[Senate Hearing 111-297]
[From the U.S. Government Publishing Office]
S. Hrg. 111-297
ESTABLISHING A FRAMEWORK FOR SYSTEMIC RISK REGULATION
=======================================================================
HEARING
before the
COMMITTEE ON
BANKING,HOUSING,AND URBAN AFFAIRS
UNITED STATES SENATE
ONE HUNDRED ELEVENTH CONGRESS
FIRST SESSION
ON
EXAMINING A FRAMEWORK FOR SYSTEMIC RISK REGULATION
__________
JULY 23, 2009
__________
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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
Edward Silverman, Staff Director
William D. Duhnke, Republican Staff Director
Amy S. Friend, Chief Counsel
Dean Shahinian, Senior Counsel
Charles Yi, Counsel
Julie Chon, Senior International Adviser
Mark Oesterle, Republican Chief Counsel
Andrew J. Olmem, Jr., Republican Counsel
Chad Davis, Professional Staff Member
Dawn Ratliff, Chief Clerk
Devin Hartley, Hearing Clerk
Shelvin Simmons, IT Director
Jim Crowell, Editor
(ii)
C O N T E N T S
----------
THURSDAY, JULY 23, 2009
Page
Opening statement of Chairman Dodd............................... 1
Prepared statement........................................... 59
Opening statements, comments, or prepared statements of:
Senator Shelby............................................... 3
Prepared statement....................................... 59
Senator Johnson
Prepared statement....................................... 60
Senator Reed
Prepared statement....................................... 61
Senator Bunning
Prepared statement....................................... 61
WITNESSES
Sheila C. Bair, Chairman, Federal Deposit Insurance Corporation.. 5
Prepared statement........................................... 62
Responses to written questions of:
Senator Shelby........................................... 98
Senator Reed............................................. 101
Senator Menendez......................................... 105
Senator Bunning.......................................... 106
Senator Crapo............................................ 108
Senator Vitter........................................... 110
Mary L. Schapiro, Chairman, Securities and Exchange Commission... 7
Prepared statement........................................... 69
Responses to written questions of:
Senator Shelby........................................... 112
Senator Reed............................................. 118
Senator Bunning.......................................... 121
Senator Crapo............................................ 124
Senator Vitter........................................... 125
Daniel K. Tarullo, Member, Board of Governors of the Federal
Reserve
System......................................................... 9
Prepared statement........................................... 74
Responses to written questions of:
Senator Shelby........................................... 125
Vincent R. Reinhart, Resident Scholar, American Enterprise
Institute...................................................... 47
Prepared statement........................................... 80
Responses to written questions of:
Senator Shelby........................................... 128
Senator Bunning.......................................... 129
Paul Schott Stevens, President and CEO, Investment Company
Institute...................................................... 48
Prepared statement........................................... 83
Responses to written questions of:
Senator Shelby........................................... 131
Alice M. Rivlin, Senior Fellow, Economic Studies, Brookings
Institution.................................................... 49
Prepared statement........................................... 89
Responses to written questions of:
Senator Shelby........................................... 135
Senator Bunning.......................................... 136
(iii)
Allan H. Meltzer, Professor of Political Economy, Tepper School
of Business, Carnegie Mellon University........................ 50
Prepared statement........................................... 94
Responses to written questions of:
Senator Shelby........................................... 137
Senator Bunning.......................................... 137&
ESTABLISHING A FRAMEWORK FOR SYSTEMIC RISK REGULATION
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THURSDAY, JULY 23, 2009
U.S. Senate,
Committee on Banking, Housing, and Urban Affairs,
Washington, DC.
The Committee met at 9:37 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. I will make some opening comments, turn to
Senator Shelby for his, and then we will invite our very
distinguished witnesses to join us at the witness table, and I
will in advance apologize to them if we interrupt your
testimony once the 12th Member arrives here, to go back into
executive calendar to deal with this legislation.
So let us shift gears, if we can now, to the hearing, and
that is, as I mentioned earlier, a hearing to establish a
framework for systemic risk regulation. Let me just share some
thoughts, if I can. And, again, we have had a lot of discussion
about this subject matter over the last number of months. We
have had some 40 hearings in this Committee since January, not
all of it on this subject matter, but the bulk of the hearings
have been on this whole issue of how do we modernize our
financial regulatory structure not only to address the problems
that have brought us to this point, but also how do we create
that architecture for the 21st century that will allow us to
move forward with innovation and creativity that has been the
hallmark of our financial services sector, and yet once again
restore that credibility of safety and soundness that has been
the hallmark, I think, of our financial services sector for so
many years, and yet collapsed, in the views of many, over the
last number of years, resulting in the economic problems that
so many of our fellow citizens are facing, with joblessness,
with house foreclosures, retirement accounts being wiped out,
and all of the ancillary problems that our economy is suffering
through.
Systemic risk is going to be an important factor in all of
this, and I cannot begin to express my gratitude to my fellow
Members here because, unlike other matters that the Congress is
dealing with, my sense is on this subject matter this is not
one that has any ideology, that I can sense, to it at all. What
all of us want is to figure out what works best, what makes
sense for us here--not that we are going to solve every future
problem. I think we make a mistake if we are sort of promising
what we cannot deliver on. There will be future problems, and
we are not going to solve every one of them. But if we look
back a bit and see where the gaps have been, either, one, where
there was no authority or, two, where there was authority but
it was not being exercised, then how we fill those gaps in a
way that makes sense I think will be a major contribution.
And I want to particularly thank Senator Shelby, the former
Chairman of this Committee, the Ranking Member now. We have had
a lot of conversations together. We do not have a bill ready at
all. There has been a lot of talk at this point. But I get a
sense among my colleagues, as I have discussed the subject
matter with them, that we share a lot of common views about
this, and that is a good place to begin. It does not mean we
are going to agree on every answer we have, but I sense that
the overwhelming majority of us here are committed to that goal
of establishing what makes sound and solid regulatory process.
The economic crisis introduced a new term in our national
vocabulary: ``systemic risk.'' Not words we use much. I do not
recall using those words at all back over the years. It is the
idea that in an interconnected global economy, it is easy for
some people's problems to become everybody's problems, and that
is what systemic risk is. The failures that destroyed some of
our Nation's most prestigious financial institutions also
devastated the economic security of millions of working
Americans who did nothing wrong and never heard of these
institutions that collapsed and put them at great risk. Jobs,
homes, and retirement security were gone in a flash because
Wall Street greed in some cases, regulatory neglect in others,
resulted in these problems.
After years of focusing on short-term profits while
ignoring long-term risk, a number of companies, giants of the
financial industry, found themselves in very serious trouble.
Some, as we know, tragically, failed. Some were sold under
duress. And an untold number only survived because of
Government intervention--loans, guarantees, direct injections
of capital.
Taxpayers had no choice but to step in--and that is my
strong view--assuming billions of risk and saved companies
because our system was not set up to withstand their failure.
Their efforts saved our economy from catastrophe, but real
damage remains, as we all are painfully aware. Investors who
lost billions were scared to invest. Credit markets dried up,
with no one willing to make loans. Businesses could not make
payrolls. Employees were laid off and families could not get
mortgages or loans to buy an automobile, even.
Wall Street's failures have hit Main Street, as we all
know, across our Nation, and it will take years, perhaps
decades, to undo the damage that a stronger regulatory system I
think could have prevented. And while many Americans understand
why we had to take extraordinary measures this time, it does
not mean that they are not angry, because they are. It does not
mean they are not worried, and they certainly are that. And it
does not mean they do not expect us to fix the problems that
allowed this to happen.
First and foremost, we need someone looking at the whole
economy for the next big problem with the authority to do
something about it. The Administration has a bold proposal to
modernize our financial regulatory system. It would give the
Federal Reserve new authority to identify, regulate, and
supervise all financial companies considered to be systemically
important. It would establish a council of regulators to serve
in a sole advisory role. And it would provide a framework for
companies to fail, if they must fail, in a way that does not
jeopardize the entire financial system.
It is a thoughtful proposal, but the devil, obviously, we
all know, is in the details, and I expect changes to be made in
this proposal.
I share my colleagues' concerns about giving the Fed
additional authority to regulate systemic risk. The Fed has not
done a perfect job, to put it mildly, with the responsibilities
it already has. This new authority could compromise the
independence the Fed needs to carry out effective monetary
policy. Additionally, systemic risk regulation involves too
broad of a range of issues, in my view, for any one regulator
to be able to oversee. And so I am especially interested to
hear from our witnesses this morning on your ideas and how we
might get this right.
Many of you have suggested a council with real authority
that would effectively use the combined knowledge of all of the
regulatory agencies. As President Obama has said, when we
rebuild our economy, we must ensure that its foundation rests
on a rock, not on sand. And today we continue our work to lay
the cornerstones of that foundation--strong, smart, effective
regulation that protects working families without hindering
growth, innovation, and creativity that has been, again, the
hallmark, as I said earlier, of our financial services sector.
With that, let me turn to Senator Shelby, and then I will
introduce our first panel.
STATEMENT OF SENATOR RICHARD C. SHELBY
Senator Shelby. Thank you, Mr. Chairman.
At the core of the Administration's financial regulatory
reform proposal is the concept of systemic risk. The President
believes that it can be regulated and that the Fed should be
the regulator. But as we begin to consider how to address
systemic risk, my main concern is that while there appears to
be a growing consensus on the need for a systemic risk
regulator, there is no agreement on how to define systemic
risk, let alone how to manage it.
I believe that it would be legislative malfeasance to
simply tell a particular regulator to manage all financial risk
without having reached some consensus on what systemic risk is
and whether it can be regulated at all. Should we reach such a
consensus, I believe we then must be very careful not to give
our markets a false sense of security that could actually
exacerbate our ``too-big-to-fail'' problem. If market
participants believe that they no longer have to closely
monitor risk presented by financial institutions, the stage
will be set for our next economic crisis.
If we can decide what systemic risk is and that it is
something that should and can be regulated, I believe our next
question should be: Who should regulate it?
Unfortunately, I believe the Administration's proposal
largely places the Federal Reserve in charge of regulating
systemic risk. It would grant the Fed, as I understand the
white paper, authority to regulate any bank, securities firm,
insurer, investment fund, or any other type of financial
institution that the Fed deems a systemic risk. The Fed would
be able to regulate any aspect of these firms, even over the
objections of other regulators. In effect, the Fed would become
a regulator giant of unprecedented size and scope.
I believe that expanding the Fed's power in this manner
could be very dangerous. The mixing of monetary policy and bank
regulation has proven to be a formula for taxpayer-funded
bailouts and poor monetary policy decisions. Giving the Fed
ultimate responsibility for the regulation of systemically
important firms will provide further incentives for the Fed to
hide its regulatory failures by bailing out troubled firms.
Rather than undertaking the politically painful task of
resolving failed institutions, the Fed could take the easy way
out and rescue them by using its lender-of-last-resort
facilities or open market operations. Even worse, it could
undertake these bailouts without having to obtain the approval
of the Congress.
In our system of Government, elected officials should make
decisions about fiscal policy and the use of taxpayers'
dollars, not unelected central bankers. Handing over the public
purse to an enhanced Fed is simply inconsistent with the
principles of democratic Government.
Augmenting the Federal Reserve's authority also risks
burdening it with more responsibility than one institution can
reasonably be expected to handle. In fact, the Federal Reserve
is already overburdened with its responsibility for monetary
policy, the payment system, consumer protection, and bank
supervision. I believe anointing the Fed as the systemic risk
regulator will make what has proven to be a bad bank regulator
even worse.
Let us not forget that it was the Fed that pushed for the
adoption of the flawed Basel II Capital Accords right here in
this Committee which would have drained our banking system of
capital. It was the Fed that failed to adequately supervise
Citigroup and Bank of America, setting the stage for bailouts
in excess of $400 billion there. It was the Fed that failed to
adopt mortgage underwriting guidelines until well after this
crisis was underway.
Yes, it was the Fed that said there was no need to regulate
derivatives right here in this Committee. It was also the Fed
that lobbied to become the regulator of financial holding
companies as part of Gramm-Leach-Bliley. The Fed won that fight
and got the additional authority it sought. Ten years later,
however, it is clear that the Fed has proven that it is
incapable of handling that responsibility.
Ultimately, I believe if we are able to reach some sort of
agreement on systemic risk and whether it can be managed, I
strongly believe that we should consider every possible
alternative to the Fed as a systemic risk regulator.
Thank you, Mr. Chairman.
Chairman Dodd. Thank you very much, Senator, and we are
still missing one, I think. Is it one? One. We need 12. If I
have a colleague that can count 12, I am willing to move ahead
on that.
[Laughter.]
Chairman Dodd. After all, this is Washington, you know. We
will wait for the 12th to arrive.
Let me invite Sheila Bair and Mary Schapiro and Dan Tarullo
to join us at the witness table, and let me briefly introduce
the people who hardly need an introduction. They have been
before this Committee on numerous occasions, and we thank them.
Sheila Bair, as we all know, is our Chair of the Federal
Deposit Insurance Corporation, served as Assistant Secretary at
the Treasury, has an extensive background in banking finance,
and, of course, many of us up here have known her over the
years when she was legal counsel to Bob Dole and did a great
job in that capacity as well, so very familiar with the Senate
as an institution.
Mary Schapiro is the new Chair of the Securities and
Exchange Commission, and prior to her appointment this year,
she served as the CEO of the Financial Industry Regulatory
Authority, or FINRA, also served as a Commissioner of the SEC
during Ronald Reagan's administration, President Bush 41, and
the Clinton administration.
Dan Tarullo--I will finish this and then turn to our
executive session--is the new member of the Board of Governors
of the Federal Reserve System and, again, a familiar figure to
many of us up here, having served in public life on numerous
occasions in the past, including Assistant Secretary of State
for Economic and Business Affairs, before he served as Chief
Counsel for Employment Policy on the staff of our good friend
Senator Ted Kennedy as well, and taught at Georgetown
University Law Center, worked in the Clinton administration. So
we thank you, Dan for your service, as we do yours, Mary, and
Sheila Bair.
[Whereupon, at 9:49 a.m., the Committee proceeded to other
business and reconvened at 9:52 a.m.]
Chairman Dodd. We will now go back to our witnesses. You
have been introduced, and, Sheila, we will begin with you. All
statements, supporting data, materials, and the like that you
think would be valuable for our Committee as we consider
modernization of the Federal regulatory structure, of course,
will be included in the record. That is also true, of course,
of all of our colleagues here as well.
We would like you, if you could, to try to keep those
remarks to 5 or 7 minutes so we can get to the questions as
quickly as possible. 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, I appreciate you holding this hearing. The
issues under discussion today approach in importance those
before the Congress in the wake of the Great Depression. We are
emerging from a credit crisis that has wreaked havoc on our
economy. Homes have been lost; jobs have been lost. Retirement
and investment accounts have plummeted in value.
The proposals put forth by the Administration to address
the causes of this crisis are thoughtful and comprehensive.
However, these are very complex issues that can be addressed in
a number of different ways.
It is clear that one of the causes of our current economic
crisis is significant regulatory gaps within the financial
system. Differences in the regulation of capital, leverage,
complex financial instruments, and consumer protection provided
an environment in which regulatory arbitrage became rampant.
Reforms are urgently needed to close these regulatory gaps.
At the same time, we must recognize that much of the risk
in the system involved financial firms that were already
subject to extensive regulation. One of the lessons of the past
several years is that regulation alone is not sufficient to
control risk taking within a dynamic and complex financial
system. Robust and credible mechanisms to ensure that market
participants will actively monitor and control risk taking must
be in place.
We must find ways to impose greater market discipline on
systemically important institutions. In a properly functioning
market economy, there will be winners and losers, and when
firms--through their own mismanagement and excessive risk
taking--are no longer viable, they should fail. Actions that
prevent firms from failing ultimately distort market
mechanisms, including the incentive to monitor the actions of
similarly situated firms and allocate resources to the most
efficient providers. Unfortunately, the actions taken during
the past year have reinforced the idea that some financial
organizations are too-big-to-fail.
The notion of ``too-big-to-fail'' creates a vicious circle
that needs to be broken. Large firms are able to raise huge
amounts of debt and equity and are given access to the credit
markets at favorable terms without sufficient consideration of
the firms' risk profile. Investors and creditors believe their
exposure is minimal since they also believe the Government will
not allow these firms to fail. The large firms leverage these
funds and become even larger, which makes investors and
creditors more complacent and more likely to extend credit and
funds without fear of losses. ``Too-big-to-fail'' must end.
Today, shareholders and creditors of large financial firms
rationally have every incentive to take excessive risk. They
enjoy all the upside. But their downside is capped at their
investment, and with ``too-big-to-fail,'' the Government even
backstops that.
For senior managers, the incentives are even more skewed.
Paid in large part through stock options, senior managers have
an even bigger economic stake in going for broke because their
upside is so much bigger than any possible loss. And, once
again, with ``too-big-to-fail'' the Government takes the
downside.
To end ``too-big-to-fail,'' we need a solution that uses a
practical, effective, and highly credible mechanism for the
orderly resolution of these institutions similar to that which
exists for the FDIC-insured banks. When the FDIC closes a bank,
shareholders and creditors take the first loss. When we call
for a resolution mechanism, we are not talking about propping
up the failed firm and its management. We are talking about a
process where the failed bank is closed, where the shareholders
and creditors typically suffer severe losses, and where
management is replaced and the assets of the failed institution
are sold off. This process is harsh, but it quickly reallocates
assets back into the private sector and into the hands of
better management. It also sends a strong message to the market
that investors and creditors will face losses when an
institution fails.
So-called ``open bank assistance,'' which puts the
interests of shareholders and creditors before that of the
Government, should be prohibited. Make no mistake. I support
the actions the regulators have collectively taken to stabilize
the financial system. Lacking an effective resolution
mechanism, we did what we had to do. But going forward, open
bank assistance by any Government entity should be allowed only
upon invoking the extraordinary systemic risk procedures, and
even then, the standards should be tightened to prohibit
assistance to prop up any individual firm.
Moreover, whatever systemwide support is provided should be
based on a specific finding that such support would be least
costly to the Government as a whole. In addition, potentially
systemic institutions should be subject to assessments that
provide disincentives for complexity and high-risk behavior. I
am very pleased that yesterday the President expressed support
for the idea of an assessment. Funds raised through this
assessment should be kept in reserve to provide working capital
for the resolution of large financial organizations to further
insulate taxpayers from loss.
Without a new comprehensive resolution regime, we will be
forced to repeat the costly ad hoc responses of the past year.
In addition to a credible resolution process, there is a need
to improve the structure for the supervision of systemically
important institutions and create a framework that proactively
identifies issues that pose risk to the financial system.
The new structure, featuring a strong oversight council,
should address such issues as the industry's excessive
leverage, inadequate capital, and overreliance on short-term
funding. A council of regulators will provide the necessary
perspective and expertise to view our financial system
holistically. A wide range of views makes it more likely we
will capture the next problems before they happen. As with the
FDIC Board, a systemic risk council can act quickly and
efficiently in a crisis.
The combination of the unequivocal prospect of an orderly
closing, a stronger supervisory structure, and a council that
anticipates and mitigates risks that are developing both within
and outside the regulated financial sector will go a long way
to assuring that the problems of the last several years are not
repeated and that any problems that do arise can be handled
without cost to the taxpayer.
Thank you very much.
Chairman Dodd. Thank you very much, Chairman Bair.
Chairman Schapiro.
STATEMENT OF MARY L. SCHAPIRO, CHAIRMAN, SECURITIES AND
EXCHANGE COMMISSION
Ms. Schapiro. Thank you. Chairman Dodd, Ranking Member
Shelby, and Members of the Committee, I am very pleased to be
here today with my colleagues from the Fed and FDIC.
There are many lessons to be learned from the recent
financial crisis, and a key one is that we as regulators need
to identify, monitor, and reduce systemic risk before they
threaten the stability of the financial system.
However, in our efforts to minimize the potential for
institutional failures to threaten the system, we must take
care not to unintentionally facilitate the growth of large,
interconnected institutions whose failure might later pose even
greater systemic risk.
To best address these risks, I believe we must rely on two
lines of defense. First, there is traditional oversight and
regulation. This includes enhancing existing regulations,
filling gaps, increasing transparency, and strengthening
enforcement to prevent systemic risks from developing. And,
second, we should establish a workable macroprudential
regulatory framework and resolution regime that can identify,
reduce, and unwind systemic risks if they do develop.
Closing regulatory gaps is an important part of reducing
systemic risk. If financial participants realize they can
achieve the same economic ends with fewer costs by flocking to
a regulatory gap, they will do so quickly, often with size and
leverage. We have seen this time and again, most recently with
over-the-counter derivatives, instruments through which major
institutions engage in enormous, virtually unregulated trading
in synthetic versions of other, often highly regulated
financial products. We can do much to reduce systemic risk if
we close these gaps and ensure that similar products are
regulated similarly.
In addition to filling gaps, we need to ensure greater
transparency of risk. Transparency helps reduce systemic risk
by enabling market participants to better allocate capital and
giving regulators more information about risks that are
building in the financial system. Transparency has been utterly
lacking in the world of unregulated over-the-counter
derivatives, hedge funds, and dark pools. Additionally, we need
to recognize the importance that vigorous enforcement plays in
sending a strong message to market participants.
As a second line of defense, I believe there is a need to
establish a framework for macroprudential oversight, a key
element of the Administration's financial regulatory plan.
Within that framework, I believe the most appropriate approach
consists of a single systemic risk regulator and a very strong
council.
In terms of a systemic risk regulator, I agree there needs
to be a governmental entity responsible for monitoring our
financial markets for systemwide risks. This role could be
performed by the Federal Reserve or by a new entity
specifically designed for this task. The systemic risk
regulator should have access to information across the
financial markets about institutions that pose significant
risk. And it should be able to monitor whether institutions are
maintaining appropriate capital levels, and it should have
clear delegated authority from the council to respond quickly
in extraordinary circumstances. Most importantly, the systemic
risk regulator should serve as a second set of eyes upon those
institutions whose failure might put the system at risk.
At the same time, I agree with the Administration that the
systemic risk regulator must be combined with a newly created
council, but I believe that any council must be strengthened
well beyond the framework set forth in the Administration's
white paper. The council should have authority to identify
institutions, practices, and markets that create potential
systemic risks and to set standards for liquidity, capital, and
other risk management practices at systemically important
institutions. This hybrid approach can help minimize systemic
risk in a number of ways.
First, a council would bring different perspectives to the
identification of risks that individual regulators might miss
or consider too small to warrant attention.
Second, the members on the council would have experience
regulating different types and sizes of institutions so that
the council would be more likely to ensure that risk-based
capital and leverage requirements do not unintentionally foster
greater systemic risk.
And, third, the council would include multiple agencies,
thereby significantly reducing potential conflicts of interest
and regulatory capture.
Finally, the council would monitor the growth and
development of financial institutions to prevent the creation
of institutions that are either too-big-to-fail or too-big-to-
succeed.
At most times, I would expect the council and systemic risk
regulator to work with and through primary regulators who are
experts on the products and activities of their regulated
entities. The systemic risk regulator, however, can provide a
second layer of review over the activities, capital, and risk
management procedures of systemically important institutions as
a backstop to ensure that no red flags are missed.
To ensure that authority is checked and decisions are not
arbitrary, the council would remain the place where general
policy is set, and if differences remain between the council
and the primary regulator, the more stringent standards should
apply.
For example, on questions of capital, the new systemic risk
framework should only be in a position to raise standards for
regulatory capital for these institutions, not lower them. This
will reduce the ability of any single regulator to compete with
other regulators by lowering standards, driving a race to the
bottom.
And, finally, the Government needs a credible resolution
mechanism for unwinding systemically important institutions.
Currently, banks and broker-dealers are subject to resolution
processes, but no corresponding resolution process exists for
the holding companies of systemically significant financial
institutions.
I believe we have an opportunity to create a regulatory
framework that will help prevent the type of systemic risk that
created havoc in our financial system, and I believe we can
create a credible regulatory regime that will help restore
investor confidence.
I look forward to working with you to address these issues
and doing all we can to foster a safer, dynamic, and more
nimble financial system. Thank you.
Chairman Dodd. Thank you very much, Chairwoman Schapiro.
Dan Tarullo, welcome to the Committee once again.
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. My prepared statement sets forth in
some detail the positions of the Federal Reserve on a number of
the proposals that have been brought before you, so I thought I
would use these introductory remarks to offer a few more
general points.
First, I think the title you have given this hearing
captures the task well, ``Establishing a Framework for Systemic
Risk Regulation.'' The task is not to enact one piece of
legislation or to establish one overarching systemic risk
regulator and then to move on. The shortcomings of our
regulatory system were too widespread, the failure of risk
management at financial firms too pervasive, and the absence of
market discipline too apparent to believe that there was a
single cause of, much less a single solution for, the financial
crisis. We need a broad agenda of basic changes at our
regulatory agencies and in financial firms, and a sustained
effort to embed market discipline in financial markets.
Second, the ``too-big-to-fail'' problem looms large on the
agenda. Therein lies the importance of proposals to ensure that
the systemically important institutions are subject to
supervision, to promote capital and other kinds of rules that
will apply more stringently because the systemic importance of
an institution increases, and to establish a resolution
mechanism that makes the prospect of losses for creditors real,
even at the largest of financial institutions.
But ``too-big-to-fail,'' for all its importance, was not
the only problem left unaddressed for too long. The
increasingly tightly wound connection between lending and
capital markets, including the explosive growth of the shadow
banking system, was not dealt with as leverage built up
throughout the financial system. That is why there are also
proposals before you pertaining to derivatives, money market
funds, ratings agencies, mortgage products, procyclical
regulations, and a host of other issues involving every
financial regulator.
Third, in keeping with my first point on a broad agenda for
change, let me say a few words about the Federal Reserve. Even
before my confirmation, I had begun conversations with many of
you on the question of how to ensure that the shortcomings of
the past would be rectified and the right institutional
structure for rigorous and efficient regulation put in place,
particularly in light of the need for a new emphasis on
systemic risk. This colloquy has continued through the prior
hearing your Committee conducted and in subsequent
conversations that I have had with many of you.
My colleagues and I have thought a good deal about this
question and are moving forward with a series of changes to
achieve these ends. For example, we are instituting closer
coordination and supervision of the largest holding companies,
with an emphasis on horizontal reviews that simultaneously
examine multiple institutions.
In addition, building on our experience with the SCAP
process that drew so successfully upon the analytic and
financial capacities of the nonsupervisory divisions of the
Board, we will create a quantitative surveillance program that
will use a variety of data sources to identify developing
strains and imbalances affecting individual firms and large
institutions as a group. This program will be distinct from the
activities of the on-site examiners, so as to provide an
independent perspective on the financial condition of the
institutions.
Fourth and finally, I would note that there are many
possible ways to organize or to reorganize the financial
regulatory structure. Many are plausible, but as experience
around the world suggests, none is perfect. There will be
disadvantages, as well as advantages, to even good ideas.
One criterion, though, that I suggest you keep in mind as
you consider various institutional alternatives is the basic
principle of accountability. Collective bodies of regulators
can serve many useful purposes: examining latent problems,
coordinating a response to new problems, recommending new
action to plug regulatory gaps, and scrutinizing proposals for
significant regulatory initiatives from all participating
agencies.
When it comes to specific regulations or programs or
implementation, though, collective bodies often diffuse
responsibility and attenuate the lines of accountability, to
which I know this Committee has paid so much attention.
Achieving an effective mix of collective process and agency
responsibility with an eye toward relevant institutional
incentives will be critical to successful reform.
Thank you very much, Mr. Chairman. I would be happy to
answer any questions.
Chairman Dodd. Thank you very much, Dan. We appreciate your
testimony and your involvement with the Committee, as well.
I will ask the Clerk to put on--why don't you put on 6
minutes and try and keep an eye on that. We have got a lot of
participation here this morning and I want to make sure we get
around to people. I have asked the staff to make sure you give
me a very accurate account of the arrival of Members in terms
of the order in which they will be asked to address the
questions to our panel.
Let me begin with you, Governor Tarullo, if I can. I
suspect a lot of the questions I am going to raise for you, you
are going to hear variations of these same kind of questions, I
suspect that sort of a theme will emerge here.
You testified that the Administration's proposal to give
the Fed systemic risk supervision is incremental. It builds on
the robust authority which you already have under the Bank
Holding Company Act, and you also detail your plan for a new
surveillance program, which you mentioned here, for large
complex financial organizations that will look at emerging
risks to the system as a whole.
Now, obviously, we are not speaking about you, because
obviously you are new to this, but given the Federal Reserve's
history and record on this as an institution as we look back,
why should we in this Congress have any confidence in the
Federal Reserve, other than what is being said today, and I
appreciate what is being said today, but given the history of
the Federal Reserve, you can argue that this authority has
already existed. We don't need new authority. It has been
there. Under the Bank Holding Company Act, you have had that
authority for a long, long time. Certainly all the powers are
there, the personnel, the resources to do a job, and yet there
was an abysmal failure when it came to these institutions.
So why at this juncture, and I raise this with you, why
should this Committee or the Congress have any heightened
degree of confidence that the Federal Reserve, having failed in
that function, given the authority for years, should now be
granted expanded authority in that same area?
Mr. Tarullo. Well, Senator, let me say a couple of things
about that. First, as you know, in my prior capacity, I had a
fairly broad-based set of criticisms about the Fed and the
regulatory system as a whole. I continue to believe that when
the final history of the financial crisis is written, there is
going to be a lot of blame to go around to regulatory agencies
and private institutions. This was not a single failing. This
was a broad-based failing at home and, as we have seen,
internationally as well. Let me be clear. I think that includes
an inadequate or flawed approach to supervision at the banking
agencies, including the Fed.
Second, I will say that I think that history shifts.
History shifts and the relative positions of agencies shift
over time. I remember when I was in law school studying this
set of issues that the Federal Reserve was regarded as the most
aggressive of the regulatory agencies and the other agencies
were regarded as somewhat more accommodating. So I think there
is a rhythm that goes with the times, with the leadership of an
agency, and with the general orientation of public policy.
So, since I have gotten to the Fed--actually before that,
since I began having conversations with you and other Members
of the Committee--what I have been trying to determine is the
degree to which the capacity and the resources are present to
do what is in some sense the same job that should have been
done better. But to be honest, in some sense, it is a different
job because I don't think anybody actually was focused on the
systemic part of the problem as much as they ought to have
been. It was a more siloed approach to regulation.
And that is why I also think some changes should be made in
prevailing law so that it is clear that the supervisor of the
holding companies has authority to do examinations of
functionally regulated subsidiaries when it is necessary. Those
sorts of things need to move forward. But, I think more
fundamentally, what has to be done is the kind of thing I
mentioned a moment ago, which is to put in place a system
within the agency that has its own kind of cross-checks,
drawing upon the substantial resources of the agency. There are
substantial resources in the research and monetary affairs
parts of the Board to provide exactly the kinds of information
that will enhance supervision.
And that is, I think, the task which someone is going to
have to perform, Senator, and it is either going to be done by
the Federal Reserve or another agency. It has got to be done
somewhere. My belief is, based upon my 6 months' experience at
the Fed, that under Chairman Bernanke's leadership, it can be
done. But I don't think anyone should underestimate the task
and I would just second something you said in your introductory
remarks. I hope people are not expecting that anything that the
Fed or the SEC or the FDIC or anybody else does is going to
eliminate all potential for systemic risk. That is just not
going to happen. And I think we have got to keep that in mind.
Let me just say one final thing. The Administration's
proposal and other proposals vary in how much authority they
really mean to invest in a particular agency. Back at our March
hearing, you and I talked back and forth a good bit about the
different possible functions of a systemic risk regulator. With
the possible exception of some of the proposals for the council
as they have been described, most proposals don't talk about a
systemic risk regulator. They talk about allocating a
particular set of responsibilities to particular agencies or
collective groups, and I think that is probably the way it
should be.
I really don't think you need or want so much
responsibility, as well as authority, lodged in any one agency
to say, you have responsibility for figuring out anywhere in
the financial system there is a problem and you have authority
to do whatever you think is necessary.
Chairman Dodd. Well, let me--thank you for that. Let me,
Sheila, quickly turn to you for two quick questions and let me
play the devil's advocate, in a sense, in this, as well. And
again, I am still sort of agnostic on this, although I am sort
of leaning toward the council approach, but let me take the
side of the argument that the Administration opposes and raise
it with you. I will give my best shot here in giving their side
of the argument.
This is a new idea we are fooling around with, a council
here, agencies that don't necessarily have the kind of
expertise and background of the Federal Reserve. You are going
to spread this out among a bunch of different agencies so no
one is really in control or authority. The Federal Reserve has
the experience. Yes, they have done a bad job of this over the
years, but historically, they have the capacity, the knowledge,
and so forth to do this. We know about the Fed. You are asking
me to create something that is altogether new and it may not
function well at all to handle the issue of systemic risk, a
very important issue.
Why should I take a leap of faith in something here
creating a whole new entity that may include the Fed, but is
going to have the problem of spreading out the responsibility
in such a way that you will never figure out who is really
running the shop? In a sense, systemic risk will be suffering
terribly. Despite the fact you have given it a nice name, hired
a bunch of nice people, it really will not make the kind of
decisions that you need to have with a single regulator with
the experience the Fed has to do the job. Why is that not a bad
idea?
Ms. Bair. Obviously, we disagree with that. We think a
council needs real teeth and rule-making authority. It needs to
have some real authorities to be highly effective in monitoring
for systemic risk and taking action to address it. The more
eyes you have looking at this from different perspectives, the
better. Clearly the FDIC has a different perspective from the
SEC or the CFTC or the Federal Reserve. So I think bringing
those multiple perspectives together is going to strengthen the
entity, not weaken it.
You are talking about tremendous regulatory power being
invested in whatever this entity is going to be, and I think in
terms of checks and balances, it is also helpful to have
multiple views being expressed and coming to a consensus. We do
a lot of this informally now, but there is no forcing
mechanism. There are a lot of discussions now about OTC
derivatives and trying to harmonize capital and margining
standards. But having a formalized group with a head who is
charged with dealing with those kinds of cross-cutting issues,
harmonizing standards to make sure there is no regulatory
arbitrage, and making sure risk throughout the system is being
appropriated addressed, I think is extremely important.
I think we have a bit of a middle ground in terms of
institution regulation. We would not advocate the Federal
Reserve losing its consolidated supervisory authorities now.
They do that. They are the reservoir for that expertise. To the
extent that there are other systemic institutions that are not
under that prudential framework, we think the council should be
able to make a determination regarding the consolidated
supervision of those entities. But, it would be fine for the
Federal Reserve to be the regulator for those systemic
institutions.
The kind of power that is contemplated in the U.S. Treasury
White Paper, that we think, frankly, is needed, is much better
vested in a council of regulators who I do believe can work
together. The FDIC Board has three different agencies
represented. We make decisions very quickly.
Chairman Dodd. Thank you very much. I was going to ask
you--I will wait for another round on the Consumer Financial
Product Safety Agency idea. I will delay that for later.
Let me turn to Senator Shelby.
Senator Shelby. Thank you, Mr. Chairman.
Governor Tarullo, in your testimony, you appear to fully
endorse the Obama administration's regulatory reform proposal.
I am curious to know if you arrived at this position as a
member of the Board of Governors after conducting an
independent assessment of the plan, which I hope is the case.
Otherwise, it would call into question the so-called
``independence'' of the Fed. Could you provide the Committee
with the data and analysis that you used to make the
determination that the Obama plan was the optimal approach?
Mr. Tarullo. Well, Senator, I actually wouldn't say that
the Board's position is an endorsement of the Administration's
plan. I think what you saw in my prepared testimony which
reflects the position of the Board, is a sense that the
Administration is moving in the right direction on these key
components, that there are obviously lots of details, many of
which, by the way, we don't know and didn't know based on the
white paper and are only beginning to find out as they send up
legislation to you.
