menendez. Mr. Chairman, I look forward to asking
some questions specifically, but I want to turn first to
Chairman Bair. I cannot pass up the opportunity, first to
compliment you on a whole host of things you are doing on
foreclosure mitigation and what not. I think you were ahead of
the curve when others were not and really applaud you for that.
But I do have a concern. I have heard from scores of
community banks who are saying, you know, we understand the
need to rebuild the Federal Deposit Insurance Fund, but I
understand when they say to me, look, we are not the ones who
drove this situation. We have to compete against entities that
are receiving TARP funds. We are not. And in some cases, we are
looking at anywhere between 50 and 100 percent of profit.
Isn't there--I know that--I understand you are statutorily
prohibited from discriminating large versus small, but in this
once--and so I understand this is supposedly a one-time
assessment. Wouldn't it be appropriate for us to give you the
authority to vary this in a way that doesn't have a tremendous
effect on the one entity, it seems to me, that is actually out
there lending in the marketplace as best as they can?
Ms. Bair. Well, a couple of things. We have signaled
strongly that if Congress will move with raising our borrowing
authority, we feel that that will give us a little more
breathing room.
Senator Menendez. With what? I am sorry, I didn't hear.
Ms. Bair. If Congress raises our borrowing authority--
Chairman Dodd and Senator Crapo have introduced a bill to do
just that--if that can be done relatively soon, then we think
we would have some flexibility to reduce the special
assessment. Right now, we have built in a good cushion above
what our loss projections would suggest would take us to zero
because we think the borrowing authority does need to be
raised. It has been at $30 billion since 1991. So we do think
that needs to happen. But if it does get raised, we feel we
could reduce our cushion a bit.
Also, the FDIC Board just approved a phase-out of our TLGP,
what we call our TLGP Debt Guarantee Program. We are raising
the cost of that program through surcharges which we will put
into the Deposit Insurance Fund. This could also reduce the
need for the special assessment and so we will be monitoring
that very closely.
We have also asked for comment about whether we should
change the assessment base for the special assessment. Right
now, we use domestic deposits. If you used all bank assets,
that would shift the burden to some of the larger institutions,
because they rely less on deposits than the smaller
institutions. So we are gathering comment on that right now. We
will probably make a final decision in late May.
Increasing the borrowing authority plus we expect to get
some significant revenue through this surcharge we have just
imposed on our TLGP--most of the larger banks are the
beneficiaries of that Debt Guarantee program--we think that
will help a lot.
Senator Menendez. Well, I look forward, Mr. Chairman, to
working with you to try to make this happen, because these
community banks are the ones that are actually out there still
lending in communities at a time in which we generally don't
see much credit available. But this is a huge blow to them and
however we can--I will submit my own comments for the
regulatory process, but however we can lighten the load, I
think will be incredibly important.
Mr. Dugan, I want to pursue a couple of things with you.
You recently said in a letter to the Congressional Oversight
Panel, essentially defending your agency. Included in that
letter is a chart of the ten worst, the lenders with the higher
subprime and Alternate A foreclosure rates. Now, I see that
three of them on this list have been originating entities under
your supervision--Wells Fargo, Countrywide, and First Franklin.
Can you tell us what your supervision of these entities told
you during 2005 to 2007 about their practices?
Mr. Dugan. Senator, as I said before, we certainly did have
some institutions that were engaged in subprime lending, and
what I said also is that it is a relatively smaller share of
overall subprime lending in the home market and what you see.
It was roughly ten to 15 percent of all subprime loans in 2005
and 2006, even though we have a much larger share of the
mortgage market.
I think you will find that of the providers of those loans,
the foreclosure rates were lower and were somewhat better
underwritten, even though there were problem loans, and I don't
deny that at all, and I would say that, historically, the
commercial banks, both State and national, were much more
heavily intensively regulating and supervising loans, including
subprime loans. We had had a very bad experience 10 years ago
or so with subprime credit cards, and as a result, we were not
viewed as a particularly hospitable place to conduct subprime
lending business.
So even with organizations that were complex bank holding
companies, they tended to do their subprime lending in holding
company affiliates rather than in the bank or in the subsidiary
of the bank where we regulated them. We did have some, but it
turned out it was a much smaller percentage of the overall
system than the subprime loans that were actually done.
Senator Menendez. Well, subprimes is one thing. The
Alternate As is another. Let me ask you this. How many
examiners, on-site examiners, did you recently have at Bank of
America, at Citi, at Wachovia, at Wells?
Mr. Dugan. It is different for each one of those, but we
have--on-site examiners can vary in our largest banks from 50
to 70 examiners. It is a very substantial number, depending on
which organization you are talking about.
Senator Menendez. And what did they say to you about these
major ``too big to fail'' lenders getting heavily into no-
document and low-document loans?
Mr. Dugan. Well, we were never the leader in no-document
and low-document loans. We did do some of it. The whole Alt A
market, by definition, was a lower-documentation market and it
was a loan product that mostly was sold into secondary markets.
When I got and became Comptroller in 2005, we began to see
the creeping situation where there were a number of layers of
risk that were being added to all sorts of loans that we--our
examiners were seeing, and that caused us to issue guidance on
nontraditional mortgages, like payment option mortgages, which
we were quite aggressively talking about the negative
amortization in it as being not a good thing for the system,
and that again we were quite vocal about pushing out of the
national banks that were doing it.
Senator Menendez. Well, let me ask you, you have twice been
criticized by your own Inspector General for keeping, quote,
``a light touch,'' light for too long when banks under your
watch were getting in trouble. And I know you have consistently
told us that you like to do things informally and in private
with your banks. Do you think that changing that strategy makes
sense in light of what we have gone through now?
Mr. Dugan. I think I would say two things. The Inspector
General does material loss reviews on all the agencies with
respect to any bank that has more than a $25 million loss, and
it is a good process, a healthy process, and we accept that
constructive criticism. And they have talked about places where
we could have moved more quickly with respect to a couple of
institutions, and we agreed with that.
What I would say is we have, as supervisors, a range of
tools that we can use that are both informal tools that
Congress has given us and formal enforcement tools. And on that
spectrum, we do different things depending on the circumstances
to try to get actions and behavior corrected. And merely
because something is not formal and public does not mean that
we are not paying attention or getting things addressed or
fixed.
Many times--many times--because we are on-site, have the
presence, identify a problem, we can get things corrected
quickly and efficiently without the need to go to a formal
enforcement action. But we will not hesitate, if we have to, to
take that action to fix those things.
So I think there are things that we constantly look about
to correct and to improve our supervision using that range of
tools.
Senator Menendez. Mr. Chairman, if I may have just one more
moment?
Chairman Dodd. Just following up on the Senator's question,
how many of those banks did you find that violated your
guidelines? And if so, what were the punishments you meted out
for them? Looking back, do you think you missed any of the
violations?
Mr. Dugan. It would range from things we have something
that--if we see something early, any kind of bank examination
that you go through, there are certain kinds of violations of
law. Some are less serious and some are more serious. And at
one end of the spectrum, we do something called ``Matters
requiring attention,'' which tells the directors we expect you
to fix this and we want it fixed by the next time we come in.
Chairman Dodd. Jump to the more serious ones.
Mr. Dugan. Well, on that point, we saw 123 of them in that
4-year period, and we got 109 of them corrected within that
period.
Chairman Dodd. Were there punishments meted out?
Mr. Dugan. Oh, yes. Not for those things, but we have other
situations in which we took actions for mortgage fraud, for
other kinds of mortgage-related actions where we had problems,
and we have provided some statistics that I could certainly get
that we have compiled for the enforcement hearing where we are
testifying tomorrow.
Chairman Dodd. I am sorry, Senator.
Senator Menendez. No. Thank you, Senator Dodd. I appreciate
it. Just one more line of questioning.
You know, we had a witness before the Committee, Professor
McCoy of the University of Connecticut School of Law, and she
made some statements that were, you know, pretty alarming to
me. She said, ``The OCC has asserted that national banks made
only 10 percent of subprime loans in 2006. But this assertion
fails to mention that national banks moved aggressively into
Alternate-A low-documentation and no-documentation loans during
the housing boom.''
``Unlike OTS, the OCC did promulgate one rule in 2004
prohibiting mortgages to borrowers who could not afford to pay.
However, the rule was vague in design and execution, allowing
lax lending to proliferate at national banks and their mortgage
lending subsidiaries through 2007.''
``Despite the 2004 rules, through 2007, large national
banks continued to make large quantities of poorly underwritten
subprime loans and low- and no-documentation loans.''
``The five largest U.S. banks in 2005 were all national
banks and too big to fail. They too made heavy inroads into
low- and no-documentation loans.''
And so it just seems to me that some of the biggest bank
failures have been under your agency's watch, and they, too,
involved thrifts heavily into nil documents, low documents,
Alternate A, and nontraditionals, and it is hard to make the
case that we had an adequate job of oversight given those
results.
We have heard a lot here about one of our problems is
regulatory arbitrage. Don't you think that they chose your
agency because they thought they would get a better break?
Mr. Dugan. I do not and, Senator, I would be happy to
respond to those specific allegations, and there are a number
of them that were raised. I looked at that testimony, and there
are a number of statistics which we flatly disagree with and
that were compiled in a way that actually do not give a true
picture of what was happening and what was not happening.
National banks increasingly have been involved in the
supervision of mortgage loans. There is no doubt about that.
But I would say that we have done a good job in that area--not
perfect, but we think we have excellent, on-the-ground
supervisors in that area, and it did not lead to all the kinds
of problems in national banks, from national banks, that is----
Senator Menendez. Well, I will submit the question for the
record because the Chairman has been very generous with my
time, but one of the things I would ask you is: What are you
doing in comparison to State regulators who, in fact--
regulators of State depositories who, in fact, have much better
performance rates, considerable better than yours?
Mr. Dugan. Actually, that is not true. I have seen that
chart, and I will provide----
Senator Menendez. OK. So I would love to either sit down
with you to get all that information----
Mr. Dugan. I would welcome that.
Senator Menendez. ----so we can dispel is not the case.
Thank you, Mr. Chairman.
Chairman Dodd. Let me follow up on that, because it is a
very important line of questioning. There were hundreds of
thousands, we know now, of bad loans. Hundreds of thousands of
them. You talk about 123 violations. I do not just focus the
question on the OCC but also the FDIC, the OTS, the Fed. What
was your experience? Obviously, Dan, you were not there at the
time, but I would like to get some information, if I could,
from the Fed as to what was going on. When you consider the
hundreds of thousands of bad loans that are the root cause of
why we are here today, the reason we are sitting here today is
because of what happened under that framework and that time,
going back 4 or 5 years ago, longer maybe. And so we have
hundreds of thousands of bad loans that were issued, and it is
awfully difficult to explain to people that out of that
quantity, 123 violations are identified.
Mr. Dugan. Well, let me say two things. One, I was
referring to one particular kind of violation. There are others
that we will be happy to submit for the record. But I think the
more fundamental point is this: There were many of these loans
that did not violate the law. They were just underwritten in a
way with easier standards than they had been historically. And
that was not necessarily a legal violation, but a prudential--
--
Chairman Dodd. But shouldn't that have raised a red flag?
You are the experts in this area, and you were watching people
get loans with no documentation, these liar loans and so forth.
Was anyone watching?
Mr. Dugan. People were watching. I think what drove that
initially--my own personal view on this--is that most of those
loans were sold into the secondary market. They were not loans
held on the books of the institutions that originated them. And
so for someone to sell it and get rid of the risk, it did not
look like it was something that was presenting the same kind of
risk to the institution.
And if you go back and look at the time when house prices
were rising and there were not high default rates on it, people
were making the argument that these things are a good thing and
provide more loans to more people.
It made our examiners uncomfortable. We eventually, I think
too late, came around to the view that it was a practice that
should not occur, and that is exactly why I was talking
earlier, if we could do one thing--two things that we should
have done as an underwriting standard earlier is, one, the low-
documentation loans and the other is the decline in
downpayments.
Chairman Dodd. I want to ask the other panelists here with
regard to Senator Menendez's line of questioning. The guidance
is not on the securitization of those loans or what happens
with rating agencies. The guidance is on the origination of the
loans, which is clearly the responsibility of the OCC. And so
the fact that these things were sold later on is a point I
take, but your responsibility is in origination, and
origination involved this kind of behavior. I appreciate you
providing us with numbers in one area, but I assume there are
more numbers you can give us in other areas. I do not think you
can get away by suggesting--I say this respectfully to you--
that because they have not been held at the institution--as
most of us here have a little gray hair on our head and have
had our mortgage for years that you could not notice changes in
the way mortgages were originated. On the other hand, when
mortgages are kept with originators and you could look at them
for 30 years if you wanted.
Mr. Dugan. Right.
Chairman Dodd. Obviously that is all changed. But your
responsibility falls into origination, which is a very
different question than what happens in terms of whether or not
the mortgage is held at the institution or sold.
Mr. Dugan. I totally agree with that point. The point I was
really trying to make was we had a market where the
securitization market got very powerful.
Chairman Dodd. Right.
Mr. Dugan. It was buying loans from people in the
marketplace, standards reduced, particularly from nonbank
brokers and mortgage originators that were providing those.
Banks were competing with them, and people were not at that
time suffering very significant losses on those loans because
house prices were going up. And I think----
Chairman Dodd. You cannot just look at losses. Is the
practice acceptable?
Mr. Dugan. I understand that, and I believe that we were
too late getting to the notion, all of us, about getting at
stated income practices and low-documentation loans. We did get
to it, but it was after the horse had left the barn in a number
of cases, and we should have gotten there earlier.
The point I was just trying to make to you, though, is that
as these things were leaving the institution, they were less of
a risk to that institution from a safety and soundness point of
view.
Chairman Dodd. We are going back around. Chairman Bair, let
me ask you to comment on this as well.
Ms. Bair. Well, I think John is right. These practices
became far too pervasive. For the most part, the smaller State-
chartered banks we regulate did not do this type of lending
they do more traditional lending, and then obviously they do
commercial real estate lending, which had a separate set of
issues.
We had one specialty lender who we ordered out of the
business in February of 2007. There have been a few others. We
have had some other actions, and I would have to go back to the
examination staff to get the details for you. But I was also
concerned that even after the guidance on the nontraditional
mortgages, which quite specifically said you are not going to
do low-doc and no-doc anymore, that we still had very weak
underwriting in 2007.
So I think that is a problem that all of us should look
back on and try to figure out, because clearly by 2007 we knew
this was epidemic in proportion, and the underwriting standards
did not improve as well as you would have thought they should
have, and the performance of those loans had been very poor as
well. I do think we need to do a lot more----
Chairman Dodd. Well, quickly the Fed and the OTS. I know it
is a little difficult to ask you this question, Dan, because
you were not there at the time, but any response to this point?
Mr. Tarullo. I do not, Senator, except as an external
observer. But anything that you would like from the Fed, if you
just----
Chairman Dodd. Well, it might be helpful to find out
whether or not there were violations, and punishments meted out
at all. Again, many of us have heard over the last couple of
years the complaint is that Congress in 1994 passed the HOEPA
legislation which mandated that the Federal Reserve promulgate
regulations to deal with fraudulent and deceptive residential
mortgage practices. Not a single regulation was ever
promulgated until the last year or so, and obviously that is
seen as a major gap in terms of the responsibility of moving
forward.
OTS quickly, do you have any----
Mr. Polakoff. Mr. Chairman, you are right. The private
label securitization market, we could have done a better job in
looking at the underwriting as those loans passed off the
institution's books and into a securitization process. Yes,
sir.
Chairman Dodd. Senator Menendez, do you want to make any
further comment on this point or not?
Senator Menendez. I think, Mr. Chairman, you are on the
road--you know, to me--and I know Mr. Tarullo was not there,
but the Federal Reserve, you know, is at the forefront of what
needed to be done because they had the ability to set the
standard. And the lack of doing so, you know, is a major part
of the challenge that we are facing today. But I appreciate it
and I look forward to the follow-up.
Chairman Dodd. Senator Bunning.
Senator Bunning. Thank you. I hurried back, and I heard
that Senator Menendez asked my question, but that is all right.
This is for Sheila.
I am not used to angry bankers. I have had a great
relationship with the Kentucky Association and their leaders,
but I did a roundtable discussion in Paducah, Kentucky.
Paducah, Kentucky, is a town of about 29,000 people. Two
community bankers. One came to me and said, ``We have just been
assessed by the Federal Deposit Insurance Corporation, and
guess what? We will not be profitable in 2009 because of that
assessment.'' No bad loans, no nothing. No bad securities. They
keep their mortgages in-house. Everything just like community
bankers in most places do.
There was a gentleman from BB&T. Now, that is not a
community bank. That is a much larger bank. The assessment for
the community bank was $800,000, wiped out their total
profitability. BB&T was $1.2 million. Now, that did not wipe
out their profitability because they have many banks all over
the country. But how can you explain to the American people
that for doing your job and doing it well, you are being
assessed your total profitability in 1 year to pay for those
who did not do their job very well? Maybe you can explain that
to me because I do not understand it.
Ms. Bair. Well, deposit insurance has always been funded by
industry assessments. The FDIC actually has never--we do have
the full faith and credit of the U.S. Government backing us. We
do have lines of credit----
Senator Bunning. There are a lot of other ways that you
could have done it.
Ms. Bair. Well, sir, all banks that get deposit insurance
pay for it. It is an expense that they need to factor in. And
we have been signaling for some time that we will need to raise
premiums. We are in a much more distressed economic
environment. Our loss projections are going up, and I think
most community banks agree that we should continue our
industry-funded self-sufficiency and not turn to taxpayers.
We did not want to do the 20-basis-point special
assessment, but our loss projections are going up
significantly, and we felt it was necessary to maintain an
adequate cushion above zero.
Senator Bunning. For this one community bank, it was a
1,000-percent increase in their assessment.
Ms. Bair. Well, I would be happy to go over those numbers
with you.
Senator Bunning. I will be glad to go over them, because
she did. She went over them with me.
Ms. Bair. OK. We would like to see that, because they are
miscalculating what the assessment is.
I would say the base assessment is 12 to 16 basis points.
The interim special assessment is 20 basis points. It is out
for comment. It has not been finalized yet. We are hoping that
through increasing our borrowing authority we can----
Senator Bunning. Don't you have a line of credit with the
Treasury? It seems like everybody else does, so I would assume
that you do.
Ms. Bair. We do. It is pretty low. It has not been raised
since 1991, and we are working with Chairman Dodd and Senator
Crapo to get it raised. But I would say the FDIC has never
borrowed from Treasury to cover our losses. We have only
borrowed once in our entire history. That was for short-term
borrowing.
Senator Bunning. We can print you some money. I mean, what
the heck. It is printed by----
[Laughter.]
Senator Bunning. Yesterday, our Chairman of the Fed
announced $1.2 trillion--not billion but trillion dollars of
printed money going out.
Ms. Bair. Right.
Senator Bunning. It is just scary.
Ms. Bair. That is a policy call. I think a lot of community
banks--Ken Guenther had an excellent blog yesterday he has
obviously been long associated with community bankers--
suggesting that it would not be in community bankers' interest,
because right now they are not tarnished with the bailout
brush. But if the FDIC starts going to taxpayers for our
funding instead of relying on our industry assessments, I think
that perception could change.
We are working very hard to reduce the special assessment.
I have already said that if the borrowing authority is
increased, we feel we can reduce it meaningfully. This week we
approved a surcharge to a debt guarantee program we have that
is heavily used by large institutions. We will put that
surcharge into our deposit insurance fund and also use that to
offset the 20-basis-point assessment.
So we are working hard to get it down. We want to get it
down. But I do think the principle of industry funding is
important to the history of the FDIC, and I think it is
important to the reputation and confidence of community banks
that they are not getting taxpayer assistance. They continue to
stand behind their fund.
Senator Bunning. Well, that all sounds really well and
good. I would like to take you to that roundtable and let you--
--
Ms. Bair. Senator, I have personally----
Senator Bunning. ----explain that to those two bankers.
Ms. Bair. I have talked to a lot of community bankers about
this. I absolutely have. I would also like to share numbers
with you, though, that show deposit insurance, even with the
special assessments, is still very cheap compared to
alternative sources of funding. Even with the special
assessments, it is much cheaper than any other sources of
funding that they would have to tap into.
Senator Bunning. You have taken up all my time. I cannot
ask another question--may I?
Chairman Dodd. Sure.
Senator Bunning. OK. The gentleman from the Federal Reserve
is here. Thank you for being here. Do you or anybody else at
the Fed have concerns about the Fed being the systemic risk
regulator or payment system regulator? And where would you say
would be the right place to place that task?
Mr. Tarullo. Senator, with respect to payment systems, I
think there is a fair consensus at the Fed that some formal
legal authority to regulate payment systems is important to
have. As you probably know, de facto right now the Fed is able
to exercise supervisory authority over payment systems. That is
because of the peculiarity of the fact that the entities
concerned are member banks of the Federal Reserve System. They
have got supervisory authority. If their corporate form were to
change, there would be some question about it, and payments, as
you know, are historically and importantly related to the
operation of the financial system.
Now, with respect to the systemic risk regulator, I think
there is much less final agreement on either one of the
questions that I think are implicit in what you asked. One,
what should a systemic risk regulator do precisely? And, two,
who should do it?
The one thing I would say--and I think this bears
repeating, so I will look for occasions to say it again--is
however the Congress comes down on this issue, I think that we
need all to be clear, you need to be clear in the legislation,
whoever you delegate tasks to needs to be clear, not just what
exactly the authorities are, which is important, but also the
expectations are, because we need to be clear as to what we
think can be accomplished. You do not want to give
responsibility without authority----
Senator Bunning. Well, sometimes we give the responsibility
and the authority----
Mr. Tarullo. That is correct.
Senator Bunning. And it is not used, just the 1994 law when
we handed the Fed the responsibility and it was 14 years before
they promulgated one rule or regulation.
Mr. Tarullo. I agree. Believe me, Senator. That is
something that I observed myself before I was in my present
job. So I have got no----
Senator Bunning. No, I am not faulting you, but I am just
stating the fact that even when we are sometimes very clear in
our demand that certain people regulate certain things, they
have to take the ball and carry it then.
Mr. Tarullo. Absolutely. Absolutely correct. And so on the
systemic risk regulator issue, there is a strong sense that if
there is to be a systemic risk regulator, the Federal Reserve
needs to be involved because of our function as lender of last
resort, because of the mission of protecting financial
stability. How that function is structured seems to me
something that is open-ended because the powers in question
need to be decided by the Congress. Let me give you one example
of that.
It is very important that there be consolidated supervision
of every systemically important institution. So with bank
holding companies, that is not a problem, because we have
already got that authority. But there are other institutions
out there currently unregulated over which no existing agency
has prudential, safety and soundness, supervisory authority.
Senator Bunning. You realize that your two Chairmen came to
us and told us that certain entities----
Mr. Tarullo. Right, absolutely.
Senator Bunning. ----should not be regulated.
Mr. Tarullo. I am sorry. Which entity----
Senator Bunning. Well, credit default swaps and other
things that are related to that. Your past Chairman and your
current Chairman.
Mr. Tarullo. OK, so I can--let me get to credit default
swaps in a moment, but let me try to address the institution
issue, because it is the case that we believe consolidated
supervision is important for each institution. A consolidated--
--
Senator Bunning. We maybe should make a regulator for each
institution.
Mr. Tarullo. If there is a good prudential regulator for
each systemically important institution, then you would not
need a systemic regulator to fulfill that----
Senator Bunning. That is correct.
Mr. Tarullo. I think that is----
Senator Bunning. And we also would not have people too big
to fail.
Mr. Tarullo. Well, you would hope that the regulation,
including a resolution mechanism and the like, would be such as
to contain that----
Senator Bunning. That is what I mean.
Mr. Tarullo. Yes, exactly, Senator.
Senator Bunning. Thank you.
Mr. Tarullo. OK, sure.
Chairman Dodd. Thanks, Senator Bunning, for the question, I
am not going to ask you to respond to this because I have taken
a lot of your time already today, not to mention there was a
little confusion with the votes we have had. But we want to
define what we mean when we talk about a systemic risk
regulator. Do you mean regulating institutions that are
inherently systemically risky or important? Or are you talking
about regulating systemically risky practices that institutions
can engage in? Or are you talking about regulating or setting
up a resolution structure so that when you have institutions
like AIG and Lehman Brothers, you have got an alternative other
than just pumping capital into them, as we did in the case of
AIG?
I get uneasy about the fact that the Fed is the lender of
last resort. Simultaneously the Fed now also falls into the
capacity of being particularly in the last function, the
resolution operation. It seems to me you get, like in the
thrift crisis years ago, the regulator becomes also the one
that also deals with these resolutions. I think that is an
inherently dangerous path to go down. That is my instinct.
Mr. Tarullo. Let me just take 30 seconds, Senator. That
little litany you had I think is right. I would just add one
thing to it. You have got supervision of systemically important
institutions not currently subject to supervision.
Chairman Dodd. That could be one role.
Mr. Tarullo. That is one role. The second role, which you
also identified, practices that are pervasive in an industry,
no matter what the size of the entity, which rise to the level
of posing true systemic risk--probably unusual, but certainly
possible.
Chairman Dodd. Right.
Mr. Tarullo. And I think we have seen it in the last couple
of years.
Third is the resolution mechanism you spoke about. It seems
to me that should not be included within the definition of
system risk regulator. You could, under some configurations,
have the same entity doing those two functions. I think what
you would need is to ensure that the systemic regulator had a
role in the decisions on resolving systemically important
institutions, as Chairman Bair pointed out, such as under the
systemic risk exception in the FDI Act that already exists.
The fourth function that I would add is the monitoring one.
I understand that is a prerequisite for some of the other ones
we talked about, but it also serves an independent purpose, and
I think, if I am not mistaken, this is some of what Senator
Reed has been getting at in the past--the need to focus on
issues and get them out, get them discussed and get them
reported.
Chairman Dodd. Right.
Mr. Tarullo. So I think that is your choice, that you have
got four functions there. My sense is that the resolution issue
is not necessarily----
Chairman Dodd. You could be right. And your fourth point,
the private sector model where you have the official or the
officer in the business doing the risk assessment. As I
understand it, in a lot of these entities, they do not have the
capacity to shut something down on their own except in very
extreme cases. But they will advise the individuals who are
engaging in that thing that their behavior is posing risks to
their company. So it does not have the ability to say no, but
it has the power or at least the information to warn.
I am a little uneasy about that because it just seems to me
whether or not you are going to get the decisions that actually
would shut things down when they arise. There are too many dots
to connect to reach that point of shutting something down
before it poses even greater risk.
Mr. Tarullo. Well, but you do, I think, Mr. Chairman,
want--again, this is why it is important for Congress
ultimately to decide what scope of authorities it wants
somewhere, and then figure out where the best place to put them
is. But that does require us all to make this judgment as to
how broadly we want authority reaching and under what
circumstances. As you can tell from my testimony, our view is
that you do not want to displace the regular prudential
supervision of all the agencies.
Chairman Dodd. No.
Mr. Tarullo. This should be something which is an oversight
mechanism on top of it in the general course of things. But as
I think you have pointed out, you will sometimes have
practices--and subprime mortgage lending that was either
predatory or not well backed by good underwriting is a
principal example--that became pervasive and should have been
regulated earlier.
Chairman Dodd. I have said over and over again I am sort of
agnostic on all of this. I want to do what works. But if you
ask me where I was inclining, it is on that point. I think you
have got to watch practices. Just because something is called
important does not mean it is. And there may be practices that
may not seem important but are terribly important. And it seems
to me we ought to be focusing on that, not at the exclusion of
the other.
Let me ask the other panelists quickly to comment if they
have--any comments on this from anyone else on this discussion?
Sheila, do you have----
Mr. Fryzel. I just have one comment. If the Congress takes
the action and puts in place a systemic regulator, that is
certainly not going to stop or prevent some of the problems
that we have now out in the financial services industry.
As Chairman Bair talked about, the fact that she has asked
for an increase in the lending from the Treasury, as we have at
NCUA, which is paramount to us taking care of the problems
between now and the time the systemic risk regulator is able to
take over and watch over all of our industries. So that there
are tools that we are going to be coming back to the Congress
for between now and then that the regulators are going to need
to solve the problems that are existing out there now. We still
need things to get those solved.
Chairman Dodd. Sheila, do you want to comment?
Ms. Bair. Yes, I would--I agree with what you said about
practices. I would only add that, to some extent, they are
connected in that if the Federal Government or the agencies do
not have the ability both to write rules--which we did have--
and enforce those rules for all institutions, you still get the
kind of dynamic we had with mortgages where it started with the
nonbanks creating competitive pressure on the banks to respond
in kind.
And another thing that--you do not have the SEC and the
CFTC here, but I think any discussion of regulatory
restructuring needs to note the need for market regulation of
the derivatives markets, especially the CDS markets.
Chairman Dodd. We do not have a table big enough.
Ms. Bair. That is not institution-specific, absolutely, but
it is another area.
Chairman Dodd. But I must say, I was sitting here looking
at this and we are missing the CFTC and the SEC at this table.
But in a sense, and I say this very respectfully, this is the
problem. With all due respect, this is the problem. In a sense,
we talk about too big to fail in the sense of private
institutions. But in a sense, we have a bureaucracy or a
regulatory structure and so forth, that is too big to succeed
because it is so duplicative.
And I can understand there is a value in that, in terms of
protecting some things, but we are having the SEC next week
testify before the Committee.
But if I wanted to capture in a photograph what is the
essence of the problem, I can't. And this is the problem. And
this is what we've got to sort out in a way that provides some
clarity to the process as we go forward.
By the way, there is going to be a hearing at 2 o'clock--I
know that is what all of you want to hear--on deposit insurance
that Senator Johnson is hosting in 538 of the Dirksen Building.
[Laughter.]
Chairman Dodd. That will be good news for our panelists, we
know I have got to wrap up here as we are getting near 2
o'clock.
We are going to proceed on this, I would say to Chairman
Bair as well, and we are trying to resolve some other issues,
if we can, in going forward. I know you are aware of that.
Obviously, we are very interested in getting the legislation
adopted, and we will move quickly.
Any other further comment on this last point? And then I
want to end, if not? Yes, John.
Mr. Dugan. Senator, I would just agree with your point. It
is not obvious that, in many cases, the gathering of the
information is not really the most important thing you need to
do. For example, if you had hedge funds, it is not clear you
would want to go in and regulate them like you regulate a bank.
You might want to find out what they were doing, how they were
doing it, have some authority to take some action if you had
to.
But the gathering of information, understanding what they
do, was completely absent during the current crisis with
respect to nonbanks, and it is a really important thing that
you are talking about, to learn what people are doing. So that
is a fundamental building block.
Chairman Dodd. Thank you.
I can see you chafing. Go ahead, Governor.
Mr. Tarullo. Just one point on that. This is what I meant
earlier about being clear about where they go, where
authority----
Chairman Dodd. We need the mic on.
Mr. Tarullo. I am sorry. Because if you say you are a
systemic risk regulator, you are responsible for everything, no
matter where it may happen. But there is not a regular system
in place for overseeing a particular market or overseeing
particular institutions. That is when I think you risk having
things falling between the cracks and expectations not being
met.
And so I come back to the point I opened with, that is why
there needs to be an agenda for systemic stability which takes
into account each of the roles that the various agencies will
play.
Chairman Dodd. Well, I thank you. There are additional
questions I will submit for the record, and I know my
colleagues will, as well. We are going to be very engaged with
all of you over the coming weeks on this matter. As I said, we
have got more hearings to hold on this, the SEC next week. We
have had seven already. And I thank each and every one of you
for your participation. It has been very, very helpful here
this morning.
The Committee will stand adjourned.
[Whereupon, at 1:40 p.m., the hearing was adjourned.]
[Prepared statements and response to written questions
supplied for the record follow:]
PREPARED STATEMENT OF SENATOR JIM BUNNING
Thank you, Mr. Chairman. This is a very important hearing, and I
hope our witnesses will give us some useful answers. AIG has been in
the news a lot this week, but it is not the only problem in our
financial system. Other firms, including some regulated by our
witnesses, have failed or been bailed out.
We all want to make any changes we can that will prevent this from
happening again. But before we jump to any conclusions about what needs
to be done to prevent similar problems in the future, we need to
consider whether any new regulations will really add to stability or
just create a false sense of security.
For example, I am not convinced that if the Fed had clear power to
oversee all of AIG they would have noticed the problems or done
anything about it. They clearly did not do a good enough job in
regulating their holding companies, as we discussed at the Securities
Subcommittee hearing yesterday. Their poor performance should throw
cold water on the idea of giving them even more responsibility.
Finally, I want to say a few words about the idea of a risk
regulator. While the idea sounds good, there are several questions that
must be answered to make such a plan work. First, we have to figure out
what risk is and how to measure it. This crisis itself is evidence that
measuring risk is not as easy as it sounds. Second, we need to consider
what to do about that risk. In other words, what powers would that
regulator have, and how do you deal with international companies?
Third, how do we keep the regulator from always being a step behind the
markets? Do we really believe the regulator will be able to recruit the
talent needed to see and understand risk in an ever-changing financial
system on government salaries? Finally, will the regulator continue the
expectation of government rescue whenever things go bad?
We should at least consider if we can accomplish the goal of a more
stable system by making sure the parties to financial deals bear the
consequences of their actions and thus act more responsibly in the
first place.
Thank you, Mr. Chairman.
______
PREPARED STATEMENT OF JOHN C. DUGAN
Comptroller of the Currency,
Office of the Comptroller of the Currency
March 19, 2009
Chairman Dodd, Ranking Member Shelby, and Members of the Committee,
I appreciate this opportunity to discuss reforming the regulation of
our financial system.
Recent turmoil in the financial markets, the unprecedented distress
and failure of large financial firms, the mortgage and foreclosure
crises, and growing numbers of problem banks--large and small--have
prompted calls to reexamine and revamp thenation's financial regulatory
system. The crisis raises legitimate questions about whether our
existing complex system has both redundancies and gaps that
significantly compromise its effectiveness. At the same time, any
restructuring effort that goes forward should be carefully designed to
avoid changes that undermine the parts of our current regulatory system
that work best.
To examine this very important set of issues, the Committee will
consider many aspects of financial regulation that extend beyond bank
regulation, including the regulation of government-sponsored
enterprises, insurance companies, and the intersection of securities
and commodities markets. Accordingly, my testimony today focuses on key
areas where I believe the perspective of the OCC--with the benefit of
hindsight from the turmoil of the last two years--can most usefully
contribute to the Committee's deliberations. Specifically, I will
discuss the need to--
improve the oversight of systemic risk, especially with
respect to systemically important financial institutions that
are not banks;
establish a better process for stabilizing, resolving or
winding down such firms;
reduce the number of bank regulators, while preserving a
dedicated prudential supervisor;
enhance mortgage regulation; and
improve consumer protection regulation while maintaining
its fundamental connection to prudential supervision.
Improving Systemic Risk Oversight
The unprecedented events of the past year have brought into sharp
focus the issue of systemic risk, especially in connection with the
failures or near failures of large financial institutions. Such
institutions are so large and so intertwined with financial markets and
other major financial institutions that the failure of one could cause
a cascade of serious problems throughout the financial system--the very
essence of systemic risk.
Years ago, systemically significant firms were generally large
banks, and our regime of extensive, consolidated supervision of banks
and bank holding companies--combined with the market expertise provided
by the Federal Reserve through its role as central bank--provided a
means to address the systemic risk presented by these institutions.
More recently, however, large nonbank financial institutions like AIG,
Fannie Mae and Freddie Mac, Bear Stearns, and Lehman began to present
similar risks to the system as large banks. Yet these nonbank firms
were subject to varying degrees and different kinds of government
oversight. In addition, no one regulator had access to risk information
from these nonbank firms in the same way that the Federal Reserve has
with respect to bank holding companies. The result, I believe, was that
the risk these firms presented to the financial system as a whole could
not be managed or controlled until their problems reached crisis
proportions.
One suggested way to address this problem going forward would be to
assign one agency the oversight of systemic risk throughout the
financial system. This approach would fix accountability, centralize
data collection, and facilitate a unified approach to identifying and
addressing large risks across the system. Such a regulator could also
be assigned responsibility for identifying as systemically significant
those institutions whose financial soundness and role in financial
intermediation is important to the stability of U.S. and global
markets.
But the single systemic regulator approach would also face
challenges due to the diverse nature of the firms that could be labeled
systemically significant. Key issues would include the type of
authority that should be provided to the regulator; the types of
financial firms that should be subject to its jurisdiction; and the
nature of the new regulator's interaction with existing prudential
supervisors. It would be important, for example, for the systemic
regulatory function to build on existing prudential supervisory
schemes, adding a systemic point of view, rather than replacing or
duplicating regulation and supervisory oversight that already exists.
How this would be done would need to be evaluated in light of other
restructuring goals, including providing clear expectations for
financial institutions and clear responsibilities and accountability
for regulators; avoiding new regulatory inefficiencies; and considering
the consequences of an undue concentration of responsibilities in a
single regulator.
It has been suggested that the Federal Reserve Board should serve
as the single agency responsible for systemic risk oversight. This
makes sense given the comparable role that the Board already plays with
respect to our largest banking companies; its extensive involvement
with capital markets and payments systems; and its frequent interaction
with central banks and supervisors from other countries.
If Congress decides to take this approach, however, it would be
necessary to define carefully the scope of the Board's authority over
institutions other than the bank holding companies and state-chartered
member banks that it already supervises. Moreover, the Board has many
other critical responsibilities, including monetary policy, discount
window lending, payments system regulation, and consumer protection
rulewriting. Adding the broad role of systemic risk overseer raises the
very real concerns of the Board taking on too many functions to do all
of them well, while at the same time concentrating too much authority
in a single government agency. The significance of these concerns would
depend very much on both the scope of the new responsibilities as
systemic risk regulator, and any other significant changes that might
be made to its existing role as the consolidated bank holding company
supervisor.
Let me add that the contours of new systemic authority may need to
vary depending on the nature of the systemically significant entity.
For example, prudential regulation of banks involves extensive
requirements with respect to risk reporting, capital, activities
limits, risk management, and enforcement. The systemic supervisor might
not need to impose all such requirements on all types of systemically
important firms. The ability to obtain risk information would be
critical for all such firms, but it might not be necessary, for
example, to impose the full array of prudential standards, such as
capital requirements or activities limits on all types of systemically
important firms, e.g., hedge funds (assuming they were subject to the
new regulator's jurisdiction). Conversely, firms like banks that are
already subject to extensive prudential supervision would not need the
same level of oversight as firms that are not--and if the systemic
overseer were the Federal Reserve Board, very little new authority
would be required with respect to banking companies, given the Board's
current authority over bank holding companies.
It also may be appropriate to allocate different levels of
authority to the systemic risk overseer at different points in time
depending on whether financial markets are functioning normally, or are
instead experiencing unusual stress or disruption. For example, in a
stable economic environment, the systemic risk regulator might focus
most on obtaining and analyzing information about risks. Such
additional information and analysis would be valuable not only for the
systemic risk regulator, but also for prudential supervisors in terms
of their understanding of firms' exposure to risks occurring in other
parts of the financial services system to which they have no direct
access. And it could facilitate the implementation of supervisory
strategies to address and contain such risk before it increased to
unmanageable levels.
On the other hand, in times of stress or disruption it may be
appropriate to authorize the systemic regulator to take actions
ordinarily reserved for prudential supervisors, such as imposing
specific conditions or requirements on operations of a firm. Such
authority would need to be crafted to ensure flexibility, but the
triggering circumstances and process for activating the authority
should be clear. Mechanisms for accountability also should be
established so that policymakers, regulated entities, and taxpayers can
understand and evaluate appropriate use of the authority.
Let me make one final point about the systemic risk regulator. Our
financial system's ``plumbing''--the major systems we have for clearing
payments and settling transactions--are not now subject to any clear,
overarching regulatory system because of the variety in their
organizational form. Some systems are clearinghouses or banking
associations subject to the Bank Service Company Act. Some are
securities clearing agencies or agency organizations pursuant to the
securities or commodities laws. Others are chartered under the
corporate laws of states. \1\
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\1\ For a description of the significance of payment and
settlement systems and the various forms under which they are organized
in the United States, see U.S. Department of the Treasury, Blueprint
for a Modernized Financial Regulatory Structure 100-103 (March 2008)
(2008 Treasury Blueprint).
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Certain of these payment and settlement systems are systemically
significant for the liquidity and stability of our financial markets,
and I believe these systems should be subjected to overarching federal
supervision to reduce systemic risk. One approach to doing so was
suggested in the 2008 Treasury Blueprint, which recommended
establishing a new federal charter for systemically significant payment
and settlement systems and authorizing the Federal Reserve Board to
supervise them. I believe this approach is appropriate given the
Board's extensive experience with payment system regulation.
Resolving Systemically Significant Firms
Events of the past year also have highlighted the lack of a
suitable process for resolving systemically significant financial firms
that are not banks. U.S. law has long provided a unique and well
developed framework for resolving distressed and failing banks that is
distinct from the federal bankruptcy regime. Since 1991, this unique
framework, administered by the Federal Deposit Insurance Corporation,
has also provided a mechanism to address the problems that can arise
with the potential failure of a systemically significant bank--
including, if necessary to protect financial stability, the ability to
use the bank deposit insurance fund to prevent uninsured depositors,
creditors, and other stakeholders of the bank from sustaining loss.
Unfortunately, no comparable framework exists for resolving most
systemically significant financial firms that are not banks, including
systemically significant holding companies of banks. Such firms must
therefore use the normal bankruptcy process unless they can obtain some
form of extraordinary government assistance to avoid the systemic risk
that might ensue from failure or the lack of a timely and orderly
resolution. While the bankruptcy process may be appropriate for
resolution of certain types of firms, it may take too long to provide
certainty in the resolution of a systemically significant firm, and it
provides no source of funding for those situations where substantial
resources are needed to accomplish an orderly solution. As a result, in
the last year as a number of large nonbank financial institutions faced
potential failure, government agencies have had to improvise with
various other governmental tools to address systemic risk issues at
nonbanks, sometimes with solutions that were less than ideal.
This gap needs to be addressed with an explicit statutory regime
for facilitating the resolution of systemically important nonbank
companies as well as banks. This new statutory regime should provide
tools that are similar to those the FDIC currently has for resolving
banks, including the ability to require certain actions to stabilize a
firm; access to a significant funding source if needed to facilitate
orderly dispositions, such as a significant line of credit from the
Treasury; the ability to wind down a firm if necessary, and the
flexibility to guarantee liabilities and provide open institution
assistance if necessary to avoid serious risk to the financial system.
In addition, there should be clear criteria for determining which
institutions would be subject to this resolution regime, and how to
handle the foreign operations of such institutions.
One possible approach to a statutory change would be to simply
extend the FDIC's current authority to nonbanks. That approach would
not appear to be appropriate given the bank-centric nature of the
FDIC's mission and resources. The deposit insurance fund is paid for by
assessments on insured banks, with a special assessment mechanism
available for certain losses caused by systemically important banks. It
would not be fair to assess only banks for problems at nonbanks. In
addition, institutional conflicts may arise when the insurer must
fulfill the dual mission of protecting the insurance fund and advancing
the broader U.S. Government interests at stake when systemically
significant institutions require resolution. Indeed, important changes
have recently been proposed to improve the FDIC's systemic risk
assessment process to provide greater equity when the FDIC's protective
actions extend beyond the insured depository institution to affiliated
entities that are not banks.
A better approach may be to provide the new authority to the new
systemic risk regulator, in combination with the Treasury Department,
given the likely need for a substantial source of government funds. The
new systemic risk regulator would by definition have systemic risk
responsibility, and the Treasury has direct accountability to
taxpayers. If the systemic risk regulator were the Federal Reserve,
then the access to discount window funding would also provide a
critical resource to help address significant liquidity problems. It is
worth noting that, in most other countries, it has been the Treasury
Department or its equivalent that has provided extraordinary assistance
to systemically important financial firms during this crisis, whether
in the form of capital injections, government guarantees, or more
significant government ownership.
Reducing the Number of Bank Regulators
It is clear that the United States has too many bank regulators. We
have four federal regulators, 12 Federal Reserve Banks, and 50 state
regulators, nearly all of which have some type of overlapping
supervising responsibilities. This system is largely the product of
historical evolution, with different agencies created for different
legitimate purposes reflecting a much more segmented banking system
from the past. No one would design such a system from scratch, and it
is fair to say that, at times, it has not been the most efficient way
to establish banking policy or supervise banks.
Nevertheless, the banking agencies have worked hard over the years
to make the system function appropriately despite its complexities. On
many occasions, the diversity in perspectives and specialization of
roles has provided real value. And from the perspective of the OCC, I
do not believe that our sharing of responsibilities with other agencies
has been a primary driver of recent problems in the banking system.
That said, I recognize the considerable interest in reducing the
number of bank regulators. The impulse to simplify is understandable,
and it may well be appropriate to streamline our current system. But we
ought not approach the task by prejudging the appropriate number of
boxes on the organization chart. The better approach is to determine
what would be achieved if the number of regulators were reduced. What
went wrong in the current crisis that changes in regulatory structure
(rather than regulatory standards) will fix? Will accountability be
enhanced? Will the change result in greater efficiency and consistency
of regulation? Will gaps be closed so that opportunities for regulatory
arbitrage in the current system are eliminated? Will overall market
regulation be improved?
In this context, while there is arguably an agreement on the need
to reduce the number of bank regulators, there is no such consensus on
what the right number is or what their roles should be. Some have
argued that we should have just one regulator responsible for bank
supervision, and that it ought to be a new agency such as the Financial
Services Agency in the UK, or that all such responsibilities should be
consolidated in our central bank, the Federal Reserve Board. Let me
explain why I don't think either of these ideas is the right one for
our banking system.
The fundamental problem with consolidating all supervision in a
new, single independent agency is that it would take bank supervisory
functions away from the Federal Reserve Board. In terms of the normal
turf wars among agencies, it may sound strange for the OCC to take this
position. But as the central bank and closest agency we have to a
systemic risk regulator, I believe the Board needs the window it has
into banking organizations that it derives from its role as bank
holding company supervisor. More important, given its substantial role
and direct experience with respect to capital markets, payments
systems, the discount window, and international supervision, the Board
provides unique resources and perspective to bank holding company
supervision.
Conversely, I believe it also would be a mistake to move all direct
banking supervision to the Board, or even all such supervision for the
most systemically important banks. The Board has many other critical
responsibilities, including monetary policy, discount window lending,
payments system regulation, and consumer protection rulewriting.
Consolidating all banking supervision there as well would raise a
serious concern about the Board taking on too many functions to do all
of them well. There would also be a very real concern about
concentrating too much authority in a single government agency. And
both these concerns would be amplified substantially if the Board were
also designated the new systemic risk regulator and took on supervisory
responsibilities for systemically significant payment and clearing
systems.
Most important, moving all supervision to the Board would lose the
very real benefit of having an agency whose sole mission is bank
supervision. That is, of course, the sole mission of the OCC, and I
realize that, coming from the Comptroller, support for preserving a
dedicated prudential banking supervisor may be portrayed by some as
merely protecting turf. That would be unfortunate, because I strongly
believe that the benefits of dedicated supervision are real. Where it
occurs, there is no confusion about the supervisor's goals and
objectives, and no potential conflict with competing objectives.
Responsibility is well defined, and so is accountability. Supervision
takes a back seat to no other part of the organization, and the result
is a strong culture that fosters the development of the type of
seasoned supervisors that are needed to confront the many challenges
arising from today's banking business.
In the case of the OCC, I would add that our role as the front-
line, on-the-ground prudential supervisor is complementary to the
current role of the Federal Reserve Board as the consolidated holding
company regulator. This model has allowed the Board to use and rely on
our work to perform its role as supervisor for complex banking
organizations that are often involved in many businesses other than
banking. Such a model would also work well with respect to any new
authority provided to a systemic risk regulator, whether or not the
Board is assigned that role.
In short, there are a number of options for reducing the number of
bank regulators, and many detailed issues involved with each. It is not
my intent to address these issues in detail in this testimony, but
instead to make two fundamental and related points about changes to the
banking agency regulatory structure. While it is important to preserve
the Federal Reserve Board's role as a holding company supervisor, it is
equally if not more important to preserve the role of a dedicated,
front-line prudential supervisor for our nation's banks.
Enhanced Mortgage Regulation
The current financial crisis began and continues with problems
arising from poorly underwritten residential mortgages, especially
subprime mortgages. While these lending practices have been brought
under control, and federal regulators have taken actions to prevent the
worst abuses, more needs to be done. As part of any regulatory reform
to address the crisis, Congress should establish a mortgage regulatory
regime that ensures that the mortgage crisis is never repeated.
A fundamental reason for poorly underwritten mortgages was the lack
of consistent regulation for mortgage providers. Depository institution
mortgage providers--whether state or federally chartered--were the most
extensively regulated, by state and federal banking supervisors.
Mortgage providers affiliated with depository institutions were less
regulated, primarily by federal holding company supervisors, but also
by state mortgage regulators. Mortgage providers not affiliated with
depository institutions--including mortgage brokers and lenders--were
the least regulated by far, with no direct supervision at the federal
level, and limited ongoing supervision at the state level.
The results have been predictable. As the 2007 Report of the
Majority Staff of the Joint Economic Committee recognized, ``[s]ince
brokers and mortgage companies are only weakly regulated, another
outcome [of the increase in subprime lending] was a marked increase in
abusive and predatory lending.'' \2\ Nondepository institution mortgage
providers originated the overwhelming preponderance of subprime and
``Alt-A'' mortgages during the crucial 2005-2007 period, and the loans
they originated account for a disproportionate percentage of defaults
and foreclosures nationwide, with glaring examples in the metropolitan
areas hardest hit by the foreclosure crisis. For example, a recent
analysis of mortgage loan data prepared by OCC staff, from a well-known
source of mortgage loan data, identified the 10 mortgage originators
with the highest number of subprime and Alt-A mortgage foreclosures--in
the 10 metropolitan statistical areas (MSAs) experiencing the highest
foreclosure rates in the period 2005-2007. While each type of mortgage
originator has experienced elevated levels of delinquencies and
defaults in recent years, of the 21 firms comprising the ``worst 10''
in those ``worst 10'' MSAs, the majority--accounting for nearly 60
percent of nonprime mortgage loans and foreclosures--were exclusively
supervised by the states. \3\
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\2\ Majority Staff of the Joint Economic Committee, 110th Cong.,
Report and Recommendations on the Subprime Lending Crisis: The Economic
Impact on Wealth, Property Values and Tax Revenues, and How We Got Here
17 (October 2007).
\3\ Letter from Comptroller of the Currency John Dugan to
Elizabeth Warren, Chair, Congressional Oversight Panel, February 12,
2009, at http://www.occ.treas.gov/ftp/occ_copresponse_021209.pdf.
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In view of this experience, Congress should take at least two
actions in connection with regulatory reform. First, it should
establish national mortgage standards that would apply consistently
regardless of originator, similar to the mortgage legislation that
passed the House of Representatives last year. In taking this
extraordinary step, Congress should provide flexibility to regulators
to implement the statutory standards through regulations that protect
consumers and balance the need for conservative underwriting with the
equally important need for access to affordable credit.
Second, Congress should also ensure that the new standards are
applied and enforced in a comparable manner, again, regardless of
originator. This objective can be accomplished relatively easily for
mortgages provided by depository institutions or their affiliates:
federal banking regulators have ample authority to ensure compliance
through ongoing examination and supervision reinforced by broad
enforcement powers. The objective is not so easily achieved with
nonbank mortgage providers regulated exclusively by the states,
however. The state regime for regulating mortgage brokers and lenders
typically focuses on licensing, rather than ongoing examination and
supervision, and enforcement by state agencies typically targets
problems after they have become severe, not before. That difference
between the federal and state regimes can result in materially
different levels of compliance, even with a common federal standard. As
a result, it will be important to develop a mechanism to facilitate a
level of compliance at the state level that is comparable to compliance
of depository institutions subject to federal standards. The goal
should be robust national standards that are applied consistently to
all mortgage providers.
Enhanced Consumer Protection Regulation
Effective protection for consumers of financial products and
services is a vital part of financial services regulation. In the OCC's
experience, and as the mortgage crisis illustrates, safe and sound
lending practices are integral to consumer protection. Indeed, contrary
to several recent proposals, we believe that the best way to implement
consumer protection regulation of banks--the best way to protect
consumers--is to do so through prudential supervision. Let me explain
why.
First, prudential supervisors' continual presence in banks through
the examination process puts them in the very best position to ensure
compliance with consumer protection requirements established by statute
and regulation. Examiners are trained to detect weaknesses in banks'
policies, systems, and procedures for implementing consumer protection
mandates, and they gather information both on-site and off-site to
assess bank compliance. Their regular communication with the bank
occurs through examinations at least once every 18 months for smaller
institutions, supplemented by quarterly calls with management, and for
the very largest banks consumer compliance examiners are on site every
day. We believe this continual supervisory presence creates especially
effective incentives for consumer protection compliance, as well as
allowing examiners to detect compliance failures much earlier than
would otherwise be the case.
Second, prudential supervisors have strong enforcement powers and
exceptional leverage over bank management to achieve corrective action.
Banks are among the most extensively supervised firms in any type of
industry, and bankers understand very well the range of negative
consequences that can ensue from defying their regulator. As a result,
when examiners detect consumer compliance weaknesses or failures, they
have a broad range of tools to achieve corrective action, from informal
comments to formal enforcement action--and banks have strong incentives
to move back into compliance as expeditiously as possible.
Indeed, behind the scenes and without public fanfare, bank
supervision results in significant reforms to bank practices and
remedies for their customers--and it can do so much more quickly than
litigation, formal enforcement actions, or other publicized events. For
example, as part of the supervisory process, bank examiners identify
weaknesses in areas pertaining both to compliance and safety and
soundness by citing MRAs--``matters requiring attention''--in the
written report of examination. An MRA describes a problem, indicates
its cause, and requires the bank to implement a remedy before the
matter can be closed. In the period between 2004 and 2007, OCC
examiners cited 123 mortgage-related MRAs. By the end of 2008,
satisfactory corrective action had been taken with respect to 109 of
those MRAs, without requiring formal enforcement actions. Corrective
actions were achieved for issues involving mortgage underwriting,
appraisal quality, monitoring of mortgage brokers, and other consumer-
related issues. We believe this type of extensive supervision and early
warning oversight is a key reason why the worst form of subprime
lending practices did not become widespread in the national banking
system.
Third, because examiners are continually exposed to the practical
effects of implementing consumer protection rules for bank customers,
the prudential supervisory agency is in the best position to formulate
and refine consumer protection regulations for banks. Indeed, while
most such rule-writing authority is currently housed in the Federal
Reserve Board, we believe that the rule-writing process would benefit
by requiring more formal consultation with other banking supervisors
that have substantial supervisory responsibilities in this area.
Recently, alternative models for financial product consumer
protection regulation have been suggested. One is to remove all
consumer protection regulation and supervision from prudential
supervisors, instead consolidating such authority in a new federal
agency. This model would be premised on an SEC-style regime of
registration and licensing for all types of consumer credit providers,
with standards set and compliance achieved through enforcement actions
by a new agency. The approach would rely on self-reporting by credit
providers, backstopped by enforcement or judicial actions, rather than
ongoing supervision and examination.
The attractiveness of this alternative model is that it would
centralize authority and accountability in a single agency, which could
write rules that would apply uniformly to financial services providers,
whether or not they are depository institutions. Because the agency
would focus exclusively on consumer protection, proponents also argue
that such a model eliminates the concern sometimes expressed that
prudential supervisors neglect consumer protection in favor of safety
and soundness supervision.
But the downside of this approach is considerable. It would not
have the benefits of on-site examination and supervision and the very
real leverage that bank supervisors have over the banks they regulate.
That means, we believe, that compliance is likely to be less effective.
Nor would this approach draw on the practical expertise that examiners
develop from continually assessing the real-world impact of particular
consumer protection rules--an asset that is especially important for
developing and adjusting such rules over time. More troubling, the
ingredients of this approach--registration, licensing and reliance on
enforcement actions to achieve compliance with standards--is the very
model that has proved inadequate to protect consumers doing business
with state regulated mortgage lenders and brokers.
Finally, I do not agree that the banking agencies have failed to
give adequate attention to the consumer protection laws that they have
been charged with implementing. For example, predatory lending failed
to gain a foothold in the banking industry precisely because of the
close supervision commercial banks, both state and national, received.
But if Congress believes that the consumer protection regime needs to
be strengthened, the best answer is not to create a new agency that
would have none of the benefits of a prudential supervisor. Instead,
the better approach is a crisp Congressional mandate to already
responsible agencies to toughen the applicable standards and close any
gaps in regulatory coverage. The OCC and the other prudential bank
supervisors will rigorously apply them. And because of the tools we
have that I've already mentioned, banks will comply more readily and
consumers will be better protected than would be the case with mandates
applied by a new federal agency.
Conclusion
My testimony today reflects the OCC's views on several key aspects
of regulatory reform. We would be happy provide more details or
additional views on other issues at the Committee's request.
PREPARED STATEMENT OF SHEILA C. BAIR
Chairman,
Federal Deposit Insurance Corporation
March 19, 2009
Chairman Dodd, Ranking Member Shelby, and Members of the Committee,
I appreciate the opportunity to testify on behalf of the Federal
Deposit Insurance Corporation (FDIC) on the need to modernize and
reform our financial regulatory system.
The events that have unfolded over the past two years have been
extraordinary. A series of economic shocks have produced the most
challenging financial crisis since the Great Depression. The widespread
economic damage has called into question the fundamental assumptions
regarding financial institutions and their supervision that have
directed our regulatory efforts for decades. The unprecedented size and
complexity of many of today's financial institutions raise serious
issues regarding whether they can be properly managed and effectively
supervised through existing mechanisms and techniques. In addition, the
significant growth of unsupervised financial activities outside the
traditional banking system has hampered effective regulation.
Our current system has clearly failed in many instances to manage
risk properly and to provide stability. U.S. regulators have broad
powers to supervise financial institutions and markets and to limit
many of the activities that undermined our financial system, but there
are significant gaps, most notably regarding very large insurance
companies and private equity funds. However, we must also acknowledge
that many of the systemically significant entities that have needed
federal assistance were already subject to extensive federal
supervision. For various reasons, these powers were not used
effectively and, as a consequence, supervision was not sufficiently
proactive. Insufficient attention was paid to the adequacy of complex
institutions' risk management capabilities.
Too much reliance was placed on mathematical models to drive risk
management decisions. Notwithstanding the lessons from Enron, off-
balance sheet-vehicles were permitted beyond the reach of prudential
regulation, including holding company capital requirements. Perhaps
most importantly, failure to ensure that financial products were
appropriate and sustainable for consumers has caused significant
problems not only for those consumers but for the safety and soundness
of financial institutions. Moreover, some parts of the current
financial system, for example, over the counter derivatives, are by
statute, mostly excluded from federal regulation.
In the face of the current crisis, regulatory gaps argue for some
kind of comprehensive regulation or oversight of all systemically
important financial firms. But, the failure to utilize existing
authorities by regulators casts doubt on whether simply entrusting
power in a single systemic risk regulator will sufficiently address the
underlying causes of our past supervisory failures. We need to
recognize that simply creating a new systemic risk regulator is a not a
panacea. The most important challenge is to find ways to impose greater
market discipline on systemically important institutions. The solution
must involve, first and foremost, a legal mechanism for the orderly
resolution of these institutions similar to that which exists for FDIC
insured banks. In short, we need an end to too big to fail.
It is time to examine the more fundamental issue of whether there
are economic benefits to institutions whose failure can result in
systemic issues for the economy. Because of their concentration of
economic power and interconnections through the financial system, the
management and supervision of institutions of this size and complexity
has proven to be problematic. Taxpayers have a right to question how
extensive their exposure should be to such entities.
The problems of supervising large, complex financial institutions
are compounded by the absence of procedures and structures to
effectively resolve them in an orderly fashion when they end up in
severe financial trouble. Unlike the clearly defined and proven
statutory powers that exist for resolving insured depository
institutions, the current bankruptcy framework available to resolve
large complex nonbank financial entities and financial holding
companies was not designed to protect the stability of the financial
system. This is important because, in the current crisis, bank holding
companies and large nonbank entities have come to depend on the banks
within the organizations as a source of strength. Where previously the
holding company served as a source of strength to the insured
institution, these entities now often rely on a subsidiary depository
institution for funding and liquidity, but carry on many systemically
important activities outside of the bank that are managed at a holding
company level or nonbank affiliate level.
While the depository institution could be resolved under existing
authorities, the resolution would cause the holding company to fail and
its activities would be unwound through the normal corporate bankruptcy
process. Without a system that provides for the orderly resolution of
activities outside of the depository institution, the failure of a
systemically important holding company or nonbank financial entity will
create additional instability as claims outside the depository
institution become completely illiquid under the current system.
In the case of a bank holding company, the FDIC has the authority
to take control of only the failing banking subsidiary, protecting the
insured depositors. However, many of the essential services in other
portions of the holding company are left outside of the FDIC's control,
making it difficult to operate the bank and impossible to continue
funding the organization's activities that are outside the bank. In
such a situation, where the holding company structure includes many
bank and nonbank subsidiaries, taking control of just the bank is not a
practical solution.
If a bank holding company or nonbank financial holding company is
forced into or chooses to enter bankruptcy for any reason, the
following is likely to occur. In a Chapter 11 bankruptcy, there is an
automatic stay on most creditor claims, with the exception of specified
financial contracts (futures and options contracts and certain types of
derivatives) that are subject to termination and netting provisions,
creating illiquidity for the affected creditors. The consequences of a
large financial firm filing for bankruptcy protection are aptly
demonstrated by the Lehman Brothers experience. As a result, neither
taking control of the banking subsidiary or a bankruptcy filing of the
parent organization is currently a viable means of resolving a large,
systemically important financial institution, such as a bank holding
company. This has forced the government to improvise actions to address
individual situations, making it difficult to address systemic problems
in a coordinated manner and raising serious issues of fairness.
My testimony will examine some steps that can be taken to reduce
systemic vulnerabilities by strengthening supervision and regulation
and improving financial market transparency. I will focus on some
specific changes that should be undertaken to limit the potential for
excessive risk in the system, including identifying systemically
important institutions, creating incentives to reduce the size of
systemically important firms and ensuring that all portions of the
financial system are under some baseline standards to constrain
excessive risk taking and protect consumers. I will explain why an
independent special failure resolution authority is needed for
financial firms that pose systemic risk and describe the essential
features of such an authority. I also will suggest improvements to
consumer protection that would improve regulators' ability to stem
fraud and abusive practices. Next, I will discuss other areas that
require legislative changes to reduce systemic risk--the over-the-
counter (OTC) derivatives market and the money market mutual fund
industry. And, finally, I will address the need for regulatory reforms
related to the originate-to-distribute model, executive compensation in
banks, fair-value accounting, credit rating agencies and counter-
cyclical capital policies.
Addressing Systemic Risk
Many have suggested that the creation of a systemic risk regulator
is necessary to address key flaws in the current supervisory regime.
According to the proposals, this new regulator would be tasked with
monitoring large or rapidly increasing exposures--such as to sub-prime
mortgages--across firms and markets, rather than only at the level of
individual firms or sectors; and analyzing possible spillovers among
financial firms or between firms and markets, such as the mutual
exposures of highly interconnected firms. Additionally, the proposals
call for such a regulator to have the authority to obtain information
and examine banks and key financial market participants, including
nonbank financial institutions that may not be currently subject to
regulation. Finally, the systemic risk regulator would be responsible
for setting standards for capital, liquidity, and risk management
practices for the financial sector.
Changes in our regulatory and supervisory approach are clearly
warranted, but Congress should proceed carefully and deliberately in
creating a new systemic risk regulator. Many of the economic challenges
we are facing continue and new aspects of interconnected problems
continue to be revealed. It will require great care to address evolving
issues in the midst of the economic storm and to avoid unintended
consequences. In addition, changes that build on existing supervisory
structures and authorities--that fill regulatory voids and improve
cooperation--can be implemented more quickly and more effectively.
While I fully support the goal of having an informed, forward
looking, proactive and analytically capable regulatory community,
looking back, if we are honest in our assessment, it is clear that U.S.
regulators already had many broad powers to supervise financial
institutions and markets and to limit many of the activities that
undermined our financial system. For various reasons, these powers were
not used effectively and as a consequence supervision was not
sufficiently proactive.
There are many examples of situations in which existing powers
could have been used to prevent the financial system imbalances that
led to the current financial crisis. For instance, supervisory
authorities have had the authority under the Home Ownership and Equity
Protection Act to regulate the mortgage industry since 1994.
Comprehensive new regulations intended to limit the worst practices in
the mortgage industry were not issued until well into the onset of the
current crisis. Failure to address lax lending standards among nonbank
mortgage companies created market pressure on banks to also relax their
standards. Bank regulators were late in addressing this phenomenon.
In other important examples, federal regulatory agencies have had
consolidated supervisory authority over institutions that pose a
systemic risk to the financial system; yet they did not to exercise
their authorities in a manner that would have enabled them to
anticipate the risk concentrations in the bank holding companies,
investment bank holding companies and thrift holding companies they
supervise. Special purpose financial intermediaries--such as structured
investment vehicles (SIVs)--played an important role in funding and
aggregating the credit risks that are at the core of the current
crisis. These intermediaries were formed outside the banking
organizations so banks could recognize asset sales and take the assets
off the balance sheet, or remotely originate assets to keep off the
balance sheet and thereby avoid minimum regulatory capital and leverage
ratio constraints. Because they were not on the bank's balance sheet
and to the extent that they were managed outside of the bank by the
parent holding company, SIVs escaped scrutiny from the bank regulatory
agencies.
With hindsight, all of the regulatory agencies will focus and find
ways to better exercise their regulatory powers. Even though the
entities and authorities that have been proposed for a systemic
regulator largely existed, the regulatory community did not appreciate
the magnitude and scope of the potential risks that were building in
the system. Having a systemic risk regulator that would look more
broadly at issues on a macro-prudential basis would be of incremental
benefit, but the success of any effort at reform will ultimately rely
on the willingness of regulators to use their authorities more
effectively and aggressively.
The lack of regulatory foresight was not specific to the United
States. As a recent report on financial supervision in the European
Union noted, financial supervisors frequently did not have, and in some
cases did not insist on obtaining--or received too late--all of the
relevant information on the global magnitude of the excess leveraging
that was accumulating in the financial system. \1\ Further, they did
not fully understand or evaluate the size of the risks, or share their
information properly with their counterparts in other countries. The
report concluded that insufficient supervisory and regulatory resources
combined with an inadequate mix of skills as well as different systems
of national supervision made the situation worse. In interpreting this
report, it is important to recall that virtually every European central
bank is required to assess and report economic and financial system
conditions and anticipate emerging financial-sector risks.