Senator Shelby. What about our legislation? They want to
send it up, but don't you think we should be preparing our own
legislation?
Mr. Tarullo. Absolutely. All I am saying is we couldn't
figure out in some cases exactly what one of their proposals
meant, which is why the testimony is phrased in such a way as
to agree with the concept of needing to have every systemically
important institution supervised and needing to have a
resolution mechanism.
As you probably saw, the Fed is certainly not endorsing the
proposal of the Administration to create the new consumer
agency. It is not opposing it, either.
Senator Shelby. Let me get into that a little bit. Safety
and soundness regulation, very important here. In your
testimony, you state there are synergies between the monetary
policy and systemic risk regulation. In order to capture these
synergies, you argue that the Fed should become a systemic risk
regulator, as I understand it. Yesterday, Chairman Bernanke
testified that he believed there are synergies between
prudential bank regulation and consumer protection. This argues
in favor of establishing one consolidated bank regulator.
Do you agree with Chairman Bernanke that there are
synergies between prudential supervision and consumer
protection, and if so, do you believe that the Obama
administration's call for a separate consumer protection agency
would undermine the safety and soundness regulation that we
have?
Mr. Tarullo. Senator, as I said in my introductory
comments, there are multiple ways to organize or to reorganize
financial services regulation. Many times you have got
competing ideas, each of which has merits and each of which has
some demerits.
With respect to the consumer protection issue, the
Administration has made a proposal which I think a lot of
people have some sympathy with because it focuses on consumer
protection. We say we are going to give one agency the
exclusive authority to regulate on consumer matters and thus
they will be 100 percent devoted to doing that.
My testimony is meant only to suggest that there are some
things that would be lost by doing that as well as some things
that would be gained, and what the Chairman, I think, was
suggesting yesterday is that there is a synergy or interaction
between prudential regulation and consumer protection
regulation, at least if they are both being done well. That
synergy is both in the substance of things--that is, having
some sense of what makes an effective consumer protection
regulation because you know the way in which the institutions
operate--but also in the practical sense that as you have one
corps of examiners, there is a certain economy of scope in
having them looking at the multiple sets of issues within the
same organization.
So, I definitely think there are synergies. There are some
benefits that go back and forth. If you take consumer
protection away and put it in another agency, you probably lose
some of those. I guess the Administration's position would be,
yes, but you gain some things along the way.
Senator Shelby. Chairman Bair, the Obama administration's
proposal, as I understand it, would have regulators designate
certain firms as systemically important. You alluded to that
earlier. These firms would be classified as Tier 1 Financial
Holding Companies and would be subject to a separate regulatory
regime.
If some firms are designated as systemically important,
would this signal to market participants that the Government
will not allow these firms to fail? And if so, how would this
worsen our ``too-big-to-fail'' problem?
Ms. Bair. We do have concerns about formally designating
certain institutions as a special class. At the same time, we
recognize there may be very large interconnected financial
entities out there that are not yet subject to Federal
consolidated supervision. I think almost all of them already
are subject to Federal consolidated supervision as a result of
the crisis. But, some type of formal designation, I think, you
would need to think hard about for just the reasons you
expressed.
Any recognition of an institution as being systemic,
though, should be a stigmatizing designation, not something
that is favorable. This is why we do feel so strongly that a
robust resolution mechanism--for very large financial
organizations needs to be combined with any type of new
supervisory entity or to even recognize whether some
institutions may be systemic.
Senator Shelby. Governor, I want to get back on the
consumer protection. I have just got a second. There was
testimony here last week on that, that this would change the
whole model from a classical approach to consumer protection to
a behavioral approach. Have you done some work in that area?
Have you looked at that closely yet?
Mr. Tarullo. Senator, I have to be honest. I am not
altogether sure what that refers to. I can only tell you--
again, based on what I have learned since I have been at the
Fed--the way in which the division there does consumer
protection and generates proposals is one that has a fairly
important behavioral orientation, up to and including the fact
that there is extensive consumer testing done before
regulations are presented to the Board to make sure, for
example, that if what you are trying to do is disclose terms of
a consumer contract, that the kind of terms you are disclosing
will actually mean something to a consumer and be useful to
them.
So in that sense, it is not just a top-down inquiry--how
would the rational person think--but you actually try to
determine how real people really do think.
Senator Shelby. It would put a lot of power in bureaucrats,
would it not?
Mr. Tarullo. To create a----
Senator Shelby. No, if we created something like they
proposed, which I hope we won't, it would put a lot of power in
the bureaucrats.
Mr. Tarullo. Well, it depends, Senator. I mean, obviously,
it depends on the mandate and the scope. That is obviously to
be determined by all of you. I think that people at the Fed
would agree strongly with the proposition that there needs to
be good, solid consumer protection in the financial services
area. Obviously, we also think that should be done in a well-
organized fashion with due process for everyone involved.
Senator Shelby. Thank you.
Chairman Dodd. Thank you very much, and I just point out
that it was, as Jim Bunning has pointed out on countless
occasions and others have, we gave the Fed the authority in
1994 to deal with consumer protection. It took them 14 years to
finally promulgate a single regulation in the area, so I
appreciate the concern about consumer protection.
Senator Reed.
Senator Reed. Thank you, Mr. Chairman. Thank you, Chairman
Bair, Chairman Schapiro, and Governor Tarullo.
I will start with Chairman Bair, but this is a general
question for everyone. As I understand the proposals by the
White House, the OTS would be eliminated, so effectively all
Financial Holding Company regulation would be lodged under the
Federal Reserve, that there would, in fact, be at least a
review and perhaps the elimination of the Unitary Savings and
Loan Holding Company Act. Those institutions would be Financial
Holding Companies under the Federal Reserve.
So direct regulation after this legislation by the Fed
would comprise most of, if not all of, the systemic
institutions, save perhaps some insurance companies that might
be outside, and we have to deal with that, and some very large
hedge funds or maybe not so large hedge funds but operating
very recklessly.
So with that framework, what does the council--how does the
council relate now to a regulator that has full direct
authority, and in fact in the proposal would eliminate the
functional--the deference to functional regulators, so that the
Fed, I think, could look through every part of the institution?
What role does the council play there in that reality, or
should play?
Ms. Bair. I think there are still issues across markets.
Even when functions within the holding company are individually
regulated, there will still be some practices and products that
other nonsystemic institutions may be doing. Mortgage
originations are a prime example. You had a lot of very small
third-party mortgage brokers originating some pretty bad
mortgages that were being funded through multiple sources,
including nonregulated finance companies, Wall Street firms, et
cetera.
So I think that there is plenty of opportunity for risk to
be assessed across the system by any entity in terms of
products and practices. Even within large holding companies,
there will be reservoirs of expertise. There will be expertise
in investment banks and broker-dealers from the SEC. There will
be expertise regarding State-chartered and nationally chartered
banks from the new prudential OCC-OTS regulator and the FDIC.
I think in particular, capital standards--applying them
across the board, making sure that there are no opportunities
for arbitrage going forward--is a very major issue. I think OTC
derivatives, some derivatives, are going to be traded on
exchanges. Some are going to be traded through central
counterparties. Others are still going to be done by OTC
derivative market makers. Seeing how margining and capital
across the system affects incentives, and whether we can all
get together to incentivize more standardized trading, are all
interagency matters that I think cry out for coordination
across agency rule making. I actually see a lot for the council
to do, even preserving the Fed's authority to be an
institutional regulator for major holding companies.
Senator Reed. Just specifically, would the council, in your
view, designate the Tier 1 or the entities----
Ms. Bair. That is tremendous power, to say to an
institution, whether you want to be regulated or not, we are
going to designate you as Tier 1. I do think that that power is
needed, but I think it is better to be exercised by a council
where there would be a diversity of views and some checks and
balances.
Senator Reed. And the council would formally begin the
resolution process?
Ms. Bair. I think we could discuss that. We have been
talking about that a lot internally. I think, certainly for
systemic institutions or institutions where the resolution
might have systemic impact, that might be a role for the
council. On the other hand, to the extent resolution will
involve potential at least short-term assistance, I think the
current approach, what we call the three keys now, the FDIC,
the Fed, the Treasury, in consultation with the President,
might be another model to look at. Those are the three entities
that actually have to put the money on the table, so to speak,
to deal with the situation. That is the way the system works
now. If you rely on that system, though, we think the systemic
risk exception, as I indicated in my testimony, should be
tightened so it is harder, much harder to provide assistance,
at least to individual institutions.
Senator Reed. Let me ask Chairman Schapiro, and I do want
Governor Tarullo to comment, too.
Ms. Schapiro. Thank you. I really agree very much with what
Sheila has said. I think a council is really critical to bring
a diversity of views about the financial markets to the
deliberations of all the regulators and this diversity of views
really does need to reach across equity markets, futures and
derivatives markets, the banking institutions, the clearance
and settlement systems, and across a huge variety of different
products. And if we don't bring the diverse perspectives
together, we run the risk of any one regulator not appreciating
a risk that is developing or not understanding the risk that
may impact other financial institutions for which that
regulator doesn't have direct responsibility.
So I think both the ability to designate the institutions
that need to be subject to additional risk-type regulation and
establish capital standards, liquidity requirements, other risk
management procedures for those institutions, in conjunction
with the primary regulators, is a very important backstop.
Senator Reed. Governor Tarullo, you have 40 seconds. This
is the lightning round.
[Laughter.]
Mr. Tarullo. So, Senator, I think it depends a lot on how
you structure things. I guess one model--maybe this is what
Sheila and Mary are talking about--has the council basically as
the rule-making entity for things that are systemically
important, the designation of the Tier 1, the capital rules, I
assume deposit insurance premiums to the degree that they are
affecting the system, as well, and money market fund
regulation.
And then the question for you, for everybody, is going to
be, do you want a system in which each major regulation that
has systemic importance--as Chairman Schapiro said, something
that will affect regulated entities of the other regulators--do
you want that done formally in a council by a vote of some
sort, or do you want it to be done through a lot of scrutiny, a
lot of discussion, perhaps bringing in outsiders as well as--
those people outside from the Government or from the Congress
as well as from the agencies to ask the hard questions--to
require the agency that has responsibility and accountability
for that regulation to defend it, to make it a better
regulation, but then ultimately to itself have the
responsibility to implement it.
And I think that is the choice, and that is what I was
alluding to earlier in terms of the tradeoff. Do you get the
incentives right?
Senator Reed. Thank you. Thank you, Mr. Chairman.
Chairman Dodd. Thank you, Senator Reed.
Senator Corker.
Senator Corker. Mr. Chairman, thank you, and I thank each
of you for your testimony.
Chairman Bair, I very much, as you know, support your
outlook as it relates to the resolution issue, and I am
surprised at the Administration's proposal and wanting to
continue to support companies that fail, much like is being
done with TARP, and I hope that that will evolve. But let me
just ask you this: On the issue of systemic risk, if there had
been a resolution mechanism in place, would that not have
actually--even though there was risk in the market, would that
not have actually reduced the risk to some degree? In other
words, if you had the appropriate ability to deal with a Lehman
Brothers or an AIG, would that actually have reduced the risk
to the system in the first place?
Ms. Bair. I think it would have, for two reasons. One, if
it had already been in place for some time, I think we would
have had better market discipline across the system. Second,
when the problems hit--and we will always have cycles,
hopefully never as severe as this one, but we will always have
cycles--there would have been a consistent statutory mechanism
in place that could be applied to all of these institutions
which would have reduced market uncertainty about who was going
to be next and who was going to win and who was going to lose.
So I absolutely think it would have reduced risk in the
system going into this crisis if we had had such a resolution
mechanism in place.
Senator Corker. I think that is really a big point. I think
that is something that--you know, we are looking at creating
something new, and I know we will debate that, and we may come
up with the right solution. But the fact of the matter is if we
had just had effective market disciplines in the first place
where there were not entities that were too-big-to-fail, they
could actually fail, the risk itself would have been less, and
I think that is an important point.
Let me ask you another question. I have served on several
public company boards, and certainly not the size of the
companies we are talking about here, but I have been before
lots of them, and each of the board members typically are
respected individuals that have a focus on their own companies,
and I respect people in that position very much. But is there
something we should be thinking about as it relates to boards?
My guess is most board members show up, really do not know,
excuse the language, squat about what is going on inside the
company. It is a nice social event. It is just the way boards
are set up, and most CEOs like it that way.
Chairman Dodd. Is this an admission on your part?
Senator Corker. No, no, no. I was very----
[Laughter.]
Senator Corker. I was not serving on highly social boards,
but, you know, it is a fact. I mean, let us face it. The board
members really, as good as they are, the respected individual,
they have their own companies. They have their own fish to fry
in many cases. They really do not know what is happening inside
these companies, and the greatest regulation would just be
knowing that people are on these boards and they actually
understand what is happening inside the company.
Again, I know most CEOs do not like that much, but I wonder
if you might respond, both Mary and Sheila, to that--excuse me,
Chairman and Chairman, to that.
Ms. Schapiro. ``Mary'' is just fine.
I actually think governance is an enormous issue here, and
I do not think it is by malintention or neglect that so many of
these institutions got into so much trouble. But I do think we
have serious examples of boards that were not paying close
enough attention or did not actually understand the business
the company was in.
I think from the perspective of the SEC, there are a couple
things we want to do about that coming directly out of the
financial crisis. One is we have proposed some new rules that
require much greater disclosure in the proxy when shareholders
get to vote about a board member's qualifications to serve on
that particular board and a risk committee or a compensation
committee or other committee that might require particular
expertise. So we can encourage boards to nominate people to sit
on their boards who actually bring that value to the company.
I think the second big problem is with compensation
schemes. To the extent that compensation schemes in some of
these institutions really incentivize excessive risk taking,
holding boards accountable through better disclosure of
compensation schemes and the link between compensation programs
and risk taking I think will help shareholders do a better job
of holding the boards accountable for how they are utilizing
compensation.
Senator Corker. Thank you.
Ms. Bair. Yes, I think that the direction the SEC is going
is great and much needed. Our own focus with regulated banks,
obviously, where our examiners identify weaknesses in
management, we look to the bank's board of directors. We want
to make sure the board has people who understand banking and
can oversee management, but also really their primary
responsibility is to make sure that the management knows how to
run the bank and will run the bank in a safe and sound manner.
So we have put a focus on this, and I believe the Federal
Reserve has as well at the holding company level. We want real
boards. We want people who are experienced, who know what is
going on in their company, who understand the derivative
positions and the risks they are taking and how their
compensation structures impact risk-taking behavior.
Senator Corker. I know the first question any board member,
a potential board member is asked, the first question they ask
the company is: How much insurance do you have? Right? I mean,
you know, ``I want to be able to be on this board, but I do not
want any liability, and if the insurance is not enough, I am
not coming on.'' And I just think that is something that we
ought to consider as we move ahead, again, not--without any
disrespect to the individuals themselves.
So I think if the resolution had been in place, the risk
would have been less. If we had boards that somehow had some
stake in the game or some different relationship, that would
reduce risk. So let me move back to the notion of a systemic
regulator, which I know we will debate, but what powers, Mr.
Tarullo, if Company A was engaging in buying one side of a risk
in a major way, unintelligently, what would the power of the
systemic regulator be to stop that action?
Mr. Tarullo. Well, Senator, again, it depends on how
Congress would choose to define a systemic risk regulator. If
you are asking could the Federal Reserve deal with it, it would
depend, of course, on whether it was a supervised institution
or not, because if it is not a supervised institution, we have
no authority over them.
Senator Corker. I am talking about--forget all the--just
tell me, I mean, at the end of the day, if you are going to
give a systemic regulator the ability to do something, if they
saw something that was creating a risk, what power would it be
given? I think we would all like to understand. What exactly
would they do in that case?
Mr. Tarullo. So, I think here it is important to draw this
distinction. Right now, if we have a supervised institution,
there is a set of rules and supervisory expectations. There are
rules on leverage, rules on capital, rules on liquidity. They
are supposed to be conforming to those, and if they are
conforming to those, there should be a containment of the kind
of risks you are talking about.
The backup effort there is supervisory examination, which
goes beyond the rules, and if that works well, it identifies
these things, and then allows the supervisor to give guidance
to the firm to say we think you ought to be moving away from
this practice or it creates certain risks.
But I think your question raises an important point, which
is--let us just assume the Administration's proposal on Tier 1
FHCs was enacted--there would still be a substantial universe
of firms out there which would not be regulated by the Fed,
which might be engaging in the kind of practices you are
talking about. Even if no one firm is systemically important,
in the aggregate a practice engaged in by a lot of firms can
still create problems. So you would have to ask who would be
able to regulate that.
Senator Corker. My time is up. I think that answer was
really interesting, Mr. Chairman, from this standpoint:
Nothing--I mean, the answer is nothing. So the notion of having
a single person, a single entity overseeing so they can act
swiftly is not even relevant, because there would be no power.
Again, if it is all conversation, looking, regulation, those
things can be done by a group. And I just think that is worthy
of hearing one of the Governors saying, no action. So----
Mr. Tarullo. Senator, could I just--just slightly amend or
add to what I said. It is important to look to see what those
rules are that prevail. The rules on leverage, the rules on
capital, the rules on liquidity are themselves supposed to be
based upon concepts of risk, and I believe they are based upon
concepts of risk, which should contain these kinds of risks I
mentioned. I think that if you set the rules properly, you have
gotten a fair way down the line to containing risks within
those institutions.
What I was saying before about the backup supervisory
examination authority is there can still be practices that
arise that somehow are evading the rules or are not falling
under the rules, and then you need to determine whether it is
an unsafe and unsound practice and make a judgment about that.
So, I do not think anybody should promise to you that as
soon as any firm starts doing anything dangerous that some
regulator is going to see it and be able to stop it. It is
going to have to evolve over time. If the rules are set right,
you should be containing a good bit of that to begin with.
Chairman Dodd. Thank you very much.
Senator Tester.
Senator Tester. Thank you, Mr. Chairman.
All of you have talked about regulatory gaps and systemic
risk in all of this. Mr. Tarullo, one of the points that you
made was on accountability, you have got to be able--you cannot
diffuse the responsibility. Later on, you talked about silos
and that, and I do not want to put words in your mouth, but you
were opposed to one agency that could determine the problem and
determine the solution to the problem. And I may be wrong in
what I heard in that, but that is what I thought I heard.
You know, we are at a point where we know there are
regulatory failures, and I think there is an opportunity to fix
that. I think that is what the President put forth with this
proposal. But shouldn't we push for further consolidation to
stop the gaps, to allow ourselves to really focus and have that
accountability that you talked in one of your main points, more
consolidation than even here.
Mr. Tarullo. Senator, I keep referring to my prior life,
but it turns out to have been relevant for this job, which I
guess is a good thing. I spent a good bit of time as an
academic looking at the different ways in which countries
structured their regulatory systems, and there are some
countries--the U.K. and Japan notable among them--that have
tried fundamentally to consolidate all financial regulation in
a single entity.
I do not think there is any denying that there are some
advantages to that. You do get some of the cross-pollination of
views. You do balance your incentives to foster the system but
protect, for example, the deposit insurance fund. You get a lot
of those incentives.
I think, though, that many people in those countries would
also say there are downsides to that as well. The advent of the
crisis in the U.K. suggested to a lot of people that that model
was not a fail-safe either.
I should say the Fed does not have a position on more
consolidation, less consolidation. But just as a kind of policy
observation, I think there would be gains to trying to get more
focus and consolidation so that you have some sense of who is
accountable for what. But I think most of us--and I suspect all
three of us at the table here--would also agree that some
measure of redundancy is actually not a bad thing; that is,
sometimes, you want accountability, but sometimes it is not the
worst thing in the world to have multiple pairs of eyes, and
even somewhat overlapping authorities.
Senator Tester. I would agree with that, but then what
happens with the instrument that is developed that has no
regulation and falls in those gaps that we talked about and
then everybody says it was----
Mr. Tarullo. I think that is a very good point, and so I
think the question for you will be: In the architecture that
you all may choose to legislate, do you provide that somewhere
there is going to be a residual or default authority to address
the unanticipated?
Senator Tester. OK. Chairman Bair, the Administration
proposes factoring in a firm's size and leverage and the impact
its failure would have on the financial system and the economy
when determining if a firm is systemically important. It is
kind of a two-edged sword once again, but if the firm size is--
and the metrics are developed around that--and we can talk
about what those metrics might be, and we might if we have
time. But wouldn't that provide--from a safety standpoint,
wouldn't that provide a competitive advantage for those bigger
banks versus the community banks if, in fact, their size and
leverage determined them to be--they cannot fail, so we are
going to make sure that they do not through the regulation?
Ms. Bair. Well, we think any designation of ``systemic''
should be a bad thing, not a good thing. That is one of the
reasons why we suggest there should be a special resolution
regime to resolve large, interconnected firms. It is the same
as the regime that applies to small banks. Also, they should
have to pay assessments to prefund a reserve that could provide
working capital if they have to be resolved.
We are not sure you need a special Tier 1 category. We
think the assessment, for instance, could apply to any firm
that could be systemic, perhaps based on some dollar threshold
or some other criteria that could be used as a means of the
first cut of who should pay the assessment. But you are right,
if you have any kind of systemic determination, without a
robust resolution authority--and, again, we think assessments
for a prefunded reserve would be helpful as well--it is going
to be viewed as a reward. It is going to reinforce ``too-big-
to-fail,'' not end it, and you want to end it.
Senator Tester. So I am not tracking as a consumer. How
would you stop it from being a reward and not----
Ms. Bair. You would need a resolution mechanism that works.
So if they become nonviable, if they could not exist without
Government support, the Government would not support them. They
would close them. They would impose losses on their
shareholders and creditors. The management would be gone, and
they would be sold off. That is what we do with----
Senator Tester. So too big----
Ms. Bair. ----smaller banks.
Senator Tester. Excuse me, but ``too-big-to-fail'' would go
away?
Ms. Bair. Well, I hope so. I certainly hope so. I think
that should be the policy goal. Right now it was a doctrine
that fed into lax market discipline that contributed to this
crisis. I think the problem is even worse now because, lacking
an adequate resolution mechanism, we have had to step in and
provide a lot of open bank assistance.
Senator Tester. And I have heard from other participants,
and I would just like to get your perspective. They would go
away by increased regulation----
Ms. Bair. No. I think ``too-big-to-fail'' would be
addressed by increased supervision combined with increased
market discipline, which we think you can get through a
resolution mechanism.
Senator Tester. Thank you.
Thank you very much.
Senator Johnson. Senator Johanns.
Senator Johanns. Let me just say this has been just a very,
very interesting discussion. I appreciate you being here. I
will tell you what I said a few weeks back, maybe a couple
months back. I tend to favor the council. The idea of the
Federal Reserve I think is just fraught with a lot of problems,
so at least today that is where I am thinking about this.
But the discussion today has really raised, I think--in my
mind at least--some very important fundamental questions. It
seems to me if you have a council, Chairman Bair, I would tend
to agree with you that the council would designate who is
classified as somebody who would fit within this. But that
raises the issue: How broad is that power? Which probably
brings us back to even a more fundamental question of what are
we meaning by systemic risk.
Is that an institution that is so entangled with the
overall economy that if they go down, it could literally shake
the economy or bring the economy down? Is that what we are
thinking about here?
Ms. Bair. I think you are, and I think it should be a very
high standard. I also believe through more robust regulation,
higher standards for large, complex entities, a robust
resolution mechanism, as well as an assessment mechanism, that
you will provide disincentives for institutions to become that
large and complex as opposed to now where all the incentives
are to become so big that they can basically blackmail us
because of a disorderly resolution. This is one of the things
that we lack, a statutory scheme that allows the Government the
powers it needs to provide a resolution on an orderly basis. It
rewards them for being very large and complex.
Senator Johanns. So under that analysis, very, very clearly
you could have a large banking operation fall within that. But
you could also have a very large insurance company fall within
that.
Ms. Bair. You could. That is right.
Senator Johanns. You could have a very large power
generating company fall within that. What if I somehow have the
wealth and capital access to start buying power generation, and
all of a sudden, someday you kind of look up and I own 60
percent of it. Now, that is a huge risk to the economy. If I go
under, power generation is at risk. Is that what we are talking
about?
Ms. Bair. No. I think we are talking about financial
intermediaries. There are things that need to be addressed with
respect to financial intermediaries such as the reliance on
short-term liabilities to fund themselves as well as the
creditors, and the borrowers, who are dependent on financial
intermediaries for continuing credit flows. So there are things
that are different about financial intermediaries that make it
more difficult to go through the standard bankruptcy process,
which can be uncertain. You cannot plan for it. The Government
cannot plan for it. They cannot control the timing for it, and
it can be very protracted and take years. And the banking
process is focused on maximizing returns for creditors as
opposed to our resolution mechanism, which is designed to
protect insured depositors, but also to make sure there is a
seamless transition so there are no disruptions, especially for
insured depositors, but also for borrowers. Through that
process, through the combination of the supervisory process
plus our legal authorities for resolution, we are able to plan
for these failures and deal with them in advance. And I would
assume that this would be the same situation you would have--as
Senator Reed pointed out, with the Federal Reserve that
virtually regulates almost every financial holding company
already. Certainly if you do away with the thrift charter, that
would be the case.
I would also say that I really do not think a very large
plain-vanilla property and casualty insurer would be systemic.
I think AIG got into trouble because it deviated from its
bread-and-butter property and casualty insurance and went into
very high-risk, unregulated activities. But if you penalize
institutions for being systemically significant, you will
reinforce incentives to stick to your knitting, stick to more
basic lower-risk activities as opposed to getting into the
higher-risk endeavors that can create systemic risk for us all,
as we have seen.
Senator Johanns. Chairman Schapiro, do you agree with that?
Ms. Schapiro. I do agree with that. I think if you have an
adequate resolution mechanism that the marketplace understands
will, in fact, be used, it can cancel out effectively the
competitive advantage that might be perceived to exist for an
institution that is systemically important and, therefore, the
Government will not let it fail. If people understand in the
marketplace the institutions will be unwound, they will be
permitted to fail, then they should not have that competitive
advantage that ``too-big-to-fail'' would give them.
I also think that a council will be much better equipped to
make an expert judgment across the many different types of
financial institutions that we have in this country about which
ones are systemically significant and important.
Senator Johanns. Governor, what are your thoughts?
Mr. Tarullo. Senator, I guess I basically agree, but maybe
with a couple of qualifications. I think that the resolution
mechanism is an important component of any program to address
``too-big-to-fail.'' But as with each of the other components,
I do not think we should look at it as a panacea. This is not
something that we have done before. It is something we think
needs to be done. And I agree with Senator Corker's earlier
observation that if it had been in place before, it would have
reduced risk. But note, he did not say eliminate the risk and
eliminate the problem, and I agree with that.
I think you are going to need a good, sound resolution
mechanism. I think you are going to need other mechanisms to
enhance market discipline as well--the capital structure of the
firm, for example. And I think you are also going to need
sound, transparent regulations because I do not think going
forward we can rely on any one instrument. We are going to have
to rely on a set of instruments to try to contain this problem.
Senator Johanns. My time has expired, but if I could just
offer this thought: I think the Chairman is absolutely right. I
do not notice any political agenda here. I do not think it is a
partisan sort of thing we are trying to come to grips with. My
hope is that as we start working through this and putting pen
to paper, the Administration will look at this from the
standpoint of there are a lot of ways of dealing with this
problem and preventing what happened and avoid locking down on
just a single approach, like it has got to be the Federal
Reserve or it cannot be anything, because I do think you can
come at this from a number of different angles. But having said
that, I will again reiterate I am hoping at some point we can
move beyond the ``who manages this'' and resolve that issue,
because there are some very, very important issues about who
does this apply to. What are the unintended consequences of
trying to define that? And I think that is where you really get
into where the rubber meets the road here, is how you structure
this in a way that makes sense, that deals with the problem,
without going off on a cul-de-sac that really is not where we
want to be today.
Thank you, Mr. Chairman.
Chairman Dodd. Well, let me just say--and I appreciate my
friend and colleague's comments, because he is on track and I
agree with him. And my sense is with the Administration as well
that this is a dynamic process. They are sending up ideas and
proposals to us, and that is as they should do, I suspect. But
my sense of it is as well that I do not get a locked down view
on this.
So I think we are still very much in that dynamic process
of thinking through these ideas, and you are absolutely
correct, we are spending a lot of time on the who. But Bob
Corker raised, I think, an important question that I have
raised any number of times. It is not just the who but what.
What powers? Just identifying who is going to be a systemic
risk is an important question, but what powers are you going to
give them is an equally important question, if you are going to
give them any powers at all, in a sense.
So I think there are a lot of really important issues, and,
again, I am very optimistic about the process that we have in
place here for arriving at some of these answers. So I thank my
colleague very much for his observation on that.
Senator Bennet of Colorado.
Senator Bennet. Thank you, Mr. Chairman. I want to pick up
right where you left off and where Senator Johanns left off,
because I think--it is, by the way, a fascinating conversation.
I appreciate all of you being here today. I think this is
fraught with incredible amounts of potential unintended
consequences, and we need to be enormously careful about
keeping our mind or our focus on what is the problem that we
are trying to solve here, because I am enormously skeptical of
our ability to predict--or the regulatory agency's ability to
predict these economic cycles and then to be able to respond in
a way that does not actually compound the problem that we are
facing. I think we have just seen 20 years of leverage piling
up on our system and lack of attention to that that has led to
the destruction of, you know, our economy and the dreams of a
lot of people who live in my State and other States.
I fully agree that we need to--that having resolution
authority in place would have made an enormous difference in
this case and kept us out of the Alice in Wonderland world that
we are in now where we are having conversations here about how
people get paid in private institutions where the taxpayer has
actually had to come to the rescue of firms that we should
never have had to rescue. I think both the Fed Chairman and the
Treasury Secretary have been doing good work trying to get us
out of here, and I think they are right to say that we were
left with an assortment of terrible choices and we took the
least bad. And I think our objective here needs to be to make
sure we never find ourselves in that place again.
I guess the question that I have for you, Chairman Bair, is
when you talk about a council--and, again, I do not have
anything against a council or any of this, and it might help.
But when you talk about a council that anticipates risk, I
think I get that. I am a little skeptical, but I get it. You
also talked about a council that mitigates risk. Could you tell
us more about what that means, if you would put some flesh on
those bones for us?
Ms. Bair. Mitigate or reduce risk--you cannot get risk
completely out of the system. We are a capitalist system, so
there has got to be some risk and return. But I think excessive
risk perhaps would be a better example.
In terms of the powers of the systemic risk council, I
would put prudential requirements at the top of my list, and
requirements for capital and margining and other constraints on
leverage. There was too much leverage that had been built up on
the system, and we believe that this council should have the
authority to set minimum standards.
For example, if the council decides that the FDIC is not
setting high enough capital standards for its banks, or if the
Federal Reserve is not setting high enough standards for its
bank holding companies, or having high enough standards for the
quality of capital, the council could step in and raise those
standards.
So I think there are some checks and balances as well that
you get that you may not with vesting all this power in one
single entity.
Senator Bennet. That is an interesting idea, and would the
effect of that be to remove some of the risk of regulatory
capture of the other agency?
Ms. Bair. I think that is exactly right.
Senator Bennet. This is a question for the panel generally.
One thing we have learned in this economic crisis is that the
United States economy is in no way isolated from the rest of
the world. As we think about this set of new laws and
regulations, how should we think about how we connect to the
rest of the world and the regulators connect to regulators
across the globe?
Ms. Bair. Well, I think we should lead the world. I do not
think we should wait for the rest of the world, or we could be
waiting a very long time--at least in my limited experience
with some of these international groups. I think especially on
resolution authority they are looking to the United States to
define the model. So I think you should seize the moment and
forge ahead and lead, not follow, because I do think there are
still a lot of folks looking to us for leadership, and I think
we can help define what the international standards ultimately
will be.
Senator Bennet. Mr. Chairman, I will end just by saying
that I hope that whatever it is we arrive at here and whatever
we do, the Administration leads toward a bias that when firms
need to fail, they fail, and we can make sure we do that in an
orderly way and that we are not ever again in the circumstance
we are in today, which is to prop up institutions simply
because we had no other good choice.
These were problems that were avoidable, and it is just a
shame that the taxpayers have found themselves where we are.
Thank you, Mr. Chairman.
Chairman Dodd. Thank you very much, Senator. I couldn't
agree more, and the point has been made by several, the options
being, one, to pour billions in or to collapse them. There have
to be alternatives within those two bookends that give us far
more flexibility to respond to these situations. If we don't do
anything else, I think a resolution mechanism is going to be a
tremendously important contribution to this.
And again, I think as I listen--as the Chair of this
Committee, my job is in part to listen to all of my
colleagues--and as I listen to this, while we haven't settled
on a process yet, I am certainly beginning to sense a consensus
developing around the importance of that issue, so I thank my
colleagues and thank Senator Bennet for raising that issue
again.
Senator Bunning.
Senator Bunning. Thank you, Mr. Chairman. I would like to
ask unanimous consent to enter my opening statement into the
record.
Chairman Dodd. Yes, and I would ask that of all my
colleagues, as well.
Senator Bunning. OK. Chairman Bair, I have asked you this
question before and probably will ask you again. When do you
expect to end the Temporary Liquidity Guarantee Program?
Ms. Bair. October 31.
Senator Bunning. For sure?
Ms. Bair. For sure, yes. All indications are that we will
be able to exit the program, yes. The guaranteed balances are
down. Use of the program is down significantly. And yes, I
anticipate we will be in a very good position to exit October
31.
Senator Bunning. Good. This is for all of the witnesses.
This question has two parts. As I have said before, I doubt we
can create a regulator that will be able to see and stop
systemic risk. So the first question for each of you is, if you
really think Government can assemble a regulator that will not
be outsmarted by Wall Street, first of all--in other words, can
the Government really understand what the financial industries
are doing and spot the risk ahead of time, or at least as they
are happening?
And second, it seems to me a more practical and effective
way to limit the damage firms can do is to limit their size and
exposure to other firms, in other words, the interaction
between major firms. That also has a benefit of allowing the
free markets to operate, but within reasonable limits.
My question for each of you is do you agree with that, and
answer also the first one, if you will. You can all take a shot
at it, in no order.
Ms. Bair. I will be happy to. Look, we can have better
quality regulation. We can have more even regulation. But
regulation will never correct all of this. You need more robust
market discipline, which is why we really need an effective
resolution mechanism. The market will then understand that when
these institutions get into trouble, those who invested with
them or extended credit to them are going to take losses.
On the interconnectedness and exposures, yes, Senator, I
think you are absolutely right to focus on that. One thing we
suggest in our testimony that would be an area ripe for
consideration through a council, if it is formed, would be
whether there should be some limits on the firms' reliance on
short-term liabilities.
Senator Bunning. Well, shouldn't we include everything,
though?
Ms. Bair. Well, I think----
Senator Bunning. In other words, we are talking about
things that are not regulated at all. Secretary Chairman Reed
and myself are having hearings on those things outside the
regulatory bodies right now.
Ms. Bair. Right. So I think you are right. The
relationships of financial intermediaries to other entities in
the economy, stress testing those on a marketwide basis, are
all things that require a lot of interagency cooperation and
something that the council would be well-equipped to provide.
You are absolutely right. Interconnectedness is a key
indicator of systemic risk and it is something, I think, we can
do a better job addressing through regulation in containing
risk.
Senator Bunning. Ms. Schapiro.
Ms. Schapiro. Senator, I think we can do better as
regulators. We will never be perfect, but we can certainly do
better.
Senator Bunning. We all know that, so you don't have to----
[Laughter.]
Ms. Schapiro. I thought self-confession was helpful here.
[Laughter.]
Ms. Schapiro. I think we can constrain risk taking through
heightened capital requirements, more effective capital
requirements, margin.
But I really want to address your second question because I
think it is particularly important in the context, for example,
of over-the-counter derivatives, which trade in the hundreds of
trillions of dollars on a bilateral or counterparty to
counterparty basis, without transparency, without in many
instances sufficient margin or collateral behind those
positions.
Senator Bunning. Our markets, they just trade.
Ms. Schapiro. Exactly right. And so the goal of moving as
many of those transactions onto central clearing platforms so
that we take out the counterparty risk and remove the bilateral
nature of those contracts so a clearinghouse is interposed
between all the parties, I think would do an enormous amount to
reduce the systemic risk and reduce the exposure of financial
institutions to each other----
Senator Bunning. Just by registering?
Ms. Schapiro. By clearing them through a central----
Senator Bunning. Clearing.
Ms. Schapiro. ----through a central clearinghouse.
Senator Bunning. OK. Mr. Tarullo.
Mr. Tarullo. Senator, with respect to the first part of
your question, I would agree and go further, actually. I think
part of what we have observed is not only that Government
observers can't figure out every instance of systemic risk, but
market participants themselves are sometimes unaware of the
fact that they are engaging in practices that are subject to
the domino effect of everything falling down.
I don't think that means we should give up. I think it
means we have to go into the exercise with a realistic sense of
what you can and cannot accomplish. You are going to have false
positives and you are going to have false negatives, which
means that there needs to be a certain modesty associated with
the exercise. But I do think that with efforts to quantify--to
get data in a standardized form where you see the amount of
leverage building up in different parts of the economy--you can
take some steps down the road.
Your interconnectedness point, I think, is critical. That
is why we suggested in the prepared testimony that in thinking
about capital regulation for larger firms, one should try to
devise a metric that looks at interconnectedness, that looks at
the very things that create systemic risk, rather than just
replicate the siloed approach to capital regulation we have had
in the past.
Senator Bunning. Let me get my last question in, and this
is for Sheila. All the largest institutions, financial
institutions, have international ties, or at least most of
them, and money can flow across borders very easily. AIG is
probably the best known example of how problems can cross
borders. How do you deal with the risk created in our country
by actions somewhere else as well as the impact of actions on
the U.S. markets themselves?
Ms. Bair. Well, I think the international component of this
is very difficult, and that is why I said earlier, I think we
should try to lead and set the standards which then we can try
to leverage into international agreements, especially when
these large institutions get into trouble. The FDIC cochairs a
working group with the Basel Committee to address the situation
where a U.S. firm with large international operations gets into
trouble, or vice-versa.
One advantage we have here in the United States is that we
require banks to be chartered here--organized under our laws,
insured separately, and regulated as if they were domiciled
here. So there is some insulation for U.S. customers of those
entities if they get into trouble.
We do not require the opposite, though--that our banks and
financial institutions doing business overseas must be
organized separately. So we suggest in our written testimony
that this might be something to think about. Clearly, with
greater legal autonomy and organization within each of these
home jurisdictions, if the entity does get into trouble, it
makes the resolution a lot simpler.
Senator Bunning. Thank you very much, Mr. Chairman.
Chairman Dodd. Thank you very much, Senator.
Senator Brown.
Senator Brown. Thank you, Mr. Chairman.
I want to follow--thank you all for joining us and thank
you, each of you, for your public service in very trying,
difficult times.
I want to follow up on Chairman Dodd's discussion or
allusion to the powers given to the systemic risk regulator. I
was intrigued by Senator Bunning's statement that we not be
outsmarted by Wall Street and that we in the Senate not be
outsmarted by Wall Street, that you as regulators in the
structure we build not be outsmarted by Wall Street.
And I think sort of the longer time you spend here
watching, whether it is the financial system or the health care
system or anything else, history is replete with industry
always trying to, in some sense--not accusing of illegality,
but in some sense staying ahead of the sheriff, that they are
always trying to find a way around whatever rules we write,
whether it is health insurance companies gaming the system and
we try to write rules for them or whether it is financial
institutions or anything else in the whole regulatory system
structure that we have built.
I ask you, and I would start with Mr. Tarullo, but I would
like all of you to just comment on it. Give me sort of a
prescriptive walk-through of what, in fact, we are able to do
with the--what kind of powers the systemic risk regulator
should have to prevent another mortgage meltdown. Be as
specific as you can walking through for us in very
understandable terms about what kind of powers the systemic
risk regulator has to prevent those kind of market meltdowns,
if you would.
Mr. Tarullo. So Senator, again, I just want to qualify the
notion of systemic risk regulator, because again, it depends on
how many of those powers you invest in a particular agency. I
would say, getting at Senator Dodd's perspective, as to where
the powers ought to be. I think you are going to need simple,
straightforward but strong rules to get at things like leverage
for precisely the reason you said. If you try to go too
activity-specific, you are always going to have people
arbitraging and trying to do something that accomplishes the
same end. So one has to look to overarching rules that provide
some constraint upon it. I would say that is number one.
Number two, I think you do have to have an adaptable set of
regulators and supervisors who are looking at emerging
practices and are able to--and have the backup authority to act
against those practices.
Number three, and I guess I would say in the consumer
protection arena, I think that there--most importantly of all--
you probably needed a change in attitude. I think--again, as an
academic, teaching through the 2000s--during that period, I
just didn't see an enormous amount of interest in financial
services consumer protection, frankly, at any of the financial
regulatory agencies. There was, as Senator Dodd pointed out,
power to take action. There was certainly examination
authority. Each of the agencies had things they could have
done. Perhaps not everything. They couldn't have stopped some
things, but could certainly have stopped a lot. So, I actually
do think in the consumer protection area the basic problem is
one of attitude, orientation, and leadership.
Senator Brown. Would you--and I want to hear from the two
Chairs, too, but would you in writing discuss with me, because
I want to get to them, what you mean by change in attitude, and
more importantly, how we get there, how we----
Mr. Tarullo. Sure.
Senator Brown. Just send me a letter about that----
Mr. Tarullo. Happy to.
Senator Brown. ----if you would think about it and come up
with it.
Mr. Tarullo. Yes.
Senator Brown. OK. Chairman Schapiro.
Ms. Schapiro. Thank you. Well, I would agree with you. It
is always a challenge for regulators to keep up with the latest
financial innovation and the latest trading practices, product
designs from Wall Street. I would say, I think to some extent,
Wall Street outsmarted itself over the last couple of years and
not just the regulators, which is why, through a lack of good
risk management procedures, perhaps a lack of understanding
entirely the nature of the businesses they were engaged in or
the degree to which they were dependent upon counterparties is
significant contributors to the situation.
I think there are a few things we can do and we really must
do. We have got to bring unregulated products under the
regulatory umbrella. I talked already about OTC derivatives and
I won't go back through that, but I think it is a very
significant gap.
I think we have to be much more robust about capital
requirements and risk management procedures within the firms.
We have to have regulators who are willing to be skeptical
every single day and every hour of every day about the quality
of risk management procedures within the firms that we are all
responsible for regulating.
I think we have to have an across-the-board commitment to
much more robust stress testing so that we are thinking more
about the huge impact but low probability events and factoring
that into how we go forward with our regulatory programs.
And to refer back to something we talked about with Senator
Corker, I think we need to find ways to encourage more engaged
and knowledgeable boards in these financial institutions.
Senator Brown. OK. Chairman Bair.
Ms. Bair. Specifically focusing on the resolution
mechanism, under the regime we would suggest going forward, a
Wall Street firm couldn't come and ask for assistance from the
Government without submitting to a resolution procedure,
meaning that they would be closed. So I think that they will
stop asking, number one, if that is the tradeoff.
I do agree that there has been some Balkanization of
regulatory responsibility . That is why we think a council with
ownership and a clear statutory mandate to be responsible for
the system, addressing systemic risk, and getting ahead of
systemic risk, will help change that attitude. It would get us
all working together as opposed to saying that it is not really
my agency's responsibility.
I do think the ability of the council to set minimum
standards, as well, will be an important check against
regulatory capture or perhaps a lax attitude. That is another
feature that could create a more robust regulatory environment.
Senator Brown. Thank you. Thank you, Mr. Chairman.
Chairman Dodd. Thank you very much, Senator.
Senator Crapo.
Senator Crapo. Thank you, Mr. Chairman, and Chairman Bair,
I am going to focus most of my questions on you, although I
may, if I have time, be able to get to the others on the same
issue.
I am going to focus on the resolution authority issue
again. I know that you have proposed that the resolution
authority be with the FDIC and that it be expanded to bank
holding companies and there is a bit of a discussion as to how
broadly it should be expanded and where this authority should
reside, or should be placed.
But when you look at the issue of the need for a resolution
authority, we have, first of all, the fact that right now, we
only have resolution authority for banks. You indicated that we
should expand that to bank holding companies. We also have the
issue or a piece of the issue that Senator Bunning raised with
regard to international holdings and what we deal with when we
have American institutions that have acquired sometimes dozens
if not hundreds of foreign subsidiaries and how we deal with
those kinds of jurisdictional issues.
I would just be curious as to your thoughts about where
should the resolution authority be placed--I think I know the
answer to that--but also how broad do we need to be in terms of
the establishment of such resolution authority.
Ms. Bair. Well, as you said, for bank holding companies,
the FDIC would like to be the resolution authority simply
because we already are for the insured depository institutions
and you need a consistent single unified resolution regime. For
other types of entities, if Congress wanted to give us that
authority, we would take it. We are really the only place where
this very specialized expertise resides. We have closed over
3,000 institutions throughout our existence, small ones, large
ones, and we have the staff and the ability to ramp up very
quickly, as we have done over the past 18 months and have in
the past. Institutionally, this is what we are equipped to do,
so I think it would make some sense.
The international component of this is very difficult and
we think that this will be a multiyear process to get some of
these institutions in shape where their resolution could be
much more streamlined. One of the things we suggest in my
written testimony, it is also suggested in the Administration's
white paper, is to require these large institutions to have
their own will, so to speak. They need to have their own
liquidation plan that they would update, say, on a quarterly
basis. The plan would also be facilitated by having greater
legal separateness among the functional components. Part of the
problem is these functional components are so intertwined, so
deposits you may get overseas may be funding assets in the
United States. Trying to tease all of that out in an orderly
fashion is difficult. So we do think there is some
infrastructure that needs to be put in place here.
By designating some entity as the resolution authority, it
will facilitate international discussions. We are doing that
now, but we just have the bank piece of it. I think whoever is
designated with the resolution authority would be the entity
that could negotiate agreements with other jurisdictions and
have systems and agreements in place to deal with situations
where an internationally active organization gets into trouble.
Protocols would be in place to deal with that situation.
Senator Crapo. Would expansion of the authority at FDIC to
include bank holding companies have allowed you to reach to
Lehman Brothers and AIG?
Ms. Bair. Well, yes, theoretically it could have. AIG was a
thrift holding company. Assuming that you expanded the
authorities to both bank and thrift holding companies or the
charters were collapsed under Federal Reserve jurisdiction,
requiring everybody to become a bank holding company, yes, it
would.
Senator Crapo. And then where would we stop--or, I guess,
is expansion to bank holding companies sufficient? I am
thinking we have insurance companies, hedge funds----
Ms. Bair. Right.
Senator Crapo. ----private equity firms, mutual funds,
pension funds----
Ms. Bair. Yes.
Senator Crapo. How broadly do we need to reach?
Ms. Bair. Yes. Well, again----
Senator Crapo. What is the systemic system that we are
talking about here?
Ms. Bair. We would not want the FDIC to decide that. I
think that is something that the Systemic Risk Council really
would be best equipped to do. And also, our process does not
contemplate that the FDIC would be the authority to decide to
close the entity. That could be done a couple of different
ways. One would be through the systemic risk process we have
now. If it is a holding company, it could be done by the
Federal Reserve Board as the primary regulator of the bank
holding company. That is the way the process works now. The
primary regulator makes the decision to close the institution--
that is frequently done in consultation with us--but then
appoints us as a receiver.
Senator Crapo. Do you think it would be adequate to simply
extend jurisdiction to bank holding companies?
Ms. Bair. That would be an option if you wanted to do
something quickly. As I said before, I am concerned that we are
not out of the woods yet, and as the market starts to
differentiate between weak and strong and we exit these
Government programs, we may be back in the soup. I hope that is
not the case, but I am not sure.
I think as an interim measure, you could very easily extend
our authority to bank holding companies. This approach would
not require Congress to address systemic risk or anything else.
I think we would still need to do address systemic risk down
the road. But yes, this could be a short-term measure. We have
drafted language at the request of some of you which would be a
very simple amendment process. That would be a very good tool
to have now.
Senator Crapo. And I assume that you would agree that
establishing an expanded resolution authority would help us to
get away from the concern that creating a systemic risk
regulator for those so-called ``too-large-to-fail'' firms----
Ms. Bair. Right.
Senator Crapo. ----would create an implicit Government
guarantee that they would be propped up as opposed to allowed
to run down.
Ms. Bair. That is right. We want it to be a bad thing, not
a good thing, to be systemic. That is exactly right. I think
you do that through a robust resolution regime that, as
Chairman Schapiro said, makes it clear to the market that this
is the process that will be used and shareholders and creditors
will take losses.
Senator Crapo. Well, thank you. My time is up. I would love
to have had this same question answered by our other two
witnesses. Maybe we will be able to get some----
Chairman Dodd. Take a minute, Mike. Go ahead.
Senator Crapo. Could we have the other two witnesses
comment on this? Thank you.
Ms. Schapiro. I really agree with what Sheila has said and
am very supportive of that. I guess the only slight amendment I
would have would be for bank holding companies that have a
broker-dealer subsidiary where customer accounts are protected
under the specific law that there be consultation in that
process with the SEC, which I fully expect there would be.
Senator Crapo. Thank you.
Mr. Tarullo. Senator, just a couple of comments here. One,
I would hope that the universe would actually not expand that
greatly. That is, as we have commented before, Chapter 11 is
the appropriate route for most entities, financial and
nonfinancial. This ought to be a somewhat discrete mechanism
which is used only in really unusual circumstances.
Senator Crapo. Thank you. In that context, if we do--I tend
to agree with that, as well, but if we do keep this narrowly
focused, or as narrow as we are talking here, then I think we
really need to face that question of the implicit Government
guarantee of the firms that are regulated by the systemic risk
regulator or the system we establish.
Mr. Tarullo. And Senator, with respect to bank holding
companies, you don't have to reach that question because there
is no need to distinguish between the systemically important
and nonsystemically important. It is only when you get to the
entities that are not currently supervised that you have that
issue.
Senator Crapo. Right.
Chairman Dodd. Thank you, Mike, very much. Good point.
Senator Merkley.
Senator Merkley. Thank you very much, Mr. Chair.
One of the components of the President's plan is the
Consumer Financial Protection Agency. There hasn't been a lot
of discussion of that this morning, so Chair Bair, can you give
us a sense of your insights on the role of this potential
institution and whether it is an appropriate one to create?
Ms. Bair. We support the creation of the agency--an agency
that is focused exclusively on consumer protection in financial
services that can apply standards across the board for both
banks and nonbanks and make sure they are the same standards.
We think that would help the banking sector because one of the
things that drove the rapid decline in mortgage origination
standards was inadequate regulation and supervision outside the
banking sector. Most of these very high-risk mortgages were
done outside of the traditional banking sector, but as
competitive pressure drew market share from banks and thrifts,
which also lowered their standards in kind. So I think making
sure there are even standards across the board is very
important.
Where we think the proposal could be strengthened is on its
enforcement focus. We strongly recommend that the examination
and enforcement component for banks be left with the bank
regulators. I say that as a bank regulator but also as an
insurer of all institutions with, ultimately, taxpayer exposure
with the deposit insurance guarantee. There is a reason why we
focus on prudential regulation of banks, as well, and a lot of
it is because of FDIC insurance, which is a taxpayer backstop.
There are important synergies you can get between
prudential and consumer supervision. We typically cross-train
our examiners. We can send in teams of both safety and
soundness and consumer compliance. A prime example of where
joint safety and soundness and compliance examination can be
beneficial can be seen in cases where mortgages that were
abusive to consumers were also found to be unsafe and unsound.
And frequently, we will find where there is a consumer
compliance problem that can flag a more fundamental problem
with risk management at the institution.
We think strongly that the rule writing should be for both
banks and nonbanks. We are fine with that. But the examination
and enforcement mechanism of a newly formed consumer protection
agency should focus outside of the banking sector where you
really don't have much examination and enforcement activity at
all with the mortgage brokers or payday lenders. There are a
lot of abuses outside the banking system that we think could
and should be addressed by this agency. But, we really think
their focus should be on creating more robust enforcement
mechanisms for the nonbank sector.
I don't understand why moving all the examiners from the
bank regulators to this new agency and then making them
responsible for both banks and nonbanks is going to work. I
don't think it will. It would be highly disruptive to the FDIC.
That is, about 21 percent of our examiners being pulled out of
the FDIC. I assume it is a similar percentage for the other
regulators. We think we do a good job on examination and
enforcement. We have never had the ability to write rules, so
that doesn't really change things for us. So we would ask you
to consider that change in the Administration's proposal, but
we do support the agency.
Senator Merkley. Somewhat related to this, the systemic
risk conversation is partly about institutions and it is partly
about practices. By practices, I would mention things such as
prepayment penalties in mortgage, regulatory arbitrage, whether
there is a fundamental conflict of interest in the rating
system in which the entity that you are rating is paying for
that rating, and the issue of the amounts of leverage that were
established in the system under Cox's supervision of the SEC.
I am trying to sort out, how does one decide when you have
a consumer issue that would be driven by the Consumer Financial
Protection Agency? When is it an issue that the systemic risk
regulators would take on? And when would it be an issue that
the regular bank regulators would take on, and how would it get
worked out in terms of how to proceed?
Ms. Bair. Well, I think it does go both ways. What we have
suggested in my written testimony, is that bank regulators
should be represented on the board of the new consumer agency.
Again, as an insurer as well as supervisor, we think the FDIC
would have a unique perspective that should be represented. We
also would be happy to have the head of these two agencies
serve on our board because there are synergies and
interconnectedness between prudential supervision and safety
and soundness, and I think those need to be dealt with and that
would be one way to deal with them.
There has always been a separation between rule writing and
enforcement for the consumer laws, at least for banks. The
Federal Reserve Board has had that authority for federally
insured banks. The FDIC and the OCC have never had the ability
to write rules. We have just had the examination enforcement
component.
Senator Merkley. I want to get in one last question before
I run out of time. Paul Volcker had a report that came out in
January--I think it was called the ``Group of 30 Report''--that
addressed the issue of proprietary trading by banks and
essentially using the capital assets of the bank, should banks
freely engage in purchasing assets regardless of the risk, and
does that create systemic risk, and they had recommendations
for constraints on proprietary trading.
I open it up to all three of you. Do you have any thoughts
about--this hasn't gotten a lot of attention and I am curious
of your thinking.
Ms. Bair. This probably doesn't surprise you, but as the
insurer of banks we would strongly prefer that the proprietary
trading occur outside the bank, in an affiliate. If it does
occur in a bank holding company that includes an insured
depositor institution, that is a risk factor that should be
considered in setting assessments if the Congress decides to
approve an assessment system for larger institutions.
Ms. Schapiro. I would just add that I think proprietary
trading with either taxpayers' money in the event of a
supported institution or a customer's money does absolutely
create risks that we need to be sensitive to. On the broker-
dealer side, you are not permitted to proprietary trade with
customer funds, and most of that activity takes place outside
the regulated broker-dealer.
Mr. Tarullo. Senator, I would just say that regardless of
where these activities are taking place, they can create risk
under some circumstances. There needs to be capital, liquidity,
and other kinds of regulation which contain the risk no matter
where it takes place.
Senator Merkley. Thank you very much.
Senator Warner [presiding]. Senator Bennett.
Senator Bennett. Thank you, Mr. Chairman. I appreciate it.
And thank you to the witnesses. I think we have covered most of
the ground, and I do not necessarily need to rerake the same
set of leaves. But I have an overall concern here, and I do not
expect a specific answer. I just want to raise it and get some
conversation.
Systemic risk, what is it? If we do not have a definition
of systemic risk that everybody can understand and buy into, we
are getting into a messy situation that could end up being just
as bad as what we have just come through.
I listened to all of this and think, OK, if I were the CEO
of one of these companies, and, Sheila, you are saying we want
to stigmatize the company if it becomes too-big-to-fail or is
showing a systemic risk, the first thing I would say to all of
my staff would be, ``Find out what will cause us to cross the
threshold of being stigmatized as a Tier 1 `too-big-to-fail'
and make sure we manage our business in such a way as to avoid
that.''
Now, if the definition of systemic risk is sufficiently
loose, we can find ways around the definition, become too-big-
to-fail without being defined as ``too-big-to-fail,'' and end
up with the board or the single regulator, whoever it is,
facing the mess that we have talked about.
If the definition is clear and accurate, then the reaction
on the part of the CEOs of the company will be, ``We want to
avoid being stigmatized,'' and the whole thing will be self-
policing. So the market will react to that definition by saying
we will not do this and we will not do that and we will not do
the other thing.
So who gets to decide what is too-big-to-fail? Who gets to
define what is a systemic risk? And what should we be looking
for as we do that?
I guess one last--I have tried to probe into the Lehman
Brothers decision because I, with the benefit of hindsight,
think the Lehman Brothers decision is probably what triggered
the mess that got us into the need for TARP. And digging down
through it, I am told ultimately we did not have enough data.
When we made the Lehman Brothers decision that said, ``yes, we
will allow Lehman to go down,'' we did not have enough data.
And if we had had more, we probably would have made the
different decision and would have stepped in to try to save
Lehman the same way we saved Bear Stearns.
So that is a real-life example of what happens when you do
not have a clear definition of what is too-big-to-fail.
Comments?
Ms. Schapiro. Senator, I think you raise really a critical
point here, and I think it is one reason I believe the
existence of a council will be so important, because making a
determination about what is a systemically important
institution and how its business practices are evolving over
time to move it perhaps in and out of that definition is
something a council, a diverse perspective and diverse
expertise on different types of financial institutions, I think
will be pretty well-suited to do based on an analysis of data,
examination reports, information from counterparties and so
forth.
And so I think for us to be able to determine--I mean, we
can come up with a definition of systemically important. It is
an institution whose failure puts at risk other institutions or
the financial system as a whole. But I do not think it tells us
very much because it is, in fact, so general.
So I think a council will actually have the ability, and it
will have to be an incredibly dynamic process, and that is why
I think designating them that way is a mistake, because you
will be designated and undesignated. People will structure
their business to fall right under the designation. But I think
for the primary regulators and the council to understand those
institutions that we need to be particularly focused on will be
important and facilitated by a council.
Senator Bennett. OK. I am glad that Sheila referred earlier
about a dollar threshold might be the trigger. An efficiency
threshold might be the trigger. An interconnected threshold
might be the trigger. There is no single trigger, is what it
has come down to.
Mr. Tarullo. Senator, I think your question is going to
have importance regardless of whether it is a council, the Fed,
a new agency, or somebody else. I think the question you put
your finger on matters, no matter who the designator is. And
here is the basic dilemma, though, that you all face.
As I said a moment ago, with respect to already supervised
institutions--bank holding companies--you do not have to draw
that sharp line in the sand. You can have an approach to
regulation and supervision which is in a sense graduated,
squeezing more tightly as there is more interconnectedness, but
there is no one place at which you say here is the line.
The problem comes with institutions that are currently
outside the perimeter of regulation.
Senator Bennett. Exactly.
Mr. Tarullo. And there, the choices, I think, are several.
Basically you have got three choices.
Choice one is you say here are the group of institutions
which we think under stressed conditions would pose a systemic
risk under some set of criteria.
Two, here is a set of institutions about which we would not
say that with that level of assurance, but it at least would be
in the ballpark to think about them in this way.
Either of those requires you to draw a line somewhere.
The third option, of course, is to say that basically every
financial firm, no matter what it calls itself, has to be
subject to basic rules and regulations. But that, of course, is
itself a change from our current circumstance because we do not
have that kind of perimeter.
I do not think any of those is a clean choice. There are
advantages and disadvantages to each, and that is why I think
the question you raised is one that we are going to have to
address as best we can no, matter which road people choose to
go down.
Senator Bennett. Sheila, you wanted to comment.
Ms. Bair. I did. We are suggesting that the resolution
authority be applicable to any bank holding company, so for
resolution purposes, you would not have to differentiate up
front. And whether it was used I think would be a determination
made by the primary supervisor about whether to avoid systemic
ramifications from a normal bankruptcy process by employing the
special resolution process, which still has the same claims
priority that bankruptcy has with unsecured creditors and
shareholders taking losses before the Government. It is a way
that we can plan and use additional powers we have to set up
bridge banks or to accept or repudiate contracts. The special
powers we have really work better for financial intermediaries.
But you do not have to make that determination in advance.
I think the dollar threshold I mentioned, in the context of
whether there would be an assessment to fund a large
institution resolution fund, would really determine who is not
systemic as opposed to who is. So for maybe anybody below--pick
a number--$25 billion, you can safely assume they are not
systemic, so they would not be caught in this assessment. But
even those caught in the assessment, the amount of the
assessment would be risk based. So if you are a plain vanilla
regional bank, you take deposits, you make loans, you do not do
much else, you are probably not going to have much of an
assessment. If you are a complex bank holding company with a
lot of proprietary trading, OTC dealmaking, et cetera, you are
probably going to have a higher assessment.
As Governor Tarullo said, really the only time where you
would need to do it in advance is if there was a large
systemically important institution that is not already under
consolidated Federal supervision. I do think the council should
have the flexibility and authority to define those institutions
and bring them under prudential supervision if that is the
case. I think that is something the council should do. It would
be a tremendous power, and I think it would benefit from the
multiplicity of views that would be on the council.
Senator Bennett. The power to define becomes ultimately the
power that controls everything.
Ms. Bair. In terms of institutions, especially if you do
away with the thrift charter, there are only a few
institutions--I am not going to name any specific
institutions--that come to mind that would not already be under
Federal prudential supervision. So I am not sure actually if
that piece of it in practice would be that profound. As a
result of the crisis, pretty much everybody has become a bank
holding company or are on their way to doing so. So I am not
sure in practical terms that it would be that huge of a change.
Senator Bennett. Thank you, Mr. Chairman.
Senator Warner. Well, I want to thank the panel for hanging
in, and I think it is down to Senator Martinez and me for the
last two on this, and we have actually a second panel. I have a
slew of questions, and I will try to ask them very quickly,
again, so that Senator Martinez can get his questions in, and
we can respect the second panel if we could try to answer
fairly quickly.
I strongly, as I made clear, believe that the council is
the right approach. I guess I would ask for rather quick
responses here--if possible, even kind of yes/no. I would love
to--should that council have an independently appointed,
Presidential appointment with congressional approval chair?
Should it have the ability to look across all financial
markets? Should it be able to be the aggregator of data from
all of the prudential regulators up to with an independent
staff that could aggregate and assess this data?
Should it have, as I think we have heard you say, the power
to issue rules, require enhanced leverage, or capital rules?
And should it be able to force the day-to-day prudential
regulators to take action and, if not, have backup authority to
take action if the prudential regulator does not?
I want to try to--I think Senator Bennett asked very
appropriate questions about how we define. I am trying now to
get into how we structure if we went forward with this council
approach, recognizing that Professor Tarullo may not concur on
the----
Mr. Tarullo. As you know, Senator, the Board at this
juncture has a somewhat more contained view of the council, so
let me just--you said ``Professor'' before rather than
``Governor,'' and I will slip back into that prior role, which
is to say that I think you need to ask yourself at some point
whether you are not basically creating a new agency that has
brought in all the functions of the other agencies. If you have
got a council that basically is able to direct everybody to do
what the council thinks you ought to do, it is not that far
from the Financial Services Authority mechanism in the U.K. or
something like that. Obviously, there are a lot of gradations
along the way.
Senator Warner. Thank you.
Chairman Schapiro and Chairman Bair.
Ms. Schapiro. I think you asked five questions, and I think
I have five yeses to all of them. I have not thought very
carefully through the structure in terms of Presidential
appointee confirmed by the Senate, but I think that makes
sense. I do believe it needs to have the ability to aggregate
data, to look across financial markets and all financial
institutions. That is the whole purpose to my way of thinking.
And I believe very strongly it needs the power to set capital
requirements, leverage limitations, and other prudential
regulatory requirements.
And I would have, I guess, one caveat on the ability to
force prudential regulators to take action if they do not do
that, and my view on that would be to raise standards, yes, not
to lower standards.
Senator Warner. Chairman Bair.
Ms. Bair. I would say yes.
Senator Warner. Thank you.
One of the things that Senator Corker has brought before
you all a number of times, and I agree with him, is this notion
of enhanced resolution authority for the FDIC for bank holding
companies. I concur with his approach and that our goal ought
to be allowing these institutions to actually fail in an
orderly process and not be simply propped up ad infinitum.
You know, there are a lot of questions beyond that, and we
may even have an interim basis here, but one of the concerns I
have with the Administration's proposal is there is still a--
how do you fund that resolution? There is still the idea of
having to go to the Treasury or the Fed to get the dollars in
the interim and go back and do a retroactive funding of the
resolution. And clearly you do not want to have prefund so much
from existing small banks.
How have you thought about a prefunding mechanism? And how
do we make sure that the prefunding, if you do agree with the
prefunding, is a large enough net that you are going to capture
potentially some of these institutions that may not obviously
fall into a current FDIC coverage area?
Ms. Bair. We support a prefunding mechanism, and it is
important to note that this fund would be for working capital.
This is not an insurance program, so we would not be
guaranteeing liabilities as we do with the Deposit Insurance
Fund. This would be for working capital to facilitate
resolutions where necessary to make sure there are no
disruptions to the system.
It would take some time to build that fund up, so initially
you might have to establish a line of credit with the Treasury
Department. This should all be completely separate from the
Deposit Insurance Fund and what goes on with insured depository
institutions. To the extent we resolved a bank holding company
with both banks, and nonbank functions, we would allocate
losses to each fund in a way that would keep them completely
separate.
Similarly, those with the large deposit bases should not be
double-assessed, so whatever they are paying into the Deposit
Insurance Fund, will take care of what is in the bank. Any
other costs would be allocated outside the bank.
I do think prefunding is important from the perspective not
only of making sure there is something to call upon so you do
not have to immediately borrow from taxpayers to facilitate one
of these resolutions. But I also think it is a tool that can
complement prudential supervision to disincent high-risk
behavior. We use risk-based assessments now for deposit
insurance. Congress gave us that authority in early 2006. We
like some of the impact it has had on behavior, and I think
through this assessment system you could do the same types of
things.
So, for instance, if you did not want to be so extreme as
to tell bank holding companies they could not do proprietary
trading anymore, maybe you say they can do that in an
affiliate, but we are going to charge you a higher assessment.
I think it does have a way to impact behavior, but not in a way
that you set hard and fast rules or limits that can be
arbitraged or may result in unintended consequences.
Mr. Tarullo. Senator, I think this is another one of those
areas where you have got downsides as well as upsides whichever
way you go. The downside of ex post funding, as has already
been suggested, is you have to go back and do an assessment ex
post. You have to borrow money from the Treasury in the
interim--I certainly hope not the Federal Reserve here--for
setting up this mechanism.
But if you go the prefunding route, there is not really
much experience to know what you are prefunding. As Sheila
already said, you are probably not going to be at a point any
time in the near future where you would have the fund you would
need, so you would need a backup line of authority.
And I guess the incentive, or signal, question would have
to be asked: If you already have a preset pot of money which is
reserved for resolution situations, does that make it more
likely that it will be used? And I do not think there is a
clear answer to that either.
Senator Warner. I have got another--I am just going to make
one quick comment, because I do not want to interfere on
Senator Martinez's time. But just as we think about these
gradations--and I think, you know, as we think size, I hope
there will be some scaling of this as opposed to a simple line
that you cross over. The one question I also would want to ask
for your answer on, but as we look at bank holding companies
taking on a whole series of additional functions that
oftentimes look a lot like hedge fund functions, as you
mentioned, Chairman Bair, in terms of their internal trading
functions, should there be additional capital requirements for
these nonbank functions that are taking place inside bank
holding companies? And as we look at putting barriers on that
``too-big-to-fail,'' ``too-big-to-fail'' is size and sometimes
also a series of additional functions.
I will move now to Senator Martinez.
Senator Martinez. Thank you, Senator Warner. I appreciate
it very much. I just believe a lot has been covered, and I do
not want to again go over ground that has been covered. But
there is one area that we have not talked about, and I would
like to know the views of all three of you. It has to do with
the GSEs, the Government-sponsored enterprises. They are
entities that I think define ``too-big-to-fail.'' I think they
also were systemically very risky. However, they had this
implied Government guarantee that they continue to enjoy.
Obviously, we have done a great deal to do what we should
have done much earlier, which is put a regulatory scheme in
place that might prevent some of the problems in the past. But
thinly capitalized, a huge and ever growing market share which
even continues to this day, an implied Government guarantee
which provided investors a buffer from reality or from the
consequences of investments, and I think the whole ball of wax
of our mortgage system became very much troubled as a result of
their activities and their actions. And I cannot--I think if we
were to look back upon this period and what we have been
through, I think it would be impossible to overestimate the
impact that they have had and all the problems we have seen.
How do they fit into what we are talking about here? What
is the appropriate place for them to fit? Is there a future
that they even should have as Government-sponsored enterprises?
Or should they be simply part of the private sector?
As I look at each of your functions, they fall under none
of you--maybe perhaps a little bit under Chair Schapiro, but
not a lot. Exactly. So we are still in the problem.
So if we look at what it is that got us where we are today,
I would love for us to focus on what got us here rather than
just--and, obviously, AIG is a big part of the problem, and,
obviously, there are a lot of other, you know, issues and
relationships and interconnectedness and all of that. But would
you please address the GSEs for me?
Mr. Tarullo. So, Senator, one thing for sure, the guarantee
is no longer implicit. It is now----
Senator Martinez. Which, by the way, some would say it
never was.
Mr. Tarullo. There is considerable force to that as well.
The Board, as you know--long before my arrival there--had
expressed concerns about the GSEs, and I do not think anything
that has happened in the last 10 months would have reduced
those concerns.
I guess I would say that there are a number of ways one can
go but, going forward, what would be critical is to distinguish
private roles from a public role. There is a real public role
that can be played by GSEs. That is why they were originally
started. But when you have a public role, that is when
guarantees, implicit or explicit, are going to be involved. And
that is when you are trying to implement a set of policies, so
those activities are going to have to be constrained, and you
are going to have to make sure that the entity is really
functioning as a public entity under a certain obvious set of
constraints.
My characterization of some of the GSEs over the last 10
years would be that nobody could tell where the public ended
and the private began.
Ms. Bair. I would just add that the Federal Reserve Board
was an early sounder of risk. And at Treasury, especially when
I was at Treasury, similarly, we tried to sound the alarms.
I think, though, one of the advantages of----
Senator Martinez. I will speak up for HUD as well.
[Laughter.]
Ms. Bair. Absolutely. A lot of people. I think this council
would be able to give voice to those concerns and have real
authority to address them. I think that is one of the
advantages of the council. I think the Administration proposal
would put the FHFA on the council. And if you continue with
these GSEs--I do not know what their future is, but if they
continue--they clearly still represent tremendous systemic
exposure. So I think this would be a prime area where in the
past you would have had a mechanism where we could have forced
some real action through this council. Going forward, if the
GSEs continue to function this way, the regulators should be
represented as well.
Ms. Schapiro. I do not have much to add, although let me
stand up for the SEC, long before I arrived, in their push for
public reporting by the GSEs.
I do think Dan makes an excellent point about
distinguishing the public and private roles and attendant
consequences of having that public policy mission. It needs to
be, I think, very transparent and well-understood by the
marketplace.