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\1\ European Union, Report of the High-level Group on Financial
Supervision in the EU, J. de Larosiere, Chairman, Brussels, 25 February
2009.
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With these examples in mind, we should recognize that while
establishing a systemic risk regulator is important, it is far from
clear that it will prevent a future systemic crisis.
Limiting Risk by Limiting Size and Complexity
Before considering the various proposals to create a systemic risk
regulator, Congress should examine a more fundamental question of
whether there should be limitations on the size and complexity of
institutions whose failure would be systemically significant. Over the
past two decades, a number of arguments have been advanced about why
financial organizations should be allowed to become larger and more
complex. These reasons include being able to take advantage of
economies of scale and scope, diversifying risk across a broad range of
markets and products, and gaining access to global capital markets. It
was alleged that the increased size and complexity of these
organizations could be effectively managed using new innovations in
quantitative risk management techniques. Not only did institutions
claim that they could manage these new risks, they also argued that
often the combination of diversification and advanced risk management
practices would allow them to operate with markedly lower capital
buffers than were necessary in smaller, less-sophisticated
institutions. Indeed many of these concepts were inherent in the Basel
II Advanced Approaches, resulting in reduced capital requirements. In
hindsight, it is now clear that the international regulatory community
relied too heavily on diversification and risk management when setting
minimum regulatory capital requirements for large complex financial
institutions.
Notwithstanding expectations and industry projections for gains in
financial efficiencies, economies of scale seem to be reached at levels
far below the size of today's largest financial institutions. Also,
efforts designed to realize economies of scope have not lived up to
their promise. In some instances, the complex institutional
combinations permitted by the Gramm-Leach-Bliley (GLB) legislation were
unwound because they failed to realize anticipated economies of scope.
The latest studies of economies produced by increased scale and scope
find that most banks could improve their cost efficiency more by
concentrating their efforts on reducing operational inefficiencies.
There also are limits to the ability to diversify risk using
securitization, structured finance and derivatives. No one disputes
that there are benefits to diversification for smaller and less-complex
institutions, but as institutions become larger and more complex, the
ability to diversify risk is diminished. When a financial system
includes a small number of very large complex organizations, the system
cannot be well-diversified. As institutions grow in size and
importance, they not only take on a risk profile that mirrors the risk
of the market and general economic conditions, but they also
concentrate risk as they become the only important counterparties to
many transactions that facilitate financial intermediation in the
economy. The fallacy of the diversification argument becomes apparent
in the midst of financial crisis when these large complex financial
organizations--because they are so interconnected--reveal themselves as
a source of risk in the system.
Managing the Transition to a Safer System
If large complex organizations concentrate risk and do not provide
market efficiencies, it may be better to address systemic risk by
creating incentives to encourage a financial industry structure that is
characterized by smaller and therefore less systemically important
financial firms, for instance, by imposing increasing financial
obligations that mirror the heightened risk posed by large entities.
Identifying Systemically Important Firms
To be able to implement and target the desired changes, it becomes
important to identify characteristics of a systemically important firm.
A recent report by the Group of Thirty highlights the difficulties that
are associated with a fixed common definition of what comprises a
systemically important firm. What constitutes systemic importance is
likely to vary across national boundaries and change over time.
Generally, it would include any firm that constitutes a significant
share of their market or the broader financial system. Ultimately,
identification of what is systemic will have to be decided within the
structure created for systemic risk regulation, but at a minimum,
should rely on triggers based on size and counterparty concentrations.
Increasing Financial Obligations To Reflect Increasing Risk
To date, many large financial firms have been given access to vast
amounts of public funds. Obviously, changes are needed to prevent this
situation from reoccurring and to ensure that firms are not rewarded
for becoming, in essence, too big to fail. Rather, they should be
required to offset the potential costs to society.
In contrast to the capital standards implied in the Basel II
Accord, systemically important firms should face additional capital
charges based on both size and complexity. In addition, they should be
subject to higher Prompt Corrective Action (PCA) limits under U.S.
laws. Regulators should judge the capital adequacy of these firms,
taking into account off-balance-sheet assets and conduits as if these
risks were on balance sheet.
Next Steps
Currently, not all parts of the financial system are subject to
federal regulation. Insurance company regulation is conducted at the
state level. There is, therefore, no federal regulatory authority
specifically designed to provide comprehensive prudential supervision
for large insurance companies. Hedge funds and private equity firms are
typically designed to operate outside the regulatory structures that
would otherwise constrain their leverage and activities. This is of
concern not only for the safety and soundness of these unregulated
firms, but for regulated firms as well. Some of banking organizations'
riskier strategies, such as the creation of SIVs, may have been driven
by a desire to replicate the financial leverage available to less
regulated entities. Some of these firms by virtue of their gross
balance sheet size or by their dominance in particular markets can pose
systemic risks on their own accord. Many others are major participants
in markets and business activities that may contribute to a systemic
collapse. This loophole in the regulatory net cannot continue. It is
important that all systemically important financial firms, including
hedge funds, insurance companies, investment banks, or bank or thrift
holding companies, be subject to prudential supervision, including
across the board constraints on the use of financial leverage.
New Resolution Procedures
There is clearly a need for a special resolution regime, outside
the bankruptcy process, for financial firms that pose a systemic risk,
just as there is for commercial banks and thrifts. As noted above,
beyond the necessity of capital regulation and prudential supervision,
having a mechanism for the orderly resolution of institutions that pose
a systemic risk to the financial system is critical. Creating a
resolution regime that could apply to any financial institution that
becomes a source of systemic risk should be an urgent priority.
The differences in outcomes from the handling of Bear Stearns and
Lehman Brothers demonstrate that authorities have no real alternative
but to avoid the bankruptcy process. When the public interest is at
stake, as in the case of systemically important entities, the
resolution process should support an orderly unwinding of the
institution in a way that protects the broader economic and taxpayer
interests, not just private financial interests.
In creating a new resolution regime, we must clearly define roles
and responsibilities and guard against creating new conflicts of
interest. In the case of banks, Congress gave the FDIC backup
supervisory authority and the power to self-appoint as receiver,
recognizing there might be conflicts between a primary regulators'
prudential responsibilities and its willingness to recognize when an
institution it supervises needs to be closed. Thus, the new resolution
authority should be independent of the new systemic risk regulator.
This new authority should also be designed to limit subsidies to
private investors (moral hazard). If financial assistance outside of
the resolution process is granted to systemically important firms, the
process should be open, transparent and subject to a system of checks
and balances that are similar to the systemic-risk exception to the
least-cost test that applies to insured financial institutions. No
single government entity should be able to unilaterally trigger a
resolution strategy outside the defined parameters of the established
resolution process.
Clear guidelines for this process are needed and must be adhered to
in order to gain investor confidence and protect public and private
interests. First, there should be a clearly defined priority structure
for settling claims, depending on the type of firm. Any resolution
should be subject to a cost test to minimize any public loss and impose
losses according to the established claims priority. Second, it must
allow continuation of any systemically significant operations. The
rules that govern the process, and set priorities for the imposition of
losses on shareholders and creditors should be clearly articulated and
closely adhered to so that the markets can understand the resolution
process with predicable outcomes.
The FDIC's authority to act as receiver and to set up a bridge bank
to maintain key functions and sell assets offers a good model. A
temporary bridge bank allows the government to prevent a disorderly
collapse by preserving systemically significant functions. It enables
losses to be imposed on market players who should appropriately bear
the risk. It also creates the possibility of multiple bidders for the
bank and its assets, which can reduce losses to the receivership.
The FDIC has the authority to terminate contracts upon an insured
depository institution's failure, including contracts with senior
management whose services are no longer required. Through its
repudiation powers, as well as enforcement powers, termination of such
management contracts can often be accomplished at little cost to the
FDIC. Moreover, when the FDIC establishes a bridge institution, it is
able to contract with individuals to serve in senior management
positions at the bridge institution subject to the oversight of the
FDIC. The new resolution authority should be granted similar statutory
authority in the resolution of financial institutions.
Congress should recognize that creating a new separate authority to
administer systemic resolutions may not be economic or efficient. It is
unlikely that the separate resolution authority would be used
frequently enough to justify maintaining an expert and motivated
workforce as there could be decades between systemic events. While many
details of a special resolution authority for systemically important
financial firms would have to be worked out, a new systemic resolution
regime should be funded by fees or assessments charged to systemically
important firms. In addition, consistent with the FDIC's powers with
regard to insured institutions, the resolution authority should have
backup supervisory authority over those firms which it may have to
resolve.
Consumer Protection
There can no longer be any doubt about the link between protecting
consumers from abusive products and practices and the safety and
soundness of the financial system. Products and practices that strip
individual and family wealth undermine the foundation of the economy.
As the current crisis demonstrates, increasingly complex financial
products combined with frequently opaque marketing and disclosure
practices result in problems not just for consumers, but for
institutions and investors as well.
To protect consumers from potentially harmful financial products, a
case has been made for a new independent financial product safety
commission. Certainly, more must be done to protect consumers. We could
support the establishment of a new entity to establish consistent
consumer protection standards for banks and nonbanks. However, we
believe that such a body should include the perspective of bank
regulators as well as nonbank enforcement officials such as the FTC.
However, as Congress considers the options, we recommend that any new
plan ensure that consumer protection activities are aligned and
integrated with other bank supervisory information, resources, and
expertise, and that enforcement of consumer protection rules for banks
be left to bank regulators.
The current bank regulation and supervision structure allows the
banking agencies to take a comprehensive view of financial institutions
from both a consumer protection and safety-and-soundness perspective.
Banking agencies' assessments of risks to consumers are closely linked
with and informed by a broader understanding of other risks in
financial institutions. Conversely, assessments of other risks,
including safety and soundness, benefit from knowledge of basic
principles, trends, and emerging issues related to consumer protection.
Separating consumer protection regulation and supervision into
different organizations would reduce information that is necessary for
both entities to effectively perform their functions. Separating
consumer protection from safety and soundness would result in similar
problems.
Our experience suggests that the development of policy must be
closely coordinated and reflect a broad understanding of institutions'
management, operations, policies, and practices--and the bank
supervisory process as a whole. Placing consumer protection policy-
setting activities in a separate organization, apart from existing
expertise and examination infrastructure, could ultimately result in
less effective protections for consumers.
One of the fundamental principles of the FDIC's mission is to serve
as an independent agency focused on maintaining consumer confidence in
the banking system. The FDIC plays a unique role as deposit insurer,
federal supervisor of state nonmember banks and savings institutions,
and receiver for failed depository institutions. These functions
contribute to the overall stability of and consumer confidence in the
banking industry. With this mission in mind, if given additional
rulemaking authority, the FDIC is prepared to take on an expanded role
in providing consumers with stronger protections that address products
posing unacceptable risks to consumers and eliminate gaps in oversight.
Under the Federal Trade Commission (FTC) Act, only the Federal
Reserve Board (FRB) has authority to issue regulations applicable to
banks regarding unfair or deceptive acts or practices, and the Office
of Thrift Supervision (OTS) and the National Credit Union
Administration (NCUA) have sole authority with regard to the
institutions they supervise. The FTC has authority to issue regulations
that define and ban unfair or deceptive acts or practices with respect
to entities other than banks, savings and loan institutions, and
federal credit unions. However, the FTC Act does not give the FDIC
authority to write rules that apply to the approximately 5,000 entities
it supervises--the bulk of state banks--nor to the OCC for their 1,700
national banks. Section 5 of the FTC Act prohibits ``unfair or
deceptive acts or practices in or affecting commerce.'' It applies to
all persons engaged in commerce, whether banks or nonbanks, including
mortgage lenders and credit card issuers. While the ``deceptive'' and
``unfair'' standards are independent of one another, the prohibition
against these practices applies to all types of consumer lending,
including mortgages and credit cards, and to every stage and activity,
including product development, marketing, servicing, collections, and
the termination of the customer relationship.
In order to further strengthen the use of the FTC Act's rulemaking
provisions, the FDIC has recommended that Congress consider granting
Section 5 rulemaking authority to all federal banking regulators. By
limiting FTC rulemaking authority to the FRB, OTS and NCUA, current law
excludes participation by the primary federal supervisors of about
7,000 banks. The FDIC's perspective--as deposit insurer and as
supervisor for the largest number of banks, many of whom are small
community banks--would provide valuable input and expertise to the
rulemaking process. The same is true for the OCC, as supervisor of some
of the nation's largest banks. As a practical matter, these rulemakings
would be done on an interagency basis and would benefit from the input
of all interested parties.
In the alternative, if Congress is inclined to establish an
independent financial product commission, it should leverage the
current regulatory authorities that have the resources, experience, and
legislative power to enforce regulations related to institutions under
their supervision, so it would not be necessary to create an entirely
new enforcement infrastructure. In fact, in creating a financial
products safety commission, it would be beneficial to include the FDIC
and principals from other financial regulatory agencies on the
commission's board. Such a commission should be required to submit
periodic reports to Congress on the effectiveness of the consumer
protection activities of the commission and the bank regulators.
Whether or not Congress creates a new commission, it is essential
that there be uniform standards for financial products whether they are
offered by banks or nonbanks. These standards must apply across all
jurisdictions and issuers, otherwise gaps create competitive pressures
to reduce standards, as we saw with mortgage lending standards. Clear
standards also permit consistent enforcement that protects consumers
and the broader financial system.
Finally, in the on-going process to improve consumer protections,
it is time to examine curtailing federal preemption of state consumer
protection laws. Federal preemption of state laws was seen as a way to
improve efficiencies for financial firms who argued that it lowered
costs for consumers. While that may have been true in the short run, it
has now become clear that abrogating sound state laws, particularly
regarding consumer protection, created an opportunity for regulatory
arbitrage that frankly resulted in a ``race-to-the-bottom'' mentality.
Creating a ``floor'' for consumer protection, based on either
appropriate state or federal law, rather than the current system that
establishes a ceiling on protections would significantly improve
consumer protection. Perhaps reviewing the existing web of state and
federal laws related to consumer protections and choosing the most
appropriate for the ``floor'' could be one of the initial priorities
for a financial products safety commission.
Changing the OTC Market and Protecting of Money Market Mutual Funds
Two areas that require legislative changes to reduce systemic risk
are the OTC derivatives market and the money market mutual fund
industry.
Credit Derivatives Markets and Systemic Risk
Beyond issues of size and resolution schemes for systemically
important institutions, recent events highlight the need to revisit the
regulation and oversight of credit derivative markets. Credit
derivatives provide investors with instruments and markets that can be
used to create tremendous leverage and risk concentration without any
means for monitoring the trail of exposure created by these
instruments. An individual firm or a security from a sub-prime, asset-
backed or other mortgage-backed pool of loans may have only $50 million
in outstanding par value and yet, the over-the-counter markets for
credit default swaps (CDS) may create hundreds of millions of dollars
in individual CDS contracts that reference that same debt. At the same
time, this debt may be referenced in CDS Index contracts that are
created by OTC dealers which creates additional exposure. If the
referenced firm or security defaults, its bond holders will likely lose
some fraction of the $50 million par value, but CDS holders face losses
that are many times that amount.
Events have shown that the CDS markets are a source of systemic
risk. The market for CDS was originally set up as an inter-bank market
to exchange credit risk without selling the underlying loans, but it
has since expanded massively to include hedge funds, insurance
companies, municipalities, public pension funds and other financial
institutions. The CDS market has expanded to include OTC index products
that are so actively traded that they spawned a Chicago Board of Trade
futures market contract. CDS markets are an important tool for hedging
credit risk, but they also create leverage and can multiply underlying
credit risk losses. Because there are relatively few CDS dealers,
absent adequate risk management practices and safeguards, CDS markets
can also create counterparty risk concentrations that are opaque to
regulators and financial institutions.
Our views on the need for regulatory reform of the CDS and related
OTC derivatives markets are aligned with the recommendations made in
the recent framework proposed by the Group of Thirty. OTC contracts
should be encouraged to migrate to trade on a nationally regulated
exchange with centralized clearing and settlement systems, similar in
character to those of the futures and equity option exchange markets.
The regulation of the contracts that remain OTC-traded should be
subject to supervision by a national regulator with jurisdiction to
promulgate rules and standards regarding sound risk management
practices, including those needed to manage counterparty credit risk
and collateral requirements, uniform close-out practices, trade
confirmation and reporting standards, and other regulatory and public
reporting standards that will need to be established to improve market
transparency. For example, OTC dealers may be required to report
selected trade information in a Trade Reporting and Compliance Engine
(TRACE)-style system, which would be made publicly available. OTC
dealers and exchanges should also be required to report information on
large exposures and risk concentrations to a regulatory authority. This
could be modeled in much the same way as futures exchanges regularly
report qualifying exposures to the Commodities Futures Trading
Commission. The reporting system would need to provide information on
concentrations in both short and long positions.
Money Market Mutual Funds
Money market mutual funds (MMMFs) have been shown to be a source of
systemic risk in this crisis. Two similar models of reform have been
suggested. One would place MMMFs under systemic risk regulation, which
would provide permanent access to the discount window and establish a
fee-based insurance fund to prevent losses to investors. The other
approach, offered by the Group of 30, would segment the industry into
MMMFs that offer bank-like services and assurances in maintaining a
stable net asset value (NAV) at par from MMMFs that that have no
explicit or implicit assurances that investors can withdraw funds on
demand at par. Those that operate like banks would be required to
reorganize as special-purpose banks, coming under all bank regulations
and depositor-like protections. But, this last approach will only be
viable if there are restrictions on the size of at-risk MMMFs so that
they do not evolve into too-big-to-fail institutions.
Regulatory Issues
Several issues can be addressed through the regulatory process
including, the originate-to-distribute business model, executive
compensation in banks, fair-value accounting, credit rating agency
reform and counter-cyclical capital policies.
The Originate-To-Distribute Business Model
One of the most important factors driving this financial crisis has
been the decline in value, liquidity and underlying collateral
performance of a wide swath of previously highly rated asset backed
securities. In 2008, over 221,000 rated tranches of private-label
asset-backed securitizations were downgraded. This has resulted in a
widespread loss of confidence in agency credit ratings for securitized
assets, and bank and investor write-downs on their holdings of these
assets.
Many of these previously highly rated securities were never traded
in secondary markets, and were subject to little or no public
disclosure about the characteristics and ongoing performance of
underlying collateral. Financial incentives for short-term revenue
recognition appear to have driven the creation of large volumes of
highly rated securitization product, with insufficient attention to due
diligence, and insufficient recognition of the risks being transferred
to investors. Moreover, some aspects of our regulatory framework may
have encouraged banks and other institutional investors in the belief
that a highly rated security is, per se, of minimal risk.
Today, in a variety of policy-making groups around the world, there
is consideration of ways to correct the incentives that led to the
failure of the originate-to-distribute model. One area of focus relates
to disclosure. For example, rated securitization tranches could be
subject to a requirement for disclosure, in a readily accessible format
on the ratings-agency Web sites, of detailed loan-level characteristics
and regular performance reports. Over the long term, liquidity and
confidence might be improved if secondary market prices and volumes of
asset backed securities were reported on some type of system analogous
to the Financial Industry Regulatory Authority's Trade Reporting and
Compliance Engine that now captures such data on corporate bonds.
Again over the longer term, a more sustainable originate-to-
distribute model might result if originators were required to retain
``skin-in-the-game'' by holding some form of explicit exposure to the
assets sold. This idea has been endorsed by the Group of 30 and is
being actively explored by the European Commission. Some in the United
States have noted that there are implementation challenges of this
idea, such as whether we can or should prevent issuers from hedging
their exposure to their retained interests. Acknowledging these issues
and correcting the problems in the originate-to-distribute model is
very important, and some form of ``skin-in-the-game'' requirement that
goes beyond the past practices of the industry should continue to be
explored.
Executive Compensation In Banks
An important area for reform includes the broad area of correcting
or offsetting financial incentives for short-term revenue recognition.
There has been much discussion of how to ensure financial firms'
compensation systems do not excessively reward a short-term focus at
the expense of longer term risks. I would note that in the Federal
Deposit Insurance Act, Congress gave the banking agencies the explicit
authority to define and regulate safe-and-sound compensation practices
for insured banks and thrifts. Such regulation would be a potentially
powerful tool but one that should be used judiciously to avoid
unintended consequences.
Fair-Value Accounting
Another broad area where inappropriate financial incentives may
need to be addressed is in regard to the recognition of potentially
volatile noncash income or expense items. For example, many problematic
exposures may have been driven in part by the ability to recognize
mark-to-model gains on OTC derivatives or other illiquid financial
instruments. To the extent such incentives drove some institutions to
hold concentrations of illiquid and volatile exposures, they should be
a concern for the safety-and-soundness of individual institutions.
Moreover, such practices can make the system as a whole more subject to
boom and bust. Regulators should consider taking steps to limit such
practices in the future, perhaps by explicit quantitative limits on the
extent such gains could be included in regulatory capital or by
incrementally higher regulatory capital requirements when exposures
exceed specified concentration limits.
For the immediate present, we are faced with a situation where an
institution confronted with even a single dollar of credit loss on its
available-for-sale and held-to-maturity securities, must write down the
security to fair value, which includes not only recognizing the credit
loss, but also the liquidity discount. We have expressed our support
for the idea that FASB should consider allowing institutions facing an
other-than-temporary impairment (OTTI) loss to recognize the credit
loss in earnings but not the liquidity discount. We are pleased that
the Financial Accounting Standards Board this week has issued a
proposal that would move in this direction.
Credit Rating Agency Reform
The FDIC generally agrees with the Group of 30 recommendation that
regulatory policies with regard to Nationally Recognized Securities
Rating Organizations (NRSROs) and the use their ratings should be
reformed. Regulated entities should do an independent evaluation of
credit risk products in which they are investing. NRSROs should
evaluate the risk of potential losses from the full range of potential
risk factors, including liquidity and price volatility. Regulators
should examine the incentives imbedded in the current business models
of NRSROs. For example, an important strand of work within the Basel
Committee on Banking Supervision that I have supported for some time
relates to the creation of operational standards for the use of
ratings-based capital requirements. We need to be sure that in the
future, our capital requirements do not incent banks to rely blindly on
favorable agency credit ratings. Preconditions for the use of ratings-
based capital requirements should ensure investors and regulators have
ready access to the loan level data underlying the securities, and that
an appropriate level of due diligence has been performed.
Counter-Cyclical Capital Policies
At present, regulatory capital standards do not explicitly consider
the stage of the economic cycle in which financial institutions are
operating. As institutions seek to improve returns on equity, there is
often an incentive to reduce capital and increase leverage when
economic conditions are favorable and earnings are strong. However,
when a downturn inevitably occurs and losses arising from credit and
market risk exposures increase, these institutions' capital ratios may
fall to levels that no longer appropriately support their risk
profiles.
Therefore, it is important for regulators to institute counter-
cyclical capital policies. For example, financial institutions could be
required to limit dividends in profitable times to build capital above
regulatory minimums or build some type of regulatory capital buffer to
cover estimated through-the-cycle credit losses in excess of those
reflected in their loan loss allowances under current accounting
standards. Through the Basel Committee on Banking Supervision, we are
working to strengthen capital to raise its resilience to future
episodes of economic and financial stress. Furthermore, we strongly
encourage the accounting standard-setters to revise the existing
accounting model for loan losses to better reflect the economics of
lending activity and enable lenders to recognize credit impairment
earlier in the credit cycle.
Conclusion
The current financial crisis demonstrates the need for changes in
the supervision and resolution of financial institutions, especially
those that are systemically important to the financial system. The
choices facing Congress in this task are complex, made more so by the
fact that we are trying to address problems while the whirlwind of
economic problems continues to engulf us. While the need for some
reforms is obvious, such as a legal framework for resolving
systemically important institutions, others are less clear and we would
encourage a thoughtful, deliberative approach. The FDIC stands ready to
work with Congress to ensure that the appropriate steps are taken to
strengthen our supervision and regulation of all financial
institutions--especially those that pose a systemic risk to the
financial system.
I would be pleased to answer any questions from the Committee.
______
PREPARED STATEMENT OF MICHAEL E. FRYZEL
Chairman,
National Credit Union Administration
March 19, 2009
Introduction
As Chairman of the National Credit Union Administration (NCUA), I
appreciate this opportunity to provide my position on ``Modernizing
Bank Supervision and Regulation.'' Federally insured credit unions
comprise a small but important part of the financial institution
community, and NCUA's perspective on this matter will add to the
overall understanding of the needs of the credit union industry and the
members they serve. \1\
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\1\ 12 U.S.C. 1759. Unlike other financial institutions, credit
unions may only serve individuals within a restricted field of
membership. Other financial institutions serve customers that generally
have no membership interest.
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As NCUA Chairman, I agree with the need for establishing a
regulatory oversight entity (systemic risk regulator) whose
responsibilities would include monitoring the financial institution
regulators and issuing principles-based regulations and guidance. I
envision this entity would be responsible for establishing general
safety and soundness guidance for federal financial regulators under
its control while the individual federal financial regulators would
implement and enforce the established guidelines in the institutions
they regulate. This entity would also monitor systemic risk across
institution types. For this structure to be effective for federally
insured credit unions, the National Credit Union Share Insurance Fund
(NCUSIF) must remain independent of the Deposit Insurance Fund to
maintain the dual regulatory and insurance roles for the NCUA that have
been tested and proven to work in the credit union industry for almost
40 years.
The NCUA's primary mission is to ensure the safety and soundness of
federally insured credit unions. It performs this important public
function by examining all federal credit unions, participating in the
examination and supervision of federally insured state chartered credit
unions in coordination with state regulators, and insuring federally
insured credit union members' accounts. In its statutory role as the
administrator of the NCUSIF, the NCUA insures and supervises 7,806
federally insured credit unions, representing 98 percent of all credit
unions and approximately 88 million members. \2\
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\2\ Approximately 162 state-chartered credit unions are privately
insured and are not subject to NCUA oversight. Based on December 31,
2008, Call Report (NCUA Form 5300) data.
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Overall, federally insured, natural person credit unions maintained
reasonable financial performance in 2008. As of December 31, 2008,
federally insured credit unions maintained a strong level of capital
with an aggregate net worth ratio of 10.92 percent. \3\ While earnings
decreased from prior levels due to the economic downturn, federally
insured credit unions were able to post a 0.30 percent return on
average assets in 2008. \4\ Delinquency was reported at 1.37 percent,
while net charge-offs was 0.84 percent. \5\ Shares in federally insured
credit unions grew at 7.71 percent with membership growing at 2.01
percent, and loans growing at 7.08 percent. \6\
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\3\ Based on December 31, 2008, Call Report (NCUA Form 5300) data.
\4\ Ibid.
\5\ Ibid.
\6\ Ibid.
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Federally Insured Credit Unions Require Separate Oversight
Federally insured credit unions' unique cooperative, not-for-profit
structure and statutory mandate of serving people of modest means
necessitate a customized approach to their regulation and supervision.
The NCUA should remain an independent agency to preserve the credit
union model and protect credit union members as mandated by Congress.
An agency responsible for all financial institutions might focus on the
larger financial institutions where the systemic risk predominates,
potentially to the detriment of smaller federally insured credit
unions. As federally insured credit unions are generally the smaller,
less complex institutions in a consolidated financial regulator
arrangement, the unique character of credit unions would quickly be
lost, absorbed by the for-profit model and culture of the banking
system.
Federally insured credit unions fulfill a specialized role in the
domestic marketplace; one that Congress acknowledged is important in
assuring consumers have access to basic financial services such as
savings and affordable credit products. Loss of federally insured
credit unions as a type of financial institution would limit access to
these affordable financial services for persons of modest means.
Federally insured credit unions serve an important competitive check on
for-profit institutions by providing low-cost products and services.
Some researchers estimate the competitive presence of credit unions
save bank customers $4.3 billion annually. \7\ Research also shows that
in many markets, credit unions provide a lower cost alternative to
abusive and predatory lenders. The research describes the fees, rates,
and terms of the largest United States credit card providers in
comparison to credit cards issued by credit unions with similar
purchase interest rates but with fewer fees, lower fees, lower default
rates, and clearer disclosures. The details of credit union credit card
programs show credit card lending is sustainable without exorbitant
penalties and misleading terms and conditions. \8\
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\7\ An Estimate of the Influence of Credit Unions on Bank CD and
Money Market Deposits in the U.S.--Idaho State University, January
2005. Also, An Analysis of the Benefits of Credit Unions to Bank Loan
Customers--American University, January 2005.
\8\ Blindfolded Into Debt: A Comparison of Credit Card Costs and
Conditions at Banks and Credit Unions. The Woodstock Institute, July
2005.
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Federally insured credit unions provide products geared to the
modest consumer at a reasonable price, such as very small loans and
low-minimum balance savings products that many banks do not offer.
Credit unions enter markets that other financial institutions have not
entered or abandoned because these markets were not profitable or there
were more lucrative markets to pursue. \9\ Loss of credit unions would
reduce service to underserved consumers and hinder outreach and
financial literacy efforts.
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\9\ Increase in Bank Branches Shortchanges Lower-Income and
Minority Communities: An Analysis of Recent Growth in Chicago Area Bank
Branching. The Woodstock Institute, February 2005, Number 27.
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When comparing the size and complexity of federally insured credit
unions to banks, even the largest federally insured credit unions are
small in comparison. As shown in the graph below, small federally
insured credit unions make up the majority of the institutions the NCUA
insures.
Eighty-four percent of federally insured credit unions have less
than $100 million in assets as opposed to 38 percent of the
institutions that the Federal Deposit Insurance Corporation (FDIC)
insures with the same asset size. \10\ Total assets in the entire
federally insured credit union industry are less than the individual
total assets of some of the nation's largest banks. \11\
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\10\ FDIC Quarterly Banking Profile--Fourth Quarter 2008.
\11\ December 31, 2008, total assets for federally insured credit
unions equaled $813.44 billion, while total assets for federally
insured banks equaled $13.85 trillion. Based on December 31, 2008, Call
Report (NCUA Form 5300) data and FDIC Quarterly Banking Profile--Fourth
Quarter 2008.
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Specialized Supervision
In recognition of the importance of small federally insured credit
unions to their memberships, the NCUA established an Office of Small
Credit Union Initiatives to foster credit union development,
particularly in the expansion of services provided by small federally
insured credit unions to all eligible members. Special purpose programs
have helped preserve the viability of several institutions by providing
access to training, grant assistance, and mentoring. \12\
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\12\ NCUA 2007 Annual Report.
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The NCUA has developed expertise to effectively supervise federally
insured credit unions. The agency has a highly trained examination
force that understands the intricacies and nuances of federally insured
credit unions and their operations.
The NCUA's mission includes serving and maintaining a safe, secure
credit union community. In order to accomplish this, the NCUA has put
in place specialized programs such as the National Examination Team to
supervise federally insured credit unions showing a higher risk to the
NCUSIF, Subject Matter Examiners to address specific areas of risk, and
Economic Development Specialists to provide hands-on assistance to
small federally insured credit unions.
NCUA's Tailored Guidance Approach
The systemic risk regulator would set the general safety and
soundness guidelines, while the NCUA would monitor and enforce the
specific rules for the federally insured credit union industry. For
example, the NCUA has long recognized the safety and soundness issues
regarding real estate lending. Real estate lending makes up fifty-four
percent of federally insured credit unions' lending portfolio. As a
result, the NCUA has provided federally insured credit unions detailed
guidance regarding this matter. The below chart outlines the regulatory
approach taken with real estate lending.
As demonstrated by the guidance issued, the NCUA proactively
addresses issues with the industry as they evolve and as they
specifically apply to federally insured credit unions. Due to federally
insured credit unions' unique characteristics, the NCUA should be
maintained as a separate regulator under an overseeing entity to ensure
the vital sector of federally insured credit unions is not ``lost in
the shuffle'' of the financial institution industry as a whole.
Maintain Separate Insurance Fund
Funds from federally insured credit unions have established the
NCUSIF. The required deposit is calculated at least annually at one
percent of each federally insured credit union's insured shares. The
fund is commensurate with federally insured credit unions' equity
interests and the risk level in the industry. The small institutions
that make up the vast majority of federally insured credit unions
should not be required to pay for the risk taken on by the large
conglomerates. The NCUA has a successful record of regulating federal
credit union charters and also serving as insurer for all federally
insured credit unions. This structure has stood the test of time,
encompassing various adverse economic cycles. The NCUA is the only
regulator with this 100 percent dual regulator/insurer role. The
overall reporting to a single regulatory body creates a level of
efficiency for federally chartered credit unions in managing the
regulatory relationship. This unique role has allowed the NCUA to
develop economies of scale as a federal agency.
The July 1991 Government Accountability Office (GAO) report to
Congress considered whether NCUA's insurance function should be
separated from the other functions of chartering, regulating, and
supervising credit unions. The GAO concluded ``[s]eparation of NCUSIF
from NCUA's chartering, regulation, and supervision responsibilities
would not, on the basis of their analyses, by itself guarantee either
strong supervision or insurance fund health. And such a move could
result in additional and duplicative oversight costs. In addition, it
could be argued that a regulator/supervisor without insurance
responsibility has less incentive to concern itself with the insurance
costs, should an institution fail.'' \16\
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\16\ GAO, July 1991 Study.
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The 1997 Treasury study reached conclusions similar to the GAO
report. The Treasury study discussed the unique capitalization
structure of the NCUSIF and how it fits the cooperative nature of
federally insured credit unions and offered the following: \17\
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\17\ Treasury, December 1997 Study of Credit Unions.
We found no compelling case for removing the Share Insurance
Fund from the NCUA's oversight and transferring it to another
federal agency such as the FDIC. The NCUA maintains some level
of separation between its insurance activities and its other
responsibilities by separating the operating costs of the Fund
from its noninsurance expenses. \18\
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\18\ Treasury, December 1997 Study of Credit Unions, page 52.
Under the current structure, the NCUA can use supervision to
control risks taken by credit unions--providing an additional
measure of protection for the Fund. We also believe that
separating the Fund from the NCUA could: (1) reduce the
regulator's incentives to concern itself with insurance costs,
should an institution fail; (2) create possible confusion over
the roles and responsibilities of the insurer and of the
regulator; and (3) place the insurer in the situation of
safeguarding the insurance fund without having control over the
risks taken by the insured entities. \19\
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\19\ Ibid, page 52.
The financing structure of the Share Insurance Fund fits the
cooperative character of credit unions. Because credit unions
must expense any losses to the Share Insurance Fund, they have
an incentive to monitor each other and the Fund. This financing
structure makes transparent the financial support that
healthier credit unions give to the members of failing credit
unions. Credit unions understand this aspect of the Fund and
embrace it as a reflection of their cooperative character. \20\
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\20\ Ibid, page 58.
The unique dual regulatory role in which the NCUA operates has
proven successful in the credit union industry. At no time under this
structure has the credit union system cost the American taxpayers any
money.
Federally Insured Credit Unions Demonstrate Unique Characteristics
Federally insured credit unions are unique financial institutions
that exist to serve the needs of their members. The statutory and
regulatory frameworks in which federally insured credit unions operate
reflect their uniqueness and are significantly different from that of
other financial institutions. Comments that follow in this section
provide specific examples for federal credit unions. However, most of
the examples also apply to federally insured state chartered credit
unions because of their similar organization as institutions designed
to promote thrift. \21\
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\21\ 12 U.S.C. 1781(c)(1)(E).
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One Member One Vote
The federal credit union charter is the only federal financial
charter in the United States that gives every member an equal voice in
how their institution is operated regardless of the amount of shares on
deposit with its ``one member, one vote'' cooperative structure. \22\
This option allows federal credit unions to be democratically governed.
The federal credit union charter provides an important pro-consumer
alternative in the financial services industry.
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\22\ 12 U.S.C. 1760.
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Field of Membership
Federal credit unions are not-for-profit, member-owned cooperatives
that exist to provide their members with the best possible rates and
service. A federal credit union is chartered to serve a field of
membership that shares a common bond such as the employees of a
company, members of an association, or a local community. Therefore,
federal credit unions may not serve the general public like other
financial institutions and the federal credit unions' activities are
largely limited to domestic activities, which has minimized the impact
of globalization in the federal credit union industry. Due to this
defined and limited field of membership, federal credit unions have
less ability to grow into large institutions as demonstrated by 84
percent of federally insured credit unions having less than $100
million in assets. \23\
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\23\ Based on December 31, 2008, Call Report (NCUA Form 5300)
data.
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Volunteer Board of Directors
Federal credit unions are managed largely on a volunteer basis. The
board of directors for each federal credit union consists of a
volunteer board of directors elected by, and from the membership. \24\
By statute, no member of the board may be compensated as such; however,
a federal credit union may compensate one individual who serves as an
officer of the board. \25\
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\24\ 12 U.S.C. 1761(a).
\25\ 12 U.S.C. 1761(c).
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Consumer Protection
The Federal Credit Union Act requires federal credit union boards
of directors to appoint not less than three members or more than five
members to serve as members of the supervisory committee. \26\ The
purpose of the supervisory committee is to ensure independent oversight
of the board of directors and management and to advocate the best
interests of the members. The supervisory committee either performs or
contracts with a third-party to perform an annual audit of the federal
credit union's books and records. \27\ The supervisory committee also
plays an important role as the member advocate.
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\26\ 12 U.S.C. 1761b.
\27\ 12 U.S.C. 1761d.
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As the member advocate, the supervisory committee is charged with
reviewing member complaints. \28\ Complaints cover a broad spectrum of
areas, including annual meeting procedures, dividend rates and terms,
and credit union services. Regardless of the nature of the complaint,
NCUA requires supervisory committees to conduct a full and complete
investigation. When addressing member complaints, supervisory
committees will determine the appropriate course of action after
thoroughly reviewing the unique circumstances surrounding each
complaint. \29\
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\28\ As noted in the preamble of final rule incorporating the
standard federal credit union bylaws into NCUA Rules and Regulations
Part 701.
\29\ Supervisory Committee Guide, Chapter 4, Publication 4017/8023
Revised December 1999.
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This committee and function of member advocacy are unique to
federal credit unions. No member of the supervisory committee can be
compensated. \30\
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\30\ 12 U.S.C. 1761.
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Regulatory Limitations
While there have been significant changes in the financial services
environment since 1934 when the Federal Credit Union Act was
implemented, federal credit unions have only had modest gains in the
breadth of services offered relative to the broad authorities and
services of other financial institutions. By virtue of their enabling
legislation along with regulations established by the NCUA, federal
credit unions are more restricted in their operation than other
financial institutions. A discussion of some of these limitations
follows.
Investment Limitations
Federal credit unions have relatively few permissible investment
options. Investments are largely limited to United States debt
obligations, federal government agency instruments, and insured
deposits. \31\ Federal credit unions cannot invest in a diverse range
of higher yielding products, including commercial paper and corporate
debt securities. Also, federal credit unions have limited authority for
broker-dealer relationships. \32\ These limitations have helped credit
unions weather the current economic downturn.
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\31\ NCUA Rules and Regulations Part 703.
\32\ NCUA Rules and Regulations Part 703.
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Affiliation Limitations
Federal credit unions are much more limited than other financial
institutions in the types of businesses in which they engage and in the
kinds of affiliates with which they deal. Federal credit unions cannot
invest in the shares of an insurance company or control another
financial depository institution. Also, they cannot be part of a
financial services holding company and become affiliates of other
depository institutions or insurance companies. Federal credit unions
are limited to only the powers established in the Federal Credit Union
Act. \33\
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\33\ 12 U.S.C. 1757.
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Capital Limitations
Unlike other financial institutions, federal credit unions cannot
issue stock to raise additional capital. \34\ Also, federal credit
unions have borrowing authority limited to 50 percent of paid-in and
unimpaired capital and surplus. \35\
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\34\ 12 U.S.C. 1790d(b)(1)(B)(i).
\35\ 12 U.S.C. 1757(9).
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A federal credit union can only build net worth through its
retained earnings, unless it is a low-income designated credit union
that can accept secondary capital contributions. \36\ Federally insured
credit unions must also hold 200 basis points more in capital than
other federally insured financial institutions in order to be
considered ``well-capitalized'' under federal ``Prompt Corrective
Action'' laws. \37\ In addition, federal credit unions must transfer
their earnings to net worth and loss reserve accounts or distribute it
to their membership through dividends, relatively lower loan rates, or
relatively lower fees.
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\36\ 12 U.S.C. 1790d(o)(2)(B).
\37\ 12 U.S.C. 1790d.
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Lending Limitations
Federal credit unions are not permitted to charge a prepayment
penalty in any type of loan whether consumer or business. \38\ With the
exception of certain consumer mortgage loans, federal credit unions
cannot make loans with a maturity greater than 15 years. \39\ Also,
federal credit unions are subject to a federal statutory usury,
currently set at 18 percent, which is unique among federally chartered
financial institutions and far more restrictive than state usury laws.
\40\
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\38\ 12 U.S.C. 1757(5)(viii).
\39\ 12 U.S.C. 1757(5).
\40\ 12 U.S.C. 1757(5)(A)(vi).
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While federal credit unions have freedom in making consumer and
mortgage loans to members, except with regard to limits to one borrower
and loan-to-value restrictions, they are severely restricted in the
kind and amount of member business loans they can underwrite. Some
member business lending limits include restrictions on the total amount
of loans, loan to value requirements, construction loan limits, and
maturity limits. \41\
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\41\ 12 U.S.C. 1757a and NCUA Rules and Regulations Part 723.
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Access to Credit
Despite regulatory constraints, federally insured credit unions
continue to follow their mission of providing credit to persons of
modest means. Amid the tightening credit situation facing the nation,
federally insured credit unions have continued to fulfill their
members' borrowing needs. While other types of lenders severely
curtailed credit, federally insured credit unions experienced a 7.08
percent loan growth in 2008.
Credit unions remain fundamentally different from other forms of
financial institutions based on their member-owned, democratically
operated, not-for-profit cooperative structure. Loss of credit unions
as a type of financial institution would severely limit the access to
financial services for many Americans.
Regulatory Framework Recommendation
I agree with the need for establishing a regulatory oversight
entity to help mitigate risk to our nation's financial system. It is my
recommendation that Congress maintain multiple financial regulators and
charter options to enable the continued checks and balances such a
structure produces. The oversight entity's main functions should be to
establish broad safety and soundness principles and then monitor the
individual financial regulators to ensure the established principles
are implemented. This structure also allows the oversight entity to set
objective-based standards in a more proactive manner, and would help
alleviate competitive conflict detracting from the resolution of
economic downturns. This type of structure would also promote
uniformity in the supervision of financial institutions while affording
the preservation of the different segments of the financial industry,
including the credit union industry.
Conclusions
Federally insured credit union service remains focused on providing
basic and affordable financial services to members. Credit unions are
an important, but relatively small, segment of the financial
institution industry serving a unique niche. \42\ As a logical
extension to this, the NCUSIF, which is funded by the required
insurance contributions of federally insured credit unions, should be
kept separate from any bank insurance fund. This would maintain an
appropriate level of diversification in the financial system.
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\42\ As of December 31, 2008, approximately $14.67 trillion in
assets were held in federally insured depository institutions. Banks
and other savings institutions insured by the FDIC held $13.85
trillion, or 94.44 percent of these assets. Credit unions insured by
the NCUSIF held $813.44 billion, or 5.56 percent of all federally
insured assets.
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While the NCUA could be supportive of a regulatory oversight
entity, the agency should maintain its dual regulatory functions of
regulator and insurer in order to ensure the federally insured credit
union segment of the financial industry is preserved.
______
PREPARED STATEMENT OF DANIEL K. TARULLO
Member,
Board of Governors of the Federal Reserve System
March 19, 2009
Chairman Dodd, Ranking Member Shelby, and other Members of the
Committee, I appreciate this opportunity to present the views of the
Federal Reserve Board on the important issue of modernizing financial
supervision and regulation.
For the last year and a half, the U.S. financial system has been
under extraordinary stress. Initially, this financial stress
precipitated a sharp downturn in the U.S. and global economies. What
has ensued is a very damaging negative feedback loop: The effects of
the downturn--rising unemployment, declining profits, and decreased
consumption and investment--have exacerbated the problems of financial
institutions by reducing further the value of their assets. The
impaired financial system has, in turn, been unable to supply the
credit needed by households and businesses alike.
The catalyst for the current crisis was a broad-based decline in
housing prices, which has contributed to substantial increases in
mortgage delinquencies and foreclosures and significant declines in the
value of mortgage-related assets. However, the mortgage sector is just
the most visible example of what was a much broader credit boom, and
the underlying causes of the crisis run deeper than the mortgage
market. They include global imbalances in savings and capital flows,
poorly designed financial innovations, and weaknesses in both the risk-
management systems of financial institutions and the government
oversight of such institutions.
While stabilizing the financial system to set the stage for
economic recovery will remain its top priority in the near term, the
Federal Reserve has also begun to evaluate regulatory and supervisory
changes that could help reduce the incidence and severity of future
financial crises. Today's Committee hearing is a timely opportunity for
us to share our thinking to date and to contribute to your
deliberations on regulatory modernization legislation.
Many conclusions can be drawn from the financial crisis and the
period preceding it, ranging across topics as diverse as capital
adequacy requirements, risk measurement and management at financial
institutions, supervisory practices, and consumer protection. In the
Board's judgment, one of the key lessons is that the United States must
have a comprehensive strategy for containing systemic risk. This
strategy must be multifaceted and involve oversight of the financial
system as a whole, and not just its individual components, in order to
improve the resiliency of the system to potential systemic shocks. In
pursuing this strategy, we must ensure that the reforms we enact now
are aimed not just at the causes of our current crisis, but at other
sources of risk that may arise in the future.
Systemic risk refers to the potential for an event or shock
triggering a loss of economic value or confidence in a substantial
portion of the financial system, with resulting major adverse effects
on the real economy. A core characteristic of systemic risk is the
potential for contagion effects. Traditionally, the concern was that a
run on a large bank, for example, would lead not only to the failure of
that bank, but also to the failure of other financial firms because of
the combined effect of the failed bank's unpaid obligations to other
firms and market uncertainty as to whether those or other firms had
similar vulnerabilities. In fact, most recent episodes of systemic risk
have begun in markets, rather than through a classic run on a bank. A
sharp downward movement in asset prices has been magnified by certain
market practices or vulnerabilities. Soon market participants become
uncertain about the values of those assets, an uncertainty that spreads
to other assets as liquidity freezes up. In the worst case, liquidity
problems become solvency problems. The result has been spillover
effects both within the financial sector and from the financial sector
to the real economy.
In my remarks, I will discuss several components of a broad policy
agenda to address systemic risk: consolidated supervision, the
development of a resolution regime for systemically important nonbank
financial institutions; more uniform and robust authority for the
prudential supervision of systemically important payment and settlement
systems; consumer protection; and the potential benefits of charging a
governmental entity with more express responsibility for monitoring and
addressing systemic risks in the financial system. In elaborating this
agenda, I will both discuss the actions the Federal Reserve is taking
under existing authorities and identify areas in which we believe
legislation is needed.
Effective Consolidated Supervision of Systemically Important Firms
For the reasons I have just stated, supervision of individual
financial firms is not a sufficient condition for fostering financial
stability. But it is surely a necessary condition. Thus a first
component of an agenda for systemic risk regulation is that each
systemically important financial firm be subject to effective
consolidated supervision. This means ensuring both that regulatory
requirements apply to each such firm and that the consequent
supervision is effective.
As to the issue of effectiveness, many of the current problems in
the banking and financial system stem from risk-management failures at
a number of financial institutions, including some firms under federal
supervision. Clearly, these lapses are unacceptable. The Federal
Reserve has been involved in a number of exercises to understand and
document the risk-management lapses and shortcomings at major financial
institutions, including those undertaken by the Senior Supervisors
Group, the President's Working Group on Financial Markets, and the
multinational Financial Stability Forum. \1\
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\1\ See Senior Supervisors Group (2008), ``Observations on Risk
Management Practices during the Recent Market Turbulence'' March 6,
www.newyorkfed.org/newsevents/news/banking/2008/
SSG_Risk_Mgt_doc_final.pdf; President's Working Group on Financial
Markets (2008), ``Policy Statement on Financial Market Developments,''
March 13, www.treas.gov/press/releases/reports/
pwgpolicystatemktturmoil_03122008.pdf; and Financial Stability Forum
(2008), ``Report of the Financial Stability Forum on Enhancing Market
and Institutional Resilience,'' April 7, www.fsforum.org/publications/
FSF_Report_to_G7_11_April.pdf.
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Based on the results of these and other efforts, the Federal
Reserve is taking steps to improve regulatory requirements and risk
management at regulated institutions. Our actions have covered
liquidity risk management, capital planning and capital adequacy, firm-
wide risk identification, residential lending, counterparty credit
exposures, and commercial real estate. Liquidity and capital have been
given special attention.
The crisis has undermined previous conventional wisdom that a
company, even in stressed environments, may readily borrow funds if it
can offer high-quality collateral. For example, the inability of Bear
Stearns to borrow even against U.S. government securities helped cause
its collapse. As a result, we have been working to bring about needed
improvements in institutions' liquidity risk-management practices.
Along with our U.S. supervisory colleagues, we are closely monitoring
the liquidity positions of banking organizations--on a daily basis for
the largest and most critical firms--and are discussing key market
developments and our supervisory analyses with senior management. We
use these analyses and findings from examinations to ensure that
liquidity and funding management, as well as contingency funding plans,
are sufficiently robust and incorporate various stress scenarios.
Looking beyond the present period, we also have underway a broader-
ranging examination of liquidity requirements.
Similarly, the Federal Reserve is closely monitoring the capital
levels of banking organizations on a regular basis and discussing our
evaluation with senior management. As part of our supervisory process,
we have been conducting our own analysis of loss scenarios to
anticipate the potential future capital needs of institutions. These
needs may arise from, among other things, future losses or the
potential for off-balance-sheet exposures and assets to come on balance
sheet. Here, too, we have been discussing our analyses with bankers and
ensuring that their own internal analyses reflect a broad range of
scenarios and capture stress environments that could impair solvency.
We have intensified efforts to evaluate firms' capital planning and to
bring about improvements where needed.
Going forward, we will need changes in the capital regime as the
financial environment returns closer to normal conditions. Working with
other domestic and foreign supervisors, we must strengthen the existing
capital rules to achieve a higher level and quality of required
capital. Institutions should also have to establish strong capital
buffers above current regulatory minimums in good times, so that they
can weather financial market stress and continue to meet customer
credit needs. This is but one of a number of important ways in which
the current pro-cyclical features of financial regulation should be
modified, with the aim of counteracting rather than exacerbating the
effects of financial stress. Finally, firms whose failure would pose a
systemic risk must be subject to especially close supervisory oversight
of their risk-taking, risk management, and financial condition, and be
held to high capital and liquidity standards.
Turning to the reach of consolidated supervision, the Board
believes there should be statutory coverage of all systemically
important financial firms--not just those affiliated with an insured
bank as provided for under the Bank Holding Company Act of 1956 (BHC
Act). The current financial crisis has highlighted a fact that had
become more and more apparent in recent years--that risks to the
financial system can arise not only in the banking sector, but also
from the activities of financial firms that traditionally have not been
subject to the type of consolidated supervision applied to bank holding
companies. For example, although the Securities and Exchange Commission
(SEC) had authority over the broker-dealer and other SEC-registered
units of Bear Stearns and the other large investment banks, it did not
have statutory authority to supervise the diversified operations of
these firms on a consolidated basis. Instead, the SEC was forced to
rely on a voluntary regime for monitoring and addressing the capital
and liquidity risks arising from the full range of these firms'
operations.
In contrast, all holding companies that own a bank--regardless of
size--are subject to consolidated supervision for safety and soundness
purposes under the BHC Act. \2\ A robust consolidated supervisory
framework, like the one embodied in the BHC Act, provides a supervisor
the tools it needs to understand, monitor and, when appropriate,
restrain the risks associated with an organization's consolidated or
group-wide activities. These tools include the authority to establish
consolidated capital requirements for the organization, obtain reports
from and conduct examinations of the organization and any of its
subsidiaries, and require the organization or its subsidiaries to alter
their risk-management practices or take other actions to address risks
that threaten the safety and soundness of the organization.
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\2\ Through the exploitation of a loophole in the BHC Act, certain
investment banks, as well as other financial and nonfinancial firms,
acquired control of a federally insured industrial loan company (ILC)
while avoiding the prudential framework that Congress established for
the corporate owners of other full-service insured banks. For the
reasons discussed in prior testimony before this Committee, the Board
continues to believe that this loophole in current law should be
closed. See Testimony of Scott G. Alvarez, General Counsel of the
Board, before the Committee on Banking, Housing, and Urban Affairs,
U.S. Senate, Oct. 4, 2007.
---------------------------------------------------------------------------
Application of a similar regime to systemically important financial
institutions that are not bank holding companies would help promote the
safety and soundness of these firms and the stability of the financial
system generally. It also is worth considering whether a broader
application of the principle of consolidated supervision would help
reduce the potential for risk taking to migrate from more-regulated to
less-regulated parts of the financial sector. To be fully effective,
consolidated supervisors must have clear authority to monitor and
address safety and soundness concerns in all parts of an organization.
Accordingly, specific consideration should be given to modifying the
limits currently placed on the ability of consolidated supervisors to
monitor and address risks at an organization's functionally regulated
subsidiaries.
Improved Resolution Processes
The importance of extending effective consolidated supervision to
all systemically important firms is, of course, linked to the
perception of market participants that such firms will be considered
too-big-to-fail, and will thus be supported by the government if they
get into financial difficulty. This perception has obvious undesirable
effects, including possible moral hazard effects if firms are able to
take excessive risks because of market beliefs that they can fall back
on government assistance. In addition to effective supervision of these
firms, the United States needs improved tools to allow the orderly
resolution of systemically important nonbank financial firms, including
a mechanism to cover the costs of the resolution if government
assistance is required to prevent systemic consequences. In most cases,
federal bankruptcy laws provide an appropriate framework for the
resolution of nonbank financial institutions. However, this framework
does not sufficiently protect the public's strong interest in ensuring
the orderly resolution of nondepository financial institutions when a
failure would pose substantial systemic risks.
Developing appropriate resolution procedures for potentially
systemic financial firms, including bank holding companies, is a
complex and challenging task that will take some time to complete. We
can begin, however, by learning from other models, including the
process currently in place under the Federal Deposit Insurance Act
(FDIA) for dealing with failing insured depository institutions and the
framework established for Fannie Mae and Freddie Mac under the Housing
and Economic Recovery Act of 2008. Both models allow a government
agency to take control of a failing institution's operations and
management, act as conservator or receiver for the institution, and
establish a ``bridge'' institution to facilitate an orderly sale or
liquidation of the firm. The authority to ``bridge'' a failing
institution through a receivership to a new entity reduces the
potential for market disruption, limits the value-destruction impact of
a failure, and--when accompanied by haircuts on creditors and
shareholders--mitigates the adverse impact of government intervention
on market discipline.
Any new resolution regime would need to be carefully crafted. For
example, clear guidelines are needed to define which firms could be
subject to the new, alternative regime and the process for invoking
that regime, analogous perhaps to the procedures for invoking the so
called systemic risk exception under the FDIA. In addition, given the
global operations of many large and diversified financial firms and the
complex regulatory structures under which they operate, any new
resolution regime must be structured to work as seamlessly as possible
with other domestic or foreign insolvency regimes that might apply to
one or more parts of the consolidated organization.
In addition to developing an alternative resolution regime for
systemically critical financial firms, policymakers and experts should
carefully review whether improvements can be made to the existing
bankruptcy framework that would allow for a faster and more orderly
resolution of financial firms generally. Such improvements could reduce
the likelihood that the new alternative regime would need to be invoked
or government assistance provided in a particular instance to protect
financial stability and, thereby, could promote market discipline.
Oversight of Payment and Settlement Systems
As suggested earlier, a comprehensive strategy for controlling
systemic risk must focus not simply on the stability of individual
firms. Another element of such a strategy is to provide close oversight
of important arenas in which firms interact with one another. Payment
and settlement systems are the foundation of our financial
infrastructure. Financial institutions and markets depend upon the
smooth functioning of these systems and their ability to manage
counterparty and settlement risks effectively. Such systems can have
significant risk-reduction benefits--by improving counterparty credit
risk management, reducing settlement risks, and providing an orderly
process to handle participant defaults--and can improve transparency
for participants, financial markets, and regulatory authorities. At the
same time, these systems inherently centralize and concentrate clearing
and settlement risks. Thus, if a system is not well designed and able
to appropriately manage the risks arising from participant defaults or
operational disruptions, significant liquidity or credit problems could
result.
Well before the current crisis erupted, the Federal Reserve was
working to strengthen the financial infrastructure that supports
trading, payments, clearing, and settlement in key financial markets.
Because this infrastructure acts as a critical link between financial
institutions and markets, ensuring that it is able to withstand--and
not amplify--shocks is an important aspect of reducing systemic risk,
including the very real problem of institutions that are too big or
interconnected to be allowed to fail in a disorderly manner.
The Federal Reserve Bank of New York has been leading a major joint
initiative by the public and private sectors to improve arrangements
for clearing and settling credit default swaps (CDS) and other over-
the-counter (OTC) derivatives. As a result, the accuracy and timeliness
of trade information has improved significantly. In addition, the
Federal Reserve, working with other supervisors through the President's
Working Group on Financial Markets, has encouraged the development of
well-regulated and prudently managed central clearing counterparties
for OTC trades. Along these lines, the Board has encouraged the
development of two central counterparties for CDS in the United
States--ICE Trust and the Chicago Mercantile Exchange. In addition, in
2008, the Board entered into a memorandum of understanding with the SEC
and the Commodity Futures Trading Commission to promote the application
of common prudential standards to central counterparties for CDS and to
facilitate the sharing of information among the agencies with respect
to such central counterparties. The Federal Reserve also is consulting
with foreign financial regulators regarding the development and
oversight of central counterparties for CDS in other jurisdictions to
promote the application of consistent prudential standards.
The New York Federal Reserve Bank, in conjunction with other
domestic and foreign supervisors, continues its effort to establish
increasingly stringent targets and performance standards for OTC market
participants. In addition, we are working with market participants to
enhance the resilience of the triparty repurchase agreement (repo)
market. Through this market, primary dealers and other major banks and
broker-dealers obtain very large amounts of secured financing from
money market mutual funds and other short-term, risk-averse investors.
\3\ We are exploring, for example, whether a central clearing system or
other improvements might be beneficial for this market, given the
magnitude of exposures generated and the vital importance of the market
to both dealers and investors.
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\3\ Primary dealers are broker-dealers that trade in U.S.
government securities with the Federal Reserve Bank of New York. The
New York Reserve Bank's Open Market Desk engages in trades on behalf of
the Federal Reserve System to implement monetary policy.
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Even as we pursue these and similar initiatives, however, the Board
believes additional statutory authority is needed to address the
potential for systemic risk in payment and settlement systems.
Currently, the Federal Reserve relies on a patchwork of authorities,
largely derived from our role as a banking supervisor, as well as on
moral suasion to help ensure that critical payment and settlement
systems have the necessary procedures and controls in place to manage
their risks. By contrast, many major central banks around the world
have an explicit statutory basis for their oversight of these systems.
Given how important robust payment and settlement systems are to
financial stability, and the functional similarities between many
payment and settlement systems, a good case can be made for granting
the Federal Reserve explicit oversight authority for systemically
important payment and settlement systems.
The Federal Reserve has significant expertise regarding the risks
and appropriate risk management practices at payment and settlement
systems, substantial direct experience with the measures necessary for
the safe and sound operation of such systems, and established working
relationships with other central banks and regulators that we have used
to promote the development of strong and internationally accepted risk
management standards for the full range of these systems. Providing
such authority would help ensure that these critical systems are held
to consistent and high prudential standards aimed at mitigating
systemic risk.
Consumer Protection
Another lesson of this crisis is that pervasive consumer protection
problems can signal, and even lead to, trouble for the safety and
soundness of financial institutions and for the stability of the
financial system as a whole. Consumer protection in the area of
financial services is not, and should not be, limited to practices with
potentially systemic consequences. However, as we evaluate the range of
measures that can help contain systemic problems, it is important to
recognize that good consumer protection can play a supporting role by--
among other things--promoting sound underwriting practices.
Last year the Board adopted new regulations under the Home
Ownership and Equity Protection Act to enhance the substantive
protections provided high-cost mortgage customers, such as requiring
tax and insurance escrows in certain cases and limiting the use of
prepayment penalties. These rules also require lenders providing such
high-cost loans to verify the income and assets of a loan applicant and
prohibit lenders from making such a loan without taking into account
the ability of the borrower to repay the loan from income or assets
other than the home's value. More recently, the Board adopted new rules
to protect credit card customers from a variety of unfair and deceptive
acts and practices. The Board will continue to update its consumer
protection regulations as appropriate to provide households with the
information they need to make informed credit decisions and to address
new unfair and deceptive practices that may develop as practices and
products change.
Systemic Risk Authority
One issue that has received much attention recently is the possible
benefit of establishing a systemic risk authority that would be charged
with monitoring, assessing and, if necessary, curtailing systemic risks
across the entire U.S. financial system.
At a conceptual level, expressly empowering a governmental
authority with responsibility to help contain systemic risks should, if
implemented correctly, reduce the potential for large adverse shocks
and limit the spillover effects of those shocks that do occur, thereby
enhancing the resilience of the financial system. However, no one
should underestimate the challenges involved with developing or
implementing a supervisory and regulatory program for systemic risks.
Nor should the establishment of such an authority be viewed as a
panacea that will eliminate periods of significant stress in the
financial markets and so reduce the need for the other important
reforms that I have discussed.
The U.S. financial sector is extremely large and diverse--with
value added amounting to nearly $1.1 trillion or 8 percent of gross
domestic product in 2007. Systemic risks may arise across a broad range
of firms or markets, or they may be concentrated in just a few key
institutions or activities. They can occur suddenly, such as from a
rapid and substantial decline in asset prices, even if the probability
of their occurrence builds up slowly over time. Moreover, as the
current crisis has illustrated, systemic risks may arise at nonbank
entities (for example, mortgage brokers), from sectors outside the
traditional purview of federal supervision (for example, insurance
firms), from institutions or activities that are based in other
countries or operate across national boundaries, or from the linkages
and interdependencies among financial institutions or between financial
institutions and markets. And, while the existence of systemic risks
may be apparent in hindsight, identifying such risks ex ante and
determining the proper degree of regulatory or supervisory action
needed to counteract a particular risk without unnecessarily hampering
innovation and economic growth is a very challenging assignment for any
agency or group of agencies. \4\
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\4\ For example, while the existence of supranormal profits in a
market segment may be an indicator of supranormal risks, it also may be
the result of innovation on the part of one or more market participants
that does not create undue risks to the system.
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For these reasons, any systemic risk authority would need a
sophisticated, comprehensive and multi-disciplinary approach to
systemic risk. Such an authority likely would require knowledge and
experience across a wide range of financial institutions and markets,
substantial analytical resources to identify the types of information
needed and to analyze the information obtained, and supervisory
expertise to develop and implement the necessary supervisory programs.
To be effective, however, these skills would have to be combined
with a clear statement of expectations and responsibilities, and with
adequate powers to fulfill those responsibilities. While the systemic
risk authority should be required to rely on the information,
assessments, and supervisory and regulatory programs of existing
financial supervisors and regulators whenever possible, it would need
sufficient powers of its own to achieve its broader mission--monitoring
and containing systemic risk. These powers likely would include broad
authority to obtain information--through data collection and reports,
or when necessary, examinations--from a range of financial market
participants, including banking organizations, securities firms, key
financial market intermediaries, and other financial institutions that
currently may not be subject to regular federal supervisory reporting
requirements.
How might a properly constructed systemic risk authority use its
expertise and authorities to help monitor, assess, and mitigate
potentially systemic risks within the financial system? There are
numerous possibilities. One area of natural focus for a systemic risk
authority would be the stability of systemically critical financial
institutions. It also likely would need some role in the setting of
standards for capital, liquidity, and risk-management practices for
financial firms, given the importance of these matters to the aggregate
level of risk within the financial system. By bringing its broad
knowledge of the interrelationships between firms and markets to bear,
the systemic risk authority could help mitigate the potential for
financial firms to be a source of, or be negatively affected by,
adverse shocks to the system.
It seems most sensible that the role of the systemic risk authority
be to complement, not displace, that of a firm's consolidated
supervisor (which, as I noted earlier, all systemically critical
financial institutions should have). Under this model, the firm's
consolidated supervisor would continue to have primary responsibility
for the day-to-day supervision of the firm's risk management practices,
including those relating to compliance risk management, and for
focusing on the safety and soundness of the individual institution.
Another key issue is the extent to which a systemic risk authority
would have appropriately calibrated ability to take measures to address
specific practices identified as posing a systemic risk--in
coordination with other supervisors when possible, or independently if
necessary. For example, there may be practices that appear sound when
considered from the perspective of a single firm, but that appear
troublesome when understood to be widespread in the financial system,
such as if these practices reveal the shared dependence of firms on
particular forms of uncertain liquidity.
Other activities that a systemic risk authority might undertake
include: (1) monitoring large or rapidly increasing exposures--such as
to subprime mortgages--across firms and markets; (2) assessing the
potential for deficiencies in evolving risk-management practices,
broad-based increases in financial leverage, or changes in financial
markets or products to increase systemic risks; (3) analyzing possible
spillovers between financial firms or between firms and markets, for
example through the mutual exposures of highly interconnected firms;
(4) identifying possible regulatory gaps, including gaps in the
protection of consumers and investors, that pose risks for the system
as a whole; and (5) issuing periodic reports on the stability of the
U.S. financial system, in order both to disseminate its own views and
to elicit the considered views of others.
Thus, there are numerous important decisions to be made on the
substantive reach and responsibilities of a systemic risk regulator.
How such an authority, if created, should be structured and located
within the federal government is also a complex issue. Some have
suggested the Federal Reserve for this role, while others have
expressed concern that adding this responsibility would overburden the
central bank. The extent to which this new responsibility might be a
good match for the Federal Reserve, acting either alone or as part of a
collective body, depends a great deal on precisely how the Congress
defines the role and responsibilities of the authority, and how well
they complement those of the Federal Reserve's long-established core
missions.
Nevertheless, as Chairman Bernanke has noted, effectively
identifying and addressing systemic risks would seem to require some
involvement of the Federal Reserve. As the central bank of the United
States, the Federal Reserve has a critical part to play in the
government's responses to financial crises. Indeed, the Federal Reserve
was established by the Congress in 1913 largely as a means of
addressing the problem of recurring financial panics. The Federal
Reserve plays such a key role in part because it serves as liquidity
provider of last resort, a power that has proved critical in financial
crises throughout modern history. In addition, the Federal Reserve has
broad expertise derived from its other activities, including its role
as umbrella supervisor for bank and financial holding companies and its
active monitoring of capital markets in support of its monetary policy
and financial stability objectives.