Senator Martinez. Well, I think the market, you know, when
you put paper in the market and people invest, I do not know
how that is ever a public role, really. I am not sure you can
have private investors and a board of directors that is then
beholden to the investors or to their public role. And that is
my trouble with the whole idea of the GSEs the way they are
chartered. So I think I for one would wonder how their future
should really be and whether, in fact, they still have a role
that ought to be as it has been in the past. Or should we very
dramatically alter that going forward?
Thank you for your input, and thank you for being here this
morning.
Senator Warner. Senator Menendez.
Senator Menendez. Well, thank you, Mr. Chairman. Thank you
all for your testimony.
Let me ask, you know, for those of us who are struggling to
define what the boundaries of systemic risk are, which is, I
think, one of the key questions--and I know you have been asked
some of these, and you have given some answers. But to me, it
is more complicated than just the size of a firm or what
business it is in, but how significant its activities are as
well as how extensive its relationships are with other firms
and consumers. So we have used very often ``too-big-to-fail.''
Sometimes I wonder whether we should be looking at too
interconnected to fail.
And in that respect, you know, should, for example,
extensive relationships with small business and consumers count
in defining systemic risk? By way of example, CIT. CIT is the
largest lender to small businesses in America and has been in
financial difficulties. It seems to me that unless an entity
like that can find its way out of its financial difficulties,
we are talking about hundreds of thousands of small businesses
across the Nation who will not have the type of financing they
need to conduct their activities, which is the greatest creator
of jobs in the country at a time in which the country is
desperately in need of jobs.
So how do we look, for example, at that? Is that an element
of systemic risk? If it is, then define it for me a little
better. If it is not, tell me why it is not.
Mr. Tarullo. So I will start, Senator. I do not think any
of us probably wants to be speaking with reference to any
particular entity, so let me just try to speak in more abstract
terms.
I think we do need to draw a distinction between entities
that are economically significant and entities that pose
systemic financial risk. There are many entities in this
country whose failure would have very adverse economic
consequences on a lot of people who deal with them--a lot of
employees, communities, suppliers, and the like--but that do
not create systemic financial risk in the sense that their
failure leads to a kind of immediate cascading effect, in which
leverage that is consecutively held by a lot of institutions
that have counterparty relationships with one another suddenly
becomes a problem. As asset values deteriorate and margin calls
increase, you have to put up more collateral or you have to
sell assets because you do not have enough collateral to put
up. That is the pattern that we saw with Bear, Lehman, and AIG,
and, in fact, you can go back 11 years and say that is the
pattern you saw with Long Term Capital Management.
Senator Menendez. So a cascading of thousands of businesses
that would not have access to capital would not be a systemic
risk?
Mr. Tarullo. It would be a very severe economic problem,
but the reason I would say it would not be a systemic financial
risk is that it does not unwind essentially overnight or----
Senator Menendez. So the automobile industry would fall in
the same context as you are describing.
Mr. Tarullo. I think the judgment on the automobile
industry was that, again, there were truly enormous costs,
particularly in a situation in which the economy was headed
down so quickly anyway, and I gather that is why the
Administration and many Members of Congress thought that action
should be taken.
But it did not pose a systemic financial risk even though
it did impose substantial financial hardship. I do not think
any of us wants to tell you that an approach to systemic risk
will either prevent or mitigate all important economic----
Senator Menendez. So let me take a different--I do not know
if any of you want to jump in to that question, but let me take
a different tack on that. So we are looking at a $3, $4
trillion commercial mortgage problem coming down the pike in a
marketplace that at this point in time I am told by entities
across the country there is no--largely speaking, in the
private sector there is not the wherewithal for that market to
take these mortgages that will be rolling over.
Now, having looked at our lack of action on the
homeownership sign and what happened there, is that something
that we think poses systemic risk? Or do you put it under your
same category, may create enormous economic consequences but
obviously does not have financial risk? Although I would say
that if all those people default and cannot find a mortgage in
the marketplace, those institutions will be holding a large
number--maybe backed up by some degree of security with the
properties, but they will have large numbers of defaults and
less under a marketplace that has reduced in value and less
than their holdings presently require. So what is that?
Mr. Tarullo. Well, I think it depends, Senator, again, on
where the concentration is to be found and what the impact of
the failure of an institution holding any form of exposure
would be.
Let me just say with respect to commercial real estate, I
agree with your assessment that it is a looming problem. It is
a looming problem for communities and for economic performance
generally. It is a looming problem for many financial
institutions in this country. I do not know that one can
classify it in and of itself as being a systemic risk or not
being a systemic risk. It is surely an issue and a problem,
which is why I think all the bank supervisors have been paying
attention to the exposures. And now speaking only for the Fed,
we extended the TALF program to commercial mortgages precisely
because of the absence of credit flows and the absence of
secondary markets there.
Ms. Schapiro. Senator, I would just add briefly that I
think there are--your question really points out something very
important. We are very focused on systemically important
institutions, but there are absolutely systemically risky
practices that, if engaged in by a broad range of institutions,
no one of which might be a systemically important institution,
but those practices taken together across the marketplace as a
whole absolutely have the potential to create broad systemic
risk for the financial system at large.
Senator Menendez. My time is up, but I will submit a
question to you, Chairman Bair, about your FDIC-OCC dispute on
big banks versus community banks, because I just do not quite
understand that community banks that were not the cause of the
challenges we face get hit at the same rate as entities that
did create some of those risks and that have greater risk
overall. So I do not quite get it, but I would love to hear the
answer.
Senator Warner. Thank you, Senator Menendez, and I would
like to thank the panel. You have hung in for a long time and
we will, I know, have additional questions which we will submit
to you. Thank you all.
If we could go ahead and move to the second panel, and my
thanks to the second panel's forbearance. If the second panel
could move quickly to their seats so that we could move
forward, I think we do have a vote, as I understand, coming up
in the next 45 minutes, so we want to make sure folks get a
chance to testify.
I am going to go ahead and introduce our panel, even though
they are in the midst of still being seated. Vincent Reinhart
has spent more than two decades working on domestic and
international aspects of U.S. monetary policy. He served for
the last 6 years of his Federal Reserve career as Secretary and
Economist to the Federal Open Market Committee and has served
in a variety of senior positions at the Federal Reserve. Mr.
Reinhart, thank you for being here.
Paul Schott Stevens has served as President and Chief
Executive Officer of the Investment Company Institute since
June 2004. Outside ICI, Mr. Stevens' career has included varied
roles in private law practices, corporate counsel, and in
Government service. Mr. Stevens, thank you for being here, as
well.
Alice Rivlin, as we all know, is the Senior Fellow in
Economic Studies Programs at Brookings. She was the Founding
Director of the CBO and has served as Director of the White
House Office of Management and Budget. Alice, thank you for
appearing here, as well.
Allan Meltzer is a Professor of Political Economy and
Public Policy at the Carnegie Mellon University and is also a
visiting scholar at AEI.
I don't normally get a chance to sit here in the chair. I
don't want to mess it up too much, but recognizing that Senator
Bunning said we actually may have a series of votes starting
even earlier than 45 minutes from now, I would ask each of the
panel, recognizing there are only three of us here still on
this side of the dais, if they could make their statements
relatively short so that we could make sure we could get a
chance to ask questions.
Mr. Reinhart.
STATEMENT OF VINCENT R. REINHART, RESIDENT SCHOLAR, AMERICAN
ENTERPRISE INSTITUTE
Mr. Reinhart. Thank you for the opportunity to testify
today, even if it is late in the session. No doubt, the
American people expect significant remedial action in the
aftermath of the extraordinary Government support to financial
institutions over the past year.
In my view, the Congress should form a committee of
existing supervisors headed by an independent director,
appointed by the President, and confirmed by the Senate. The
director should have a budget for staff and real powers to
compel cooperation among the constituent agencies and reporting
from unregulated entities, if necessary. The constituent
agencies should regularly be directed to draft reports in their
areas of expertise for consideration by the full committee and
transmittal to the Congress. This could include twice-a-year
reports on financial stability from the Fed, appraisals of the
health of the banking system from the FDIC, and assessments of
the resilience of markets from the CFTC and the SEC.
I believe there are compelling reasons that the
responsibility of the financial stability supervisor should not
be given to the Fed. I worked in the Federal Reserve system for
a quarter century and hold its staff in high esteem. But any
group of people in an independent agency given too many goals
will be pulled in too many directions. And there is one goal
given to the Fed that should not be jeopardized, the pursuit of
maximum employment and stable prices. Indeed, that goal is so
pivotal that Congress should be thinking of narrowing, not
broadening, the Fed's focus.
A financial stability committee could foster the
achievement over time for robust rules on the resolution of
private firms, simplification of the financial system, and
consolidation of financial agencies. That is the opportunity
for real, long-lasting benefits.
Senator Warner. Thank you, Mr. Reinhart.
Mr. Stevens.
STATEMENT OF PAUL SCHOTT STEVENS, PRESIDENT AND CEO, INVESTMENT
COMPANY INSTITUTE
Mr. Stevens. Thank you, Senator Warner, Senator Shelby, and
Members of the Committee. You may recall I testified before the
Committee in March and recommended at that time that the best
way to approach systemic risk regulation would be to create a
statutory council of senior Federal regulators. Such a body
would be best equipped to look across the system and anticipate
and address emerging threats to its stability.
As I thought about the challenge, I told the Committee that
my model was the National Security Council, which Congress
established in 1947 to coordinate and integrate, quote,
``domestic foreign and military policies relating to the
national security.'' From 1987 to 1989, I served on the NSC
staff. I was its first legal advisor. I helped lead a
reorganization of the NSC, of the system and of its staff, and
I then served as Chief of the NSC staff under National Security
Advisor Colin Powell.
Based on that experience, I believe an interagency council
with a strong authority in a focused area, in this case
monitoring and directing the response to risks that threaten
overall financial stability, could, like the NSC, serve the
Nation well in addressing complex and multifaceted risks.
The Administration has proposed creation of a Financial
Services Oversight Council, but one that would have at best an
advisory or consultative role. The lion's share of systemic
risk authority would be vested in the Fed, and that approach
strikes me as achieving the wrong balance. Most importantly, it
fails to make meaningful use of the expertise and viewpoints of
other regulators and it represents, as some Members of the
Committee have observed, a very worrisome expansion of the
Federal Reserve's authority over the Nation's entire financial
system.
I would note my reading of the Administration's legislative
proposals would, for example, suggest that dozens of mutual
fund companies could conceivably be under scrutiny as Tier 1
Financial Holding Companies, a result that was, to say the
least, surprising to me.
I would urge Congress instead to create a strong Systemic
Risk Council, one with teeth. Effectively addressing risk to
the financial system at large requires diverse inputs and
perspectives. The standing membership of the council should
include the core Federal regulators, within my judgment, the
Treasury Secretary serving as Chair. For independence, the
council should be supported by a very strong Executive Director
appointed by the President and a small, highly experienced
staff. For accountability, the council should be required to
report regularly on its activities to the Congress.
By statute, the council should be charged with identifying
risks and directing regulatory actions needed to mitigate them.
Responsibility for addressing the risks should lie with the
functional regulators, operating for this purpose only under
the council's direction. The council would thus have clear
authority, but over a very limited range of issues, only major
unaddressed hazards, not day-to-day regulation.
This approach has several advantages. The council would
enlist expertise across the spectrum of financial services. It
would be well-suited to balancing competing interests. It would
engage the functional regulators as full partners. At the same
time, its independent staff could serve as a check on the
functional regulators and avoid the regulatory capture that
could result if one agency were set over all institutions
deemed systemically risky or too-big-to-fail. And the council
could be up and running quickly, while it might take years for
any existing agency to assemble the requisite skills to oversee
all areas of the financial system.
Critics of the model have said that convening a committee
is not the best way to put out a fire, and that may be, but the
goal of systemic risk regulation should be to prevent or
contain fires before they consume our financial system, and a
broad-based council surely is the very best body for designing
a strong fire code.
Thank you for the opportunity to testify. I look forward to
your questions.
Senator Warner. Thank you for both getting your statements
in under your time.
Ms. Rivlin, the Chairman is back. Let us see if we can keep
this, you know, if I can show off a little bit to show that
everybody gets through their statements quickly.
STATEMENT OF ALICE M. RIVLIN, SENIOR FELLOW, ECONOMIC STUDIES,
BROOKINGS INSTITUTION
Ms. Rivlin. We are on a roll here. Thank you, Mr. Chairman
and Members of the Committee.
Controlling systemic risk breaks into two questions, I
think, how to avoid the excesses of a bubble economy that can
burst and cause a catastrophic downward spiral, and second, how
to make sure that if a large interconnected institution fails,
it doesn't start that downward spiral and take others with it.
On the first question, how to prevent the excesses of a
bubble, we need to fix regulatory gaps. Ineffective regulation
contributed to the excesses and allowed lax lending standards
and all of the things that we have worried about. And we need
to correct the perverse incentives that crept into the system,
as with the originate-to-distribute model.
That can be done, correcting the gaps and perverse
incentives, but however we do that, the job is not over.
Participants in the financial system will try to avoid the
rules, whatever they are. The system will need constant
monitoring to make sure that new gaps and perverse incentives
are not creeping in that lead to new excesses and instability.
So I think one job is this monitoring function. The Obama
Administration would put this function with a Financial
Oversight Council chaired by the Treasury but with its own
staff. I think it would make more sense to put this function at
the Federal Reserve, perhaps consulting with a council. The Fed
has the clear overview of the whole economy. It fits with the
job that they already have for monitoring the economy and the
health of the banking system.
I would also give the Fed another tool, broader control of
the amount of leverage in the system. Bubbles get out of hand
when demand is fueled by big increases in speculation with
other people's money. The short-term interest rate is not a
sufficient tool for controlling as that price bubbles. So I
would recommend working out a system in which not only capital
requirements, but other constraints on leverage across the
system could be tightened in the face of a serious bubble
threat.
Then there is the problem of the large interconnected
institution. This can be mitigated by making it more expensive
to get big, having capital requirements rise as institutions
grow, for instance. We need much more effective prudential
regulation of all financial institutions, especially as they
get big enough to threaten the system.
The Obama Administration proposes designating institutions
that pose systemic risk and giving the Fed responsibility for
consolidated prudential regulation of what they call Tier 1
Financial Holding Companies. I think both parts of that
proposition would be a mistake.
We should not designate institutions as too-big-to-fail and
give them their own regulator. It is hard to make up that list.
But we would also be creating a new set of GSEs. There is a
danger that the regulator of too-big-to-fail institutions would
see its job as keeping them from failing and the result would
eventually be expensive bailouts.
Second, I would definitely not put additional regulatory
responsibility at the Federal Reserve. The Fed is very good at
monetary policy. It should be headed and staffed by strong
macroeconomists who are charged with keeping on top of economic
developments. These are different skills from regulation and I
think putting an additional regulatory responsibility which
they have historically not been very good at at the Fed would
dilute their monetary policy focus.
I also fear that adding a new set of regulatory authorities
to the Fed's task would threaten the independence of monetary
policy, which is very important to preserve. Congress would
justifiably want more control over such a powerful agency,
appropriations, accountability for policy, and so forth. It
might easily threaten the independence of the Federal Reserve
in taking unpopular decisions to rein in the bubble economy.
Thank you, Mr. Chairman.
Senator Warner. Professor Meltzer.
STATEMENT OF ALLAN H. MELTZER, PROFESSOR OF POLITICAL ECONOMY,
TEPPER SCHOOL OF BUSINESS, CARNEGIE MELLON UNIVERSITY
Mr. Meltzer. Mr. Chairman, Senator Shelby, thank you for
the opportunity to be here. I believe that effective regulation
should await evidence and conclusions about the causes of the
recent crisis. There are so many assertions about those causes
that Congress should want to avoid a rush to regulate.
During much of the past 15 years, I have written three
volumes entitled The History of the Federal Reserve. Working
with several assistants, we have read virtually all of the
minutes of the Board of Governors, the Federal Open Market
Committee, the Directors of the Federal Reserve Bank of New
York, staff papers, internal memos, and so on. I speak from
that perspective. I speak also from experience in Japan, where
I served as the honorary advisor to the Bank of Japan during
the 1990s when they were undergoing their banking and financial
crisis.
First, I do not know of any clear examples in the history
of the Federal Reserve in which the Federal Reserve acted in
advance of a crisis or a series of banking and financial
failures. I have had the privilege of working with various
Secretaries of the Treasury. Here is how the problem presents
itself to them.
There are a group of people who say, if you don't do the
bailout now, you are going to have a crisis and it will go down
in the history books with your name on it. There will be a few
people who will say--very few, I may say--who will say, let the
failing institution fail and make sure that you protect the
market from having the failure spread. That is a question that
really is at the center of this. It is not whether we should
get rid of ``too-big-to-fail.'' I think many people recognize
that ``too-big-to-fail'' is a disaster. What we need to worry
about is how do we prevent problems from spreading. I am
pleased to see that there is a good deal of skepticism among
the Members of the Committee about simply appointing another
regulator and saying to them, do what Secretaries of the
Treasury, Chairmen of the Federal Reserve have done
historically. That won't work.
There are three things which I think are central to any
such discussion. First is the question of incentives. How do we
make incentives for prudent behavior on the part of bankers? We
let them fail.
Second, how do we make sure that bankers will not want to
fail? We tell them you can fail and the best way to avoid
failure is to hold capital. We need to buildup the capital. In
the 1920s, banks everywhere had much more capital than they do
now. A bank's window said, some of you may remember, listed the
paid-in surplus and capital. By the 1950s, that was gone and it
said, ``Member FDIC.'' That was a change in attitude. So we
need to worry about capital.
And last but something that I have not heard here but which
should be part of your discussion is we need a lender of last
resort proposal. The Federal Reserve in 96 years has never
clearly enunciated what its role as lender of last resort is.
It must be a role that the Congress will accept. No role will
be viable if the Congress doesn't accept it. But there must be
such a rule and that rule should say, hold capital and hold
negotiable assets that you can sell to the Federal Reserve at
the discount window what they will accept. That is the way in
which we keep crises from spreading. We say, you are
responsible as a banker and you must hold capital to protect
yourself and you must have negotiable assets that you can sell
to the Federal Reserve discount window because that is what it
is there for. Without that, we won't have safety.
What difference will there be if we establish one of these
super-regulators? Why will they behave differently than the
Treasury Secretaries that I have talked about, Federal Reserve
Chairmen? Why will they not say about the Tier 1 risk people,
you are too-big-to-fail. We can't allow that to happen. We have
to use taxpayer money to bail you out. I don't believe that it
will work.
The first law of regulation--my first law of regulation is
regulators make rules. Markets learn to circumvent them. You
have heard lots of examples of that. It is a dynamic process.
There is no set of rules which is going to for all time
regulate this process. We need to change the incentives and the
incentives have to be, you fail, we protect the market.
Senator Warner. Thank you all for your testimony. Thank you
for your abbreviated testimony.
If I ever get a chance to sit here again, I am not going to
go first, Chairman Dodd.
[Laughter.]
Chairman Dodd [presiding]. He has got a future in the
Senate, I would say.
[Laughter.]
Chairman Dodd. Thank you, Mark, very much, and thanks for
chairing the Committee for a few minutes.
Well, thank all of you. What a wealth of talent at this
table and a wealth of experience, as well. You really offer
some very great counsel and advice to us as we try to navigate
these waters. I think all of us, as I said earlier, are very
conscious of the fact that this is a tremendous challenge and
we want to get it right.
I think you have heard a number of us make the point that,
unlike other efforts ongoing today, this is one that is almost
devoid of ideology as we are looking at it and how do we do
this in a way that is going to provide the kind of confidence-
building measures that are so critical for the stability of our
financial institutions, and that word ``confidence'' more than
anything else is one that--I don't know of any specific formula
that gets you there. It is one of those items that you know it
when you have it and you know it when you don't, and trying to
create through this process, even the process itself we are
going through, I hope has some confidence-building qualities to
it, as the Committee of primary jurisdiction over these matters
to what steps do we take in order to reestablish that level of
confidence.
On the part of all the consumers and users of financial
services, from the shareholder to the borrower to the depositor
to the policy holder, all of whom have different assumptions of
risk as they engage in financial activities, but essential in
all of them, weaving its way through each one of them is
confidence--confidence the system is going to work, that it is
going to be there to protect them, that they are going to be
safe, not that they necessarily have a guaranteed return on the
activities they engage in, but the system won't fail them. They
may make a bad bet, but it is not because the system was
corrupt or fell apart on them. And so that is really, I think,
what we are all trying to achieve in this.
Senator Shelby chaired this Committee and has a strong
understanding and sense of it. People like Mark Warner and Jim
Bunning, Mark has had a great background and experience in this
in his private life, and Jim Bunning was ahead of the curve on
this Committee, working with others on the Committee,
identifying very early on the issue of the residential
mortgages. So there has been a lot of history on the Committee
going back, so we are appreciative of it.
And let me start with a question you have somewhat
addressed already. The Fed has long argued that its prudential
supervisory regulatory powers over banks and holding companies
are critical to the effectiveness of its monetary policy, that
they are interrelated, and three out of the four of you have
experience at the Fed. Given your own past roles in setting and
executing monetary policy at the Fed, we would like to hear
your views on this. This idea that you can separate and
distinguish in those roles is one that really is not wise.
And a follow-up, Dr. Meltzer. Based on your study of the
Federal Reserve's history, do you see the Fed's bank
supervisory role as critical to its monetary policy function,
as well----
Mr. Meltzer. No, sir, and the staff has told them many
times the answer is it really is unrelated. I mean, they can
get the information from the other agencies. The reason the
Fed, I believe, the reason the Fed wants supervisory authority
is because it wants a coalition of people to protect themselves
against pressures that come from the Administration and
Congress. It wants people who know about the Fed, that want to
protect its monetary policy responsibilities and they have used
it in that way.
At one time in the history, the Committee, your Committee--
not you, but your Committee got very angry at Chairman Burns
because of the extent to which he had used that mechanism to
protect himself against something that the Congress wanted to
do.
Chairman Dodd. Alice.
Ms. Rivlin. I don't think that the supervising individual
banks is important to making monetary policy. I know that was
said around the table when I was at the Fed, but I didn't
really experience that we learned a lot from the supervising
particular banking institutions that was useful to monetary
policy.
What is important is for the Fed to have access to
information about how things are going and that is why I think
the monitoring function of being in charge of monitoring for
systemic risk is--they ought to be doing that anyway, but to
give them that formal responsibility, I think, would be
helpful. But I don't think they have to supervise individual
institutions. In fact, I think it would be bad to do that.
Chairman Dodd. Let me ask you this, Alice, and the question
has been raised with others and you may have addressed it
before I walked back in in your statements, and that is the
potential conflict. Given the principal function and
responsibility of the Fed of monetary policy--and I don't think
anyone disagrees, that is the primary responsibility--is there
not the risk of being in conflict from time to time when you
are asked to be both simultaneously the systemic risk regulator
and functioning as the fundamental, chief responsibility of
monetary policy, where you could actually--you are letting one
trump the other. There are not necessarily going to be
consistent objectives at given moments in time.
Ms. Rivlin. That could be true. I think the more important
point, though, is that they are different skills. If you really
want a set of people who are good at regulating institutions
and helping them not make stupid decisions, then it is a
different kind of staff and leadership than the people who are
good at macroeconomics and figuring out what to do about the
economy.
Chairman Dodd. Yes. Mr. Reinhart, do you have a view on
this?
Mr. Reinhart. Sure, a couple points. One is when you give
an entity that has macropowers a supervisory responsibility,
they have the ability to clean up their mistakes after the
fact. Would a Fed that can lend to an institution be more
willing to lend to it when it hadn't identified it as a
systemic threat? Would it be willing to use its monetary policy
tool to make markets function better in an environment where it
had failed to identify some market areas as posing systemic
risk?
Now, for 6 years, I signed off on the minutes and
transcripts of the Federal Open Market Committee, a wonderful
resource actually giving the details of deliberations of
monetary policy. And the next time you hear someone say there
is important cross-pollination between monetary policy
decisions and bank supervision, you should ask them to go back
to the FOMC transcripts and give you the examples where there
was a significant discussion about bank supervisory matters
that informed the monetary policy decision.
The fact is, as has already been noted, an agency is filled
with hardened silos and the economists don't talk to the
lawyers who don't talk to the bank supervisors. What is
important is to enforce an information sharing, and in some
ways, it is easier to do that across agencies than within an
agency.
Chairman Dodd. Paul, I want to give you a quick chance to
respond to that. My time is up, but it is good to see you and
thanks for being here.
Mr. Stevens. Thank you, Chairman Dodd. Lacking the
experience that my colleagues have at the Fed, I will pass on
that question.
Chairman Dodd. All right.
Mr. Meltzer. Mr. Chairman, may I just say, Congress passed
FDICIA to try to prevent exactly what you just described. They
have not used FDICIA.
Chairman Dodd. Good point.
Senator Shelby.
Senator Shelby. Dr. Reinhart, you were the Director, it is
my understanding, of the Division of Monetary Policy at the
Fed.
Mr. Reinhart. Yes, sir.
Senator Shelby. And from what I gather from your testimony,
you do not believe the Fed needs to regulate financial
institutions in order to conduct or perform its monetary policy
functions, do you, or do you not?
Mr. Reinhart. Yes. I think the Fed needs an understanding,
a deep understanding of the ways markets work, about the way
the institutions work in general. They need to share
information from other agencies. But the talents to be able to
tell a macrostory to fit all those parts of the picture
together for the implications for policy are not ones that need
supervision.
Senator Shelby. Dr. Meltzer, in your testimony, you
question the wisdom of relying too much on capital standards to
guard against systemic risk. You point out the problems of the
Basel Accord that they caused. You also note that banks have
been very successful in circumventing regulation, which we see.
My question to you, are there limits on how much Congress can
manage systemic risk through regulation, and if so, what
measures can be adopted to create incentives for the private
sector to better manage risk?
Mr. Meltzer. Two critical things. Get rid of ``too-big-to-
fail'' and replace it with more capital in the banks.
Second, get a lender of last resort rule that you are
willing to live with, that the Fed is willing to live with,
that the regulators are willing to live with, which says
institutions can fail. The market will be protected from the
spread of that failure to other institutions. Without those
changes, no regulation is going to work.
I gave this talk at the council on Foreign Relations and I
said, lawyers make regulations. Markets learn to circumvent
them. The first question was from a lawyer. He said, it is we
lawyers who teach them how to circumvent them.
Senator Shelby. You have got it right.
Doctor, in your examination of history, has the Federal
Reserve demonstrated that it is inherently better at
identifying systemic risk than any other regulator?
Mr. Meltzer. It is hard to identify systemic risk. You
know, the term ``systemic risk'' is a term of art. I mean, it
is indeed a term of art, because as the questions on the
Committee showed earlier, every Congressman, every Senator will
see--properly see--a failing institution in his region as a
problem which is systemic. How are they going to fight that? I
mean, you, Senator, along with many people argued against the
GSEs----
Senator Shelby. That is right.
Mr. Meltzer. ----thought that something had to be done. But
Congress wasn't going to do that. Is a systemic regulator going
to say, ignore Congress and do that? Is that what we want? No.
Is it possible? I don't believe it is possible in the American
system of Government, nor do I think it should be possible in
the American system of Government for people to say the
Congress doesn't have a right even to make the mistakes that it
makes.
Senator Shelby. Ms. Rivlin, the Fed's wide-ranging
responsibilities seem to me to appear at times to distract it
from its primary mission of monetary policy. For example, just
the other day, the topics covered at our recent Humphrey-
Hawkins hearing demonstrate this point. While the discussion
should have centered on monetary policy, by our count, only
about 27 percent of the questions even addressed monetary
policy from this Committee. How concerned are you that we may
be asking one institution to do too much?
Ms. Rivlin. I am very concerned, Senator Shelby, and that
is why I don't think it is a good idea to have a new
responsibility for ``too-big-to-fail'' institutions at the Fed
or indeed to identify those institutions at all. I am not sure
that the Humphrey-Hawkins questioning, since we are in the
middle of a catastrophe and there were all sorts of things to
ask about, is exactly an example of that, but I do fear that we
will distract the Fed from monetary policy.
Senator Shelby. Thank you very much. Thank you, Mr.
Chairman.
Senator Warner [presiding]. Senator Reed.
Senator Reed. Thank you, Mr. Chairman, and thank you for
your testimony today and for your answers.
As the President's plan evolves, if it is not modified, the
Federal Reserve essentially would be the direct regulator of
most of the major financial institutions of the country. It
would eliminate OTS, et cetera. There has been the suggestion
here, or at least the recommendation, that they get out of the
business of regulating banks. But then I would presume they
would still have the authority, in fact, the responsibility to
regulate the holding company structure, the subsidiaries, the
affiliates where a lot of the problems really evolved. Is that
your sense, Mr. Reinhart?
Mr. Reinhart. That is why actually I would be a strong
proponent of simplification of the rules, consolidation of the
agencies, and putting in place a forceful resolution mechanism
for entities. So my preference would be to roll in the existing
agencies, including the supervisory part of the Federal Reserve
for holding companies, into a new Federal regulator.
Senator Reed. Mr. Stevens, do you have an opinion?
Mr. Stevens. Yes. Thank you, Senator. I had an occasion to
look through, at least briefly, the Administration's
legislative language and the entities that would be vetted to
determine whether they are Tier 1 Financial Holding Companies,
at least potentially, represent an enormous universe of firms--
$10 billion or more in assets, $100 billion or more in assets
under management, $2 billion or more in gross annual revenue.
All of those firms would be potentially subject to review for
whether they should be designated Tier 1 Financial Holding
Companies under a series of standards, the last of which is any
other factor that the Fed thinks is important.
So I don't know, reading the legislation, what the universe
of Fed-regulated entities will be, but it is potentially
enormously large. I asked our research department, how many
mutual fund firms are there, through their mutual funds or
other asset management activities, that may have $100 billion
or more in assets under management, and as I said in my
statement, our best guess is that there are dozens of them,
many of whom would be quite surprised to learn that they are
systemically risky, none of whom thinks that they are too-big-
to-fail.
Senator Reed. Dr. Rivlin.
Ms. Rivlin. I would go with Mr. Reinhart on this. Moving to
a consolidated regulator with less potential for regulatory
arbitrage would seem to me fine, and moving the regulation of
bank holding companies out of the Fed would also seem to me
fine. But the real point is, don't make it worse. Don't put a
huge new regulatory responsibility at the Federal Reserve.
Senator Reed. And Dr. Meltzer.
Mr. Meltzer. Senator, I don't have any quarrel with Vince
Reinhart's proposal. I would say that if you look around the
world, we have separation of regulation and monetary policy. We
have it together. It doesn't seem to make a great deal of
difference. That is, for the failures that we have, why is
that? Because we lack the incentives on the regulators to close
down ``too-big-to-fail'' and protect the market.
Senator Reed. And your proposal is, I think, a very direct
response to that, which would be to have higher capital levels
which presumably smaller institutions could result or would
result from that.
One other question, because it is implicit, I think, in
what we are talking about in terms of dealing with derivatives,
et cetera, and that is establishing capital ratios for risky
operations. Can you comment on that approach, too?
Mr. Meltzer. Yes. I would say, let the institution choose
its size, but increase the capital requirement more than
proportional to the size of the assets so that we--the reason I
want that is I want the stockholders and the management to bear
the losses. There is no gain in economies of scale and
economies of scope that the public is going to realize from
large institutions that compensates for the costs we just paid.
So we want the costs to be on them, and that gives them an
incentive not to do the things they have been doing.
Senator Reed. Thank you, Mr. Chairman. Thank you.
Senator Warner. A vote has started and----
Senator Bunning. I am going to be very short. I have got
one question, because I have waited for this panel a long time.
[Laughter.]
Senator Bunning. This is for anybody that would like to
answer. Do you think the Federal Reserve would do a better job
at monetary policy if its only mission was keeping a stable
currency?
Mr. Meltzer. I will start with that. I believe--I like the
dual requirement. I think that represents what all central
banks, whatever their requirements are, all central banks have
to be concerned about what is happening to the public. But they
also need to have much more attention on maintaining price
stability. I think the Committee needs to say, we are going to
require the Federal Reserve to adopt some principle by which
they operate that limits their discretion to make the mistakes
that they have been making.
Senator Bunning. Thank you, because they don't pay any
attention to us. Go ahead.
Mr. Meltzer. They do it if it is in the law.
Senator Bunning. Well, even if we write it into the law,
they don't do it, because in 1994, we wrote it into the law
that they monitor all mortgages within the banking system that
they control and within the mortgage brokers. And for 14 years,
they didn't write a regulation.
Alice.
Ms. Rivlin. I would actually keep the dual focus on
employment, as well as inflation.
Senator Bunning. OK.
Ms. Rivlin. And I think the Fed gets pretty high marks,
actually, on the inflation front, as do other central banks
over the last few years.
Senator Bunning. Depending on who is scoring.
Ms. Rivlin. Well, OK, but we have not had a big inflation
problem. Now, maybe the Fed doesn't get all the credit for it,
but it is not that they haven't paid attention on that front.
They may not have paid attention----
Senator Bunning. Oh, I didn't say they didn't pay
attention, but they failed to act is all I can tell you.
Go ahead.
Mr. Stevens. Senator, all I would say, not being the Fed
expert here, is----
Senator Bunning. You don't have to be a Fed expert to
understand.
Mr. Stevens. ----at least there is a strong question to
ask--why the authority should be so dramatically expanded.
Senator Bunning. OK.
Mr. Reinhart. I believe the Fed Reserve would be better off
if it had a narrow mandate. Maximum employment and stable
prices sounds right to me. I think are many reasons why that
would be better, including keeping the focus of the
institution, also providing----
Senator Bunning. Rather than expanding their portfolio.
Mr. Reinhart. Certainly not expanding. Also making it
clearer to the public exactly what the Federal Reserve does and
improving the relationships with the Congress.
Senator Bunning. That would take a lot of work.
Mr. Reinhart. If it was narrowly focused. When you think
about it, a lot of these hearings get consumed by issues other
than monetary policy.
Senator Bunning. When they came to us, when they asked for
the TARP money and said, this is going to be as transparent as
anything that we have ever dealt with, and they have completely
stonewalled who they lent the money to, how much money they
printed, and what banks got it and what they spent it for. So
transparency is out the door.
Thank you for your answers. Thank you.
Senator Warner. Well, I am not going to get a chance to ask
my questions. That is the last time I will take this middle
position here as the temporary Chair. But just two quick
comments because we are going to have to run off and vote.
One, thank you all very much for your testimony this
morning. My apologies that the session started late. We will, I
am sure, all have additional questions.
I share the overwhelming view of the panel that systemic
risk ought to not be placed with the Fed and ought to be
empowered with a new independent council that includes the Fed.
I also would like to hear a longer--a written question I will
submit. I do believe we ought to further explore the idea of a
single end-to-end depository regulator for all prudential
regulation and take that out of the Fed and out of the FDIC as
well as the consolidation of the OCC and OTS.
And I do share Professor Meltzer's concerns about how we
put stumbling blocks in front of ``too-big-to-fail.'' Increased
capital, obviously one. I think we have to look at increased
capital on resolution and whether even a contingent liability
fund inside firms of ``too-large'' that might actually cause
some self-policing among those institutions.
The question I will also submit to you is whether those
nontraditional banking activities, as more and more of these
large bank holding companies look like hedge funds, look like
trading funds, have all these other nontraditional banking
aspects, should there be higher capital requirements on those
what would be arguably riskier activities. But I will submit
those as questions and look forward to your answers.
I again thank the panel for their patience and indulgence.
Thank you all very much.
The hearing is adjourned.
[Whereupon, at 12:44 p.m., the hearing was adjourned.]
[Prepared statements and responses to written questions
supplied for the record follow:]
PREPARED STATEMENT OF CHAIRMAN CHRISTOPHER J. DODD
The economic crisis introduced a new term to our national
vocabulary--systemic risk. It is the idea that in an interconnected
global economy, it's easy for some people's problems to become
everybody's problems.
The failures that destroyed some of our Nation's most prestigious
financial institutions also devastated the economic security of
millions of working Americans who did nothing wrong--their jobs, homes,
retirement security, gone in a flash because of Wall Street greed and
regulatory neglect.
After years of focusing on short term profits while ignoring long
term risks, a number of companies, giants of the financial industry
found themselves in serious trouble.
Some failed. Some were sold under duress. And an untold number only
survived because of Government intervention: loans, guarantees, and
direct injections of capital.
Taxpayers had no choice but to step in, assuming billions of
dollars of risk, and save companies because our system wasn't set up to
withstand their failure. These efforts saved our economy from
catastrophe, but real damage remains.
Investors, who lost billions, were scared to invest. Credit markets
dried up. With no one willing to make loans, businesses couldn't make
payroll, employees were laid off, and families couldn't get mortgages
or loans to buy an automobile.
Wall Street's failures have hit Main Streets across the country. It
will take years, perhaps decades, to undo damage that a stronger
regulatory system could have prevented.
While many Americans understand why we had to take extraordinary
measures this time, it doesn't mean they aren't angry. It doesn't mean
they aren't worried. And it doesn't mean they don't expect us to fix
the problems that allowed this to happen.
First and foremost, we need somebody looking at the whole economy
for the next big problem, with the authority to do something about it.
The Administration has a bold proposal to modernize our financial
regulatory system. It would give the Federal Reserve new authority to
identify, regulate, and supervise all financial companies considered to
be systemically important.
It would establish a council of regulators to serve in a solely
advisory role.
And it would provide a framework for companies to fail, if they
must fail, in a way that does not jeopardize the entire financial
system.
It's a thoughtful proposal. But the devil is in the details and I
expect changes to be made.
I share my colleagues' concerns about giving the Fed additional
authority to regulate systemic risk.
The Fed hasn't done a perfect job with the responsibilities it
already has.
This new authority could compromise the independence the Fed needs
to carry out effective monetary policy.
Additionally, systemic risk regulation involves too broad of a
range of issues for any one regulator to oversee.
And so, I am especially interested to hear from our witnesses your
ideas on how we get this right.
Many of you have suggested a council with real authority that would
effectively use the combined knowledge of all of the regulatory
agencies.
As President Obama has said, when we rebuild our economy, we must
ensure that its foundation rests on rock, not on sand. Today, we
continue our work to lay the cornerstones for that foundation--strong,
smart, effective regulation that protects working families without
hindering growth.
______
PREPARED STATEMENT OF SENATOR RICHARD C. SHELBY
Thank you Mr. Chairman.
At the core of the Administration's financial regulatory reform
proposal is the concept of systemic risk. The President believes that
it can be regulated and that the Fed should be the regulator.
As we begin to consider how to address systemic risk, my main
concern is that while there appears to be a growing consensus on the
need for a systemic risk regulator, there is no agreement on how to
define systemic risk, let alone how to manage it.
I believe that it would be legislative malfeasance to simply tell a
particular regulator to manage all financial risks without having
reached some consensus on what systemic risk is and whether it can be
regulated at all.
Should we reach such a consensus, we then must be very careful not
to give our markets a false sense of security that could actually
exacerbate our ``too-big-to-fail'' problem.
If market participants believe that they no longer have to closely
monitor risks presented by financial institutions, the stage will be
set for our next economic crisis.
If we can decide what systemic risk is and that it is something
that should and can be regulated, our next question should be: Who
should regulate it?
Unfortunately, the Administration's proposal largely places the
Federal Reserve in charge of regulating systemic risk.
It would grant the Fed authority to regulate any bank, securities
firm, insurer, investment fund or any other type of financial
institution that the Fed deems a systemic risk.
The Fed would be able to regulate any aspect of these firms, even
over the objections of other regulators. In effect, the Fed would
become a regulatory leviathan of unprecedented size and scope.
I believe that expanding the Fed's powers in this manner could be
very dangerous.
The mixing of monetary policy and bank regulation has proven to be
a formula for taxpayer-funded bailouts and poor monetary policy
decisions.
Giving the Fed ultimate responsibility for the regulation of
systemically important firms will provide further incentive for the Fed
to hide its regulatory failures by bailing out troubled firms.
Rather than undertaking the politically painful task of resolving
failed institutions, the Fed could take the easy way out and rescue
them by using its lender-of-last-resort facilities or open market
operations.
Even worse, it could undertake these bailouts without having to
obtain the approval of Congress.
In our system of Government, elected-officials should make
decisions about fiscal policy and the use of taxpayer dollars, not
unelected central bankers.
Handing over the public purse to an enhanced Fed is simply
inconsistent with the principles of democratic Government.
Augmenting the Federal Reserve's authority also risks burdening it
with more responsibility than one institution can reasonably be
expected to handle.
In fact, the Federal Reserve is already overburdened with its
responsibility for monetary policy, the payment system, consumer
protection, and bank supervision.
I believe anointing the Fed as the systemic risk regulator will
make what has proven to be a bad bank regulator even worse.
Let us not forget that it was the Fed that pushed for the adoption
of the flawed Basel II capital accords, which would have drained our
banking system of capital.
It was the Fed that failed to adequately supervise Citigroup and
Bank of America, setting the stage for bailouts in excess of $400
billion.
It was the Fed that failed to adopt mortgage underwriting
guidelines until well after this crisis was underway.
It was the Fed that said there was no need to regulate derivatives.
It was also the Fed that lobbied to become the regulator of
financial holding companies as part of Gramm-Leach-Bliley.
The Fed won that fight and got the additional authority it sought.
Ten years later, however, it is clear that the Fed has proven that it
is incapable of handling that responsibility.
Ultimately, if we are able to reach some sort of agreement on
systemic risk and whether it can be managed, I strongly believe that we
should consider every possible alternative to the Fed as the systemic
risk regulator.
Thank you Mr. Chairman.
______
PREPARED STATEMENT OF SENATOR TIM JOHNSON
Thank you Mr. Chairman for holding today's hearing. Hearings like
this will be important as the Committee prepares to consider
legislation to modernize our financial regulatory system and establish
a mechanism to identify systemic risks to our economy.
There is widespread agreement that institutions exploiting gaps in
our regulatory system greatly contributed to the current economic
crisis. These institutions, while oftentimes large and complex, were
able to offer products with minimal regulation and operate with little
oversight. The scope of the economic crisis is indicative of the
breadth of the gaps in our regulatory system.
Many have suggested that the best way to close these gaps is
through the creation of an entity to oversee systemically risky firms,
what some have termed ``too-big-to-fail.'' This entity could watch,
evaluate, and when necessary, intervene to prevent failures of large
firms from leading to an economy-wide meltdown.
That said, we must be able to identify systemic risks without
creating unnecessary regulation and without giving large firms the idea
that the Federal Government is there to bail them out if they make poor
decisions. A systemic risk regulator would have to put taxpayer
protection at the top of its priority list.
It is my hope that Members of this Committee from both sides of the
aisle can find a proposal to better monitor systemic risk, whether
within an existing agency or with the creation of a new entity.
Regardless of who does it, we need to identify systemic risk in our
financial markets to prevent another crisis like the one we are
experiencing from happening again and to aid in our economic recovery
and reform. We must get this right. I look forward to hearing from
today's witnesses.
______
PREPARED STATEMENT OF SENATOR JACK REED
Today's hearing will help us create a new framework for identifying
and minimizing systemic risks, so that we can prevent our financial
markets from ever again facing the turmoil we have witnessed over the
last year. We need to be thoughtful and deliberate in our approach, but
we need to act soon. As part of this process, we should think carefully
about some key remaining questions.
First, there seems to be a consensus emerging among regulators and
many in Congress on the need for a Council to address risks in the
financial system. But my colleagues and I will need to think carefully
about the specific role and tools available to such a Council. The
Administration's proposal would establish a Financial Services
Oversight Council, to be chaired by Treasury and consisting of the
banking, securities, and other financial regulators.
Such an approach gathers the right people around the table but may
leave them with no ``teeth'' to intervene to prevent or react to
problems. Much of the responsibility for setting standards would remain
with the Federal Reserve, which raises serious concerns given its
failure in recent years to identify serious risks to our financial
system, and the agency's inaction on consumer protection issues.
Second, under the Administration's plan, there would be heightened
supervision and consolidation of all large, interconnected financial
firms, including a process for identifying Tier 1 financial holding
companies. This approach has merit, but requires careful consideration,
especially as it would apply to firms that have operated under various
exemptions and grandfathering provisions. We will also need to
carefully consider if and how to identify Tier 1 firms on an ongoing
basis. Today's hearing will allow for the consideration of the best
approach in this area, including whether it is best done by a Council
or a single regulator.
Finally, among the issues we should consider is the
Administration's proposal to enhance the Federal Reserve's authority
with respect to the safety and soundness of systemically important
payment, clearing, and settlement arrangements. This issue is of
particular importance because of the role of these systems in
increasing regulation of over-the-counter derivatives, and the existing
responsibilities of the SEC and the CFTC in this area.
I appreciate the testimony of the witnesses today and I look
forward to discussing these important questions.
______
PREPARED STATEMENT OF SENATOR JIM BUNNING
Thank you, Mr. Chairman.
As I have said several times before, I do not think we can create a
new regulator that will be able to outsmart Wall Street and prevent
future financial failures. And I know the Federal Reserve is not up to
the task. In fact, the Fed needs to be reformed so it can get monetary
policy right and not create future bubbles through easy money.
Instead of putting all our faith in a super regulator, I think we
are better off taking steps to reduce the damage done by future
failures. That means making financial institutions smaller, reducing
risk factors like leverage, banning some risky practices, sound
supervision, and making financial actors live with the consequences of
their actions. That also means treating similar activities the same way
no matter if they are done by a bank, broker, or other firm, and ending
regulation shopping. If we do these things, we will greatly reduce the
impact of future failures.
Finally, of all the proposals we have seen, the one outlined in
Chairman Bair's testimony today makes the most sense so far. While I
think there are other matters that need to be addressed and I may not
agree with everything she proposes, I think her plan is a better
starting point than the proposal from Treasury and the Fed.
Thank you, Mr. Chairman. I look forward to hearing from the
witnesses today.
______
PREPARED STATEMENT OF SHEILA C. BAIR
Chairman, Federal Deposit Insurance Corporation
July 23, 2009
Chairman Dodd, Ranking Member Shelby, and Members of the Committee,
I appreciate the opportunity to testify on behalf of the Federal
Deposit Insurance Corporation (FDIC) on the importance of reforming our
financial regulatory system. The issues under discussion today rival in
importance those before the Congress in the wake of the Great
Depression.
The proposals put forth by the Administration regarding the
structure of the financial system, the supervision of financial
entities, the protection of consumers, and the resolution of
organizations that pose a systemic risk to the economy provide a useful
framework for discussion of areas in vital need of reform. However,
these are complex issues that can be addressed in a number of different
ways. We all agree that we must get this right and enact regulatory
reforms that address the fundamental causes of the current crisis
within a carefully constructed framework that guards against future
crises.
It is clear that one of these causes was the presence of
significant regulatory gaps within the financial system. Differences in
the regulation of capital, leverage, complex financial instruments, and
consumer protection provided an environment in which regulatory
arbitrage became rampant. Reforms are urgently needed to close these
regulatory gaps.
At the same time, we must recognize that much of the risk in recent
years was built up, within and around, financial firms that were
already subject to extensive regulation and prudential supervision. One
of the lessons of the past several years is that regulation and
prudential supervision alone are not sufficient to control risk taking
within a dynamic and complex financial system. Robust and credible
mechanisms to ensure that market participants will actively monitor and
control risk taking must be in place.
We must find ways to impose greater market discipline on
systemically important institutions. In a properly functioning market
economy there will be winners and losers, and when firms--through their
own mismanagement and excessive risk taking--are no longer viable, they
should fail. Actions that prevent firms from failing ultimately distort
market mechanisms, including the market's incentive to monitor the
actions of similarly situated firms. Unfortunately, the actions taken
during the past year have reinforced the idea that some financial
organizations are too-big-to-fail. The solution must involve a
practical, effective and highly credible mechanism for the orderly
resolution of these institutions similar to that which exists for FDIC-
insured banks. In short, we need an end to ``too-big-to-fail.''
The notion of ``too-big-to-fail'' creates a vicious circle that
needs to be broken. Large firms are able to raise huge amounts of debt
and equity and are given access to the credit markets at favorable
terms without consideration of the firms' risk profile. Investors and
creditors believe their exposure is minimal since they also believe the
Government will not allow these firms to fail. The large firms leverage
these funds and become even larger, which makes investors and creditors
more complacent and more likely to extend credit and funds without fear
of losses. In some respects, investors, creditors, and the firms
themselves are making a bet that they are immune from the risks of
failure and loss because they have become too big, believing that
regulators will avoid taking action for fear of the repercussions on
the broader market and economy.
If anything is to be learned from this financial crisis, it is that
market discipline must be more than a philosophy to ward off
appropriate regulation during good times. It must be enforced during
difficult times. Given this, we need to develop a resolution regime
that provides for the orderly wind-down of large, systemically
important financial firms, without imposing large costs to the
taxpayers. In contrast to the current situation, this new regime would
not focus on propping up the current firm and its management. Instead,
under the proposed authority, the resolution would concentrate on
maintaining the liquidity and key activities of the organization so
that the entity can be resolved in an orderly fashion without
disrupting the functioning of the financial system. Losses would be
borne by the stockholders and bondholders of the holding company, and
senior management would be replaced. Without a new comprehensive
resolution regime, we will be forced to repeat the costly, ad hoc
responses of the last year.
My testimony discusses ways to address and improve the supervision
of systemically important institutions and the identification of issues
that pose risks to the financial system. The new structure should
address such issues as the industry's excessive leverage, inadequate
capital, and overreliance on short-term funding. In addition, the
regulatory structure should ensure real corporate separateness and the
separation of the bank's management, employees, and systems from those
affiliates. Risky activities, such as proprietary and hedge fund
trading, should be kept outside of insured banks and subject to
enhanced capital requirements.
Although regulatory gaps clearly need to be addressed, supervisory
changes alone are not enough to address these problems. Accordingly,
policy makers should focus on the elements necessary to create a
credible resolution regime that can effectively address the resolution
of financial institutions regardless of their size or complexity and
assure that shareholders and creditors absorb losses before the
Government. This mechanism is at the heart of our proposals--a bank and
bank holding company resolution facility that will impose losses on
shareholders and unsecured debt investors, while maintaining financial
market stability and minimizing systemic consequences for the national
and international economy. The credibility of this resolution mechanism
would be further enhanced by the requirement that each bank holding
company with subsidiaries engaged in nonbanking financial activities
would be required to have, under rules established by the FDIC, a
resolution plan that would be annually updated and published for the
benefit of market participants and other customers.
The combined enhanced supervision and unequivocal prospect of an
orderly resolution will go a long way to assuring that the problems of
the last several years are not repeated and that any problems that do
arise can be handled without cost to the taxpayer.
Improving Supervision and Regulation
The widespread economic damage that has occurred over the past 2
years has called into question the fundamental assumptions regarding
financial institutions and their supervision that have directed our
regulatory efforts for decades. The unprecedented size and complexity
of many of today's financial institutions raise serious issues
regarding whether they can be properly managed and effectively
supervised through existing mechanisms and techniques. Our current
system clearly failed in many instances to manage risk properly and to
provide stability. Many of the systemically significant entities that
have needed Federal assistance were already subject to extensive
Federal supervision. For various reasons, these powers were not used
effectively and, as a consequence, supervision was not sufficiently
proactive.
Insufficient attention was paid to the adequacy of complex
institutions' risk management capabilities. Too much reliance was
placed on mathematical models to drive risk management decisions.
Notwithstanding the lessons from Enron, off-balance sheet-vehicles were
permitted beyond the reach of prudential regulation, including holding
company capital requirements. The failure to ensure that financial
products were appropriate and sustainable for consumers caused
significant problems not only for those consumers but for the safety
and soundness of financial institutions. Lax lending standards employed
by lightly regulated nonbank mortgage originators initiated a downward
competitive spiral which led to pervasive issuance of unsustainable
mortgages. Ratings agencies freely assigned AAA credit ratings to the
senior tranches of mortgage securitizations without doing fundamental
analysis of underlying loan quality. Trillions of dollars in complex
derivative instruments were written to hedge risks associated with
mortgage-backed securities and other exposures. This market was, by and
large, excluded from Federal regulation by statute.
A strong case can be made for creating incentives that reduce the
size and complexity of financial institutions. A financial system
characterized by a handful of giant institutions with global reach and
a single regulator is making a huge bet on the performance of those
banks and that regulator.
Financial firms that pose systemic risks should be subject to
regulatory and economic incentives that require these institutions to
hold larger capital and liquidity buffers to mirror the heightened risk
they pose to the financial system. In addition, restrictions on
leverage and the imposition of risk-based premiums on institutions and
their activities would act as disincentives to growth and complexity
that raise systemic concerns. In contrast to the standards implied in
the Basel II Accord, systemically important firms should face
additional capital charges based on both their size and complexity. To
address procyclicality, the capital standards should provide for higher
capital buffers that increase during expansions and are available to be
drawn down during contractions. In addition, these firms should be
subject to higher Prompt Corrective Action standards under U.S. laws
and holding company capital requirements that are no less stringent
than those applicable to insured banks. Regulators also should take
into account off-balance-sheet assets and conduits as if these risks
were on-balance-sheet.
The Need for a Financial Services Oversight Council
The significant size and growth of unsupervised financial
activities outside the traditional banking system--in what is termed
the shadow financial system--has made it all the more difficult for
regulators or market participants to understand the real dynamics of
either bank credit markets or public capital markets. The existence of
one regulatory framework for insured institutions and a much less
effective regulatory scheme for nonbank entities created the conditions
for arbitrage that permitted the development of risky and harmful
products and services outside regulated entities.
A distinction should be drawn between the direct supervision of
systemically significant financial firms and the macroprudential
oversight and regulation of developing risks that may pose systemic
risks to the U.S. financial system. The former appropriately calls for
the identification of a prudential supervisor for any potential
systemically significant entity. Entities that are already subject to a
prudential supervisor, such as insured depository institutions and
financial holding companies, should retain those supervisory
relationships.
The macroprudential oversight of systemwide risks requires the
integration of insights from a number of different regulatory
perspectives--banks, securities firms, holding companies, and perhaps
others. Only through these differing perspectives can there be a
holistic view of developing risks to our system. As a result, for this
latter role, the FDIC supports the creation of a Council to oversee
systemic risk issues, develop needed prudential policies and mitigate
developing systemic risks. In addition, for systemic entities not
already subject to a Federal prudential supervisor, this Council should
be empowered to require that they submit to such oversight, presumably
as a financial holding company under the Federal Reserve--without
subjecting them to the activities restrictions applicable to these
companies.
Supervisors across the financial system failed to identify the
systemic nature of the risks before they were realized as widespread
industry losses. The performance of the regulatory system in the
current crisis underscores the weakness of monitoring systemic risk
through the lens of individual financial institutions and argues for
the need to assess emerging risks using a systemwide perspective. The
Administration's proposal addresses the need for broader-based
identification of systemic risks across the economy and improved
interagency cooperation through the establishment of a new Financial
Services Oversight Council. The Oversight Council described in the
Administration's proposal currently lacks sufficient authority to
effectively address systemic risks.
In designing the role of the Council, it will be important to
preserve the longstanding principle that bank regulation and
supervision are best conducted by independent agencies. Careful
attention should be given to the establishment of appropriate
safeguards to preserve the independence of financial regulation from
political influence. The Administration's plan gives the role of
Chairman of the Financial Services Oversight Council to the Secretary
of the Treasury. To ensure the independence and authority of the
Council, consideration should be given to a configuration that would
establish the Chairman of the Council as a Presidential appointee,
subject to Senate confirmation. This would provide additional
independence for the Chairman and enable the Chairman to focus full
time on attending to the affairs of the Council and supervising Council
staff. Other members on the Council could include, among others, the
Federal financial institution, securities and commodities regulators.
In addition, we would suggest that the Council include an odd number of
members in order to avoid deadlocks.
The Council should complement existing regulatory authorities by
bringing a macroprudential perspective to regulation and being able to
set or harmonize prudential standards to address systemic risk. Drawing
on the expertise of the Federal regulators, the Oversight Council
should have broad authority and responsibility for identifying
institutions, products, practices, services and markets that create
potential systemic risks, implementing actions to address those risks,
ensuring effective information flow, and completing analyses and making
recommendations. In order to do its job, the Council needs the
authority to obtain any information requested from systemically
important entities.
The crisis has clearly revealed that regulatory gaps, or
significant differences in regulation across financial services firms,
can encourage regulatory arbitrage. Accordingly, a primary
responsibility of the Council should be to harmonize prudential
regulatory standards for financial institutions, products and practices
to assure that market participants cannot arbitrage regulatory
standards in ways that pose systemic risk. The Council should evaluate
differing capital standards which apply to commercial banks, investment
banks, and investment funds to determine the extent to which differing
standards circumvent regulatory efforts to contain excess leverage in
the system. The Council could also undertake the harmonization of
capital and margin requirements applicable to all OTC derivatives
activities--and facilitate interagency efforts to encourage greater
standardization and transparency of derivatives activities and the
migration of these activities onto exchanges or Central Counterparties.
The Council also could consider requiring financial companies to
issue contingent debt instruments--for example, long-term debt that,
while not counting toward the satisfaction of regulatory capital
requirements, automatically converts to equity under specific
conditions. Conditions triggering conversion could include the
financial companies' capital falling below prompt corrective action
mandated capital levels or regulators declaring a systemic emergency.
Financial companies also could be required to issue a portion of their
short-term debt in the form of debt instruments that similarly
automatically convert to long-term debt under specific conditions,
perhaps tied to liquidity. Conversion of long-term debt to equity would
immediately recapitalize banks in capital difficulty. Conversion of
short-term debt to long-term debt would ameliorate liquidity problems.
Also, the Council should be able to harmonize rules regarding
systemic risks to serve as a floor that could be met or exceeded, as
appropriate, by the primary prudential regulator. Primary regulators
would be charged with enforcing the requirements set by the Council.
However, if the primary regulators fail to act, the Council should have
the authority to do so. The standards set by the Council should be
designed to provide incentives to reduce or eliminate potential
systemic risks created by the size or complexity of individual
entities, concentrations of risk or market practices, and other
interconnections between entities and markets. Any standards set by the
Council should be construed as a minimum floor for regulation that can
be exceeded, as appropriate, by the primary prudential regulator.
The Council should have the authority to consult with systemic and
financial regulators from other countries in developing reporting
requirements and in identifying potential systemic risk in the global
financial market. The Council also should report to Congress annually
about its efforts, identify emerging systemic risk issues and recommend
any legislative authority needed to mitigate systemic risk.
Some have suggested that a council approach would be less effective
than having this authority vested in a single agency because of the
perception that a deliberative council such as this would need
additional time to address emergency situations that might arise from
time to time. Certainly, some additional thought and effort will be
needed to address any dissenting views in council deliberations.
However, a Council with regulatory agency participation will provide
for an appropriate system of checks and balances to ensure that
decisions reflect the various interests of public and private
stakeholders. In this regard, it should be noted that the board
structure at the FDIC, with the participation of the Comptroller of the
Currency and the Director of the Office of Thrift Supervision, is not
very different from the way the Council would operate. In the case of
the FDIC, quick decisions have been made with respect to systemic
issues and emergency bank resolutions on many occasions. Based on our
experience with a board structure, we believe that decisions could be
made quickly by a deliberative council.
Resolution Authority
Even if risk-management practices improve dramatically and we
introduce effective macroprudential supervision, the odds are that a
large systemically significant firm will become troubled or fail at
some time in the future. The current crisis has clearly demonstrated
the need for a single resolution mechanism for financial firms that
will preserve stability while imposing the losses on shareholders and
creditors and replacing senior management to encourage market
discipline. A timely, orderly resolution process that could be applied
to both banks and nonbank financial institutions, and their holding
companies, would prevent instability and contagion and promote
fairness. It would enable the financial markets to continue to function
smoothly, while providing for an orderly transfer or unwinding of the
firm's operations. The resolution process would ensure that there is
the necessary liquidity to complete transactions that are in process at
the time of failure, thus addressing the potential for systemic risk
without creating the expectation of a bailout.
Under the new resolution regime, Congress should raise the bar
higher than existing law and eliminate the possibility of open
assistance for individual failing entities. The new resolution powers
should result in the shareholders and unsecured creditors taking losses
prior to the Government, and consideration also should be given to
imposing some haircut on secured creditors to promote market discipline
and limit costs potentially borne by the Government.
Limitations of the Current Resolution Authority
The FDIC's resolution powers are very effective for most failed
bank situations (see Appendix). However, systemic financial
organizations present additional issues that may complicate the FDIC's
process of conducting an efficient and economical resolution. As noted
above, many financial activities today take place in financial firms
that are outside the insured depository institution where the FDIC's
existing authority does not reach. These financial firms must be
resolved through the bankruptcy process, as the FDIC's resolution
powers only apply to insured depository institutions. Resolving large
complex financial firms through the bankruptcy process can be
destabilizing to regional, national, and international economies since
the timing is uncertain and the process can be complex and protracted
and may vary by jurisdiction.
By contrast, the powers that are available to the FDIC under its
statutory resolution authorities can resolve financial entities much
more rapidly than under bankruptcy. The FDIC bears the unique
responsibility for resolving failed depository institutions and is
therefore able to plan for an orderly resolution process. Through this
process, the FDIC works with the primary supervisor to gather
information on a troubled bank before it fails and plans for the
transfer or orderly wind-down of the bank's assets and businesses. In
doing so, the FDIC is able to maintain public confidence and perform
its public policy mandate of ensuring financial stability.
Resolution Authority for Systemically Important Financial Firms
To ensure an orderly and comprehensive resolution mechanism for
systemically important financial firms, Congress should adopt a
resolution process that adheres to the following principles:
The resolution scheme and processes should be transparent,
including the imposition of losses according to an established
claims priority where stockholders and creditors, not the
Government, are in the first loss position.
The resolution process should seek to minimize costs and
maximize recoveries. The resolution should be conducted to
achieve the least cost to the Government as a whole with the
FDIC allocating the losses among the various affiliates and
subsidiaries proportionate to their responsibilities for the
cost of the failure.
There should be a unified resolution process housed in a
single entity.
The resolution entity should have the responsibility and
the authority to set assessments to fund systemic resolutions
to cover working capital and unanticipated losses.
The resolution process should allow the continuation of any
systemically significant operations, but only as a means to
achieve a final resolution of the entity. A bridge mechanism,
applicable to the parent company and all affiliated entities,
allows the Government to preserve systemically significant
functions. It enables losses to be imposed on market players
who should appropriately bear the risk. It also creates the
possibility of multiple bidders for the financial organization
and its assets, which can reduce losses to the receivership.
The resolution entity must effectively manage its financial
and operational risk exposure on an ongoing basis. The
receivership function necessarily entails certain activities
such as the establishment of bridge entities, implementing
purchase and assumption agreements, claims processing, asset
liquidation or disposition, and franchise marketing. The
resolving entity must establish, maintain, and implement these
functions for a covered parent company and all affiliated
entities.
Financial firms often operate on a day-to-day basis without regard
to the legal structure of the firm. That is, employees of the holding
company may provide vital services to a subsidiary bank because the
same function exists in both the bank and the holding company. However,
this intertwining of functions can present significant issues when
trying to wind down the firm. For this reason, there should be
requirements that mandate greater functional autonomy of holding
company affiliates.
In addition, to facilitate the resolution process, the holding
companies should have an acceptable resolution plan that could
facilitate and guide the resolution in the event of a failure. Through
a carefully considered rule making, each financial holding company
should be required to make conforming changes to their organization to
ensure that the resolution plans could be effectively implemented. The
plans should be updated annually and made publicly available.
Congress also should alter the current process that establishes a
procedure for open bank assistance that benefits shareholders and
eliminates the requirement that the resolution option be the least
costly to the Deposit Insurance Fund (DIF). As stated above,
shareholders and creditors should be required to absorb losses from the
institution's failure before the Government.
Current law allows for an exception to the standard claims priority
where the failure of one or more institutions presents ``systemic
risk.'' In other words, once a systemic risk determination is made, the
law permits the Government to provide assistance irrespective of the
least cost requirement, including ``open bank'' assistance which inures
to the benefit of shareholders. The systemic risk exception is an
extraordinary procedure, requiring the approval of super majorities of
the FDIC Board, the Federal Reserve Board, and the Secretary of the
Treasury in consultation with the President.
We believe that the systemic risk exception should be narrowed so
that it is available only where there is a finding that support for
open institutions is necessary to address problems which pervade the
system, as opposed to problems which are particular to an individual
institution. Whatever support is provided should be broadly available
and justified in that it will result in least cost to the Government as
a whole. If the Government suffers a loss as a result an institution's
performance under this exception, the institution should be required to
be resolved in accordance with the standard claims priority.
Had this narrower systemic risk exception been in place during the
past year, open institution assistance would not have been permitted
for individual institutions. An individual institution would likely
have been put into a bridge entity, with shareholders and unsecured
creditors taking losses before the Government. Broader programs that
benefit the entire system, such as the Temporary Liquidity Guarantee
Program and the Federal Reserve's liquidity facilities, would have been
permitted. However if any individual institution participating in these
programs had caused a loss, the normal resolution process would be
triggered.
The initiation of this type of systemic assistance should require
the same concurrence of the supermajority of the FDIC Board, the
Federal Reserve Board and the Treasury Department (in consultation with
the President) as under current law. No single Government entity should
be able to unilaterally trigger a resolution strategy outside the
defined parameters of the established resolution process. Further, to
ensure transparency, these determinations should be made in
consultation with Congress, documented and reviewed by the Government
Accountability Office.
Other Improvements to the Resolution Process
Consideration should be given to allowing the resolution authority
to impose limits on financial institutions' abilities to use collateral
to mitigate credit risk ahead of the Government for some types of
activities. The ability to fully collateralize credit risks removes an
institution's incentive to underwrite exposures by assessing a
counterparty's ability to perform from revenues from continuing
operations. In addition, the recent crisis has demonstrated that
collateral calls generate liquidity pressures that can magnify systemic
risks. For example, up to 20 percent of the secured claim for companies
with derivatives claims against the failed firm could be haircut if the
Government is expected to suffer losses. This would ensure that market
participants always have an interest in monitoring the financial health
of their counterparties. It also would limit the sudden demand for more
collateral because the protection could be capped and also help to
protect the Government from losses. Other approaches could include
increasing regulatory and supervisory disincentives for excessive
reliance on secured borrowing.
As emphasized at the beginning of this statement, a regulatory and
resolution structure should, among other things, ensure real corporate
separateness and the separation of the bank's management, employees,
and systems from those of its affiliates. Risky activities, such as
proprietary trading, should be kept outside the bank. Consideration
also should be given to enhancing restrictions against transactions
with affiliates, including the elimination of 23A waivers. In addition,
the resolution process could be greatly enhanced if companies were
required to have an acceptable resolution plan that and guides the
liquidation in the event of a failure. Requiring that the plans be
updated annually and made publicly available would provide additional
transparency that would improve market discipline.
Funding Systemic Resolutions
To be credible, a resolution process for systemically significant
institutions must have the funds necessary to accomplish the
resolution. It is important that funding for this resolution process be
provided by the set of potentially systemically significant financial
firms, rather than by the taxpayer. To that end, Congress should
establish a Financial Company Resolution Fund (FCRF) to provide working
capital and cover unanticipated losses for the resolution.
One option for funding the FCRF is to prefund it through a levy on
larger financial firms--those with assets above a certain large
threshold. The advantage of prefunding the FCRF is the ability to
impose risk-based assessments on large or complex institutions that
recognize their potential risks to the financial system. This system
also could provide an economic incentive for an institution not to grow
too large. In addition, building the fund over time through consistent
levies would avoid large procyclical charges during times of systemic
stress.
Alternatively, the FCRF could be funded after a systemic failure
through an assessment on other large, complex institutions. The
advantage to this approach is that it does not take capital out of
institutions until there is an actual systemic failure. The
disadvantages of this approach are that it is not risk sensitive, it is
initially dependent on the ability to borrow from the Treasury, it
assess institutions when they can least afford it and the institution
causing the loss is the only one that never pays an assessment.
The systemic resolution entity should have the authorities needed
to manage this resolution fund, as the FDIC does for the DIF. The
entity should also be authorized to borrow from the Treasury if
necessary, but those borrowings should be repaid by the financial firms
that contribute to the FCRF.
International Issues
Some significant challenges exist for international banking
resolution actions since existing bank crisis management and resolution
arrangements are not designed to deal specifically with cross-border
banking problems. However, providing resolution authority to a specific
entity in the U.S. would enhance the ability to enter into definitive
memoranda of understanding with other countries. Many of these same
countries have recognized the benefits of improving their resolution
regimes and are considering improvements. This provides a unique
opportunity for the U.S. to be the leader in this area and provide a
model for the effective resolution of failed entities.
Dealing with cross-border banking problems is difficult. For
example, provisions to allow the transfer of assets and liabilities to
a bridge bank or other institution may have limited effectiveness in a
cross-border context because these actions will not necessarily be
recognized or promptly implemented in other jurisdictions. In the
absence of other arrangements, it is presumed that ring fencing will
occur. Ring fencing may secure the interests of creditors or
individuals in foreign jurisdictions to the detriment of the resolution
as a whole.
In the United States, the Foreign Bank Supervision Enhancement Act
of 1991 requires foreign banks that wish to do a retail deposit-taking
business to establish a separately chartered subsidiary bank. This
structural arrangement ensures that assets and capital will be
available to U.S. depositors or the FDIC should the foreign parent bank
and its U.S. subsidiary experience difficulties. In this sense, it is
equivalent to ``prepackaged'' ring fencing. An idea to consider would
be to have U.S. banks operating abroad to do so through bank
subsidiaries. This could streamline the FDIC's resolution process for a
U.S. bank with foreign operations. U.S. operations would be resolved by
the FDIC and the foreign operations by the appropriate foreign
regulator. However, this would be a major change and could affect the
ability of U.S. banks to attract foreign deposits overseas.
Resolution Authority for Depository Institution Holding Companies
To have a process that not only maintains liquidity in the
financial system but also terminates stockholders' rights, it is
important that the FDIC have the authority to resolve both systemically
important and nonsystemically important depository institution holding
companies, affiliates and majority-owned subsidiaries in the case of
failed or failing insured depository institutions. When a failing bank
is part of a large, complex holding company, many of the services
essential for the bank's operation may reside in other portions of the
holding company, beyond the FDIC's authority. The loss of essential
services can make it difficult to preserve the value of a failed
institution's assets, operate the bank or resolve it efficiently. The
business operations of large, systemic financial organizations are
intertwined with business lines that may span several legal entities.
When one entity is in the FDIC's control while the other is not, it
significantly complicates resolution efforts. Unifying the holding
company and the failed institution under the same resolution authority
can preserve value, reduce costs and provide stability through an
effective resolution. Congress should enhance the authority of the FDIC
to resolve the entire organization in order to achieve a more orderly
and comprehensive resolution consistent with the least cost to the DIF.
When the holding company structure is less complex, the FDIC may be
able to effect a least cost resolution without taking over the holding
company. In cases where the holding company is not critical to the
operations of the bank or thrift, the FDIC should be able to opt out--
that is, allow the holding company to be resolved through the
bankruptcy process. The decision on whether to employ enhanced
resolution powers or allow the bank holding company to declare
bankruptcy would depend on which strategy would result in the least
cost to the DIF. Enhanced authorities that allow the FDIC to
efficiently resolve failed depository institutions that are part of a
complex holding company structure when it achieves the least costly
resolution will provide immediate efficiencies in bank resolutions.