It seems equally clear that each financial regulator must be
involved in a successful overall strategy for containing systemic risk.
In the first place, of course, appropriate attention to systemic issues
in the normal regulation of financial firms, markets, and practices may
itself support this strategy. Second, the information and insight
gained by financial regulators in their own realms of expertise will be
important contributions to the demanding job of analyzing inchoate
risks to financial stability. Still, while a collective process will
surely be valuable in assessing systemic risk, it will be important to
assign clearly any responsibilities and authorities for actual systemic
risk regulation, since shared authority without clearly delineated
responsibility for action is sometimes a prescription for inaction.
Conclusion
I have tried today to identify the elements of an agenda for
limiting the potential for financial crises, including actions that the
Federal Reserve is taking to address systemic risks and several
measures that Congress should consider to make our financial system
stronger and safer. In doing so, we must avoid responding only to the
current crisis, but must instead fashion a system that will be up to
the challenge of regulating a dynamic and innovative financial system.
We at the Federal Reserve look forward to working with the Congress on
legislation that meets these objectives.
______
PREPARED STATEMENT OF SCOTT M. POLAKOFF
Acting Director,
Office of Thrift Supervision
March 19, 2009
Introduction
Good morning Chairman Dodd, Ranking Member Shelby, and Members of
the Committee. Thank you for inviting me to testify on behalf of the
Office of Thrift Supervision (OTS) on Modernizing Bank Supervision and
Regulation.
It has been pointed out many times that our current system of
financial supervision is a patchwork with pieces that date to the Civil
War. If we were to start from scratch, no one would advocate
establishing a system like the one we have cobbled together over the
last century and a half. The complexity of our financial markets has in
some cases reached mind-boggling proportions. To effectively address
the risks in today's financial marketplace, we need a modern,
sophisticated system of regulation and supervision that applies evenly
across the financial services landscape.
The economic crisis gripping this nation and much of the rest of
the world reinforces the theme that the time is right for an in-depth,
careful review and meaningful, fundamental change. Any restructuring
should take into account the lessons learned from this crisis.
Of course, the notion of regulatory reform is not new. When
financial crisis strikes, it is natural to look for the root causes and
logical fixes, asking whether the nation's regulatory framework allowed
problems to occur, either because of gaps in oversight, a lack of
vigilance, or overlaps in responsibilities that bred a lack of
accountability.
Since last year, a new round of studies, reports and
recommendations have entered the public arena. In one particularly
notable study in January 2009--Financial Regulation: A Framework for
Crafting and Assessing Proposals to Modernize the Outdated U. S.
Financial Regulatory System--the Government Accountability Office (GAO)
listed four broad goals of financial regulation:
Ensure adequate consumer protections,
Ensure integrity and fairness of markets,
Monitor the safety and soundness of institutions, and
Ensure the stability of the overall financial system.
The OTS recommendations discussed in this testimony align with
those goals.
Although a review of the current financial services regulatory
framework is a necessary exercise, the OTS recommendations do not
represent a realignment of the current regulatory system. Rather, these
recommendations represent a fresh start, using a clean slate. They
present the OTS vision for the way financial services regulation in
this country should be. Although they seek to remedy some of the
problems of the past, they do not simply rearrange the current
regulatory boxes. What we are proposing is fundamental change that
would affect virtually all of the current federal financial regulators.
It is also important to note that these are high-level
recommendations. Before adoption and implementation, many details would
need to be worked out and many questions would need to be answered. To
provide all of those details and answer all of those questions would
require reams beyond the pages of this testimony.
The remaining sections of the OTS testimony begin by describing the
problems that led to the current economic crisis. We also cite some of
the important lessons learned from the OTS's perspective. The testimony
then outlines several principles for a new regulatory framework before
describing the heart of the OTS proposal for reform.
What Went Wrong?
The problems at the root of the financial crisis fall into two
groups, nonstructural and structural. The nonstructural problems relate
to lessons learned from the current economic crisis that have been, or
can be, addressed without changes to the regulatory structure. The
structural problems relate to gaps in regulatory coverage for some
financial firms, financial workers and financial products.
Nonstructural Problems
In assessing what went wrong, it is important to note that several
key issues relate to such things as concentration risks, extraordinary
liquidity pressures, weak risk management practices, the influence of
unregulated entities and product markets, and an over-reliance on
models that relied on insufficient data and faulty assumptions. All of
the regulators, including the OTS, were slow to foresee the effects
these risks could have on the institutions we regulate. Where we have
the authority, we have taken steps to deal with these issues.
For example, federal regulators were slow to appreciate the
severity of the problems arising from the increased use of mortgage
brokers and other unregulated entities in providing consumer financial
services. As the originate-to-distribute model became more prevalent,
the resulting increase in competition changed the way all mortgage
lenders underwrote loans, and assigned and priced risk. During the then
booming economic environment, competition to originate new loans was
fierce between insured institutions and less well regulated entities.
Once these loans were originated, the majority of them were removed
from bank balance sheets and sold into the securitization market. These
events seeded many residential mortgage-backed securities with loans
that were not underwritten adequately and that would cause significant
problems later when home values fell, mortgages became delinquent and
the true value of the securities became increasingly suspect.
Part of this problem stemmed from a structural issue described in
the next section--inadequate and uneven regulation of mortgage
companies and brokers--but some banks and thrifts that had to compete
with these companies also started making loans that were focused on the
rising value of the underlying collateral, rather than the borrower's
ability to repay. By the time the federal bank regulators issued the
nontraditional mortgage guidance in September 2006, reminding insured
depository institutions to consider borrowers' ability to repay when
underwriting adjustable-rate loans, numerous loans had been made that
could not withstand a severe downturn in real estate values and payment
shock from changes in adjustable rates.
When the secondary market stopped buying these loans in the fall of
2007, too many banks and thrifts were warehousing loans intended for
sale that ultimately could not be sold. Until this time, bank examiners
had historically looked at internal controls, underwriting practices
and serviced loan portfolio performance as barometers of safety and
soundness. In September 2008, the OTS issued guidance to the industry
reiterating OTS policy that for all loans originated for sale or held
in portfolio, savings associations must use prudent underwriting and
documentation standards. The guidance emphasized that the OTS expects
loans originated for sale to be underwritten to comply with the
institution's approved loan policy, as well as all existing regulations
and supervisory guidance governing the documentation and underwriting
of residential mortgages. Once loans intended for sale were forced to
be kept in the institutions' portfolios, it reinforced the supervisory
concern that concentrations and liquidity of assets, whether
geographically or by loan type, can pose major risks.
One lesson from these events is that regulators should consider
promulgating requirements that are counter-cyclical, such as conducting
stress tests and lowering loan-to-value ratios during economic
upswings. Similarly, in difficult economic times, when house prices are
not appreciating, regulators could permit loan-to-value (LTV) ratios to
rise. Other examples include increasing capital and allowance for loan
and lease losses in times of prosperity, when resources are readily
available.
Another important nonstructural problem that is recognizable in
hindsight and remains a concern today is the magnitude of the liquidity
risk facing financial institutions and how that risk is addressed. As
the economic crisis hit banks and thrifts, some institutions failed and
consumers whose confidence was already shaken were overtaken in some
cases by panic about the safety of their savings in insured accounts at
banks and thrifts. This lack of consumer confidence resulted in large
and sudden deposit drains at some institutions that had serious
consequences. The federal government has taken several important steps
to address liquidity risk in recent months, including an increase in
the insured threshold for bank and thrift deposits.
Another lesson learned is that a lack of transparency for consumer
products and complex instruments contributed to the crisis. For
consumers, the full terms and details of mortgage products need to be
understandable. For investors, the underlying details of their
investments must be clear, readily available and accurately evaluated.
Transparency of disclosures and agreements should be addressed.
Some of the blame for the economic crisis has been attributed to
the use of ``mark-to-market'' accounting under the argument that this
accounting model contributes to a downward spiral in asset prices. The
theory is that as financial institutions write down assets to current
market values in an illiquid market, those losses reduce regulatory
capital. To eliminate their exposure to further write-downs,
institutions sell assets into stressed, illiquid markets, triggering a
cycle of additional sales at depressed prices. This in turn results in
further write-downs by institutions holding similar assets. The OTS
believes that refining this type of accounting is better than
suspending it. Changes in accounting standards can address the concerns
of those who say fair value accounting should continue and those
calling for its suspension.
These examples illustrate that nonstructural problems, such as weak
underwriting, lack of transparency, accounting issues and an over-
reliance on performance rather than fundamentals, all contributed to
the current crisis.
Structural Problems
The crisis has also demonstrated that gaps in regulation and
supervision that exist in the mortgage market have had a negative
impact on the world of traditional and complex financial products. In
recent years, the lack of consistent regulation and supervision in the
mortgage lending area has become increasingly apparent.
Independent mortgage banking companies are state-chartered and
regulated. Currently, there are state-by-state variations in the
authorities of supervising agencies, in the level of supervision by the
states and in the licensing processes that are used. State regulation
of mortgage banking companies is inconsistent and varies on a number of
factors, including where the authority for chartering and oversight of
the companies resides in the state regulatory structure.
The supervision of mortgage brokers is even less consistent across
the states. In response to calls for more stringent oversight of
mortgage lenders and brokers, a number of states have debated and even
enacted licensing requirements for mortgage originators. Last summer, a
system requiring the licensing of mortgage originators in all states
was enacted into federal law. The S.A.F.E. Mortgage Licensing Act in
last year's Housing and Economic Recovery Act is a good first step.
However, licensing does not go far enough. There continues to be
significant variation in the oversight of these individuals and
enforcement against the bad actors.
As the OTS has advocated for some time, one of the paramount goals
of any new framework should be to ensure that similar bank or bank-like
products, services and activities are scrutinized in the same way,
whether they are offered by a chartered depository institution, or an
unregulated financial services provider. The product should receive the
same review, oversight and scrutiny regardless of the entity offering
the product. Consumers do not understand--nor should they need to
understand--distinctions between the types of lenders offering to
provide them with a mortgage. They deserve the same service, care and
protection from any lender. The ``shadow bank system,'' where bank or
bank-like products are offered by nonbanks using different standards,
should be subject to as rigorous supervision as banks. Closing this gap
would support the goals cited in the GAO report.
Another structural problem relates to unregulated financial
products and the confluence of market factors that exposed the true
risk of credit default swaps (CDS) and other derivative products. CDS
are unregulated financial products that lack a prudential derivatives
regulator or standard market regulation, and pose serious challenges
for risk management. Shortcomings in data and in modeling certain
derivative products camouflaged some of those risks. There frequently
is heavy reliance on rating agencies and in-house models to assess the
risks associated with these extremely complicated and unregulated
products. In hindsight, the banking industry, the rating agencies and
prudential supervisors, including OTS, relied too heavily on stress
parameters that were based on insufficient historical data. This led to
an underestimation of the economic shock that hit the financial sector,
misjudgment of stress test parameters and an overly optimistic view of
model output.
We have also learned there is a need for consistency and
transparency in over-the-counter (OTC) CDS contracts. The complexity of
CDS contracts masked risks and weaknesses. The OTS believes
standardization and simplification of these products would provide more
transparency to market participants and regulators. We believe many of
these OTC contracts should be subject to exchange-traded oversight,
with daily margining required. This kind of standardization and
exchange-traded oversight can be accomplished when a single regulator
is evaluating these products. Congress should consider legislation to
bring such OTC derivative products under appropriate regulatory
oversight.
One final issue on the structural side relates to the problem of
regulating institutions that are considered to be too big and
interconnected to fail, manage, resolve, or even formally deem as
problem institutions when they encounter serious trouble. We will
discuss the pressing need for a systemic risk regulator with the
authority and resources adequate to the meet this enormous challenge
later in this testimony.
The array of lessons learned from the crisis will be debated for
years. One simple lesson is that all financial products and services
should be regulated in the same manner regardless of the issuer.
Another lesson is that some institutions have grown so large and become
so essential to the economic well-being of the nation that they must be
regulated in a new way.
Guiding Principles for Modernizing Bank Supervision and Regulation
The discussion on how to modernize bank supervision and regulation
should begin with basic principles to apply to a bank supervision and
consumer protection structure. Safety and soundness and consumer
protection are fundamental elements of any regulatory regime. Here are
recommendations for four other guiding principles:
1. Dual banking system and federal insurance regulator--The system
should contain federal and state charters for banks, as well as
the option of federal and state charters for insurance
companies. The states have provided a charter option for banks
and thrifts that have not wanted to have a national charter. A
number of innovations have resulted from the kind of focused
product development that can occur on a local level. Banks
would be able to choose whether to hold a federal charter or
state charter. For large insurance companies, a federal
insurance regulator would be available to provide more
comprehensive, coordinated and effective oversight than a
collection of individual state insurance regulators.
2. Choice of charter, not of regulator--A depository institution
should be able to choose between state or federal banking
charters, but if it selects a federal charter, its charter type
and regulator should be determined by its operating strategy
and business model. In other words, there would be an option to
choose a business plan and resulting charter, but that decision
would then dictate which regulator would supervise the
institution.
3. Organizational and ownership options--Financial institutions
should be able to choose the organizational and ownership form
that best suits their needs. Mutual, public or private stock
and subchapter S options should continue to be available.
4. Self-sustaining regulators--Each regulator should be able to
sustain itself financially through assessments. Funding the
agencies differently could expose bank supervisory decisions to
political pressures, or create conflicts of interest within the
entity controlling the purse strings. An agency that supervises
financial institutions must control its funding to make
resources available quickly to respond to supervision and
enforcement needs. For example, when the economy declines, the
safety-and-soundness ratings of institutions generally drop and
enforcement actions rise. These changes require additional
resources and often an increase in hiring to handle the larger
workload.
5. Consistency--Each federal regulator should have the same
enforcement tools and the authority to use those tools in the
same manner. Every entity offering financial products should
also be subject to the same set of laws and regulations.
Federal Bank Regulation
The OTS proposes two federal bank regulators, one for banks
predominately focused on consumer-and-community banking products,
including lending, and the other for banks primarily focused on
commercial products and services. The business models of a commercial
bank and a consumer-and-community bank are fundamentally different
enough to warrant these two distinct federal banking charters.
The consumer-and-community bank regulator would supervise
depository institutions of all sizes and other companies that are
predominately engaged in providing financial products and services to
consumers and communities. Establishing such a regulator would address
the gaps in regulatory oversight that led to a shadow banking system of
unevenly regulated mortgage companies, brokers and consumer lenders
that were significant causes of the current crisis.
The consumer-and-community bank regulator would also be the primary
federal regulator of all state-chartered banks with a consumer-and-
community business model. The regulator would work with state
regulators to collaborate on examinations of state-chartered banks,
perhaps on an alternating cycle for annual state and federal
examinations. State-chartered banks would pay a prorated federal
assessment to cover the costs of this oversight.
In addition to safety and soundness oversight, the consumer-and-
community bank regulator would be responsible for developing and
implementing all consumer protection requirements and regulations.
These regulations and requirements would be applicable to all entities
that offer lending products and services to consumers and communities.
The same standards would apply for all of these entities, whether a
state-licensed mortgage company, a state bank or a federally insured
depository institution. Noncompliance would be addressed through
uniform enforcement applied to all appropriate entities.
The current crisis has highlighted consumer protection as an area
where reform is needed. Mortgage brokers and others who interact with
consumers should meet eligibility requirements that reinforce the
importance of their jobs and the level of trust consumers place in
them. Although the recently enacted licensing requirements are a good
first step, limitations on who may have a license are also necessary.
Historically, federal consumer protection policy has been based on
the premise that if consumers are provided with enough information,
they will be able to choose products and services that meet their
needs. Although timely and effective disclosure remains necessary,
disclosure alone may not be sufficient to protect consumers against
abuses. This is particularly true as products and services, including
mortgages, have become more complex.
The second federal bank regulator--the commercial bank regulator--
would charter and supervise banks and other entities that primarily
provide products and services to corporations and companies. The
commercial bank regulator would have the expertise to supervise banks
and other entities predominately involved in commercial transactions
and offering complex products. This regulator would develop and
implement the regulations necessary to supervise these entities. The
commercial bank regulator would supervise issuers of derivative
products. Nonbank providers of the same products and services would be
subject to the same rules and regulations.
The commercial bank regulator would not only have the tools
necessary to understand and supervise the complex products already
mentioned, but would also possess the expertise to evaluate the safety
and soundness of loans that are based on suchthings as income streams
and occupancy rates, which are typical of loans for projects such as
shopping centers and commercial buildings.
The commercial bank regulator would also be the primary federal
supervisor of state-chartered banks with a commercial business model,
coordinating with the states on supervision and imposing federal
assessments just as the consumer-and-communityregulator would.
Because most depositories today are engaged in some of each of
these business lines, the predominant business focus of the institution
would govern which regulator would be the primary federal regulator. In
determining the federal supervisor, a percentage of assets test could
apply. If the operations of the institution or entity changed for a
significant period of time, the primary federal regulator would change.
More discussion and analysis would be needed to determine where to draw
the line between institutions qualifying as commercial banks and
institutions qualifying as consumer and community banks.
Holding Company Regulation
The functional regulator of the largest entity within a diversified
financial company would be the holding company regulator. The holding
company regulator would have authority to monitor the activities of all
affiliates, to exercise enforcement authority and to impose
information-sharing arrangements between entities in the holding
company structure and their functional regulators. To the extent
necessary for the safety and soundness of the depository subsidiary or
the holding company, the regulator would have the authority to impose
capital requirements, restrict activities, issue source-of support
requirements and otherwise regulate the operations of the holding
company and the affiliates.
Systemic Risk Regulation
The establishment of a systemic risk regulator is an essential
outcome of any initiative to modernize bank supervision and regulation.
OTS endorses the establishment of a systemic risk regulator with broad
authority to monitor and exercise supervision over any company whose
actions or failure could pose a risk to financial stability. The
systemic risk regulator should have the ability and the responsibility
for monitoring all data about markets and companies, including but not
limited to companies involved inbanking, securities and insurance.
For systemically important institutions, the systemic risk
regulator would supplement, not supplant, the holding company regulator
and the primary federal bank supervisor.
A systemic regulator would have the authority and resources to
supervise institutions and companies during a crisis situation. The
regulator should have ready access to funding sources that would
provide the capability to resolve problems at these institutions,
including providing liquidity when needed.
Given the events of the past year, it is essential that such a
regulator have the ability to act as a receiver and to provide an
orderly resolution to companies. Efficiently resolving a systemically
important institution in a measured, well-managed manner is an
important element in restructuring the regulatory framework. A lesson
learned from recent events is that the failure or unwinding of
systemically important companies has a far reaching impact on the
economy, not just on financial services.
The continued ability of banks and other entities in the United
States to compete in today's global financial services marketplace is
critical. The systemic risk regulator would be charged with
coordinating the supervision of conglomerates that have international
operations. Safety and soundness standards, including capital adequacy
and other factors, should be as comparable as possible for entities
that have multinational businesses.
Although the systemic risk regulator would not have supervisory
authority over nonsystemically important banks, the systemic regulator
would need access to data regarding the health and activities of these
institutions for purposes of monitoring trendsand other matters.
Conclusion
Thank you again, Mr. Chairman, Ranking Member Shelby, and Members
of the Committee, for the opportunity to testify on behalf of the OTS
on Modernizing Bank Supervision and Regulation.
We look forward to continuing to work with the members of this
Committee and others to fashion a system of financial services
regulation that better serves all Americans and helps to ensure the
necessary clarity and stability for this nation's economy.
______
PREPARED STATEMENT OF JOSEPH A. SMITH, JR.
North Carolina Commissioner of Banks, and
Chair-Elect of the Conference of State Bank Supervisors
March 19, 2009
Introduction
Good morning Chairman Dodd, Ranking Member Shelby, and Members of
the Committee. My name is Joe Smith, and I am the North Carolina
Commissioner of Banks. I also serve as incoming Chairman of the
Conference of State Bank Supervisors (CSBS) and a member of the CSBS
Task Force on Regulatory Restructuring. I am pleased to be here today
to offer a state perspective on our nation's financial regulatory
structure--its strengths and its deficiencies, and suggestions for
reform.
As we work through a federal response to this financial crisis, we
need to carry forward a renewed understanding that the concentration of
financial power and a lack of transparency are not in the long-term
interests of our financial system, our economic system or our
democracy. This lesson is one our country has had to learn in almost
every generation, and I hope that the current lesson will benefit
future generations. While our largest and most complex institutions are
no doubt central to a resolution of the current crisis, my colleagues
and I urge you to remember that the health and effectiveness of our
nation's financial system also depends on a diverse and competitive
marketplace that includes community and regional institutions.
While changing our regulatory system will be far from simple, some
fairly simple concepts should guide these reforms. In evaluating any
governmental reform, we must ask if our financial regulatory system:
Ushers in a new era of cooperative federalism, recognizing
the rights of states to protect consumers and reaffirming the
state role in chartering and supervising financial
institutions;
Fosters supervision tailored to the size, scope and
complexity of an institution and the risk it poses to the
financial system;
Assures the promulgation and enforcement of consumer
protection standards that are applicable to both state and
federally chartered institutions and are enforceable by state
officials;
Encourages a diverse universe of financial institutions as
a method of reducing risk to the system, encouraging
competition, furthering innovation, insuring access to
financial markets, and promoting efficient allocation of
credit;
Supports community and regional banks, which provide
relationship lending and fuel local economic development; and
Requires financial institutions that are recipients of
governmental assistance or pose systemic risk to be subject to
safety and soundness and consumer protection oversight.
We have often heard the consolidation of financial regulation at
the federal level is the ``modern'' answer to the challenges our
financial system. We need to challenge this assumption. For reasons
more fully discussed below, my colleagues and I would suggest to you
that an appropriately coordinated system of state and federal
supervision and regulation will promote a more effective system of
financial regulation and a more diverse, stable and responsive
financial system.
The Role of the States in Financial Services Supervision and Regulation
The states charter and supervise more than 70 percent of all U.S.
banks (Exhibit A), in coordination with the FDIC and Federal Reserve.
The rapid consolidation of the industry over the past decade, however,
has created a system in which a handful of large national banks control
the vast majority of assets in the system. The more than 6,000 banks
supervised and regulated by the states now represent less than 30
percent of the assets of the banking system (Exhibit B). While these
banks are smaller than the global institutions now making headlines,
they are important to all of the markets they serve and are critical in
the nonmetropolitan markets where they are often the major sources of
credit for local households, small businesses and farms.
Since the enactment of nationwide banking in 1994, the states,
working through CSBS, have developed a highly coordinated system of
state-to-state and state-to-federal bank supervision. This is a model
that has served this nation well, embodying our uniquely American
dynamic of checks and balances--a dynamic that has been missing from
certain areas of federal financial regulation, with devastating
consequences.
The dynamic of state and federal coordinated supervision for state-
chartered banks allows for new businesses to enter the market and grow
to meet the needs of the markets they serve, while maintaining
consistent nationwide standards. Community and regional banks are a
vital part of America's economic fabric because of the state system.
As we continue to work through the current crisis, we need to do
more to support community and regional banks. The severe economic
recession and market distortions caused by bailing out the largest
institutions have caused significant stress on these institutions.
While some community and regional banks have had access to the TARP's
capital purchase program, the processing and funding has grown
cumbersome and slow. We need a more nimble and effective program for
these institutions. This program must be administered by an entity with
an understanding of community and regional banking. This capital will
enhance stability and provide support for consumer and small business
lending.
In addition to supervising banks, I and many of my colleagues
regulate the residential mortgage industry. All 50 states and the
District of Columbia now provide some regulatory oversight of the
residential mortgage industry. The states currently manage over 88,000
mortgage company licenses, over 68,000 branch licenses, and
approximately 357,000 loan officer licenses. In 2003, the states,
acting through the CSBS and the American Association of Residential
Mortgage Regulators, first proposed a nationwide mortgage licensing
system and database to coordinate our efforts in regulating the
residential mortgage market. The system launched on January 2, 2008, on
time and on budget. The Nationwide Mortgage Licensing System (NMLS) was
incorporated in the federal S.A.F.E. Act and, as a result, has
established a new and important partnership with the United States
Department of Housing and Urban Development, the federal banking
agencies and the Farm Credit Administration. We are confident that this
partnership will result in an efficient and effective combination of
state and federal resources and a nimble, responsive and comprehensive
system of regulation. This is an example of what we mean by ``a new era
of cooperative federalism.''
Where Federalism Has Fallen Short
For the past decade it has been clear to the states that our system
of mortgage finance and mortgage regulation was flawed and that a
destructive and widening chasm had formed between the interests of
borrowers and of lenders. Over that decade, through participation in
GAO reports and through congressional testimony, one can observe an
ever-increasing level of state concern over this growing chasm and its
reflection in the state and federal regulatory relationship.
Currently, 35 states plus the District of Columbia have enacted
predatory lending laws. \1\ First adopted by North Carolina in 1999,
these state laws supplement the federal protections of the Home
Ownership and Equity Protection Act of 1994 (HOEPA). The innovative
actions taken by state legislatures have prompted significant changes
in industry practices, as the largest multi-state lenders have adjusted
their practices to comply with the strongest state laws. All too often,
however, we are frustrated in our efforts to protect consumers by the
preemption of state consumer protection laws by federal regulations.
Preemption must be narrowly targeted and balance the interest of
commerce and consumers.
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\1\ Source: National Conference of State Legislatures.
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In addition to the extensive regulatory and legislative efforts,
state attorneys general and state regulators have cooperatively pursued
unfair and deceptive practices in the mortgage market. Through several
settlements, state regulators have returned nearly one billion dollars
to consumers. A settlement with Household resulted in $484 million paid
in restitution, a settlement with Ameriquest resulted in $295 million
paid in restitution, and a settlement with First Alliance Mortgage
resulted in $60 million paid in restitution. These landmark settlements
further contributed to changes in industry lending practices.
But successes are sometimes better measured by actions that never
receive media attention. States regularly exercise their authority to
investigate or examine mortgage companies for compliance not only with
state law, but with federal law as well. These examinations are an
integral part of a balanced regulatory system. Unheralded in their
everyday routine, enforcement efforts and examinations identify
weaknesses that, if undetected, might be devastating to the company and
its customers. State examinations act as a check on financial problems,
evasion of consumer protections and sales practices gone astray.
Examinations can also serve as an early warning system of a financial
institution conducting misleading, predatory or fraudulent practices.
Attached as Exhibit C is a chart of enforcement actions taken by state
regulatory agencies against mortgage providers. In 2007, states took
nearly 6,000 enforcement actions against mortgage lenders and brokers.
These actions could have resulted in a dialog between state and
federal authorities about the extent of the problems in the mortgage
market and the best way to address the problem. That did not happen.
The committee should consider how the world would look today if the
ratings agencies and the OCC had not intervened and the assignee
liability and predatory lending provisions of the Georgia Fair Lending
Act had been applicable to all financial institutions. I would suggest
we would have far fewer foreclosures and may have avoided the need to
bailout our largest financial institutions. It is worth noting that the
institutions whose names were attached to the OCC's mortgage preemption
initiative--National City, First Franklin, and Wachovia--were all
brought down by the mortgage crisis. That fact alone should indicate
how out of balance the system has become.
From the state perspective, it has not been clear for many years
exactly who was setting the risk boundaries for the market. What is
clear is that the nation's largest and most influential financial
institutions have been major contributing factors in our regulatory
system's failure to respond to this crisis. At the state level, we
sometimes perceived an environment at the federal level that is skewed
toward facilitating the business models and viability of our largest
financial institutions rather than promoting the strength of the
consumer or our diverse economy.
It was the states that attempted to check the unhealthy evolution
of the mortgage market and apply needed consumer protections to
subprime lending. Regulatory reform must foster a system that
incorporates the early warning signs that state laws and regulations
provide, rather than thwarting or banning them.
Certainly, significant weaknesses exist in our current regulatory
structure. As GAO has noted, incentives need to be better aligned to
promote accountability, a fair and competitive market, and consumer
protection.
Needed Regulatory Reforms: Mortgage Origination
I would like to thank this committee for including the Secure and
Fair Enforcement for Mortgage Licensing Act (S.A.F.E.) in the Housing
and Economic Recovery Act of 2008 (HERA). It has given us important
tools that continue our efforts to reform mortgage regulation.
CSBS and the states are working to enhance the regulatory regime
for the residential mortgage industry to ensure legitimate lending
practices, provide adequate consumer protection, and to once again
instill both consumer and investor confidence in the housing market and
the economy as a whole. The various state initiatives are detailed in
Exhibit D.
Needed Regulatory Reforms: Financial Services Industry
Many of the problems we are experiencing are both the result of
``bad actors'' and bad assumptions by the architects of our modern
mortgage finance system. Enhanced supervision and improved industry
practices can successfully weed out the bad actors and address the bad
assumptions. If regulators and the industry do not address both causes
of our current crisis, we will have only the veneer of reform and will
eventually repeat our mistakes. Some lessons learned from this crisis
must be to prevent the following: the over-leveraging that was allowed
to occur in the nation's largest institutions; outsourcing of loan
origination with no controls in place; and industry consolidation to
allow institutions to become so large and complex that they become
systemically vital and too big to effectively supervise or fail.
While much is being done to enhance supervision of the mortgage
market, more progress must be made towards the development of a
coordinated and cooperative system of state-federal supervision.
Preserve and Enhance Checks and Balances/Forge a New Era of Federalism
The state system of chartering and regulating has always been a key
check on the concentration of financial power, as well as a mechanism
to ensure that our banking system remains responsive to local
economies' needs and accountable to the public. The state system has
fostered a diversity of institutions that has been a source of
stability and strength for our country, particularly locally owned and
controlled community banks. To promote a strong and diverse system of
banking-one that can survive the inevitable economic cycles and absorb
failures-preservation of state-chartered banking should be a high
priority for Congress. The United States boasts one of the most
powerful and dynamic economies in the world because of those checks and
balances, not despite them.
Consolidation of the industry and supervision and preemption of
applicable state law does not address the cause of this crisis, and has
in fact exacerbated the problem.
The flurry of state predatory lending laws and new state regulatory
structures for lenders and mortgage brokers were indicators that
conditions and practices were deteriorating in our mortgage lending
industry. It would be incongruous to eliminate the early warning signs
that the states provide. Just as checks and balances are a vital part
of our democratic government, they serve an equally important role in
our financial regulatory structure. Put simply, states have a lower
threshold for crisis and will most likely act sooner. This is an
essential systemic protection.
Most importantly, it serves the consumer interest that the states
continue to have a role in financial regulation. While CSBS recognizes
the financial services market is a nationwide industry that has
international implications, local economies and individual consumers
are most drastically affected by mortgage market fluctuations. State
regulators must remain active participants in mortgage supervision
because of our knowledge of local economies and our ability to react
quickly and decisively to protect consumers.
Therefore, CSBS urges Congress to implement a recommendation made
by the Congressional Oversight Panel in their ``Special Report on
Regulatory Reform'' to eliminate federal preemption of the application
of state consumer protection laws to national banks. In its report, the
Panel recommends Congress ``amend the National Banking Act to provide
clearly that state consumer protection laws can apply to national banks
and to reverse the holding that the usury laws of a national bank's
state of incorporation govern that bank's operation through the
nation.'' \2\ We believe the same policy should apply to the Office of
Thrift Supervision. To preserve a responsive system, states must be
able to continue to produce innovative solutions and regulations to
provide consumer protection.
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\2\ The Congressional Oversight Panel's ``Special Report on
Regulatory Reform'' can be viewed at http://cop.senate.gov/documents/
cop-012909-report-regulatoryreform.pdf
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The federal government would better serve our economy and our
consumers by advancing a new era of cooperative federalism. The
S.A.F.E. Act enacted by Congress requiring licensure and registration
of mortgage loan originators through the Nationwide Mortgage Licensing
System provides a model for achieving systemic goals of high regulatory
standards and a nationwide regulatory roadmap and network, while
preserving state authority for innovation and enforcement. The Act sets
expectations for greater state-to-state and state-to-federal regulatory
coordination.
Congress should complete this process by enacting a federal
predatory lending standard. A federal standard should allow for further
state refinements in lending standards and be enforceable by state and
federal regulators. Additionally, a federal lending standard should
clarify expectations of the obligations of securitizers.
Consumer Protection/Enforcement
Consolidated regulation minimizes resources dedicated to
supervision and enforcement. As FDIC Chairman Sheila Bair recently told
the states' Attorneys General, ``if ever there were a time for the
states and the feds to work together, that time is right here, right
now. The last thing we need is to preempt each other.'' Congress should
establish a mechanism among the financial regulators for identifying
and responding to emerging consumer issues. This mechanism, perhaps
through the Federal Financial Institutions Examination Council (FFIEC),
should include active state regulator and law enforcement participation
and develop coordinated responses. The coordinating federal entity
should report to Congress regularly. The states must retain the right
to pursue independent enforcement actions against all financial
institutions as an appropriate check on the system.
Systemic Supervision/Capital Requirements
As Congress evaluates our regulatory structure, I urge you to
examine the linkages between the capital markets, the traditional
banking sector, and other financial services providers. Our top
priority for reform must be a better understanding of systemic risks.
The federal government must facilitate the transparency of financial
markets to create a financial system in which stakeholders can
understand and manage their risks. Congress should establish clear
expectations about which regulatory authority or authorities are
responsible for assessing risk. The regulator must have the necessary
tools to identify and mitigate risk, and resolve failures.
Congress, the administration, and federal regulators must also
consider how the federal government itself may inadvertently contribute
to systemic risk--either by promoting greater industry consolidation or
through policies that increase risk to the system. Perhaps we should
contemplate that there are some institutions whose size and complexity
make their risks too large to effectively manage or regulate. Congress
should aggressively address the sources of systemic risk to our
financial system.
While this crisis has demanded a dramatic response from the federal
government, the short-term result of many of these programs, including
the Troubled Asset Relief Program (TARP), has been to create even
larger and more complex institutions and greater systemic risk. These
responses have created extreme disparity in the treatment of financial
institutions, with the government protecting those deemed to be too big
or too complex to fail, perhaps at the expense of smaller institutions
and the diversity of our financial system.
At the federal level, our state-chartered banks may be too-small-
to-care but in our cities and communities, they are too important to
ignore. It is exactly the same dynamic that told us that the plight of
the individual homeowner trapped in a predatory loan was less important
than the needs of an equity market hungry for new mortgage-backed
securities.
There is an unchallenged assumption that federal regulatory reforms
can address the systemic risk posed by our largest and most complex
institutions. If these institutions are too large or complex to fail,
the government must give preferential treatment to prevent these
failures, and that preferential treatment distorts and harms the
marketplace, with potentially disastrous consequences.
Our experience with Fannie Mae and Freddie Mac exemplifies this
problem. Large systemic institutions such as Fannie and Freddie
inevitably garner advantages and political favor, and the lines between
government and industry blur in ways that do not reflect American
values of fair competition and merit-based success.
My fellow state supervisors and I have long believed capital and
leverage ratios are essential tools for managing risk. For example,
during the debate surrounding the advanced approach under Basel II,
CSBS supported FDIC Chairman Sheila Bair in her call to institute a
leverage ratio for participating institutions. Federal regulation needs
to prevent capital arbitrage among institutions that pose systemic
risks, and should require systemic risk institutions to hold more
capital to offset the grave risks their collapse would pose to our
financial system.
Perhaps most importantly, Congress must strive to prevent
unintended consequences from doing irreparable harm to the community
and regional banking system in the United States. Federal policy to
prevent the collapse of those institutions considered too big to fail
should ultimately strengthen our system, not exacerbate the weaknesses
of the system. Throughout the current recession, community and regional
banks have largely remained healthy and continued to provide much
needed credit in the communities where they operate. The largest banks
have received amazing sums of capital to remain solvent, while the
community and regional banks have continued to lend in this difficult
environment with the added challenge of having to compete with
federally subsidized entities.
Congress should consider creating a bifurcated system of
supervision that is tailored to the size, scope, and complexity of
financial institutions. The largest, most systemically significant
institutions should be subject to much more stringent oversight that is
comprehensive enough to account for the complexity of the institution.
Community and regional banks should be subject to regulations that are
tailored to the size and sophistication of the institutions. In
financial supervision, one size should no longer fit all.
Roadmap for Unwinding Federal Liquidity Assistance and Systemic
Responses
The Treasury Department and the Federal Reserve should be required
to provide a plan for how to unwind the various programs established to
provide liquidity and prevent systemic failure. Unfortunately, the
attempts to avert crisis through liquidity programs have focused
predominantly upon the needs of the nation's largest institutions,
without consideration for the unintended consequences for our diverse
financial industry as a whole, particularly community and regional
banks. Put simply, the government is now in the business of picking
winners and losers. In the extreme, these decisions determine survival,
but they also affect the overall competitive landscape and relative
health and profitability of institutions. The federal government should
develop a plan that promotes fair and equal competition, rather than
sacrificing the diversity of our financial industry to save those
deemed too big to fail.
Conclusion
Chairman Dodd, Ranking Member Shelby, and Members of the Committee,
the task before us is a daunting one. The current crisis is the result
of well over a decade's worth of policies that promoted consolidation,
uniformity, preemption and the needs of the global marketplace over
those of the individual consumer.
If we have learned nothing else from this experience, we have
learned that big organizations have big problems. As you consider your
responses to this crisis, I ask that you consider reforms that promote
diversity and create new incentives for the smaller, less troubled
elements of our financial system, rather than rewarding the largest and
most reckless.
At the state level, we are constantly pursuing methods of
supervision and regulation that promote safety and soundness while
making the broadest possible range of financial services available to
all members of our communities. We appreciate your work toward this
common goal, and thank you for inviting us to share our views today.
APPENDIX ITEMS
Exhibit D: State Initiatives To Enhance Supervision of the Mortgage
Industry
CSBS-AARMR Nationwide Mortgage Licensing System
The states first recognized the need for a tool to license mortgage
originators several years ago. Since then, states have dedicated
tremendous monetary and staff resources to develop and enact the
Nationwide Mortgage Licensing System (NMLS). First proposed among state
regulators in late 2003, NMLS launched on time and on budget on January
2, 2008. The Nationwide Mortgage Licensing System is more than a
database. It serves as the foundation of modern mortgage supervision by
providing dramatically improved transparency for regulators, the
industry, investors, and consumers. Seven inaugural participating
states began using the system on January 2, 2008. Only 15 months later,
23 states are using NMLS and by January 2010--just 2 years after its
launch--CSBS expects 40 states to be using NMLS.
NMLS currently maintains a single record for every state-licensed
mortgage company, branch, and individual that is shared by all
participating states. This single record allows companies and
individuals to be definitively tracked across state lines and over time
as entities migrate among companies, industries, and federal and state
jurisdictions. Additionally, this year consumers and industry will be
able to check on the license status and history of the companies and
individuals with which they wish to do business.
NMLS provides profound benefits to consumers, state supervisory
agencies, and the mortgage industry. Each state regulatory agency
retains its authority to license and supervise, but NMLS shares
information across state lines in real-time, eliminates any duplication
and inconsistencies, and provides more robust information to state
regulatory agencies. Consumers will have access to a central repository
of licensing and publicly adjudicated enforcement actions. Honest
mortgage lenders and brokers will benefit from the removal of
fraudulent and incompetent operators, and from having one central point
of contact for submitting and updating license applications.
The hard work and dedication of the states was ultimately
recognized by Congress as they enacted the Housing and Economic
Recovery Act of 2008 (HERA). The bill acknowledged and built upon the
work that had been done in the states to protect consumers and restore
the public trust in our mortgage finance and lending industries.
Title V of HERA, titled the Secure and Fair Enforcement for
Mortgage Licensing Act of 2008 (S.A.F.E. Act), is designed to increase
uniformity, reduce regulatory burden, enhance consumer protection, and
reduce fraud by requiring all mortgage loan originators to be licensed
or registered through NMLS.
In addition to loan originator licensing and mandatory use of NMLS,
the S.A.F.E. Act requires the states to do the following:
1. Eliminate exemptions from mortgage loan originator licensing that
currently exist in state law;
2. Screen and deny mortgage loan originator licenses for felonies of
any kind within 7 years and certain financially related
felonies permanently;
3. Screen and deny licenses to individuals who have ever had a loan
originator license revoked;
4. Require loan originators to submit personal history information
and authorize background checks to determine the applicant's
financial responsibility, character, and general fitness;
5. Require mortgage loan originators to take 20 hours of pre-
licensure education in order to enter the state system of
licensure;
6. Require mortgage loan originators to pass a national mortgage
loan originator test developed by NMLS;
7. Establish either a bonding or net worth requirement for companies
employing mortgage loan originators or a recovery fund paid
into by mortgage loan originators or their employing company in
order to protect consumers;
8. Require companies licensed or registered through NMLS to submit a
Mortgage Call Report on at least an annual basis;
9. Adopt specific confidentiality and information sharing
provisions; and
10. Establish effective authority to investigate, examine, and
conduct enforcement of licensees.
Taken together, these background checks, testing, and education
requirements will promote a higher level of professionalism and
encourage best practices and responsible behavior among all mortgage
loan originators. Under the legislative guidance provided by Congress,
the states drafted the Model State Law for uniform implementation of
the S.A.F.E. Act. The Model State Law not only achieves the minimum
licensing requirements under the federal law, but also accomplishes
Congress' ten objectives addressing uniformity and consumer protection.
The Model State Law, as implementing legislation at the state
level, assures Congress that a framework of localized regulatory
controls are in place at least as stringent as those pre-dating the
S.A.F.E. Act, while setting new uniform standards aimed at responsible
behavior, compliance verification and protecting consumers. The Model
State Law enhances the S.A.F.E. Act by providing significant
examination and enforcement authorities and establishing prohibitions
on specific types of harmful behavior and practices.
The Model State Law has been formally approved by the Secretary of
the U.S. Department of Housing and Urban Development and endorsed by
the National Conference of State Legislatures and the National
Conference of Insurance Legislators. The Model State Law is well on its
way to approval in almost all state legislatures, despite some
unfortunate efforts by industry associations to frustrate, weaken or
delay the passage of this important Congressional mandate.
Nationwide Cooperative Protocol and Agreement for Mortgage Supervision
In December 2007, CSBS and AARMR launched the Nationwide
Cooperative Protocol and Agreement for Mortgage Supervision to assist
state mortgage regulators by outlining a basic framework for the
coordination and supervision of Multi-State Mortgage Entities (those
institutions conducing business in two or more states). The goals of
this initiative are to protect consumers; ensure the safety and
soundness of institutions; identify and prevent mortgage fraud;
supervise in a seamless, flexible, and risk-focused manner; minimize
regulatory burden and expense; and foster consistency, coordination,
and communication among state regulators. Currently, 48 states plus the
District of Columbia and Puerto Rico have signed the Protocol and
Agreement.
The states have established risk profiling procedures to determine
which institutions are in the greatest need of a multi-state presence
and we are scheduled to begin the first multi-state examinations next
month. Perhaps the most exciting feature of this initiative is the
planned use of robust software programs to screen the institutions
portfolios for risk, compliance, and consumer protection issues. With
this software, the examination team will be able to review 100 percent
of the institution's loan portfolio, thereby replacing the ``random
sample'' approach that left questions about just what may have been
missed during traditional examinations.
CSBS-AARMR Reverse Mortgage Initiatives
In early 2007, the states identified reverse mortgage lending as
one of the emerging threats facing consumers, financial institutions,
and supervisory oversight. In response, the states, through CSBS and
AARMR, formed the Reverse Mortgage Regulatory Council and began work on
several initiatives:
Reverse Mortgage Examination Guidelines (RMEGs). In
December 2008, CSBS and AARMR released the RMEGs to establish
uniform standards for regulators in the examination of
institutions originating and funding reverse mortgage loans.
The states also encourage industry participants to adopt these
standards as part of an institution's ongoing internal review
process.
Education materials. The Reverse Mortgage Regulatory
Council is also developing outreach and education materials to
assist consumers in understanding these complex products before
the loan is made.
CSBS-AARMR Guidance on Nontraditional Mortgage Product Risks
In October 2006, the federal financial agencies issued the
Interagency Guidance on Nontraditional Mortgage Product Risks which
applies to insured depository institutions. Recognizing that the
interagency guidance does not apply to those mortgage providers not
affiliated with a bank holding company or an insured financial
institution, CSBS and AARMR developed parallel guidance in November
2006 to apply to state-supervised residential mortgage brokers and
lenders, thereby ensuring all residential mortgage originators were
subject to the guidance.
CSBS-AARMR-NACCA Statement on Subprime Mortgage Lending
The federal financial agencies also issued the Interagency
Statement on Subprime Mortgage Lending. Like the Interagency Guidance
on Nontraditional Mortgage Product Risks, the Subprime Statement
applies only to mortgage providers associated with an insured
depository institution. Therefore, CSBS, AARMR, and the National
Association of Consumer Credit Administrators (NACCA) again developed a
parallel statement that is applicable to all mortgage providers. The
Nontraditional Mortgage Guidance and the Subprime Statement strike a
fair balance between encouraging growth and free market innovation and
draconian restrictions that will protect consumers and foster fair
transactions.
AARMR-CSBS Model Examination Guidelines
Further, to promote consistency, CSBS and AARMR developed state
Model Examination Guidelines (MEGs) for field implementation of the
Guidance on Nontraditional Mortgage Product Risks and the Statement on
Subprime Mortgage Lending.
Released on July 31, 2007, the MEGs enhance consumer protection by
providing state regulators with a uniform set of examination tools for
conducting examinations of subprime lenders and mortgage brokers. Also,
the MEGs were designed to provide consistent and uniform guidelines for
use by lender and broker compliance and audit departments to enable
market participants to conduct their own review of their subprime
lending practices. These enhanced regulatory guidelines represent a new
and evolving approach to mortgage supervision.
Mortgage Examinations With Federal Regulatory Agencies
Late in 2007, CSBS, the Federal Reserve System (Fed), the Federal
Trade Commission (FTC), and the Office of Thrift Supervision (OTS)
engaged in a pilot program to examine the mortgage industry. Under this
program, state examiners worked with examiners from the Fed and OTS to
examine mortgage businesses over which both state and federal agencies
had regulatory jurisdiction. The FTC also participated in its capacity
as a law enforcement agency. In addition, the states separately
examined a mortgage business over which only the states had
jurisdiction. This pilot is truly the model for coordinated state-
federal supervision.
______
PREPARED STATEMENT OF GEORGE REYNOLDS
Chairman,
National Association of State Credit Union Supervisors, and
Senior Deputy Commissioner,
Georgia Department of Banking and Finance
March 19, 2009
NASCUS History and Purpose
Good morning, Chairman Dodd, and distinguished Members of the
Senate Committee on Banking, Housing, and Urban Affairs. I am George
Reynolds, Senior Deputy Commissioner of Georgia Department of Banking
and Finance and chairman of the National Association of State Credit
Union Supervisors (NASCUS). \1\ I appear today on behalf of NASCUS, the
professional association of state credit union regulators.
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\1\ NASCUS is the professional association of the 47 state credit
union regulatory agencies that charter and supervise the nation's 3,300
state-chartered credit unions.
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The mission of NASCUS is to enhance state credit union supervision
and advocate for a safe and sound state credit union system. We achieve
our mission by serving as an advocate for the dual chartering system, a
system that recognizes the traditional and essential role of state
governments in the national system of depository financial
institutions.
Thank you for holding this important hearing today to explore
modernizing financial institution supervision and regulation. The
regulatory structure in this country has been a topic of discussion for
many years. The debate began when our country's founders held healthy
dialogue about how to protect the power of the states. More recently,
commissions have been created to study the issue and several
administrations have devoted further time to examine the financial
regulatory system. Most would agree that if the regulatory system were
created by design, the current system may not have been deliberately
engineered; however, one cannot overlook the benefits offered by the
current system. It has provided innovation, competition and diversity
to our nation's financial institutions and consumers.
In light of our country's economic distress, many suggest that
regulatory reform efforts should focus, in part, on improving the
structure of the regulatory framework. However, I suggest that it is
not the structure of our regulatory system that has failed our country,
but rather the functionality and accountability within the regulatory
system.
A financial regulatory system, regardless of its structure, must
delineate clear lines of responsibility and provide the necessary
authority to take action. Accountability and transparency must also be
inherent in our financial system. This system must meet these
requirements while remaining sufficiently competitive and responsive to
the evolving financial service needs of American consumers and our
economy. Credit union members and the American taxpayer are demanding
each of these qualities be present in the nation's business operations
and they must be present in a modernized financial regulatory system.
These regulatory principles must exist in a revised regulatory
system. This is accomplished by an active system of federalism, a
system in which the power to govern is shared between national and
state governments allowing for clear communication and coordination
between state and federal regulators. Further, this system provides
checks and balances and the necessary accountability for a strong
regulatory system. I detail more about this system in my comments.
NASCUS Priorities for Regulatory Restructuring
NASCUS' priorities for regulatory restructuring focus on reforms
that strengthen the state system of credit union supervision and
enhance the capabilities of state-chartered credit unions. The ultimate
goal is to meet the financial needs of consumer members while assuring
that the state system is operating in a safe and sound manner. This
provides consumer confidence and contributes to a sound national and
global financial system.
In this testimony, I discuss the following philosophies that we
believe Congress must address in developing a revised financial
regulatory system. These philosophies are vital to the future growth
and safety and soundness of state-chartered credit unions.
Preserve Charter Choice and Dual Chartering
Preserve States' Role in Financial Regulation
Modernize the Capital System for Credit Unions
Maintain Strong Consumer Protections, which often Originate
at the State Level
My comments today will focus solely on the credit union regulatory
system; I will highlight successful aspects and areas Congress should
carefully consider for refinement.
Preserving Charter Choice and Dual Chartering
The goal of prudential regulation is to ensure safety and soundness
of depositors' funds, creating both consumer confidence and stability
within the financial regulatory system.
Today's regulatory system is structured so that states and the
federal government act independently to charter and supervise financial
institutions. The dual chartering system for financial institutions has
successfully functioned for more than 140 years, since the National
Bank Act was passed in 1863, allowing the option of chartering banks
nationally. It is important that Congress continue to recognize the
distinct roles played by state and federal regulatory agencies.
Dual chartering remains viable in the financial marketplace because
of the distinct benefits provided by charter choice and due to the
interaction between state and federal regulatory agencies. This
structure works effectively and creates the confidence and stability
needed for the national credit union system.
Importance of Dual Chartering
The first credit union in the United States was chartered in New
Hampshire in 1909. State chartering remained the sole means for
establishing credit unions for the next 25 years, until Congress passed
the Federal Credit Union Act (FCUA) in 1934.
Dual chartering allows an institution to select its primary
regulator. For credit unions, it is either the state agency that
regulates state-chartered credit unions in a particular state or the
National Credit Union Administration (NCUA) that regulates federal
credit unions. Forty-seven states have laws that permit state-chartered
credit unions, as does the U.S. territory of Puerto Rico.
Any modernized regulatory restructuring must recognize charter
choice. The fact that laws differ for governing state and federal
credit unions is positive for credit unions and consumers. A key
feature of the dual chartering system is that individual institutions
can select the charter that will benefit their members or consumers the
most. Credit union boards of directors and CEOs have the ability to
examine the advantages of each charter and determine which charter
matches the goals of the institution and its members.
Congress intended state and federal credit union regulators to work
closely together, as delineated in the FCUA. Section 201 of the FCUA
states, `` . . . examinations conducted by State regulatory agencies
shall be utilized by the Board for such purposes to the maximum extent
feasible.'' \2\ NCUA accepts examinations conducted by state regulatory
agencies, demonstrating the symbiotic relationship between state and
federal regulators.
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\2\ 12 U.S. Code 1781(b)(1).
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Congress must continue to recognize and to affirm the distinct
roles played by state and federal regulatory agencies. The U.S.
regulatory structure must enable state credit union regulators to
retain regulatory authority over state-chartered credit unions. This
system is tried and it has worked for the state credit union system for
100 years. It has been successful because dual chartering for credit
unions provides a system of ``consultation and cooperation'' between
state and federal regulators. \3\ This system creates the appropriate
balance of power between state and federal credit union regulators.
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\3\ The Consultation and Cooperation With State Credit Union
Supervisors provision contained in The Federal Credit Union Act, 12
U.S. Code 1757a(e) and 12 U.S. Code 1790d(l).
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A recent example of state and federal credit union examiners
working together and sharing information is the bimonthly
teleconferences held since October of 2008 to discuss liquidity in the
credit union system. Further, state regulators and the NCUA meet in-
person several times a year to discuss national policy issues. The
intent of Congress was that these regulators share information and work
together and in practice, we do work together.
Another exclusive aspect of the credit union system is that both
state and federal credit unions have access to the National Credit
Union Share Insurance Fund (NCUSIF). Federally insured credit unions
capitalize this fund by depositing one percent of their shares into the
fund. This concept is unique to credit unions and it minimizes taxpayer
exposure. Any modernized regulatory system should recognize the NCUSIF.
The deposit insurance system has been funded by the credit union
industry and has worked well for credit unions. We believe that credit
unions should have access to this separate and distinct deposit
insurance fund. A separate federal regulator for credit unions has also
worked well and effectively since the FCUA was passed in 1934. NASCUS
and others are concerned about any proposal to consolidate regulators
and state and federal credit union charters.
Charter choice also creates healthy competition and provides an
incentive for regulators (both state and federal) to maximize
efficiency in their examinations and reduce costs. It allows regulators
to take innovative approaches to regulation while maintaining high
standards for safety and soundness.
The dual chartering system is threatened by the preemption of state
laws and the push for a more uniform regulatory system. As new
challenges arise, it is critical that the benefits of each charter are
recognized. As Congress discusses regulatory modernization, it is
important that new policies do not squelch the innovation and enhanced
regulatory structure provided by the dual chartering system. As I
stated previously, dual chartering benefits consumers, provides
enhanced regulation and allows for innovation in our nation's credit
unions.
Ideally, the best of each charter should be recognized and enhanced
to allow competition in the marketplace. NASCUS believes dual
chartering is an essential component to the balance of power and
authority in the regulatory structure. The strength and health of the
credit union system, both state and federal, rely on the preservation
of the principles of the dual chartering system.
Strengths of the State System
State-chartered credit unions make many contributions to the
economic vitality of consumers in individual states. Our current
regulatory system benefits citizens and provides consumer confidence.
To begin, one of the strengths of the state system is that states
operate as the ``laboratories'' of financial innovation. Many consumer
protection programs were designed by state legislators and state
regulators to recognize choice and innovation. The successes of state
programs have been recognized at the federal level, when like programs
are introduced to benefit consumers at the federal level. It is crucial
that state legislatures maintain the primary authority to enact
consumer protection statutes for residents in their states and to
promulgate and enforce state consumer protection regulations, without
the threat of federal preemption.
We caution Congress about putting too much power in the hands of
the federal regulatory structure. Dual chartering allows power to be
distributed throughout the system and it provides a system of checks
and balances between state and federal authorities. A system where the
primary regulatory authority is given to the federal government may not
provide what is in the best interest of consumers.
Preserve States' Role in Financial Regulation
The dual chartering system is predicated on the rights of states to
authorize varying powers for their credit unions. NASCUS supports state
authority to empower credit unions to engage in activities under state-
specific rules, deemed beneficial in a particular state. States should
continue to have the authority to create and to maintain appropriate
credit union powers in any new regulatory reform structure debated by
Congress.
However, we are cognizant that our state systems are continuously
challenged by modernization, globalization and new technologies. We
believe that any regulatory structure considered by Congress should not
limit state regulatory authority and innovation. Preemption of state
laws and the push for more uniform regulatory systems will negatively
impact our nation's financial services industry, and ultimately
consumers.
Congress should ensure that states have the authority to supervise
state credit unions and that supervision is tailored to the size, scope
and complexity of the credit union and the risk they may pose to their
members. Further, Congress should reaffirm state legislatures' role as
the primary authority to enact consumer protection statutes in their
states.
Added consumer protections at the state level can better serve and
better protect the consumer and provide greater influence on public
policy than they can at the federal level. This has proved true with
data security and mortgage lending laws, to name a few. It is crucial
that states maintain authority to pursue enforcement actions for state-
chartered credit unions. Congress' regulatory restructuring efforts
should expand the states' high standards of consumer protection.
Recently, Chairman Barney Frank (D, Mass.) of the House Financial
Services Committee, said, ``States do a better job,'' when referring to
consumer protection. NASCUS firmly believes this, too.
Comprehensive Capital Reform for Credit Unions
The third principle I want to highlight is modernizing the capital
system for credit unions. Congress should recognize capital reform as
part of regulatory modernization. Capital sustains the viability of
financial institutions. It is necessary for their survival.
NASCUS has long supported comprehensive capital reform for credit
unions. Credit unions need access to supplemental credit union capital
and risk-based capital requirements; these related but distinctly
different concepts are not mutually exclusive. The current economic
environment necessitates that now is the time for capital reform for
credit unions.
Access to Supplemental Capital
State credit union regulators are committed to protecting credit
union safety and soundness. Allowing credit unions access to
supplemental capital would protect the safety and soundness of the
credit union system and provide a tool to use if a credit union faces
declining net worth or liquidity needs.
A simple fix to the FCUA would authorize state and federal
regulators the discretion, when appropriate, to allow credit unions to
use supplemental capital.
NASCUS follows several guiding principles in our quest for
supplemental capital for credit unions. First, a capital instrument
must preserve the not-for-profit, mutual, member-owned and cooperative
structure of credit unions. Next, it must preserve credit unions' tax-
exempt status. \4\ Finally, regulatory approval would be required
before a credit union could access supplemental capital. We realize
that supplemental capital will not be allowed for every credit union,
nor would every credit union need access to supplemental capital.
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\4\ State-chartered credit unions are exempt from federal income
taxes under Section 501(c)(14) of the Internal Revenue Code, which
requires that (a) credit union cannot access capital stock; (b) they
are organized/operated for mutual purposes; and without profit. The
NASCUS white paper, ``Alternative Capital for Credit Unions . . . Why
Not?'' addresses Section 501(c)(14).
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Access to supplemental capital will enhance the safety and
soundness of credit unions and provide further stability in this
unpredictable market. Further, supplemental capital will provide an
additional layer of protection to the NCUSIF thereby maintaining credit
unions' independence from the federal government and taxpayers.
Allowing credit unions access to supplemental capital with
regulatory approval and oversight will enhance their ability to react
to market conditions, grow safely into the future, serve their nearly
87 million members and provide further stability for the credit union
system. We feel strongly that now is the time to permit this important
change. Unlike other financial institutions, credit union access to
capital is limited to reserves and retained earnings from net income.
Since net income is not easily increased in a fast-changing
environment, state regulators recommend additional capital-raising
capabilities for credit unions. Access to supplemental capital will
enable credit unions to respond proactively to changing market
conditions, enhancing their future viability and strengthening their
safety and soundness.
Supplemental capital is not new to the credit union system; several
models are already in use. Low-income credit unions are authorized to
raise uninsured secondary capital. Corporate credit unions have access,
too; they have both membership capital shares and permanent capital
accounts, known as paid-in capital. These models work and could be
adjusted for natural-person credit unions.
Risk-Based Capital for Credit Unions
Today, every insured depository institution, with the exception of
credit unions, uses risk-based capital requirements to build and to
monitor capital levels. Risk-based capital requirements enable
financial institutions to better measure capital adequacy and to avoid
excessive risk on their balance sheets. A risk-based capital system
acknowledges the diversity and complexity between financial
institutions. It requires increased capital levels for financial
institutions that choose to maintain a more complex balance sheet,
while reducing the burden of capital requirements for institutions
holding assets with lower levels or risk. This system recognizes that a
one-size-fits-all capital system does not work.
The financial community continues to refine risk-based capital
measures as a logical and an important part of evaluating and
quantifying capital adequacy. Credit unions are the only insured
depository institutions not allowed to use risk-based capital measures
as presented in the Basel Accord of 1988 in determining required levels
or regulatory capital. A risk-based capital regime would require credit
unions to more effectively monitor risks in their balance sheets. It
makes sense that credit unions should have access to risk-based
capital; it is a practical and necessary step in addressing capital
reform for credit unions.
Systemic Risk Regulation
The Committee asked for comment regarding the need for systemic
risk regulation. Certainly, the evolution of the financial services
industry and the expansion of risk outside of the more regulated
depository financial institutions into the secondary market, investment
banks and hedge funds reflect that further consideration needs to be
given to having expanded systemic risk supervision. Many suggest that
the Federal Reserve System due to its structural role in the financial
services industry might be well suited to be assigned an expanded role
in this area.
The Role of Proper Risk Management
During this period of economic disruption, Congress should consider
regulatory restructuring and also areas where risk management
procedures might need to be strengthened or revised to enhance
systemic, concentration and credit risk in the financial services
industry.
Congress needs to address the reliance on credit rating agencies
and credit enhancement features in the securitization of mortgage-
backed securities in the secondary market.
These features were used to enhance the marketability of securities
backed by subprime mortgages. Reliance on more comprehensive structural
analysis of such securities and expanded stress testing would have
provided more accurate and transparent information to market analysts
and investors.
Further, there is a debate occurring about the impact of ``mark-to-
market'' accounting on the financial services industry as the secondary
market for certain investment products has been adversely impacted by
market forces. While this area deserves further consideration, we urge
Congress to approach this issue carefully in order to maintain
appropriate transparency and loss recognition in the financial services
industry.
Finally, consideration needs to be given to compensation practices
that occurred in the financial services industry, particularly in the
secondary market for mortgage-backed securities. Georgia requires
depository financial institutions that are in Denovo status or subject
to supervisory actions that use bonus features in their management
compensation structure not to simply pay bonuses based on production or
sales, but also to include an asset quality component. Such a feature
will ``claw back'' bonuses if production or sales result in excessive
volumes of problematic or nonperforming assets. If such a feature were
used in the compensation structure for the marketing of asset-backed
securities, perhaps this would have been a deterrent to the excessive
risk taking that occurred in this industry and resulted in greater
market discipline.
Conclusion
Modernizing our financial regulatory system is a continuous
process, one that will need to be fine-tuned over time. It will take
careful study and foresight to ensure a safe and sound regulatory
structure that allows enhanced products and services while ensuring
consumer protections. NASCUS recognizes this is not an easy process.
To protect state-chartered credit unions in a modernized regulatory
system, we encourage Congress to consider the following points:
Enhancing consumer choice provides a stronger financial
regulatory system; therefore charter choice and dual chartering
must be preserved.
Preserve states' role in financial regulation.
Modernize the capital system for credit unions to protect
safety and soundness.
Maintain strong consumer protections, which often originate
at the state level.
It is important that Congress take the needed time to scrutinize
proposed financial regulatory systems.
NASCUS appreciates the opportunity to testify today and share our
priorities for a modernized credit union regulatory framework. We urge
this Committee to be watchful of federal preemption and to remember the
importance of dual chartering and charter choice in regulatory
modernization. We welcome questions from Committee Members.
Thank you.
RESPONSE TO WRITTEN QUESTIONS OF SENATOR SHELBY
FROM JOHN C. DUGAN
Q.1. Consumer Protection Regulation--Some have advocated that
consumer protection and prudential supervision should be
divorced, and that a separate consumer protection regulation
regime should be created. They state that one source of the
financial crisis emanated from the lack of consumer protection
in the underwriting of loans in the originate-to-distribute
space.
What are the merits of maintaining it in the same agency?
Alternatively, what is the best argument each of you can make
for a new consumer protection agency?
A.1. Effective protection for consumers of financial products
and services is a vital part of financial services regulation.
The attractiveness of the single financial product protection
agency model is that it would presumably centralize authority
and functions in this area in a single agency, which could
write and apply rules that would apply uniformly to all
financial services providers, whether or not they are
depository institutions. Because the agency would focus
exclusively on consumer protection, proponents of the concept
also argue that such a model eliminates the concerns sometimes
expressed that prudential supervisors neglect consumer
protection in favor of safety and soundness supervision. These
asserted attributes need to be closely evaluated, however. In
the case of federally regulated depository institutions, the
benefits could well be outweighed by the costs of diminishing
the real consumer protections that flow from the Federal
banking agencies' comprehensive supervision and oversight of
depository institutions.
In the OCC's experience, and as the mortgage crisis
illustrates, safe and sound lending practices are integral to
consumer protection. Indeed, I believe that the best way to
implement consumer protection regulation of banks--and the best
way to protect their customers--is to do so through
comprehensive prudential supervision.
Effective consumer protection of financial institutions
includes three vital components: (1) strong regulatory
standards; (2) consistent and thorough oversight of compliance
with these standards; and (3) an effective corrective/
enforcement response when it is determined that those standards
are not met.
The appropriate structure for the rulemaking function can
be debated. With respect to federally supervised banks that are
subject to regular, ongoing supervision by the Federal banking
agencies, there are good reasons why these agencies, by virtue
of their familiarity with the issues these institutions
present, should have a role in the rulemaking process. They
bring expertise regarding potentially complex issues, and they
are in a position to warn against potential unintended
consequences of rulemaking initiatives under consideration. At
the very least, if rulemaking for financial product consumer
protection is vested in any single agency, there should be a
requirement to consult with the Federal banking agencies with
respect to the impact of proposed rules on federally regulated
depository institutions.
Next is the question of consistent and thorough oversight
of applicable consumer protection standards. Here, significant
differences exist in the manner in which federally regulated
depository institutions are examined and supervised, and the
oversight schemes applicable to the ``shadow banking system''--
nonbank firms that provide products and services comparable to
those offered by depository institutions. I think it would be a
mistake to displace the extensive role of the Federal banking
agencies in examination and supervision of the operations of
depository institutions--including their compliance with
consumer protection standards.
The Federal banking agencies' regular and continual
presence in institutions through the process of examination and
supervision puts them in the best position to ensure compliance
with applicable consumer protection laws and regulations.
Examiners are trained to detect weaknesses in institutions'
policies, systems, and procedures for implementing consumer
protection mandates, as well as substantive violations of laws
and regulations. Their regular communication with institutions
occurs through examinations at least once every 18 months for
smaller institutions, supplemented by quarterly contacts, and
for the largest banks, the consumer compliance examination
function is conducted continuously, by examiners on site at
large banks every day. The extensive examination and
supervisory presence creates especially effective incentives
for achieving consumer protection compliance, and allows
examiners to detect compliance weaknesses much earlier than
would otherwise be the case.
Moreover, in many respects, for purposes of examination and
supervision by the Federal banking agencies, safety and
soundness and consumer protection issues are inextricably
linked. Take, for example, mortgage lending. Safe and sound
credit underwriting for a mortgage loan requires sound credit
judgments about a borrower's ability to repay a loan, while the
same sound underwriting practices help protect a borrower from
an abusive loan with terms that the borrower does not
understand and cannot repay. Bank examiners see both
perspectives and require corrections that respond to both
aspects of the problem. This system did not fail in the current
mortgage crisis. It is well recognized the overwhelming source
of toxic mortgages precipitating the mortgage crisis were
originated by lenders that were not federally supervised banks.