Conclusion
The current financial crisis demonstrates the need for changes in
the supervision and resolution of financial institutions, especially
those that are systemically important to the financial system. The FDIC
stands ready to work with Congress to ensure that the appropriate steps
are taken to strengthen our supervision and regulation of all financial
institutions--especially those that pose a systemic risk to the
financial system.
I would be pleased to answer any questions from the Committee.
Appendix
The FDIC's Resolution Authority
The FDIC has standard procedures that go into effect when an FDIC-
insured bank or thrift is in danger of failing. When the FDIC is
notified that an insured institution is in danger of failing, we begin
assembling an information package for bidders that specifies the
structure and terms of the transaction. FDIC staff review the bank's
books, contact prospective bidders, and begin the process of auctioning
the bank--usually prior to its failure--to achieve the best return to
the bank's creditors, and the Deposit Insurance Fund (DIF).
When the appropriate Federal or State banking authority closes an
insured depository institution, it appoints the FDIC as conservator or
receiver. On the day of closure by the chartering entity, the FDIC
takes control of the bank and in most cases removes the failed bank's
management. Shareholder control rights are terminated, although
shareholders maintain a claim on any residual value remaining after
depositors' and other creditors' claims are satisfied.
Most bank failures are resolved by the sale of some or all of the
bank's business to an acquiring bank. FDIC staff work with the
acquiring bank, and make the transfer as unobtrusive, seamless and
efficient as possible. Generally, all the deposits that are transferred
to the acquiring bank are made immediately available online or through
ATMs. The bank usually reopens the next business day with a new name
and under the control of the acquiring institution. Those assets of the
failed bank that are not taken by the acquiring institution are then
liquidated by the FDIC.
Sometimes banks must be closed quickly because of an inability to
meet their funding obligations. These ``liquidity failures'' may
require that the FDIC set up a bridge bank. The bridge bank structure
allows the FDIC to provide liquidity to continue the bank's operations
until the FDIC has time to market and sell the failed bank. The
creation of a bridge also terminates stockholders rights as described
earlier.
Perhaps the greatest benefit of the FDIC's process is the quick
reallocation of resources. It is a process that can be painful to
shareholders, creditors and bank employees, but history has shown that
early recognition of losses with closure and sale of nonviable
institutions is the fastest path back to economic health.
______
PREPARED STATEMENT OF MARY L. SCHAPIRO
Chairman, Securities and Exchange Commission
July 23, 2009
Introduction
Chairman Dodd, Ranking Member Shelby, and Members of the Committee:
I am pleased to have the opportunity to testify concerning the
regulation of systemic risk in the U.S. financial industry. \1\
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\1\ My testimony is on my own behalf, as Chairman of the SEC. The
commission has not voted on this testimony.
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We have learned many lessons from the recent financial crisis and
events of last fall, central among them being the need to identify,
monitor, and reduce the possibility that a sudden shock will lead to a
market seizure or cascade of failures that puts the entire financial
system at risk.
In turning those lessons into reforms, the following should guide
us:
First, there are two different kinds of ``systemic risk'': (1) the
risk of sudden, near-term systemic seizures or cascading failures, and
(2) the longer-term risk that our system will unintentionally favor
large systemically important institutions over smaller, more nimble
competitors, reducing the system's ability to innovate and adapt to
change. We must be very careful that our efforts to protect the system
from near-term systemic seizures do not inadvertently result in a long-
term systemic imbalance.
Second, there are two different kinds of ``systemic risk
regulation'': (1) the traditional oversight, regulation, market
transparency and enforcement provided by primary regulators that helps
keep systemic risk from developing in the first place, and (2) the new
``macroprudential'' regulation designed to identify and minimize
systemic risk if it does.
Third, we must be cognizant of both kinds of regulation if we are
to minimize both kinds of ``systemic risk.'' I believe the best way to
achieve this balance is to:
Address structural imbalances that facilitate the
development of systemic risk by closing gaps in regulation,
improving transparency and strengthening enforcement; and
Establish a workable, macroprudential regulatory framework
consisting of a single systemic risk regulator (SRR) with clear
authority and accountability and a Financial Stability
Oversight Council (Council) that can identify risks across the
system, write rules to minimize systemic risk and help ensure
that future regulatory gaps--and arbitrage opportunities--are
minimized or avoided.
Throughout this process, however, we must remain vigilant that our
efforts to minimize ``sudden systemic risk'' do not inadvertently
create new structural imbalances that undermine the long-term vibrancy
of our capital markets.
Addressing Structural Imbalances Through Traditional Oversight
Much of the debate surrounding ``systemic risk'' and financial
regulatory reform has focused on new ``macroprudential'' oversight and
regulation. This debate has focused on whether we need a systemic risk
regulator to identify and minimize systemic risk and how to resolve
large interconnected institutions whose failure might affect the health
of others or the system. The debate also has focused on whether it is
possible to declare our readiness to ``resolve'' systemically important
institutions without unintentionally facilitating their growth and
systemic importance.
Before turning to those issues, it is important that we not forget
the role that traditional oversight, regulation and market transparency
play in reducing systemic risk. This is the traditional ``block and
tackle'' oversight and regulation, that is vital to ensuring that
systemic risks do not develop in the first place.
Filling Regulatory Gaps
One central mechanism for reducing systemic risk is to ensure the
same rules apply to the same or similar products and participants. Our
global capital markets are incredibly fast and competitive: financial
participants are competing with each other not just for ideas and
talent but also with respect to ``microseconds'' and basis points. In
such an environment, if financial participants realize they can achieve
the same economic ends with fewer costs by flocking to a regulatory
gap, they will do so quickly, often with size and leverage.
We have seen this time and again, most recently with over-the-
counter derivatives, instruments through which major institutions
engage in enormous, virtually unregulated trading in synthetic versions
of other, often regulated financial products. We can do much to reduce
systemic risk if we close these gaps and ensure that similar products
are regulated similarly.
Improving Market Transparency
In conjunction with filling regulatory gaps, market transparency
can help to decrease systemic risk. We have seen tremendous growth in
financial products and vehicles that work exactly like other products
and vehicles, but with little or no transparency.
For example, there are ``dark pools'' in which securities are
traded that work like traditional markets without the oversight or
information flow. Also, enormous risk resides in ``off-balance-sheet''
vehicles hidden from investors and other market participants who likely
would have allocated capital more efficiently--and away from these
risks--had the risks been fully disclosed.
Transparency reduces systemic risk in several ways. It gives
regulators and investors better information about markets, products and
participants. It also helps regulators leverage market behavior to
minimize the need for larger interventions.
Where market participants are given sufficient information about
assets, liabilities and risks, they, following their risk-reward
analyses, could themselves allocate capital away from risk or demand
higher returns for it. This in turn would help to reduce systemic risk
before it develops. In this sense, the new ``macroprudential'' systemic
risk regulation (set forth later in this testimony) can be seen as an
important tool for identifying and reducing systemic risk, but not a
first or only line of defense.
I support the Administration's efforts to fill regulatory gaps and
improve market transparency, particularly with respect to over-the-
counter derivatives and hedge funds, and I believe they will go a long
way toward reducing systemic risk.
Active Enforcement
It is important to note the role active regulation and enforcement
plays in changing behavior and reducing systemic risks.
Though we need vibrant capital markets and financial innovation to
meet our country's changing needs, we have learned there are two sides
to financial innovation. At their best, our markets are incredible
machines capable of taking ``ordinary'' investments and savings and
transforming them into new, highly useful products--turning today's
thrift into tomorrow's stable wealth. At their worst, the self-
interests of financial engineers seeking short-term profit can lead to
ever more complex and costly products designed less to serve investors'
needs than to generate fees.
Throughout this crisis we have seen how traditional processes
evolved into questionable business practices, that, when combined with
leverage and global markets, created extensive systemic risk. A
counterbalance to this is active enforcement that serves as a ready
reminder of (1) what the rules are and (2) why we need them to protect
consumers, investors, and taxpayers--and indeed the system itself.
Macroprudential Oversight: The Need for a Systemic Risk Regulator and
Financial Stability Oversight Council
Although I believe in the critical role that traditional oversight,
regulation, enforcement, and market transparency must play in reducing
systemic risk, they alone are not sufficient.
Functional regulation alone has shown several key shortcomings.
First, information--and thinking--can remain ``siloed.'' Functional
regulators typically look at particular financial participants or
vehicles even as individual financial products flow through them all,
often resulting in their seeing only small pieces of the broader
financial landscape.
Second, because financial actors can use different vehicles or
jurisdictions from which to engage in the same activity, actors can
sometimes ``choose'' their regulatory framework. This choice can
sometimes result in regulatory competition--and a race to the bottom
among competing regulators and jurisdictions, lowering standards and
increasing systemic risk.
Third, functional regulators have a set of statutory powers and a
legal framework designed for their particular types of financial
products or entities. Even if a regulator could extend its existing
powers over other entities not typically within its jurisdiction, these
legal frameworks are not easily transferrable either to other entities
or other types of risk.
Given these shortcomings, I agree with the Administration on the
need to establish a regulatory framework for macroprudential oversight.
Within that framework, I believe a hybrid approach consisting of a
single systemic risk regulator and a powerful council is most
appropriate. Such an approach would provide the best structure to
ensure clear accountability for systemic risk, enable a strong, nimble
response should circumstances arise and maintain the broad and
differing perspectives needed to best identify developing risks and
minimize unintended consequences.
A Systemic Risk Regulator
Given the (1) speed, size, and complexity of our global capital
markets; (2) large role a relatively small number of major financial
intermediaries play in that system; and (3) extent of Government
interventions needed to address the recent turmoil, I agree there needs
to be a Government entity responsible for monitoring our entire
financial system for systemwide risks, with the tools to forestall
emergencies. I believe this role could be performed by the Federal
Reserve or a new entity specifically designed for this task.
This ``systemic risk regulator'' should have access to information
across the financial markets and, in addition to the individual
functional regulators, serve as a second set of eyes upon those
institutions whose failure might put the system at risk. It should have
ready access to information about institutions that might pose a risk
to the system, including holding company liquidity and risk exposures;
monitor whether institutions are maintaining capital levels required by
the Council; and have clear delegated authority to respond quickly in
extraordinary circumstances.
In addition, an SRR should be required to report to the Council on
its supervisory programs and the risks and trends it identifies at the
institutions it supervises.
Financial Stability Oversight Council
Further, I agree with the Administration and FDIC Chairman Bair
that this SRR must be combined with a newly created Council. I believe,
however, that any Council must be strengthened beyond the framework set
forth in the Administration's ``white paper.''
This Council should have the tools needed to identify emerging
risks, be able to establish rules for leverage and risk-based capital
for systemically important institutions; and be empowered to serve as a
ready mechanism for identifying emerging risks and minimizing the
regulatory arbitrage that can lead to a regulatory race to the bottom.
To balance the weakness of monitoring systemic risk through the
lens of any single regulator, the Council would permit us to assess
emerging risks from the vantage of a multidisciplinary group of
financial experts with responsibilities that extend to different types
of financial institutions, both large and small. Members could include
representatives of the Department of the Treasury, SEC, CFTC, FRB, OCC,
and FDIC.
The Council should have authority to identify institutions,
practices, and markets that create potential systemic risks and set
standards for liquidity, capital and other risk management practices at
systemically important institutions. The SRR would then be responsible
for implementing these standards.
The Council also should provide a forum for discussing and
recommending regulatory standards across markets, helping to identify
gaps in the regulatory framework before they morph into larger
problems. This hybrid approach can help minimize systemic risk in a
number of ways:
First, a Council would ensure different perspectives to
help identify risks that an individual regulator might miss or
consider too small to warrant attention. These perspectives
would also improve the quality of systemic risk requirements by
increasing the likelihood that second-order consequences are
considered and flushed out;
Second, the financial regulators on the Council would have
experience regulating different types of institutions
(including smaller institutions) so that the Council would be
more likely to ensure that risk-based capital and leverage
requirements do not unintentionally foster systemic risk. Such
a result could occur by giving large, systemically important
institutions a competitive advantage over smaller institutions
that would permit them to grow even larger and more risky; and
Third, the Council would include multiple agencies, thereby
significantly reducing potential conflicts of interest (e.g.,
conflicts with other regulatory missions).
The Council also would monitor the development of financial
institutions to prevent the creation of institutions that are either
too-big-to-fail or too-big-to-succeed. In that regard, I believe that
insufficient attention has been paid to the risks posed by institutions
whose businesses are so large and diverse that they have become, for
all intents and purposes, unmanageable. Given the potential daily
oversight role of the SRR, it would likely be less capable of
identifying and avoiding these risks impartially. Accordingly, the
Council framework is vital to ensure that our desire to minimize short-
term systemic risk does not inadvertently undermine our system's long-
term health.
Coordination of Council/SRR With Primary Regulators
In most times, I would expect the Council and SRR to work with and
through primary regulators of systemically important institutions. The
primary regulators understand the markets, products and activities of
their regulated entities. The SRR, however, can provide a second layer
of review over the activities, capital, and risk management procedures
of systemically important institutions as a backstop to ensure that no
red flags are missed.
If differences arise between the SRR and the primary regulator
regarding the capital or risk management standards of systemically
important institutions, I strongly believe that the higher (more
conservative) standard should govern. The systemic risk regulatory
structure should serve as a ``brake'' on a systemically important
institution's riskiness; it should never be an ``accelerator.''
In emergency situations, the SRR may need to overrule a primary
regulator (for example, to impose higher standards or to stop or limit
potentially risky activities). However, to ensure that authority is
checked and decisions are not arbitrary, the Council should be where
general policy is set, and only then to implement a more rigorous
policy than that of a primary regulator. This will reduce the ability
of any single regulator to ``compete'' with other regulators by
lowering standards, driving a race to the bottom.
Unwinding Systemic Risk--A Third Option
I agree with the Administration, the FDIC, and others that the
Government needs a credible resolution mechanism for unwinding
systemically important institutions.
Currently, banks and broker-dealers are subject to well-established
resolution processes under the Federal Deposit Insurance Corporation
Improvement Act and the Securities Investor Protection Act,
respectively. No corresponding resolution process exists, however, for
the holding companies of systemically significant financial
institutions.
In times of crisis when a systemically important institution may be
teetering on the brink of failure, policy makers are left in the
difficult position of choosing between two highly unappealing options:
(1) providing Government assistance to a failing institution (or an
acquirer of a failing institution), thereby allowing markets to
continue functioning but potentially fostering more irresponsible risk
taking in the future; or (2) not providing Government assistance but
running the risk of market collapses and greater costs in the future.
Markets recognize this Hobson's choice and can actually fuel more
systemic risk by ``pricing in'' the possibility of a Government
backstop of large-interconnected institutions. This can give them an
advantage over their smaller competitors and make them even larger and
more interconnected.
A credible resolution regime can help address these risks by giving
policy makers a third option: a controlled unwinding of the institution
over time. Structured correctly, such a regime could force market
participants to realize the full costs of their decisions and help
reduce the ``too-big-to-fail'' dilemma. Structured poorly, such a
regime could strengthen market expectations of Government support, as a
result fueling ``too-big-to-fail'' risks.
Avoidance of conflicts of interest in this regime will be
paramount. Different regulators with different missions may have
different priorities. For example, both customer accounts with broker-
dealers and depositor accounts in banks must be protected and should
not be used to cross-subsidize other efforts. A healthy consultation
process with a regulated entity's primary regulator will provide needed
institutional knowledge to ensure that potential conflicts such as this
are minimized.
Conclusion
To better ensure that systemwide risks will be identified and
minimized without inadvertently creating larger risk down the road, I
recommend that Congress establish a strong Financial Stability
Oversight Council, comprised of the primary regulators.
The Council should have responsibility for identifying systemically
significant institutions and systemic risks, making recommendations
about and implementing actions to address those risks, promoting
effective information flow, setting liquidity and capital standards,
and ensuring key supervisors apply those standards appropriately.
The various primary regulators offer broad perspectives across
markets that represent a wide range of institutions and investors. This
array of perspectives is essential to build a foundation for the
development of a robust regulatory framework better designed to
withstand future periods of market or economic volatility and help
restore investors' confidence in our Nation's markets. I believe a
structure such as this provides the best balance for reducing sudden
systemic risk without undermining the competitive and resilient capital
markets needed over the long term.
Thank you again for the opportunity to present my views. I look
forward to working with the Committee on any financial reform efforts
it may undertake, and I would be pleased to answer any questions.
PREPARED STATEMENT OF DANIEL K. TARULLO
Member, Board of Governors of the Federal Reserve System
July 23, 2009
Chairman Dodd, Ranking Member Shelby, and other Members of the
Committee, I appreciate the opportunity to discuss how to improve the
U.S. financial regulatory system so as to contain systemic risk and to
address the related problem of too-big-to-fail financial institutions.
Experience over the past 2 years clearly demonstrates that the United
States needs a comprehensive strategy to help prevent financial crises
and to mitigate the effects of crises that may occur.
The roots of this crisis lie in part in the fact that regulatory
powers and capacities lagged the increasingly tight integration of
conventional lending activities with the issuance, trading, and
financing of securities. This crisis did not begin with depositor runs
on banks, but with investor runs on firms that financed their holdings
of securities in the wholesale money markets. An effective agenda for
containing systemic risk thus requires adjustments by all our financial
regulatory agencies under existing authorities. It also invites action
by the Congress to fill existing gaps in regulation, remove impediments
to consolidated oversight of complex institutions, and provide the
instruments necessary to cope with serious financial problems that do
arise.
In keeping with the Committee's interest today in a systemic risk
agenda, I will identify some of the key administrative and legislative
elements that should be a part of that agenda. Ensuring that all
systemically important financial institutions are subject to effective
consolidated supervision is a critical first step. Second, a more
macroprudential outlook--that is, one that takes into account the
safety and soundness of the financial system as a whole, as well as
individual institutions--needs to be incorporated into the supervision
and regulation of these firms and financial institutions more
generally. Third, better and more formal mechanisms should be
established to help identify, monitor, and address potential or
emerging systemic risks across the financial system as a whole,
including gaps in regulatory or supervisory coverage that could present
systemic risks. A council with broad representation across agencies and
departments concerned with financial supervision and regulation is one
approach to this goal. Fourth, a new resolution process for
systemically important nonbank financial firms should be created that
would allow the Government to wind down a troubled systemically
important firm in an orderly manner. Fifth, all systemically important
payment, clearing, and settlement arrangements should be subject to
consistent and robust oversight and prudential standards.
The role of the Federal Reserve in a reoriented financial
regulatory system derives, in our view, directly from its position as
the Nation's central bank. Financial stability is integral to the
achievement of maximum employment and price stability, the dual mandate
that Congress has conferred on the Federal Reserve as its objectives in
the conduct of monetary policy. Indeed, there are some important
synergies between systemic risk regulation and monetary policy, as
insights garnered from each of those functions informs the performance
of the other. Close familiarity with private credit relationships,
particularly among the largest financial institutions and through
critical payment and settlement systems, makes monetary policy makers
better able to anticipate how their actions will affect the economy.
Conversely, the substantial economic analysis that accompanies monetary
policy decisions can reveal potential vulnerabilities of financial
institutions.
While the improvements in the financial regulatory framework
outlined above would involve some expansion of Federal Reserve
responsibilities, that expansion would be an incremental and natural
extension of the Federal Reserve's existing supervisory and regulatory
responsibilities, reflecting the important relationship between
financial stability and the roles of a central bank. An effective and
comprehensive agenda for addressing systemic risk will also require new
responsibilities for other Federal agencies and departments, including
the Treasury, Securities and Exchange Commission (SEC), Commodity
Futures Trading Commission (CFTC), and Federal Deposit Insurance
Corporation (FDIC).
Consolidated Supervision of Systemically Important Financial
Institutions
The current financial crisis has clearly demonstrated that risks to
the financial system can arise not only in the banking sector, but also
from the activities of other financial firms--such as investment banks
or insurance organizations--that traditionally have not been subject,
either by law or in practice, to the type of regulation and
consolidated supervision applicable to bank holding companies. While
effective consolidated supervision of potentially systemic firms is
not, by itself, sufficient to foster financial stability, it certainly
is a necessary condition. The Administration's recent proposal for
strengthening the financial system would subject all systemically
important financial institutions to the same framework for prudential
supervision on the same consolidated or groupwide basis that currently
applies to bank holding companies. In doing so, it would also prevent
systemically important firms that have become bank holding companies
during the crisis from reversing this change and escaping prudential
supervision in calmer financial times. While this proposal is an
important piece of an agenda to contain systemic risk and the ``too-
big-to-fail'' problem, it would not actually entail a significant
expansion of the Federal Reserve's mandate.
The proposal would entail two tasks--first identifying, and then
effectively supervising, these systemically important institutions. As
to supervision, the Bank Holding Company Act of 1956 (BHCA) designates
the Federal Reserve as the consolidated supervisor of all bank holding
companies. That act provides the Federal Reserve a range of tools to
understand, monitor, and, when appropriate, restrain the risks
associated with an organization's consolidated or groupwide activities.
Under this framework, the Federal Reserve has the authority to
establish consolidated capital requirements for bank holding companies.
In addition, subject to certain limits I will discuss later, the act
permits the Federal Reserve to obtain reports from and conduct
examinations of a bank holding company and any of its subsidiaries. It
also grants authority to require the organization or its subsidiaries
to alter their risk-management practices or take other actions to
address risks that threaten the safety and soundness of the
organization.
Under the BHCA, the Federal Reserve already supervises some of the
largest and most complex financial institutions in the world. In the
course of the financial crisis, several large financial firms that
previously were not subject to mandatory consolidated supervision--
including Goldman Sachs, Morgan Stanley, and American Express--became
bank holding companies, in part to assure market participants that they
were subject to robust prudential supervision on a consolidated basis.
While the number of additional financial institutions that would be
subject to supervision under the Administration's approach would of
course depend on standards or guidelines adopted by the Congress, the
criteria offered by the Administration suggest to us that the initial
number of newly regulated firms would probably be relatively limited.
One important feature of this approach is that it provides ongoing
authority to identify and supervise other firms that may become
systemically important in the future, whether through organic growth or
the migration of activities from regulated entities.
Determining precisely which firms would meet these criteria will
require considerable analysis of the linkages between firms and
markets, drawing as much or more on economic and financial analysis as
on bank supervisory expertise. Financial institutions are systemically
important if the failure of the firm to meet its obligations to
creditors and customers would have significant adverse consequences for
the financial system and the broader economy. At any point in time, the
systemic importance of an individual firm depends on a wide range of
factors. Obviously, the consequences of a firm's failure are more
likely to be severe if the firm is large, taking account of both its
on- and off-balance sheet activities. But size is far from the only
relevant consideration. The impact of a firm's financial distress
depends also on the degree to which it is interconnected, either
receiving funding from, or providing funding to, other potentially
systemically important firms, as well as on whether it performs crucial
services that cannot easily or quickly be executed by other financial
institutions. In addition, the impact varies over time: the more
fragile the overall financial backdrop and the condition of other
financial institutions, the more likely a given firm is to be judged
systemically important. If the ability of the financial system to
absorb adverse shocks is low, the threshold for systemic importance
will more easily be reached. Judging whether a financial firm is
systemically important is thus not a straightforward task, especially
because a determination must be based on an assessment of whether the
firm's failure would likely have systemic effects during a future
stress event, the precise parameters of which cannot be fully known.
For supervision of firms identified as systemically important to be
effective, we will need to build on lessons learned from the current
crisis and on changes we are already undertaking in light of the
broader range of financial firms that have come under our supervision
in the last year. In October, we issued new consolidated supervision
guidance for bank holding companies that provides for supervisory
objectives and actions to be calibrated more directly to the systemic
significance of individual institutions and bolsters supervisory
expectations with respect to the corporate governance, risk management,
and internal controls of the largest, most complex organizations. \1\
We are also adapting our internal organization of supervisory
activities to take better advantage of the information and insight that
the economic and financial analytic capacities of the Federal Reserve
can bring to bear in financial regulation.
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\1\ See Supervision and Regulation Letter 08-9, ``Consolidated
Supervision of Bank Holding Companies and the Combined U.S. Operations
of Foreign Banking Organizations'', and the associated interagency
guidance.
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The recently completed Supervisory Capital Assessment Process
(SCAP) reflects some of these changes in the Federal Reserve's system
for prudential supervision of the largest banking organizations. This
unprecedented process specifically incorporated forward-looking, cross-
firm, and aggregate analyses of the 19 largest bank holding companies,
which together control a majority of the assets and loans within the
financial system. Importantly, supervisors in the SCAP defined a
uniform set of parameters to apply to each firm being evaluated, which
allowed us to evaluate on a consistent basis the expected performance
of the firms, drawing on individual firm information and independently
estimated outcomes using supervisory models. Drawing on this
experience, we will conduct horizontal examinations on a periodic basis
to assess key operations, risks, and risk-management activities of
large institutions.
We also plan to create a quantitative surveillance program for
large, complex financial organizations that will use supervisory
information, firm-specific data analysis, and market-based indicators
to identify developing strains and imbalances that may affect multiple
institutions, as well as emerging risks to specific firms. Periodic
scenario analyses across large firms will enhance our understanding of
the potential impact of adverse changes in the operating environment on
individual firms and on the system as a whole. This work will be
performed by a multidisciplinary group composed of our economic and
market researchers, supervisors, market operations specialists, and
accounting and legal experts. This program will be distinct from the
activities of on-site examination teams so as to provide an independent
supervisory perspective, as well as to complement the work of those
teams.
To be fully effective, consolidated supervisors must have clear
authority to monitor and address safety and soundness concerns and
systemic risks in all parts of an organization, working in coordination
with other supervisors wherever possible. As the crisis has
demonstrated, the assessment of nonbank activities is essential to
understanding the linkages between depository and nondepository
subsidiaries and the risk profile of the organization as a whole. The
Administration's proposal would make useful modifications to the
provisions added to the law in 1999 that limit the ability of the
Federal Reserve to monitor and address risks within an organization and
its subsidiaries on a groupwide basis. \2\
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\2\ The Administration's proposal also would close the loophole in
current law that allowed certain investment banks, as well as other
financial and nonfinancial firms, to acquire control of a federally
insured industrial loan company (ILC) while avoiding the prudential
framework that Congress established for the corporate owners of other
full-service insured banks. The Board has for many years supported such
a change.
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A Macroprudential Approach to Supervision and Regulation
The existing framework for the regulation and supervision of
banking organizations is focused primarily on the safety and soundness
of individual organizations, particularly their insured depository
institutions. As the Administration's proposal recognizes, the
resiliency of the financial system could be improved by incorporating a
more explicit macroprudential approach to supervision and regulation. A
macroprudential outlook, which considers interlinkages and
interdependencies among firms and markets that could threaten the
financial system in a crisis, complements the current microprudential
orientation of bank supervision and regulation.
Indeed, a more macroprudential focus is essential in light of the
potential for explicit regulatory identification of systemically
important firms to exacerbate the ``too-big-to-fail'' problem. Unless
countervailing steps are taken, the belief by market participants that
a particular firm is too-big-to-fail, and that shareholders and
creditors of the firm may be partially or fully protected from the
consequences of a failure, has many undesirable effects. It materially
weakens the incentive of shareholders and creditors of the firm to
restrain the firm's risk taking, provides incentives for financial
firms to become very large in order to be perceived as too-big-to-fail,
and creates an unlevel competitive playing field with smaller firms
that may not be regarded as having implicit Government support.
Creation of a mechanism for the orderly resolution of systemically
important nonbank financial firms, which I will discuss later, should
help remediate this problem. In addition, capital, liquidity, and risk-
management requirements for systemically important firms will need to
be strengthened to help counteract moral hazard effects, as well as the
greater potential risks these institutions pose to the financial system
and to the economy. We believe that the agency responsible for
supervision of these institutions should have the authority to adopt
and apply such requirements, and thus have clear accountability for
their efficacy. Optimally, these requirements should be calibrated
based on the relative systemic importance of the institution, a
different measure than a firm's direct credit and other risk exposures
as calculated in traditional capital or liquidity regulation.
It may also be beneficial for supervisors to require that
systemically important firms maintain specific forms of capital so as
to increase their ability to absorb losses outside of a bankruptcy or
formal resolution procedure. Such capital could be in contingent form,
converting to common equity only when necessary to mitigate systemic
risk. A macroprudential approach also should be reflected in regulatory
capital standards more generally, so that banks are required to
increase their capital levels in good times in order to create a buffer
that can be drawn down as economic and financial conditions
deteriorate.
The development and implementation of capital standards for
systemically important firms is but one of many elements of an
effective macroprudential approach to financial regulation. Direct and
indirect exposures among systemically important firms are an obvious
source of interdependency and potential systemic risk. Direct credit
exposures may arise from lending, loan commitments, guarantees, or
derivative counterparty relationships among institutions. Indirect
exposures may arise through exposures to a common risk factor, such as
the real estate market, that could stress the system by causing losses
to many firms at the same time, through common dependence on
potentially unstable sources of short-term funding, or through common
participation in payment, clearing, or settlement systems.
While large, correlated exposures have always been an important
source of risk and an area of focus for supervisors, macroprudential
supervision requires special attention to the interdependencies among
systemically important firms that arise from common exposures.
Similarly, there must be monitoring of exposures that could grow
significantly in times of systemwide financial stress, such as those
arising from OTC derivatives or the sponsorship of off-balance-sheet
financing conduits funded by short-term liabilities that are
susceptible to runs. One tool that would be useful in identifying such
exposures would be the cross-firm horizontal reviews that I discussed
earlier, enhanced to focus on the collective effects of market
stresses.
The Federal Reserve also would expect to carefully monitor and
address, either individually or in conjunction with other supervisors
and regulators, the potential for additional spillover effects.
Spillovers may occur not only due to exposures currently on a firm's
books, but also as a result of reactions to stress elsewhere in the
system, including at other systemically important firms or in key
markets. For example, the failure of one firm may lead to deposit or
liability runs at other firms that are seen by investors as similarly
situated or that have exposures to such firms. In the recent financial
crisis, exactly this sort of spillover resulted from the failure of
Lehman Brothers, which led to heightened pressures on other investment
banks. One tool that could be helpful in evaluating spillover risks
would be multiple-firm or system-level stress tests focused
particularly on such risks. However, this type of test would greatly
exceed the SCAP in operational complexity; thus, properly developing
and implementing such a test would be a substantial challenge.
Potential Role of a Council
The breadth and heterogeneity of the U.S. financial system have
been great economic strengths of our country. However, these same
characteristics mean that common exposures or practices across a wide
range of financial markets and financial institutions may over time
pose risks to financial stability, but may be difficult to identify in
their early stages. Moreover, addressing the pervasive problem of
procyclicality in the financial system will require efforts across
financial sectors. To help address these issues, the Administration has
proposed the establishment of a Financial Services Oversight Council
composed of the Treasury and all of the Federal financial supervisory
and regulatory agencies, including the Federal Reserve.
The Board sees substantial merit in the establishment of a council
to conduct macroprudential analysis and coordinate oversight of the
financial system as a whole. The perspective of, and information from,
supervisors on such a council with different primary responsibilities
would be helpful in identifying and monitoring emerging systemic risks
across the full range of financial institutions and markets. A council
could be charged with identifying emerging sources of systemic risk,
including: large and rising exposures across firms and markets;
emerging trends in leverage or activities that could result in
increased systemic fragility; possible misalignments in asset markets;
potential sources of spillovers between financial firms or between
firms and markets that could propagate, or even magnify, financial
shocks; and new markets, practices, products, or institutions that may
fall through the gaps in regulatory coverage and become threats to
systemic stability. In addition, a council could play a useful role in
coordinating responses by member agencies to mitigate emerging systemic
risks identified by the council, and by helping coordinate actions to
address procylicality in capital regulations, accounting standards
(particularly with regard to reserves), deposit insurance premiums, and
other supervisory and regulatory practices. In light of these
responsibilities and its broad membership, a council also would be a
useful forum for identifying financial firms that are at the cusp of
being systemically important and, when appropriate, recommending such
firms for designation as systemically important. Finally, should
Congress choose to create default authority for regulation of
activities that do not fall under the jurisdiction of any existing
financial regulator, the council would seem the appropriate
instrumentality to determine how the expanded jurisdiction should be
exercised.
A council could be tasked with gathering and evaluating information
from the various supervisory agencies and producing an annual report to
the Congress on the state of the financial system, potential threats to
financial stability, and the responses of member agencies to identified
threats. Such a report could include recommendations for statutory
changes where needed to address systemic threats due to, for example,
growth or changes in unregulated sectors of the financial system. More
generally, a council could promote research and other efforts to
enhance understanding, both nationally and internationally, of the
underlying causes of financial instability and systemic risk and
possible approaches to countering such developments.
To fulfill such responsibilities, a council would need access to a
broad range of information from its member financial supervisors
regarding the institutions and markets under their purview, as well as
from other Government agencies. Where the information necessary to
monitor emerging risks was not available from a member agency, a
council likely would need the authority to collect such information
directly from financial institutions and markets. \3\
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\3\ To facilitate information collections and interagency sharing,
a council should have the clear authority for protecting confidential
information subject, of course, to applicable law, including the
Freedom of Information Act.
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Improved Resolution Process
A key element to addressing systemic risk is the creation of a new
regime that would allow the orderly resolution of systemically
important nonbank financial firms. In most cases, the Federal
bankruptcy laws provide an appropriate framework for the resolution of
nonbank financial institutions. However, the bankruptcy code does not
sufficiently protect the public's strong interest in ensuring the
orderly resolution of a nonbank financial firm whose failure would pose
substantial risks to the financial system and to the economy. Indeed,
after the Lehman and AIG experiences, there is little doubt that there
needs to be a third option between the choices of bankruptcy and
bailout.
The Administration's proposal would create such an option by
allowing the Treasury to appoint a conservator or receiver for a
systemically important nonbank financial institution that has failed or
is in danger of failing. The conservator or receiver would have a
variety of authorities--similar to those provided the FDIC with respect
to failing insured banks--to stabilize and either rehabilitate or wind
down the firm in a way that mitigates risks to financial stability and
to the economy. For example, the conservator or receiver would have the
ability to take control of the management and operations of the failing
firm; sell assets, liabilities, and business units of the firm; and
repudiate contracts of the firm. These are appropriate tools for a
conservator or receiver. However, Congress may wish to consider adding
some constraints as well--such as requiring that shareholders bear
losses and that creditors be entitled to at least the liquidation value
of their claims.
Importantly, the proposal would allow the Government, through a
receivership, to impose ``haircuts'' on creditors and shareholders of
the firm, either directly or by ``bridging'' the failing institution to
a new entity, when consistent with the overarching goal of protecting
the financial system and the broader economy. This aspect of the
proposal is critical to addressing the ``too-big-to-fail'' problem and
the resulting moral hazard effects that I discussed earlier.
The Administration's proposal appropriately would establish a high
standard for invocation of this new resolution regime and would create
checks and balances on its potential use, similar to the provisions
governing use of the systemic risk exception to least-cost resolution
in the Federal Deposit Insurance Act (FDI Act). The Federal Reserve's
participation in this decision-making process would be an extension of
our long-standing role in protecting financial stability, involvement
in the current process for invoking the systemic risk exception under
the FDI Act, and status as consolidated supervisor for large banking
organizations. The Federal Reserve, however, is not well suited, nor do
we seek, to serve as the resolution agency for systemically important
institutions under the new framework.
As we have seen during the recent crisis, a substantial commitment
of public funds may be needed, at least on a temporary basis, to
stabilize and facilitate the orderly resolution of a large, highly
interconnected financial firm. The Administration's proposal provides
for such funding needs to be addressed by the Treasury, with the
ultimate costs of any assistance to be recouped through assessments on
financial firms over an extended period of time. We believe the
Treasury is the appropriate source of funding for the resolution of
systemically important financial institutions, given the unpredictable
and inherently fiscal nature of this function. The availability of such
funding from Treasury also would eliminate the need for the Federal
Reserve to use its emergency lending authority under section 13(3) of
the Federal Reserve Act to prevent the failure of specific
institutions.
Payment, Clearing, and Settlement Arrangements
The current regulatory and supervisory framework for systemically
important payment, clearing, and settlement arrangements is fragmented,
with no single agency having the ability to ensure that all
systemically important arrangements are held to consistent and strong
prudential standards. The Administration's proposal would provide the
Federal Reserve certain additional authorities for ensuring that all
systemically important payment, clearing, and settlement arrangements
are subject to robust standards for safety and soundness.
Payment, settlement, and clearing arrangements are the foundation
of the Nation's financial infrastructure. These arrangements include
centralized market utilities for clearing and settling payments,
securities, and derivatives transactions, as well as decentralized
activities through which financial institutions clear and settle such
transactions bilaterally. While payment, clearing, and settlement
arrangements can create significant efficiencies and promote
transparency in the financial markets, they also may concentrate
substantial credit, liquidity, and operational risks. Many of these
arrangements also have direct and indirect financial or operational
linkages and, absent strong risk controls, can themselves be a source
of contagion in times of stress. Thus, it is critical that systemically
important systems and activities be subject to strong and consistent
prudential standards designed to ensure the identification and sound
management of credit, liquidity, and operational risks.
The proposed authority would build on the considerable experience
of the Federal Reserve in overseeing systemically important payment,
clearing, and settlement arrangements for prudential purposes. Over the
years, the Federal Reserve has worked extensively with domestic and
foreign regulators to develop strong and internationally recognized
standards for critical systems. Further, the Federal Reserve already
has direct supervisory responsibility for some of the largest and most
critical systems in the United States, including the Depository Trust
Company and CLS Bank and has a role in overseeing several other
systemically important systems. Yet, at present, this authority depends
to a considerable extent on the specific organizational form of these
systems as State member banks. The safe and efficient operation of
payment, settlement, and clearing systems is critical to the execution
of monetary policy and the flow of liquidity throughout the financial
sector, which is why many central banks around the world currently have
explicit oversight responsibilities for critical systems.
Importantly, the proposed enhancements to our responsibilities for
the safety and soundness of systemically important arrangements would
complement--and not displace--the authority of the SEC and CFTC for the
systems subject to their supervision under the Federal securities and
commodities laws. We have an extensive history of working cooperatively
with these agencies, as well as international authorities. For example,
the Federal Reserve works closely with the SEC in supervising the
Depository Trust Company and also works closely with 21 other central
banks in supervising the foreign exchange settlements of CLS Bank.
Consumer Protection
A word on the consumer protection piece of the Administration's
plan may be appropriate here, insofar as we have seen how problems in
consumer protection can in some cases contain the seeds of systemic
problems. The Administration proposes to shift responsibility for
writing and enforcing regulations to protect consumers from unfair
practices in financial transactions from the Federal Reserve to a new
Consumer Financial Protection Agency.
Without extensively entering the debate on the relative merits of
this proposal, I do think it important to point out some of the
benefits that would be lost through this change.
Both the substance of consumer protection rules and their
enforcement are complementary to prudential supervision. Poorly
designed financial products and misaligned incentives can at once harm
consumers and undermine financial institutions. Indeed, as with
subprime mortgages and securities backed by these mortgages, these
products may at times also be connected to systemic risk. At the same
time, a determination of how to regulate financial practices both
effectively and efficiently can be facilitated by the understanding of
institutions' practices and systems that is gained through safety and
soundness regulation and supervision. Similarly, risk assessment and
compliance monitoring of consumer and prudential regulations are
closely related, and thus entail both informational advantages and
resource savings.
Under Chairman Bernanke's leadership, the Federal Reserve has
adopted strong consumer protection measures in the mortgage and credit
card areas. These regulations benefited from the supervisory and
research capabilities of the Federal Reserve, including expertise in
consumer credit markets, retail payments, banking operations, and
economic analysis. Involving all these forms of expertise is important
for tailoring rules that prevent abuses while not impeding the
availability of sensible extensions of credit.
Conclusion
Thank you again for the opportunity to testify on these important
matters. The Federal Reserve looks forward to working with Congress and
the Administration to enact meaningful regulatory reform that will
strengthen the financial system and reduce both the probability and
severity of future crises.
______
PREPARED STATEMENT OF VINCENT R. REINHART
Resident Scholar, American Enterprise Institute
July 23, 2009
For Best Results: Simplify
Chairman Dodd, Ranking Member Shelby, and Members of the Committee
thank you for the opportunity to testify today.
No doubt, the American people expect significant remedial action in
the aftermath of the extraordinary Government support to financial
institutions over the past year. Indeed, this is probably a
generational moment in which this Congress will shape the financial
landscape for decades to come. At the outset, however, we must remember
that greater discipline does not always follow from more intricate
oversight.
The Problem
In fact, complexity has been the bane of our financial system for
decades and cannot be the solution going forward. We have created an
intricate, multifaceted terrain of opportunities through our financial
regulations, tax codes, and accounting rules. There are multiple
Federal regulators and State alternatives. Different jurisdictions
offer varied enticements in terms of favorable legal structure and tax
treatment. And the tax code ranges across region and over time.
Financial firms have burrowed into every nook and cranny. This has
required the effort of legal specialists, accounting experts, and
financial engineers. As a result, the balance sheets of large firms
have been splintered into a collection of special purpose vehicles, and
securities have been issued with no other purpose than extracting as
much value as possible from the Basel II Supervisory Accord.
This complexity introduces three fundamental problems in monitoring
behavior.
First, supervisors are at a decided disadvantage in understanding
risk taking and compliance for a firm that might involve dozens of
jurisdictions, hundreds of legal entities, and thousands of contractual
relationships. Firms know this and tailor individual instruments to a
small slice of its clientele to take advantage of tax and accounting
rules. Its balance sheet might respond quickly to advances in finance
and legal interpretations. And the same risks might be booked in
different ways across affiliates, let alone across different
institutions, with evident consequences for capital requirements.
Indeed, the reliance of self-regulation inherent in the Basel II
supervisory agreement can be seen as an official admission of defeat: A
large complex financial institution cannot be understood from outside.
But if an institution is so difficult to understand from the
outside, how can we expect market discipline to be effective? The
second cost of complexity is that the outside discipline of credit
counterparties and equity owners is blunted. Creditors are more likely
to look to the firm's reputation or a stamp from a rating agency rather
than the underlying collateral provided by the financial contract.
Equity owners are more likely to defer to senior management, opening
the way to compensation abuses and twisting incentives to emphasize
short-term gains. In this regard, it is probably not an accident that
financial firms tend not to be targets for hostile takeovers--their
balance sheets are impenetrable from the outside.
Third, the problems in understanding the workings of a complicated
firm are not limited to those on the outside. A complicated firm is
also difficult to manage. Employers will find it more difficult to
monitor employees, especially when staff on the ground have highly
specialized expertise in finance, law, and accounting. Simply put,
employees who are difficult to monitor cannot be expected to promote
the long-term interests of their workplace. What follows are abuses in
matching loans and investments to the appropriate customer and, in some
cases, outright fraud.
Note the irony. A firm's effort to take advantage of Government
induced distortions by becoming more complicated and by making its
instruments more complex lessens the owner's ability to monitor
management and management's ability to monitor workers. Market
discipline breaks down.
The Simple Solution
Sometimes the answer to a complicated problem is simple, as
Alexander found with the Gordian Knot. Cut through the existing tangle
of financial regulation. Consolidate Federal financial regulators and
assume State responsibilities. Simplify accounting rules and the tax
code. Make the components of financial firms modular so that the whole
can be split up into basic parts at a time of stress, advice that may
have eased resolution of AIG's financial products division. With simple
rules that define lines more sharply, our Federal regulators will find
enforcement much easier. If firms are more transparent, official
supervision will be reinforced by the newfound discipline exercised by
shareholders and creditors. And with fewer places for self-interest to
hide, employees will be more accountable in their efforts to preserve
the longer-term value of their firms.
I recognize that a Congress pressed for results might be reluctant
to enact radical simplification. The consolidation of multiple agencies
and the shift of power away from States to a single Federal entity seem
daunting. Even harder might be the necessary reduction in the variety
of corporate charters and the pruning of the tax code and accounting
rules. Indeed, this is an invitation to jurisdictional warfare, as each
regulator jockeys for viability. But a more established set of rules
for the resolution of large firms, simplification of regulations
generally, and consolidation of supervision specifically should be the
aspiration of this Congress. I shall argue that a well-designed
financial stability supervisor can be a means to that end.
A Distinct Choice
The Treasury recently laid out a new foundation for financial
regulation. It envisions granting the Federal Reserve new authority to
supervise all firms that could pose a threat to financial stability,
even those that do not own banks. I disagree. Such powers should not be
given to an existing agency, especially not the Nation's central bank.
Rather, the Congress should form a committee of existing supervisors,
headed by an independent director, appointed by the President, and
confirmed by the Senate. The director should have a budget for staff
and real powers to compel cooperation among the constituent agencies
and reporting from unregulated entities, if necessary.
Why shouldn't an existing agency head the committee? From the
Congress's perspective, an agency is a black box that is difficult to
monitor, filled with technicians given multiple tools directed toward
multiple goals. The more complicated is its mission, the more
opportunities those technicians will have to trade off among those
goals. For example, consider the plight, admittedly abstract, of an
agency told to enforce a capital standard and to foster lending. At a
downturn in the business cycle, it might be tempted to allow overly
optimistic asset valuations so as to prevent balance-sheet constraints
from slackening lending. Perhaps, this compromise might be consistent
with the implied wishes of the Congress. But perhaps not. Because an
agency, especially focused on technical matters, tends to be opaque, it
will be difficult for its legislative creators to hold it accountable.
There are adverse implications of burdening an agency, any agency,
with multiple goals. First, the public will be confused about what goes
on behind the curtain. This makes it less likely that the agency will
find widespread support for its core responsibilities or anyone who
identifies with its mission. Second, and a bit more inside the Beltway,
it will be hard to fill the slots at agencies where the job description
calls for multiple technical talents and competing demands on time.
Third, key relationships of an agency with the Congress and other
regulators can become hostage to peripheral turf fights. From my own
experience, the atmosphere at Fed hearings was especially charged in
2004 and 2005 in both chambers. Some members and staff thought that
Chairman Greenspan was dragging his feet on consumer disclosure
regulation. My point is not that they were wrong in criticizing the
Chairman. Rather, my point is that time set aside in legislation to
discuss the plans and objectives of the Fed for monetary policy was
chewed up on other topics. As a result, Fed credibility was impaired
for reasons other than the performance of the economy.
The Fed Exception
I have thus far offered general objections to giving financial
stability responsibilities to an existing agency. I believe that there
are even more compelling reasons that those responsibilities should not
be given to the Fed. Please recognize that I worked in the Federal
Reserve System for a quarter-century and that I hold its staff in high
esteem. They are knowledgeable, competent, and committed to their
mission. But any group of people in an independent agency assigned too
many goals will be pulled in too many directions. And there is one goal
given to the Fed that should not be jeopardized: the pursuit of maximum
employment and stable prices. Indeed, that goal is so pivotal to the
Nation's interest that the Congress should be thinking of narrowing,
not broadening, the Fed's focus.
Three other concerns should give you pause before signing on to the
Treasury's blueprint of a new role for the Fed.
First, as compared to other agencies, the Fed has significant
macroeconomic policy and lending tools. If it failed in its role as
systemic supervisor to identify the originator of the next financial
crisis, might it be more likely to use those tools beyond what is
necessary for the achievement of its core monetary policy
responsibility?
Second, you might hear that the expertise gained in assessing
financial stability will help to inform the Fed's pursuit of
macropolicy goals. That would work in principal. In practice, I believe
that there are precious few instances of that favorable feedback,
despite the Fed's involvement in bank supervision since its inception.
But I stand willing to be proved wrong. The Fed's monetary policy
deliberations over the years are extremely well-documented in thousands
of pages of minutes and transcripts. Anyone making the case for
beneficial spillovers should be asked to produce numerous relevant
excerpts from that treasure trove. I do not think they will be able to
do so because I do not think those examples exist.
Third, the gift of extraordinary powers to an agency merits
forthright accountability from that agency. It is up to you to
determine whether the Fed has been sufficiently accountable during this
recent episode. In that regard, however, I would note an inconsistency
in the Treasury blueprint. It wants to give the Fed new powers
regarding financial stability. At the same time, it seeks to
circumscribe the one unusual power that the Fed has exercised over the
past year by requiring the Treasury Secretary to sign off in advance of
lending in unusual and exigent circumstances. Which best describes the
true Fed--empowerment or limitation?
An Alternative
My strong preference, absent radical simplification, is that the
supervision of financial stability be delegated to a committee of
existing financial supervisors. Those constituent agencies have the
specific expertise to understand our complicated financial world. At
the head should be someone appointed by the President and confirmed by
the Senate. He or she should have a budget to staff a secretariat
deemed suitable. And that agency should have independent powers. It
should be able to compel the information sharing among the constituent
supervisors and the reporting of information, if necessary, from
unregulated entities. The constituent agencies should regularly be
directed to draft reports in their areas of expertise for consideration
by the full Committee and transmittal to the Congress. This would
include twice-a-year reports on macroeconomic stability from the Fed,
appraisals of the health of the banking system from the FDIC, and
assessments on the resilience of financial market infrastructure from
the SEC and the CFTC.
Why does the committee head need to be appointed in that capacity
and have unique powers? The committee head needs the heft associated
with an independent selection. Without power, the committee would
devolve to a debating society that spends the first 5 years of its
existence negotiating memoranda of understanding on the sharing of
information.
Think about this analogy. In the run-up to the financial crisis,
every single large complex financial institution had a senior risk
management committee. In most cases, all those committees managed to do
was to allow the build-up of large risks. Now the U.S. Government has a
significant ownership stake in many of them. The few exceptional,
successful firms were the ones that gave the risk managers real powers
to control positioning. Why should the Federal Government settle for a
toothless authority?
A Longer-Term Vision
The real benefits of a financial stability committee would come if
the Congress were forward-looking in writing its mandate. The committee
could be a vehicle to foster the achievement over time of robust rules
for the resolution of private firms, simplification of the financial
system, and consolidation of financial agencies.
Let me take each in turn.
Resolution. At a time of crisis, we resort to the injection of
public funds into private firms because we are afraid of letting market
forces play out. Each major firm should negotiate a ``living will''
with its regulator each year. That living will should detail how the
firm should be disassembled in the event of bankruptcy. It should list
the segments of the firm that are systemically important and provide
contractual mechanisms to ring-fence them. The secretariat of the
financial stability committee should assess those plans to make sure
what looked good on paper could be applied in extremis. Also, the
secretariat can recommend industry initiatives to narrow over time the
ambit of firm-specific systemically important activities.
Periodically, the head of the committee should report to the
Congress--in closed session if necessary--about the status of
resolution plans. This would be the opportunity to identify areas for
legislation, if necessary, to give the Government more effective
resolution powers.
Simplification. It will not take long for anyone tasked with
working through the innermost machinations of major financial firms to
conclude that our system is hopelessly complicated. The head of the
financial stability committee should report annually on opportunities
to hack away at that underbrush, be it agency regulations, accounting
rules, or the tax code. The ambition of the new agency to simplify
financial rules, across industries and products, should be as wide as
the net cast for threats to financial stability. Those opportunities
are both in Federal and State legislation and agency regulation. On a
flow basis, new legislation should be scored, much as is already done
for budgetary impact, for the effects on the complexity of the
financial system.
Consolidation. The low hanging fruit of simplification will most
likely come in consolidating Federal agencies and State
responsibilities. An independent agency head should have the
perspective and stature to identify such opportunities that can be the
basis of future legislation. That is, part of the job of the
committee's chair should be explaining how the committee should get
smaller over time.
Conclusion
Facilitating resolution, simplifying rules, and consolidating
regulators will go a long way in making financial firms more
transparent. This will aid in enforcing remaining regulation,
disciplining credit decisions, and monitoring employees. It is also
patently fairer. Being bigger or more complicated or having better
lobbyists will not covey an advantage in a world of clear lines, strict
enforcement, and no exceptions. We have lived in a world of fine print
and sharp lawyers and look where that got us. We are ready for change.
I would prefer that this change come quickly, but others might see
this as too abrupt. If significant simplification does not come now, a
strong independent financial stability committee could provide
immediate protection and the promise of identifying areas for future
progress along the lines I have laid out.
______
PREPARED STATEMENT OF PAUL SCHOTT STEVENS
President and CEO, Investment Company Institute
July 23, 2009
I. Introduction
My name is Paul Schott Stevens. I am President and CEO of the
Investment Company Institute, the national association of U.S.
investment companies, including mutual funds, closed-end funds,
exchange-traded funds (ETFs), and unit investment trusts (UITs)
(collectively, ``funds''). Members of ICI manage total assets of $10.6
trillion and serve over 93 million shareholders.
Millions of American investors have chosen funds to help meet their
long-term financial goals. In addition, funds are among the largest
investors in U.S. companies--they hold, for example, about 25 percent
of those companies' outstanding stock, approximately 45 percent of U.S.
commercial paper (an important source of short-term funding for
corporate America), and about 33 percent of tax-exempt debt issued by
U.S. municipalities. As both issuers of securities to investors and
purchasers of securities in the market, funds have a strong interest in
the ongoing consideration by policy makers and other stakeholders of
how to strengthen our financial regulatory system in response to the
most significant financial crisis many of us have ever experienced.
In early March, ICI released a white paper outlining detailed
recommendations on how to reform the U.S. financial regulatory system,
with particular emphasis on reforms most directly affecting the
functioning of the capital markets and the regulation of funds, as well
as the subject of this hearing--how best to monitor for potential
systemic risks and mitigate the effect of such risks on our financial
system and the broader economy. \1\ At a March hearing before this
Committee, I summarized ICI's recommendations and offered some of my
own thoughts on a council approach to systemic risk regulation, based
on my personal experience as the first Legal Adviser to and,
subsequently, Executive Secretary of, the National Security Council.
Since March, ICI has continued to develop and refine its reform
recommendations and to study proposals advanced by others. I very much
appreciate the opportunity to appear before this Committee again and
offer further perspectives on establishing a framework for systemic
risk regulation.
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\1\ See Investment Company Institute, Financial Services
Regulatory Reform: Discussion and Recommendations (March 3, 2009),
available at http://www.ici.org/pdf/ppr_09_reg_reform.pdf (ICI White
Paper).
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Section II below offers general observations on establishing a
formal mechanism for identifying, monitoring, and managing potential
risks to our financial system. Section III comments on the
Administration's proposed approach to systemic risk regulation.
Finally, Section IV describes in detail a proposal to structure a
systemic risk regulator as a statutory council of senior Federal
financial regulators.
II. Systemic Risk Regulation: General Observations
The ongoing financial crisis has highlighted our vulnerability to
risks that accompany products, structures, or activities that may
spread rapidly throughout the financial system; and that may occasion
significant damage to the system at large. Over the past year, various
policy makers, financial services industry representatives, and other
commentators have called for the establishment of a formal mechanism
for identifying, monitoring, and managing risks of this dimension--one
that would allow Federal regulators to look across the system and to
better anticipate and address such risks.
ICI was an early supporter of creating a systemic risk regulator.
But we also have long advocated that two important cautions should
guide Congress in determining the composition and authority of such a
regulator. \2\ First, the legislation establishing a systemic risk
regulator should be crafted to avoid imposing undue constraints or
inapposite forms of regulation on normally functioning elements of the
financial system that may stifle innovations, impede competition, or
impose needless inefficiencies. Second, a systemic risk regulator
should not be structured to simply add another layer of bureaucracy or
to displace the primary regulator(s) responsible for capital markets,
banking, or insurance.
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\2\ See id. at 4.
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Accordingly, in our judgment, legislation establishing a systemic
risk regulator should clearly define the nature of the relationship
between this new regulator and the primary regulator(s) for the various
financial sectors. It should delineate the extent of the authority
granted to the systemic risk regulator, as well as identify
circumstances under which the systemic risk regulator and primary
regulator(s) should coordinate their efforts and work together. We
believe, for example, that the primary regulators should continue to
act as the first line of defense in addressing potential risks within
their spheres of expertise.
In view of the two cautions outlined above, ICI was an early
proponent of structuring a systemic risk regulator as a statutory
council comprised of senior Federal regulators. As noted above, I
testified before this Committee at a March hearing focused on investor
protection and the regulation of securities markets. At that time, I
recommended that the Committee give serious consideration to the
council model, based on my personal experience with the National
Security Council (NSC), a body which has served the Nation well for
more than 60 years. As the first Legal Adviser to the NSC in 1987, I
was instrumental in reorganizing the NSC system and staff following the
Iran-Contra affair. I subsequently served from 1987 to 1989 as chief of
the NSC staff under National Security Adviser Colin Powell.
III. The Administration's Proposed Approach
The council approach to a systemic risk regulator has received
support from Federal and State regulators and others. \3\ It is
noteworthy that the Administration's white paper on regulatory reform
likewise includes recommendations for a Financial Services Oversight
Council (Oversight Council). \4\ The Oversight Council would monitor
for emerging threats to the stability of the financial system, and
would have authority to gather information from the full range of
financial firms to enable such monitoring. As envisioned by the
Administration, the Oversight Council also would serve to facilitate
information sharing and coordination among the principal Federal
financial regulators, provide a forum for consideration of issues that
cut across the jurisdictional lines of these regulators, and identify
gaps in regulation. \5\
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\3\ See, e.g., Statement of Damon A. Silvers, Associate General
Counsel, AFL-CIO, before the Senate Committee on Homeland Security and
Government Affairs, Hearing on ``Systemic Risk and the Breakdown of
Financial Governance'' (March 4, 2009); Statement of Sheila C. Bair,
Chairman, Federal Deposit Insurance Corporation, before the Senate
Committee on Banking, Housing, and Urban Affairs, Hearing on
``Regulating and Resolving Institutions Considered `Too-Big-To-Fail' ''
(May 6, 2009) (``Bair Testimony''); Senator Mark R. Warner, ``A Risky
Choice for a Risk Czar'', Washington Post (June 28, 2009).
\4\ See Financial Regulatory Reform, A New Foundation: Rebuilding
Financial Supervision and Regulation (June 17, 2009), available at
http://www.financialstability.gov/docs/regs/FinalReport_web.pdf
(Administration white paper), at 17-19.
\5\ See id. at 18.
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Unfortunately, the Administration's proposal would vest the lion's
share of authority and responsibility for systemic risk regulation with
the Federal Reserve, relegating the Oversight Council to at most an
advisory or consultative role. In particular, the Administration
recommends granting broad new authority to the Federal Reserve in
several respects. \6\ The Administration's white paper acknowledges
that ``[t]hese proposals would put into effect the biggest changes to
the Federal Reserve's authority in decades.'' \7\
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\6\ Under this new authority, the Federal Reserve would have: (1)
the ultimate voice in determining which financial firms would
potentially pose a threat to financial stability, through designation
of so-called ``Tier 1 Financial Holding Companies;'' (2) the ability to
collect reports from all financial firms meeting minimum size
thresholds and, in certain cases, to examine such firms, in order to
determine whether a particular firm should be classified as a Tier 1
FHC; (3) consolidated supervisory and regulatory authority over Tier 1
FHCs and their subsidiaries, including the application of stricter and
more conservative prudential standards than those applicable to other
financial firms; and (4) the role of performing ``rigorous assessments
of the potential impact of the activities and risk exposures of [Tier 1
FHCs] on each other, on critical markets, and on the broader financial
system.'' See id. at 19-24.
\7\ Id. at 25.
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I believe that the Administration's approach would strike the wrong
balance. Significantly, it fails to draw in a meaningful way on the
experience and expertise of other regulators responsible for the
oversight of capital markets, commodities and futures markets,
insurance activities, and other sectors of the banking system. The
Administration's white paper fails to explain why its proposed
identification and regulation of Tier 1 Financial Holding Companies
(Tier 1 FHCs) is appropriate in view of concerns over market
distortions that could accompany ``too-big-to-fail'' designations. The
standards that would govern determinations of Tier 1 FHC status are
highly ambiguous. \8\ Finally, by expanding the mandate of the Federal
Reserve well beyond its traditional bounds, the Administration's
approach could jeopardize the Federal Reserve's ability to conduct
monetary policy with the requisite degree of independence.
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\8\ The Administration proposes requiring the Federal Reserve to
consider certain specified factors (including the firm's size and
leverage, and the impact its failure would have on the financial system
and the economy) and to get input from the Oversight Council. The
Federal Reserve, however, would have discretion to consider other
factors, and the final decision of whether to designate a particular
firm for Tier 1 FHC status would be its alone. See id. at 20-21. This
approach, in our view, would vest wide discretion in the Federal
Reserve and provide financial firms with insufficient clarity about
what activities, lines of business, or other factors might result in a
Tier 1 FHC designation.
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The shortcomings that we see with the Administration's plan
reinforce our conclusion that a properly structured statutory council
would be the most effective mechanism to orchestrate and oversee the
Federal Government's efforts to monitor for potential systemic risks
and mitigate the effect of such risks. Below, we set forth our detailed
recommendations for the composition, role, and scope of authority that
should be afforded to such a council.
IV. Fashioning an Effective Systemic Risk Council
In concept, an effective Systemic Risk Council (Council) could be
similar in structure and approach to the National Security Council,
which was established by the National Security Act of 1947. In the
aftermath of World War II, Congress recognized the need to assure
better coordination and integration of ``domestic, foreign, and
military policies relating to the national security'' and the ongoing
assessment of ``policies, objectives, and risks.'' The 1947 Act
established the NSC under the President as a Cabinet-level council with
a dedicated staff. In succeeding years, the NSC has proved to be a key
mechanism used by Presidents to address the increasingly complex and
multifaceted challenges of national security policy.
a. Composition of the Council and Its Staff
As with formulating national security policy, addressing risks to
the financial system at large requires diverse inputs and perspectives.
The Council's standing membership accordingly should draw upon a broad
base of expertise, and should include the core Federal financial
regulators--the Secretary of the Treasury, Chairman of the Board of
Governors of the Federal Reserve System, Chairman of the Securities and
Exchange Commission, Chairman of the Commodity Futures Trading
Commission, the Comptroller of the Currency (or head of any combined
Office of the Comptroller of the Currency and of the Office of Thrift
Supervision), the Chairman of the Federal Deposit Insurance
Corporation, and the head of a Federal insurance regulator, if one
emerges from these reform efforts. As with the NSC, flexibility should
exist for the Council to enlist other Federal and State regulators into
the work of the Council on specific issues as required--including, for
example, self-regulatory organizations and State regulators for the
banking, insurance or securities sectors.
The Secretary of the Treasury, as a Presidential appointee
confirmed by the Senate and the senior-most member of the Council,
should be designated chairman. An executive director, appointed by the
President, should run the day-to-day operations of the Council and
serve as head of the Council's staff. The Council should meet on a
regular basis, with an interagency process coordinated through the
Council's staff to support and follow through on its ongoing
deliberations.
To accomplish its mission, the Council should have the support of a
dedicated, highly experienced staff. The staff should represent a mix
of disciplines (e.g., economics, accounting, finance, law) and areas of
expertise (e.g., securities, commodities, banking, insurance). It
should consist of individuals seconded from Government departments and
agencies, as well as individuals having a financial services business,
professional, or academic background recruited from the private sector.
The Council's staff should operate, and be funded, independently from
the functional regulators. \9\ Nonetheless, the background and
experience of the staff, including those seconded from other parts of
Government, would help assure the kind of strong working relationships
with the functional regulators necessary for the Council's success.
Such a staff could be recruited and at work in a relatively short
period of time. The focus in recruiting a staff should be on quality,
not quantity, and the Council's staff accordingly need not and should
not be large.
---------------------------------------------------------------------------
\9\ A Council designed in this way would differ from the
Administration's Oversight Council, which would be staffed and operated
within the Treasury Department.
---------------------------------------------------------------------------
b. Mission and Operation of the Council
By statute, the Council should have a mandate to monitor conditions
and developments in the domestic and international financial markets,
and to assess their implications for the health of the U.S. financial
system at large. The Council would be responsible for making threshold
determinations concerning the systemic risks posed by given products,
structures, or activities. It would identify regulatory actions to be
taken to address these systemic risks as they emerge, would assess the
effectiveness of these actions, and would advise the President and
Congress regularly on emerging risks and necessary legislative or
regulatory responses. The Council would be responsible for coordinating
and integrating the national response to such risks. Nonetheless, it
would not have a direct operating role (just as the NSC coordinates and
integrates military and foreign policy that is implemented by the
Defense or State Department and not by the NSC itself). Rather,
responsibility for addressing identified risks would lie with the
existing functional regulators, which would act pursuant to their
normal statutory authorities but--for these purposes only--under the
Council's direction.
Similar to the Administration's Oversight Council proposal, the
Council should have two separate but interrelated mandates--(1) the
prevention and mitigation of systemic risk and (2) policy coordination
and information sharing across the various functional regulators. Under
this model, where all the functional regulators have an equal voice and
stake in the success of the Council, the stronger working relationships
and the sense of shared purpose that would grow out of the Council's
collaborative efforts would greatly assist in sound policy development,
prioritization of effort, and cooperation with the international
regulatory community. Further, the staffing and resources of the
Council could be leveraged for both purposes. This would address some
of the criticisms and limitations of the existing President's Working
Group on Financial Markets (PWG).
Information will be the lifeblood of the Council's deliberations
and the work of the Council's staff. Having information flow from
regulated entities through their functional regulators to the Council
and its staff would appropriately draw upon the regulators' existing
information and data collection capabilities and avoid unnecessary
duplication of effort. To the extent that a particular financial firm
is not subject to direct supervision by a Council member, the Council
should have the authority to require periodic or other reporting from
such firm as the Council determines is necessary to evaluate the extent
to which a particular product, structure, or activity poses a systemic
risk. \10\
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\10\ The Administration likewise proposes to grant its Oversight
Council the authority to require periodic reporting from financial
firms, but the authority would extend to all firms, with simply a
caveat that the Oversight Council ``should, wherever possible,'' rely
upon information already being collected by Council members. See
Administration white paper, supra note 4, at 19.
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Although the Council and its staff would continually monitor
conditions and developments in the financial markets, the range of
issues requiring action by the Council itself should be fairly limited
in scope--directed only at major unaddressed hazards to the financial
system, as opposed to day-to-day regulatory concerns. As noted above,
the Council should be required, as a threshold matter, to make a formal
determination that some set of circumstances could pose a risk to the
financial system at large. That determination would mark the beginning
of a consultative process among the Council members, with support from
the Council's staff, to develop a series of responses to the identified
risks. The Council could then recommend or direct action by the
appropriate functional regulators to implement these responses.
Typically, the Council should be able to reach consensus, both on
identifying potential risks and developing responses to such risks. To
address the rare instance where Council members are unable to reach
consensus on a course of action, however, there should be a mechanism--
specified in the authorizing legislation--that would require the
elevation of disputes to the President for resolution. There likewise
should be reporting to Congress of such disputes and their resolution,
so as to assure timely Congressional oversight.
To ensure proper follow-through, we envision that the individual
regulators would report back to the Council, which would monitor
progress and ensure that the regulators are acting in accord with the
policy direction set by the Council. At the same time, to ensure
appropriate accountability, we recommend that the Council be required
to report to Congress whenever it makes a threshold finding or
recommends or directs a functional regulator to take action, so that
the relevant oversight committees in Congress also may monitor progress
and assess the adequacy of the regulatory response.
c. Advantages of a Council Model
We believe that the council model outlined above would offer
several important advantages.
First, the Council would avoid risks inherent in designating an
existing agency like the Federal Reserve to serve essentially as an
all-purpose systemic risk regulator. In such a role, the Federal
Reserve understandably may tend to view risks and risk mitigation
through its lens as a commercial bank regulator focused on prudential
regulation and ``safety and soundness'' concerns, potentially to the
detriment of consumer and investor protection concerns and of nonbank
financial institutions. A Council with a diverse membership would bring
all competing perspectives to bear and, as a result, would be more
likely to strike the proper balance. In ICI's view, such perspectives
most certainly must include those of the SEC and the CFTC. In this
regard, we are pleased to note that the Administration's reform
proposals would preserve the role of the SEC as a strong regulator with
broad responsibilities for overseeing the capital markets and key
market functions such as clearance, settlement and custody
arrangements, while also maintaining its investor protection focus. It
is implausible that we could effectively regulate systemic risk in the
financial markets without fully incorporating the SEC into that
process.
Second, systemic risks may arise in different ways and affect
different parts of the domestic and global financial system. No
existing agency or department has a comprehensive frame of reference or
the necessary expertise to assess and respond to any and all such
risks. In contrast, the Council would enlist the expertise of the
entire regulatory community in identifying and devising strategies to
mitigate systemic risks. These diverse perspectives are essential if we
are to successfully identify new and unanticipated risks, and avoid
simply refighting the ``last war.'' Whatever may be the specified cause
of a future financial crisis, it is certain to be different than the
one we are now experiencing.
Third, the Council would provide a high degree of flexibility in
convening those Federal and State regulators whose input and
participation is necessary to addressing a specific issue, without
creating an unwieldy or bureaucratic structure. As is the case with the
NSC, the Council should have a core membership of senior Federal
officials and the ability to expand its participants on an ad hoc basis
when a given issue so requires. It also could be established and begin
operation in relatively short order. Creating an all-purpose systemic
risk regulator, on the other hand, would be a long and complex
undertaking, and would involve developing expertise that duplicates
that which already exists in the various functional regulators.
Fourth, with an independent staff dedicated solely to pursuing the
Council's agenda, the Council would be well-positioned to test or
challenge the policy judgments or priorities of various functional
regulators. This would help address any concerns about ``regulatory
capture,'' including those raised by the Administration's proposal
concerning the Federal Reserve's exclusive oversight of Tier 1 FHCs.
Moreover, by virtue of their participation on the Council, the various
functional regulators would themselves likely be more attentive to
emerging risks or regulatory gaps. This would help assure a far more
coordinated and integrated approach. Over time, the Council also could
assist in framing a political consensus about addressing significant
regulatory gaps and necessary policy responses.
Fifth, the functional regulators, as distinct from the Council
itself, would be charged with implementing regulations to mitigate
systemic risks as they emerge. This operational role is appropriate
because the functional regulators have the greatest knowledge of their
respective regulated industries. Nonetheless, the Council and its staff
would have an important independent role in evaluating the
effectiveness of the measures taken by functional regulators to
mitigate systemic risk and, where necessary, in prompting further
actions.
Finally, the council model outlined above would be sufficiently
robust to ensure sustained follow-through to address critical and
complex issues posing risk to the financial system. By way of
illustration, consider the case of Long-Term Capital Management (LTCM),
a very large and highly leveraged U.S. hedge fund, which in September
1998 lost 90 percent of its capital and nearly collapsed. Concerned
that the hedge fund's collapse might pose a serious threat to the
markets at large, the Federal Reserve arranged a private sector
recapitalization of LTCM. In the aftermath of this incident, there were
studies, reports, and recommendations, including by the PWG and the
U.S. Government Accountability Office (GAO). But 10 years later, a
January 2008 GAO report noted ``the continuing relevance of questions
raised over LTCM'' and concluded that it was still ``too soon to
evaluate [the] effectiveness'' of the regulatory and industry response
to the LTCM experience. \11\
---------------------------------------------------------------------------
\11\ United States Government Accountability Office, ``Hedge
Funds, Regulators, and Market Participants Are Taking Steps To
Strengthen Market Discipline, But Continued Attention Is Needed''
(January 2008), at 3 and 8.