To shift the responsibility for examining for and reacting
to the consumer protection issues to an entirely separate
agency is less efficient than the integrated approach bank
examiners apply today. Shifting the examination and supervision
role to a new and separate agency also would seem to require
the establishment of a very substantial new workforce, with a
major budget, to carry out those responsibilities.
Where substantial enhancement of examination and
supervision is warranted, however, is for nonbank firms that
are not subject to federal examination and supervision. Again,
it is important to remember that these nondepository
institutions were the predominant source of the toxic subprime
mortgages that fueled the current mortgage crisis. The
providers of these mortgages--part of the ``shadow banking
system''--are not subject to examination and supervision
comparable to that received by federally supervised depository
institutions. Rather than displace the extensive consumer
protection examination and supervisory functions of the federal
banking agencies, any new financial product protection agency
should focus on ensuring that the ``shadow banking system'' is
subject to the same robust consumer protection standards as are
applicable to depository institutions, and that those standards
are in fact effectively applied and enforced.
Finally, in the area of enforcement, the Federal banking
agencies have strong enforcement powers and exceptional
leverage over depository institutions to achieve correction
actions. As already mentioned, depository institutions are
among the most extensively supervised firms in any type of
industry, and bankers understand very well the range of
negative consequences that can ensue from failing to be
response to their regulator. As a result, when examiners detect
consumer compliance weaknesses or failures, they have a broad
range of tools to achieve corrective action, and banks have
strong incentives to achieve compliance as promptly as
possible. It is in the interests of consumers that this
authority not be undermined by the role and responsibilities of
any new consumer protection agency.
Q.2. Regulatory Gaps or Omissions--During a recent hearing, the
Committee has heard about massive regulatory gaps in the
system. These gaps allowed unscrupulous actors like AIG to
exploit the lack of regulatory oversight. Some of the
counterparties that AIG did business with were institutions
under your supervision.
Why didn't your risk management oversight of the AIG
counterparties trigger further regulatory scrutiny? Was there
flawed assumption that AIG was adequately regulated, and
therefore no further scrutiny was necessary?
A.2. A critical focus of our examination of trading activities
at our large national banks is to assess how well the bank
manages its counterparty exposures. We regularly review large
counterparty exposures at our large national banks; however,
the counterparty exposure to AIG did not trigger heightened
regulatory scrutiny by the OCC because it was a AAA-rated
company, was generally well-respected in the financial services
industry, and was not a meaningful risk concentration to any of
the banks under our supervision. Because AIG had such a strong
credit rating, many counterparties, including national banks,
did not require AIG to post collateral on its exposures. A key
lesson learned for bankers and supervisors is the need to
carefully manage all counterparty exposures, especially those
that may have sizable unsecured exposures, regardless of the
counterparty's rating. In particular, regulators need to
revisit the issue of the extent to which collateral should be
required in counterparty relationships, merely due to AAA
ratings.
Q.3. Was there dialogue between the banking regulators and the
state insurance regulators? What about the SEC?
A.3. We did not have any meaningful dialogue with state
insurance regulators or the SEC about AIG since we had no
compelling reason to do so, given the lack of supervisory
concerns at the time with regard to the exposure to AIG.
Q.4. If the credit default swap contracts at the heart of this
problem had been traded on an exchange or cleared through a
clearinghouse, with requirement for collateral and margin
payments, what additional in formation would have been
available? How would you have used it?
A.4. Because the transactions between AIG and its
counterparties were highly customized to specific CDOs, it is
unlikely that they would have been eligible for trading on an
exchange or clearing through a clearinghouse. Transactions that
use exchanges or clearinghouses generally require a fairly high
degree of standardization. In addition, for a contract to trade
on an exchange, the exchange/clearinghouse needs to be able to
determine prices for the underlying reference entities, in this
case super-senior ABS CDOs, yet, even the most sophisticated
market participants had great difficulty valuing these
securities. If the transactions could have been traded on an
exchange, then AIG would have been forced to post initial and
variation margin. These margin requirements would likely have
limited the volume of trades that AIG could have done, or
forced them to exit the transactions prior to the losses
becoming so significant that they threatened the firm's
solvency. In addition, because an exchange or clearinghouse
provides for more price transparency, if these transactions had
been cleared through a clearinghouse, market participants may
have had greater knowledge of the pricing of the underlying CDO
assets.
Q.5. Over-Reliance on Credit Rating Agencies--While many
national banks did not engage in substandard underwriting for
the loans they originated, many of these institutions bought
and held these assets in the form of triple-A rated mortgage-
backed securities.
Why was it inappropriate for these institutions to
originate these loans, but it was acceptable for them to hold
the securities collateralized by them?
A.5. National banks are allowed to purchase and hold as
investments various highly rated securities that are supported
by a variety of asset types. Examples of such asset types
include mortgages, autos, credit cards, equipment leases, and
commercial and student loans. National banks are expected to
conduct sufficient due diligence to understand and control the
risks associated with such investment securities and the
collateral that underlies those securities. In recent years,
many national banks increased their holdings of highly rated
senior ABS CDO securitization exposures. These senior positions
were typically supported by subordinated or mezzanine tranches
and equity or first-loss positions, as well as other forms of
credit enhancement such as over-collateralization and, in
certain instances, credit default swaps provided by highly
rated counterparties. In hindsight, bankers, regulators, and
the rating agencies put too much reliance on these credit
enhancements and failed to recognize the leverage and
underlying credit exposures embedded in these securities,
especially with respect to a systematic decline in value of the
underlying loans based on a nationwide decline in house prices.
Our supervisory approach going forward will emphasize an
increased need for banks to consider the underwriting on the
underlying loans in a securitization and understand the
potential effect of those underlying exposures on the
performance of the securitized asset.
In addition, as previously noted, another key lesson
learned from the recent financial turmoil is the need for firms
to enhance their ability to identify and aggregate risk
exposures across business, product lines, and legal entities.
With regard to subprime mortgage exposures, many national banks
thought they had avoided subprime risk exposures by
deliberately choosing to not originate such loans in the bank,
only to find out after the fact that their investment bank
affiliates had purchased subprime loans elsewhere to structure
them into collateralized debt obligations.
Q.6. What changes are you capable of making absent statutory
changes, and have you made those changes yet?
A.6. As noted above, while we expect bankers to conduct
sufficient due diligence on their investment holdings, in
recent years both bankers and regulators became too complacent
in relying on NSRO ratings and various forms of credit
enhancements for complex structured products, which often were
based on various modeled scenarios.
The market disruptions have made bankers and regulators
much more aware of the risk within models, including over-
reliance on historical information and inappropriate
correlation assumptions. Because of our heightened appreciation
of the limitation of models and the NSRO ratings that were
produced from those models, we are better incorporating
quantitative and qualitative factors to adjust for these
weaknesses. We are also emphasizing the need for bankers to
place less reliance on models and NSRO ratings and to better
stress-test internal model results. We also have told banks
that they need a better understanding of the characteristics of
the assets underlying these securities.
Finally, enhancements to the Basel II capital framework
that were announced by the Basel Committee on Banking
Supervision in January 2009 will require banks to hold
additional capital for re-securitizations, such as
collateralized debt obligations comprised of asset-back
securities. In addition to the higher capital that banks will
be required to hold, these enhancements will also require banks
that use credit ratings in their measurement of required
regulatory capital for securitization exposures to have:
A comprehensive understanding on an ongoing basis
of the risk characteristics of their individual
securitization exposures.
Access to performance information on the underlying
pools on an ongoing basis in a timely manner. For re-
securitizations, banks should have information not only
on the underlying securitization tranches, such as the
issuer name and credit quality, but also on the
characteristics and performance of the pools underlying
the securitization tranches.
A thorough understanding of all structural features
of a securitization transaction that would materially
impact the performance of the bank's exposures to the
transaction, such as the contractual waterfall and
waterfall-related triggers, credit enhancements,
liquidity enhancements, market value triggers, and
deal-specific definitions of default.
The comment period for the proposed enhancements has ended,
and the Basel Committee is expected to adopt the final changes
before year-end 2009. The U.S. federal banking agencies will
consider whether to propose adding these or similar standards
to their Basel II risk-based capital requirements.
Q.7. Liquidity Management--A problem confronting many financial
institutions currently experiencing distress is the need to
roll-over short-term sources of funding. Essentially these
banks are facing a shortage of liquidity. I believe this
difficulty is inherent in any system that funds long-term
assets, such as mortgages, with short-term funds. Basically the
harm from a decline in liquidity is amplified by a bank's level
of ``maturity-mismatch.''
I would like to ask each of the witnesses, should
regulators try to minimize the level of a bank's maturity-
mismatch? And if so, what tools would a bank regulator use to
do so?
A.7. There are a myriad of a factors that influence a bank's
liquidity risk profile and that need to be effectively managed.
Some of these factors include the stability and level of a
bank's core deposits versus its dependence on more volatile
wholesale and retail funds; the diversification of the bank's
overall funding base in terms of instrument types, nature of
funds providers, repricing, and maturity characteristics; and
the level of readily available liquid assets that could be
quickly converted to cash. We do use a number of metrics, such
as net short-term liabilities to total assets, to identify
banks that may have significant liquidity risk. However, we
believe that it has been difficult to distill all of the
factors that influence a bank's liquidity risk into a single
regulatory metric that is applicable to all types and sizes of
financial institutions. As a result, we direct banks to develop
a robust process for measuring and controlling their liquidity
risk. A key component of an effective liquidity risk management
process are cash flow projections that include discrete and
cumulative cash flow mismatches or gaps over specified future
time horizons under both expected and adverse business
conditions. We expect bankers to have effective strategies in
place to address any material mismatches under both normal and
adverse operating scenarios.
The Basel Working Group on Liquidity (WGL) issued revised
principles last year that emphasized the importance of cash
flow projections, diversified funding sources, comprehensive
stress testing, a cushion of liquid assets, and a well-
developed contingency funding plan. Financial institutions are
in the process of implementing these additional principles into
their existing risk management practices. The WGL is currently
reviewing proposals for enhanced supervisory metrics to monitor
a financial institution's liquidity position and the OCC is
actively involved in those efforts.
Q.8. What Is Really Off-Balance Sheet--Chairman Bair noted that
structured investment vehicles (SIVs) played an important role
in funding credit risk that are at the core of our current
crisis. While the banks used the SIVs to get assets off their
balance sheet and avoid capital requirements, they ultimately
wound up reabsorbing assets from these SIV's.
Why did the institutions bring these assets back on their
balance sheet? Was there a discussion between the OCC and those
with these off-balance sheet assets about forcing the investor
to take the loss?
A.8. For much of the past two decades, SIVs provided a cost
effective way for financial companies to use the short-term
commercial paper and medium term note (MTN) markets to fund
various types of loans and credit receivables. Beginning in
August 2007, as investor concerns about subprime mortgage
exposures spilled over into the general asset-backed commercial
paper (ABCP) and MTN markets, banks were facing increased
difficulties in rolling over these funding sources for their
SIVs. As a result, banks began purchasing their sponsored SIVs'
ABCP as a short term solution to the market disruption. In some
instances, banks had pre-approved liquidity facilities
established for this purpose. Over time, it became apparent
that market disruptions would continue for an extended period,
making it impossible for SIVs to roll ABCP or MTNs as they
matured. In order to avoid possible rating downgrades of senior
SIV debt and to maintain investor relationships, banks
supported their sponsored SIV structures by either purchasing
SIV assets or maturing ABCP. As a result of these purchases,
many banks were required to consolidate SIV assets under GAAP.
The OCC had ongoing discussions with banks on this topic,
and OCC examiners emphasized the need for bank management to
consider all potential ramifications of their actions,
including liquidity and capital implications, as well as other
strategic business objectives.
Q.9. How much of these assets are now being supported by the
Treasury and the FDIC?
A.9. Treasury's TAW Capital Purchase Program and the FDIC's
Temporary Liquidity Guaranty Program are providing funds that
are helping to bolster participating banks' overall capital and
liquidity levels and thus may be indirectly supporting some of
these assets that banks may still be holding on their balance
sheets. However, given the fungible nature of this funding, it
is not possible to identify specific assets that may be
supported.
Q.10. Based on this experience, would you recommend a different
regulatory treatment for similar transactions in the future?
What about accounting treatment?
A.10. Regulatory capital requirements for securitization
exposures generally are based on whether the underlying assets
held by the securitization structure are reported on- or off-
balance sheet of the bank under generally accepted accounting
principles (GAAP). Most SIVs have been structured to qualify
for off-balance sheet treatment under GAAP. As such, bank
capital requirements are based on the bank's actual exposures
to the structure, which may include, for example, recourse
obligations, residual interests, liquidity facilities, and
loans, and which typically are far less than the amount of
assets held in the structure.
The Financial Accounting Standards Board (FASB), in part as
a response to banks' supporting SIV structures beyond their
contractual obligation to do so, proposed changes to the
standards that require banks to consolidate special purpose
vehicles and conduits such as SIVs. Under the proposed new
standards, which are expected to become effective January 1,
2010, the criteria for consolidation would require banks to
conduct a qualitative analysis, based on facts and
circumstances (power, rights, and obligations), to determine if
the bank is the primary beneficiary of the structure. One
factor in determining whether the bank sponsoring a SIV
structure is the primary beneficiary would be whether the risk
to the bank's reputation in the marketplace if the structure
entity does not operate as designed would create an implicit
financial responsibility for the bank to support the structure.
The proposed new standards likely would require banks to
consolidate more SIV structures than they are required to
consolidate under current GAAP. The U.S. banking agencies are
evaluating what changes, if any, to propose to our regulatory
capital rules in response to the proposed FASB changes.
In addition, in January 2009, the Basel Committee on
Banking Supervision proposed enhancements to the Basel II
framework that include increasing the credit conversion factor
for short-term liquidity facilities from 20 percent to 50
percent. This change would make the conversion factor for
short-term liquidity facilities equal to the credit conversion
factor for long-term liquidity facilities. The U.S. banking
agencies are evaluating whether to propose a rule change to
increase the credit conversion factor for short-term liquidity
facilities to 50 percent for banks operating in the United
States under both Basel I and Basel II.
Q.11. Regulatory Conflict of Interest--Federal Reserve Banks
which conduct bank supervision are run by bank presidents that
are chosen in part by bankers that they regulate.
Mr. Dugan and Mr. Polakoff does the fact that your
agencies' funding stream is affected by how many institutions
you are able to keep under your charters affect your ability to
conduct supervision?
A.11. No. Receiving funding through assessments on regulated
entities is the norm in the financial services industry. In the
case of the OCC and OTS, Congress has determined that
assessments and fees on national banks and thrifts,
respectively, will fund supervisory activities, rather than
appropriations from the United States Treasury. Neither the
Federal Reserve Board nor the FDIC receives appropriations.
State banking regulators typically are also funded by
assessments on the entities they charter and supervise.
Since enactment of the National Bank Act in 1864, the OCC
has been funded by various types of fees imposed on national
banks. Over the more than 145 years that the OCC has regulated
national banks, in times of prosperity and times of economic
stress, there has never been any evidence that this funding
mechanism has caused the OCC to fail to hold national banks
responsible for unsafe or unsound practices or violations of
law, including laws that protect consumers.
Rather, through comprehensive examination processes, the
OCC's track record is one of proactively addressing both
consumer protection and safety and soundness issues. Among the
banking agencies, we have pioneered enforcement approaches,
including utilization of section 5 of the Federal Trade
Commission Act, to protect consumers. Indeed, the OCC
frequently has been criticized for being too ``tough,'' and we
have seen institutions leave the national banking system to
seek more favorable regulatory treatment of their operations.
\1\
---------------------------------------------------------------------------
\1\ Applebaum, Washington Post, By Switching Their Charters, Banks
Skirt Supervision, January 22, 2009; A01.
---------------------------------------------------------------------------
Simply put, the OCC never has compromised robust bank
supervision, including enforcement of consumer protection laws,
to attract or retain bank charters.
Q.12. Too-Big-To-Fail--Chairman Bair stated in her written
testimony that ``the most important challenge is to find ways
to impose greater market discipline on systemically important
institutions. The solution must involve, first and foremost, a
legal mechanism for the orderly resolution of those
institutions similar to that which exists for FDIC-insured
bank. In short we need to end too big to fail.''
I would agree that we need to address the too-big-to-fail
issue, both for banks and other financial institutions. Could
each of you tell us whether putting a new resolution regime in
place would address this issue? How would we be able to
convince the market that these systemically important
institutions would not be protected by taxpayer resources as
they had been in the past?
A.12. As noted in the previous responses to Senator Crapo,
there is currently no system for the orderly resolution of
nonbank firms. This needs to be addressed with an explicit
statutory regime for facilitating the resolution of
systemically important nonbank companies. This new statutory
regime should provide tools that are similar to those the FDIC
currently has for resolving banks, including the ability to
require certain actions to stabilize a firm; access to a
significant funding source if needed to facilitate orderly
dispositions, such as a significant line of credit from the
Treasury; the ability to wind down a firm if necessary, and the
flexibility to guarantee liabilities and provide open
institution assistance if necessary to avoid serious risk to
the financial system. In addition, there should be clear
criteria for determining which institutions would be subject to
this resolution regime, and how to handle the foreign
operations of such institutions. While such changes would make
orderly resolutions of systemically important firms more
feasibly, they would not eliminate the possibility of using
extraordinary government assistance to protect the financial
system.
Q.13. Pro-Cyclicality--I have some concerns about the pro-
cyclical nature of our present system of accounting and bank
capital regulation. Some commentators have endorsed a concept
requiring banks to hold more capital when good conditions
prevail, and then allow banks to temporarily hold less capital
in order not to restrict access to credit during a downturn.
Advocates of this system believe that counter cyclical policies
could reduce imbalances within financial markets and smooth the
credit cycle itself.
What do you see as the costs and benefits of adopting a
more counter-cyclical system of regulation ?
A.13. The question as to how best to address pro-cyclicality
concerns associated with our present system of accounting and
capital regulation is an area of significant focus for policy
makers domestically and internationally. In addressing this
matter, it is important to distinguish between cyclicality and
pro-cyclicality. Due to their sensitivity to risk, the current
accounting and capital regimes are clearly, and intentionally,
cyclical, broadly reflecting the prevailing trends in the
economy. The more difficult and unresolved issue is whether
those regimes are also ``pro-cyclical,'' by amplifying
otherwise normal business fluctuations.
As noted, there are ongoing efforts to assess pro-
cyclicality issues with respect to both our current accounting
and regulatory capital regimes. The most recent public
statement on this matter is found in the Financial Stability
Board's April 2, 2009 document ``Report of the Financial
Stability Forum on Addressing Pro-cyclicality in the Financial
System'' (FSB Report). \2\ In this report, the FSB makes
numerous policy recommendations to address pro-cyclicality
concerns in three broad areas: regulatory capital; bank loan
loss provisioning practices; and valuation.
---------------------------------------------------------------------------
\2\ The FSB Report was developed as a result of collaborative work
carried out by working groups composed of staff from: banking agencies
from the U.S. and other jurisdictions; securities regulators from the
U.S. and other jurisdictions; accounting standard setters; the Basel
Committee on Banking Supervision; International Organization of
Securities Commissions; and other organizations.
---------------------------------------------------------------------------
With respect to capital, the FSB Report set forth various
recommendations to address potential pro-cyclicality, including
the establishment of counter-cyclical capital buffers. In that
regard, the Report encouraged the Basel Committee to ``develop
mechanisms by which the quality of the capital base and the
buffers above the regulatory minimum are built up during
periods of strong earnings growth so that they are available to
absorb greater losses in stressful environments.'' In terms of
benefits, building such a counter-cyclical capital buffer on
banks' earnings capacity would provide a simple and practical
link between: (i) the portfolio composition and risk profile of
individual banks; (ii) the build-up of risk in the banking
system; and (iii) cycles of credit growth, financial innovation
and leverage in the broader economy. We also believe it is
critically important to focus on the quality of capital, with
common stock, retained earnings, and reserves for loan losses,
being the predominant form of capital within the Tier 1
requirement.
The establishment of counter-cyclical capital buffers do
present challenges, the most significant of which relate to
international consistency and operational considerations. In
normal cyclical downturns, there are clear differences in
national economic cycles, with certain regions experiencing
material deterioration in economic activity, while other
regions are completely unaffected. In such an environment, it
will be extremely difficult to balance the need for
international consistency while reflecting differences in
national economic cycles.
With respect to loan loss reserves, the FSB Report stated
that earlier recognition of loan losses could have dampened
cyclical moves in the current crisis. Under the current
accounting requirements of an incurred loss model, a provision
for loan losses is recognized only when a loss impairment event
or events have taken place that are likely to result in
nonpayment of a loan in the future. Earlier identification of
credit losses is consistent both with financial statement
users' needs for transparency regarding changes in credit
trends and with prudential objectives of safety and soundness.
To address this issue, the FSB Report set forth recommendations
to accounting standard setters and the Basel Committee.
Included in the Report was a recommendation to accounting
standard setters to reconsider their current loan loss
provisioning requirements and related disclosures.
The OCC and other Federal banking agencies continue to
discuss these difficult issues within the Basel Committee and
other international forums.
Q.14. Do you see any circumstances under which your agencies
would take a position on the merits of counter-cyclical
regulatory policy?
A.14. The OCC has actively participated in various efforts to
assess and mitigate possible pro-cyclical effects of current
accounting and regulatory capital regimes and I served as a
chairperson of the FSB's Working Group on Provisioning
discussed in the FSB Report discussed above. Consistent with
recommendations in the FSB Report, I have publicly endorsed
enhancements to existing provisions of regulatory capital rules
and generally accepted accounting principles (GAAP) to address
pro-cyclicality concerns.
Q.15. G20 Summit and International Coordination--Many foreign
officials and analysts have said that they believe the upcoming
G20 summit will endorse a set of principles agreed to by both
the Financial Stability Forum and the Basel Committee, in
addition to other government entities. There have also been
calls from some countries to heavily re-regulate the financial
sector, pool national sovereignty in key economic areas, and
create powerful supranational regulatory institutions.
(Examples are national bank resolution regimes, bank capital
levels, and deposit insurance.) Your agencies are active
participants in these international efforts.
What do you anticipate will be the result of the G20
summit?
A.15. The materials subsequent to the April 2, 2009, G20 Summit
offer a constructive basis for a coordinated international
response to the current economic crisis. The documents issued
by the G20 working groups, especially Working Group 1:
Enhancing Sound Regulation and Strengthening Transparency; and
Working Group 2: Reinforcing International Cooperation and
Promoting Integrity in Financial Markets, will be a particular
focus of attention for the OCC and the other Federal banking
agencies.
Q.16. Do you see any examples or areas where supranational
regulation of financial services would be effective?
A.16. Issues uniquely related to the activities and operations
of internationally active banking organizations compel a higher
level of coordination among international supervisors. In fact,
the Standards Implementation Group of the Basel Committee is
designed to provide international supervisors a forum to
discuss such issues and, to the extent possible, harmonize
examination activities and supervisory policies related to
those institutions.
Q.17. How far do you see your agencies pushing for or against
such supranational initiatives?
A.17. The OCC is supportive of continued efforts to harmonize
activities and policies related to the supervision of
internationally active banks. The actions of the G20 and its
working groups present the opportunity to continue current
dialogue with a broader array of jurisdictions. However, we are
keenly aware of the need to protect U.S. sovereignty over the
supervision of national banks, and will not delegate that
responsibility.
Q.18. What steps has the OCC taken to promote the use of
central counterparties for credit default swap transactions by
national banks?
A.18. The OCC is an active participant in the Derivatives
Infrastructure Project. One of the key accomplishments of this
project is working with industry participants in developing a
central counterparty solution for credit derivatives.
Representatives from the OCC previously testified that credit
derivatives risk mitigation is encouraged including the use of
a central clearing party. The industry committed in its July
31, 2008, letter to use central clearing for eligible index,
single name, and tranche index CDS where practicable. The
industry renewed this commitment in October of 2008. Our
ongoing supervision efforts continue to track the progress of
this commitment in the institutions where the OCC is the
primary supervisor. As a result, central clearinghouses have
been established and central clearing of index trades began in
March of this year.
The OCC granted national banks the legal authority to
become members of a central clearing house for credit
derivatives. The legal approval is also subject to stringent
safety and soundness requirements to ensure banks can
effectively manage and measure their exposures to central
counterparties.
The OCC continues to work with market participants and
other regulators on increasing the volume and types of credit
derivatives cleared via a central counterparty. In a meeting on
April 1 at the Federal Reserve Bank of New York, market
participants discussed broadening the use of a central clearing
party to include a wider range of firms and credit derivative
products. Participants agreed to form an industry group to
address challenges to achieving these objectives and associated
issues surrounding initial margin segregation and portability.
The industry will report back to regulators with plans on how
to progress.
Q.19. What other classes of OTC derivatives are good candidates
for central clearing and what steps is the OCC taking to
encourage the development and use of central clearing
counterparties?
A.19. The OCC believes that all types of OTC derivative
products, including foreign exchange, interest rate,
commodities, and equities, will have some contracts that are
appropriate candidates for central clearing. The key to
increasing the volume of centrally cleared derivatives is
increasing product standardization. Some OTC derivatives
products are more amenable to this standardization than others.
Over time, a central question for policymakers will be the
extent to which the risks of customized OTC derivatives
products can be effectively managed off of centralized
clearinghouses or exchanges, and whether the benefits exceed
the risks.
------
RESPONSE TO WRITTEN QUESTIONS OF SENATOR REED
FROM JOHN C. DUGAN
Q.1. It is clear that our current regulatory structure is in
need of reform. At my subcommittee hearing on risk management,
March 18, 2009, GAO pointed out that regulators often did not
move swiftly enough to address problems they had identified in
the risk management systems of large, complex financial
institutions.
My questions may be difficult, but please answer the
following:
If this lack of action is a persistent problem
among the regulators, to what extent will changing the
structure of our regulatory system really get at the
issue?
Along with changing the regulatory structure, how
can Congress best ensure that regulators have clear
responsibilities and authorities, and that they are
accountable for exercising them ``effectively and
aggressively''?
A.1. As was discussed in Senior Deputy Comptroller Long's March
18th testimony before the Subcommittee on Securities,
Insurance, and Investment, looking back on the events of the
past two years, there are clearly things we may have done
differently or sooner, but I do not believe our supervisory
record indicates that there was a ``lack of action'' by the
OCC. For example, we began alerting national banks to our
concerns about increasingly liberal underwriting practices in
certain loan products as early as 2003. Over the next few
years, we progressively increased our scrutiny and responses,
especially with regard to credit cards, residential mortgages,
and commercial real estate loans even though the underlying
``fundamentals'' for these products and market segments were
still robust. Throughout this period, our examiners were
diligent in identifying risks and directing banks to take
corrective action. Nonetheless, we and the industry initially
underestimated the magnitude and severity of the disruptions
that we have subsequently seen in the market and the rapidity
at which these disruptions spilled over into the overall
economy. In this regard, we concur with the GAO that regulators
and large, complex banking institutions need to develop better
stress test mechanisms that evaluate risks across the entire
firm and that identify interconnected risks and potential tail
events. We also agree that more transparency and capital is
needed for certain off-balance sheet conduits and products that
can amplify a bank's risk exposure.
While changes to our regulatory system are warranted--
especially in the area of systemic risk--I do not believe that
fundamental changes are required to the structure for
conducting banking supervision.
Q.2. How do we overcome the problem that in the boom times no
one wants to be the one stepping in to tell firms they have to
limit their concentrations of risk or not trade certain risky
products?
What thought has been put into overcoming this problem for
regulators overseeing the firms? Is this an issue that can be
addressed through regulatory restructure efforts?
A.2. A key issue for bankers and supervisors is determining
when the accumulation of risks either within an individual firm
or across the system has become too high, such that corrective
or mitigating actions are needed. Knowing when and how to
strike this balance is one of the most difficult jobs that
supervisors face. Taking action too quickly can constrain
economic growth and impede access to credit by credit-worthy
borrowers. Waiting too long can result in an overhang of risk
becoming embedded into banks that can lead to failure and, in
the marketplace, that can lead to the types of dislocations we
have seen over the past year. This need to balance supervisory
actions, I believe, is fundamental to bank supervision and is
not an issue that can be addressed through regulatory
restructure--the same issue will face whatever entity or agency
is ultimately charged with supervision.
There are, however, actions that I believe we can and
should take to help dampen some of the effects of business and
economic cycles. First, as previously noted, I believe we need
to insist that large institutions establish more rigorous and
comprehensive stress tests that can identify risks that may be
accumulating across various business and product lines. As we
have seen, some senior bank managers thought they had avoided
exposure to subprime residential mortgages by deliberately
choosing not to originate such loans in the bank, only to find
out after the fact that their investment banks affiliates had
purchased subprime loans elsewhere. For smaller, community
banks, we need to develop better screening mechanisms that we
can use to help identify banks that are building up
concentrations in a particular product line and where
mitigating actions may be necessary. We have been doing just
that for our smaller banks that may have significant commercial
real estate exposures.
We also need to ensure that banks have the ability to
strengthen their loan loss reserves at an appropriate time in
the credit cycle, as their potential future loans losses are
increasing. A more forward-looking ``life of the loan'' or
``expected loss'' concept would allow provisions to incorporate
losses expected over a more realistic time horizon, and would
not be limited to losses incurred as of the balance sheet date,
as under the current regime. Such a revision would help to
dampen the decidedly pro-cyclical effect that the current rules
are having today. This is an issue that I am actively engaged
in through my role as Chairman of the Financial Stability
Board's Working Group on Provisioning.
Similarly, the Basel Committee on Bank Supervision recently
announced an initiative to introduce standards that would
promote the build up of capital buffers that can be drawn upon
in periods of stress. Such a measure could also potentially
serve as a buffer or governor to the build up of risk
concentrations.
There are additional measures we could consider, such as
establishing absolute limits on the concentration a bank could
have to a particular industry or market segment, similar to the
loan limits we currently have for loans to an individual
borrower. The benefits of such actions would need to be
carefully weighed against the potential costs this may impose.
For example, such a regime could result in a de facto
regulatory allocation of credit away from various industries or
markets. Such limits could also have a disproportionate affect
on smaller, community banks whose portfolios by their very
nature, tend to be concentrated in their local communities and,
often, particular market segments such as commercial real
estate.
Q.3. As Mr. Tarullo and Mrs. Bair noted in their testimony,
some financial institution failures emanated from institutions
that were under federal regulation. While I agree that we need
additional oversight over and information on unregulated
financial institutions, I think we need to understand why so
many regulated firms failed.
Why is it the case that so many regulated entities failed,
and many still remain struggling, if our regulators in fact
stand as a safety net to rein in dangerous amounts of risk-
taking?
A.3. As alluded to in Governor Tarullo and Chairman Bair's
testimonies, most of the prominent failures that have occurred
and contributed to the current market disruption primarily
involved systemically important firms that were not affiliated
with an insured bank and were thus not overseen by the Federal
Reserve or subject to the provisions of the Bank Holding
Company Act. Although portions of these firms may have been
subject to some form of oversight, they generally were not
subject to the type or scope of consolidated supervision
applied to banks and bank holding companies.
Nonetheless, large national banking companies clearly have
not been immune to the problems we have seen over the past
eighteen months and several have needed active supervisory
intervention or the assistance of the capital and funding
programs instituted by the U.S. Treasury, Federal Reserve, and
FDIC. As I noted in my previous answer, prior to the recent
market disruptions our examiners had been identifying risks and
risk management practices that needed corrective action and
were working with bank management teams to ensure that such
actions were being implemented. We were also directing our
large banks to shore up their capital levels and during the
eight month period from October 2007 through early June 2008,
the largest national banking companies increased their capital
and debt levels through public and private offerings by over
$100 billion.
I firmly believe that our actions that resulted in banks
strengthening their underwriting standards, increasing their
capital and reserves, and shoring up their liquidity were
instrumental to the resilience that the national banking system
as whole has shown during this period of unprecedented
disruption in bank funding markets and significant credit
losses. Indeed several of the largest national banks have
served as a source of strength to the financial system by
acquiring significant problem thrift institutions (i.e.,
Countrywide and Washington Mutual) and broker-dealer operations
(i.e., Bear Stearns and Merrill Lynch). In addition, we worked
to successfully resolve via acquisition by other national
banks, two large national banks--National City and Wachovia--
that faced severe funding pressures in the latter part of 2008.
While both of these banks had adequate capital levels, they
were unable to roll over their short term liabilities in the
marketplace at a time when market perception and sentiment for
many banking companies were under siege. Due to these funding
pressures, both banks had to be taken over by companies with
stronger capital and funding bases. As the breadth and depth of
credit problems accelerated in late 2008, two other large
banking companies, Citigroup and Bank of America, required
additional financial assistance through Treasury's Asset
Guarantee and Targeted Investment programs to help stabilize
their financial condition. As part of the broader Supervisory
Capital Assessment Program that the OCC, Federal Reserve, and
FDIC recently conducted on the largest recipients of funds
under the Treasury's Troubled Assets Relief Program, we are
closely monitoring the adequacy of these firms' capital levels
to withstand further adverse economic conditions and will be
requiring them to submit capital plans to ensure that they have
sufficient capital to weather such conditions. In almost all
cases, our large national banking organizations are on track to
meet any identified capital needs and have been able to raise
private capital through the marketplace, a sign that investor
confidence may be returning to these institutions.
While the vast majority of national banks remain sound,
many national banks will continue to face substantial credit
losses as credit problems work through the banking system. In
addition, until the capital and securitization markets are more
fully restored, larger banks will continue to face potential
liquidity pressures and funding constraints. As I have stated
in previous testimonies, we do expect that the number of
problem banks and bank failures will continue to increase for
some time given current economic conditions. In problem bank
situations, our efforts focus on developing a specific plan
that takes into consideration the ability and willingness of
management and the board to correct deficiencies in a timely
manner and return the bank to a safe and sound condition. In
most instances our efforts, coupled with the commitment of bank
management, result in a successful rehabilitation of the bank.
There will be cases, however, where the situation is of such
significance that we will require the sale, merger, or
liquidation of the bank, if possible. Where that is not
possible, we will appoint the FDIC as receiver.
Q.4. While we know that certain hedge funds, for example, have
failed, have any of them contributed to systemic risk?
A.4. The failure of certain hedge funds, while not by
themselves systemically important (in contrast to the failure
of Long Term Capital Management in 1998), led to a reduction in
market liquidity as leveraged investors accelerated efforts to
reduce exposures by selling assets. Given significant
uncertainty over asset values, reflecting sharply reduced
market liquidity, this unwinding of leveraged positions has put
additional strains on the financial system and contributed to
lack of investor confidence in the markets.
Q.5. Given that some of the federal banking regulators have
examiners on-site at banks, how did they not identify some of
these problems we are facing today?
A.5. At the outset, it is important to be clear that bank
examiners do not have authority over the nonbank companies in a
holding company. These nonbank firms were the source of many of
the issues confronting large banking firms. With respect to
banks, as noted above, we were identifying issues and taking
actions to address problems that we were seeing in loan
underwriting standards and other areas. At individual banks, we
were directing banks to strengthen risk management and
corporate governance practices and, at some institutions, were
effecting changes in key managerial positions. Nonetheless, in
retrospect, it is clear that we should have been more
aggressive in addressing some of the practices and risks that
were building up across the banking system during this period.
For example, it is clear that we and many bank managers put too
much reliance on the various credit enhancements used to
support certain collateralized debt obligations and not enough
emphasis on the quality of, and correlations across, the
underlying assets supporting those obligations. Similarly, we
were not sufficiently attuned to the systemic risk implications
of the significant migration by large banks to an ``originate-
to-distribute model'' for commercial and leveraged loan
products. Under this model, banks originated a significant
volume of loans with the express purpose of packaging and
selling them to institutional investors who generally were
willing to accept more liberal underwriting standards than the
banks themselves would accept, in return for marginally higher
yields. In the fall of 2007, when the risk appetite of
investors changed dramatically (and at times for reasons not
directly related to the exposures they held), banks were left
with significant pipelines of loans that they needed to fund,
thus exacerbating their funding and capital pressures. As has
been well-documented, similar pressures were leading to
relaxation of underwriting standards within the residential
mortgage loan markets. While the preponderance of the subprime
and ``Alt-A'' loans that have been most problematic were
originated outside of the national banking system, the
subsequent downward spiral in housing prices that these
practices triggered have clearly affected all financial
institutions, including national banks.
------
RESPONSE TO WRITTEN QUESTIONS OF SENATOR CRAPO
FROM JOHN C. DUGAN
Q.1. The convergence of financial services providers and
financial products has increased over the past decade.
Financial products and companies may have insurance, banking,
securities, and futures components. One example of this
convergence is AIG. Is the creation of a systemic risk
regulator the best method to fill in the gaps and weaknesses
that AIG has exposed, or does Congress need to reevaluate the
weaknesses of federal and state functional regulation for
large, interconnected, and large firms like AIG?
A.1. The financial crisis has highlighted significant
regulatory gaps in the oversight of our financial system. Large
nonbank financial institutions like AIG, Fannie Mae and Freddie
Mac, Bear Steams, and Lehman were subject to varying degrees
and different kinds of government oversight. No one regulator
had access to risk information from these nonbank firms in the
same way that the Federal Reserve has with respect to bank
holding companies. The result was that the risk these firms
presented to the financial system as a whole could not be
managed or controlled before their problems reached crisis
proportions.
Assigning to one agency the oversight of systemic risk
throughout the financial system could address certain of these
regulatory gaps. For example, such an approach would fix
accountability, centralize data collection, and facilitate a
unified approach to identifying and addressing large risks
across the system. However, a single systemic regulator
approach also would face challenges due to the diverse nature
of the firms that could be labeled systemically significant.
Key issues would include the type of authority that should be
provided to the regulator; the types of financial firms that
should be subject to its jurisdiction; and the nature of the
new regulator's interaction with existing prudential
supervisors. It would be important, for example, for the
systemic regulatory function to build on existing prudential
supervisory schemes, adding a systemic point of view, rather
than replacing or duplicating regulation and supervisory
oversight that already exists. How this would be done would
need to be evaluated in light of other restructuring goals,
including providing clear expectations for financial
institutions and clear responsibilities and accountability for
regulators; avoiding new regulatory inefficiencies; and
considering the consequences of an undue concentration of
responsibilities in a single regulator.
Moreover, the contours of new systemic authority may need
to vary depending on the nature of the systemically significant
entity. For example, prudential regulation of banks involves
extensive requirements with respect to risk reporting, capital,
activities limits, risk management, and enforcement. The
systemic supervisor might not need to impose all such
requirements on all types of systemically important firms. The
ability to obtain risk information would be critical for all
such firms, but it might not be necessary, for example, to
impose the full array of prudential standards, such as capital
requirements or activities limits on all types of systemically
important firms, e.g., hedge funds (assuming they were subject
to the new regulator's jurisdiction). Conversely, firms like
banks that are already subject to extensive prudential
supervision would not need the same level of oversight as firms
that are not--and if the systemic overseer were the Federal
Reserve Board, very little new authority would be required with
respect to banking companies, given the Board's current
authority over bank holding companies.
Q.2. Recently there have been several proposals to consider for
financial services conglomerates. One approach would be to move
away from functional regulation to some type of single
consolidated regulator like the Financial Services Authority
model. Another approach is to follow the Group of 30 Report
which attempts to modernize functional regulation and limit
activities to address gaps and weaknesses. An in-between
approach would be to move to an objectives-based regulation
system suggested in the Treasury Blueprint. What are some of
the pluses and minuses of these three approaches?
A.2. A number of options for regulatory reform have been put
forward, including those mentioned in this question. Each
raises many detailed issues.
The Treasury Blueprint offers a thoughtful approach to the
realities of financial services regulation in the 21st century.
In particular, the Blueprint's recommendation to establish a
new federal charter for systemically significant payment and
settlement systems and authorizing the Federal Reserve Board to
supervise them is appropriate given the Board's extensive
experience with payment system regulation.
The Group of 30 Report compares and analyzes the financial
regulatory approaches of seventeen jurisdictions--including the
United Kingdom, the United States and Australia--in order to
illustrate the implications of the four principal models of
supervisory oversight. The Group of 30 Report then sets forth
18 proposals for banks and nonbanks. For all countries, the
Report recommends that bank supervision be consolidated under
one prudential regulator. Under the proposals, banks that are
deemed systemically important would face restrictions on high-
risk proprietary activities. The report also calls for raising
the level at which banks are considered to be well-capitalized,
Proposals for nonbanks include regulatory oversight and the
production or regular reports on leverage and performance. For
banks and nonbanks alike, the Report calls for a more refined
analysis of liquidity in stressed markets and more robust
contingency planning.
The Financial Services Authority model is one in which all
supervision is consolidated in one agency.
As debate on these and other proposals continues, the OCC
believes two fundamental points are essential. First, it is
important to preserve the Federal Reserve Board's role as a
holding company supervisor. Second, it is equally if not more
important to preserve the role of a dedicated, front-line
prudential supervisor for our nation's banks.
The Financial Services Authority model raises the
fundamental problem that consolidating all supervision in a
new, single independent agency would take bank supervisory
functions away from the Federal Reserve Board. As the central
bank and closest agency we have to a systemic risk regulator,
the Board needs the window it has into banking organizations
that it derives from its role as bank holding company
supervisor. Moreover, given its substantial role and direct
experience with respect to capital markets, payments systems,
the discount window, and international supervision, the Board
provides unique resources and perspective to bank holding
company supervision.
Second, and perhaps more important, is preserving the very
real benefit of having an agency whose sole mission is bank
supervision. The benefits of dedicated supervision are
significant. Where it occurs, there is no confusion about the
supervisor's goals and objectives, and no potential conflict
with competing objectives. Responsibility is well defined, and
so is accountability. Supervision does not take a back seat to
any other part of the organization, and the result is a strong
culture that fosters the development of the type of seasoned
supervisors that are needed to confront the many challenges
arising from today's banking business.
Q.3. If there are institutions that are too big to fail, how do
we identify that? How do we define the circumstance where a
single company is so systemically significant to the rest of
our financial circumstances and our economy that we must not
allow it to fail? We need to have a better idea of what this
notion of too big to fail is--what it means in different
aspects of our industry and what our proper response to it
should be. How should the federal government approach large,
multinational and systemically significant companies? What does
``fail'' mean? In the context of AIG, we are talking about
whether we should have allowed an orderly Chapter 11 bankruptcy
proceeding to proceed. Is that failure?
A.3. There a number of ways ``too big to fail'' can be defined,
including the size of an institution, assets under management,
interrelationships or interconnections with other significant
economic entities, or global reach. Likewise, ``failure'' could
have several definitions, including bankruptcy. But whatever
definition of these terms Congress may choose, it is important
that there be an orderly process for resolving systemically
significant firms.
U.S. law has long provided a unique and well developed
framework for resolving distressed and failing banks that is
distinct from the federal bankruptcy regime. Since 1991, this
unique framework, contained in the Federal Deposit Insurance
Act, has also provided a mechanism to address the problems that
can arise with the potential failure of a systemically
significant bank--including, if necessary to protect financial
stability, the ability to use the bank deposit insurance fund
to prevent uninsured depositors, creditors, and other
stakeholders of the bank from sustaining loss.
No comparable framework exists for resolving most
systemically significant financial firms that are not banks,
including systemically significant holding companies of banks.
Such firms must therefore use the normal bankruptcy process
unless they can obtain some form of extraordinary government
assistance to avoid the systemic risk that might ensue from
failure or the lack of a timely and orderly resolution. While
the bankruptcy process may be appropriate for resolution of
certain types of firms, it may take too long to provide
certainty in the resolution of a systemically significant firm,
and it provides no source of funding for those situations where
substantial resources are needed to accomplish an orderly
solution.
This gap needs to be addressed with an explicit statutory
regime for facilitating the resolution of systemically
important nonbank companies as well as banks. This new
statutory regime should provide tools that are similar to those
currently available for resolving banks, including the ability
to require certain actions to stabilize a firm; access to a
significant funding source if needed to facilitate orderly
dispositions, such as a significant line of credit from the
Treasury; the ability to wind down a firm if necessary; and the
flexibility to guarantee liabilities and provide open
institution assistance if needed to avoid serious risk to the
financial system. In addition, there should be clear criteria
for determining which institutions would be subject to this
resolution regime, and how to handle the foreign operations of
such institutions.
------
RESPONSE TO WRITTEN QUESTIONS OF SENATOR KOHL
FROM JOHN C. DUGAN
Q.1. Two approaches to systemic risk seem to be identified, (1)
monitoring institutions and taking steps to reduce the size/
activities of institutions that approach a ``too large to
fail'' or ``too systemically important to fail'' or (2) impose
an additional regulator and additional rules and market
discipline on institutions that are considered systemically
important. Which approach do you endorse?
A.1. The functions and authorities of a systemic risk regulator
may need to differ depending on the nature of the systemically
significant entity. Some types of firms, including banks,
already are subject to federally imposed capital requirements,
federal constraints on their activities, and the enforcement
jurisdiction of a federal prudential regulator. These oversight
functions should not be duplicated in the systemic supervisor.
Doing so increases the potential for uncertainty about the
standards to which firms will be held and for inconsistency
between requirements administered by the primary and the
systemic regulator.
In practice, the role of a systemic risk overseer may vary
at different points in time depending on whether financial
markets are functioning normally, or are instead experiencing
unusual stress or disruption. For example, in a stable economic
environment, the systemic risk regulator might focus most on
obtaining and analyzing information about risks. Such
additional information and analysis would be valuable not only
for the systemic risk regulator, but also for prudential
supervisors in terms of their understanding of firms' exposure
to risks occurring in other parts of the financial services
system to which they have no direct access. And it could
facilitate the implementation of supervisory strategies to
address and contain such risk before it increased to
unmanageable levels. On the other hand, in times of stress or
disruption it may be desirable for the systemic regulator to
take actions to stabilize a firm or apply stricter than normal
standards to aspects of its operations.
Q.2. Please identify all regulatory or legal barriers to the
comprehensive sharing of information among regulators including
insurance regulators, banking regulators, and investment
banking regulators. Please share the steps that you are taking
to improve the flow of communication among regulators within
the current legislative environment.
A.2. At the federal level, no barriers to information sharing
exist between federal banking regulators because the Federal
Deposit Insurance Act, at 12 U.S.C. 1821t, provides that ``a
covered agency'' does not waive any privilege when it transfers
information or permits information to be used by a covered
agency or any other agency of the federal government. A
``covered agency'' includes a federal banking agency, but not a
state authority. This would also protect privilege when the OCC
shares information with other federal agencies, such as the
SEC, with which the OCC shares information pursuant to letter
agreements in connection with the SEC's enforcement
investigations and inspection functions.
In 1984, a joint statement of policy was issued by the OCC,
FRB, FDIC, and the FHLBB that contained agreements relating to
confidentiality safeguards that would be observed in connection
with the sharing of certain categories of confidential
supervisory information between those agencies. Presently,
these and other protocols are observed in connection with the
sharing of broader and other categories of supervisory
information with other federal agencies that occurs pursuant to
OCC's regulations or, as indicated above with respect to the
SEC, written agreements or memoranda of understanding. It is
crucial that the confidentiality of any information shared
between federal and state authorities concerning bank condition
or personal consumer information be assured. The OCC has
therefore entered into a number of agreements with various
state regulators that govern the sharing, and protect the
confidentiality, of information held by federal and state
regulators:
The OCC has entered into written sharing agreements
or memoranda with 48 of the 50 states, the District of
Columbia, and Puerto Rico. These documents, most of
which were executed between 1987 and 1992, generally
provide for the sharing of broad categories of
information when needed for supervisory purposes.
The OCC has executed a model Memorandum of
Understanding with the Conference of State Bank
Supervisors (CSBS) that is intended to facilitate the
referral of customer complaints between the OCC and
individual states, and to share information about the
disposition of these complaints. As of December, 2008,
this model agreement has served as the basis for
information sharing agreements between the OCC and 44
states and Puerto Rico.
In addition, the OCC has insurance information-
sharing agreements with 49 States and the District of
Columbia.
The OCC has entered into many case specific
agreements with states attorneys general in order to
obtain information relevant to misconduct within the
national banking system. We also encourage states
attorneys general to refer complaints of misconduct by
OCC regulated entities directly to the OCC's Customer
Assistance Group. Finally, the OCC Customer Assistance
Group refers consumer complaints that it receives with
respect to State regulated entities to the appropriate
state officials.
The OCC exchanges information with state securities
regulators on a case-by-case basis pursuant to letter
agreements.
Moreover, the OCC has worked cooperatively with the states
to address specific supervisory and consumer protection issues.
For example, in the area of supervisory guidance, federal and
state regulators have worked constructively in connection with
implementation of the nontraditional mortgage and subprime
mortgage guidance issued initially by the federal banking
agencies.
More generally, under the auspices of the Federal Financial
Institutions Examination Council (FFIEC), the OCC actively
participates in the development and implementation of uniform
principles, standards, and report forms for the examination of
financial institutions by the federal agencies who are members
of the FFIEC, which include (in addition to the OCC) the
Federal Reserve Board, the FDIC, the OTS, and the NCUA. In
2006, the Chair of the State Liaison Committee (SLC) was added
to the FFIEC as a voting member. The SLC includes
representatives of the Conference of State Bank Supervisors
(CSBS), the American Council of State Savings Supervisors
(ACSSS), and the National Association of State Credit Union
Supervisors (NASCUS). Working through its Task Forces (such as
the Task Force on Supervision and the Task Force on
Compliance), the FFIEC also develops recommendations to promote
uniformity in the supervision of financial institutions.
The OCC also participates in the President's Working Group
on Financial Markets, a group composed of the Treasury
Department, the Federal Reserve Board, the SEC, and the CFTC,
which considers significant financial institutions' policy
issues on an ongoing basis.
------
RESPONSE TO WRITTEN QUESTIONS OF SENATOR HUTCHISON
FROM JOHN C. DUGAN
Q.1. Will each of you commit to do everything within your power
to prevent performing loans from being called by lenders?
Please outline the actions you plan to take.
A.1. The OCC has and will continue to encourage bankers to work
with borrowers and to meet the credit needs of credit-worthy
borrowers. Ultimately, however, the decision about whether to
call a particular loan is a business decision that a banker
must make. Such decisions must be based on the specific facts
and circumstances of the bank, including its overall risk
profile and its relationship with the borrower.
There has been a perception that examiners are requiring
bankers to call or classify performing loans, resulting in what
some have called a ``performing nonperforming loan.'' Let me be
clear, examiners do not tell bankers to call or renegotiate a
loan, nor will they direct bankers to classify a loan or
borrowers who have the demonstrated ability to service their
debts under reasonable repayment schedules. In an effort to
clarify how examiners approach this issue, it is important to
define the term ``performing loan.'' Some define performance as
simply being contractually current on all principal and
interest payments. In many cases this definition is sufficient
for a particular credit relationship and accurately portrays
the status of the loan. In other cases, however, being
contractually current on payments can be a very misleading
gauge of the credit risk embedded in the loan. This is
especially the case where the loan's underwriting structure can
mask credit weaknesses and obscure the fact that a borrower may
be unable to meet the full terms of the loan. This phenomenon
was vividly demonstrated in certain nontraditional rate
residential mortgage products where a borrower may have been
qualified at a low ``teaser'' rate or with interest-only
payments, without regard as to whether they would be able to
afford the loan once the rates or payments adjusted to a fully
indexed rate or included principal repayments.
Analysis of payment performance must consider under what
terms the performance has been achieved. For example, in many
acquisition, development and construction loans for residential
developments, it is common for the loans to be structured with
what is referred to as an ``interest reserve'' for the initial
phase of the project. These interest reserves are established
as part of the initial loan proceeds at the time the loan is
funded and provide funds for interest payments as lots are
being developed, with repayment of principal occurring as each
lot or parcel is sold and released. However, if the development
project stalls for any number of reasons, the interest will
continue to be paid from the initial interest reserve even
though the project is not generating any cash flows to repay
loan principal. In such cases, the loan will be contractually
current due to the interest payments being made from the
reserves, but the repayment of principal is in jeopardy. We are
seeing instances where projects such as these have completely
stalled with lot sales significantly behind schedule or even
nonexistent and the loan, including the interest reserve, is
set to mature shortly. This is an example where a loan is
contractually current, but is not performing as intended.
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RESPONSE TO WRITTEN QUESTIONS OF SENATOR SHELBY
FROM SHEILA C. BAIR
Q.1. Consumer Protection Regulation--Some have advocated that
consumer protection and prudential supervision should be
divorced, and that a separate consumer protection regulation
regime should be created. They state that one source of the
financial crisis emanated from the lack of consumer protection
in the underwriting of loans in the originate-to-distribute
space.
What are the merits of maintaining it in the same agency?
Alternatively, what is the best argument each of you can make
for a new consumer protection agency?
A.1. As I said in my testimony, there can no longer be any
doubt about the link between protecting consumers from abusive
products and practices and the safety and soundness of the
financial system. Products and practices that strip individual
and family wealth undermine the foundation of the economy. As
the current crisis demonstrates, increasingly complex financial
products combined with frequently opaque marketing and
disclosure practices result in problems not just for consumers,
but for institutions and investors as well.
To protect consumers from potentially harmful financial
products, a case has been made for a new independent financial
product safety commission. Certainly, more must be done to
protect consumers. The FDIC could support the establishment of
a new entity to establish consistent consumer protection
standards for banks and nonbanks. However, we believe that such
a body should include the perspective of bank regulators as
well as nonbank enforcement officials such as the FTC. However,
as Congress considers the options, we recommend that any new
plan ensure that consumer protection activities are aligned and
integrated with other bank supervisory information, resources,
and expertise, and that enforcement of consumer protection
rules for banks be left to bank regulators.
The current bank regulation and supervision structure
allows the banking agencies to take a comprehensive view of
financial institutions from both a consumer protection and
safety-and-soundness perspective. Banking agencies' assessments
of risks to consumers are closely linked with and informed by a
broader understanding of other risks in financial institutions.
Conversely, assessments of other risks, including safety and
soundness, benefit from knowledge of basic principles, trends,
and emerging issues related to consumer protection. Separating
consumer protection regulation and supervision into different
organizations would reduce information that is necessary for
both entities to effectively perform their functions.
Separating consumer protection from safety and soundness would
result in similar problems. Our experience suggests that the
development of policy must be closely coordinated and reflect a
broad understanding of institutions' management, operations,
policies, and practices--and the bank supervisory process as a
whole.
One of the fundamental principles of the FDIC's mission is
to serve as an independent agency focused on maintaining
consumer confidence in the banking system. The FDIC plays a
unique role as deposit insurer, federal supervisor of state
nonmember banks and savings institutions, and receiver for
failed depository institutions. These functions contribute to
the overall stability of and consumer confidence in the banking
industry. With this mission in mind, if given additional
rulemaking authority, the FDIC is prepared to take on an
expanded role in providing consumers with stronger protections
that address products posing unacceptable risks to consumers
and eliminate gaps in oversight.
Q.2. Regulatory Gaps or Omissions--During a recent hearing, the
Committee has heard about massive regulatory gaps in the
system. These gaps allowed unscrupulous actors like AIG to
exploit the lack of regulatory oversight. Some of the
counterparties that AIG did business with were institutions
under your supervision.
Why didn't your risk management oversight of the AIG
counterparties trigger further regulatory scrutiny? Was there a
flawed assumption that AIG was adequately regulated, and
therefore no further scrutiny was necessary?
A.2. The FDIC did not have supervisory authority over AIG.
However, to protect taxpayers the FDIC recommends that a new
resolution regime be created to handle the failure of large
nonbanks such as AIG. This special receivership process should
be outside bankruptcy and be patterned after the process we use
for bank and thrift failures.
Q.3. Was there dialogue between the banking regulators and the
state insurance regulators? What about the SEC?
A.3. The FDIC did not have supervisory authority for AIG and
did not engage in discussions regarding the entity. However,
the need for improved interagency communication demonstrates
that the reform of the regulatory structure also should include
the creation of a systemic risk council (SRC) to address issues
that pose risks to the broader financial system. The SRC would
be responsible for identifying institutions, practices, and
markets that create potential systemic risks, implementing
actions to address those risks, ensuring effective information
flow, completing analyses and making recommendations on
potential systemic risks, setting capital and other standards
and ensuring that the key supervisors with responsibility for
direct supervision apply those standards. The macro-prudential
oversight of system-wide risks requires the integration of
insights from a number of different regulatory perspectives--
banks, securities firms, holding companies, and perhaps others.
Only through these differing perspectives can there be a
holistic view of developing risks to our system.
Q.4. If the credit default swap contracts at the heart of this
problem had been traded on an exchange or cleared through a
clearinghouse, with requirement for collateral and margin
payments, what additional information would have been
available? How would you have used it?
A.4. As with other exchange traded instruments, by moving the
contracts onto an exchange or central counterparty, the overall
risk to any counterparty and to the system as a whole would
have been greatly reduced. The posting of daily variance margin
and the mutuality of the exchange as the counterparty to market
participants would almost certainly have limited the potential
losses to any of AIG's counterparties.
For exchange traded contracts, counterparty credit risk,
that is, the risk of a counterparty not performing on the
obligation, would be substantially less than for bilateral OTC
contracts. That is because the exchange becomes the
counterparty for each trade.
The migration to exchanges or central clearinghouses of
credit default swaps and OTC derivatives in general should be
encouraged and perhaps required. The opacity of CDS risks
contributed to significant concerns about the transmission of
problems with a single credit across the financial system.
Moreover, the customized mark to model values associated with
OTC derivatives may encourage managements to be overly
optimistic in valuing these products during economic
expansions, setting up the potential for abrupt and
destabilizing reversals.
The FDIC or other regulators could use better information
derived from exchanges or clearinghouses to analyze both
individual and systemic risk profiles. For those contracts
which are not standardized, we urge complete reporting of
information to trade repositories so that information would be
available to regulators. With additional information,
regulators may better analyze and ascertain concentrated risks
to the market participants. This is particularly true for large
counterparty exposures that may have systemic ramifications if
the contracts are not well collateralized among counterparties.
Q.5. Liquidity Management--A problem confronting many financial
institutions currently experiencing distress is the need to
roll-over short-term sources of funding. Essentially these
banks are facing a shortage of liquidity. I believe this
difficulty is inherent in any system that funds long-term
assets, such as mortgages, with short-term funds. Basically the
harm from a decline in liquidity is amplified by a bank's level
of ``maturity-mismatch.''
I would like to ask each of the witnesses, should
regulators try to minimize the level of a bank's maturity-
mismatch? And if so, what tools would a bank regulator use to
do so?
A.5. The funding of illiquid assets, whose cash flows are
realized over time and with uncertainty, with shorter-maturity
volatile or credit sensitive funding, is at the heart of the
liquidity problems facing some financial institutions. If a
regulator determines that a bank is assuming amounts of
liquidity risk that are excessive relative to its capital
structure, then the regulator should require the bank to
address this issue.
In recognition of the significant role that liquidity risks
have played during this crisis, regulators the world over are
considering ways to enhance supervisory approaches. There is
better recognition of the need for banks to have an adequate
cushion of liquid assets, supported by pro forma cash flow
analysis under stressful scenarios, well diversified and tested
funding sources, and a liquidity contingency plan. The FDIC
issued supervisory guidance on liquidity risk in August of
2008.
Q.6. Too-Big-To-Fail--Chairman Bair stated in her written
testimony that ``the most important challenge is to find ways
to impose greater market discipline on systemically important
institutions. The solution must involve, first and foremost, a
legal mechanism for the orderly resolution of those
institutions similar to that which exists for FDIC-insured
banks. In short we need to end too big to fail. I would agree
that we need to address the too-big-to-fail issue, both for
banks and other financial institutions.''
Could each of you tell us whether putting a new resolution
regime in place would address this issue?
A.6. There are three key elements to addressing the problem of
systemic risk and too big to fail.
First, financial firms that pose systemic risks should be
subject to regulatory and economic incentives that require
these institutions to hold larger capital and liquidity buffers
to mirror the heightened risk they pose to the financial
system. In addition, restrictions on leverage and the
imposition of risk-based assessments on institutions and their
activities would act as disincentives to the types of growth
and complexity that raise systemic concerns.
The second important element in addressing too big to fail
is an enhanced structure for the supervision of systemically
important institutions. This structure should include both the
direct supervision of systemically significant financial firms
and the oversight of developing risks that may pose risks to
the overall U.S. financial system. Centralizing the
responsibility for supervising these institutions in a single
systemic risk regulator would bring clarity and accountability
to the efforts needed to identify and mitigate the buildup of
risk at individual institutions. In addition, a systemic risk
council could be created to address issues that pose risks to
the broader financial system by identifying cross-cutting
practices, and products that create potential systemic risks.
The third element to address systemic risk is the
establishment of a legal mechanism for quick and orderly
resolution of these institutions similar to what we use for
FDIC insured banks. The purpose of the resolution authority
should not be to prop up a failed entity indefinitely or to
insure all liabilities, but to permit a timely and orderly
resolution and the absorption of assets by the private sector
as quickly as possible. Done correctly, the effect of the
resolution authority will be to increase market discipline and
protect taxpayers.
Q.7. How would we be able to convince the market that these
systemically important institutions would not be protected by
taxpayer resources as they had been in the past?
A.7. Given the long history of government bailouts for
economically and systemically important firms, it will be
extremely difficult to convince market participants that
current practices have changed. Still, it is critical that we
dispel the presumption that some institutions are ``too big to
fail.''
As outlined in my testimony, it is imperative that we
undertake regulatory and legislative reforms that force TBTF
institutions to internalize the social costs of bailouts and
put shareholders, creditors, and managers at real risk of loss.
Capital and other requirements should be put in place to
provide disincentives for institutions to become too large or
complex. This must be linked with a legal mechanism for the
orderly resolution of systemically important nonbank financial
firms--a mechanism similar to that which currently exists for
FDIC-insured depository institutions.
Q.8. Pro-Cyclicality--I have some concerns about the pro-
cyclical nature of our present system of accounting and bank
capital regulation. Some commentators have endorsed a concept
requiring banks to hold more capital when good conditions
prevail, and then allow banks to temporarily hold less capital
in order not to restrict access to credit during a downturn.
Advocates of this system believe that counter cyclical policies
could reduce imbalances within financial markets and smooth the
credit cycle itself.
What do you see as the costs and benefits of adopting a
more counter-cyclical system of regulation?
A.8. The FDIC would be supportive of a capital and accounting
framework for insured depository institutions that avoids the
unintended pro-cyclical outcomes we have experienced in the
current crisis. Capital and other appropriate buffers should be
built up during more benign parts of the economic cycle so that
they are available during more stressed periods. The FDIC
firmly believes that financial statements should present an
accurate depiction of an institution's capital position, and we
strongly advocate robust capital levels during both prosperous
and adverse economic cycles. Some features of existing capital
regimes, and certainly the Basel II Advanced Approaches, lead
to reduced capital requirements during good times and increased
capital requirements during more difficult economic periods.
Some part of capital should be risk sensitive, but it must
serve as a cushion throughout the economic cycle. We believe a
minimum leverage capital ratio is a critical aspect of our
regulatory process as it provides a buffer against unexpected
losses and the vagaries of models-based approaches to assessing
capital adequacy.
Adoption of banking guidelines that mitigate the effects of
pro-cyclicality could potentially lessen the government's
financial risk arising from the various federal safety nets. In
addition, they would help financial institutions remain
sufficiently reserved against loan losses and adequately
capitalized during good and bad times. In addition, some
believe that counter-cyclical approaches would moderate the
severity of swings in the economic cycle as banks would have to
set aside more capital and reserves for lending, and thus take
on less risk during economic expansions.
Q.9. Do you see any circumstances under which your agencies
would take a position on the merits of counter-cyclical
regulatory policy?
A.9. The FDIC would be supportive of a capital and accounting
framework for insured depository institutions that avoids the
unintended pro-cyclical outcomes we have experienced in the
current crisis. Again, we are strongly supportive of robust
capital standards for banks and thrifts as well as conservative
accounting guidelines which accurately represent the financial
position of insured institutions.
Q.10. G20 Summit and International Coordination--Many foreign
officials and analysts have said that they believe the upcoming
G20 summit will endorse a set of principles agreed to by both
the Financial Stability Forum and the Basel Committee, in
addition to other government entities. There have also been
calls from some countries to heavily re-regulate the financial
sector, pool national sovereignty in key economic areas, and
create powerful supranational regulatory institutions.
(Examples are national bank resolution regimes, bank capital
levels, and deposit insurance.) Your agencies are active
participants in these international efforts.
What do you anticipate will be the result of the G20
summit?
A.10. The G20 summit communique addressed a long list of
principles and actions that were originally presented in the
so-called Washington Action Plan. The communique provided a
full progress report on each of the 47 actions in that plan.
The major reforms included expansion and enhancement of the
Financial Stability Board (formerly the Financial Stability
Forum). The FSB will continue to assess the state of the
financial system and promote coordination among the various
financial authorities. To promote international cooperation,
the G20 countries also agreed to establish supervisory colleges
for significant cross-border firms, implement cross-border
crisis management, and launch an Early Warning Exercise with
the IMF. To strengthen prudent financial regulation, the G20
endorsed a supplemental nonrisk based measure of capital
adequacy to complement the risk-based capital measures,
incentives for improving risk management of securitizations,
stronger liquidity buffers, regulation and oversight of
systemically important financial institutions, and a broad
range of compensation, tax haven, and accounting provisions.
Q.11. Do you see any examples or areas where supranational
regulation of financial services would be effective?
A.11. If we are to restore financial health across the globe
and be better prepared for the next global financial situation,
we must develop a sound basis of financial regulation both in
the U.S. and internationally. This is particularly important in
the area of cross-border resolutions of systemically important
financial institutions. Fundamentally, the focus must be on
reforms of national policies and laws in each country. Among
the important requirements in many laws are on-site
examinations, a leverage ratio as part of the capital regime,
an early intervention system like prompt corrective action,
more flexible resolution powers, and a process for dealing with
troubled financial companies. This last reform also is needed
in this country. However, we do not see any appetite for
supranational financial regulation of financial services among
the G20 countries at this time.
Q.12. How far do you see your agencies pushing for or against
such supranational initiatives?
A.12. At this time and until the current financial situation is
resolved, I believe the FDIC should focus its efforts on
promoting an international leverage ratio, minimizing the pro-
cyclicality of the Basel II capital standards, cross-border
resolutions, and other initiatives that the Basel Committee is
undertaking. In the short run, achieving international
cooperation on these issues will require our full attention.
Q.13. Regulatory Reform--Chairman Bair, Mr. Tarullo noted in
his testimony the difficulty of crafting a workable resolution
regime and developing an effective systemic risk regulation
scheme.
Are you concerned that there could be unintended
consequences if we do not proceed with due care?
A.13. Once the government formally appoints a systemic risk
regulator (SRR), market participants may assume that the
likelihood of systemic events will be diminished going forward.
By explicitly accepting the task of ensuring financial sector
stability and appointing an agency responsible for discharging
this duty, the government could create expectations that weaken
market discipline. Private sector market participants may
incorrectly discount the possibility of sector-wide
disturbances. Market participants may avoid expending private
resources to safeguard their capital positions or arrive at
distorted valuations in part because they assume (correctly or
incorrectly) that the SRR will reduce the probability of
sector-wide losses or other extreme events. In short, the
government may risk increasing moral hazard in the financial
system unless an appropriate system of supervision and
regulation is in place. Such a system must anticipate and
mitigate private sector incentives to attempt to profit from
this new form of government oversight and protection at the
expense of taxpayers.
When establishing a SRR, it is also important for the
government to manage expectations. Few if any existing systemic
risk monitors were successful in identifying financial sector
risks prior to the current crisis. Central banks have, for some
time now, acted as systemic risk monitors and few if any
institutions anticipated the magnitude of the current crisis or
the risk exposure concentrations that have been revealed.
Regulators and central banks have mostly had to catch up with
unfolding events with very little warning about impending firm
and financial market failures.
The need for and duties of a SRR can be reduced if we alter
supervision and regulation in a manner that discourages firms
from forming institutions that are systemically important or
too-big-to fail. Instead of relying on a powerful SSR, we need
instead to develop a ``fail-safe'' system where the failure of
any one large institution will not cause the financial system
to break down. In order to move in this direction, we need to
create disincentives that limit the size and complexity of
institutions whose failure would otherwise pose a systemic
risk.
In addition, the reform of the regulatory structure also
should include the creation of a systemic risk council (SRC) to
address issues that pose risks to the broader financial system.
The SRC would be responsible for identifying institutions,
practices, and markets that create potential systemic risks,
implementing actions to address those risks, ensuring effective
information flow, completing analyses and making
recommendations on potential systemic risks, setting capital
and other standards and ensuring that the key supervisors with
responsibility for direct supervision apply those standards.
The macro-prudential oversight of system-wide risks requires
the integration of insights from a number of different
regulatory perspectives--banks, securities firms, holding
companies, and perhaps others. Only through these differing
perspectives can there be a holistic view of developing risks
to our system.
It also is essential that these reforms be time to the
establishment of a legal mechanism for quick and orderly
resolution of these institutions similar to what we use for
FDIC insured banks. The purpose of the resolution authority
should not be to prop up a failed entity indefinitely or to
insure all liabilities, but to permit a timely and orderly
resolution and the absorption of assets by the private sector
as quickly as possible. Done correctly, the effect of the
resolution authority will be to increase market discipline and
protect taxpayers.
Q.14. Credit Rating Agencies--Ms. Bair, you note the role of
the regulatory framework, including capital requirements, in
encouraging blind reliance on credit ratings. You recommend
pre-conditioning ratings based capital requirements on wide
availability of the underlying data.
Wouldn't the most effective approach be to take ratings out
of the regulatory framework entirely?
A.14. We need to consider a range of options for prospective
capital requirements based on the lessons we are learning from
the current crisis. Data from credit rating agencies can be a
valuable component of a credit risk assessment process, but
capital and risk management should not rely on credit ratings.
This issue will need to be explored further as regulatory
capital guidelines are considered.
Q.15. Systemic Regulator--Ms. Bair, you observed that many of
the failures in this crisis were failures of regulators to use
authority that they had.
In light of this, do you believe layering a systemic risk
regulator on top of the existing regime is the optimal way to
proceed with regulatory restructuring?
A.15. A distinction should be drawn between the direct
supervision of systemically significant financial firms and the
macro-prudential oversight of developing risks that may pose
systemic risks to the U.S. financial system. The former
appropriately calls for a single regulator for the largest,
most systemically significant firms, including large bank
holding companies. The macro-prudential oversight of system-
wide risks requires the integration of insights from a number
of different regulatory perspectives--banks, securities firms,
holding companies, and perhaps others. Only through these
differing perspectives can there be a holistic view of
developing risks to our system. As a result, for this latter
role, the FDIC would suggest creation of a systemic risk
council (SRC) to provide analytical support, develop needed
prudential policies, and have the power to mitigate developing
risks.
------
RESPONSE TO WRITTEN QUESTIONS OF SENATOR REED
FROM SHEILA C. BAIR
Q.1.a. It is clear that our current regulatory structure is in
need of reform. At my subcommittee hearing on risk management,
March 18, 2009, GAO pointed out that regulators often did not
move swiftly enough to address problems they had identified in
the risk management systems of large, complex financial
institutions.
Chair Bair's written testimony for today's hearing put it
very well: `` . . . the success of any effort at reform will
ultimately rely on the willingness of regulators to use their
authorities more effectively and aggressively.''
My questions may be difficult, but please answer the
following:
If this lack of action is a persistent problem among the
regulators, to what extent will changing the structure of our
regulatory system really get at the issue?
A.1.a. It is unclear whether a change in the U.S. regulatory
structure would have made a difference in mitigating the
outcomes of this crisis. Countries that rely on a single
financial regulatory body are experiencing the same financial
stress the U.S. is facing now. Therefore, it is not certain
that a single powerful federal regulator would have acted
aggressively to restrain risk taking during the years leading
up to the crisis.
For this reason, the reform of the regulatory structure
also should include the creation of a systemic risk council
(SRC) to address issues that pose risks to the broader
financial system. The SRC would be responsible for identifying
institutions, practices, and markets that create potential
systemic risks, implementing actions to address those risks,
ensuring effective information flow, completing analyses and
making recommendations on potential systemic risks, setting
capital and other standards and ensuring that the key
supervisors with responsibility for direct supervision apply
those standards. The macro-prudential oversight of system-wide
risks requires the integration of insights from a number of
different regulatory perspectives--banks, securities firms,
holding companies, and perhaps others. Only through these
differing perspectives can there be a holistic view of
developing risks to our system.
In the long run it is important to develop a ``fail-safe''
system where the failure of any one large institution will not
cause the financial system to break down-that is, a system
where firms are not systemically large and are not too-big-to
fail. In order to move in this direction, we need to create
incentives that limit the size and complexity of institutions
whose failure would otherwise pose a systemic risk.
Finally, a key element to address systemic risk is the
establishment of a legal mechanism for quick and orderly
resolution of these institutions similar to what we use for
FDIC insured banks. The purpose of the resolution authority
should not be to prop up a failed entity indefinitely or to
insure all liabilities, but to permit a timely and orderly
resolution and the absorption of assets by the private sector
as quickly as possible. Done correctly, the effect of the
resolution authority will be to increase market discipline and
protect taxpayers.
Q.1.b. Along with changing the regulatory structure, how can
Congress best ensure that regulators have clear
responsibilities and authorities, and that they are accountable
for exercising them ``effectively and aggressively''?
A.1.b. History shows that banking supervisors are reluctant to
impose wholesale restrictions on bank behavior when banks are
making substantial profits. Regulatory reactions to safety and
soundness risks are often delayed until actual bank losses
emerge from the practices at issue. While financial theory
suggests that above average profits are a signal that banks
have been taking above average risk, bankers often argue
otherwise and regulators are all too often reluctant to
prohibit profitable activities, especially if the activities
are widespread in the banking system and do not have a history
of generating losses. Supervision and regulation must become
more proactive and supervisors must develop the capacity to
intervene before significant losses are realized.
In order to encourage proactive supervision, Congress could
require semi-annual hearings in which the various regulatory
agencies are required to: (1) report on the condition of their
supervised institutions; (2) comment on the sustainability of
the most profitable business lines of their regulated entities;
(3) outline emerging issues that may engender safety and
soundness concerns within the next three years; (4) discuss
specific weaknesses or gaps in regulatory authorities that are
a source of regulatory concern and, when appropriate, propose
legislation to attenuate safety and soundness issues. This
requirement for semi-annual testimony on the state of regulated
financial institutions is similar in concept to the Humphrey-
Hawkins testimony requirement on Federal Reserve Board monetary
policy.
Q.2.a. How do we overcome the problem that in the boom times no
one wants to be the one stepping in to tell firms they have to
limit their concentrations of risk or not trade certain risky
products?
What thought has been put into overcoming this problem for
regulators overseeing the firms?
A.2.a. During good times and bad, regulators must strike a
balance between encouraging prudent innovation and strong bank
supervision. Without stifling innovation, we need to ensure
that banks engage in new activities in a safe-and-sound manner
and originate responsible loans using prudent underwriting
standards and loan terms that borrowers can reasonably
understand and have the capacity to repay.
Going forward, the regulatory agencies should be more
aggressive in good economic times to contain risk at
institutions with high levels of credit concentrations,
particularly in novel or untested loan products. Increased
examination oversight of institutions exhibiting higher-risk
characteristics is needed in an expanding economy, and
regulators should have the staff expertise and resources to
vigilantly conduct their work.
Q.2.b. Is this an issue that can be addressed through
regulatory restructure efforts?
A.2.b. Reforming the existing regulatory structure will not
directly solve the supervision of risk concentration issues
going forward, but may play a role in focusing supervisory
attention on areas of emerging risk. For example, a more
focused regulatory approach that integrates the supervision of
traditional banking operations with capital markets business
lines supervised by a nonbanking regulatory agency will help to
address risk across the entire banking company.
Q.3.a. As Mr. Tarullo and Mrs. Bair noted in their testimony,
some financial institution failures emanated from institutions
that were under federal regulation. While I agree that we need
additional oversight over and information on unregulated
financial institutions, I think we need to understand why so
many regulated firms failed.
Why is it the case that so many regulated entities failed,
and many still remain struggling, if our regulators in fact
stand as a safety net to rein in dangerous amounts of risk-
taking?
A.3.a. Since 2007, the failure of community banking
institutions was caused in large part by deterioration in the
real estate market which led to credit losses and a rapid
decline in capital positions. The causes of such failures are
consistent with our receivership experience in past crises, and
some level of failures is not totally unexpected with the
downturn in the economic cycle. We believe the regulatory
environment in the U.S. and the implementation of federal
financial stability programs has actually prevented more
failures from occurring and will assist weakened banks in
ultimately recovering from current conditions. Nevertheless,
the bank regulatory agencies should have been more aggressive
earlier in this decade in dealing with institutions with
outsized real estate loan concentrations and exposures to
certain financial products.
For the larger institutions that failed, unprecedented
changes in market liquidity had a significant negative effect
on their ability to fund day-to-day operations as the
securitization and inter-bank lending markets froze. The
rapidity of these liquidity related failures was without
precedent and will require a more robust regulatory focus on
large bank liquidity going forward.
Q.3.b. While we know that certain hedge funds, for example,
have failed, have any of them contributed to systemic risk?
A.3.b. Although hedge funds are not regulated by the FDIC, they
can comprise large asset pools, are in many cases highly
leveraged, and are not subject to registration or reporting
requirements. The opacity of these entities can fuel market
concern and uncertainty about their activities. In times of
stress these entities are subject to heightened redemption
requests, requiring them to sell assets into distressed markets
and compounding downward pressure on asset values.
Q.3.c. Given that some of the federal banking regulators have
examiners on-site at banks, how did they not identify some of
these problems we are facing today?
A.3.c. As stated above, the bank regulatory agencies should
have been more aggressive earlier in this decade in dealing
with institutions with outsized real estate loan concentrations
and exposures to certain financial products. Although the
federal banking agencies identified concentrations of risk and
a relaxation of underwriting standards through the supervisory
process, we could have been more aggressive in our regulatory
response to limiting banks' risk exposures.
Q.4.a. From your perspective, how dangerous is the ``too big to
fail'' doctrine and how might it be addressed?
Is it correct that deposit limits have been in place to
avoid monopolies and limit risk concentration for banks?
A.4.a. While there is no formal ``too big to fail'' (TBTF)
doctrine, some financial institutions have proven to be too
large to be resolved within our traditional resolution
framework. Many argued that creating very large financial
institutions that could take advantage of modem risk management
techniques and product and geographic diversification would
generate high enough returns to assure the solvency of the
firm, even in the face of large losses. The events of the past
year have convincingly proven that this assumption was
incorrect and is why the FDIC has recommended the establishment
of resolution authority to handle the failure of large
financial firms. There are three key elements to addressing the
problem of systemic risk and too big to fail.
First, financial firms that pose systemic risks should be
subject to regulatory and economic incentives that require
these institutions to hold larger capital and liquidity buffers
to mirror the heightened risk they pose to the financial
system. In addition, restrictions on leverage and the
imposition of risk-based assessments on institutions and their
activities would act as disincentives to the types of growth
and complexity that raise systemic concerns.
The second important element in addressing too big to fail
is an enhanced structure for the supervision of systemically
important institutions. This structure should include both the
direct supervision of systemically significant financial firms
and the oversight of developing risks that may pose risks to
the overall U.S. financial system. Centralizing the
responsibility for supervising these institutions in a single
systemic risk regulator would bring clarity and accountability
to the efforts needed to identify and mitigate the buildup of
risk at individual institutions. In addition, a systemic risk
council could be created to address issues that pose risks to
the broader financial system by identifying cross-cutting
practices, and products that create potential systemic risks.
The third element to address systemic risk is the
establishment of a legal mechanism for quick and orderly
resolution of these institutions similar to what we use for
FDIC insured banks. The purpose of the resolution authority
should not be to prop up a failed entity indefinitely or to
insure all liabilities, but to permit a timely and orderly
resolution and the absorption of assets by the private sector
as quickly as possible. Done correctly, the effect of the
resolution authority will be to increase market discipline and
protect taxpayers.
With regard to statutory limits on deposits, there is a 10
percent nationwide cap on domestic deposits imposed in the
Riegle-Neal Interstate Banking and Branching Efficiency Act of
1994. While this regulatory limitation has been somewhat
effective in preventing concentration in the U.S. system, the
Riegle-Neal constraints have some significant limitations.
First, these limits only apply to interstate bank mergers.
Also, deposits in savings and loan institutions generally are
not counted against legal limits. In addition, the law
restricts only domestic deposit concentration and is silent on
asset concentration, risk concentration or product
concentration. The four largest banking organizations have
slightly less than 35 percent of the domestic deposit market,
but have over 45 percent of total industry assets. As we have
seen, even with these deposit limits, banking organizations
have become so large and interconnected that the failure of
even one can threaten the financial system.
Q.4.b. Might it be the case that for financial institutions
that fund themselves less by deposits and more by capital
markets activities that they should be subject to concentration
limits in certain activities? Would this potentially address
the problem of too big to fail?
A.4.b. A key element in addressing TBTF would be legislative
and regulatory initiatives that are designed to force firms to
internalize the costs of government safety-net benefits and
other potential costs to society. Firms should face additional
capital charges based on both size and complexity, higher
deposit insurance related premiums or systemic risk surcharges,
and be subject to tighter Prompt Corrective Action (PCA) limits
under U.S. laws.
In addition, we need to end investors' perception that TBTF
continues to exist. This can only be accomplished by convincing
the institutions (their management, their shareholders, and
their creditors) that they are at risk of loss should the
institution become insolvent. Although limiting concentrations
of risky activities might lower the risk of insolvency, it
would not change the presumption that a government bailout
would be forthcoming to protect creditors from losses in a
bankruptcy proceeding.
An urgent priority in addressing the TBTF problem is the
establishment of a special resolution regime for nonbank
financial institutions and for financial and bank holding
companies--with powers similar to those given to the FDIC for
resolving insured depository institutions. The FDIC's authority
to act as receiver and to set up a bridge bank to maintain key
functions and sell assets as market conditions allow offers a
good model for such a regime. A temporary bridge bank allows
the government time to prevent a disorderly collapse by
preserving systemically critical functions. It also enables
losses to be imposed on market players who should appropriately
bear the risk.
Q.5. It appears that there were major problems with these risk
management systems, as I heard in GAO testimony at my
subcommittee hearing on March 18, 2009, so what gave the Fed
the impression that the models were ready enough to be the
primary measure for bank capital?
A.5. Throughout the development and implementation of Basel II,
large U.S. commercial and investment banks touted their
sophisticated systems for measuring and managing risks, and
urged regulators to align regulatory capital requirements with
banks' own risk measurements. The FDIC consistently expressed
concerns that the U.S. and international regulatory communities
collectively were putting too much reliance on financial
institutions' representations about the quality of their risk
measurement and management systems.
Q.6. Moreover, how can the regulators know what ``adequately
capitalized'' means if regulators rely on models that we now
know had material problems?
A.6. The FDIC has had long-standing concerns with Basel II's
reliance on model-based capital standards. If Basel II had been
implemented prior to the recent financial crisis, we believe
capital requirements at large institutions would have been far
lower going into the crisis and our financial system would have
been worse off as a result. Regulators are working
internationally to address some weaknesses in the Basel II
capital standards and the Basel Committee has announced its
intention to develop a supplementary capital requirement to
complement the risk based requirements.
Q.7. Can you tell us what main changes need to be made in the
Basel II framework so that it effectively calculates risk?
Should it be used in conjunction with a leverage ratio of some
kind?
A.7. The Basel II framework provides a far too pro-cyclical
capital approach. It is now clear that the risk mitigation
benefits of modeling, diversification and risk management were
overestimated when Basel II was designed to set minimum
regulatory capital requirements for large, complex financial
institutions. Capital must be a solid buffer against unexpected
losses, while modeling by its very nature tends to reflect
expectations of losses looking back over relatively recent
experience.
The risk-based approach to capital adequacy in the
Basel II framework should be supplemented with an
international leverage ratio. Regulators should judge
the capital adequacy of banks by applying a leverage
ratio that takes into account off-balance-sheet assets
and conduits as if these risks were on-balance-sheet.
Institutions should be required to hold more
capital through the cycle and we should require better
quality capital. Risk-based capital requirements should
not fall so dramatically during economic expansions
only to increase rapidly during a downturn.
The Basel Committee is working on both of these concepts as
well as undertaking a number of initiatives to improve the
quality and level of capital. That being said, however, the
Committee and the U.S. banking agencies do not intend to
increase capital requirements in the midst of the current
crisis. The plan is to develop proposals and implement these
when the time is right, so that the banking system will have a
capital base that is more robust in future times of stress.
------
RESPONSE TO WRITTEN QUESTIONS OF SENATOR CRAPO
FROM SHEILA C. BAIR
Q.1. The convergence of financial services providers and
financial products has increased over the past decade.
Financial products and companies may have insurance, banking,
securities, and futures components. One example of this
convergence is AIG. Is the creation of a systemic risk
regulator the best method to fill in the gaps and weaknesses
that AIG has exposed, or does Congress need to reevaluate the
weaknesses of federal and state functional regulation for
large, interconnected, and large firms like AIG?
A.1. The activities that caused distress for AIG were primarily
those related to its credit default swap (CDS) and securities
lending businesses. The issue of lack of regulation of the
credit derivatives market had been debated extensively in
policy circles since the late 1990s. The recommendations
contained in the 1999 study by the President's Working Group on
Financial Markets, ``Over-the-Counter Derivatives Markets and
the Commodity Exchange Act,'' were largely adopted in the
Commodity Futures Modernization Act of 2000, where credit
derivatives contracts were exempted from CFTC and SEC
regulations other than those related to SEC antifraud
provisions. As a consequence of the exclusions and environment
created by these legislative changes, there were no major
coordinated U.S. regulatory efforts undertaken to monitor CDS
trading and exposure concentrations outside of the safety and
soundness monitoring that was undertaken on an intuitional
level by the primary or holding company supervisory
authorities.
AIG chartered AIG Federal Savings Bank in 1999, an OTS
supervised institution. In order to meet European Union (EU)
Directives that require all financial institutions operating in
the EU to be subject to consolidated supervision, the OTS
became AIG's consolidated supervisor and was recognized as such
by the Bank of France on February 23, 2007 (the Bank of France
is the EU supervisor with oversight responsibility for AIG's EU
operations). In its capacity as consolidated supervisor of AIG,
the OTS had the authority and responsibility to evaluate AIG's
CDS and securities lending businesses. Even though the OTS had
supervisory responsibility for AIG's consolidated operations,
the OTS was not organized or staffed in a manner that provided
the resources necessary to evaluate the risks underwritten by
AIG.
The supervision of AIG demonstrates that reliance solely on
the supervision of these institutions is not enough. We also
need a ``fail-safe'' system where if any one large institution
fails, the system carries on without breaking down. Financial
firms that pose systemic risks should be subject to regulatory
and economic incentives that require these institutions to hold
larger capital and liquidity buffers to mirror the heightened
risk they pose to the financial system. In addition,
restrictions on leverage and the imposition of risk-based
premiums on institutions and their activities would act as
disincentives to growth and complexity that raise systemic
concerns.
In addition to establishing disincentives to unchecked
growth and increased complexity of institutions, two additional
fundamental approaches could reduce the likelihood that an
institution will be too big to fail. One action is to create or
designate a supervisory framework for regulating systemic risk.
Another critical aspect to ending too big to fail is to
establish a comprehensive resolution authority for systemically
significant financial companies that makes the failure of any
systemically important institution both credible and feasible.
Q.2. Recently there have been several proposals to consider for
financial services conglomerates. One approach would be to move
away from functional regulation to some type of single
consolidated regulator like the Financial Services Authority
model. Another approach is to follow the Group of 30 Report
which attempts to modernize functional regulation and limit
activities to address gaps and weaknesses. An in-between
approach would be to move to an objectives-based regulation
system suggested in the Treasury Blueprint. What are some of
the pluses and minuses of these three approaches?
A.2. Financial firms that pose systemic risks should be subject
to regulatory and economic incentives that require these
institutions to hold larger capital and liquidity buffers to
mirror the heightened risk they pose to the financial system.
In addition, the supervisory structure should include both the
direct supervision of systemically significant financial firms
and the oversight of developing risks that may pose risks to
the overall U.S. financial system. Effective institution
specific supervision is needed by functional regulators focused
on safety and soundness as well as consumer protection.
Finally, there should be a legal mechanism for quick and
orderly resolution of these institutions similar to what we use
for FDIC insured banks.
Whatever the approach to regulation and supervision, any
system must be designed to facilitate coordination and
communication among supervisory agencies and the relevant
safety-net participants.
In response to your question:
Single Consolidated Regulator. This approach regulates and
supervises a total financial organization. It designates a
single supervisor to examine all of an organization's
operations. Ideally, it must appreciate how the integrated
organization works and bring a unified regulatory focus to the
financial organization. The supervisor can evaluate risk across
product lines and assess the adequacy of capital and
operational systems that support the organization as a whole.
Integrated supervisory and enforcement actions can be taken,
which will allow supervisors to address problems affecting
several different product lines. If there is a single
consolidated regulator, the potential for overlap and
duplication of supervision and regulation is reduced with fewer
burdens for the organization and less opportunity for
regulatory arbitrage. By centralizing supervisory authority
over all subsidiaries and affiliates that comprise a financial
organization, the single consolidated regulator model should
increase regulatory and supervisory efficiency (for example
through economies of scale) and accountability.
With regard to disadvantages, a financial system
characterized by a handful of giant institutions with global
reach and a single regulator is making a huge bet that those
few banks and their regulator over a long period of time will
always make the right decisions at the right time. Another
disadvantage is the potential for an unwieldy structure and a
very cumbersome and bureaucratic organization. It may work best
in financial systems with few financial organizations.
Especially in larger systems, it may create the risk of a
single point of regulatory failure.
The U.S. has consolidated supervision, but individual
components of financial conglomerates are supervised by more
than one supervisor. For example, the Federal Reserve functions
as the consolidated supervisor for bank holding companies, but
in most cases it does not supervise the activities of the
primary depository institutions. Similarly, the Securities and
Exchange was the consolidated supervisor for many
internationally active investment banking groups, but these
institutions often included depository institutions that were
regulated by a banking supervisor.
Functional Regulation. Functional regulation and
supervision applies a common set of rules to a line of business
or product irrespective of the type of institution involved. It
is designed to level the playing field among financial firms by
eliminating the problem of having different regulators govern
equivalent products and services. It may, however, artificially
divide a firm's operations into departments by type of
financial activity or product. By separating the regulation of
the products and services and assigning different regulators to
supervise them, absent a consolidated supervisor, no functional
supervisor has an overall picture of the firm's operations and
how those operations may affect the safety and soundness of the
individual pieces. To be successful, this approach requires
close coordination among the relevant supervisors. Even then,
it is unclear how these alternative functional supervisors can
be organized to efficiently focus on the overall safety and
soundness of the enterprise.
Functional regulation may be the most effective means of
supervising highly sophisticated and emerging aspects of
finance that are best reviewed by teams of examiners
specializing in such technical areas
Objectives-Based Regulation. This approach attempts to
gamer the benefits of the single consolidated regulator
approach, but with a realization that the efficacy of safety-
and-soundness regulation and supervision may benefit if it is
separated from consumer protection supervision and regulation.
This regulatory model maintains a system of multiple
supervisors, each specializing in the regulation of a
particular objective-typically safety and soundness and
consumer protection (there can be other objectives as well).
The model is designed to bring uniform regulation to firms
engaged in the same activities by regulating the entire entity.
Arguments have been put forth that this model may be more
adaptable to innovation and technological advance than
functional regulation because it does not focus on a particular
product or service. It also may not be as unwieldy as the
consolidated regulator model in large financial systems. It
may, however, produce a certain amount of duplication and
overlap or could lead to regulatory voids since multiple
regulators are involved.
Another approach to organize a system-wide regulatory
monitoring effort is through the creation of a systemic risk
council (SRC) to address issues that pose risks to the broader
financial system. Based on the key roles that they currently
play in determining and addressing systemic risk, positions on
this council should be held by the U.S. Treasury, the FDIC, the
Federal Reserve Board, and the Securities and Exchange
Commission. It may be appropriate to add other prudential
supervisors as well.
The SRC would be responsible for identifying institutions,
practices, and markets that create potential systemic risks,
implementing actions to address those risks, ensuring effective
information flow, completing analyses and making
recommendations on potential systemic risks, setting capital
and other standards, and ensuring that the key supervisors with
responsibility for direct supervision apply those standards.
The standards would be designed to provide incentives to reduce
or eliminate potential systemic risks created by the size or
complexity of individual entities, concentrations of risk or
market practices, and other interconnections between entities
and markets.
The SRC could take a more macro perspective and have the
authority to overrule or force actions on behalf of other
regulatory entities. In order to monitor risk in the financial
system, the SRC also should have the authority to demand better
information from systemically important entities and to ensure
that information is shared more readily.
The creation of comprehensive systemic risk regulatory
regime will not be a panacea. Regulation can only accomplish so
much. Once the government formally establishes a systemic risk
regulatory regime, market participants may assume that the
likelihood of systemic events will be diminished. Market
participants may incorrectly discount the possibility of
sector-wide disturbances and avoid expending private resources
to safeguard their capital positions. They also may arrive at
distorted valuations in part because they assume (correctly or
incorrectly) that the regulatory regime will reduce the
probability of sector-wide losses or other extreme events.
To truly address the risks posed by systemically important
institutions, it will be necessary to utilize mechanisms that
once again impose market discipline on these institutions and
their activities. For this reason, improvements in the
supervision of systemically important entities must be coupled
with disincentives for growth and complexity, as well as a
credible and efficient structure that permits the resolutions
of these entities if they fail while protecting taxpayers from
exposure.
Q.3. If there are institutions that are too big to fail, how do
we identify that? How do we define the circumstance where a
single company is so systemically significant to the rest of
our financial circumstances and our economy that we must not
allow it to fail?
A.3. At present, the federal banking regulatory agencies likely
have the best information regarding which large, complex,
financial organizations (LCFO) would be ``systemically
significant'' institutions if they were in danger of failing.
Whether an institution is systemically important, however,
would depend on a number of factors, including economic
conditions. For example, if markets are functioning normally, a
large institution could fail without systemic repercussions.
Alternatively, in times of severe financial sector distress,
much smaller institutions might well be judged to be systemic.
Ultimately, identification of what is systemic will have to be
decided within the structure created for systemic risk
regulation.
Even if we could identify the ``too big to fail'' (TBTF)
institutions, it is unclear that it would be prudent to
publicly identify the institutions or fully disclose the
characteristics that identify an institution as systemic.
Designating a specific firm as TBTF would have a number of
undesirable consequences: market discipline would be fully
suppressed and the firm would have a competitive advantage in
raising capital and funds. Absent some form of regulatory cost
associated with systemic status, the advantages conveyed by
such status create incentives for other firms to seek TBTF
status--a result that would be counterproductive.
Identifying TBTF institutions, therefore, must be
accompanied by legislative and regulatory initiatives that are
designed to force TBTF firms to internalize the costs of
government safety-net benefits and other potential costs to
society. TBTF firms should face additional capital charges
based on both size and complexity, higher deposit insurance
related premiums or systemic risk surcharges, and be subject to
tighter Prompt Corrective Action (PCA) limits under U.S. laws.
Q.4. We need to have a better idea of what this notion of too
big to fail is--what it means in different aspects of our
industry and what our proper response to it should be. How
should the federal government approach large, multinational and
systemically significant companies?
A.4. ``Too-Big-To-Fail'' implies that an organization is of
such importance to the financial system that its failure will
impose widespread costs on the economy and the financial system
either by causing the failure of other linked financial
institutions or by seriously disrupting intermediation in
banking and financial markets. In such cases, the failure of
the organization has potential spillover effects that could
lead to widespread depositor runs, impair public confidence in
the broader financial system, or cause serious disruptions in
domestic and international payment and settlement systems that
would in turn have negative and long lasting implications for
economic growth.
Although TBTF is generally associated with the absolute
size of an organization, it is not just a function of size, but
also of the complexity of the organization and its position in
national and international markets (market share). Systemic
risk may also arise when organizations pose a significant
amount of counterparty risk (for example, through derivative
market exposures of direct guarantees) or when there is risk of
important contagion effects when the failure of one institution
is interpreted as a negative signal to the market about the
condition of many other institutions.
As described above, a financial system characterized by a
handful of giant institutions with global reach and a single
regulator is making a huge bet that those few banks and their
regulator over a long period of time will always make the right
decisions at the right time. There are three key elements to
addressing the problem of too big to fail.
First, financial firms that pose systemic risks should be
subject to regulatory and economic incentives that require
these institutions to hold larger capital and liquidity buffers
to mirror the heightened risk they pose to the financial
system. In addition, restrictions on leverage and the
imposition of risk-based assessments on institutions and their
activities would act as disincentives to the types of growth
and complexity that raise systemic concerns.
The second important element in addressing too big to fail
is an enhanced structure for the supervision of systemically
important institutions. This structure should include both the
direct supervision of systemically significant financial firms
and the oversight of developing risks that may pose risks to
the overall U.S. financial system. Centralizing the
responsibility for supervising these institutions in a single
systemic risk regulator would bring clarity and accountability
to the efforts needed to identify and mitigate the buildup of
risk at individual institutions. In addition, a systemic risk
council could be created to address issues that pose risks to
the broader financial system by identifying cross-cutting
practices, and products that create potential systemic risks.
The third element to address systemic risk is the
establishment of a legal mechanism for quick and orderly
resolution of these institutions similar to what we use for
FDIC insured banks. The purpose of the resolution authority
should not be to prop up a failed entity indefinitely or to
insure all liabilities, but to permit a timely and orderly
resolution and the absorption of assets by the private sector
as quickly as possible. Done correctly, the effect of the
resolution authority will be to increase market discipline and
protect taxpayers.
Q.5. What does ``fail'' mean? In the context of AIG, we are
talking about whether we should have allowed an orderly Chapter
11 bankruptcy proceeding to proceed. Is that failure?
A.5. A firm fails when it becomes insolvent; the value of its
assets is less than the value of its liabilities or when its
regulatory capital falls below required regulatory minimum
values. Alternatively, a firm can fail when it has insufficient
liquidity to meet its payment obligations which may include
required payments on liabilities or required transfers of cash-
equivalent instruments to meet collateral obligations.
According to the above definition, AIG's initial liquidity
crisis qualifies it as a failure. AIG's need for cash arose as
a result of increases in required collateral obligations
triggered by a ratings downgrade, increases in the market value
of the CDS protection AIG sold, and by mass redemptions by
counterparties in securities lending agreements where borrowers
returned securities and demand their cash collateral. At the
same time, AIG was unable to raise capital or renew commercial
paper financing to meet increased need for cash.
Subsequent events suggest that AIG's problems extended
beyond a liquidity crisis to insolvency. Large losses AIG has
experienced depleted much of its capital. For instance, AIG
reported a net loss in the fourth quarter 2008 of $61.7 billion
bringing its net loss for the full year (2008) to $99.3
billion. Without government support, which is in excess of $180
billion, AIG would be insolvent and a bankruptcy filing would
have been unavoidable.
------
RESPONSE TO WRITTEN QUESTIONS OF SENATOR KOHL
FROM SHEILA C. BAIR
Q.1. Two approaches to systemic risk seem to be identified, (1)
monitoring institutions and taking steps to reduce the size/
activities of institutions that approach a ``too large to
fail'' or ``too systemically important to fail'' or (2) impose
an additional regulator and additional rules and market
discipline on institutions that are considered systemically
important.
Which approach do you endorse? If you support approach one
how you would limit institution size and how would you identify
new areas creating systemic importance?
If you support approach two how would you identify
systemically important institutions and what new regulations
and market discipline would you recommend?
A.1. There are three key elements to addressing the problem of
systemic risk and too big to fail.
First, financial firms that pose systemic risks should be
subject to regulatory and economic incentives that require
these institutions to hold larger capital and liquidity buffers
to mirror the heightened risk they pose to the financial
system. In addition, restrictions on leverage and the
imposition of risk-based assessments on institutions and their
activities would act as disincentives to the types of growth
and complexity that raise systemic concerns.
The second important element in addressing too big to fail
is an enhanced structure for the supervision of systemically
important institutions. This structure should include both the
direct supervision of systemically significant financial firms
and the oversight of developing risks that may pose risks to
the overall U.S. financial system. Centralizing the
responsibility for supervising these institutions in a single
systemic risk regulator would bring clarity and accountability
to the efforts needed to identify and mitigate the buildup of
risk at individual institutions. In addition, a systemic risk
council could be created to address issues that pose risks to
the broader financial system by identifying cross-cutting
practices, and products that create potential systemic risks.
Based on the key roles that they currently play in determining
and addressing systemic risk, positions on this council should
be held by the U.S. Treasury, the FDIC, the Federal Reserve
Board, and the Securities and Exchange Commission. It may be
appropriate to add other prudential supervisors as well.
The creation of comprehensive systemic risk regulatory
regime will not be a panacea. Regulation can only accomplish so
much. Once the government formally establishes a systemic risk
regulatory regime, market participants may assume that the
likelihood of systemic events will be diminished. Market
participants may incorrectly discount the possibility of
sector-wide disturbances and avoid expending private resources
to safeguard their capital positions. They also may arrive at
distorted valuations in part because they assume (correctly or
incorrectly) that the regulatory regime will reduce the
probability of sector-wide losses or other extreme events.
To truly address the risks posed by systemically important
institutions, it will be necessary to utilize mechanisms that
once again impose market discipline on these institutions and
their activities. This leads to the third element to address
systemic risk--the establishment of a legal mechanism for quick
and orderly resolution of these institutions similar to what we
use for FDIC insured banks. The purpose of the resolution
authority should not be to prop up a failed entity indefinitely
or to insure all liabilities, but to permit a timely and
orderly resolution and the absorption of assets by the private
sector as quickly as possible. Done correctly, the effect of
the resolution authority will be to increase market discipline
and protect taxpayers.
Q.2. Please identify all regulatory or legal barriers to the
comprehensive sharing of information among regulators including
insurance regulators, banking regulators, and investment
banking regulators. Please share the steps that you are taking
to improve the flow of communication among regulators within
the current legislative environment.
A.2. Through the Federal Financial Institutions Examination
Council (FFIEC), the federal and state bank regulatory agencies
have adopted a number of information-sharing protocols and
joint operational work streams to promote consistent
information flow and reasonable access to supervisory
activities among the agencies. The FFIEC's coordination efforts
and joint examination process (when necessary) is an efficient
means to conduct joint federal and state supervision efforts at
banking organizations with multiple lines of business. The
FFIEC initiates projects regularly to enhance our supervision
processes, examination policies and procedures, examiner
training, and outreach to the industry.
The FFIEC collaboration process for bank supervision works
well. However, for the larger and more complex institutions,
the layering of insurance and securities/capital markets units
on a traditional banking organization increases the complexity
of the overall federal supervisory process. This complexity is
most pronounced within the small universe of systemically
important institutions which represent a concentration of risk
to the FDIC's Deposit Insurance Fund. The banking regulators
generally do not have jurisdiction over securities and
insurance activities which are vested in the U.S. Securities
and Exchange Commission (SEC) and the U.S. Commodity Futures
Trading Commission (CFTC) for securities activities, and state
insurance regulators for insurance operations.
In some cases, large banking organizations have significant
involvement in securities and capital markets-related
activities supervised by the SEC. The FFIEC agencies do have
information sharing protocols with the securities regulators
and rely significantly on the SEC's examination findings when
evaluating a company's overall financial condition. In fact,
the FDIC has signed information-sharing agreements with the SEC
as well as the state securities and insurance commissioners.
Prospectively, it may be appropriate to integrate the
securities regulators' activities more closely with the FFIEC's
processes to enhance information sharing and joint supervisory
analyses.
Finally, as mentioned in the previous question, an
additional way to improve information sharing would be through
the creation of a systemic risk council (SRC) to address issues
that pose risks to the broader financial system. The SRC would
be responsible for identifying institutions, practices, and
markets that create potential systemic risks, implementing
actions to address those risks, ensuring effective information
flow, completing analyses and making recommendations on
potential systemic risks, setting capital and other standards
and ensuring that the key supervisors with responsibility for
direct supervision apply those standards. In order to monitor
risk in the financial system, the SRC also should have the
authority to demand better information from systemically
important entities and to ensure that information is shared
among regulators more readily.
Q.3. If Congress charged the FDIC with the responsibility for
the ``special resolution regime'' that you discuss in your
written testimony, what additional regulatory authorities would
you need and what additional resources would you need to be
successful? Can you describe the difference in treatment for
the shareholders of Bear Sterns under the current situation
verses the situation if the ``special resolution regime'' was
already in place?
A.3. Additional Regulatory Authorities--Resolution authority
for both (1) systemically significant financial companies and
(2) nonsystemically significant depository institution holding
companies, including:
Powers and authorities similar to those provided in
the Federal Deposit Insurance Act for resolving failed
insured depository institutions;
Funding mechanisms, including potential borrowing
from and repayment to the Treasury;
Separation from bankruptcy proceedings for all
holding company affiliates, including those directly
controlling the IDI, when necessary to address the
interdependent enterprise carried out by the insured
depository institution and the remainder of the
organization; and
Powers and authorities similar to those provided in
the Federal Deposit Insurance Act for assistance to
open entities in the case of systemically important
entities, conservatorships, bridge institutions, and
receiverships.
Additional Resources--The FDIC seeks to rely on in-house
expertise to the extent possible. Thus, for example, the FDIC's
staff has experts in capital markets, including
securitizations. When pertinent expertise is not readily
available in-house, the FDIC contracts out to complement its
resources. If the FDIC identifies a longer-term need for such
expertise, it will bring the necessary expertise in-house.
Difference in the Treatment for the Shareholders of Bear
Stearns--With the variety of liquidation options now proposed,
the FDIC would have had a number of tools at its disposal that
would have enhanced its ability to effect an orderly resolution
of Bear Stearns. In particular, the appointment of the FDIC as
receiver would have essentially terminated the rights of the
shareholders. Any recovery on their equity interests would be
limited to whatever net proceeds of asset liquidations remained
after the payment in full of all creditors. This prioritization
of recovery can assist to establish greater market discipline.
Q.4. Your testimony recommends that ``any new plan ensure that
consumer protection activities are aligned with other bank
supervisory information, resources, and expertise, and that
enforcement of consumer protection rules be left to bank
regulators.''
Can you please explain how the agency currently takes into
account consumer complaints and how the agency reflects those
complaints when investigating the safety and soundness of an
institution? Do you feel that the FDIC has adequate information
sharing between the consumer protection examiners and safety
and soundness examiners? If not, what are your suggestions to
increase the flow of information between the different types of
examiners?
A.4. Consumer complaints can indicate potential safety-and-
soundness or consumer protection issues. Close cooperation
among FDIC Consumer Affairs, compliance examination, and
safety-and-soundness examination staff in the Field Office,
Regional Office, and Washington Office is essential to
addressing issues raised by consumer complaints and determining
the appropriate course of action.
Consumer complaints are received by the FDIC and financial
institutions. Complaints against non FDIC-supervised
institutions are forwarded to the appropriate primary
regulator. The FDIC's Consumer Affairs staff receives the
complaints directed to the FDIC and responds to and maintains
files on these complaints. Consumer Affairs may request that
examiners assist with a complaint investigation if an on-site
review at a financial institution is deemed necessary.
Consumer complaints received by the FDIC, as well as the
complaints received by a financial institution (or by third
party service providers), are reviewed by compliance examiners
during the pre-examination planning phase of a compliance
examination. In addition, information obtained from the
financial institution pertaining to consumer-related
litigation, investigations by other government entities, and
any institution management reports on the type, frequency, and
distribution of consumer complaints are also reviewed.
Compliance examiners consider this information, along with
other types of information about the institution's operations,
when establishing the scope of a compliance examination,
including issues to be investigated and regulatory areas to be
assessed during the examination. During the on-site compliance
examination, examiners review the institution's complaint
response processes as part of a comprehensive evaluation of the
institution's compliance management system.
During risk management examinations, examiners will review
information about consumer complaints and determine the
potential for safety-and-soundness concerns. This, along with
other types of information about the institution's operations,
is used to determine the scope of a safety-and-soundness
examination. Examples of complaints that may raise such
concerns include allegations that the bank is extending poorly
underwritten loans, a customer's account is being fraudulently
manipulated, or insiders are receiving benefits not available
to other bank customers. Where feasible, safety-and-soundness
and compliance examinations may be conducted concurrently. At
times, joint examination teams have been formed to evaluate and
address risks at institutions offering complex products or
services that prompted an elevated level of supervisory
concern.
Apart from examination-related activity, the Consumer
Affairs staff forwards to regional management all consumer
complaints that appear to raise safety-and-soundness concerns
as quickly as possible. Regional management will confirm that a
consumer complaint raises safety-and-soundness issues and
determine the appropriate course of action to investigate the
complaint under existing procedures and guidance. If the
situation demonstrates safety-and-soundness issues, a Case
Manager will assume responsibility for coordinating the
investigation and, in certain situations, may prepare the
FDIC's response to the complaint or advise the Consumer Affairs
staff in their efforts to respond to the complaint. The Case
Manager determines whether the complaint could be an indicator
of a larger, more serious issue within the institution.
Quarterly, the Consumer Affairs staff prepares a consumer
complaint summary report from its Specialized Tracking and
Reporting System for institutions identified on a regional
office's listing of institutions that may generate a higher
number of complaints. These types of institutions may include,
but are not limited to, banks with composite ratings of ``4''
and ``5,'' subprime lenders, high loan-to-value lenders,
consumer lenders, and credit card specialty institutions. This
report provides summary data on the number and nature of
consumer complaints received during the previous quarter. The
Case Manager reviews the consumer complaint information for
trends that may indicate a safety-and-soundness issue and
documents the results of the review.
We believe FDIC examination staff effectively communicates,
coordinates, and collaborates. Safety-and-soundness and
compliance examiners work in the same field offices, and
therefore, the regular sharing of information is commonplace.
To ensure that pertinent examination or other relevant
information is shared between the two groups of examiners,
field territories hold quarterly meetings where consumer
protection/compliance and risk management issues are discussed.
In addition, Relationship Managers, Case Managers, and Review
Examiners in every region monitor institutions and facilitate
communication about compliance and risk management issues and
develop cohesive supervisory plans. Both compliance examination
and risk management examination staff share the same senior
management. Effective information sharing ensures the FDIC is
consistent in its examination approach, and compliance and risk
management staffs are working hand in hand.
Although some suggest that an advantage of a separate
agency for consumer protection would be its single-focus
mission, this position may not acknowledge the reality of the
interconnectedness of safety-and-soundness and consumer
protection concerns, as well as the value of using existing
expertise and examination infrastructure, noted above. Thus,
even if such an agency only were tasked with rule-writing
responsibilities, it would not be in a position to fully
consider the safety-and-soundness dimensions of consumer
protection issues. Moreover, if the agency also were charged
with enforcing those rules, replicating the uniquely
comprehensive examination and supervisory presence to which
federally regulated financial institutions are currently
subject would involve creating an extremely large new federal
bureaucracy. Just providing enforcement authority, without
examination or supervision, would simply duplicate the Federal
Trade Commission.
Placing consumer compliance examination activities in a
separate organization, apart from other supervisory
responsibilities, ultimately will limit the effectiveness of
both programs. Over time, staff at both agencies would lose the
expertise and understanding of how consumer protection and the
safe and sound conduct of a financial institution's business
operations interrelate.
Q.5. In your written testimony you state that ``failure to
ensure that financial products were appropriate and sustainable
for consumers has caused significant problems, not only for
those consumers, but for the safety and soundness of financial
institutions.'' Do you believe that there should be a
suitability standard placed on lending institutions?
A.5. Certainly, as a variety of nontraditional mortgage
products became widely available, a growing number of consumers
began to receive mortgage loans that were unlikely to be
affordable in the long term. This was a major precipitating
factor in the current financial crisis.
With regard to mortgage lending, lenders should apply an
affordability standard to ensure that a borrower has the
ability to repay the debt according to the terms of the
contract. Loans should be affordable and sustainable over the
long-term and should be underwritten to the fully indexed rate.
Such a standard would also be valuable if applied across all
credit products, including credit cards, and should help
eliminate practices that do not provide financial benefits to
consumers.
However, an affordability standard will serve its intended
purpose only if it is applied to all originators of home loans,
including financial institutions, mortgage brokers, and other
third parties.
Q.6. Deposit Insurance Question--Recently, the FDIC has asked
Congress to increase their borrowing authority from the
Treasury up to $100 billion, citing that this would be
necessary in order avoid imposing significant increases in
assessments on insured financial institutions. Currently, the
FDIC provides rebates to depository financial institutions when
the DIF reaches 1.5 percent. Given the increase in bank
closings over the past 12 months, do you believe the rebate
policy should be reviewed or eliminated? What do you think is
an appropriate level for the insurance fund in order to protect
depositors at the increased amount of $250,000?
A.6. While the Federal Deposit Insurance Reform Act of 2005
provided the FDIC with greater flexibility to base insured
institutions' assessments on risk, it restricted the growth of
the DIF. Under the Reform Act, when the DIF reserve ratio is
above 1.35 percent, the FDIC is required to dividend half of
the amount in excess of the amount required to maintain the
reserve ratio at 1.35 percent. In addition, when the DIF
reserve ratio is above 1.50 percent, the FDIC is required to
dividend all amounts above the amount required to maintain the
reserve ratio at 1.5 percent. The result of these mandatory
dividends is to effectively cap the size of the DIF and to
limit the ability of the fund to grow in good times.
A deposit insurance system should be structured with a
counter-cyclical bias-that is, funds should be allowed to
accumulate during strong economic conditions when deposit
insurance losses may be low, as a cushion against future needs
when economic circumstances may be less favorable and losses
higher. However, the current restrictions on the size of the
DIF limit the ability of the FDIC to rebuild the fund to levels
that can offset the pro-cyclical effect of assessment increases
during times of economic stress. Limits on the size of the DIF
of this nature inevitably mean that the FDIC will have to
charge higher premiums when economic conditions cause
significant numbers of bank failures. As part of the
consideration of broader regulatory restructuring, Congress may
want to consider the impact of the mandatory rebate requirement
or the possibility of providing for greater flexibility to
permit the DIF to grow to levels in good times that will
establish a sufficient cushion against losses in the event of
an economic downturn.
Although the process of weighing options against the
backdrop of the current crisis is only starting, taking a look
at what might have occurred had the DIF reserve ratio been
higher at its onset may be instructive.
The reserve ratio of the DIF declined from 1.22 percent as
of December 31, 2007, to 0.36 percent as of December 31, 2008,
a decrease of 86 basis points. If at the start of the current
economic downturn the reserve ratio of the DIF had been 2.0
percent, allowing for a similar 86 basis point decrease, the
reserve ratio would have been 1.14 percent at the end of the
first quarter of 2009. At that level, given the current
economic climate and the desire to structure the deposit
insurance system in a counter-cyclical manner, it is debatable
whether the FDIC would have found either the special assessment
or an immediate increase in deposit insurance premiums
necessary.
An increase in the deposit insurance level will increase
total insured deposits. While increasing the coverage level to
$250,000 will decrease the actual DIF reserve ratio (which is
the ratio of the fund to estimated insured deposits), it will
not necessarily change the appropriate reserve ratio. As noted
in the response to the previous question, building reserve
ratios to higher levels during good times may obviate the need
for higher assessments during downturns.
------
RESPONSE TO WRITTEN QUESTIONS OF SENATOR HUTCHISON
FROM SHEILA C. BAIR
Q.1. I have concerns about the recent decision by the Federal
Deposit Insurance Corporation (FDIC) Board of Directors to
impose a special assessment on insured institutions of 20 basis
points, with the possibility of assessing an additional 10
basis points at any time as may be determined by the Board.
Since this decision was announced, I have heard from many
Texas community bankers, who have advised me of the potential
earnings and capital impact on their financial institutions,
and more importantly, the resulting loss of funds necessary to
lend to small business customers and consumers in Texas
communities. It is estimated that assessments on Texas banks,
if implemented as proposed, will remove nearly one billion
dollars from available capital. When leveraged, this results in
nearly eight to twelve billion dollars that will no longer be
available for lending activity throughout Texas. At a time when
responsible lending is critical to pulling our nation out of
recession, this sort of reduction in local lending has the
potential to extend our economic downturn.
I understand you believe that any assessments on the
banking industry may be reduced by roughly half, or 10 basis
points, should Congress provide the FDIC an increase in its
line of credit at the Department of Treasury from $30 billion
to $100 billion. That is why I have signed on as a cosponsor of
The Depositor Protection Act of 2009, which accomplishes that
goal.
However, my banking community informs me that even this
modest proposed reduction in the special assessments will still
disproportionately penalize community banks, the vast majority
of which neither participated nor contributed to the
irresponsible lending tactics that have led to the erosion of
the FDIC deposit insurance fund (DIF).
I understand that there are various alternatives to ensure
the fiscal stability of the DIF without adversely affecting the
community banking industry, such as imposing a systemic risk
premium, basing assessments on assets with an adjustment for
capital rather than total insured deposits, or allowing banks
to amortize the expenses over several years.
I respectfully request the following:
Could you outline several proposals to improve the
soundness of the DIF while mitigating the negative
effects on the community banking industry?
Could you outline whether the FDIC has the
authority to implement these policy proposals, or
whether the FDIC would need additional authorities?
If additional authority is needed, from which
entity (i.e., Congress? Treasury?) Would the FDIC need
those additional authorities?
A.1. The FDIC realizes that assessments are a significant
expense for the banking industry. For that reason, we continue
to consider alternative ways to alleviate the pressure on the
DIF. In the proposed rule on the special assessment (adopted in
final on May 22, 2009), we specifically sought comment on
whether the base for the special assessment should be total
assets or some other measure that would impose a greater share
of the special assessment on larger institutions. The Board
also requested comment on whether the special assessment should
take into account the assistance that has been provided to
systemically important institutions. The final rule reduced the
proposed special assessment to five basis points on each
insured depository institutions assets, minus its Tier 1
capital, as of June 30, 2009. The assessment is capped at 10
basis points of an institution's domestic deposits so that no
institution will pay an amount greater than they would have
paid under the proposed interim rule.
The FDIC has taken several other actions under its existing
authority in an effort to alleviate the burden of the special
assessment. On February 27, 2009, the Board of Directors
finalized new risk-based rules to ensure that riskier
institutions bear a greater share of the assessment burden. We
also imposed a surcharge on guaranteed bank debt under the
Temporary Liquidity Guarantee Program (TLGP) and will use the
money raised by the surcharge to reduce the proposed special
assessment.
Several other steps to improve the soundness of the DIF
would require congressional action. One such step would be for
Congress to establish a statutory structure giving the FDIC the
authority to resolve a failing or failed depository institution
holding company (a bank holding company supervised by the
Federal Reserve Board or a savings and loan holding company,
including a mutual holding company, supervised by the Office of
Thrift Supervision) with one or more subsidiary insured
depository institutions that are failing or have failed.
As the corporate structures of bank holding companies,
their insured depository and other affiliates continue to
become more complex, an insured depository institution is
likely to be dependent on affiliates that are subsidiaries of
its holding company for critical services, such as loan and
deposit processing and loan servicing. Moreover, there are many
cases in which the affiliates are dependent for their continued
viability on the insured depository institution. Failure and
the subsequent resolution of an insured depository institution
whose key services are provided by affiliates present
significant legal and operational challenges. The insured
depository institutions' failure may force its holding company
into bankruptcy and destabilize its subsidiaries that provide
indispensable services to the insured depository institution.
This phenomenon makes it extremely difficult for the FDIC to
effectuate a resolution strategy that preserves the franchise
value of the failed insured depository institution and protects
the DIF. Bankruptcy proceedings, involving the parent or
affiliate of an insured depository institution, are time-
consuming, unwieldy, and expensive. The threat of bankruptcy by
the bank holding company or its affiliates is such that the
Corporation may be forced to expend considerable sums propping
up the bank holding company or entering into disadvantageous
transactions with the bank holding company or its subsidiaries
in order to proceed with an insured depository institution's
resolution. The difficulties are particularly extreme where the
Corporation has established a bridge depository institution to
preserve franchise value, protect creditors (including
uninsured depositors), and facilitate disposition of the failed
institution's assets and liabilities.
Certainty regarding the resolution of large, complex
financial institutions would also help to build confidence in
the strength of the DIF. Unlike the clearly defined and proven
statutory powers that exist for resolving insured depository
institutions, the current bankruptcy framework available to
resolve large complex nonbank financial entities and financial
holding companies was not designed to protect the stability of
the financial system. Without a system that provides for the
orderly resolution of activities outside of the depository
institution, the failure of a systemically important holding
company or nonbank financial entity will create additional
instability. This problem could be ameliorated or cured if
Congress provided the necessary authority to resolve a large,
complex financial institution and to charge systemically
important firms fees and assessments necessary to fund such a
systemic resolution system.
In addition, financial firms that pose systemic risks
should be subject to regulatory and economic incentives that
require these institutions to hold larger capital and liquidity
buffers to mirror the heightened risk they pose to the
financial system. Restrictions on leverage and the imposition
of risk-based assessments on institutions and their activities
also would act as disincentives to the types of growth and
complexity that raise systemic concerns.
Q.2. I commend you for your tireless efforts in helping our
banking system survive this difficult environment, and I look
forward to working closely with you to arrive at solutions to
support the community banking industry while ensuring the long-
term stability of the DIF to protect insured depositors against
loss.
Will each of you commit to do everything within your power
to prevent performing loans from being called by lenders?
Please outline the actions you plan to take.
A.2. The FDIC understands the tight credit conditions in the
market and is engaged in a number of efforts to improve the
current situation. Over the past year, we have issued guidance
to the institutions we regulate to encourage banks to maintain
the availability of credit. Moreover, our examiners have
received specific instructions on properly applying this
guidance to FDIC supervised institutions.
On November 12, 2008, we joined the other federal banking
agencies in issuing the Interagency Statement on Meeting the
Needs of Creditworthy Borrowers (FDIC FIL-128-2008). This
statement reinforces the FDIC's view that the continued
origination and refinancing of loans to creditworthy borrowers
is essential to the vitality of our domestic economy. The
statement encourages banks to continue making loans in their
markets, work with borrowers who may be encountering difficulty
during this challenging period, and pursue initiatives such as
loan modifications to prevent unnecessary foreclosures.
In light of the present challenges facing banks and their
customers, the FDIC hosted in March a roundtable discussion
focusing on how regulators and financial institutions can work
together to improve credit availability. Representatives from
the banking industry were invited to share their concerns and
insights with the federal bank regulators and representatives
from state banking agencies. The attendees agreed that open,
two-way communication between the regulators and the industry
was vital to ensuring that safety and soundness considerations
are well balanced with the critical need of providing credit to
businesses and consumers.
One of the important points that came out of the session
was the need for ongoing dialog between bankers and their
regulators as they work jointly toward a solution to the
current financial crisis. Toward this end, the FDIC created a
new senior level position to expand community bank outreach. In
conjunction with this office, the FDIC plans to establish an
advisory committee to address the unique concerns of this
segment of the banking community.
As part of our ongoing supervisory evaluation of banks that
participate in federal financial stability programs, the FDIC
also is taking into account how available capital is deployed
to make responsible loans. It is necessary and prudent for
banking organizations to track the use of the funds made
available through federal programs and provide appropriate
information about the use of these funds. On January 12, 2009,
the FDIC issued a Financial Institution Letter titled
Monitoring the Use of Funding from Federal Financial Stability
and Guarantee Programs (FDIC FIL-1-2009), advising insured
institutions that they should track their use of capital
injections, liquidity support, and/or financing guarantees
obtained through recent financial stability programs as part of
a process for determining how these federal programs have
improved the stability of the institution and contributed to
lending to the community. Equally important to this process is
providing this information to investors and the public. This
Financial Institution Letter advises insured institutions to
include information about their use of the funds in public
reports, such as shareholder reports and financial statements.
Internally at the FDIC, we have issued guidance to our bank
examiners for evaluating participating banks' use of funds
received through the TARP Capital Purchase Program and the
Temporary Liquidity Guarantee Program, as well as the
associated executive compensation restrictions mandated by the
Emergency Economic Stabilization Act. Examination guidelines
for the new Public-Private Investment Fund will be forthcoming.
During examinations, our supervisory staff will be reviewing
banks' efforts in these areas and will make comments as
appropriate to bank management. We will review banks' internal
metrics on the loan origination activity, as well as more broad
data on loan balances in specific loan categories as reported
in Call Reports and other published financial data. Our
examiners also will be considering these issues when they
assign CAMELS composite and component ratings. The FDIC will
measure and assess participating institutions' success in
deploying TARP capital and other financial support from various
federal initiatives to ensure that funds are used in a manner
consistent with the intent of Congress, namely to support
lending to U.S. businesses and households.
------
RESPONSE TO WRITTEN QUESTIONS OF SENATOR SHELBY
FROM MICHAEL E. FRYZEL
Q.1. Consumer Protection Regulation--Some have advocated that
consumer protection and prudential supervision should be
divorced, and that a separate consumer protection regulation
regime should be created. They state that one source of the
financial crisis emanated from the lack of consumer protection
in the underwriting of loans in the originate-to-distribute
space.
What are the merits of maintaining it in the same agency?
Alternatively, what is the best argument each of you can make
for a new consumer protection agency?
A.1. Credit unions occupy a very small space within the
originate-to-distribute landscape. Less than 8 percent of the
$250 billion in loans originated by credit unions in 2008 were
sold in whole to another party. While selling loans has grown
within the credit union industry, it remains a small portion of
business, with most credit unions choosing to hold their loans
in portfolio when possible. Additionally, the abuses of
consumers seen in some areas have not manifested themselves
within the credit union community.
The originate-to-distribute model would seem to create an
environment where the loan originator is less concerned about
consumer protection and more concerned with volume and fee
generation. The lender using this model may focus less on what
is best for the borrower, as they will not be the entity
retaining the liability should the borrower later default.
Maintaining consumer protection with the same regulator who
is responsible for prudential supervision adds economies of
scale and improves efficiencies for completing the supervision
of the institutions. This approach allows one regulator to
possess all information and authority regarding the supervision
of individual institutions. In the past, NCUA has performed
consumer compliance examinations separate from safety and
soundness examinations. However, in order to maximize economies
of scales and allow examiners to possess all information
regarding the institution, the separation of consumer
compliance and safety and soundness examinations was
discontinued. Some federal and state agencies currently perform
those functions as two separate types of examination under one
regulator.
The oversight of consumer protection could be given to a
separate regulatory agency. The agency would likely have broad
authority over all financial institutions and affiliated
parties. In theory, creating such an agency would allow safety
and soundness examiners to focus on those particular risks. For
those agencies without consumer compliance examiners, it would
create an agency of subject matter experts to help ensure
consumer protection laws are adhered to.
Q.2. Regulatory Gaps or Omissions--During a recent hearing, the
Committee has heard about massive regulatory gaps in the
system. These gaps allowed unscrupulous actors like AIG to
exploit the lack of regulatory oversight. Some of the
counterparties that AIG did business with were institutions
under your supervision.
Why didn't your risk management oversight of the AIG
counterparties trigger further regulatory scrutiny? Was there a
flawed assumption that AIG was adequately regulated, and
therefore no further scrutiny was necessary?
Was there dialogue between the banking regulators and the
state insurance regulators? What about the SEC?
If the credit default swap contracts at the heart of this
problem had been traded on an exchange or cleared through a
clearinghouse, with requirement for collateral and margin
payments, what additional information would have been
available? How would you have used it?
A.2. NCUA does not directly or indirectly regulate or oversee
the operation of AIG. Therefore, we defer to the other
regulatory bodies. Chartering and regulatory restrictions
prevent federally chartered credit unions from investing in
companies such as AIG. Federally chartered credit unions are
generally limited to investing in government issued or
guaranteed securities and cannot invest in the diverse range of
higher yielding products, including commercial paper and
corporate debt securities.
Q.3. Liquidity Management--A problem confronting many financial
institutions currently experiencing distress is the need to
roll-over short-term sources of funding. Essentially these
banks are facing a shortage of liquidity. I believe this
difficulty is inherent in any system that funds long-term
assets, such as mortgages, with short-term funds. Basically the
harm from a decline in liquidity is amplified by a bank's level
of ``maturity-mismatch.''
I would like to ask each of the witnesses, should
regulators try to minimize the level of a bank's maturity-
mismatch? And if so, what tools would a bank regulator use to
do so?
A.3. Funding long-term, fixed-rate loans with short-term funds
is a significant concern. The inherent risk in such balance
sheet structuring is magnified with the increased probability
that the United States may soon enter a period of inflation and
rising rates on short-term funding sources. The effects of a
rising interest rate environment when most funding sources have
no maturity or a maturity of less than one year creates the
potential for substantial narrowing of net interest margins
moving forward.
NCUA recently analyzed how credit union balance sheets have
transformed over the last 10 years, especially in the larger
institutions. Letter to Credit Unions 08-CU-20, Evaluating
Current Risks to Credit Unions, examines the changing balance
sheet risk profile. The Letter provides the industry words of
caution as well as direction on addressing current risks. NCUA
has also issued several other Letters to Credit Unions over the
past several years regarding this very issue and has developed
additional examiner tools for evaluating liquidity and interest
rate risk.
While there are various tools the industry uses for
measuring interest rate and liquidity risk, the tools involve
making many assumptions. The assumptions become more involved
as balance sheets become more complex. Each significant
assumption needs to be evaluated for reasonableness, with the
underlying assumption not necessarily having been tested over
time or over all foreseeable scenarios. The grey area in such
analysis is significant. In our proposed regulatory changes for
corporate credit unions, better matching of maturities of
assets and liabilities will be regulated with concentration and
sector limits as well as other controls.
Q.4. Too-Big-To-Fail--Chairman Bair stated in her written
testimony that ``the most important challenge is to find ways
to impose greater market discipline on systemically important
institutions. The solution must involve, first and foremost, a
legal mechanism for the orderly resolution of those
institutions similar to that which exists for FDIC-insured
banks. In short we need to end too big to fail. I would agree
that we need to address the too-big-to-fail issue, both for
banks and other financial institutions.''
Could each of you tell us whether putting a new resolution
regime in place would address this issue?
A.4. While the NCUA continues to recommend maintaining multiple
financial regulators and charter options to enable the
continued checks and balances such a structure produces, the
agency also agrees with the need for establishing a regulatory
oversight entity to help mitigate risk to the nation's
financial system. Extending the reach of this entity beyond the
federally regulated financial institutions may help impose
market discipline on systemically important institutions. Care
needs to be taken in deciding how to address the too-big-to-
fail issue. Overreaching could stifle financial innovation and
actually cause more harm than good. At the same time, under
reaching could provide inadequate resolution when it is needed
most.
The statutory construct of federal credit unions limits
growth with membership restrictions, so no new initiatives are
deemed necessary to address the ``too big to faily7is sue for
credit unions. Federally insured credit unions hold $8 13.44
billion in assets, while financial institutions insured by the
FDIC hold $13.85 trillion in assets. Federally insured credit
unions make up only 5.56 percent of all federally insured
assets. \1\ Therefore, the credit union industry as a whole
does not pose a systemic risk to the financial industry.
However, federally insured credit unions serve a unique role in
the financial industry by providing basic and affordable
financial services to their members. In order to preserve this
role, federally insured credit unions must maintain their
independent regulator and insurer.
---------------------------------------------------------------------------
\1\ Based on December 31, 2008, financial data.
Q.5. How would we be able to convince the market that these
systemically important institutions would not be protected by
---------------------------------------------------------------------------
taxpayer resources as they had been in the past?
A.5. It will be difficult to convince a market accustomed to
seeing taxpayer bailouts of systemically important institutions
that those institutions will no longer be protected by taxpayer
resources. A regulatory oversight entity empowered to resolve
institutions deemed systemically important would help impose
greater market discipline. Given the recent and historical
government intercession, consumers and the marketplace have
become accustomed to and grown to expect financial assistance
from the government. The greater the expectation for government
to use taxpayer resources to resolve institutions the greater
the moral hazard becomes. This could cause institutions to take
greater levels of risk knowing they will not have to face the
consequences.
Q.6. Pro-Cyclicality--I have some concerns about the pro-
cyclical nature of our present system of accounting and bank
capital regulation. Some commentators have endorsed a concept
requiring banks to hold more capital when good conditions
prevail, and then allow banks to temporarily hold less capital
in order not to restrict access to credit during a downturn.
Advocates of this system believe that counter cyclical policies
could reduce imbalances within financial markets and smooth the
credit cycle itself.
What do you see as the costs and benefits of adopting a
more counter-cyclical system of regulation?
A.6. In managing the National Credit Union Share Insurance Fund
(NCUSIF), the NCUA Board's Normal Operating Level policy
considers the counter-cyclical impact when managing the Fund's
equity level. During otherwise stable or prosperous economic
periods, the Board may assess a premium, up to the statutory
limits, to increase the Fund equity level, in order to avoid
the need to charge premiums at the trough of the business
cycle. In order to improve this system, NCUA would need the
ability to charge premiums, during good times, above the
current threshold (an equity level of 1.30).
A more robust and flexible risk-based capital requirement
for credit unions would improve counter-cyclical impact.
Currently, NCUA does not have authority to allow overall
capital levels to vary based on swings in the business cycle.
Prompt Corrective Action (12 U.S.C. 1790d) establishes
statutory minimum levels of capital which are not flexible.
Q.7. Do you see any circumstances under which your agencies
would take a position on the merits of counter-cyclical
regulatory policy?
A.7. NCUA will support efforts to improve counter-cyclical
regulatory policy. Greater flexibility in the management of the
NCUSIF's equity level and improvements in the measurement and
retention of capital for credit unions are good starting
points.
Q.8. G20 Summit and International Coordination--Many foreign
officials and analysts have said that they believe the upcoming
G20 summit will endorse a set of principles agreed to by both
the Financial Stability Forum and the Basel Committee, in
addition to other government entities. There have also been
calls from some countries to heavily re-regulate the financial
sector, pool national sovereignty in key economic areas, and
create powerful supranational regulatory institutions.
(Examples are national bank resolution regimes, bank capital
levels, and deposit insurance.) Your agencies are active
participants in these international efforts.
What do you anticipate will be the result of the G20
summit?
Do you see any examples or areas where supranational
regulation of financial services would be effective?
How far do you see your agencies pushing for or against
such supranational initiatives?
A.8. Many news accounts characterize the recent G20 summit as a
forum for international cooperation to discuss the condition of
the international financial system and to promote international
financial stability. NCUA supports these efforts to share
information and ideas and to marshal international support for
a concerted effort to stabilize the global economy.
In comparison to banks, federally insured credit unions are
relatively small institutions. Additionally, because of the
limited nature of a credit union's field of membership (those
individuals a credit union is authorized to serve), U.S. credit
unions are almost exclusively domestic institutions with
virtually no, or highly limited, international presence.
Accordingly, NCUA believes that a supranational regulatory
institution would not be an effective tool for credit union
regulation. Because of credit unions' small size and unique
structure, NCUA believes credit unions need the customized
supervisory approach that can only be provided by an agency
dedicated to the exclusive regulation of credit unions, and
which understands the unique nature of credit union operations.
In the broader financial regulatory context, NCUA is hesitant
to endorse the creation of powerful supranational regulatory
institutions without knowing more about the extent of authority
and jurisdiction those regulatory entities would have over U.S.
financial institutions. While NCUA supports international
cooperation, NCUA believes it is vital to economic and national
security to maintain complete U.S. sovereignty over U.S.
financial institutions.
------
RESPONSE TO WRITTEN QUESTIONS OF SENATOR REED
FROM MICHAEL E. FRYZEL
Q.1. It is clear that our current regulatory structure is in
need of reform. At my subcommittee hearing on risk management,
March 18, 2009, GAO pointed out that regulators often did not
move swiftly enough to address problems they had identified in
the risk management systems of large, complex financial
institutions.
Chair Bair's written testimony for today's hearing put it
very well: `` . . . the success of any effort at reform will
ultimately rely on the willingness of regulators to use their
authorities more effectively and aggressively.''
My questions may be difficult, but please answer the
following:
If this lack of action is a persistent problem among the
regulators, to what extent will changing the structure of our
regulatory system really get at the issue?
A.1. For the most part, the credit unions have not become
large, complex financial institutions. By virtue of their
enabling legislation along with regulations established by the
NCUA, federal credit unions are more restricted in their
operation than other financial institutions. For example,
investment options for federal credit unions are largely
limited to U.S. debt obligations, federal government agency
instruments, and insured deposits. Federal credit unions cannot
invest in a diverse range of higher yielding products,
including commercial paper and corporate debt securities.
Another example of restrictions in the credit union industry
includes the affiliation limitations. Federal credit unions are
much more limited than other financial institutions in the
types of businesses in which they engage and in the kinds of
affiliates with which they deal. Federal credit unions cannot
invest in the shares of an insurance company or control another
financial depository institution. Limitations such as these
have helped the credit union industry weather the current
economic downturn. These limitations among the other unique
characteristics of credit unions make credit unions
fundamentally different from other forms of financial
institutions and demonstrate the need to ensure their charter
is preserved in order to continue to meet their members'
financial needs.
Restructuring the regulatory system to include a systemic
regulator would add a level of checks and balances to the
system to address the issue of regulators using their
authorities more effectively and aggressively. The systemic
regulator should be responsible for establishing general safety
and soundness guidelines for financial institutions and then
monitoring the financial regulators to ensure these guidelines
are implemented. This extra layer of monitoring would help
ensure financial regulators effectively and aggressively
address problems at hand.
Q.2. Along with changing the regulatory structure, how can
Congress best ensure that regulators have clear
responsibilities and authorities, and that they are accountable
for exercising them ``effectively and aggressively''?
A.2. If a systemic regulator is established, one of its
responsibilities should include monitoring the implementation
of the established safety and soundness guidelines. This
monitoring will help ensure financial regulators effectively
and aggressively enforce the established guidelines. The
oversight entity's main functions should be to establish broad
safety and soundness principles and then monitor the individual
financial regulators to ensure the established principles are
implemented. This structure also allows the oversight entity to
set objective-based standards in a more proactive manner, and
would help alleviate competitive conflict detracting from the
resolution of economic downturns. This type of structure would
also promote uniformity in the supervision of financial
institutions while affording the preservation of the different
segments of the financial industry, including the credit union
industry.
Financial regulators should be encouraged to aggressively
address areas of increased risk as they are discovered. Rather
than financial institution management alone determining risk
limits, financial regulators must take administrative action
when the need arises. Early recognition of problems and
implementing resolutions will help ensure necessary actions are
taken earlier rather than later. In addition, financial
regulators should more effectively use off-site monitoring to
identify and then increase supervision in areas of greater risk
within the financial institutions.
Q.3. How do we overcome the problem that in the boom times no
one wants to be the one stepping in to tell firms they have to
limit their concentrations of risk or not trade certain risky
products?
What thought has been put into overcoming this problem for
regulators overseeing the firms?
A.3. There is a need to establish concentration limits on risky
products. NCUA already has limitations in place that have
helped the credit union industry avoid some of the issues
currently faced by other institutions. For example:
Federal credit unions' investments are largely
limited to United States debt obligations, federal
government agency instruments, and insured deposits.
\2\ Federal credit unions cannot invest in a diverse
range of higher yielding products, including commercial
paper and corporate debt securities. Also, federal
credit unions have limited authority for broker-dealer
relationships. \3\
---------------------------------------------------------------------------
\2\ NCUA Rules and Regulations Part 703.
\3\ NCUA Rules and Regulations Part 703.
Federal credit unions are much more limited than
other financial institutions in the types of businesses
in which they engage and in the kinds of affiliates
with which they deal. Federal credit unions cannot
invest in the shares of an insurance company or control
another financial depository institution. Also, they
cannot be part of a financial services holding company
and become affiliates of other depository institutions
---------------------------------------------------------------------------
or insurance companies.
Unlike other financial institutions, federal credit
unions cannot issue stock to raise additional capital.
\4\ Also, federal credit unions have borrowing
authority limited to 50 percent of paid-in and
unimpaired capital and surplus. \5\
---------------------------------------------------------------------------
\4\ 12 U.S.C. 1790d(b)(1)(B)(i).
\5\ 12 U.S.C. 1757(9).
Sound decision making should always take precedence over
following the current trend. The addition of a systemic
regulator would provide the overall monitoring for systemic
risk that should be limited. The systemic regulator would then
establish principles-based regulations for the financial
regulators to implement. This would provide checks and balances
to ensure regulators were addressing the issues identified. The
systemic regulator should be charged with monitoring and
implementing guidelines for the systemic risks to the industry,
while the financial regulators would supervise the financial
institutions and implement the guidelines established by the
systemic regulator. Since the systemic regulator only has
oversight over the financial regulators, they would not have
direct supervision of the financial institutions. This buffer
would help overcome the issue of when limits should be
---------------------------------------------------------------------------
implemented.
Q.4. Is this an issue that can be addressed through regulatory
restructure efforts?
A.4. As stated above, the addition of a systemic regulator
would help address these issues by providing a buffer between
the systemic regulator establishing principles-based
regulations and the financial regulators implementing the
regulations. The addition of the systemic regulator could
change the approach of when and how regulators address areas of
risk.
The monitoring performed by the systemic regulator would
help ensure the financial regulators were taking a more
proactive approach to supervising the institutions for which
they are responsible.
Q.5. As Mr. Tarullo and Mrs. Bair noted in their testimony,
some financial institution failures emanated from institutions
that were under federal regulation. While I agree that we need
additional oversight over and information on unregulated
financial institutions, I think we need to understand why so
many regulated firms failed.
Why is it the case that so many regulated entities failed,
and many still remain struggling, if our regulators in fact
stand as a safety net to rein in dangerous amounts of risk-
taking?
A.5. While regulators are a safety net to guard against
dangerous amounts of risk taking, the confluence of events that
led to the current level of failures and troubled institutions
may have been beyond the control of individual regulators.
While many saw the risk in lower mortgage loan standards and
the growth of alternative mortgage products, the combination of
these and the worst recessionary conditions and job losses in
decades ended with devastating results to the financial
industry. Exacerbating this combination was the layering of
excess leverage that built over time, not only in businesses
and the financial industry, but also in individual households.
In regards to the credit union industry's record in the
current economic environment, 82 federally insured credit
unions have failed in the past 5 years (based on the number of
credit unions causing a loss to the National Credit Union Share
Insurance Fund). Overall, federally insured credit unions
maintained reasonable financial performance in 2008. As of
December 31, 2008, federally insured credit unions maintained a
strong level of capital with an aggregate net worth ratio of
10.92 percent. While earnings decreased from prior levels due
to the economic downturn, federally insured credit unions were
able to post a 0.30 percent return on average assets in 2008.
Delinquency was reported at 1.37 percent, while net charge-offs
was 0.84 percent. Shares in federally insured credit unions
grew at 7.71 percent, with membership growing at 2.01 percent,
and loans growing at 7.08 percent. \6\
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\6\ Based on December 31, 2008, Call Report (NCUA Form 5300) data.
Q.6. While we know that certain hedge funds, for example, have
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failed, have any of them contributed to systemic risk?
A.6. As the NCUA does not regulate or oversee hedge funds, it
is not within our scope to be able to comment on the impact of
failed hedge funds and whether or not those failures
contributed to systemic risk.
Q.7. Given that some of the federal banking regulators have
examiners on-site at banks, how did they not identify some of
these problems we are facing today?
A.7. NCUA does not have on-site examiners in natural person
credit unions. However, as a result of the current economy,
NCUA has shortened the examination cycle to 12 months versus
the prior 18 months schedule. NCUA also performs quarterly
reviews of the financial data submitted to the agency by the
credit union.
NCUA does have on-site examiners in some corporate credit
unions. Natural person credit unions serve members of the
public, whereas corporate credit unions serve the natural
person credit unions. On March 20,2009, NCUA placed two
corporate credit unions into conservatorship, due mainly to the
decline in value of mortgage backed securities held on their
balance sheets. Conventional evaluation techniques did not
sufficiently identify the risks of these newer structured
securities or the insufficiency of the credit enhancements that
supposedly protected the securities from losses. NCUA's
evaluation techniques did not fully keep pace with the speed of
change in the structure and risk of these securities.
Additionally, much of the information obtained by on-site
examiners is provided by the regulated institutions. These
institutions may become less than forthcoming in providing
negative information when trends are declining. NCUA is
currently evaluating the structure of the corporate credit
union program to determine what changes are necessary. NCUA is
also reviewing the corporate credit union regulations and will
be making changes to strengthen these entities.
------
RESPONSE TO WRITTEN QUESTIONS OF SENATOR CRAPO
FROM MICHAEL E. FRYZEL
Q.1. The convergence of financial services providers and
financial products has increased over the past decade.
Financial products and companies may have insurance, banking,
securities, and futures components. One example of this
convergence is AIG. Is the creation of a systemic risk
regulator the best method to fill in the gaps and weaknesses
that AIG has exposed, or does Congress need to reevaluate the
weaknesses of federal and state functional regulation for
large, interconnected, and large firms like AIG?
A.1. NCUA has previously expressed its support for establishing
a systemic risk regulator to monitor financial institution
regulators, issue principles-based regulations and guidance,
and establish general safety and soundness guidance for
financial regulators under its control. This oversight entity
would monitor systemic risk across institution types. \7\ This
broad oversight would complement NCUA's more in-depth and
customized approach to regulating federally insured credit
unions.
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\7\ For purposes of this response, financial institutions include
commercial banks and other insured depository institutions, insurers,
companies engaged in securities and futures transactions, finance
companies, and specialized companies established by the government as
defined by the Treasury Blueprint. Individual financial regulators
would implement and enforce the established guidelines for the
institutions they regulate.
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Credit unions are unique, cooperative, not-for-profit
entities with a statutory mandate to serve people of modest
means. NCUA believes the combination of federal functional
regulators performing front-line examinations and oversight by
a systemic risk regulator would be a good method to fill
weaknesses exposed by AIG. Additionally, because of the small
size of most credit unions and the limitations placed on their
charters, credit unions generally do not become part of a large
conglomerate of business entities.
Q.2. Recently there have been several proposals to consider for
financial services conglomerates. One approach would be to move
away from functional regulation to some type of single
consolidated regulator like the Financial Services Authority
model. Another approach is to follow the Group of 30 Report
which attempts to modernize functional regulation and limit
activities to address gaps and weaknesses. An in-between
approach would be to move to an objectives-based regulation
system suggested in the Treasury Blueprint. What are some of
the pluses and minuses of these three approaches?
A.2. Credit unions have not become financial service
conglomerates due to limitations within the laws impacting
credit unions including restricted fields of membership and
limited potential activity. Therefore, the functional
regulatory approach currently in place has worked in the credit
union industry. While there is no perfect regulatory model to
adopt and follow that addresses all of the current issues in
the financial services industry, we can take portions from
different plans to create a regulatory system that meets the
needs of the current economy.
A modernized functional regulatory system would divide the
financial services industry into at least five categories:
credit unions, banks, insurance, securities, and futures. This
approach would allow the functional regulators to operate with
expertise within their segment of the financial institutions. A
functional regulator provides regulation for the specific
issues facing their financial sector. This approach also allows
a single regulator to possess the information and authority
necessary to completely oversee the regulated entities within
their segment of the industry while eliminating inefficiencies
made with multiple overseers of the same entity. One drawback
of this system is the possibility of regulators addressing the
same issue with different approaches. One way to address this
issue is the addition of a systemic oversight agency to the
financial services industry. A systemic oversight agency could
issue principles-based regulations and guidance, promoting
uniformity in the supervision of the industry, while allowing
the functional regulators to implement the regulations and
guidance in a manner most appropriate for their financial
segment. This type of structure would help preserve the
different segments of the industry and maintain the checks and
balances afforded by the different segments within the
industry.
With the single consolidated regulator approach, authority
over all aspects of regulated institutions would be established
under one regulator. This approach would allow the regulator to
possess all information and authority regarding individual
institutions, which would eliminate inefficiencies of multiple
overseers for the same institution. This approach would also
ensure the financial services industry operated under a
consistent regulatory approach. However, this approach could
result in the loss of specialized attention and focus on the
various distinct segments of the financial institutions. An
agency responsible for all institutions might focus on the
larger institutions where the systemic risk predominates,
potentially to the detriment of smaller institutions. For
example, as federally insured credit unions are generally the
smaller, less complex institutions in a consolidated financial
regulator arrangement, the unique character of credit unions
would quickly be lost, absorbed by the for-profit model and
culture of other financial institutions. Loss of credit unions
as a type of financial institution would limit access to the
affordable services for persons of modest means that are
offered by credit unions.
An objectives-based regulatory approach as outlined in the
Treasury Blueprint (market stability, prudential, and business
conduct regulators) would ensure all financial institutions
operated under a consistent regulatory approach. However, like
the single consolidated regulator, this approach could also
result in the loss of specialized attention and focus on the
distinct segments of financial institutions, thus harming the
credit union charter. Again, each regulator might focus on the
larger financial institutions where the systemic risk
predominates, while not addressing the different types of risks
found in the smaller institutions. This approach also would
result in multiple regulators for the same institution, where
no single regulator possessed all of the information and
authority necessary to monitor the overall systemic risk of the
institution. In addition, disputes between the regulators
regarding jurisdiction over the different objectives would
arise. Inefficiencies would be created with multiple regulators
supervising the same institution. Again, the focus on the
objective rather than the charter could potentially harm the
credit union industry where credit unions only comprise a small
part of the financial institution community.
In closing, the approach selected to regulate the financial
services providers must protect the unique regulatory needs of
the various components of the financial sectors, including the
credit union industry.
Q.3. If there are institutions that are too big to fail, how do
we identify that? How do we define the circumstance where a
single company is so systemically significant to the rest of
our financial circumstances and our economy that we must not
allow it to fail?
A.3. If the definition of ``too big to fail'' encompasses only
those institutions that are systemically significant enough
where their failure would have an adverse impact on financial
markets and the economy, then credit unions would not be
considered too big to fail.
Within the credit union system there are regulatory
safeguards in place to reduce the potential for ``too big to
fail'' entities. The field of membership restrictions that
govern membership of the credit union limit the potential for
any systemic risk. The impact of a failure of a large natural
person credit union would be limited to any cost of the
failure, which would be passed on to all other federally
insured credit unions via the assessment of a premium should
the equity level of the NCUSIF fall below the required level.
Q.4. We need to have a better idea of what this notion of too
big to fail is--what it means in different aspects of our
industry and what our proper response to it should be. How
should the federal government approach large, multinational and
systemically significant companies?
A.4. In large, multinational and systemically significant
institutions, federal regulators should take an aggressive
approach to examining and monitoring. As issues are discovered,
the regulator must quickly and firmly take the appropriate
action before the issue escalates.
Very few federally insured credit unions have a
multinational presence. Due to field of membership limitations,
only credit unions where a portion of their members are located
in foreign counties, such as a Department of Defense related
credit union, would have multinational exposure. \8\ In those
cases, there is limited multinational significance to the
credit union business model.
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\8\ Credit unions are chartered to serve a field of membership
that shares a common bond such as the employees of a company, members
of an association, or a local community. Therefore, credit unions may
not serve the general public like other financial institutions and the
credit unions' activities are largely limited to domestic activities,
which has minimized the impact of globalization in the credit union
industry.
Q.5. What does ``fail'' mean? In the context of AIG, we are
talking about whether we should have allowed an orderly Chapter
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11 bankruptcy proceeding to proceed. Is that failure?
A.5. NCUA regulates federally insured credit unions, which do
not file Chapter 11 bankruptcies. However, federally insured
credit unions can become insolvent and be liquidated. No member
of a federally insured credit union has ever lost a penny of
insured shares. In order to preserve confidence in the credit
union industry, NCUA usually pays out members within three days
from the time a federally insured credit union fails. NCUA has
an Asset Management and Assistance Center that is available to
quickly handle credit union liquidations and perform management
and asset recovery.
Based on the requirements set forth in 12 U.S.C. 1790d of
the Federal Credit Union Act, NCUA considers a credit union in
danger of closing (a potential failure) when the credit union:
Is subject to mandatory conservatorship,
liquidation or ``other corrective action'' for not
maintaining required levels of capital;
Is subject to discretionary conservatorship or
liquidation or is required to merge for not maintaining
required levels of capital;
Is subject to a high probability of sustaining an
identifiable loss (e.g., fraud, unexpected and sudden
outflow of funds, operational failure, natural
disaster, etc.) and could not maintain required levels
of capital, so that it would be subject to
conservatorship or liquidation.
------
RESPONSE TO WRITTEN QUESTIONS OF SENATOR KOHL
FROM MICHAEL E. FRYZEL
Q.1. Two approaches to systemic risk seem to be identified, (1)
monitoring institutions and taking steps to reduce the size/
activities of institutions that approach a ``too large to
fail'' or ``too systemically important to fail'' or (2) impose
an additional regulator and additional rules and market
discipline on institutions that are considered systemically
important.
Which approach do you endorse? If you support approach one
how you would limit institution size and how would you identify
new areas creating systemic importance?
If you support approach two how would you identify
systemically important institutions and what new regulations
and market discipline would you recommend?
A.1. Federally insured credit unions hold $8 13.44 billion in
assets, while financial institutions insured by the FDIC hold
$13.85 trillion in assets. Federally insured credit unions make
up only 5.56 percent of all federally insured asset. \9\
Therefore, the credit union industry as a whole does not pose a
systemic risk to the financial industry. However, federally
insured credit unions serve a unique role in the financial
industry by providing basic and affordable financial services
to their members. The credit union system of regulation has
produced natural limits on size. Though under stress, the
credit union system has continued their long history of
financial stability and quality service. So, implementing some
limits on size may be prudent given the success of the credit
union regulatory model.
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\9\ Based on December 31, 2008, financial data.
Q.2. Please identify all regulatory or legal barriers to the
comprehensive sharing of information among regulators including
insurance regulators, banking regulators, and investment
banking regulators. Please share the steps that you are taking
to improve the flow of communication among regulators within
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the current legislative environment.
A.2. NCUA does not believe there are any significant regulatory
or legal barriers to prevent it from information sharing with
other agency regulators. NCUA currently shares information with
state credit union supervisors on a regular basis, trains and
provides computer equipment to state examiners, and often
conducts joint supervisory examinations with state agencies.
NCUA regional management meets with state credit union
supervisors in order to discuss such things as problem areas,
problem institutions, and economic issues. In addition, NCUA
executive management meets with the National Association of
State Credit Union Supervisors (NASCUS) at least semi-annually
to discuss current issues.
NCUA also participates in Federal Financial Institutions
Examination Council (FFIEC) \10\ where information is shared
and resources are pooled together to develop regulations,
policies, training materials, etc. Working groups within the
FFIEC also include representatives from other federal agencies
outside of the financial regulatory agencies as needed.
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\10\ The FFIEC includes the Board of Governors of the Federal
Reserve (FRB), the Federal Deposit Insurance Corporation (FDIC), the
NCUA, the Office of the Comptroller of the Currency (OCC), the Office
of Thrift Supervision (OTS), and the State Liaison Committee (SLC).
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NCUA believes information sharing can be a valuable tool to
ensure safe and sound operations for various kinds of financial
institutions. Of course, appropriate parameters must be
established to clarify what information is to be shared and for
what purposes and to ensure the confidential treatment of
sensitive information.
------
RESPONSE TO WRITTEN QUESTIONS OF SENATOR HUTCHISON
FROM MICHAEL E. FRYZEL
Q.1. Will each of you commit to do everything within your power
to prevent performing loans from being called by lenders?
Please outline the actions you plan to take.
A.1. NCUA has strongly encouraged federally insured credit
unions to work with borrowers under financial stress. While
credit unions must be prudent in their approach, there are
avenues they need to explore in working through these
situations that can result in positive outcomes for both
parties. In April of 2007, NCUA issued Letter to Credit Unions
07-CU-06 titled ``Working with Residential Mortgage
Borrowers,'' which included an FFIEC initiative to encourage
institutions to consider all loan workout arrangements. NCUA
subsequently issued Letter to Credit Unions 08-CU-05 in March
of 2008 supporting the Hope NOW alliance, which focuses on
modifying qualified loans. More recently, NCUA Letter to Credit
Unions 09-CU-04, issued in March 2009, encourages credit union
participation in the Making Home Affordable loan modification
program. NCUA is currently in the process of developing a
Letter to Credit Unions that will further address loan
modifications. NCUA has been, and will remain, supportive of
all prudent efforts to avoid calling loans and taking
foreclosure actions.
While NCUA remains supportive of workout arrangements in
general, the data available does not suggest performing loans
are being called at a significant level within the credit union
industry. What is more likely to occur is the curtailing of
existing lines of credit for both residential and construction
and development lending. It is conceivable that underlying
collateral values supporting such loans have deteriorated and
no longer support lines of credit outstanding or unused
commitments. In those instances, a business decision must be
made regarding whether to curtail the line of credit. There
likely will be credit union board established credit risk
parameters that need to be considered as well as regulatory
considerations, especially as it relates to construction and
development lending.
Credit union business lending is restricted by statute to
the lesser of 1.75 times the credit union's net worth or 12.25
percent of assets (some exceptions apply). There are further
statutory thresholds on the level of construction and
development lending, borrower equity requirements for such
lending, limits on unsecured business lending, and maximum loan
to value limitations (generally 80 percent without insurance or
up to 95 percent with insurance). While business lending
continues to grow within credit unions, the level of such
lending as of December 31, 2008, is 3.71 percent of total
credit union assets and 5.32 percent of total credit union
loans. Only 6.15 percent of outstanding credit union business
loans, or $1.95 billion, are for construction and development,
which is a very small piece of the overall construction and
development loan market.
Credit union loan portfolios grew at a rate of over 7
percent in 2008. The level of total unfunded loan commitments
continues to grow, which suggests there is not a pervasive
calling of lines of credit. Credit unions need to continue to
act independently in regard to credit decisions. Each loan will
involve unique circumstances including varying levels of risk.
Some markets have been much more severely impacted by the
change in market conditions, creating specific risk
considerations for affected loans. Additionally, there are
significant differences between loans to the average
residential home owner who is current on their loan even though
their loan to value ratio is now 110 percent, versus the
developer who has a line of credit to fund his commercial use
or residential construction project. Continued funding for the
developer may be justified or may be imprudent. Continued
funding may place the institution at additional risk or beyond
established risk thresholds, depending on the circumstances.
The agency continues to support the thoughtful evaluation
by credit union management of each performing loan rather than
a blanket approach to curtailing the calling of performing
loans.
------
RESPONSE TO WRITTEN QUESTIONS OF SENATOR SHELBY
FROM DANIEL K. TARULLO
Q.1. Consumer Protection Regulation--Some have advocated that
consumer protection and prudential supervision should be
divorced, and that a separate consumer protection regulation
regime should be created. They state that one source of the
financial crisis emanated from the lack of consumer protection
in the underwriting of loans in the originate-to-distribute
space.
What are the merits of maintaining it in the same agency?
Alternatively, what is the best argument each of you can make
for a new consumer protection agency?
A.1. The best argument for maintaining supervision of consumer
protection in the same agency that provides safety and
soundness and supervision is that the two are linked both
substantiveIy and practically. Thus there are substantial
efficiency and information advantages from having the two
functions housed in the same agency. For example, risk
assessments related to an institution's management of consumer
compliance functions are closely linked with other safety and
soundness risks, and factor in to assessments of bank
management and financial, legal, and reputation risks.
Likewise, evaluations of management or controls in lending
processes in safety and soundness examinations factor in to
assessments of compliance risk management. Supervisory
assessments for both safety and soundness and consumer
protection, as well as enforcement actions or supervisory
follow up, are best made with the benefit of the broader
context of the entire organization's risks and capacity.
Furthermore, determinations that certain products or practices
are ``unfair and deceptive'' in some cases require an
understanding of how products are priced, offered, and marketed
in an individual institution. This information is best obtained
through supervisory monitoring and examinations.
A related point is that responsibility for prudential and
consumer compliance examinations and enforcement benefits
consumer protection rulewriting responsibilities. Examiners are
often the first government officials to see problems with the
application and implementation of rules in consumer
transactions. Examiners are an important source of expertise in
banking operations and lending activities, and they are trained
to understand the interplay of all the risks facing individual
banking organizations.
The best argument for an independent consumer agency within
the financial regulatory structure is that it will focus
single-mindedly on consumer protection as its primary mission.
The argument is that the leadership of an agency with multiple
functions may trade one off against the other one, at times, be
distracted by responsibilities in one area and less attentive
to problems in the other. A corollary of this basic point is
that the agency would be more inclined to act to deter use of
harmful financial products and, if properly structured and
funded, may be less susceptible to the sway of powerful
industry influences. Proponents of a separate agency also argue
that a single consumer regulator responsible for monitoring and
enforcing compliance would end the competition among regulatory
agencies that they believe promotes a ``competition in laxity''
for fear that supervised entities will engage in charter
shopping.
Apart from the relative merits of the foregoing arguments,
two points of context are probably worth making: First, any
agency assigned rulewriting authority will be effective only if
it has considerable expertise in consumer credit markets,
retail payments, banking operations, and economic analysis.
Successful rulewriting requires an understanding of the likely
effects of protections to prevent abuses on the availability of
responsible and affordable credit. Second, the policies and
performance of both an ``integrated'' agency and a free-
standing consumer protection agency will depend importantly on
the leadership appointed to head those entities.
Q.2. Regulatory Gaps or Omissions--During a recent hearing, the
Committee has heard about massive regulatory gaps in the
system. These gaps allowed unscrupulous actors like AIG to
exploit the lack of regulatory oversight. Some of the
counterparties that AIG did business with were institutions
under your supervision.
Why didn't your risk management oversight of the AIG
counterparties trigger further regulatory scrutiny? Was there a
flawed assumption that AIG was adequately regulated, and
therefore no further scrutiny was necessary?
Was there dialogue between the banking regulators and the
state insurance regulators? What about the SEC?
If the credit default swap contracts at the heart of this
problem had been traded on an exchange or cleared through a
clearinghouse, with requirement for collateral and margin
payments, what additional information would have been
available? How would you have used it?
A.2. The problems created by AIG provide perhaps the best case
study in showing the need for regulatory reform, enhanced
consolidated supervision of institutions and business lines
that perform the same function, and an explicit regulatory
emphasis on systemic risk. Importantly, some of the largest
counterparties to AIG were foreign institutions and investments
banks not directly supervised by the Federal Reserve. Even
then, however, established industry practices prior to the
crisis among financial institution counterparties with high
credit ratings called for little exchange of initial margins on
OTC derivative contracts. Such practices and AIG's high credit
rating thus inhibited the checks and balances initial margins
would have placed on AIG's positions. Federal Reserve
supervisory reviews of counterparty credit risk exposures at
individual firms prior to the crisis did not flag AIG as posing
significant counterparty credit risk since AIG was regularly
able to post its variation margins on OTC derivative contracts
thus reducing its exposure. Moreover, AIG spread its exposures
across a number of different counterparties and instruments.
The over-reliance on credit ratings in a number of areas
leading up to the current crisis, as well as the need for
better information on market-wide exposures in the OTC
derivatives market, have motivated supervisory efforts to move
the industry to the use of central clearing parties and the
implementation of a data warehouse on OTC derivative
transactions. This effort, reinforced with appropriate
statutory authority, is a critical part of a systemic risk
agenda.
The Federal Reserve actively participates on an insurance
working group, which includes other federal banking and thrift
agencies and the National Association of Insurance
Commissioners (NAIC). The working group meets quarterly to
discuss developments in the insurance and banking sectors,
legislative developments, and other topics of particular
significant. In addition, to the working group, the Federal
Reserve communicates regularly with the NAIC and insurance
regulators on specific matters. With respect to the SEC, the
Federal Reserve has information sharing arrangements in place
for companies under our supervision. Since the Federal Reserve
had no supervisory responsibility for AIG, we did not discuss
the company or its operations with either the state insurance
regulators or the SEC until the time of our initial discount
window loan in September 2008.
Credit default swap contracts may be centrally cleared
(whether they are traded over the counter or listed on an
exchange) only if they are sufficiently standardized.
Presently, sufficiently standardized CDS contracts comprise
those written on CDS indices, on tranches of CDS indices, and
on some corporate single-name entities. The CDS contracts at
the heart of the AIG collapse were written mainly on tranches
of ABS CDOs, which are generally individually tailored (e.g.,
bespoke transactions) in nature and therefore not feasible
either for exchange trading or central clearing. For such
nonstandard transactions we are strongly advocating the use of
centralized trade repositories, which would maintain official
records of all noncentrally-cleared CDS deals. It is important
to note that the availability of information on complex deals
in a central repository or otherwise is necessary but not
sufficient for fully understanding the risks of these
positions. Even if additional information on AIG's positions
had been available from trade repositories and other sources,
the positions would have been as difficult to value and monitor
for risk without considerable additional analysis.
Most critically, both trade repositories and clearinghouses
provide information on open CDS contracts. Of most value and
interest to regulators are the open interest in CDS written on
specific underliers and the open positions of a given entity
vis-a-vis its counterparties. Both could provide regulators
with information on aggregate and participant exposures in near
real time. A clearinghouse could in addition provide
information on collateral against these exposures and the CCP's
valuation of the contracts cleared. An exchange on top of a
clearinghouse would be able to provide real-time information on
trading interest in terms of prices and volumes, which could be
used by regulators to monitor market activity.
Q.3. Systemic Risk Regulation--The Federal Reserve and the OTS
currently have consolidated supervisory authority over bank and
thrift holding companies respectively. This authority grants
the regulators broad powers to regulate some of our Nation's
largest, most complex firms, yet some of these firms have
failed or are deeply troubled.
Mr. Tarullo, do you believe there were failures of the
Federal Reserve's holding company supervision regime and, if
so, what would be different under a new systemic risk
regulatory scheme?
A.3. I expect that when the history of the financial crisis is
finally written, culpability will be shared by essentially
every part of the government responsible for constructing and
implementing financial regulation, including the Federal
Reserve. Since just about all financial institutions have been
adversely affected by the financial crisis--not just those that
have failed--all supervisors have lessons to learn from this
crisis.
As to what will be different going forward, I would suggest
the following:
First, the Federal Reserve is already implementing a number
of changes, such as enhancing risk identification processes to
more quickly detect emerging risks. The Board is also improving
the processes to issue supervisory guidance and policies to
make them more timely and effective. In 2008 the Board issued
supervisory guidance on consolidated supervision to clarify the
Federal Reserve's role as consolidated supervisor and to assist
the examination staff as they carry out supervision of banking
institutions, particularly large, complex firms with multiple
legal entities.
Second, I would hope that both statutory provisions and
administrative practices would change so as to facilitate a
truly comprehensive approach to consolidated supervision. This
would include, among other things, amending the Gramm-Leach-
Bliley Act, whose emphasis on ``functional regulation'' for
prudential purposes is at odds with the comprehensive approach
that is needed to supervise large, complex institutions
effectively for safety and soundness and systemic risks. For
example, the Act places certain limits on the Federal Reserve's
ability to examine or obtain reports from functionally
regulated subsidiaries of a bank holding company.
Third, our increasing focus on risks that are created
across institutions and in interactions among institutions
should improve identification of incipient risks within
specific institutions that may not be so evident based on
examination of a single firm. In this regard, the Federal
Reserve is expanding and refining the use of horizontal
supervisory reviews. An authority charged with systemic risk
regulatory tasks would presumably build on this kind of
approach, but it is also important in more conventional,
institution-specific consolidated supervision.
Fourth, I believe it is fair to say that there is a
different orientation towards regulation and supervision within
the current Board than may have been the case at times in the
past.
Q.4. Liquidity Management--A problem confronting many financial
institutions currently experiencing distress is the need to
roll-over short-term sources of funding. Essentially these
banks are facing a shortage of liquidity. I believe this
difficulty is inherent in any system that funds long-term
assets, such as mortgages, with short-term funds. Basically the
harm from a decline in liquidity is amplified by a bank's level
of ``maturity-mismatch.''
I would like to ask each of the witnesses, should
regulators try to minimize the level of a bank's maturity-
mismatch? And if so, what tools would a bank regulator use to
do so?
A.4. The current crisis has proven correct those who have
maintained in recent years that liquidity risk management
needed considerably more attention from banks, holding
companies, and supervisors. As will be described below, a
number of steps are already being taken to address this need,
but additional analysis will clearly be needed. At the outset,
though, it is worth emphasizing that maturity transformation
through adequately controlled maturity mismatches is an
important economic function that banks provide in promoting
overall economic growth. Indeed, the current problems did not
arise solely from balance sheet maturity mismatches that banks
carried into the current crisis. For almost 2 years, many
financial institutions have been unable to roll over short-term
and maturing intermediate-term funding or have incurred
maturity mismatches primarily because of their inability to
obtain longer-term funds as a result of solvency concerns in
the market. This has been exacerbated by some institutions
having to take onto their balance sheets assets that were
previously considered off-balance sheet.
To elaborate this point, it is important to note that most
of the serious mismatches that led to significant ``tail''
liquidity risks occurred in instruments and activities outside
of traditional bank lending and borrowing businesses. The most
serious mismatches encountered were engineered into various
types of financial products and securitization vehicles such as
structured investment vehicles (SIVs), variable rate demand
notes (VRDNs) and other products sold to institutional and
retail customers. In addition, a number of managed stable value
investment products such as registered money market mutual
funds and unregistered stable value investment accounts and
hedge funds undertook significant mismatches that compromised
their integrity. Many of these mismatches were transferred to
banking organizations during the crisis through contractual
commitments to extend liquidity to such vehicles and products.
Where no such contractual commitments existed, assets came onto
banks' balance sheets as a result of their decisions to support
sponsored securitization vehicles, customer funding products,
and investment management funds in the interest of mitigating
the banks' brand reputation risks.
However, such occurrences do not minimize the significant
mismatches that occurred through financial institutions', and
their hedge fund customers', significant use of short-term
repurchase agreements and reverse repurchase agreements to
finance significant potions off their dealer inventories and
trading positions. Such systemic reliance on short-term funding
placed significant pressures on the triparty repo market.
The task for regulators and policy makers is to ensure that
any mismatches taken by banking organizations are appropriately
managed and controlled. The tools used by supervisors to
achieve this goal include the clear articulation of supervisory
expectations surrounding sound practices for liquidity risk
management and effective on-site assessment as to whether
institutions are complying with those expectations. In an
effort to strengthen these tools, supervisors have taken a
number of steps. In September 2008 the Basel Committee on Bank
Supervision (BCBS) issued a revised set of international
principles on liquidity risk management. The U.S. bank
regulatory agencies plan to issue joint interagency guidance
endorsing those principles and providing a single set of U.S.
supervisory expectations that aggregates well-established
guidance issued by each agency in the past. Both the
international and U.S. guidance, which highlight the need for
banks to assess the liquidity risk embedded in off-balance
sheet exposures, should re-enforce both banks' efforts to
enhance their liquidity risk management processes and
supervisory actions to improve oversight of these processes. In
addition, the BCBS currently has efforts underway to establish
international standards on liquidity risk exposures that is
expected to be issued for comment in the second half of 2009.
Such standards have the potential for setting the potential
limits on maturity mismatches and requirements for more stable
funding of dealer operations, while acknowledging the important
role maturity mismatches play in promoting economic growth.
Q.5. What Is Really Off-Balance Sheet--Chairman Bair noted that
structured investment vehicles (SIVs) played an important role
in funding credit risk that are at the core of our current
crisis. While the banks used the SIVs to get assets of their
balance sheet and avoid capital requirements, they ultimately
wound up reabsorbing assets from these SIVs.
Why did the institutions bring these assets back on their
balance sheet? Was there a discussion between the OCC and those
with these off-balance sheet assets about forcing the investor
to take the loss?
How much of these assets are now being supported by the
Treasury and the FDIC?
Based on this experience, would you recommend a different
regulatory treatment for similar transactions in the future?
What about accounting treatment?
A.5. Companies that sponsored SIVs generally acted as
investment managers for the SIVs and funded holdings of longer-
term assets with short-term commercial paper and medium-term
notes. As the asset holdings began to experience market value
declines and the liquidity for commercial paper offerings
deteriorated, SIVs faced ratings pressure on outstanding debt.
In addition, SIV sponsors faced legal and reputational risk as
losses began accruing to third-party holders of equity
interests in the SIVs. Market events caused some SIV sponsors
to reconsider their interests in the vehicles they sponsored
and to conclude that they were the primary beneficiary as
defined in FASB Interpretation No. 46(R), which required them
to consolidate the related SIVs. In addition, market events
caused some SIV sponsors to commit formally to support SIVs
through credit or liquidity facilities with the intention of
maintaining credit ratings on outstanding senior debt. Those
additional commitments caused the sponsors to conclude that
they were the primary beneficiary of the related vehicles and,
therefore, to consolidate.
Very few U.S. banks consolidated SIV assets in 2007 and
2008. Citigroup disclosed in their 2008 Annual Report that $6.4
billion in SIV assets were part of an agreed asset pool covered
in the U.S. government loss sharing arrangement announced
November 23, 2008. We are not aware of other material direct
support of SIV assets through the Treasury Department or the
FDIC.
Recent events have demonstrated the need for supervisors
and banks to better assess risks associated with off-balance
sheet exposures. The Federal Reserve participated in the
development of proposed guidance published by the BCBS in
January 2009, to strengthen supervisory expectations for
capturing firm-wide risk concentrations arising from both on-
and off-balance-sheet exposures. These include both contractual
exposures, as well as the potential impact on overall risk,
capital, and liquidity of noncontractual exposures such as
reputational risk exposure to off-balance-sheet vehicles and
asset management activities. Exercises to evaluate possible
additional supervisory and regulatory changes to the
requirements for off-balance-sheet exposures are ongoing and
include the BCBS efforts to develop international standards
surrounding banks' liquidity risk profiles.
The Federal Reserve supports recent efforts by the
Financial Accounting Standards Board to amend and clarify the
accounting treatment for off-balance-sheet vehicles such as
SIVs, securitization trusts, and structured finance conduits.
We applauded the FASB for requiring additional disclosure of
such entities in public company financials starting with year-
end 2008 reports, as well. We are hopeful that the amended
accounting guidance for consolidation of special purpose
entities like SIVs will result in consistent application in
practice and enhanced transparency. That outcome would permit
financial statement users, including regulators, to assess
potential future risks facing financial institutions by virtue
of the securitization and structured finance activities in
which it engages.
Q.6. Regulatory Conflict of Interest--Federal Reserve Banks
which conduct bank supervision are run by bank presidents that
are chosen in part by bankers that they regulate.
Mr. Tarullo, do you see the potential for any conflicts of
interest in the structural characteristics of the Fed's bank
supervisory authorities?
A.6. The Board of Governors has the statutory responsibility
for supervising bank holding companies, state member banks, and
the other banking organizations for which the Federal Reserve
System has supervisory authority under the Bank Holding Company
Act, the Federal Reserve Act, and other federal laws. See,
e.g., 12 U.S.C. 248(a) (state member banks), 1844 (bank
holding companies), and 3106(c) (U.S. branches and agencies of
foreign banks). Although the Board has delegated authority to
the Reserve Banks to conduct many of the Board's supervisory
functions with respect to banking organizations, applicable
regulations and policies are adopted by the Board alone. The
Reserve Banks conduct supervisory activities subject to
oversight and monitoring by the Board. It is my expectation
that the Board will exercise this oversight vigorously.
The recently completed Supervisory Capital Assessment
Program (SCAP) provides an excellent example of how this
oversight and interaction can operate effectively in practice.
The SCAP process was a critically important part of the
government's efforts to promote financial stability and ensure
that the largest banking organizations have sufficient capital
to continue providing credit to households and businesses even
under adverse economic conditions. The Board played a lead and
active role in the design of the SCAP, the coordination and
implementation of program policies, and the assessment of
results across all Federal Reserve districts. These efforts
were instrumental in ensuring that the SCAP was rigorous,
comprehensive, transparent, effective, and uniformly applied.
The Board is considering ways to apply the lessons learned from
the SCAP to the Federal Reserve's regular supervisory
activities to make them stronger, more effective, and more
consistent across districts.
Q.7. Too-Big-To-Fail--Chairman Bair stated in her written
testimony that ``the most important challenge is to find ways
to impose greater market discipline on systemically important
institutions. The solution must involve, first and foremost, a
legal mechanism for the orderly resolution of those
institutions similar to that which exists for FDIC-insured
banks. In short we need to end too big to fail.'' I would agree
that we need to address the too-big-to-fail issue, both for
banks and other financial institutions.
Could each of you tell us whether putting a new resolution
regime in place would address this issue?
How would we be able to convince the market that these
systemically important institutions would not be protected by
taxpayer resources as they had been in the past?
A.7. As we have seen in the current financial crisis, large,
complex, interconnected financial firms pose significant
challenges to supervisors. Policymakers have strong incentives
to prevent the failure of such firms because of the risks such
a failure would pose to the financial system and the broader
economy. However, the belief of market participants that a
particular firm will receive special government assistance if
it becomes troubled has many undesirable effects. For instance,
it reduces market discipline and encourages excessive risk-
taking by the firm. It also provides an artificial incentive
for firms to grow in size and complexity, in order to be
perceived as too big to fail. And it creates an unlevel playing
field with smaller firms, which may not be regarded as having
implicit government support. Moreover, of course, the
government rescues of such firms are potentially very costly to
taxpayers.
Improved resolution procedures for systemically important
financial firms would help reduce the too-big-to-fail problem
in two ways. First, such procedures would visibly provide the
authorities with the legal tools needed to manage the failure
of a systemically important firm while still ensuring that
creditors and counterparties suffer appropriate losses in the
event of the firm's failure. As a result, creditors and
counterparties should have greater incentives to impose market
discipline on financial firms. Second, by giving the government
options other than general support to keep a distressed firm
operating, resolution procedures should give the managers of
systemically important firms somewhat better incentives to
limit risk taking and avoid failure.
While resolution authority of this sort is an important
piece of an agenda to control systemic risk, it is no panacea.
In the first place, resolving a large, complex financial
institution is a completely different task from resolving a
small or medium-sized bank. No part of the U.S. Government has
experience in this task. Although one or more agencies could
acquire relevant expertise as needed, we cannot be certain how
this resolution mechanism would operate in practice. Second,
precisely because of the uncertainties that will, at least for
a time, surround a statutory mechanism of this sort, there must
also be effective supervision and regulation of these
institutions that is targeted more directly at their systemic
importance.
Q.8. Pro-Cyclicality--I have some concerns about the pro-
cyclical nature of our present system of accounting and bank
capital regulation. Some commentators have endorsed a concept
requiring banks to hold more capital when good conditions
prevail, and then allow banks to temporarily hold less capital
in order not to restrict access to credit during a downturn.
Advocates of this system believe that counter-cyclical policies
could reduce imbalances within financial markets and smooth the
credit cycle itself.
What do you see as the costs and benefits of adopting a
more counter-cyclical system of regulation?
Do you see any circumstances under which your agencies
would take a position on the merits of counter-cyclical
regulatory policy?
A.8. There is a good bit of evidence that current capital
standards, accounting rules, certain other regulations, and
even deposit insurance premiums have made the financial sector
excessively pro-cyclical--that is, they lead financial
institutions to ease credit in booms and tighten credit in
downturns more than is justified by changes in the
creditworthiness of borrowers, thereby intensifying cyclical
changes.
For example, capital regulations require that banks'
capital ratios meet or exceed fixed minimum standards in order
for the bank to be considered safe and sound by regulators.
Because banks typically find raising capital to be difficult in
economic downturns or periods of financial stress, their best
means of boosting their regulatory capital ratios during
difficult periods may be to reduce new lending, perhaps more so
than is justified by the credit environment.
As I noted in my testimony, the Federal Reserve is working
with other U.S. and foreign supervisors to strengthen the
existing capital rules to achieve a higher level and quality of
required capital. As one part of this overall effort, we have
been assessing various proposals for mitigating the pro-
cyclical effects of existing capital rules, including dynamic
provisioning or a requirement that financial institutions
establish strong capital buffers above current regulatory
minimums in good times, so that they can weather financial
market stress and continue to meet customer credit needs. This
is but one of a number of important ways in which the current
pro-cyclical features of financial regulation could be
modified, with the aim of counteracting rather than
exacerbating the effects of financial stress.
Q.9. G20 Summit and International Coordination--Many foreign
officials and analysts have said that they believe the upcoming
G20 summit will endorse a set of principles agreed to by both
the Financial Stability Forum and the Basel Committee, in
addition to other government entities. There have also been
calls from some countries to heavily re-regulate the financial
sector, pool national sovereignty in key economic areas, and
create powerful supranational regulatory institutions.
(Examples are national bank resolution regimes, bank capital
levels, and deposit insurance.) Your agencies are active
participants in these international efforts.
What do you anticipate will be the result of the G20
summit?
Do you see any examples or areas where supranational
regulation of financial services would be effective?
How far do you see your agencies pushing for or against
such supranational initiatives?
A.9. As you point out, the Federal Reserve has for many years
worked with international organizations such as the Basel
Committee on Banking Supervision, the Financial Stability Forum
(now the Financial Stability Board), the Joint Forum and others
on matters of mutual interest. Our participation reflects our
long-held belief, reinforced by the current financial crisis,
that the international dimensions of financial supervision and
regulation and financial stability are critical to the health
and stability of the U.S. financial system and economy, as well
as to the competitiveness of our financial firms. Thus, it is
very much in the self-interest of the United States to play an
active role in international forums. Our approach in these
groups has not been on the development of supranational
authorities. Rather, it has been on the voluntary collection
and sharing of information, the open discussion of views, the
development of international contacts and knowledge, the
transfer of technical expertise, cooperation in supervising
globally active financial firms, and agreements an basic
substantive rules such as capital requirements. As evidenced in
the activities of the G20 and the earlier-mentioned
international fora, the extraordinary harm worked by the
current financial crisis on an international scale suggests the
need for continued evolution of these approaches to ensure the
stability of major financial firms and systems around the
world.
Q.10. Consolidated Supervised Entities--Mr. Tarullo, in your
testimony you noted that ``the SEC was forced to rely on a
voluntary regime'' because it lacked the statutory authority to
act as a consolidated supervisor.
Who forced the SEC to set up the voluntary regime? Was it
the firm that wanted to avoid being subject to a more rigorous
consolidated supervision regime?
A.10. Under the Securities Exchange Act of 1934 (15 U.S.C.
78a, et seq.), the Securities and Exchange Commission (SEC)
has broad supervisory authority over SEC-registered broker-
dealers, but only limited authority with respect to a company
that controls a registered broker-dealer. See 15 U.S.C. 78o
and 78q(h). In 2002, the European Union (EU) adopted a
directive that required banking groups and financial
conglomerates based outside the EU to receive, by August 2004,
a determination that the financial group was subject to
consolidated supervision by its home country authorities in a
manner equivalent to that required by the EU for EU-based
financial groups. If a financial group could not obtain such a
determination, the directive permitted EU authorities to take a
range of actions with respect to the non-EU financial group,
including requiring additional reports from the group or,
potentially, requiring the group to reorganize all its EU
operations into a single EU holding company that would be
subject to consolidated supervision by a national regulator
within the EU. See Directive 2002/87/EC of the European
Parliament and of the Council of 16 (Dec. 2002). After this
directive was adopted, several of the large U.S. investment
banks that were not affiliated at the time with a bank holding
company expressed concern that, if they were unable to obtain
an equivalency determination from the EU, the firms'
significant European operations could be subject to potentially
costly or disruptive EU-imposed requirements under the
directive.
In light of these facts, and to improve its own ability to
monitor and address the risks at the large U.S. investment
banks that might present risks to their subsidiary broker-
dealers, the SEC in 2004 adopted rules establishing a voluntary
consolidated supervision regime for those investment banking
firms that controlled U.S. broker-dealers with at least $1
billion in tentative net capital, and at least $500 million of
net capital, under the SEC's broker-dealer capital rules. The
Goldman Sachs Group, Inc. (Goldman Sachs), Morgan Stanley,
Merrill Lynch & Co., Inc. (Merrill Lynch), Lehman Brothers
Holdings, Inc. (Lehman), and The Bear Stearns Companies, Inc.,
each applied and received approval to become consolidated
supervised entities (CSEs) under the SEC's rules. These rules
were not the same as would have applied to these entities had
they became bank holding companies. While operating as CSEs,
Goldman Sachs, Morgan Stanley, Merrill Lynch, and Lehman also
controlled FDIC-insured state banks under a loophole in current
law that allows any type of company to acquire an FDIC-insured
industrial loan company (LC) chartered in certain states
without becoming subject to the prudential supervisory and
regulatory framework established under the Bank Holding Company
Act of 1956 (BHC Act). \1\ As I noted in my testimony, the
Board continues to believe that this loophole in current law
should be closed.
---------------------------------------------------------------------------
\1\ The ownership of such ILCs also disqualified such firms from
potential participation in the alternative, voluntary consolidated
supervisory regime that Congress authorized the SEC to establish for
``investment bank holding companies'' as part of the Gramm-Leach-Bliley
Act of 1999. See 15 U.S.C. 78q(i)(1)(A)(i).
Q.11. Credit Default Swaps--Mr. Tarullo, the Federal Reserve
Bank of New York has been actively promoting the central
clearing of credit default swaps.
How will you encourage market participants, some of whom
benefit from an opaque market, to clear their trades?
Is it your intent to see the establishment of one
clearinghouse or are you willing to allow multiple central
clearing facilities to exist and compete with one another?
Is the Fed working with European regulators to coordinate
efforts to promote clearing of CDS transactions?
How will the Fed encourage market participants, some of
whom benefit from an opaque market, to clear their credit
default swap transactions?
Is it the Fed's expectation that there will be only one
credit default swap clearinghouse or do you envision multiple
central clearing counterparties existing in the long run?
How is the Fed working with European regulators to
coordinate efforts to promote clearing of credit default swap
transactions?
What other classes of OTC derivatives are good candidates
for central clearing and what steps is the Fed taking to
encourage the development and use of central clearing
counterparties?
A.11. The Federal Reserve can employ supervisory tool to
encourage derivatives dealers that are banks or part of a bank
holding company to centrally clear CDS. These include the use
of capital charges to provide incentives, as well as direct
supervisory guidance for firms to ensure that any product to
which such a dealer is a party will, if possible, be submitted
to and cleared by a CCP.
The Federal Reserve is also encouraging greater
transparency in the CDS market. Through the Federal Reserve
Bank of New York's (FRBW) ongoing initiatives with market
participants, the major dealers have been providing regulators
with data on the volumes of CDS trades that are recorded in the
trade repository and will soon begin reporting data around the
volume of CDS trades cleared through a CCP.
There are multiple existing or proposed CCPs for CDS. The
Federal Reserve has not endorsed any one CCP proposal. Our top
priority is that any CDS CCP be well-regulated and prudently
managed. We believe that market forces in a competitive
environment should determine which and how many CDS CCPs exist
in the long run.
The FRBNY has hosted a series of meetings with U.S. and
foreign regulators to discuss possible information sharing
arrangements and other methods of cooperation within the
regulatory community. Most recently, the FRBNY hosted a
workshop on April 17, attended by 28 financial regulators
including those with direct regulatory authority over a CCP, as
well as other interested regulators and governmental
authorities that are currently considering CDS market matters.
Workshop participants included European regulators with broad
coverage such as the European Commission, the European Central
Bank and the Committee of European Securities Regulators. \2\
Participants discussed CDS CCP regulatory interests and
information needs of other authorities and the market more
broadly and agreed to a framework to facilitate information
sharing and cooperation.
---------------------------------------------------------------------------
\2\ Regulators and other interested authorities that attended the
April 17 Workshop included: Belgian Banking, Finance and Insurance
Commission (CBFA), National Bank of Belgium, Committee of European
Securities Regulators (CESR), European Central Bank, European
Commission, Bank of France, Commission Bancaire, French Financial
Markets Authority (AMF), Deutsche Bundesbank, German Financial
Supervisory Authority (BaFin), Committee on Payment and Settlement
Systems (CPSS) Bank of Italy, Bank of Japan, Japan Financial Services
Agency , Netherlands Authority for the Financial Markets (AFM),
Netherlands Bank , Bank of Spain, Spanish National Securities Market
Commission (CNMV), Swiss Financial Market Supervisory Authority
(FINMA). Swiss National Bank, Bank of England, UK Financial Services
Authority, Commodity Futures Trading Commission, Federal Deposit
Insurance Corporation, Federal Reserve Bank of New York, Federal
Reserve Board, New York State Banking Department, Office of the
Comptroller of the Currency, and the Securities and Exchange
Commission.
---------------------------------------------------------------------------
The FRBNY will continue to coordinate with other regulators
in the U.S. and Europe to establish a coherent approach for
communicating supervisory expectations, to encourage consistent
treatment of CCPs across jurisdictions, and to ensure that
regulators have adequate access to the information necessary to
carry out their respective objectives.
Additionally, since 2005 the FRBNY has been coordinating
with foreign regulators \3\ in its ongoing work with major
dealers and large buy-side firms to strengthen the operational
infrastructure of the OTC derivatives market more broadly. The
regulatory community holds monthly calls to discuss, these
efforts, which include central clearing for CDS.
---------------------------------------------------------------------------
\3\ Foreign regulators engaged in this effort include the UK
Financial Services Authority, the German Federal Financial Supervisory
Authority, the French Commission Bancaire, and the Swiss Financial
Market Supervisory Authority.
---------------------------------------------------------------------------
The degree of risk reduction and enhanced operational
efficiency that might be obtained from the use of a CCP may
vary across asset classes. However, a CCP for any OTC
derivatives asset class must be well designed with effective
risk management controls that meet, at a minimum, international
standards for central counterparties.
A number of CCPs are already in use for other OTC
derivatives asset classes including LCH.Clearnet's SwapClear
for interest rates and CME/NYMEX's ClearPort for energy and
other OTC commodities. The FRBNY is working with the market
participants to ensure that clearing members utilize more fully
available clearing services and to encourage CCPs to support
additional products and include a wider range of participants.
The industry will provide further details to regulators and the
public at the end of May addressing many of these issues for
the various derivative asset classes.
------
RESPONSE TO WRITTEN QUESTIONS OF SENATOR REED
FROM DANIEL K. TARULLO
Q.1. It is clear that our current regulatory structure is in
need of reform. At my subcommittee hearing on risk management,
March 18, 2009, GAO pointed out that regulators often did not
move swiftly enough to address problems they had identified in
the risk management systems of large, complex financial
institutions.
Chair Bair's written testimony for today's hearing put it
very well: `` . . . the success of any effort at reform will
ultimately rely on the willingness of regulators to use their
authorities more effectively and aggressively.''
My questions may be difficult, but please answer the
following:
If this lack of action is a persistent problem
among the regulators, to what extent will changing the
structure of our regulatory system really get at the
issue?
Along with changing the regulatory structure, how
can Congress best ensure that regulators have clear
responsibilities and authorities, and that they are
accountable for exercising them ``effectively and
aggressively''?
A.1. Changing regulatory structures and--for that matter--
augmenting existing regulatory authorities are necessary, but
not sufficient, steps to engender strong and effective
financial regulation. The regulatory orientation of agency
leadership and staff are also central to achieving this end.
While staff capacities and expertise will generally not
deteriorate (or improve) rapidly, leadership can sometimes
change extensively and quickly.
While this fact poses a challenge in organizing regulatory
systems, there are some things that can be done. Perhaps most
important is that responsibilities and authorities be both
clearly defined and well-aligned, so that accountability is
clear. Thus, for example, assigning a particular type of
rulemaking and rule implementation to a specific agency makes
very clear who deserves either blame or credit for outcomes.
Where a rulemaking or rule enforcement process is collective,
on the other hand, the apparent shared responsibility may mean
in practice that no one is responsible: Procedural delays and
substantive outcomes can also be attributed to someone else's
demands or preferences.
When responsibility is assigned to an agency, the agency
should be given adequate authority to execute that
responsibility effectively. In this regard, Congress may wish
to review the Gramm-Leach-Bliley Act and other statutes to
ensure that authorities and responsibilities are clearly
defined for both primary and consolidated supervisors of
financial firms and their affiliates. Some measure of
regulatory overlap may be useful in some circumstances--a kind
of constructive redundancy--so long as both supervisors have
adequate incentives for balancing various policy objectives.
But if, for example, access to information is restricted or one
supervisor must rely on the judgments of the other, the risk of
misaligned responsibility and authority recurs.
Q.2. How do we overcome the problem that in the boom times no
one wants to be the one stepping in to tell firms they have to
limit their concentrations of risk or not trade certain risky
products?
What thought has been put into overcoming this problem for
regulators overseeing the firms?
Is this an issue that can be addressed through regulatory
restructure efforts?
A.2. Your questions highlight a very real and important issue--
how best to ensure that financial supervisors exercise the
tools at their disposal to address identified risk management
weaknesses at an institution or within an industry even when
the firm, the industry, and the economy are experiencing growth
and appear in sound condition. In such circumstances, there is
a danger that complacency or a belief that a ``rising tide will
lift all boats'' may weaken supervisory resolve to forcefully
address issues. In addition, the supervisor may well face
pressure from external sources--including the supervised
institutions, industry or consumer groups, or elected
officials--to act cautiously so as not to change conditions
perceived as supporting growth. For example, in 2006, the
Federal Reserve, working in conjunction with the other federal
banking agencies, developed guidance highlighting the risks
presented by concentrations in commercial real estate. This
guidance drew criticism from many quarters, but is particularly
relevant today given the substantial declines in many regional
and local commercial real estate markets.
Although these dangers and pressures are to some degree
inherent in any regulatory framework, there are ways these
forces can be mitigated. For example, sound and effective
leadership at any supervisory agency is critical to the
consistent achievement of that agency's mission. Moreover,
supervisory agencies should be structured and funded in a
manner that provides the agency appropriate independence. Any
financial supervisory agency also should have the resources,
including the ability to attract and retain skilled staff,
necessary to properly monitor, analyze and--when necessary--
challenge the models, assumptions and other risk management
practices and internal controls of the firms it supervises,
regardless of how large or complex they may be.
Ultimately, however, supervisors must show greater resolve
in demanding that institutions remain in sound financial
condition, with strong capital and liquidity buffers, and that
they have strong risk management. While these may sound like
obvious statements in the current environment, supervisors will
be challenged when good times return to the banking industry
and bankers claim that they have learned their lessons. At
precisely those times, when bankers and other financial market
actors are particularly confident, when the industry and others
are especially vocal about the costs of regulatory burden and
international competitiveness, and when supervisors cannot yet
cite recognized losses or writedowns, regulators must be firm
in insisting upon prudent risk management.
Once again, regulatory restructuring can he helpful, but
will not be a panacea. Financial regulators should speak with
one, strong voice in demanding that institutions maintain good
risk management practices and sound financial condition. We
must be particularly attentive to cases where different
agencies could be sending conflicting messages. Improvements to
the U.S. regulatory structure could provide added benefit by
ensuring that there are no regulatory gaps in the U.S.
financial system, and that entities cannot migrate to a
different regulator or, in some cases, beyond the boundary of
any regulation, so as to place additional pressure on those
supervisors who try to maintain firm safety and soundness
policies.
Q.3. As Mr. Tarullo and Mrs. Bair noted in their testimony,
some financial institution failures emanated from institutions
that were under federal regulation. While I agree that we need
additional oversight over and information on unregulated
financial institutions, I think we need to understand why so
many regulated firms failed.
Why is it the case that so many regulated entities failed,
and many still remain struggling, if our regulators in fact
stand as a safety net to rein in dangerous amounts of risk-
taking?
While we know that certain hedge funds, for example, have
failed, have any of them contributed to systemic risk?
Given that some of the federal banking regulators have
examiners on-site at banks, how did they not identify some of
these problems we are facing today?
A.3. My expectation is that, when the history of this financial
crisis and its origins is ultimately written, culpability will
be shared by essentially every part of the government
responsible for constructing and implementing financial
regulation, as well as many financial institutions themselves.
Since just about all financial institutions have been adversely
affected by the financial crisis, all supervisors have lessons
to learn from this crisis. The Federal Reserve is already
implementing a number of changes, such as enhancing risk
identification processes to more quickly detect emerging risks,
not just at individual institutions but across the banking
system. This latter point is particularly important, related as
it is to the emerging consensus that more attention must be
paid to risks created across institutions. The Board is also
improving the processes to issue supervisory guidance and
policies to make them more timely and effective. In 2008 the
Board issued supervisory guidance on consolidated supervision
to clarify the Federal Reserve's role as consolidated
supervisor and to assist examination staff as they carry out
supervision of banking institutions, particularly large,
complex firms with multiple legal entities.
With respect to hedge funds, although their performance was
particularly poor in 2008, and several large hedge funds have
failed over the past 2 years, to date none has been a
meaningful source of systemic risk or resulted in significant
losses to their dealer bank counterparties. Indirectly, the
failure of two hedge funds in 2007 operated by Bear Stearns
might be viewed as contributing to the ultimate demise of that
investment bank 9 months later, given the poor quality of
assets the firm had to absorb when it decided to support the
funds. However, these failures in and of themselves were not
the sole cause of Bear Stearns' problems. Of course, the
experience with Long Term Capital Management in 1998 stands as
a reminder that systemic risk can be associated with the
activities of large, highly leveraged hedge funds.
On-site examiners of the federal banking regulators did
identify a number of issues prior to the current crisis, and in
some cases developed policies and guidance for emerging risks
and issues that warranted the industry's attention--such as in
the areas of nontraditional mortgages, home equity lending, and
complex structured financial transactions. But it is clear that
examiners should have been more forceful in demanding that
bankers adhere to policies and guidance, especially to improve
their own risk management capacities. Going forward, changes
have been made in internal procedures to ensure appropriate
supervisory follow-through on issues that examiners do
identify, particularly during good times when responsiveness to
supervisory policies and guidance may be lower.
Q.4. While I think having a systemic risk regulator is
important, I have concerns with handing additional authorities
to the Federal Reserve after hearing GAO's testimony yesterday
at my subcommittee hearing.
Some of the Fed's supervision authority currently looks a
lot like what it might conduct as a systemic risk regulator,
and the record there is not strong from what I have seen.
If the Federal Reserve were to be the new systemic risk
regulator, has there been any discussion of forming a board,
similar to the Federal Open Market Committee, that might
include other regulators and meet quarterly to discuss and
publicly report on systemic risks?
If the Federal Reserve were the systemic risk regulator,
would it conduct horizontal reviews that it conducts as the
supervisor for bank holding companies, in which it looks at
specific risks across a number of institutions?
If so, and given what we heard March 18, 2009, at my
subcommittee hearing from GAO about the weaknesses with some of
the Fed's follow-up on reviews, what confidence can we have
that the Federal Reserve would do a better job than it has so
far?
A.4. In thinking about reforming financial regulation, it may
be useful to begin by identifying the desirable components of
an agenda to contain systemic risk, rather than with the
concept of a specific systemic risk regulator. In my testimony
I suggested several such components--consolidated supervision
of all systemically important financial institutions, analysis
and monitoring of potential sources of systemic risk, special
capital and other rules directed at systemic risk, and
authority to resolve nonbank, systemically important financial
institutions in an orderly fashion. As a matter of sound
administrative structure and practice, there is no reason why
all four of these tasks need be assigned to the same agency.
Indeed, there may be good reasons to separate some of these
functions--for example, conflicts may arise if the same agency
were to be both a supervisor of an institution and the
resolution authority for that institution if it should fail.
Similarly, there is no inherent reason why an agency
charged with enacting and enforcing special rules addressed to
systemic risk would have to be the consolidated supervisor of
all systemically important institutions. If another agency had
requisite expertise and experience to conduct prudential
supervision of such institutions, and so long as the systemic
risk regulator would have necessary access to information
through examination and other processes and appropriate
authority to address potential systemic risks, the roles could
be separated. For example, were Congress to create a federal
insurance regulator with a safety and soundness mission, that
regulator might be the most appropriate consolidated supervisor
for nonbank holding company firms whose major activities are in
the insurance area.
With respect to analysis and monitoring, it would seem
useful to incorporate an interagency process into the framework
for systemic risk regulation. Identification of inchoate or
incipient systemic risks will in some respects be a difficult
exercise, with a premium on identifying risk correlations among
firms and markets. Accordingly, the best way to incorporate
more expertise and perspectives into the process is through a
collective process, perhaps a designated sub-group of the
President's Working Group on Financial Markets. Because the
aim, of this exercise would be analytic, rather than
regulatory, there would be no problem in having both executive
departments and independent agencies cooperating. Moreover, as
suggested in your question, it may be useful to formalize this
process by having it produce periodic public reports. An
additional benefit of such a process would be that to allow
nongovernmental analysts to assess and, where appropriate,
critique these reports. As to potential rule-making, on the
other hand, experience suggests that a single agency should
have both authority and responsibility. While it may be helpful
for a rule-maker to consult with other agencies, having a
collective process would seem a prescription for delay and for
obscuring accountability.
Regardless of whether the Federal Reserve is given
additional responsibilities, we will continue to conduct
horizontal reviews. Horizontal reviews of risks, risk
management practices and other issues across multiple financial
firms are very effective vehicles for identifying both common
trends and institution-specific weaknesses. The recently
completed Supervisory Capital Assessment Program (SCAP)
demonstrates the effectiveness of such reviews and marked an
important evolutionary step in the ability of such reviews to
enhance consolidated supervision. This exercise was
significantly more comprehensive and complex than horizontal
supervisory reviews conducted in the past. Through these
reviews, the Federal Reserve obtained critical perspective on
the capital adequacy and risk management capabilities of the 19
largest U.S. bank holding companies in light of the financial
turmoil of the last year.
While the SCAP process was an unprecedented supervisory
exercise in an unprecedented situation, it does hold important
lessons for more routine supervisory practice. The review
covered a wide range of potential risk exposures and available
firm resources. Prior supervisory reviews have tended to focus
on fewer firms, specific risks and/or individual business
lines, which likely resulted in more, ``siloed'' supervisory
views. A particularly innovative and effective element of the
SCAP review was the assessment of individual institutions using
a uniform set of supervisory devised stress parameters,
enabling better supervisory targeting of institution-specific
strengths and weaknesses. Follow-up from these assessments was
rapid, and detailed capital plans for the institutions will
follow shortly.
As already noted, we expect to incorporate lessons from
this exercise into our consolidated supervision of bank holding
companies. In addition, though, the SCAP process suggests some
starting points for using horizontal reviews in systemic risk
assessment.
Regarding your concerns about the Federal Reserve's
performance in the run-up to the financial crisis, we are in
the midst of a comprehensive review of all aspects of our
supervisory practices. Since last year, Vice Chairman Kohn has
led an effort to develop recommendations for improvements in
our conduct of both prudential supervision and consumer
protection. We are including advice from the Government
Accountability Office, the Congress, the Treasury, and others
as we look to improve our own supervisory practices. Among
other things, our analysis reaffirms that capital adequacy,
effective liquidity planning, and strong risk management are
essential for safe and sound banking; the crisis revealed
serious deficiencies on the part of some financial institutions
in one or more of the areas. The crisis has likewise
underscored the need for more coordinated, simultaneous
evaluations of the exposures and practices of financial
institutions, particularly large, complex firms.
Q.5. Mr. Tarullo, the Federal Reserve has been at the forefront
of encouraging countries to adopt Basel II risk-based capital
requirements. This model requires, under Pillar I of Basel II,
that risk-based models calculate required minimum capital.
It appears that there were major problems with these risk
management systems, as I heard in GAO testimony at my
subcommittee hearing on March l8th, 2009, so what gave the Fed
the impression that the models were ready enough to be the
primary measure for bank capital?
Moreover, how can the regulators know what ``adequately
capitalized'' means if regulators rely on models that we now
know had material problems?
A.5. The current status of Basel II implementation is defined
by the November 2007 rule that was jointly issued by the Office
of the Comptroller of the Currency, Federal Deposit Insurance
Corporation, Office of Thrift Supervision, and Federal Reserve
Board. Banks will not be permitted to operate under the
advanced approaches until supervisors are confident the
underlying models are functioning in a manner that supports
using them as basis for determining inputs to the risk-based
capital calculation. The rule imposes specific model
validation, stress testing, and internal control requirements
that a bank must meet in order to use the Basel II advanced
approaches. In addition, a bank must demonstrate that its
internal processes meet all of the relevant qualification
requirements for a period of at least 1 year (the parallel run)
before it may be permitted by its supervisor to begin using
those processes to provide inputs for its risk-based capital
requirements. During the first 3 years of applying Basel II, a
bank's regulatory capital requirement would not be permitted to
fall below floors established by reference to current capital
rules. Moreover, banks will not be allowed to exit this
transitional period if supervisors conclude that there are
material deficiencies in the operation of the Basel II approach
during these transitional years. Finally, supervisors have the
continued authority to require capital beyond the minimum
requirements, commensurate with a bank's credit, market,
operational, or other risks.
Quite apart from these safeguards that U.S. regulators will
apply to our financial institutions, the Basel Committee has
undertaken initiatives to strengthen capital requirements--both
those directly related to Basel II and other areas such as the
quality of capital and the treatment of market risk. Staff of
the Federal Reserve and other U.S. regulatory agencies are
participating fully in these reviews. Furthermore, we have
initiated an internal review on the pace and nature of Basel II
implementation, with particular attention to how the long-
standing debate over the merits and limitations of Basel II has
been reshaped by experience in the current financial crisis.
While Basel II was not the operative capital requirement for
U.S. banks in the prelude to the crisis, or during the crisis
itself, regulators must understand how it would have made
things better or worse before permitting firms to use it as the
basis for regulatory capital requirements.
------
RESPONSE TO WRITTEN QUESTIONS OF SENATOR CRAPO
FROM DANIEL K. TARULLO
Q.1. The convergence of financial services providers and
financial products has increased over the past decade.
Financial products and companies may have insurance, banking,
securities, and futures components. One example of this
convergence is AIG. Is the creation of a systemic risk
regulator the best method to fill in the gaps and weaknesses
that AIG has exposed, or does Congress need to reevaluate the
weaknesses of federal and state functional regulation for
large, interconnected, and large firms like AIG?
A.1. The approaches of establishing systemic risk regulation
and reassessing current statutory patterns of functional
regulation need not be mutually exclusive, and Congress may
want to consider both. Empowering a governmental authority to
monitor, assess and, if necessary, curtail systemic risks
across the entire U.S. financial system is one way to help
protect the financial system from risks that may arise within
or across financial industries or markets that may be
supervised or regulated by different financial supervisors or
that may be outside the jurisdiction of any financial
supervisor. AIG is certainly an example of a firm whose
connections with other financial entities constituted a
distinct source of systemic risk.
At the same time, strong and effective consolidated
supervision provides the institution-specific focus necessary
to help ensure that large, diversified organizations operate in
a safe and sound manner, regardless of where in the
organization its various activities are conducted. Indeed as I
indicated in my testimony, systemic risk regulatory authority
should complement, not displace, consolidated supervision.
While all holding companies that own a bank are subject to
group-wide consolidated supervision under the Bank Holding
Company Act (12 U.S.C. 184141 et seq.) other systemically
significant companies may currently escape such supervision. In
addition, as suggested by your question, Congress may wish to
consider whether a broader and more robust application of the
principle of consolidated supervision would help reduce the
potential for the build up of risk-taking in different parts of
a financial organization or the financial sector more broadly.
This could entail, among other things, revising the provisions
of Gramm-Leach-Bliley Act that currently limit the ability of
consolidated supervisors to monitor and address risks at
functionally regulated subsidiaries within a financial
organization and specifying that consolidated supervisors of
financial firms have clear authority to monitor and address
safety and soundness concerns in all parts of an organization.
Q.2. Recently there have been several proposals to consider for
financial services conglomerates. One approach would be to move
away from functional regulation to some type of single
consolidated regulator like the Financial Services Authority
model. Another approach is to follow the Group of 30 Report
which attempts to modernize functional regulation and limit
activities to address gaps and weaknesses. An in-between
approach would be to move to an objectives-based regulation
system suggested in the Treasury Blueprint. What are some of
the pluses and minuses of these three approaches?
A.2. There are two separate, but related, questions to answer
in thinking about regulation of large, complex financial
institutions. The first pertains to the substantive regulatory
approaches to be adopted, the second to how those regulatory
tasks will be allocated to specific regulatory agencies. As to
the former question, in considering possible changes to current
arrangements, Congress should be guided by a few basic
principles that should help shape a legislative program.
First, recent experience has shown that it is critical that
all systemically important firms be subject to effective
consolidated supervision. The lack of consolidated supervision
can leave gaps in coverage that allow large financial firms to
take actions that put themselves, other firms, and the entire
financial sector at risk. To be fully effective, consolidated
supervisors must have clear authority to monitor and address
safety and soundness concerns in all parts of an organization.
Accordingly, specific consideration should be given to
modifying the limits currently placed on the ability of
consolidated supervisors to monitor and address risks at an
organization's functionally regulated subsidiaries.
Second, it is important to have a resolution regime that
facilitates managing the failure of a systemically important
financial firm in an orderly manner, including a mechanism to
cover the costs of the resolution. In most cases, federal
bankruptcy laws provide an appropriate framework for the
resolution of nonbank financial institutions. However, this
framework does not sufficiently protect the public's interest
in ensuring the orderly resolution of nonbank financial
institutions when a failure would pose substantial systemic
risks.
With respect to the allocation of regulatory missions among
agencies, one can imagine a range of institutional arrangements
that could provide for the effective supervision of financial
services firms. While models adopted in other countries can be
useful in suggesting options, the breadth and complexity of the
financial services industry in the United States suggests that
the most workable arrangements will take account of the
specific characteristics of our industry. As previously
indicated, we suggest that Congress consider charging an agency
with an explicit financial stability mission, including such
tasks as assessing and, if necessary, curtailing systemic risks
across the U.S. financial system. While establishment of such
an authority would not be a panacea, this mission could
usefully complement the focus of safety and soundness
supervisors of individual firms.
Q.3. If there are institutions that are too big to fail, how do
we identify that? How do we define the circumstance where a
single company is so systemically significant to the rest of
our financial circumstances and our economy that we must not
allow it to fail?
A.3. Identifying whether a given institution's failure is
likely to impose systemic risks on the U.S. financial system
and our overall economy depends on specific economic and market
conditions, and requires substantial judgment by policymakers.
That said, several key principles should guide policymaking in
this area.
No firm should be considered too big to fail in the sense
that existing stockholders cannot lose their entire investment,
existing senior management and boards of directors cannot be
replaced, and over time the organization cannot be wound down
or sold in whole or in part. In addition, from the point of
view of maintaining financial stability, it is critical that
such a wind down occur in an orderly manner, the reason for our
recommendation for improved resolution procedures for
systemically financial firms. Still, even without improved
procedures, it is important to try to resolve the firm in an
orderly manner without guaranteeing the longer-term existence
of any individual firm.
The core concern of policymakers should be whether the
failure of the firm would likely have contagion, or knock-on,
effects on other key financial institutions and markets, and
ultimately on the real economy. Such interdependencies can be
direct, such as through deposit and loan relationships, or
indirect, such as through concentrations in similar types of
assets. Interdependencies can extend to broader financial
markets and can also be transmitted through payment and
settlement systems. The failure of the firm and other
interconnected firms might affect the real economy through a
sharp reduction in the supply of credit, or rapid declines in
the prices of key financial and nonfinancial assets. Of course,
contagion effects are typically more likely in the case of a
very large institution than with a smaller institution.
However, size is not the only criterion for determining whether
a firm is potentially systemic. A firm may have systemic
importance if it is critical to the functioning of key markets
or critical payment and settlement systems.
Q.4. We need to have a better idea of what this notion of too
big to fail is--what it means in different aspects of our
industry and what our proper response to it should be. How
should the federal government approach large, multinational,
and systemically significant companies?
A.4. As we have seen in the current financial crisis, large,
complex, interconnected financial firms pose significant
challenges to supervisors. Policymakers have strong incentives
to prevent the failure of such firms, particularly in a crisis,
because of the risks that a failure would pose to the financial
system and the broader economy. However, the belief of market
participants that a particular firm will receive special
government assistance if it becomes troubled has many
undesirable effects. It reduces market discipline and
encourages excessive risk-taking by the firm. It also provides
an incentive for firms to grow in size and complexity, in order
to be perceived as too big to fail. And it creates an unlevel
playing field with smaller firms, which may not be regarded as
having implicit government support. Moreover, government
rescues of such firms can involve the commitment of substantial
public resources, as we have seen recently, with the potential
for taxpayer losses.
In the midst of this crisis, given the highly fragile state
of financial markets and the global economy, government
assistance to avoid the failures of major financial
institutions was deemed necessary to avoid a further serious
destabilization of the financial system, with adverse
consequences for the broader economy. Looking to the future,
however, it is imperative that policymakers address this issue
by better supervising systemically critical firms to prevent
excessive risk-taking and by strengthening the resilience of
the financial system to minimize the consequences when a large
firm must be unwound.
Achieving more effective supervision of large and complex
financial firms will require, at a minimum, the following
actions. First, supervisors need to move vigorously to address
the capital, liquidity, and risk management weaknesses at major
financial institutions that have been revealed by the crisis.
Second, the government must ensure a robust framework--both in
law and practice--for consolidated supervision of all
systemically important financial firms. Third, the Congress
should put in place improved tools to allow the authorities to
resolve systemically important nonbank financial firms in an
orderly manner, including a mechanism to cover the costs of the
resolution. Improved resolution procedures for these firms
would help reduce the too-big-to-fail problem by narrowing the
range of circumstances that might be expected to prompt
government intervention to keep a firm operating.
Q.5. What does ``fail'' mean? In the context of AIG, we are
talking about whether we should have allowed an orderly Chapter
11 bankruptcy proceeding to proceed. Is that failure?
A.5. As a general matter, a company is considered to have
``failed'' if it no longer has the capacity to fund itself and
meet its obligations, is insolvent (that is its obligations to
others exceed its assets), or other conditions exist that
permit a governmental authority, a court or stakeholders of the
company to put the firm into liquidation or place the company
into a conservatorship, receivership, or similar custodial
arrangement. Under the Federal Deposit Insurance Act (FDIA),
for example, a conservator or receiver may be appointed for an
insured depository institution if any of a number of grounds
exist. See 12 U.S.C. 1821(c)(5). Such grounds include that the
institution is in an unsafe or unsound condition to transact
business, or the institution has incurred or is likely to incur
losses that deplete all or substantially all of its capital and
there is no reasonable prospect for the institution to become
adequately capitalized without federal assistance.
In the fall of 2008, American International Group, Inc.
(AIG) faced severe liquidity pressures that threatened to force
it imminently into bankruptcy. As Chairman Bernanke has
testified, the Federal Reserve and the Treasury determined that
AIG's bankruptcy under the conditions then prevailing would
have posed unacceptable risks to the global financial system
and to the economy. Such an event could have resulted in the
seizure of its insurance subsidiaries by their regulators--
leaving policyholders facing considerable uncertainty about the
status of their claims--and resulted in substantial losses by
the many banks, investment banks, state and local government
entities, and workers that had exposures to AIG. The Federal
Reserve and Treasury also believed that the risks posed to the
financial system as a whole far outstripped the direct effects
of a default by AIG on its obligations. For example, the
resulting losses on AIG commercial paper would have exacerbated
the problems then facing money market mutual funds. The failure
of the firm in the middle of a financial crisis also likely
would have substantially increased the pressures on large
commercial and investment banks and could have caused
policyholders and creditors to pull back from the insurance
industry more broadly.
The AIG case provides strong support for a broad policy
agenda that would address both systemic risk and the problems
caused by firms that may be viewed as being too big, or too
interconnected, to fail, particularly in times of more
generalized financial stress. A key aspect of such an agenda
includes development of appropriate resolution procedures for
potentially systemic financial firms that would allow the
government to resolve such a firm in an orderly manner and in a
way that mitigates the potential for systemic shocks. As
discussed in my testimony, other important measures that would
help address the current too-big-to-fail problem include
ensuring that all systemically important financial firms are
subject to an effective regime for consolidated prudential
supervision and vesting a government authority with more direct
responsibility for monitoring and regulation of potential
systemic risks in the financial system.
------
RESPONSE TO WRITTEN QUESTIONS OF SENATOR KOHL
FROM DANIEL K. TARULLO
Q.1. Two approaches to systemic risk seem to be identified: (1)
monitoring institutions and taking steps to reduce the size/
activities of institutions that approach a ``too large to
fail'' or ``too systemically important to fail'' or (2) impose
an additional regulator and additional rules and market
discipline on institutions that are considered systemically
important.
Which approach do you endorse? If you support approach one
how you would limit institution size and how would you identify
new areas creating systemic importance?
If you support approach two how would you identify
systemically important institutions and what new regulations
and market discipline would you recommend?
A.1. As we have seen in the current financial crisis, large,
complex, interconnected financial firms pose significant
challenges to supervisors. In the current environment, market
participants recognize that policymakers have strong incentives
to prevent the failure of such firms because of the risks such
a failure would pose to the financial system and the broader
economy. A number of undesirable consequences can ensue: a
reduction in market discipline, the encouragement of excessive
risk-taking by the firm, an artificial incentive for firms to
grow in size and complexity in order to be perceived as too big
to fail, and an unlevel playing field with smaller firms that
are not regarded as having implicit government support.
Moreover, of course, government rescues of such firms can be
very costly to taxpayers.
The nature and scope of this problem suggests that multiple
policy instruments may be necessary to contain it. Firms whose
failure would pose a systemic risk should be subject to
especially close supervisory oversight of their risk-taking,
risk management, and financial condition, and should be held to
high capital and liquidity standards. As I emphasized in my
testimony, the government must ensure a robust framework--both
in law and practice--for consolidated supervision of all
systemically important financial firms. In addition, it is
important to provide a mechanism for resolving systemically
important nonbank financial firm in an orderly manner.
A systemic risk authority that would be charged with
assessing and, if necessary, curtailing systemic risks across
the entire U.S. financial system could complement firm-specific
consolidated supervision. Such an authority would focus
particularly on the systemic connections and potential risks of
systemically important financial institutions.
Whatever the nature of reforms that are eventually adopted,
it may well be necessary at some point to identify those firms
and other market participants whose failure would be likely to
impose systemic effects. Identifying such firms is a very
complex task that would inevitably depend on the specific
circumstances of a given situation and requires substantial
judgment by policymakers. That being said, several key
principles should guide policymaking in this area.
No firm should be considered too big to fail in the sense
that existing stockholders cannot lose their entire investment,
existing senior management and boards of directors cannot be
replaced, and over time the organization cannot be wound down
or sold in an orderly way either in whole or in part, which is
why we have recommended that Congress create an orderly
resolution procedure for systemically important financial
firms. The core concern of policymakers should be whether the
failure of the firm would be likely to have contagion, or
knock-on, effects on other key financial institutions and
markets and ultimately on the real economy. Of course,
contagion effects are typically more likely in the case of a
very large institution than with a smaller institution.
However, size is not the only criterion for determining whether
a firm is potentially systemic. A firm may have systemic
importance if it is critical to the functioning of key markets
or critical payment and settlement systems.
Q.2. Please identify all regulatory or legal barriers to the
comprehensive sharing of information among regulators including
insurance regulators, banking regulators, and investment
banking regulators. Please share the steps that you are taking
to improve the flow of communication among regulators within
the current legislative environment.
A.2. In general, there are few formal regulatory or legal
barriers to sharing bank supervisory information among
regulators, and such sharing is done routinely. Like other
federal banking regulators, the Board's regulations generally
prohibit the disclosure of confidential supervisory information
(such as examination reports and ratings, and other supervisory
correspondence) and other confidential information relating to
supervised financial institutions without the Board's consent.
See 12 C.F.R. 261, Subpart C. These regulations, however,
expressly permit designated Board and Reserve Bank staff to
make this information available to other Federal banking
supervisors on request. 12 C.F.R. 261.20(c).. As a practical
matter, federal banking regulators have access to a database
that contains examination reports for regulated institutions,
including commercial banks, bank holding companies, branches of
foreign banks, and other entities, and can view examination
material relevant to their supervisory responsibility. State
banking supervisors also have access to this database for
entities they regulate. State banking supervisors may also
obtain other information on request if they have direct
supervisory authority over the institution or if they have
entered into an information sharing agreement with their
regional Federal Reserve Bank and the information concerns an
institution that has acquired or applied to acquire a financial
institution subject to the state regulator's jurisdiction. Id.
at 261.20(d).
The Board has entered into specific sharing agreements with
a number of state and federal regulators, including most state
insurance regulators, the Securities and Exchange Commission,
the Commodity Futures Trading Commission, the Office of Foreign
Asset Control (OFAC), and the Financial Crimes Enforcement
Network (FinCEN), authorizing sharing of information of common
regulatory and supervisory interest. We frequently review these
agreements to see whether it would be appropriate to broaden
the scope of these agreements to permit the release of
additional information without compromising the examination
process.
Other supervisory or regulatory bodies may request access
to the Board's confidential information about a financial
institution by directing a request to the Board's general
counsel. Financial supervisors also may use this process to
request access to information that is not covered by one of the
regulatory provisions or agreements discussed above. Normally
such requests are granted subject to agreement on the part of
the regulatory body to maintain the confidentiality of the
information, so long as the requester bas identified a
legitimate basis for its interest in the information.
Because the Federal Reserve is responsible for the
supervision of all bank holding companies and financial holding
companies on a consolidated basis, it is critical that the
Federal Reserve also have timely access to the confidential
supervisory information of other bank supervisors or functional
regulators relating to the bank, securities, or insurance
subsidiaries of such holding companies. Indeed, the Gramm-
Leach-Bliley Act (GLBA) provides that the Federal Reserve must
rely to the fullest extent possible on the reports of
examinations prepared by the Office of the Comptroller of the
Currency, the Federal Deposit Insurance Corporation, the SEC,
and the state insurance authorities for the national bank,
state nonmember bank, broker-dealer, and insurance company
subsidiaries of a bank holding company. The GLBA also places
certain limits on the Federal Reserve's ability to examine or
obtain reports from functionally regulated subsidiaries of a
bank holding company.
Consistent with these provisions, the Federal Reserve has
worked with other regulators to ensure the proper flow of
information to the Federal Reserve through information sharing
arrangements and other mechanisms similar to those described
above. However, the restrictions in current law still can
present challenges to timely and effective consolidated
supervision in light of, among other things, differences in
supervisory models--for example, between those favored by bank
supervisors and those used by regulators of insurance and
securities subsidiaries--and differences in supervisory
timetables, resources, and priorities. In its review of the
U.S. financial architecture, we hope that the Congress will
consider revising the provisions of Gramm-Leach-Bliley Act to
help ensure that consolidated supervisors have the necessary
tools and authorities to monitor and address safety and
soundness concerns in all parts of an organization.
Q.3. What delayed the issuance of regulations under the Home
Ownership Equity Protection Act for more than 10 years? Was the
Federal Reserve receiving outside pressure not to write these
rules? Is it necessary for Congress to implement target
timelines for agencies to draft and implement rules and
regulations as they pertain to consumer protections?
A.3. In responding, I will briefly report the history of the
Federal Reserve's rulemakings under the Home Ownership and
Equity Protection Act (HOEPA). Although I did not join the
Board until January 2009, I support the action taken by
Chairman Bernanke and the Board in 2007 to propose stronger
HOEPA rules to address practices in the subprime mortgage
market. I should note, however, that in my private academic
capacity I believed that the Board should have acted well
before it did.
HOEPA, which defines a class of high-cost mortgage loans
that are subject to restrictions and special disclosures, was
enacted in 1994 as an amendment to the Truth in Lending Act. In
March 1995, the Federal Reserve published rules to implement
HOEPA, which are contained in the Board's Regulation Z. HOEPA
also gives the Board responsibility for prohibiting acts or
practices in connection with mortgage loans that the Board
finds to be unfair or deceptive. The statute further requires
the Board to conduct public hearings periodically, to examine
the home equity lending market and the adequacy of existing
laws and regulations in protecting consumers, and low-income
consumers in particular. Under this mandate, during the summer
of 1997 the Board held a series of public hearings. In
connection with the hearings, consumer representatives
testified about abusive lending practices, while others
testified that it was too soon after the statute's October 1995
implementation date to determine the effectiveness of the new
law. The Board made no changes to the HOEPA rules resulting
from the 1997 hearings.
Over the next several years, the volume of home-equity
lending increased significantly in the subprime mortgage
market. With the increase in the number of subprime loans,
there was increasing concern about a corresponding increase in
the number of predatory loans. In response, during the summer
of 2000 the Board held a series of public hearings focused on
abusive lending practices and the need for additional rules.
Those hearings were the basis for rulemaking under HOEPA that
the Board initiated in December 2000 to expand HOEPA's
protections.
The Board issued final revisions to the HOEPA rules in
December 2001. These amendments lowered HOEPA's rate trigger
for first-lien mortgage loans to extend HOEPA's protections to
a larger number of high-cost loans. The 2001 final rules also
strengthened HOEPA's prohibition on unaffordable lending by
requiring that creditors generally document and verify
consumers' ability to repay a high-cost HOEPA loan. In
addition, the amendments addressed concerns that high-cost
HOEPA loans were ``packed'' with credit life insurance or other
similar products that increased the loan's cost without
commensurate benefit to consumers. The Board also used the
rulemaking authority in HOEPA that authorizes the Board to
prohibit practices that are unfair, deceptive, or associated
with abusive lending. Specifically, to address concerns about
``loan flipping'' the Board prohibited a HOEPA lender from
refinancing one of its own loans with another HOEPA loan within
the first year unless the new loan is in the borrower's
interest. The December 2001 final rule addressed other issues
as well.
As the subprime market continued to grow, concerns about
``predatory lending'' grew. During the summer of 2006, the
Board conducted four public hearings throughout the country to
gather information about the effectiveness of its HOEPA rules
and the impact of the state predatory lending laws. By the end
of 2006, it was apparent that the nation was experiencing an
increase in delinquencies and defaults, particularly for
subprime mortgages, in part as a result of lenders' relaxed
underwriting practices, including qualifying borrowers based on
discounted initial rates and the expanded use of ``stated
income'' or ``no doc'' loans. In response, in March 2007, the
Board and other federal financial regulatory agencies published
proposed interagency guidance addressing certain risks and
emerging issues relating to subprime mortgage lending
practices, particularly adjustable-rate mortgages. The agencies
finalized this guidance in June 2007.
Also in June 2007, the Board held a fifth hearing to
consider ways in which the Board might use its HOEPA rulemaking
authority to further curb abuses in the home mortgage market,
including the subprime sector. This became the basis for the
new HOEPA rules that the Board proposed in December 2007 and
finalized in July 2008. Among other things, the Board's 2008
final rules adopt the same standard for subprime mortgage loans
that the statute previously required for high cost HOEPA
loans--a prohibition on making loans without regard to
borrowers' ability to repay the loan from income and assets
other than the home's value. The July 2008 final rule also
requires creditors to verify the income and assets they rely
upon to determine borrowers' repayment ability for subprime
loans. In addition, the final rules restrict creditors' use of
prepayment penalties and require creditors to establish escrow
accounts for property taxes and insurance. The rules also
address deceptive mortgage advertisements, and unfair practices
related to real estate appraisals and mortgage servicing.
We can certainly understand the desire of Congress to
provide timelines for regulation development and
implementation. This could be especially important to address a
crisis situation. However, in the case of statutory provisions
that require consumer disclosure for implementation, we hope
that any statutory timelines would account for robust consumer
testing in order to make the disclosures useful and effective.
Consumer testing is an iterative process, so it can take some
additional time, but we have found that it results in much
clearer disclosures. Additionally, interagency rulemakings are
also more time consuming. While they have the potential benefit
of bringing different perspectives to bear on an issue,
arriving at consensus is always more time consuming than when
regulations are assigned to a single rule writer. Moreover,
assigning rulewriting responsibility, to multiple agencies can
result in diffused accountability, with no one agency clearly
responsible for outcomes.
------
RESPONSE TO WRITTEN QUESTIONS OF SENATOR HUTCHISON
FROM DANIEL K. TARULLO
Q.1. Will each of you commit to do everything within your power
to prevent performing loans from being called by lenders?
Please outline the actions you plan to take.
A.1. The Federal Reserve's survey of senior loan officers at
banks has indicated that banks have been tightening standards
for both new commercial and industrial loans and new consumer
loans since the beginning of 2008, although the net percentage
of banks that have tightened standards in both categories has
diminished a bit in recent months. We also are aware of reports
that some banking organizations have declined to renew or
extend new credit to borrowers that had performed on previously
provided credit, or have exercised their rights to lower the
amount of credit available to performing customers under
existing lines of credit, such as home equity lines of credit.
There is a variety of factors that potentially could influence
a banking organization's decision to not renew or extend credit
to a currently performing borrower, or reduce the amount of
credit available to such a borrower. Many of these factors may
be unique to the individual transaction, customer or banking
organization involved. However, other more general factors also
may be involved.
For example, due to the ongoing turmoil in the financial
markets, many credit and securitization markets have
experienced substantial disruptions in the past year and a
half, which have limited the ability of banking organizations
to find outlets for their loans and obtain the financing to
support new lending activities. In addition, losses on
mortgage-related and other assets reduced the capital position
of many banking organizations, which also weakened their
ability to make or renew loans. The Federal Reserve, working in
conjunction with the Treasury Department, has taken a number of
important steps to help restore the flow of credit to
households and businesses. For example, the Term Asset-Backed
Securities Leading Facility (TALF), which began operations in
March 2009, is designed to restart the securitization markets
for several types of consumer and commercial credit. In
addition, the recently completed Supervisory Capital Assessment
Program was designed to ensure that the largest banking
organizations have the capital necessary to fulfill their
critical credit intermediation functions even in seriously
adverse economic conditions.
Besides these actions, we continue to actively work with
banking organizations to encourage them to continue lending
prudently to creditworthy borrowers and work constructively
with troubled customers in a manner consistent with safety and
soundness. I note that, in some instances, it may be
appropriate from a safety and soundness perspective for a
banking organization to review the creditworthiness of an
existing borrower, even if the borrower is current on an
existing loan from the institution. For example, the collateral
supporting repayment of the loan may have declined in value.
However, we are very cognizant of the need to ensure that
banking organizations do not make credit decisions that are not
supported by a fair and sound analysis of creditworthiness,
particularly in the current economic environment. Striking the
right balance between credit availability and safety and
soundness is difficult, but vitally important. The Federal
Reserve has long-standing policies and procedures in place to
promote sound risk identification and management practices at
regulated institutions that also support bank lending, the
credit intermediation process, and working with borrowers. For
example, guidance issued as long ago as 1991, during the
commercial real estate crisis that began in the late 1980s,
specifically instructs examiners to ensure that regulatory
policies and actions do not inadvertently curtail the
availability of credit to sound borrowers. \1\ The 1991
guidance also states that examiners are to ``ensure that
supervisory personnel are reviewing loans in a consistent,
prudent, and balanced fashion and to ensure that all interested
parties are aware of the guidance.''
---------------------------------------------------------------------------
\1\ ``Interagency Policy Statement on the Review and
Classification of Commercial Real Estate Loans,'' (November 1991).
---------------------------------------------------------------------------
This emphasis on achieving an appropriate balance between
credit availability and safety and soundness continues today.
To the extent that institutions have experienced losses, hold
less capital, and are operating in a more risk-sensitive
environment, supervisors expect banks to employ appropriate
risk-management practices to ensure their viability. At the
same time, it is important that supervisors remain balanced and
not place unreasonable or artificial constraints on lenders
that could hamper credit availability.
As part of our effort to help stimulate appropriate bank
lending, the Federal Reserve and the other federal banking
agencies issued a statement in November 2008 to encourage banks
to meet the needs of creditworthy borrowers. \2\ The statement
was issued to encourage bank lending in a manner consistent
with safety and soundness--specifically, by taking a balanced
approach in assessing borrowers' ability to repay and making
realistic assessments of collateral valuations. This guidance
has been reviewed and discussed with examination staff within
the Federal Reserve System.
---------------------------------------------------------------------------
\2\ ``Interagency Statement on Meeting the Needs of Credit Worthy
Borrowers,'' (November 2008).
---------------------------------------------------------------------------
Earlier, in April 2007, the federal financial institutions
regulatory agencies issued a statement encouraging financial
institutions to work constructively with residential borrowers
who are financially unable to make their contractual payment
obligations on their home loans. \3\ The statement noted that
``prudent workout arrangements that are consistent with safe
and sound lending practices are generally in the long-term
interest of both the financial institution and the borrower.''
The statement also noted that ``the agencies will not penalize
financial institutions that pursue reasonable workout
arrangements with borrowers who have encountered financial
problems.'' It further stated that, ``existing supervisory
guidance and applicable accounting standards do not require
institutions to immediately foreclose on the collateral
underlying a loan when the borrower exhibits repayment
difficulties.'' This guidance has also been reviewed by
examiners within the Federal Reserve System.
---------------------------------------------------------------------------
\3\ ``Federal Regulators Encourage Institutions To Work With
Mortgage Borrowers Who Are Unable To Make TheirPayments,'' (April
2007).
---------------------------------------------------------------------------
More generally, we have directed our examiners to be
mindful of the pro-cyclical effects of excessive credit
tightening and to encourage banks to make economically viable
loans, provided such lending is based on realistic asset
valuations and a balanced assessment of borrowers' repayment
capacities. Banks are also expected to work constructively with
troubled borrowers and not unnecessarily call loans or
foreclose on collateral. Across the Federal Reserve System, we
have implemented training and outreach to underscore these
objectives.
------
RESPONSE TO WRITTEN QUESTIONS OF SENATOR SHELBY
FROM SCOTT M. POLAKOFF
Q.1. Consumer Protection Regulation--Some have advocated that
consumer protection and prudential supervision should be
divorced, and that a separate consumer protection regulation
regime should be created. They state that one source of the
financial crisis emanated from the lack of consumer protection
in the underwriting of loans in the originate-to-distribute
space.
What are the merits of maintaining it in the same agency?
Alternatively, what is the best argument each of you can make
for a new consumer protection agency?
A.1. The key advantage of creating a separate agency for
consumer protection would be its single-focus on consumer
protection. One hundred percent of its resources would be
devoted to consumer protection, regulations and the balance and
tension between both aspects is extraordinarily beneficial,
policies, and enforcement. However, safety and soundness and
consumer protection concerns are interconnected. For example,
requiring that a lender responsibly consider a borrower's
repayment ability has implications for both areas.
Consequently, if consumer protection and prudential supervision
were separated, the new consumer protection agency would not be
in a position to take into account the safety and soundness
dimensions of consumer protection issues. Placing consumer
compliance examination activities in a separate organization
would reduce the effectiveness of both programs by removing the
ability for regulators to evaluate an institution across both
the safety and soundness and compliance functions. The same is
true for rulemaking functions.
With respect to consumer protection regulation, some may
argue that assigning one agency responsibility for writing all
consumer protection regulations would speed the process.
However, past experience indicates that providing one agency
such exclusive responsibility does not guarantee this result.
Moreover, such a strategy may weaken the outcome because it
deprives other agencies of the opportunity to make
contributions based on their considerable expertise.
Q.2. Regulatory Gaps or Omissions--During a recent hearing, the
Committee has heard about massive regulatory gaps in the
system. These gaps allowed unscrupulous actors like AIG to
exploit the lack of regulatory oversight. Some of the
counterparties that AIG did business with were institutions
under your supervision.
Why didn't your risk management oversight of the AIG
counterparties trigger further regulatory scrutiny? Was there a
flawed assumption that AIG was adequately regulated, and
therefore no further scrutiny was necessary?
A.2. OTS actions demonstrate that we had a progressive level of
supervisory criticism of AIG's corporate governance. OTS
criticisms addressed AIG's risk management, corporate
oversight, and financial reporting. There was not a flawed
assumption that AIG was adequately regulated. Instead, OTS did
not recognize in time the extent of the liquidity risk to AIG
of the ``super senior'' credit default swaps in AIG Financial
Products' (AIGFP) portfolio. In hindsight, we focused too
narrowly on the perceived creditworthiness of the underlying
securities and did not sufficiently assess the susceptibility
of highly illiquid, complex instruments to downgrades in the
ratings of the company or the underlying securities, and to
declines in the market value of the securities. No one
predicted the amount of funds that would be required to meet
collateral calls and cash demands on the credit default swap
transactions.
Q.3. Was there dialogue between the banking regulators and the
state insurance regulators? What about the SEC?
A.3. The OTS role in reaching out to insurance regulators (both
domestic and foreign) was to obtain information regarding
functionally regulated entities. This included information
regarding examination efforts and results, requests for
approval for transactions, market conduct activities and other
items of a regulatory nature. In the U.S., state insurance
departments conduct financial examinations of insurance
companies every 3-5 years, depending on state law. In addition,
regulatory approval is required for certain types of
transactions or activities. OTS contact with state insurance
regulators was done with the intent to identify issues with
regulated insurance companies and to determine if regulatory
actions were being taken. In addition, regulatory
communications were maintained in an informal way to ensure
that the lines of communication remained open.
Annually, OTS hosted a supervisory conference that provided
an opportunity for insurance (and banking) regulators to share
information regarding the company. At each of the three annual
conferences held, OTS provided general information regarding
our examination approach, plans for our supervisory efforts and
current concerns. Other regulators attending the sessions
provided the same type of information and the session provided
an opportunity to discuss these concerns.
Collateralized debt obligation (CDO) activities at AIG were
housed in AIGFP, an unregulated entity. AIGFP is not a
regulated insurance company or depository institution. State
insurance departments did not have the legal authority to
examine or regulate AIGFP activities. Therefore, OTS did not
engage in discussions with state insurance departments
regarding AIGFP. The types of activities engaged in, and the
products sold, are not the types of activities that insurance
structures typically engage in within regulated insurance
company subsidiaries. Also, since AIGFP was not a regulated
insurance company, OTS did not contact state regulators to
discuss AIGFP or its activities. Upon the announcement of
Federal Reserve intervention in the company, OTS engaged in
many calls with regulators in the U.S. and abroad.
AIG did have a network of registered investment advisers,
retail investment brokerage firms and mutual funds, all
supervised by the SEC. OTS stayed abreast of AIG's compliance
with SEC laws and regulations through a monthly regulatory
issues report. OTS also interacted with an individual placed at
AIG by the SEC and Department of Justice as an independent
monitor in connection with the 2005 settlement regarding
accounting irregularities. The independent monitor is still
working within AIG, and he interacts directly with the
Regulatory Group.
Q.4. If the credit default swap contracts at the heart of this
problem had been traded on an exchange or cleared through a
clearinghouse, with requirement for collateral and margin
payments, what additional information would have been
available? How would you have used it?
A.4. There is no centralized exchange or clearing house for
credit default swap (CDS) transactions. Currently, CDS trade as
a bilateral contract between two counterparties that are done
on the over-the-counter (OTC) market. They are not traded on an
exchange and there are no specific record-keeping requirements
of who traded, how much, and when. As a result, the market is
opaque, lacking the transparency that would be expected for a
market of its size, complexity, and importance. The lack of
transparency creates significant opportunity for manipulation
and insider trading in the CDS market as well as in the
regulated markets for securities. Also, the lack of
transparency allows the CDS market to be largely immune to
market discipline.
The creation of a central counterparty (CCP) would be an
important first step in maintaining a fair, orderly, and
efficient CDS market and thereby helping to mitigate systemic
risk. It would help to reduce the counterparty risks inherent
in CDS market. A central clearing house could further reduce
systemic risk by novating trades to the CCP, which means that
two dealers would no longer be exposed to each others' credit
risk. Other benefits would include reducing the risk of
collateral flows by netting positions in similar instruments,
and by netting all gains and losses across different
instruments; helping to ensure that eligible trades are cleared
and settled in a timely manner, thereby reducing the
operational risks associated with significant volumes of
unconfirmed and failed trades; helping to reduce the negative
effects of misinformation and rumors; and serving as a source
of records for CDS transactions. Furthermore, this would likely
allow for much greater market discipline, increased
transparency, enhanced liquidity, and improved price discovery.
The presence of an exchange with margin and daily position
marking would have given regulators greater visibility into the
dangerous concentration of posted collateral. Regulators could
have had more time and flexibility to react through the firm's
risk management and corporate governance units if a CDS
exchange existed. Also, if a counterparty had failed to post
required margin/collateral, its positions may have been
liquidated sooner in the process.
We have learned there is a need for consistency and
transparency in over-the-counter (OTC) CDS contracts. The
complexity of CDS contracts masked risks and weaknesses. The
OTS believes standardization and simplification of these
products would provide more transparency to market participants
and regulators. We believe many of these OTC contracts should
be subject to exchange-traded oversight, with daily margining
required. This kind of standardization and exchange-traded
oversight can be accomplished when a single regulator is
evaluating these products. Congress should consider legislation
to bring such OTC derivative products under appropriate
regulation.
Q.5. Liquidity Management--A problem confronting many financial
institutions currently experiencing distress is the need to
roll-over short-term sources of funding. Essentially these
banks are facing a shortage of liquidity. I believe this
difficulty is inherent in any system that funds long-term
assets, such as mortgages, with short-term funds. Basically the
harm from a decline in liquidity is amplified by a bank's level
of ``maturity-mismatch.''
I would like to ask each of the witnesses, should
regulators try to minimize the level of a bank's maturity-
mismatch? And if so, what tools would a bank regulator use to
do so?
A.5. Maturity mismatches are a significant supervisory concern
from both a liquidity risk and interest rate risk standpoint.
However, OTS does not believe that regulators should try to
simply minimize the mismatch without consideration of different
business models, portfolio structures, and mitigating factors.
Furthermore, maturity mismatches are heavily affected by
unknowns such as loan prepayments and deposit withdrawals which
can have serious implications on an institution's cash needs
and sources. The embedded optionality in some instruments can
lead to a rapid shortening of stated maturities and can
compromise the effectiveness of following a simple maturity gap
measure in the management of liquidity risk.
Given the thrift industry's heavy reliance on longer-term
mortgages and shorter-term funding, however, OTS has always
placed a heavy emphasis on maturity-mismatch risk management
and we are constantly exploring ways to improve our supervisory
process in light of the ongoing crisis.
On an international basis, OTS is a member of the Basel
Committee for Banking Supervision's Working Group on Liquidity
which is currently seeking to identify a range of measures and
metrics to better assess liquidity risk at regulated
institutions. Metrics specifically dealing with maturity-
mismatch are being considered as part of this work. On the
domestic front, OTS's supervisory process has long stressed the
need for OTS-regulated banks to identify and manage the
maturity mismatch inherent in their operations; and OTS
examiners routinely assess this aspect of a bank's operation
during their on-site safety and soundness examinations.
From an off-sight monitoring perspective, OTS utilizes
information from the Thrift Financial Report to identify
institutions with a heavy reliance on short-term or volatile
sources of funding. In addition, OTS is exploring ways to
better lever the information it collects from institutions for
interest rate risk purposes. Each quarter, OTS collects
detailed interest rate data, re-pricing characteristics, and
maturity information from most of its thrifts through a
specialized reporting schedule called Consolidated Maturity and
Rate (Schedule CMR). The CMR data is fed into a proprietary
interest rate risk model called the Net Portfolio Value (NPV)
Model. The NPV Model was created in 1991, in response to the
industry's significant interest rate risk problems which were a
major contributor to the savings and loan crisis. The NPV Model
provides a quarterly analysis of an institution's interest rate
risk profile and plays an integral role in the examination
process.
Interest rate risk and ``maturity-mismatch'' risk are
intimately related. Indeed, much of the same information that
is used for interest rate risk purposes can also be used to
provide a more structured view of liquidity risk and maturity
mismatch. As a first step, OTS is using the model to generate
individual Maturing Gap Reports for a large segment of the
industry. This report provides a snapshot of a bank's current
maturity-mismatch as well as how that mismatch changes under
different interest rate stress scenarios.
Q.6. Regulatory Conflict of Interest--Federal Reserve Banks
which conduct bank supervision are run by bank presidents that
are chosen in part by bankers that they regulate.
Mr. Polakoff, does the fact that your agencies' funding
stream is affected by how many institutions you are able to
keep under your charters affect your ability to conduct
supervision?
A.6. No it does not. The OTS conducts its supervisory function
in a professional, consistent, and fair manner. Ensuring the
safety and soundness of the institutions that we supervise is
always paramount. Moreover, the use of assessments on the
industry to fund the agency has many advantages. It permits the
agency to develop a budget that is based on the supervisory
needs of the industry. The agency does not rely on the
Congressional appropriations process and can assess the
industry based on a number of factors including the number,
size, and complexity of regulated institutions. Such a method
of funding also provides the agency the ability to determine
whether fees should be increased as a result of supervisory
concerns.
This funding mechanism permits the agency to sustain itself
financially. Funding an agency differently may lead to
conflicts of interest with congress or any other entity that
determines the budget necessary to run the agency. As a result,
political pressure or matters outside the control of the agency
may negatively affect the agency's ability to supervise its
regulated institutions. An agency that must supervise
institutions on a regular basis needs to have more control over
its funding and budget than is possible through an
appropriations process. Funding through assessments also
eliminates the concern that taxpayers are responsible for
paying for the running of the agency.
Q.7. Too-Big-To-Fail--Chairman Bair stated in her written
testimony that ``the most important challenge is to find ways
to impose greater market discipline on systemically important
institutions. The solution must involve, first and foremost, a
legal mechanism for the orderly resolution of those
institutions similar to that which exists for FDIC-insured
banks. In short we need to end too big to fail.'' I would agree
that we need to address the too-big-to-fail issue, both for
banks and other financial institutions.
Could each of you tell us whether putting a new resolution
regime in place would address this issue?
A.7. The events of the past year have put into stark focus the
need to address whether a resolution regime is necessary for
nonbank financial companies. Whatever resolution regime is
adopted would address too big to fail issue but it may not
bring it to a final conclusion. There currently exists a
resolution mechanism for federally insured depository
institutions and instances have arisen in which an insured
institution has been found to be too big to fail. As the
framers of the resolution develop the mechanism for nonbank
financial companies, it will be important to establish whether
there will be a circumstance in which such a company will not
be allowed to fail or the circumstances under which it will be
permitted. A resolution mechanism will make it less likely that
a company will be determined to be too big to fail.
Q.8. How would we be able to convince the market that these
systemically important institutions would not be protected by
taxpayer resources as they had been in the past?
A.8. There are two ways that the market can be convinced that
systemically important institutions will not be protected by
taxpayer resources. The first is if they are permitted to fail
and do not receive the benefit of taxpayer funds. The second is
through the establishment of a resolution mechanism that
provides for funding through assessments on the institutions
that may be resolved. Even the second alternative would not
preclude that the taxpayer might not ultimately pay for part of
the resolution.
In the creation of the resolution mechanism, the funding of
the entity and the process would need to be specifically
addressed and communicated to the market.
Q.9. Pro-Cyclicality--I have some concerns about the pro-
cyclical nature of our present system of accounting and bank
capital regulation. Some commentators have endorsed a concept
requiring banks to hold more capital when good conditions
prevail, and then allow banks to temporarily hold less capital
in order not to restrict access to credit during a downturn.
Advocates of this system believe that counter-cyclical policies
could reduce imbalances within financial markets and smooth the
credit cycle itself.
What do you see as the costs and benefits of adopting a
more counter-cyclical system of regulation?
A.9. Different proposals have been raised to achieve a more
counter-cyclical system of capital regulation. One of the most
promising ideas would mandate that banks build up an additional
capital buffer during good times that would be available to
draw upon in bad times, essentially a rainy day fund. In our
view, such a fund would be an amount of allocated retained
earnings that would be over and above the bank's minimum
capital requirement. Initially, it would appear that for an
individual bank, the cost of such a requirement would be a
decreased level of available retained earnings: fewer funds
would be available for dividends and share buybacks for
example. The benefit would be that the rainy day fund might
save the bank from failing (or threat of failure) when economic
conditions deteriorate and therefore help the bank remain in
sound condition so that it can continue lending. Systemically,
a restriction on banks' retained earnings would act as a
restraint on bank activity during high points in the economic
cycle and could diminish share prices when times are good. It
might also curtail some lending at high points in the economic
cycle. However, the availability of those funds when conditions
deteriorate ought to allow banks to continue lending at more
reasonable levels even when economic conditions deteriorate.
Q.10. Do you see any circumstances under which your agencies
would take a position on the merits of counter-cyclical
regulatory policy?
A.10. Yes, we support the concept of a counter-cyclical policy.
There are a variety of ideas as to how to achieve this
including the concept we have outlined above. Together with the
other Federal Banking Agencies we are participating in
international Basel Committee efforts to consider various
counter-cyclical proposals with the goal of having a uniform
method, not only within the United States, but internationally
as well--so as to create a more level competitive environment
for U.S. Banks and a sound counter-cyclical proposal.
Q.11. G20 Summit and International Coordination--Many foreign
officials and analysts have said that they believe the upcoming
G20 summit will endorse a set of principles agreed to by both
the Financial Stability Forum and the Basel Committee, in
addition to other government entities. There have also been
calls from some countries to heavily re-regulate the financial
sector, pool national sovereignty in key economic areas, and
create powerful supranational regulatory institutions.
(Examples are national bank resolution regimes, bank capital
levels, and deposit insurance.) Your agencies are active
participants in these international efforts.
What do you anticipate will be the result of the G20
summit?
A.11. At the conclusion of the G20 summit, several documents
were issued by G20 working groups and by the Financial
Stability Forum (now renamed the Financial Stability Board).
These laid out principles for international cooperation between
supervisors and stressed the importance of coordinated
supervisory action. With its largest firms, OTS has for some
years held annual college meetings to foster communication
between regulators, and understands the value of cross-border
cooperation. OTS believes that insofar as the agreements coming
out of the G20 summit encourage greater international
cooperation, supervision overall will be enhanced.
Q.12. Do you see any examples or areas where supranational
regulation of financial services would be effective?
A.12. As a member of the Basel Committee, OTS has been involved
in the past efforts of that body to set capital and other
regulatory standards. We believe there is value in coordinating
such standards at the international level, primarily for two
reasons. First, such coordination is a vehicle for enshrining
high quality standards. In a globally interconnected capital
market, it is important that all players be subject to basic
requirements. Second, common standards foster a level playing
field for U.S. institutions that must compete internationally.
Q.13. How far do you see your agencies pushing for or against
such supranational initiatives?
A.13. As indicated above, OTS supports active cooperation among
supervisors and the setting of international regulatory
standards, where appropriate. Ultimately, of course, authority
must be commensurate with responsibility, and OTS would not be
supportive of initiatives that would diminish its capacity to
carry out its responsibility to preserve the safety and
soundness of the institutions it regulates or the rights and
protections of the customers they serve.
Q.14. Effectiveness of Functional Regulation \1\--Mr. Polakoff,
in your testimony you point out that the OTS, as the holding
company supervisor of AIG, relies on the specific functional
regulators for information regarding regulated subsidiaries of
AIG's holding company.
---------------------------------------------------------------------------
\1\ Mr. Polakoff has been on leave from OTS since March 26, 2009,
and will retire from the agency effective July 3, 2009. The answers to
the Committee's supplemental questions were prepared by other OTS staff
members.
---------------------------------------------------------------------------
When did the OTS first learn of the problems related to
AIG's securities lending program? Did any state insurance
commissioner alert the OTS, as the holding company supervisor,
of these problems?
A.14. Annually, the OTS hosted a supervisory conference that
provided an opportunity for regulators (insurance and banking)
to share information regarding the AIG. At each of the three
annual conferences held, the OTS provided general information
regarding our examination approach, plans for our supervisory
efforts and current concerns. Other regulators attending the
sessions provided the same type of information and the session
provided an opportunity to discuss these concerns.
The OTS was first advised of potential financial problems
in the AIG Securities Lending Program (SLP) during the OTS
Annual AIG Supervisor's Conference on November 7, 2007, when
the representative from the Texas Department of Insurance's
(DOI) office raised the issue during the Supervisor's
roundtable session. This representative stated the Texas DOI
was looking into the exposure that the various Texas-based life
companies had to the SLP and was seeking assurance from AIG
that any market value losses would be covered by the corporate
parent.
Subsequently, on November 27, 2007, the OTS met with Price
Waterhouse Coopers (PwC) as part of its regular supervisory
process. During this meeting the SLP exposure topic was raised
and a discussion ensued. PwC advised that as of Q3 2007, the
exposure to market value decline in the portfolio was $1.3
billion and expected to worsen in Q4. PwC further advised that
AIG was planning to indemnify its subsidiary companies for
losses up to $5 billion. This was verified in the year end 2007
regulatory financial statement filings (required by state
insurance departments) by the AIG life insurance subsidiaries.
The disclosure went on to cite AIG's indemnification agreement
to reimburse losses of up to $5 billion for all (not each) of
AIG's impacted subsidiaries.
Q.15. Holding Company Regulation--Mr. Polakoff, AIG's Financial
Products subsidiary has been portrayed in the press as a
renegade subsidiary that evaded regulation by operating from
London. A closer examination reveals, however, that a majority
of its employees and many of its officers were located in the
United States.
Did the OTS have adequate authority to supervise AIG's
Financial Products subsidiary? If not why did the OTS fail to
inform Congress about this hole in its regulatory authority,
especially since your agency had identified serious
deficiencies in Financial Products' risk management processes
since 2005? How was the Financial Products subsidiary able to
amass such a large, unhedged position on credit default swaps
(CDS)?
A.15. AIG became a savings and loan holding company in 2000. At
that time. the OTS's supervision focused primarily on the
impact of the holding company enterprise on the subsidiary
savings association. With the passage of Gramm-Leach-Bliley,
and not long before AIG became a savings and loan holding
company, the OTS recognized that large corporate enterprises,
made up of a number of different companies or legal entities,
were changing the way they operated and needed to be
supervised. These companies, commonly called conglomerates,
began operating differently and in a more integrated fashion as
compared to traditional holding companies. These conglomerates
required a more enterprise-wide review of their operations.
Consistent with changing business practices and how
conglomerates were managed at that time, in late 2003 the OTS
embraced a more enterprise-wide approach to supervising
conglomerates. This approach aligned well with core supervisory
principles adopted by the Basel Committee and with requirements
implemented in 2005 by European Union (EU) regulators that
required supplemental regulatory supervision at the
conglomerate level. The OTS was recognized as an equivalent
regulator for the purpose of AIG consolidated supervision
within the EU, a process that was finalized with a
determination of equivalence by AIG's French regulator,
Commission Bancaire.
AIG Financial Products' (AIGFP) CDS portfolio was largely
originated in the 2003 to 2005 period and was facilitated by
AIG's full and unconditional guarantee (extended to all AIGFP
transactions since its creation), which enabled AIGFP to assume
the AAA rating for market transactions and counterparty
negotiations. AIGFP made the decision to stop origination of
these derivatives in December 2005 based on the general
observation that underwriting standards for mortgages backing
securities were declining. At the time the decision was made,
however, AIGFP already had $80 billion of CDS commitments. This
activity stopped before the OTS targeted examination which
commenced March 6, 2006.
The OTS actions demonstrate a progressive level of
supervisory criticism of AIG's corporate governance. The OTS
criticisms addressed AIG's risk management, corporate
oversight, and financial reporting. There was not a flawed
assumption that AIG was adequately regulated. Instead, the OTS
did not fully recognize the extent of the liquidity risk to AIG
of the ``super senior'' credit default swaps in AIGFP's
portfolio or the profound systemic impact of a nonregulated
financial product. There was a narrow focus on the perceived
creditworthiness of the underlying securities rather than an
assessment of the susceptibility of highly illiquid, complex
instruments to downgrades in the public ratings of the company
or the underlying securities, and to declines in the market
value of the securities. No one predicted the amount of funds
that would be required to meet collateral calls and cash
demands on the credit default swap transactions.
CDS are financial products that are not regulated by any
authority and impose serious challenges to the ability to
supervise this risk proactively without any prudential
derivatives regulator or standard market regulation. There is a
need to fill the regulatory gaps the CDS market has exposed.
There is a need for consistency and transparency in CDS
contracts. The complexity of CDS contracts masked risks and
weaknesses in the program that led to one type of CDS
performing extremely poorly. The current regulatory means of
measuring off-balance sheet risks do not fully capture the
inherent risks of CDS. The OTS believes standardization of CDS
contracts would provide more transparency to market
participants and regulators.
------
RESPONSE TO WRITTEN QUESTIONS OF SENATOR REED
FROM SCOTT M. POLAKOFF
Q.1. It is clear that our current regulatory structure is in
need of reform. At my subcommittee hearing on risk management,
March 18, 2009, GAO pointed out that regulators often did not
move swiftly enough to address problems they had identified in
the risk management systems of large, complex financial
institutions.
Chair Bair's written testimony for today's hearing put it
very well: `` . . . the success of any effort at reform will
ultimately rely on the willingness of regulators to use their
authorities more effectively and aggressively.''
My questions may be difficult, but please answer the
following:
If this lack of action is a persistent problem
among the regulators, to what extent will changing the
structure of our regulatory system really get at the
issue?
Along with changing the regulatory structure, how
can Congress best ensure that regulators have clear
responsibilities and authorities, and that they are
accountable for exercising them ``effectively and
aggressively''?
A.1. A change in the structure of the regulatory system alone
will not achieve success. While Congress should focus on
ensuring that all participants in the financial markets are
subject to the same set of regulations, the regulatory agencies
must adapt using the lessons learned from the financial crisis
to improve regulatory oversight. OTS conducts internal failed
bank reviews for thrifts that fail and has identified numerous
lessons learned from recent financial institution failures. The
agency has revised its policies and procedures to correct gaps
in regulatory oversight. OTS has also been proactive in
improving the timeliness of formal and informal enforcement
action.
Q.2. How do we overcome the problem that in the boom times no
one wants to be the one stepping in to tell firms they have to
limit their concentrations of risk or not trade certain risky
products? What thought has been put into overcoming this
problem for regulators overseeing the firms? Is this an issue
that can be addressed through regulatory restructure efforts?
A.2. OTS believes that the best way to improve the regulatory
oversight of financial activities is to ensure that all
entities that provide specific financial services are subject
to the same level of regulatory requirements and scrutiny. For
example, there is no justification for mortgage brokers not to
be bound by the same laws and rules as banks. A market where
unregulated or under-regulated entities can compete alongside
regulated entities offering complex loans or other financial
products to consumers provides a disincentive to protect the
consumer. Any regulatory restructure effort must ensure that
all entities engaging in financial services are subject to the
same laws and regulations.
In addition, the business models of community banks versus
that of commercial banks are fundamentally different.
Maintaining and strengthening a federal regulatory structure
that provides oversight of these two types of business models
is essential. Under this structure, the regulatory agencies
will need to continue to coordinate regulatory oversight to
ensure they apply consistent standards for common products and
services.
Q.3. As Mr. Tarullo and Mrs. Bair noted in their testimony,
some financial institution failures emanated from institutions
that were under federal regulation. While I agree that we need
additional oversight over and information on unregulated
financial institutions, I think we need to understand why so
many regulated firms failed.
Why is it the case that so many regulated entities failed,
and many still remain struggling, if our regulators in fact
stand as a safety net to rein in dangerous amounts of risk-
taking?
A.3. While undesirable, failures are inevitable in a dynamic
and competitive market. The housing downturn and resulting
economic strain highlights that even traditionally lower-risk
lending activities can become higher-risk when products evolve
and there is insufficient regulatory oversight covering the
entire market. There is no way to predict with absolute
certainty how economic factors will combine to cause stress.
For example, in late 2007, financial institutions faced severe
erosion of liquidity due to secondary markets not functioning.
This problem compounded for financial institutions engaged
in mortgage banking who found they could not sell loans from
their warehouse, nor could they rely on secondary sources of
liquidity to support the influx of loans on their balance
sheets. While the ideal goal of the regulatory structure is to
limit and prevent failures, it also serves as a safety net to
manage failures with no losses to insured depositors and
minimal cost to the deposit insurance fund.
Q.4. While we know that certain hedge funds, for example, have
failed, have any of them contributed to systemic risk?
A.4. Hedge funds are unregulated entities that are considered
impermissible investments for thrifts. As such, OTS has no
direct knowledge of hedge fund failures or how they have
specifically contributed to systemic risk. Anecdotally,
however, we understand that many of these entities were highly
exposed to sub-prime loans through their investment in private
label securities backed by subprime or Alt-A loan collateral,
and they were working with higher levels of leverage than were
commercial banks and savings institutions. As defaults on these
loans began to rise, the value of those securities fell, losses
mounted and capital levels declined. As this occurred, margin
calls increased and creditors began cutting these firms off or
stopped rolling over lines of credit. Faced with greater
collateral requirements, creditors demanding lower levels of
leverage, eroding capital, and dimming prospects on their
investments, these firms often perceived the sale of these
unwanted assets as the best option. The glut of these
securities coming to the market and the lack of private sector
buyers likely further depressed prices.
Q.5. Given that some of the federal banking regulators have
examiners on-site at banks, how did they not identify some of
these problems we are facing today?
A.5. The problem was not a lack of identifying risk areas, but
in understanding and predicting the severity of the economic
downturn and its resulting impact on entire asset classes,
regardless of risk. The magnitude and severity of the economic
downturn was unprecedented. The confluence of events leading to
the financial crisis extends beyond signals that bank examiners
alone could identify or correct. OTS believes it is important
for Congress to establish a systemic risk regulator that will
work with the federal bank regulatory agencies to identify
systemic risks and how they affect individual regulated
entities.
There is evidence in reports of examination and other
supervisory documents that examiners identified several of the
problems we are facing, particularly the concentrations of
assets. There was no way to predict how rapidly the market
would reverse and housing prices would decline. The agency has
taken steps to improve its regulatory oversight through the
lessons learned during this economic cycle. For its part, OTS
has strengthened its regulatory oversight, including the
timeliness of enforcement actions and monitoring practices to
ensure timely corrective action.
Q.6. There have been many thrifts that failed under the watch
of the OTS this year. While not all thrift or bank failures can
or should be stopped, the regulators need to be vigilant and
aware of the risks within these financial institutions. Given
the convergence within the financial services industries, and
that many financial institutions offer many similar products,
what is distinct about thrifts? Other than holding a certain
proportion of mortgages on their balance sheets, do they not
look a lot like other financial institutions?
A.6. In recent years, financial institutions of all types have
begun offering many of the same products and services to
consumers and other customers. It is hard for customers to
distinguish one type of financial institution from another.
This is especially true of insured depository institutions.
Despite the similarities, savings associations have statutory
limitations on the assets they may have or in the activities in
which they may engage. They still must have 65 percent of their
assets in housing related loans, as defined. As a result,
savings associations are not permitted to diversify to the same
extent as are national banks or state chartered banks. Within
the confines of the statute, savings associations have begun to
engage in more small business and commercial real estate
lending in order to diversify their activities, particularly in
times of stress in the mortgage market.
Savings associations are the insured depositories that
touch the consumer. They are local community banks providing
services that families and communities need and value. Many of
the institutions supervised by the OTS are in the mutual form
of ownership and are small. While many savings associations
offer a variety of lending and deposit products and they are
competitors in communities nationwide, they generally are
retail, customer driven community banks.
------
RESPONSE TO WRITTEN QUESTIONS OF SENATOR CRAPO
FROM SCOTT M. POLAKOFF
Q.1. The convergence of financial services providers and
financial products has increased over the past decade.
Financial products and companies may have insurance, banking,
securities, and futures components. One example of this
convergence is AIG. Is the creation of a systemic risk
regulator the best method to fill in the gaps and weaknesses
that AIG has exposed, or does Congress need to reevaluate the
weaknesses of federal and state functional regulation for
large, interconnected, and large firms like AIG?
A.1. There have been positive results of the convergence of
financial services providers. Consumers and customers seeking
financial products have benefited from products and services
that are more varied and specifically targeted to meet their
needs. At the same time, the regulatory oversight framework has
not kept pace with the developments in all areas of the
companies offering these products and services. If a systemic
risk regulator had existed, it may not have filled in all of
the gaps, but such a regulator would have looked at the entire
organization with a view to identifying concerns in all areas
of the company and would have identified how the operations of
one line of business or business unit would affect the company
as a whole. A systemic risk regulator with access to
information about all aspects of a company's operations would
be responsible for evaluating the overall condition and
performance of the entity and the impact a possible failure
would have on the rest of the market. Such a broad overview
would enable the systemic regulator to work with the functional
regulators to ensure that the risks of products and the
interrelationships of the businesses are understood and
monitored.
The establishment of a systemic risk regulator need not
eliminate functional regulators for the affiliated entities in
a structure. Functional regulators are necessary to supervise
the day to day activities of the entities and provide input on
the entities and activities to the systemic risk regulator.
Working together with the functional regulators and putting
data and developments into a broader context would provide the
ability to identify and close gaps in regulation and oversight.
In order to benefit from having a framework with a systemic
risk regulator and functional regulation of the actual
activities and products, information sharing arrangements among
the regulators must be established.
Further, the systemic risk regulator would need access to
information regarding nonsystemically important institutions in
order to monitor trends, but would not regulate or supervise
those entities.
Q.2. Recently there have been several proposals to consider for
financial services conglomerates. One approach would be to move
away from functional regulation to some type of single
consolidated regulator like the Financial Services Authority
model. Another approach is to follow the Group of 30 Report
which attempts to modernize functional regulation and limit
activities to address gaps and weaknesses. An in-between
approach would be to move to an objectives-based regulation
system suggested in the Treasury Blueprint. What are some of
the pluses and minuses of these three approaches?
A.2. A number of proposals to change the financial services
regulatory framework have been issued in the past year. Some of
these proposals would establish a new framework for financial
services regulation and others would make changes by merging
existing regulatory agencies. The proposals of recent months
all have identified the supervision of conglomerates as a key
element to be addressed in any restructuring. There are pros
and cons to each of the proposals for supervision of
conglomerates. Three recommendations represent different
perspectives on how to accomplish the goals.
The example of the single consolidated regulator similar to
the Financial Services Authority has been highlighted by its
proponents as a solution to the regulation of large
conglomerates that offer a variety of products and services
through a number of affiliates. Because the single regulator
model using a principles based approach to regulation and
supervision has been in place in the UK since 1997, the
benefits and negative aspects of this type of regulatory
framework can be viewed from the perspective of actual
practice.
A single regulator, instead of functional regulators for
different substantive businesses, coupled with a principles
based approach to regulation was not successful in avoiding a
financial crisis in the UK. The causes of the crisis in the UK
are similar to those identified as causes in the U.S., and
elsewhere, and the FSA model for supervision did not fully
eliminate the gaps in regulation or mitigate other risk factors
that lead to the crisis. Several factors may have contributed
to the shortcomings in the FSA model. The most frequently cited
factor was principles based regulation. Critics of this
framework have identified the lack of close supervision and
enforcement over conglomerates, their component companies and
other financial services companies. The FSA employed a system
that did not adequately require ongoing supervision or account
for changes in the risk profiles of the entities involved.
Finally, in an effort to streamline the framework and eliminate
regulatory overlap, important roles were not fulfilled.
The Group of 30 issued a report on January 15, 2009, that
included a number of recommendations for financial stability.
The recommendations presented in the report respond to the same
factors that have become the focus of the causes of the current
crisis. The first core recommendation is that gaps and
weaknesses in the coverage of prudential regulation and
supervision must be eliminated, the second is that the quality
and effectiveness of prudential regulation and supervision must
be improved, the third is that institutional policies and
standards must be strengthened, with particular emphasis on
standards of governance, risk management, capital and liquidity
and finally, financial markets and products must be more
transparent with better aligned risk and prudential incentives.
The first core recommendation is one about which there is
little disagreement. The elimination of gaps and weakness in
the coverage of prudential regulation and supervision is an
important goal in a number of areas. Whether it is the
unregulated participants in the mortgage origination process,
hedge funds or creators and sellers of complex financial
instruments changing the regulatory framework to include those
entities is a priority for a number of groups making
recommendations for change. The benefits of the adaptation of
the current system are evident and the core principles proposed
by the Group of 30 are common themes in addressing supervision
of conglomerates.
A final proposal is the Treasury Blueprint that was issued
in March 2008. That document was a top to bottom review of the
current regulatory framework, with result that financial
institutions would be regulated by a market stability
regulator, a prudential regulator and/or a business conduct
regulator. In addition, an optional federal charter would be
created for insurance companies, a regulator for payment
systems would be established, and a corporate finance regulator
would be created. This approach to regulation would move toward
the idea that supervision should be product driven and not
institution driven. The framework proposed would not use the
positive features in the current system, but a systemic
regulator would be created.
Q.3. If there are institutions that are too big to fail, how do
we identify that? How do we define the circumstance where a
single company is so systemically significant to the rest of
our financial circumstances and our economy that we must not
allow it to fail?
A.3. Establishing the criteria by which financial institutions
or other companies are identified as too big to fail is not
easy. Establishing a test with which to judge whether an entity
is of a size that makes it too big to fail, or the business is
sufficiently interconnected, requires looking at a number of
factors, including the business as a whole. The threshold is
not simply one of size. The degree of integration of the
company with the financial system also is a consideration. A
company does not need to be a bank, an insurance company or a
securities company to be systemically important. As we have
seen in recent months, manufacturing companies as well as
financial services conglomerates are viewed differently because
of the impact that the failure would have on the economy as a
whole. The identification of companies that are systemically
important should be decided after a subjective analysis of the
facts and circumstances of the company and not just based on
the size of the entity.
The factors used to make the determination might include:
the risks presented by the other parties with which the company
and its affiliates do business; liquidity risks, capital
positions; interrelationships of the affiliates; relationships
of the affiliates with nonaffiliated companies; and the
prevalence of the product mix in the market.
Q.4. We need to have a better idea of what this notion of too
big to fail is--what it means in different aspects of our
industry and what our proper response to it should be. How
should the federal government approach large, multinational,
and systemically significant companies?
A.4. The array of lessons learned from the crisis will be
debated for years. One lesson is that some institutions have
grown so large and become so essential to the economic well-
being of the nation that they must be regulated in a new way.
The establishment of a systemic risk regulator is an essential
outcome of any initiative to modernize bank supervision and
regulation. OTS endorses the establishment of a systemic risk
regulator with broad authority to monitor and exercise
supervision over any company whose actions or failure could
pose a risk to financial stability. The systemic risk regulator
should have the ability and the responsibility for monitoring
all data about markets and companies including, but not limited
to, companies involved in banking, securities, and insurance.
For systemically important institutions, the systemic risk
regulator should supplement, not supplant, the holding company
regulator and the primary federal bank supervisor. A systemic
regulator should have the authority and resources to supervise
institutions and companies during a crisis situation. The
regulator should have ready access to funding sources that
would provide the capability to resolve problems at these
institutions, including providing liquidity when needed.
Given the events of the past year, it is essential that
such a regulator have the ability to act as a receiver and to
provide an orderly resolution to companies. Efficiently
resolving a systemically important institution in a measured,
well-managed manner is an important element in restructuring
the regulatory framework. A lesson learned from recent events
is that the failure or unwinding of systemically important
companies has a far reaching impact on the economy, not just on
financial services. The continued ability of banks and other
entities in the United States to compete in today's global
financial services marketplace is critical. The systemic risk
regulator would be charged with coordinating the supervision of
conglomerates that have international operations. Safety and
soundness standards, including capital adequacy and other
factors, should be as comparable as possible for entities that
have multinational businesses.
Q.5. What does ``fail'' mean? In the context of AIG, we are
talking about whether we should have allowed an orderly Chapter
11 bankruptcy proceeding to proceed. Is that failure?
A.5. In the context of AIG, OTS views the financial failure of
a company as occurring when it can no longer repay its
liabilities or satisfy other obligations from its liquid
financial resources. OTS is not in a position to state whether
AIG should have proceeded to a Chapter 11 bankruptcy. As stated
in the March 18, 2009, testimony on Lessons Learned in Risk
Management Oversight at Federal Financial Regulators and the
March 19, 2009, testimony on Modernizing Bank Supervision and
Regulation, OTS endorses establishing a systemic risk regulator
with broad regulatory and monitoring authority of companies
whose failure or activities could pose a risk to financial
stability. Such a regulator should be able to access funds,
which would present options to resolve problems at these
institutions.
------
RESPONSE TO WRITTEN QUESTIONS OF SENATOR KOHL
FROM SCOTT M. POLAKOFF
Q.1. Two approaches to systemic risk seem to be identified: (1)
monitoring institutions and taking steps to reduce the size/
activities of institutions that approach a ``too large to
fail'' or ``too systemically important to fail'' or (2) impose
an additional regulator and additional rules and market
discipline on institutions that are considered systemically
important.
Which approach do you endorse? If you support approach one
how you would limit institution size and how would you identify
new areas creating systemic importance?
If you support approach two how would you identify
systemically important institutions and what new regulations
and market discipline would you recommend?
A.1. OTS endorses the establishment of a systemic risk
regulator with broad authority, including regular monitoring,
over companies that if, due to the size or interconnected
nature of their activities, their actions or their failure
would pose a risk to the financial stability of the country.
Such a regulator should be able to access funds, which would
present options to resolve problems at these institutions. The
systemic risk regulator should have the ability and the
responsibility for monitoring all data about markets and
companies including, but not limited to, companies involved in
banking, securities, and insurance.
Any systemic regulator should have all of the authority
necessary to supervise institutions and companies especially in
a crisis situation, but this regulator would be in addition to
the functional regulator. The systemic risk regulator would not
have supervisory authority over nonsystemically important
banks. However, the systemic risk regulator would need access
to data regarding the health and activities of these
institutions for purposes of monitoring trends and other
matters influencing monetary policy.
In addition, the systemic risk regulator would be charged
with coordination of supervision of conglomerates that have
international operations. The safety and soundness standards
including capital adequacy and other measurable factors should
be as comparable as possible for entities that have
multinational businesses. The ability of banks and other
entities in the United States to compete in today's global
financial services market place is critical.
The identification of systemically important entities would
be accomplished by looking at those entities whose business is
so interconnected with the financial services market that its
failure would have a severe impact on the market generally. Any
systemic risk regulator would have broad authority to monitor
the market and products and services offered by a systemically
important entity or that dominate the market. Important
additional regulations would include additional requirements
for transparency regarding the entity and the products.
Further, such a regulator would have the authority to require
additional capital commensurate with the risks of the
activities of the entity and would monitor liquidity with the
risks of the activities of the entity. Finally, such a
regulator would have authority to impose a prompt corrective
action regime on the entities it regulates.
Q.2. Please identify all regulatory or legal barriers to the
comprehensive sharing of information among regulators including
insurance regulators, banking regulators, and investment
banking regulators. Please share the steps that you are taking
to improve the flow of communication among regulators within
the current legislative environment.
A.2. The most significant barrier to disclosure is that if a
regulator discloses confidential supervisory information to
another regulator, the disclosure could lead to further,
unintended disclosure to other persons. Disclosure to another
regulator raises two significant risks: the risk that
information shared with the other regulator will not be
maintained confidential by that regulator, or that legal
privileges that apply to the information will be waived by
sharing.
The regulator in receipt of the information may not
maintain confidentiality of the information because the
regulator is required by law to disclose the information in
certain circumstances or because the regulator determines that
it is appropriate to do so. For example, most regulators in the
United States or abroad may be required to disclose
confidential information that they received from another
supervisor in response to a subpoena related to litigation in
which the regulator may or may not be a party. While the
regulator may seek to protect the confidentiality of the
information that it received, the court overseeing the
litigation may require disclosure. In addition, the U.S.
Congress and other legislative bodies may require a regulator
to disclose confidential information received by that regulator
from another regulator. Moreover, if a regulator receives
information from another regulator that indicates that a crime
may have been committed, the regulator in receipt of the
information may provide the information to a prosecutor. Other
laws may require or permit a regulator in receipt of
confidential information to disclose the information, for
example, to an authority responsible for enforcement of anti-
trust laws. These laws mean that the regulator that provides
the information can no longer control disclosure of it because
the regulator in receipt of the information cannot guarantee
that it will not disclose the information further.
With respect to waiver of privileges through disclosure to
another regulator, legislation provides only partial protection
against the risk that legal privileges that apply to the
information will be waived by sharing. When privileged
information is shared among covered U.S. federal agencies,
privileges are not waived. 12 U.S.C. 1821(t). This statutory
protection does not, however, extend to state regulators (i.e.,
insurance regulators) or foreign regulators.
To reduce these risks, OTS has information-sharing
arrangements with all but one state insurance regulator, 16
foreign bank regulators, and one foreign insurance regulator.
(Some of these foreign bank regulators may also regulate
investment banking or insurance.) OTS is in the process of
negotiating information-sharing arrangements with approximately
20 additional foreign regulators.
OTS also shares information with regulators with which it
does not have an information-sharing arrangement on a case-by-
case basis, subject to an agreement to maintain confidentiality
and compliance with other legal requirements. See 12 U.S.C.
1817(a)(2)(C), 1818(v), 3109(b); 12 C.F.R. 510.5.
In terms of practical steps to ensure a robust flow of
communication, OTS, as part of its supervisory planning,
identifies foreign and functional regulators responsible for
major affiliates of its thrifts and maintains regular contact
with them. This interaction includes phone and e-mail
communication relating to current supervisory matters, as well
as exchanging reports of examination and other supervisory
documentation as appropriate. With its largest holding
companies, OTS sponsors an annual supervisory conference to
which U.S. and foreign regulators are invited to discuss group-
wide supervisory issues.
------
RESPONSE TO WRITTEN QUESTIONS OF SENATOR HUTCHISON
FROM SCOTT M. POLAKOFF
Q.1. Will each of you commit to do everything within your power
to prevent performing loans from being called by lenders?
Please outline the actions you plan to take.
A.1. OTS is encouraging financial institutions to develop
effective loan modification programs in lieu of calling loans,
whether they are performing or delinquent. OTS and OCC are
working jointly to produce a quarterly Mortgage Metrics Report
that analyzes mortgage servicing data and also provides data on
the affordability and sustainability of loan modifications. The
2008 fourth quarter report revealed that delinquencies were
still rising, but financial institutions were also increasing
efforts aimed at home retention, including loan modifications
or payment plans.
The first quarter 2009 data continued to show increases in
seriously delinquent prime mortgages and a jump in the number
of foreclosures in process across all risk categories as a
variety of moratoria on foreclosures expired during the first
quarter of 2009. A positive development is the significant
increase in the number of modifications made by servicers. In
addition to the increase in the overall numbers of
modifications, servicers also implemented a higher percentage
of modifications that reduced monthly payments than in previous
quarters. Modifications with lower payments continued to show
fewer delinquencies each month following modification than
those that left payments unchanged or increased payments.
Therefore, even in the midst of an overall worsening of
conditions in mortgage performance, there is a strong industry
response in the form of increased modifications. The OTS will
continue to monitor the types of home retention actions
implemented by servicers in efforts to stem home foreclosure
actions.
------
RESPONSE TO WRITTEN QUESTIONS OF SENATOR SHELBY
FROM JOSEPH A. SMITH, JR.
Q.1. Consumer Protection Regulation--Some have advocated that
consumer protection and prudential supervision should be
divorced, and that a separate consumer protection regulation
regime should be created. They state that one source of the
financial crisis emanated from the lack of consumer protection
in the underwriting of loans in the originate-to-distribute
space.
What are the merits of maintaining it in the same agency?
Alternatively, what is the best argument each of you can make
for a new consumer protection agency?
A.1. CSBS believes safety and soundness and consumer protection
should be maintained for the benefit of the system. While CSBS
recognizes there is a tension between consumer protection and
safety and soundness supervision, we believe these two forms of
supervision strengthen the other. Consumer protection is
integral to the safety and soundness of consumer protections.
The health of a financial institution ultimately is connected
to the health of its customers. If consumers lack confidence in
their institution or are unable to maintain their economic
responsibilities, the institution will undoubtedly suffer.
Similarly, safety and soundness of our institutions is vital to
consumer protection. Consumers are protected if the
institutions upon which they rely are operated in a safe and
sound manner. Consumer complaints have often spurred
investigations or even enforcement actions against institutions
or financial service providers operating in an unsafe and
unsound manner.
States have observed that federal regulators, without the
checks and balances of more locally responsive state regulators
or state law enforcement, do not always give fair weight to
consumer issues or lack the local perspective to understand
consumer issues fully. CSBS considers this a weakness of the
current system that would be exacerbated by creating a consumer
protection agency.
Further, federal preemption of state law and state law
enforcement by the OCC and the OTS has resulted in less
responsive consumer protections and institutions that are much
less responsive to the needs of consumers in our states.
CSBS is currently reviewing and developing robust policy
positions upon the administration's proposed financial
regulatory reform plan. Our initial thoughts, however, are
pleased the administration has recognized the vital role states
play in preserving consumer protection. We agree that federal
standards should be applicable to all financial entities, and
must be a floor, allowing state authorities to impose more
stringent statutes or regulations if necessary to protect the
citizens of our states. CSBS is also pleased the
administration's plan would allow for state authorities to
enforce all applicable law--state and federal--on those
financial entities operating within our state, regardless of
charter type.
Q.2. Regulatory Gaps or Omissions--During a recent hearing, the
Committee has heard about massive regulatory gaps in the
system. These gaps allowed unscrupulous actors like AIG to
exploit the lack of regulatory oversight. Some of the
counterparties that AIG did business with were institutions
under your supervision.
Why didn't your risk management oversight of the AIG
counterparties trigger further regulatory scrutiny? Was there a
flawed assumption that AIG was adequately regulated, and
therefore no further scrutiny was necessary?
Was there dialogue between the banking regulators and the
state insurance regulators? What about the SEC?
If the credit default swap contracts at the heart of this
problem had been traded on an exchange or cleared through a
clearinghouse, with requirement for collateral and margin
payments, what additional information would have been
available? How would you have used it?
A.2. CSBS believes this is a question best answered by the
Federal Reserve and the OCC. However, we believe this provides
an example of why consolidated supervision would greatly weaken
our system of financial oversight. Institutions have become so
complex in size and scope, that no single regulator is capable
of supervising their activities. It would be imprudent to
lessen the number of supervisors. Instead, Congress should
devise a system which draws upon the strength, expertise, and
knowledge of all financial regulators.
Q.3. Liquidity Management--A problem confronting many financial
institutions currently experiencing distress is the need to
roll-over short-term sources of funding. Essentially these
banks are facing a shortage of liquidity. I believe this
difficulty is inherent in any system that funds long-term
assets, such as mortgages, with short-term funds. Basically the
harm from a decline in liquidity is amplified by a bank's level
of ``maturity-mismatch.''
I would like to ask each of the witnesses, should
regulators try to minimize the level of a bank's maturity-
mismatch? And if so, what tools would a bank regulator use to
do so?
A.3. While banks tend to have an inherent maturity-mismatch,
greater access to diversified funding has mitigated this risk.
Beyond traditional retail deposits, banks can access brokered
deposits, public entity deposits, and secured borrowings from
the FHLB. Since a bank essentially bids or negotiates for these
funds, they can structure the term of the funding to meet their
asset and liability management objectives.
In the current environment, the FDIC's strict
interpretation of the brokered deposit rule has unnecessarily
led banks to face a liquidity challenge. Under the FDIC's
rules, when a bank falls below ``well capitalized'' they must
apply for a waiver from the FDIC to continue to accept brokered
deposits. The FDIC has been overly conservative in granting
these waivers or allowing institutions to reduce their
dependency on brokered deposits over time, denying an
institution access to this market. Our December 2008 letter to
the FDIC on this topic is attached.
Q.4. Regulatory Conflict of Interest--Federal Reserve Banks
which conduct bank supervision are run by bank presidents that
are chosen in part by bankers that they regulate.
Mr. Tarullo, do you see the potential for any conflicts of
interest in the structural characteristics of the Fed's bank
supervisory authorities?
Mr. Dugan and Mr. Polakoff does the fact that your
agencies' funding stream is affected by how many institutions
you are able to keep under your charters affect your ability to
conduct supervision?
A.4. I believe these questions are best answered by the Federal
Reserve, the OCC, and the OTS.
Q.5. Too-Big-To-Fail--Chairman Bair stated in her written
testimony that ``the most important challenge is to find ways
to impose greater market discipline on systemically important
institutions. The solution must involve, first and foremost, a
legal mechanism for the orderly resolution of those
institutions similar to that which exists for FDIC-insured
banks. In short we need to end too big to fail.'' I would agree
that we need to address the too-big-to-fail issue, both for
banks and other financial institutions.
Could each of you tell us whether putting a new resolution
regime in place would address this issue?
How would we be able to convince the market that these
systemically important institutions would not be protected by
taxpayer resources as they had been in the past?
A.5. CSBS strongly agrees with Chairman Bair that we must end
``too big to fail.'' Our current crisis has shown that our
regulatory structure was incapable of effectively managing and
regulating the nation's largest institutions and their
affiliates.
Further, CSBS believes a regulatory system should have
adequate safeguards that allow financial institution failures
to occur while limiting taxpayers' exposure to financial risk.
The federal government, perhaps through the FDIC, must have
regulatory tools in place to manage the orderly failure of the
largest financial institutions regardless of their size and
complexity. The FDIC's testimony effectively outlines the
checks and balances provided by a regulator with resolution
authority and capability.
Part of this process must be to prevent institutions from
becoming ``too big to fail'' in the first place. Some methods
to limit the size of institutions would be to charge
institutions additional assessments based on size and
complexity, which would be, in practice, a ``too big to fail''
premium. In a February 2009 article published in Financial
Times, Nassim Nicholas Taleb, author of The Black Swan,
discusses a few options we should avoid. Basically, Taleb
argues we should no longer provide incentives without
disincentives. The nation's largest institutions were
incentivized to take risks and engage in complex financial
transactions. But once the economy collapsed, these
institutions were not held accountable for their failure.
Instead, the U.S. taxpayers have further rewarded these
institutions by propping them up and preventing their failure.
Accountability must become a fundamental part of the American
financial system, regardless of an institution's size.
Q.6. Pro-Cyclicality--I have some concerns about the pro-
cyclical nature of our present system of accounting and bank
capital regulation. Some commentators have endorsed a concept
requiring banks to hold more capital when good conditions
prevail, and then allow banks to temporarily hold less capital
in order not to restrict access to credit during a downturn.
Advocates of this system believe that counter-cyclical policies
could reduce imbalances within financial markets and smooth the
credit cycle itself.
What do you see as the costs and benefits of adopting a
more counter-cyclical system of regulation?
Do you see any circumstances under which your agencies
would take a position on the merits of counter-cyclical
regulatory policy?
A.6. Our legislative and regulatory efforts should be counter-
cyclical. In order to have an effective counter-cyclical
regulatory regime, we must have the will and political support
to demand higher capital standards and reduce risk-taking when
the economy is strong and companies are reporting record
profits. We must also address accounting rules and their impact
on the depository institutions, recognizing that we need these
firms to originate and hold longer-term, illiquid assets. We
must also permit and encourage these institutions to build
reserves for losses over time. Similarly, the FDIC must be
given the mandate to build upon their reserves over time and
not be subject to a cap. This will allow the FDIC to reduce
deposit insurance premiums in times of economic stress.
A successful financial system is one that survives market
booms and busts without collapsing. The key to ensuring our
system can survive these normal market cycles is to maintain
and strengthen the diversity of our industry and our system of
supervision. Diversity provides strength, stability, and
necessary checks-and-balances to regulatory power.
Consolidation of the industry or financial supervision
could ultimately produce a financial system of only mega-banks,
or the behemoth institutions that are now being propped up and
sustained by taxpayer bailouts. An industry of only these types
of institutions would not be resilient. Therefore, Congress
must ensure this consolidation does not take place by
strengthening our current system and preventing supervisory
consolidation.
Q.7. G20 Summit and International Coordination--Many foreign
officials and analysts have said that they believe the upcoming
G20 summit will endorse a set of principles agreed to by both
the Financial Stability Forum and the Basel Committee, in
addition to other government entities. There have also been
calls from some countries to heavily re-regulate the financial
sector, pool national sovereignty in key economic areas, and
create powerful supranational regulatory institutions.
(Examples are national bank resolution regimes, bank capital
levels, and deposit insurance.) Your agencies are active
participants in these international efforts.
What do you anticipate will be the result of the G20
summit?
Do you see any examples or areas where supranational
regulation of financial services would be effective?
How far do you see your agencies pushing for or against
such supranational initiatives?
A.7. This question is obviously targeted to the federal
financial agencies. However, while our supervisory structure
will continue to evolve, CSBS does not believe international
influences or the global marketplace should solely determine
the design of regulatory initiatives in the United States. CSBS
believes it is because of our unique dual banking system, not
in spite of it, that the United States boasts some of the most
successful institutions in the world. U.S. banks are required
to hold high capital standards compared to their international
counterparts. U.S. banks maintain the highest tier 1 leverage
capital ratios but still generate the highest average return on
equity. The capital levels of U.S. institutions have resulted
in high safety and soundness standards. In turn, these
standards have attracted capital investments worldwide because
investors are confident in the strength of the U.S. system.
Viability of the global marketplace and the international
competitiveness of our financial institutions are important
goals. However, our first priority as regulators must be the
competitiveness between and among domestic banks operating
within the United States. It is vital that regulatory
restructuring does not adversely affect the financial system in
the U.S. by putting banks at a competitive disadvantage with
larger, more complex institutions. The diversity of financial
institutions in the U.S. banking system has greatly contributed
to our economic success.
CSBS believes our supervisory structure should continue to
evolve as necessary and prudent to accommodate our institutions
that operate globally as well as domestically.
------
RESPONSE TO WRITTEN QUESTIONS OF SENATOR REED
FROM JOSEPH A. SMITH, JR.
Q.1. It is clear that our current regulatory structure is in
need of reform. At my subcommittee hearing on risk management,
March 18, 2009, GAO pointed out that regulators often did not
move swiftly enough to address problems they had identified in
the risk management systems of large, complex financial
institutions.
Chairman Bair's written testimony for today's hearing put
it very well: `` . . . the success of any effort at reform will
ultimately rely on the willingness of regulators to use their
authorities more effectively and aggressively.''
My questions may be difficult, but please answer the
following:
If this lack of action is a persistent problem
among the regulators, to what extent will changing the
structure of our regulatory system really get at the
issue?
Along with changing the regulatory structure, how
can Congress best ensure that regulators have clear
responsibilities and authorities, and that they are
accountable for exercising them ``effectively and
aggressively''?
A.1. First of all, CSBS agrees completely with Chairman Bair.
In fact, in a letter to the Government Accountability Office
(GAO) in December 2008, CSBS Executive Vice President John Ryan
wrote, ``While there are clearly gaps in our regulatory system
and the system is undeniably complex, CSBS has observed that
the greater failing of the system has been one of insufficient
political and regulatory will, primarily at the federal
level.'' Perhaps the resilience of our financial system during
previous crises gave policymakers and regulators a false sense
of security and a greater willingness to defer to powerful
interests in the financial industry who assured them that all
was well.
From the state perspective, it is clear that the nation's
largest and most influential financial institutions have
themselves been major contributors to our regulatory system's
failure to prevent the current economic collapse. All too
often, it appeared as though legislation and regulation
facilitated the business models and viability of our largest
institutions, instead of promoting the strength of consumers or
encouraging a diverse financial industry.
CSBS believes consolidating supervisory authority will only
exacerbate this problem. Regulatory capture by a variety of
interests would become more likely with a consolidated
supervisory structure. The states attempted to check the
unhealthy evolution of the mortgage market and it was the
states and the FDIC that were a check on the flawed assumptions
of the Basel II capital accord. These checks should be enhanced
by regulatory restructuring, not eliminated.
To best ensure that regulators exercise their authorities
``effectively and aggressively,'' I encourage Congress to
preserve and enhance the system of checks and balances amongst
regulators and to forge a new era of cooperative federalism. It
serves the best interest of our economy, our financial services
industry, and our consumers that the states continue to have a
role in financial regulation. States provide an important
system of checks and balances to financial oversight, are able
to identify emerging trends and practices before our federal
counterparts, and have often exhibited a willingness to act on
these trends when our federal colleagues did not.
Therefore, CSBS urges Congress to implement a
recommendation made by the Congressional Oversight Panel in
their ``Special Report on Regulatory Reform'' to eliminate
federal preemption of the application of state consumer
protection laws. To preserve a responsive system, states must
be able to continue to produce innovative solutions and
regulations to provide consumer protection.
Further, the federal government would best serve our
economy and our consumers by advancing a new era of cooperative
federalism. The SAFE Act enacted by Congress requiring
licensure and registration of mortgage loan originators through
NMLS provides a mode for achieving systemic goals of high
regulatory standards and a nationwide regulatory roadmap and
network, while preserving state authority for innovation and
enforcement. The SAFE Act sets expectations for greater state-
to-state and state-to-federal regulatory coordination.
Congress should complete this process by enacting a federal
predatory lending standard as outlined in H.R. 1728, the
Mortgage Reform and Anti-Predatory Lending Act. However, a
static legislative solution would not keep pace of market
innovation. Therefore, any federal standard must be a floor for
all lenders that does not stifle a state's authority to protect
its citizens through state legislation that builds upon the
federal standard. States should also be allowed to enforce-in
cooperation with federal regulators-both state and federal
predatory lending laws for institutions that act within their
state.
Finally, rule writing authority by the federal banking
agencies should be coordinated through the FFIEC. Better state/
federal coordination and effective lending standards is needed
if we are to establish rules that are appropriately written and
applied to financial services providers. While the biggest
institutions are federally chartered, the vast majority of
institutions are state chartered and regulated. Also, the
states have a breadth of experience in regulating the entire
financial services industry, not just banks. Unlike our federal
counterparts, my state supervisory colleagues and I oversee all
financial service providers, including banks, thrifts, credit
unions, mortgage banks, and mortgage brokers.
Q.2. How do we overcome the problem that in the boom times no
one wants to be the one stepping in to tell firms they have to
limit their concentrations of risk or not trade certain risky
products?
What thought has been put into overcoming this problem for
regulators overseeing the firms?
Is this an issue that can be addressed through regulatory
restructure efforts?
A.2. Our legislative and regulatory efforts must be counter-
cyclical. A successful financial system is one that survives
market booms and busts without collapsing. The key to ensuring
our system can survive these normal market cycles is to
maintain and strengthen the diversity of our industry and our
system of supervision. Diversity provides strength, stability,
and necessary checks-and-balances to regulatory power.
Consolidation of the industry or financial supervision
could ultimately product a financial system of only mega-banks,
or the behemoth institutions that are now being propped up and
sustained by taxpayer bailouts. An industry of only these types
of institutions would not be resilient. Therefore, Congress
must ensure this consolidation does not take place by
strengthening our current system and preventing supervisory
consolidation.
Q.3. As Mr. Tarullo and Mrs. Bair noted in their testimony,
some financial institution failures emanated from institutions
that were under federal regulation. While I agree that we need
additional oversight over and information on unregulated
financial institutions, I think we need to understand why so
many regulated firms failed.
Why is it the case that so many regulated entities failed,
and many still remain struggling, if our regulators in fact
stand as a safety net to rein in dangerous amounts of risk-
taking?
While we know that certain hedge funds, for example, have
failed, have any of them contributed to systemic risk?
Given that some of the federal banking regulators have
examiners on-site at banks, how did they not identify some of
these problems we are facing today?
A.3. To begin, the seeming correlation between federal
supervision and success now appears to be unwarranted and
should be better understood. The failures we have seen are
divided between institutions that are suffering because of an
extreme business cycle, and others that had more fundamental
flaws that precipitated the downturn. In a healthy and
functional economy, financial oversight must allow for some
failures. In a competitive marketplace, some institutions will
cease to be feasible. Our supervisory structure must be able to
resolve failures. Ultimately, more damage is done to the
financial system if toxic institutions are allowed to remain in
business, instead of allowed to fail. Propping up these
institutions can create lax discipline and risky practices as
management relies upon the government to support them if their
business models become untenable.
------
RESPONSE TO WRITTEN QUESTIONS OF SENATOR CRAPO
FROM JOSEPH A. SMITH, JR.
Q.1. The convergence of financial services providers and
financial products has increased over the past decade.
Financial products and companies may have insurance, banking,
securities, and futures components. One example of this
convergence is AIG. Is the creation of a systemic risk
regulator the best method to fill in the gaps and weaknesses
that AIG has exposed, or does Congress need to reevaluate the
weaknesses of federal and state functional regulation for
large, interconnected, and large firms like AIG?
A.1. The current economic crisis has shown that our financial
regulatory structure in the United States was incapable of
effectively managing and regulating the nation's largest
institutions, such as AIG.
Institutions, such as AIG, that provide financial services
similar to those provided by a bank, should be subject to the
same oversight that supervises banks.
CSBS believes the solution, however, is not to expand the
federal government bureaucracy by creating a new super
regulator. Instead, we should enhance coordination and
cooperation among federal and state regulators. We believe
regulators must pool their resources and expertise to better
identify and manage systemic risk. The Federal Financial
Institutions Examination Council (FFIEC) provides a vehicle for
working toward this goal of seamless federal and state
cooperative supervision.
Q.2. Recently there have been several proposals to consider for
financial services conglomerates. One approach would be to move
away from functional regulation to some type of single
consolidated regulator like the Financial Services Authority
model. Another approach is to follow the Group of 30 Report
which attempts to modernize functional regulation and limit
activities to address gaps and weaknesses. An in-between
approach would be to move to an objectives-based regulation
system suggested in the Treasury Blueprint. What are some of
the pluses and minuses of these three approaches?
A.2. Each of the models discussed would result in further
consolidation of the financial industry, and would create
institutions that would be inherently too big to fail. If we
allowed our financial industry to consolidate to only a handful
of institutions, the nation and the global economy would be
reliant upon those institutions to remain functioning. CSBS
believes all financial institutions must be allowed to fail if
they become insolvent. Currently, our system of financial
supervision is inadequate to effective supervise the nation's
largest institutions and to resolve them in the event of their
failure.
More importantly, however, consolidation of the industry
would destroy the community banking system within the United
States. The U.S. has over 8,000 viable insured depository
institutions to serve the people of this nation. The diversity
of our industry has enabled our economy to continue despite the
current recession. Community and regional banks have continued
to make credit available to qualified borrowers throughout the
recession and have prevented the complete collapse of our
economy.
Q.3. If there are institutions that are too big to fail, how do
we identify that? How do we define the circumstance where a
single company is so systemically significant to the rest of
our financial circumstances and our economy that we must not
allow it to fail?
A.3. A specific definition for ``too big to fail'' will be
difficult for Congress to establish. Monetary thresholds will
eventually become insufficient as the market rebounds and works
around any asset-size restrictions, just as institutions have
avoided deposit caps for years now. Some characteristics of an
institution that is ``too big to fail'' include being so large
that the institution's regulator is unable to provide
comprehensive supervision of the institution's lines of
business or subsidiaries. An institution is also ``too big to
fail'' if a sudden collapse of the institution would have a
devastating impact upon separate market segments.
Q.4. We need to have a better idea of what this notion of too
big to fail is--what it means in different aspects of our
industry and what our proper response to it should be. How
should the federal government approach large, multinational,
and systemically significant companies?
A.4. The federal government should utilize methods to prevent
companies from growing too big to fail, either through
incentives and disincentives (such as higher regulatory fees
and assessments for higher amounts of assets or engaging in
certain lines of business), denying certain business mergers or
acquisitions that allow a company to become ``systemic,'' or
through establishing anti-trust laws that prevent the creation
of financial monopolies. Congress should also grant the Federal
Deposit Insurance Corporation (FDIC) resolution authority over
all financial firms, regardless of their size or complexity.
This authority will help instill market discipline to these
systemic institutions by providing a method to close any
institution that becomes insolvent. Finally, Congress should
consider establishing a bifurcated system of supervision
designed to meet the needs not only of the nation's largest and
most complex institutions, but also the needs of the smallest
community banks.
Q.5. What does ``fail'' mean? In the context of AIG, we are
talking about whether we should have allowed an orderly Chapter
11 bankruptcy proceeding to proceed. Is that failure?
A.5. CSBS believes failures and resolutions take on a variety
of forms based upon the type of institution and its impact upon
the financial system as a whole. In the context of AIG, an
orderly Chapter 11 bankruptcy would have been considered a
failure.
But it is more important that we do not create an entire
system of financial supervision that is tailored only to our
nation's largest and most complex institutions. It is our
belief the greatest strength of our unique financial structure
is the diversity of the financial industry. The U.S. banking
system is comprised of thousands of financial institutions of
vastly different sizes. Therefore, legislative and regulatory
decisions that alter our financial regulatory structure or
financial incentives should be carefully considered against how
those decisions affect the competitive landscape for
institutions of all sizes.
------
RESPONSE TO WRITTEN QUESTIONS OF SENATOR KOHL
FROM JOSEPH A. SMITH, JR.
Q.1. Two approaches to systemic risk seem to be identified: (1)
monitoring institutions and taking steps to reduce the size/
activities of institutions that approach a ``too large to
fail'' or ``too systemically important to fail'' or (2) impose
an additional regulator and additional rules and market
discipline on institutions that are considered systemically
important.
Which approach do you endorse? If you support approach one
how you would limit institution size and how would you identify
new areas creating systemic importance?
If you support approach two how would you identify
systemically important institutions and what new regulations
and market discipline would you recommend?
A.1. CSBS endorses the first approach monitor institutions and
take steps to reduce the size and activities of institutions
that approach either ``too large to fail'' or ``too
systemically important to fail.'' Our current crisis has shown
that our regulatory structure was incapable of effectively
managing and regulating the nation's largest institutions. CSBS
believes the solution, however, is not to expand the federal
government bureaucracy by creating a new super regulator, or
granting those authorities to a single existing agency.
Instead, we should enhance coordination and cooperation among
the federal government and the states to identify systemic
importance and mitigate its risk. We believe regulators must
pool resources and expertise to better manage systemic risk.
The FFIEC provides a vehicle for working towards this goal of
seamless federal and state cooperative supervision.
Further, CSBS believes a regulatory system should have
adequate safeguards that allow financial institution failures
to occur while limiting taxpayers' exposure to financial risk.
The federal government, perhaps through the FDIC, must have
regulatory tools in place to manage the orderly failure of the
largest financial institutions regardless of their size and
complexity.
Part of this process must be to prevent institutions from
becoming ``too big to fail'' in the first place. Some methods
to limit the size of institutions would be to charge
institutions additional assessments based on size and
complexity, which would be, in practice, a ``too big to fail''
premium. In a February 2009 article published in Financial
Times, Nassim Nicholas Taleb, author of The Black Swan,
discusses a few options we should avoid. Basically, Taleb
argues we should no longer provide incentives without
disincentives. The nation's largest institutions were
incentivized to take risks and engage in complex financial
transactions. But once the economy collapsed, these
institutions were not held accountable for their failure.
Instead, the U.S. taxpayers have further rewarded these
institutions by propping them up and preventing their failure.
Accountability must become a fundamental part of the American
financial system, regardless of an institution's size.
Q.2. Please identify all regulatory or legal barriers to the
comprehensive sharing of information among regulators including
insurance regulators, banking regulators, and investment
banking regulators. Please share the steps that you are taking
to improve the flow of communication among regulators within
the current legislative environment.
A.2. Regulatory and legal barriers exist at every level of
state and federal government. These barriers can be cultural,
regulatory, or legal in nature.
Despite the hurdles, state and federal authorities have
made some progress towards enhancing coordination. Since
Congress added full state representation to the FFIEC in 2006,
federal regulators are working more closely with state
authorities to develop processes and guidelines to protect
consumers and prohibit certain acts or practices that are
either systemically unsafe or harmful to consumers.
The states, working through CSBS and the American
Association of Residential Mortgage Regulators (AARMR), have
made tremendous strides towards enhancing coordination and
cooperation among the states and with our federal counterparts.
The model for cooperative federalism among state and
federal authorities is the CSBS-AARMR Nationwide Mortgage
Licensing System (NMLS) and the SAFE Act enacted last year. In
2003, CSBS and AARMR began a very bold initiative to identify
and track mortgage entities and originators through a database
of licensing and registration. In January 2008, NMLS was
successfully launched with seven inaugural participating
states. Today, 25 states plus the District of Columbia and
Puerto Rico are using NMLS. The hard work and dedication of the
states was recognized by Congress as you enacted the Housing
and Economic Recovery Act of 2008 (HERA). Title V of HERA,
known as the SAFE Act, is designed to increase mortgage loan
originator professionalism and accountability, enhance consumer
protection, and reduce fraud by requiring all mortgage loan
originators be licensed or registered through NMLS.
Combined, NMLS and the SAFE Act create a seamless system of
accountability, interconnectedness, control, and tracking that
has long been absent in the supervision of the mortgage market.
Please see the Appendix of my written testimony for a
comprehensive list of state initiatives to enhance coordination
of financial supervision.
------
RESPONSE TO WRITTEN QUESTIONS OF SENATOR SHELBY
FROM GEORGE REYNOLDS
Q.1. Consumer Protection Regulation--Some have advocated that
consumer protection and prudential supervision should be
divorced, and that a separate consumer protection regulation
regime should be created. They state that one source of the
financial crisis emanated from the lack of consumer protection
in the underwriting of loans in the originate-to-distribute
space.
What are the merits of maintaining it in the same agency?
Alternatively, what is the best argument each of you can make
for a new consumer protection agency?
A.1. A separate consumer protection regulation regime would not
recognize state law. State legislators and regulators are in
the first and best position to identify trends and abusive
practices. One regulator for consumer protection eliminates the
dual oversight that is made possible by state and federal laws
and regulations. It would also inhibit coordination and
cooperation between regulators or worse, provide a gap in
regulation and oversight by the state regulatory system.
The Treasury Blueprint for a Modernized Financial
Regulatory Structure, presented in March 2008, suggests the
creation of a business conduct regulator to conduct regulation
across all types of financial firms. The business conduct
regulator would include key aspects of consumer protection,
including rule writing for disclosures and business practices.
This structure proposes to eliminate gaps in oversight and
provide effective consumer and investor protections.
The proposed business conduct regulator at the federal
level would be separate and distinct from the suggested
prudential regulator. NASCUS \1\ believes such a system would
curtail, not enhance, consumer protections.
---------------------------------------------------------------------------
\1\ NASCUS is the professional association of state credit union
regulatory agencies that charter, examine and supervise the nation's
3,100 state-chartered credit unions. The NASCUS , mission is to enhance
state credit union supervision and advocate for a safe and sound credit
union system.
---------------------------------------------------------------------------
The Treasury Blueprint would create a new federal
bureaucracy, taking away most supervisory, enforcement and rule
making authority from the states and federalizing those
authorities in a new business conduct regulator.
Much of the focus of attention of the OCC, OTS and NCUA has
been on seeking preemption from state consumer protection laws.
An example of this is the preemption efforts undertaken by
these agencies regarding the Georgia Fair Lending Act (GFLA).
It is vital that consumer protection statutes adopted at the
state level apply consistently to all financial institutions
regardless of charter type.
Q.2. Regulatory Gaps or Omissions--During a recent hearing, the
Committee has heard about massive regulatory gaps in the
system. These gaps allowed unscrupulous actors like AIG to
exploit the lack of regulatory oversight. Some of the
counterparties that AIG did business with were institutions
under your supervision.
Why didn't your risk management oversight of the AIG
counterparties trigger further regulatory scrutiny? Was there a
flawed assumption that AIG was adequately regulated, and
therefore no further scrutiny was necessary?
A.2. NASCUS members do not have regulatory oversight of AIG.
The answers provided by NASCUS focus on issues related to our
expertise regulating state credit unions and issues concerning
the state credit union system.
Q.3. Was there dialogue between the banking regulators and the
state insurance regulators? What about the SEC?
A.3. This question does not apply to state credit union
regulators. The answers provided by NASCUS focus on issues
related to our expertise regulating state credit unions and
issues concerning the state credit union system.
Q.4. If the credit default swap contracts at the heart of this
problem had been traded on an exchange or cleared through a
clearinghouse, with requirement for collateral and margin
payments, what additional information would have been
available? How would you have used it?
A.4. Credit unions did not and currently do not engage in
credit default swap contracts to the best of our knowledge.
Q.5. Liquidity Management--A problem confronting many financial
institutions currently experiencing distress is the need to
roll-over short-term sources of funding. Essentially these
banks are facing a shortage of liquidity. I believe this
difficulty is inherent in any system that funds long-term
assets, such as mortgages, with short-term funds. Basically the
harm from a decline in liquidity is amplified by a bank's level
of ``maturity-mismatch.''
I would like to ask each of the witnesses, should
regulators try to minimize the level of a bank's maturity-
mismatch? And if so, what tools would a bank regulator use to
do so?
A.5. Most credit unions supervised by state regulators have
strong core liquidity funding in the form of member deposits.
Unlike other financial institutions which use brokered funding,
Internet deposit funding and other noncore funding, these
practices are rare in credit unions.
Many credit unions' liquidity position would be favorably
impacted if they had access to supplemental capital.
Supplemental capital would bolster the safety and soundness of
credit unions and provide further stability in this
unpredictable market. It would also provide an additional layer
of protection to the NCUSIF thereby maintaining credit unions'
independence from the federal government and taxpayers.
Credit union access to supplemental capital is more
important than ever given the impact of losses in the corporate
system on federally insured natural-person credit unions.
Stabilizing the corporate credit union system requires natural-
person federally insured credit unions to write off their
existing one percent deposit in the NCUSIF, as well as an
assessment of a premium to return NCUSIF's equity ratio to 1.3
percent. Additionally, credit unions with capital investments
in the retail corporate credit union could be forced to write-
down as much as another $2 billion in corporate capital. This
will impact the bottom line of many credit unions, and
supplemental capital could have helped their financial position
in addressing this issue.
State regulators are committed to taking every feasible
step to protect credit union safety and safety and soundness--
we must afford the nation's credit unions with the opportunity
to protect and grow liquidity as well as the tools to react to
unusual market conditions. The NASCUS Board of Directors and
NASCUS state regulators urge you to enact legislation allowing
supplemental capital.
Q.6. Too-Big-To-Fail--Chairman Bair stated in her written
testimony that ``the most important challenge is to find ways
to impose greater market discipline on systemically important
institutions. The solution must involve, first and foremost, a
legal mechanism for the orderly resolution of those
institutions similar to that which exists for FDIC-insured
banks. In short we need to end too big to fail.'' I would agree
that we need to address the too-big-to-fail issue, both for
banks and other financial institutions.
Could each of you tell us whether putting a new resolution
regime in place would address this issue?
A.6. While relatively few credit unions fall into the category
of ``too big to fail,'' with the exception perhaps of some of
the larger corporate credit unions, I believe as a general rule
that if an institution is too big to fail, then perhaps it is
also too large to exist. Perhaps the answer is to functionally
separate and decouple the risk areas of a ``too big to fail''
organization so that a component area can have the market
discipline of potential failure, without impairing the entire
organization. Financial institutions backed by federal deposit
insurance need to have increased expectations of risk control
and risk management.
Q.7. How would we be able to convince the market that these
systemically important institutions would not be protected by
taxpayer resources as they had been in the past?
A.7. Again this area has relatively little application to
state-chartered credit unions. But the most effective message
can be conveyed to the marketplace by clearly indicating that
these riskier decoupled operations will not be supported by
taxpayer resources and then following through by letting these
entities enter bankruptcy or fail without government
intervention.
Q.8. Pro-Cyclicality--I have some concerns about the pro-
cyclical nature of our present system of accounting and bank
capital regulation. Some commentators have endorsed a concept
requiring banks to hold more capital when good conditions
prevail, and then allow banks to temporarily hold less capital
in order not to restrict access to credit during a downturn.
Advocates of this system believe that counter-cyclical policies
could reduce imbalances within financial markets and smooth the
credit cycle itself.
What do you see as the costs and benefits of adopting a
more counter-cyclical system of regulation?
Do you see any circumstances under which your agencies
would take a position on the merits of counter-cyclical
regulatory policy?
A.8. Perhaps the most needed measure relative to a counter-
cyclical system of regulation is the need to increase deposit
insurance premiums during periods of heightened earnings, as
opposed to the current practice of basing these assessment on
deposit insurance losses. Financial institutions end up with
high assessments typically at the same time that their capital
and earnings are under pressure due to asset quality concerns.
The deposit insurance funds need to be built up during the good
times and banks and credit unions need to be able to have lower
assessments during periods of economic uncertainty.
It would also be wise to review examination processes to
see where greater emphasis can be placed on developing counter-
cyclical processes and procedures. This will always be a
challenge during periods of economic expansion, where financial
institutions are experiencing low levels of nonperforming loans
and loan losses, strong capital and robust earnings. Under
these circumstances supervisors are subject to being accused by
financial institutions and policy makers as impeding economic
progress and credit availability. It would be beneficial to
take a stronger and more aggressive posture regarding
concentration risk and funding and asset/liability management
risk during periods of economic expansion.
Q.9. G20 Summit and International Coordination--Many foreign
officials and analysts have said that they believe the upcoming
G20 summit will endorse a set of principles agreed to by both
the Financial Stability Forum and the Basel Committee, in
addition to other government entities. There have also been
calls from some countries to heavily re-regulate the financial
sector, pool national sovereignty in key economic areas, and
create powerful supranational regulatory institutions.
(Examples are national bank resolution regimes, bank capital
levels, and deposit insurance.) Your agencies are active
participants in these international efforts.
What do you anticipate will be the result of the G20
summit?
Do you see any examples or areas where supranational
regulation of financial services would be effective?
How far do you see your agencies pushing for or against
such supranational initiatives?
A.9. To ensure a comprehensive regulatory system for credit
unions, Congress should consider the current dual chartering
system as a regulatory model. Dual chartering and the value
offered to consumers by the state and federal systems provide
the components that make a comprehensive regulatory system.
Dual chartering also reduces the likelihood of gaps in
financial regulation because there are two interested
regulators. Often, states are in the first and best position to
identify current trends that need to be regulated and this
structure allows the party with the most information to act to
curtail a situation before it becomes problematic. Dual
chartering should continue. This system provides accountability
and the needed structure for effective and aggressive
regulatory enforcement.
The dual chartering system has provided comprehensive
regulation for 140 years. Dual chartering remains viable in the
financial marketplace because of the distinct benefits provided
by each charter, state and federal. This system allows each
financial institution to select the charter that benefits its
members or consumers the most. Ideally, for any system, the
best elements of each charter should be recognized and enhanced
to allow for competition in the marketplace so that everyone
benefits. In addition, the dual chartering system allows for
the checks and balances between state and federal government
necessary for comprehensive regulation. Any regulatory system
should recognize the value of the dual chartering system and
how it contributes to a comprehensive regulatory structure.
Regulators should evaluate products and services based on
safety and soundness and consumer protection criterion. This
will maintain the public's confidence.
------
RESPONSE TO WRITTEN QUESTIONS OF SENATOR REED
FROM GEORGE REYNOLDS
Q.1. It is clear that our current regulatory structure is in
need of reform. At my subcommittee hearing on risk management,
March 18, 2009, GAO pointed out that regulators often did not
move swiftly enough to address problems they had identified in
the risk management systems of large, complex financial
institutions.
Chair Bair's written testimony for today's hearing put it
very well: `` . . . the success of any effort at reform will
ultimately rely on the willingness of regulators to use their
authorities more effectively and aggressively.''
My questions may be difficult, but please answer the
following: If this lack of action is a persistent problem among
the regulators, to what extent will changing the structure of
our regulatory system really get at the issue?
A.1. We do not perceive that lack of action is a problem among
the state credit union regulators. In fact, the authority given
to state regulators by state legislatures allows state
regulators to move quickly to mitigate problems and address
risk in their state-chartered credit unions. NASCUS \1\
believes that the dual chartering structure which allows for
both a strong state and federal regulator is an effective
regulatory structure for credit unions.
---------------------------------------------------------------------------
\1\ NASCUS is the professional association of state credit union
regulatory agencies that charter, examine and supervise the nation's
3,100 state-chartered credit unions. The NASCUS mission is to enhance
state credit union supervision and advocate for a safe and sound credit
union system.
---------------------------------------------------------------------------
State and federal credit union regulators regularly
exchange information about the credit unions they supervise; it
is a cooperative relationship. The Federal Credit Union Act
(FCUA) provides that ``examinations conducted by State
regulatory agencies shall be utilized by the Board for such
purposes to the maximum extent feasible.'' \2\ Further,
Congress has recognized and affirmed the distinct roles played
by state and federal regulatory agencies in the FCUA by
providing a system of consultation and cooperation between
state and federal regulators. \3\ It is important that all
statutes and regulations written in the future include
provisions that require consultation and cooperation between
state and federal credit union regulators to prevent regulatory
and legal barriers to the comprehensive information sharing.
This cooperation helps regulators identify and act on issues
before they become a problem.
---------------------------------------------------------------------------
\2\ 12 U.S. Code 1781(b)(1).
\3\ The ``Consultation and Cooperation With State Credit Union
Supervisors'' provision contained in The Federal Credit Union Act, 12
U.S. Code 1757a(e) and 12 U.S. Code 1790d(l).
---------------------------------------------------------------------------
State regulators play an important role in protecting the
safety and soundness of the state credit union system. It is
imperative that any regulatory structure preserve state
regulators role in overseeing and writing regulations for state
credit unions. In addition, it is critical that state
regulators and National Credit Union Administration (NCUA) have
parity and comparable systemic risk authority with the Federal
Deposit Insurance Corporation (FDIC).
Q.2. Along with changing the regulatory structure, how can
Congress best ensure that regulators have clear
responsibilities and authorities, and that they are accountable
for exercising them ``effectively and aggressively''?
A.2. To ensure a comprehensive regulatory system, Congress
should consider the current dual chartering system as a
regulatory model. Dual chartering and the value offered to
consumers by the state and federal systems provide the
components that make a comprehensive regulatory system. Dual
chartering also reduces the likelihood of gaps in financial
regulation because there are two interested regulators. Often,
states are in the first and best position to identify current
trends that need to be regulated and this structure allows the
party with the most information to act to curtail a situation
before it becomes problematic. Dual chartering should continue.
This system provides accountability and the needed structure
for effective and aggressive regulatory enforcement.
The dual chartering system has provided comprehensive
regulation for 140 years. Dual chartering remains viable in the
financial marketplace because of the distinct benefits provided
by each charter, state and federal. This system allows each
financial institution to select the charter that benefits its
members or consumers the most. Ideally, for any system, the
best elements of each charter should be recognized and enhanced
to allow for competition in the marketplace so that everyone
benefits. In addition, the dual chartering system allows for
the checks and balances between state and federal government
necessary for comprehensive regulation. Any regulatory system
should recognize the value of the dual chartering system and
how it contributes to a comprehensive regulatory structure.
Regulators should evaluate products and services based on
safety and soundness and consumer protection criterion. This
will maintain the public's confidence.
Q.3. How do we overcome the problem that in the boom times no
one wants to be the one stepping in to tell firms they have to
limit their concentrations of risk or not trade certain risky
products?
What thought has been put into overcoming this problem for
regulators overseeing the firms?
Is this an issue that can be addressed through regulatory
restructure efforts?
A.3. The current credit union regulatory structure
appropriately provides state credit union regulators rulemaking
and enforcement authority. This authority helps state
regulators respond to problems and trends at state-chartered
credit unions and it places them in a position to help state
credit unions manage risks on their balance sheets.
It is sometimes difficult, particularly during a period of
economic expansion to motivate financial institutions to reduce
concentration risk when institutions are strongly capitalized
and have robust earnings. This is, nevertheless, the
appropriate role of a regulator and it is not really a factor
that can be addressed through regulatory restructuring. It can
only be impacted by having effective, experienced and well
trained examiners that are supported in consistent manner by
experienced supervisory management.
Q.4. As Mr. Tarullo and Mrs. Bair noted in their testimony,
some financial institution failures emanated from institutions
that were under federal regulation. While I agree that we need
additional oversight over and information on unregulated
financial institutions, I think we need to understand why so
many regulated firms failed.
Why is it the case that so many regulated entities failed,
and many still remain struggling, if our regulators in fact
stand as a safety net to rein in dangerous amounts of risk-
taking?
A.4. The current economic crisis and resulting destabilization
of portions of the financial services system has revealed
certain gaps and lapses in overall regulatory oversight.
Currently, state and federal regulators are assessing those
lapses, identifying gaps, and working diligently to address
weaknesses in the system. As part of this process, it is also
important to recognize regulatory oversight that worked,
whether preventing failure, or identifying undue risk in a
manner that allowed for an orderly unwinding of a going
concern.
To the extent that regulators miscalculated a calibration
of acceptable risk, as opposed to undue risk, it may be safe to
conclude that undue reliance was placed on underlying market
assumptions that failed upon severe market dislocation.
Q.5. While we know that certain hedge funds, for example, have
failed, have any of them contributed to systemic risk?
A.5. NASCUS members do not regulate hedge funds. The answers
provided by NASCUS focus solely on issues related to our
expertise regulating state credit unions and issues concerning
the state credit union system.
Q.6. Given that some of the federal banking regulators have
examiners on-site at banks, how did they not identify some of
these problems we are facing today?
A.6. Given NASCUS members regulatory scope, this question does
not apply. The answers provided by NASCUS focus solely on
issues related to our expertise regulating state credit unions
and issues concerning the state credit union system.
NASCUS background: The NASCUS, \4\ mission is to enhance
state credit union supervision and advocate for a safe and
sound credit union system. NASCUS represents the interests of
state agencies before Congress and is the liaison to federal
agencies, including the National Credit Union Administration
(NCUA). NCUA is the chartering authority for federal credit
unions and the administrator of the National Credit Union Share
Insurance Fund (NCUSIF), the insurer of most state-chartered
credit unions.
---------------------------------------------------------------------------
\4\ NASCUS is the professional association of state credit union
regulatory agencies that charter, examine and supervise the nation's
3,100 state-chartered credit unions.
---------------------------------------------------------------------------
Credit unions in this country are structured in three
tiers. The first tier consists of 8,088 natural-person credit
unions \5\ that provide services to consumer members.
Approximately 3,100 of these institutions are state-chartered
credit unions and are regulated by state regulatory agencies.
There are 27 \6\ retail corporate credit unions, which provide
investment, liquidity and payment system services to credit
unions; corporate credit unions do not serve consumers. The
final tier of the credit union system is a federal wholesale
corporate that acts as a liquidity and payment systems provider
to the corporate system and indirectly to the consumer credit
unions.
---------------------------------------------------------------------------
\5\ Credit Union Report, Year-End 2008, Credit Union National
Association.
\6\ There are 14 state-chartered retail corporate credit unions
and 13 federally chartered corporate credit unions.
---------------------------------------------------------------------------
------
RESPONSE TO WRITTEN QUESTIONS OF SENATOR CRAPO
FROM GEORGE REYNOLDS
Q.1. The convergence of financial services providers and
financial products has increased over the past decade.
Financial products and companies may have insurance, banking,
securities, and futures components. One example of this
convergence is AIG. Is the creation of a systemic risk
regulator the best method to fill in the gaps and weaknesses
that AIG has exposed, or does Congress need to reevaluate the
weaknesses of federal and state functional regulation for
large, interconnected, and large firms like AIG?
A.1. NASCUS \1\ members do not have oversight responsibilities
for AIG. The answers provided by NASCUS focus on issues related
to our expertise regulating state credit unions and issues
concerning the state credit union system. Although NASCUS does
not have specific comments related to AIG, the following views
on systemic risk are provided for your consideration.
---------------------------------------------------------------------------
\1\ NASCUS is the professional association of state credit union
regulatory agencies that charter, examine and supervise the nation's
3,100 state-chartered credit unions.
---------------------------------------------------------------------------
It is important that systemic risk that is outside of the
normal supervisory focus of financial institution regulators be
monitored and controlled, but it is also imperative that the
systemic risk process not interfere or add additional
regulatory burden to financial institutions that are already
supervised by their chartering authorities (state and federal)
and their deposit insurers.
Regarding systemic risk, NASCUS believes that systemic risk
and concentration risk can be mitigated through state and
federal regulation cooperation. Regardless of which approach is
selected to mitigate systemic risk, it presents all regulators
with challenges, even those without direct jurisdiction over
the entity representing the risk. By drawing on the expertise
of many regulatory agencies, state and federal regulators could
improve their ability to detect and address situations before
they achieve critical mass.
State regulators play an important role in mitigating
systemic risk in the state credit union system. Congress
provides and affirms this distinct role in the Federal Credit
Union Act (FCUA) by providing a system of ``consultation and
cooperation'' between state and federal regulators. \2\ It is
imperative that any regulatory structure preserve state
regulators role in overseeing and writing regulations for state
credit unions. In addition, it is critical that state
regulators and NCUA have parity and comparable systemic risk
authority with the Federal Deposit Insurance Corporation
(FDIC). NASCUS would be concerned about systemic risk
regulation that introduces a new layer of regulation for credit
unions or proposes to consolidate regulators and state and
federal credit union charters.
---------------------------------------------------------------------------
\2\ The Consultation and Cooperation With State Credit Union
Supervisors provision contained in The Federal Credit Union Act, 12
U.S. Code 1757a(e) and 12 U.S. Code 1790d(l).
Q.2. Recently there have been several proposals to consider for
financial services conglomerates. One approach would be to move
away from functional regulation to some type of single
consolidated regulator like the Financial Services Authority
model. Another approach is to follow the Group of 30 Report
which attempts to modernize functional regulation and limit
activities to address gaps and weaknesses. An in-between
approach would be to move to an objectives-based regulation
system suggested in the Treasury Blueprint. What are some of
---------------------------------------------------------------------------
the pluses and minuses of these three approaches?
A.2. The Treasury Blueprint for a Modernized Financial
Regulatory Structure, presented in March 2008, suggests an
objectives-based approach to address market failures. NASCUS
opposes this approach because it does not recognize the
supervisory, enforcement and rule-making authority of the
states. The suggested prudential financial regulator usurps the
role of the National Credit Union Administration (NCUA) and it
eliminates the National Credit Union Share Insurance Fund
(NCUSIF), a fund that federally insured credit unions
recapitalized in 1985 by depositing one percent of their shares
into the Share Insurance Fund.
The Blueprint would eliminate the credit union dual
chartering system, a system that is based on the important
foundation of competition and choice between state and federal
charters.
Disruption of the current dual chartering structure would
have various negative impacts. It would diminish state and
federal regulator cooperation, tip the balance of power between
states and the federal government and minimize the economic
benefit and enhanced consumer protections available to states
through state-chartered institutions. State legislators and
regulators would no longer determine what is appropriate for a
state-chartered institution.
Q.3. If there are institutions that are too big to fail, how do
we identify that? How do we define the circumstance where a
single company is so systemically significant to the rest of
our financial circumstances and our economy that we must not
allow it to fail?
A.3. While relatively few credit unions fall into the category
of ``too big to fail,'' with the exception of perhaps some of
the larger corporate credit unions, I believe as a general rule
that if an institution is ``too big to fail,'' then perhaps it
is also too large to exist. Perhaps the answer is to
functionally separate and decouple the risk areas of a ``too
big to fail'' organization so that a component area can have
the market discipline of potential failure, without impairing
the entire organization. Financial institutions backed by
federal deposit insurance need to have increased expectations
of risk control and risk management.
Clearly it is important to take steps to reduce systemic
risk and lessen the impact of ``too big to fail.'' Many of the
credit unions that I supervise in Georgia would argue that the
result of having these large institutions with systemic risk is
that when problems arise, they get passed on to smaller credit
unions through increased deposit insurance assessments.
Q.4. We need to have a better idea of what this notion of too
big to fail is--what it means in different aspects of our
industry and what our proper response to it should be. How
should the federal government approach large, multinational,
and systemically significant companies?
A.4. See response to previous question above.
Q.5. What does ``fail'' mean? In the context of AIG, we are
talking about whether we should have allowed an orderly Chapter
11 bankruptcy proceeding to proceed. Is that failure?
A.5. While AIG does not directly relate to the state-chartered
credit unions supervised by NASCUS state regulators, my general
view as a financial services regulator is that institutions
which become insolvent should face market based solutions;
either bankruptcy or some type of corporate reorganization.
Seeking government based solutions under these circumstances
encourages excessive risk taking and creates moral hazard.
------
RESPONSE TO WRITTEN QUESTIONS OF SENATOR KOHL
FROM GEORGE REYNOLDS
Q.1. Two approaches to systemic risk seem to be identified: (1)
monitoring institutions and taking steps to reduce the size/
activities of institutions that approach a ``too large to
fail'' or ``too systemically important to fail'' or (2) impose
an additional regulator and additional rules and market
discipline on institutions that are considered systemically
important.
Which approach do you endorse? If you support approach one
how you would limit institution size and how would you identify
new areas creating systemic importance?
If you support approach two how would you identify
systemically important institutions and what new regulations
and market discipline would you recommend?
A.1. NASCUS \1\ believes that systemic risk can be mitigated
through state and federal regulator cooperation. Regardless of
which approach is selected to mitigate systemic risk, it
presents all regulators with challenges, even those without
direct jurisdiction over the entity representing the risk. By
drawing on the expertise of many regulatory agencies, state and
federal regulators could improve their ability to detect and
address situations before they achieve critical mass.
---------------------------------------------------------------------------
\1\ NASCUS is the professional association of state credit union
regulatory agencies that charter, examine and supervise the nation's
3,100 state-chartered credit unions. The NASCUS mission is to enhance
state credit union supervision and advocate for a safe and sound credit
union system.
---------------------------------------------------------------------------
State regulators play an important role mitigating systemic
risk in the state credit union system. It is imperative that
any regulatory structure preserve state regulators role in
overseeing and writing regulations for state credit unions. In
addition, it is critical that state regulators and National
Credit Union Administration (NCUA) have parity and comparable
systemic risk authority with the Federal Deposit Insurance
Corporation (FDIC).
Systemic risk mitigation should recognize and utilize both
state and federal credit union regulators and draw on their
combined regulatory expertise. NASCUS would be concerned about
a systemic risk regulation that introduces a new layer of
regulation for credit unions or proposes to consolidate
regulators and state and federal credit union charters.
Q.2. Please identify all regulatory or legal barriers to the
comprehensive sharing of information among regulators including
insurance regulators, banking regulators, and investment
banking regulators. Please share the steps that you are taking
to improve the flow of communication among regulators within
the current legislative environment.
A.2. NASCUS does not believe that any regulatory or legal
barriers to the comprehensive sharing of information between
state and federal credit union regulators are insurmountable.
Cooperation exists between state and federal credit union
regulators and they regularly exchange information about the
credit unions they supervise; it is a cooperative relationship.
The Federal Credit Union Act (FCUA) provides that
``examinations conducted by State regulatory agencies shall be
utilized by the [NCUA] Board for such purposes to the maximum
extent feasible.'' \2\ Further, Congress has recognized and
affirmed the distinct roles played by state and federal
regulatory agencies in the FCUA by providing a system of
consultation and cooperation between state and federal
regulators. \3\ It is important that all statutes and
regulations written in the future include provisions that
require consultation and cooperation between state and federal
credit union regulators to prevent barriers that could impede
comprehensive information sharing.
---------------------------------------------------------------------------
\2\ 12 U.S. Code 1781(b)(1).
\3\ The Consultation and Cooperation With State Credit Union
Supervisors provision contained in The Federal Credit Union Act, 12
U.S. Code 1757a(e) and 12 U.S. Code 1790d(l).
---------------------------------------------------------------------------
There are processes established for comprehensive
information sharing. Two examples come to mind: State
regulators signed both a memorandum of understanding with the
Financial Crimes Enforcement Network and a Document of
Cooperation with the NCUA to facilitate the critical
information sharing necessary for regulatory compliance.
The memorandum of understanding sets forth procedures for
the exchange of information between the Financial Crimes
Enforcement Network (FinCEN), a bureau within the U.S.
Department of the Treasury and state financial regulatory
agencies. Information exchange is intended to assist FinCEN in
fulfilling its role as administrator of the Bank Secrecy Act
and it assists state agencies in fulfilling their role as the
financial institution supervisor. It fulfills the collective
goal of the parties to enhance communication and coordination
that help financial institutions identify and deter terrorist
activities.
The Document of Cooperation is the formal agreement between
NASCUS, on behalf of state regulatory agencies and the NCUA,
the federal credit union regulator and administrator of the
National Share Insurance Fund. The purpose of the document is
to show the alliance between state and federal regulators to
work with the common goal of providing solid credit union
examination and supervision.
Both of these documents illustrate the respect and mutual
cooperation that exists between state and federal credit union
regulators.