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Hopefully, had a Systemic Risk Council such as that described above
been in operation at the time of LTCM's near collapse, it might have
prompted more searching analysis of, and more timely and comprehensive
regulatory action with respect to, the activities that led to LTCM's
near collapse--such as the growing use of derivatives to achieve
leverage. For example, under the construct outlined above, the Council
would have the authority to direct functional regulators to take action
to implement policy responses--authority that the PWG does not possess.
d. Potential Criticisms--And How They Can Be Addressed
It has been argued that, because of the Federal Reserve's unique
crisis-management capability as the central bank and lender of last
resort, it is the only logical choice as a systemic risk regulator. To
be sure, should our Nation encounter serious financial instability, the
Federal Reserve's authorities will be indispensable to remedy the
problems. So, too, will be any new resolution authority established for
failing large and complex financial institutions. But the overriding
purpose of systemic risk regulation should be to identify in advance,
and prevent or mitigate, the causes of such instability. This is a role
to which the Council, with its diversity of expertise and perspectives,
would seem best suited. Put another way, critics of a council model may
contend that convening a committee is not the best way to put out a
roaring fire. But a broad-based council is the best body for designing
a strong fire code--without which we cannot hope to prevent the fire
before it ignites and consumes our financial system.
Another potential criticism of the Council is that it may diffuse
responsibility and pose difficulties in assuring proper follow-through
by the functional regulators. While it is true that each functional
regulator would have responsibility for implementing responses to
address identified risks, it must be made clear in the legislation
creating the Council (and in corresponding amendments to the organic
statutes governing the functional regulators) that these responses must
reflect the policy direction determined by the Council. Additionally,
as suggested by FDIC Chairman Bair, the Council should have the
authority to require a functional regulator to act as directed by the
Council. \12\ In this way, Congress would be assured of creating a
Systemic Risk Council with ``teeth.''
---------------------------------------------------------------------------
\12\ See Bair Testimony, supra note 3.
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Finally, claiming that a council of Federal regulators ``would add
a layer of regulatory bureaucracy without closing the gaps that
regulators currently have in skills, experience and authority needed to
track systemic risk comprehensively,'' a recent report instead calls
for the creation of a wholly independent board to serve as a systemic
risk ``adviser.'' \13\ As proposed, the board's mission would be to:
(1) collect and analyze risk exposure of bank and nonbank institutions
and their practices and products that could threaten financial
stability; (2) report on those risks and other systemic
vulnerabilities; and (3) make recommendations to regulators on how to
reduce those risks. We believe this approach would be highly
problematic. It would have precisely the effect that its proponents
wish to avoid--by adding another layer of bureaucracy to the regulatory
system. It would engender a highly intrusive mechanism that would
increase regulatory costs and burdens for financial firms. For example,
duplication likely would result from giving a new advisory board the
authority to gather the financial information it needs to assess
potential systemic risks. And if the board's sole function were to look
for systemic risks in the financial system, it almost goes without
saying that it would surely find them.
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\13\ See ``Investors' Working Group, U.S. Financial Regulatory
Reform: The Investors' Perspective'' (July 2009), available at http://
www.cii.org/UserFiles/file/resource%20center/investment%20issues/
Investors'%20Working%20Group%20Report%20(July%202009).pdf.
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V. Conclusion
I appreciate this opportunity to testify before the Committee, and
I hope that the perspectives I have offered today will assist the
Committee in its deliberations about the mechanism(s) needed to monitor
and mitigate potential risks to our financial system. More broadly, I
would like to commend Chairman Dodd, Ranking Member Shelby, and the
other Members of the Committee for their considerable efforts in
seeking meaningful reform of our financial services regulatory regime.
I--and ICI and its members--look forward to working further with this
Committee and Congress to achieve such reform.
______
PREPARED STATEMENT OF ALICE M. RIVLIN
Senior Fellow, Economic Studies, Brookings Institution
July 23, 2009
Mr. Chairman and Members of the Committee, I am happy to be back
before this Committee to give my views on reducing systemic risk in
financial services. I will focus on changes in our regulatory structure
that might prevent another catastrophic financial meltdown and what
role the Federal Reserve should play in a new financial regulatory
system.
It is hard to overstate the importance of the task facing this
Committee. Market capitalism is a powerful system for enhancing human
economic well-being and allocating savings to their most productive
uses. But markets cannot be counted on to police themselves. Irrational
herd behavior periodically produces rapid increases in asset values,
lax lending and overborrowing, excessive risk taking, and outsized
profits followed by crashing asset values, rapid deleveraging, risk
aversion, and huge loses. Such a crash can dry up normal credit flows
and undermine confidence, triggering deep recession and massive
unemployment. When the financial system fails on the scale we have
experienced recently the losers are not just the wealthy investors and
executives of financial firms who took excessive risks. They are
average people here and around the world whose jobs, livelihoods, and
life savings are destroyed and whose futures are ruined by the effect
of financial collapse on the world economy. We owe it to them to ferret
out the flaws in the financial system and the failures of regulatory
response that allowed this unnecessary crisis to happen and to mend the
system so to reduce the chances that financial meltdowns imperil the
world's economic well-being.
Approaches To Reducing Systemic Risk
The crisis was a financial ``perfect storm'' with multiple causes.
Different explanations of why the system failed--each with some
validity--point to at least three different approaches to reducing
systemic risk in the future.
The highly interconnected system failed because no one was in charge of
spotting the risks that could bring it down.
This explanation suggests creating a Macro System Stabilizer with
broad responsibility for the whole financial system charged with
spotting perverse incentives, regulatory gaps and market pressures that
might destabilize the system and taking steps to fix them. The Obama
Administration would create a Financial Services Oversight Council (an
interagency group with its own staff) to perform this function. I think
this responsibility should be lodged at the Fed and supported by a
Council.
The system failed because expansive monetary policy and excessive
leverage fueled a housing price bubble and an explosion of
risky investments in asset backed securities.
While low interest rates contributed to the bubble, monetary policy
has multiple objectives. It is often impossible to stabilize the
economy and fight asset price bubbles with a single instrument. Hence,
this explanation suggests stricter regulation of leverage throughout
the financial system. Since monetary policy is an ineffective tool for
controlling asset price bubbles, it should be supplemented by the power
to change leverage ratios when there is evidence of an asset price
bubble whose bursting that could destabilize the financial sector.
Giving the Fed control of leverage would enhance the effectiveness of
monetary policy. The tool should be exercised in consultation with a
Financial Services Oversight Council.
The system crashed because large interconnected financial firms failed
as a result of taking excessive risks, and their failure
affected other firms and markets.
This explanation might lead to policies to restrain the growth of
large interconnected financial firms--or even break them up--and to
expedited resolution authority for large financial firms (including
nonbanks) to lessen the impact of their failure on the rest of the
system. Some have argued for the creation of a single consolidated
regulator with responsibility for all systemically important financial
institutions. The Obama Administration proposes making the Fed the
consolidated regulator of all Tier 1 Financial Institutions. I believe
it would be a mistake to identify specific institutions as too-big-to-
fail and an even greater mistake to give this responsibility to the
Fed. Making the Fed the consolidated prudential regulator of big
interconnected institutions would weaken its focus on monetary policy
and the overall stability of the financial system and could threaten
its independence.
The Case for a Macro System Stabilizer
One reason that regulators failed to head off the recent crisis is
that no one was explicitly charged with spotting the regulatory gaps
and perverse incentives that had crept into our rapidly changing
financial structure in recent decades. In recent years, antiregulatory
ideology kept the United States from modernizing the rules of the
capitalist game in a period of intense financial innovation and
perverse incentives to creep in.
Perverse Incentives. Lax lending standards created the bad
mortgages that were securitized into the toxic assets now weighting
down the books of financial institutions. Lax lending standards by
mortgage originators should have been spotted as a threat to stability
by a Macro System Stabilizer--the Fed should have played this role and
failed to do so--and corrected by tightening the rules (minimum down
payments, documentation, proof that the borrow understands the terms of
the loan and other no-brainers). Even more important, a Macro System
Stabilizer should have focused on why the lenders had such irresistible
incentives to push mortgages on people unlikely to repay. Perverse
incentives were inherent in the originate-to-distribute model which
left the originator with no incentive to examine the credit worthiness
of the borrower. The problem was magnified as mortgage-backed
securities were resecuritized into more complex instruments and sold
again and again. The Administration proposes fixing that system design
flaw by requiring loan originators and securitizers to retain 5 percent
of the risk of default. This seems to me too low, especially in a
market boom, but it is the right idea.
The Macro System Stabilizer should also seek other reasons why
securitization of asset-backed loans--long thought to be a benign way
to spread the risk of individual loans--became a monster that brought
the world financial system to its knees. Was it partly because the
immediate fees earned by creating and selling more and more complex
collateralized debt instruments were so tempting that this market would
have exploded even if the originators retained a significant portion of
the risk? If so, we need to change the reward structure for this
activity so that fees are paid over a long enough period to reflect
actual experience with the securities being created.
Other examples, of perverse incentives that contributed to the
violence of the recent perfect financial storm include Structured
Investment Vehicles (SIV's) that hid risks off balance sheets and had
to be either jettisoned or brought back on balance sheet at great cost;
incentives of rating agencies to produce excessively high ratings; and
compensation structures of corporate executives that incented focus on
short-term earnings at the expense the longer run profitability of the
company.
The case for creating a new role of Macro System Stabilizer is that
gaps in regulation and perverse incentives cannot be permanently
corrected. Whatever new rules are adopted will become obsolete as
financial innovation progresses and market participants find ways
around the rules in the pursuit of profit. The Macro System Stabilizer
should be constantly searching for gaps, weak links and perverse
incentives serious enough to threaten the system. It should make its
views public and work with other regulators and Congress to mitigate
the problem.
The Treasury makes the case for a regulator with a broad mandate to
collect information from all financial institutions and ``identify
emerging risks.'' It proposes putting that responsibility in a
Financial Services Oversight Council, chaired by the Treasury, with its
own permanent expert staff. The Council seems to me likely to be
cumbersome. Interagency councils are usually rife with turf battles and
rarely get much done. I think the Fed should have the clear
responsibility for spotting emerging risks and trying to head them off
before it has to pump trillions into the system to avert disaster. The
Fed should make a periodic report to the Congress on the stability of
the financial system and possible threats to it. The Fed should consult
regularly with the Treasury and other regulators (perhaps in a
Financial Services Oversight Council), but should have the lead
responsibility. Spotting emerging risks would fit naturally with the
Fed's efforts to monitor the State of the economy and the health of the
financial sector in order to set and implement monetary policy. Having
explicit responsibility for monitoring systemic risk--and more
information on which to base judgments would enhance its effectiveness
as a central bank.
Controlling Leverage. The biggest challenge to restructuring the
incentives is: How to avoid excessive leverage that magnified the
upswing and turned the downswing into a rout? The aspect of the recent
financial extravaganza that made it truly lethal was the overleveraged
superstructure of complex derivatives erected on the shaky foundation
of America's housing prices. By itself, the housing boom and bust would
have created distress in the residential construction, real estate, and
mortgage lending sectors, as well as consumer durables and other
housing related markets, but would not have tanked the economy. What
did us in was the credit crunch that followed the collapse of the
highly leveraged financial superstructure that pumped money into the
housing sector and became a bloated monster.
One approach to controlling serious asset-price bubbles fueled by
leverage would be to give the Fed the responsibility for creating a
bubble Threat Warning System that would trigger changes in permissible
leverage ratios across financial institutions. The warnings would be
public like hurricane or terrorist threat warnings. When the threat was
high--as demonstrated by rapid price increases in an important class of
assets, such as land, housing, equities, and other securities without
an underlying economic justification--the Fed would raise the threat
level from, say, Three to Four or Yellow to Orange. Investors and
financial institutions would be required to put in more of their own
money or sell assets to meet the requirements. As the threat moderated,
the Fed would reduce the warning level.
The Fed already has the power to set margin requirements--the
percentage of his own money that an investor is required to put up to
buy a stock if he is borrowing the rest from his broker. Policy makers
in the 1930s, seeking to avoid repetition of the stock price bubble
that preceded the 1929 crash, perceived that much of the stock market
bubble of the late 1920s had been financed with money borrowed on
margin from broker dealers and that the Fed needed a tool distinct from
monetary policy to control such borrowing in the future.
During the stock market bubble of the late 1990s, when I was Vice
Chair of the Fed's Board of Governors, we talked briefly about raising
the margin requirement, but realized that the whole financial system
had changed dramatically since the 1920s. Stock market investors in the
1990s had many sources of funds other than borrowing on margin. While
raising the margin requirements would have been primarily symbolic, I
believe with hindsight that we should have done it anyway in hopes of
showing that we were worried about the bubble.
The 1930s legislators were correct: monetary policy is a poor
instrument for counteracting asset price bubbles; controlling leverage
is likely to be more effective. The Fed has been criticized for not
raising interest rates in 1998 and the first half of 1999 to discourage
the accelerating tech stock bubble. But it would have had to raise
rates dramatically to slow the market's upward momentum--a move that
conditions in the general economy did not justify. Productivity growth
was increasing, inflation was benign and responding to the Asian
financial crisis argued for lowering rates, not raising them.
Similarly, the Fed might have raised rates from their extremely low
levels in 2003 or raised them earlier and more steeply in 2004-5 to
discourage the nascent housing price bubble. But such action would have
been regarded as a bizarre attempt to abort the economy's still slow
recovery. At the time there was little understanding of the extent to
which the highly leveraged financial superstructure was building on the
collective delusion that U.S. housing prices could not fall. Even with
hindsight, controlling leverage (along with stricter regulation of
mortgage lending standards) would have been a more effective response
to the housing bubble than raising interest rates. But regulators
lacked the tools to control excessive leverage across the financial
system.
In the wake of the current crisis, financial system reformers have
approached the leverage control problem in pieces, which is appropriate
since financial institutions play diverse roles. However the Federal
Reserve--as Macro System Stabilizer--could be given the power to tie
the system together so that various kinds of leverage ratios move in
the same direction simultaneously as the threat changes.
With respect to large commercial banks and other systemically
important financial institutions, for example, there is emerging
consensus that higher capital ratios would have helped them weather the
recent crisis, that capital requirements should be higher for larger,
more interconnected institutions than for smaller, less interconnected
ones, and that these requirements should rise as the systemic threat
level (often associated with asset price bubbles) goes up.
With respect to hedge funds and other private investment funds,
there is also emerging consensus that they should be more transparent
and that financial derivatives should be traded on regulated exchanges
or at least cleared on clearinghouses. But such funds might also be
subject to leverage limitations that would move with the perceived
threat level and could disappear if the threat were low.
One could also tie asset securitization into this system. The
percent of risk that the originator or securitizer was required to
retain could vary with the perceived threat of an asset price bubble.
This percentage could be low most of the time, but rise automatically
if Macro System Stabilizer deemed the threat of a major asset price
bubble was high. One might even apply the system to rating agencies. In
addition to requiring rating agencies to be more transparent about
their methods and assumptions, they might be subjected to extra
scrutiny or requirements when the bubble threat level was high.
Designing and coordinating such a leverage control system would not
be an easy thing to do. It would require create thinking and care not
to introduce new loopholes and perverse incentives. Nevertheless, it
holds hope for avoiding the run away asset price exuberance that leads
to financial disaster.
Systemically Important Institutions
The Obama administration has proposed that there should be a
consolidated prudential regulator of large interconnected financial
institutions (Tier 1 Financial Holding Companies) and that this
responsibility be given to the Federal Reserve. I think this is the
wrong way to go.
It is certainly important to reduce the risk that large
interconnected institutions fail as a result of engaging in highly
risky behavior and that the contagion of their failure brings down
others. However, there are at least three reasons for questioning the
wisdom of identifying a specific list of such institutions and giving
them their own consolidated regulator and set of regulations. First, as
the current crisis has amply illustrated, it is very difficult to
identify in advance institutions that pose systemic risk. The
regulatory system that failed us was based on the premise that
commercial banks and thrift institutions that take deposits and make
loans should be subject to prudential regulation because their deposits
are insured by the Federal Government and they can borrow from the
Federal Reserve if they get into trouble. But in this crisis, not only
did the regulators fail to prevent excessive risk taking by depository
institutions, especially thrifts, but systemic threats came from other
quarters. Bear Stearns and Lehman Brothers had no insured deposits and
no claim on the resources of the Federal Reserve. Yet when they made
stupid decisions and were on the edge of failure the authorities
realized they were just as much a threat to the system as commercial
banks and thrifts. So was the insurance giant, AIG, and, in an earlier
decade, the large hedge fund, LTCM. It is hard to identify a
systemically important institution until it is on the point of bringing
the system down and then it may be too late.
Second, if we visibly cordon off the systemically important
institutions and set stricter rules for them than for other financial
institutions, we will drive risky behavior outside the strictly
regulated cordon. The next systemic crisis will then likely come from
outside the ring, as it came this time from outside the cordon of
commercial banks.
Third, identifying systemically important institutions and giving
them their own consolidated regulator tends to institutionalize ``too-
big-to-fail'' and create a new set of GSE-like institutions. There is a
risk that the consolidated regulator will see its job as not allowing
any of its charges to go down the tubes and is prepared to put taxpayer
money at risk to prevent such failures.
Higher capital requirements and stricter regulations for large
interconnected institutions make sense, but I would favor a continuum
rather than a defined list of institutions with its own special
regulator. Since there is no obvious place to put such a
responsibility, I think we should seriously consider creating a new
financial regulator. This new institution could be similar to the
U.K.'s FSA, but structured to be more effective than the FSA proved in
the current crisis. In the U.S. one might start by creating a new
consolidated regulator of all financial holding companies. It should be
an independent agency but might report to a board composed of other
regulators, similar to the Treasury proposal for a Council for
Financial Oversight. As the system evolves the consolidated regulator
might also subsume the functional regulation of nationally chartered
banks, the prudential regulation of broker-dealers and nationally
chartered insurance companies.
I don't pretend to have a definitive answer to how the regulatory
boxes should best be arranged, but it seems to me a mistake to give the
Federal Reserve responsibility for consolidated prudential regulation
of Tier 1 Financial Holding Companies, as proposed by the Obama
Administration. I believe the skills needed by an effective central
bank are quite different from those needed to be an effective financial
institution regulator. Moreover, the regulatory responsibility would
likely grow with time, distract the Fed from its central banking
functions, and invite political interference that would eventually
threaten the independence of monetary policy.
Especially in recent decades, the Federal Reserve has been a
successful and widely respected central bank. It has been led by a
series of strong macroeconomists--Paul Volcker, Alan Greenspan, Ben
Bernanke--who have been skillful at reading the ups and downs of the
economy and steering a monetary policy course that contained inflation
and fostered sustainable economic growth. It has played its role as
banker to the banks and lender of last resort--including aggressive
action with little used tools in the crisis of 2008-9. It has kept the
payments system functioning even in crises such as 9/11, and worked
effectively with other central banks to coordinate responses to credit
crunches, especially the current one. Populist resentment of the Fed's
control of monetary policy has faded as understanding of the importance
of having an independent institution to contain inflation has grown--
and the Fed has been more transparent about its objectives. Although
respect for the Fed's monetary policy has grown in recent years, its
regulatory role has diminished. As regulator of Bank Holding Companies,
it did not distinguish itself in the run up to the current crisis (nor
did other regulators). It missed the threat posed by the deterioration
of mortgage lending standards and the growth of complex derivatives.
If the Fed were to take on the role of consolidated prudential
regulator of Tier 1 Financial Holding Companies, it would need strong,
committed leadership with regulatory skills--lawyers, not economists.
This is not a job for which you would look to a Volcker, Greenspan, or
Bernanke. Moreover, the regulatory responsibility would likely grow as
it became clear that the number and type of systemically important
institutions was increasing. My fear is that a bifurcated Fed would be
less effective and less respected in monetary policy. Moreover, the
concentration of that much power in an institution would rightly make
the Congress nervous unless it exercised more oversight and
accountability. The Congress would understandably seek to appropriate
the Fed's budget and require more reporting and accounting. This is not
necessarily bad, but it could result in more Congressional interference
with monetary policy, which could threaten the Fed's effectiveness and
credibility in containing inflation.
In summary, Mr. Chairman: I believe that we need an agency with
specific responsibility for spotting regulatory gaps, perverse
incentives, and building market pressures that could pose serious
threats to the stability of the financial system. I would give the
Federal Reserve clear responsibility for Macro System Stability,
reporting periodically to Congress and coordinating with a Financial
System Oversight Council. I would also give the Fed new powers to
control leverage across the system--again in coordination with the
Council. I would not create a special regulator for Tier 1 Financial
Holding Companies, and I would certainly not give that responsibility
to the Fed, lest it become a less effective and less independent
central bank.
Thank you, Mr. Chairman and Members of the Committee.
______
PREPARED STATEMENT OF ALLAN H. MELTZER
Professor of Political Economy, Tepper School of Business, Carnegie
Mellon University
July 23, 2009
Regulatory Reform and the Federal Reserve
Thank you for the opportunity to present my appraisal of the
Administration's proposal for regulatory changes. I will confine most
of my comments to the role of the Federal Reserve as a systemic
regulator and will offer an alternative proposal. I share the belief
that change is needed and long delayed, but appropriate change must
protect the public, not bankers. And I believe that effective
regulation should await evidence and conclusions about the causes of
the recent crisis. There are many assertions about causes. The Congress
should want to avoid a rush to regulate before the relevant facts are
established. If we are to avoid repeating this crisis, make sure you
know what caused it.
During much of the past 15 years, I have written three volumes
entitled ``A History of the Federal Reserve.'' Working with two
assistants we have read virtually all of the minutes of the Board of
Governors, the Federal Open Market Committee, and the Directors of the
Federal Reserve Bank of New York. We have also read many of the staff
papers and internal memos supporting decisions. I speak from that
perspective. I speak also from experience in Japan. During the 1990s,
the years of the Japanese banking and financial crisis, I served as
Honorary Adviser to the Bank. Their policies included preventing bank
failures. This did not restore lending and economic growth.
Two findings are very relevant to the role of the Federal Reserve.
First, I do not know of any clear examples in which the Federal Reserve
acted in advance to head off a crisis or a series of banking or
financial failures. We know that the Federal Reserve did nothing about
thrift industry failures in the 1980s. Thrift failures cost taxpayers
$150 billion. AIG, Fannie, and Freddie will be much more costly. Of
course, the Fed did not have responsibility for the thrift industry,
but many thrift failures posed a threat to the financial system that
the Fed should have tried to mitigate. The disastrous outcome was not a
mystery that appeared without warning. Peter Wallison, Alan Greenspan,
Bill Poole, Senator Shelby, and others warned about the excessive risks
taken by Fannie and Freddie, but Congress failed to legislate. Why
should anyone expect a systemic risk regulator to get requisite
Congressional action under similar circumstances? Can you expect the
Federal Reserve as systemic risk regulator to close Fannie and Freddie
after Congress declines to act?
Conflicts of this kind, and others, suggest that that the
Administration's proposal is incomplete. Defining ``systemic risk'' is
an essential, but missing part of the proposal. Trying to define the
authority of the regulatory authority when Congress has expressed an
interest points up a major conflict.
During the Latin American debt crisis, the Federal Reserve acted to
hide the failures and losses at money center banks by arranging with
the IMF to pay the interest on Latin debt to those banks. This served
to increase the debt that the Governments owed, but it kept the banks
from reporting portfolio losses and prolonged the debt crisis. The
crisis ended after one of the New York banks decided to write off the
debt and take the loss. Others followed. Later, the Treasury offered
the Brady plans. The Federal Reserve did nothing.
In the dot-com crisis of the late 1990s, we know the Federal
Reserve was aware of the growing problem, but it did not act until
after the crisis occurred. Later, Chairman Greenspan recognized that it
was difficult to detect systemic failures in advance. He explained that
the Federal Reserve believed it should act after the crisis, not
before. Intervention to control soaring asset prices would impose large
social costs of unemployment, so the Federal Reserve, as systemic risk
regulator would be unwise to act.
The dot-com problem brings out that there are crises for which the
Federal Reserve cannot be effective. Asset market exuberance and supply
shocks, like oil price increases, are nonmonetary so cannot be
prevented by even the most astute, far-seeing central bank.
We all know that the Federal Reserve did nothing to prevent the
current credit crisis. Before the crisis it kept interest rates low
during part of the period and did not police the use that financial
markets made of the reserves it supplied. The Board has admitted that
it did not do enough to prevent the crisis. It has not recognized that
its actions promoted moral hazard and encouraged incentives to take
risk. Many bankers talked openly about a ``Greenspan put,'' their
belief that the Federal Reserve would prevent or absorb major losses.
It was the Reconstruction Finance Corporation, not the Fed, that
restructured banks in the 1930s. The Fed did not act promptly to
prevent market failure during the 1970 Penn Central failure, the
Lockheed and Chrysler problems, or on other occasions. In 2008, the Fed
assisted in salvaging Bear Stearns. This continued the ``too-big-to-
fail'' (TBTF) policy and increased moral hazard. Then without warning,
the Fed departed from the course it had followed for at least 30 years
and allowed Lehman to fail in the midst of widespread financial
uncertainty. This was a major error. It deepened and lengthened the
current deep recession. Much of the recent improvement results from the
unwinding of this terrible mistake.
In 1990-91, the Fed kept the spread between short- and long-term
interest rates large enough to assist many banks to rebuild their
capital and surplus. This is a rare possible exception, a case in which
Federal Reserve action to delay an increase in the short-term rate may
have prevented banking failures.
Second, in its 96-year history, the Federal Reserve has never
announced a lender-of-last-resort policy. It has discussed internally
the content of such policy several times, but it rarely announced what
it would do. And the appropriate announcements it made, as in 1987,
were limited to the circumstances of the time. Announcing and following
a policy would alert financial institutions to the Fed's expected
actions and might reduce pressures on Congress to aid failing entities.
Following the rule in a crisis would change bankers' incentives and
reduce moral hazard. A crisis policy rule is long overdue. The
Administration proposal recognizes this need.
A lender-of-last-resort rule is the right way to implement policy
in a crisis. We know from monetary history that in the 19th century the
Bank of England followed Bagehot's rule for a half-century or more. The
rule committed the Bank to lend on ``good'' collateral at a penalty
rate during periods of market disturbance. Prudent bankers borrowed
from the Bank of England and held collateral to be used in a panic.
Banks that lacked collateral failed.
Financial panics occurred. The result of following Bagehot's rule
in crises was that the crises did not spread and did not last long.
There were bank failures, but no systemic failures. Prudent bankers
borrowed and paid depositors cash or gold. Bank deposits were not
insured until much later, so bank runs could cause systemic failures.
Knowing the Bank's policy rule made most bankers prudent, they held
more capital and reserves in relation to their size than banks
currently do, and they held more collateral to use in a crisis also.
These experiences suggest three main lessons. First, we cannot
avoid banking failures but we can keep them from spreading and creating
crises. Second, neither the Federal Reserve nor any other agency has
succeeded in predicting crises or anticipating systemic failure. It is
hard to do, in part because systemic risk is not well-defined.
Reasonable people will differ, and since much is often at stake, some
will fight hard to deny that there is a systemic risk.
One of the main reasons that Congress in 1991 passed FDICIA
(Federal Deposit Insurance Corporation Improvement Act) was to prevent
the Federal Reserve from delaying closure of failing banks, increasing
losses and weakening the FDIC fund. The Federal Reserve and the FDIC
have not used FDICIA against large banks in this crisis. That should
change.
The third lesson is that a successful policy will alter bankers'
incentives and avoid moral hazard. Bankers must know that risk taking
brings both rewards and costs, including failure, loss of managerial
position and equity followed by sale of continuing operations.
An Alternative Proposal
Several reforms are needed to reduce or eliminate the cost of
financial failure to the taxpayers. Members of Congress should ask
themselves and each other: Is the banker or the regulator more likely
to know about the risks on a bank's balance sheet? Of course it is the
banker, and especially so if the banker is taking large risks that he
wants to hide. To me that means that reform should start by increasing
a banker's responsibility for losses. The Administration's proposal
does the opposite by making the Federal Reserve responsible for
systemic risk.
Systemic risk is a term of art. I doubt that it can be defined in a
way that satisfies the many parties involved in regulation. Members of
Congress will properly urge that any large failure in their district or
State is systemic. Administrations and regulators will have other
objectives. Without a clear definition, the proposal will bring
frequent controversy. And without a clear definition, the proposal is
incomplete and open to abuse.
Resolving the conflicting interests is unlikely to protect the
general public. More likely, regulators will claim that they protect
the public by protecting the banks. That's what they do now.
The Administration's proposal sacrifices much of the remaining
independence of the Federal Reserve. Congress, the Administration, and
failing banks or firms will want to influence decisions about what is
to be bailed out. I believe that is a mistake. If we use our capital to
avoid failures instead of promoting growth we not only reduce growth in
living standards we also sacrifice a socially valuable arrangement--
central bank independence. We encourage excessive risk taking and moral
hazard.
I believe there are better alternatives than the Administration's
proposal. First step: End TBTF. Require all financial institutions to
increase capital more than in proportion to their increase in size of
assets. TBTF gives perverse incentives. It allows banks to profit in
good times and shifts the losses to the taxpayers when crises or
failures occur.
My proposal reduces the profits from giant size, increases
incentives for prudent banker behavior by putting losses back to
managements and stockholders where they belong. Benefits of size come
from economies of scale and scope. These benefits to society are more
than offset by the losses society takes in periods of crisis. Congress
should find it hard to defend a system that distributes profits and
losses as TBTF does. I believe that the public will not choose to
maintain that system forever. Permitting losses does not eliminate
services; failure means that management loses its position and
stockholders take the losses. Profitable operations continue and are
sold at the earliest opportunity.
Second step: Require the Federal Reserve to announce a rule for
lender-of-last-resort. Congress should adopt the rule that they are
willing to sustain. The rule should give banks an incentive to hold
collateral to be used in a crisis period. Bagehot's rule is a great
place to start.
Third step: Recognize that regulation is an ineffective way to
change behavior. My first rule of regulation states that lawyers
regulate but markets circumvent burdensome regulation. The Basel Accord
is an example. Banks everywhere had to increase capital when they
increased balance sheet risk. The banks responded by creating entities
that were not on their balance sheet. Later, banks had to absorb the
losses, but that was after the crisis. There are many other examples of
circumvention from Federal Reserve history. The reason we have money
market funds was that Fed regulation Q restricted the interest that the
public could earn. Money market funds bought unregulated, large
certificates of deposit. For a small fee they shared the higher
interest rate with the public. Much later Congress agreed to end
interest rate regulation. The money funds remained.
Fourth step: Recognize that regulators do not allow for the
incentives induced by their regulations. In the dynamic, financial
markets it is difficult, perhaps impossible, to anticipate how clever
market participants will circumvent the rules without violating them.
The lesson is to focus on incentives, not prohibitions. Shifting losses
back to the bankers is the most powerful incentive because it changes
the risk-return tradeoff that bankers and stockholders see.
Fifth step: Either extend FDICIA to include holding companies or
subject financial holding companies to bankruptcy law. Make the holding
company subject to early intervention either under FDICIA or under
bankruptcy law. That not only reduces or eliminates taxpayer losses,
but it also encourages prudential behavior.
Other important changes should be made. Congress should close
Fannie Mae and Freddie Mac and put any subsidy for low-income housing
on the budget. The same should be done to other credit market
subsidies. The budget is the proper place for subsidies.
Congress, the regulators, and the Administration should encourage
financial firms to change their compensation systems to tie
compensation to sustained average earnings. Compensation decisions are
too complex for regulation and too easy to circumvent. Decisions should
be management's responsibility. Part of the change should reward due
diligence by traders. We know that rating agencies contributed to
failures. The rating problem would be lessened if users practiced
diligence of their own.
Three principles should be borne in mind. First, banks borrow short
and lend long. Unanticipated large changes can and will cause failures.
Our problem is to minimize the cost of failures to society. Second,
remember that capitalism without failure is like religion without sin.
It removes incentives for prudent behavior. Third, those that rely on
regulation to reduce risk should recall that this is the age of Madoff
and Stanford. The Fed, too, lacks a record of success in managing large
risks to the financial system, the economy and the public. Incentives
for fraud, evasion, and circumvention of regulation often have been far
more powerful than incentives to enforce regulation that protects the
public.
RESPONSES TO WRITTEN QUESTIONS OF SENATOR SHELBY
FROM SHEILA C. BAIR
Q.1. Too-Big-To-Fail--Chairman Bair, the Obama administration's
proposal would have regulators designate certain firms as
systemically important. These firms would be classified as Tier
1 Financial Holding Companies and would be subject to a
separate regulatory regime. If some firms are designated as
systemically important, would this signal to market
participants that the Government will not allow these firms to
fail? If so, how would this worsen our ``too-big-to-fail''
problem?
A.1. We have concerns about formally designating certain
institutions as a special class. Any recognition of an
institution as systemically important risks invoking the moral
hazard that accompanies institutions that are considered too-
big-to-fail. That is why, most importantly, a robust resolution
mechanism, in addition to enhanced supervision, is important
for very large financial organizations. A vigorous systemic
risk regulatory regime, along with resolution authority for
bank holding companies and systemically risky financial firms
would go far toward eliminating ``too-big-to-fail.''
Q.2. Government Replacing Management?--In your testimony, while
discussing the need for a systemic risk regulator to provide a
resolution regime, you state that ``losses would be borne by
the stockholders and bondholders of the holding company, and
senior management would be replaced.'' Could you expand upon
how the senior management would be replaced? Would the systemic
risk regulator decide who needed to be replaced and who would
replace them?
A.2. When the FDIC takes over a large insured bank and
establishes a bridge bank, the normal business practice is to
replace certain top officials in the bank, usually the CEO,
plus any other senior officials whose activities were tied to
the cause of the bank failure. The resolution authority would
decide who to replace based on why the firm failed.
Q.3. ``Highly Credible Mechanism'' for Orderly Resolution--
Chairman Bair, in your testimony you suggest that we must
redesign our system to allow the market to determine winners
and losers, ``and when firms--through their own mismanagement
and excessive risk taking--are no longer viable, they should
fail.'' You also suggest that the solution must involve a
``highly credible mechanism'' for orderly resolution of failed
institutions similar to that which exists for FDIC-insured
banks.
Do you believe that our current bankruptcy system is
inadequate, or do you believe that we must create a new
resolution regime simply to fight the perception that we will
not allow a systemically important institution to fail?
A.3. In the United States, liquidation and rehabilitation of
most failing corporations are governed by the Federal
bankruptcy code and administered primarily in the Federal
bankruptcy courts. Separate treatment, however, is afforded to
banks, which are resolved under the Federal Deposit Insurance
Act and administered by the FDIC. \1\ The justifications for
this separate treatment are banks' importance to the aggregate
economy, and the serious adverse effect of their insolvency on
others.
---------------------------------------------------------------------------
\1\ Another exception would be the liquidation or rehabilitation
of insurance companies, which are handled under State law.
---------------------------------------------------------------------------
Bankruptcy focuses on returning value to creditors and is
not geared to protecting the stability of the financial system.
When a firm is placed into bankruptcy, an automatic stay is
placed on most creditor claims to allow management time to
develop a reorganization plan. This can create liquidity
problems for creditors--especially when a financial institution
is involved--who must wait to receive their funds. Bankruptcy
cannot prevent a meltdown of the financial system when a
systemically important financial firm is troubled or failing.
Financial firms--especially large and complex financial
firms--are highly interconnected and operate through financial
commitments. Most obtain a significant share of their funding
from wholesale markets using short-term instruments. They
provide key credit and liquidity intermediation functions. Like
banks, financial firms (holding companies and their affiliates)
can be vulnerable to ``runs'' if their short-term liabilities
come due and cannot be rolled over. For these firms, bankruptcy
can trigger a rush to the door, since counterparties to
derivatives contracts--which are exempt from the automatic stay
placed on other contracts--will exercise their rights to
immediately terminate contracts, net out their exposures, and
sell any supporting collateral.
The statutory right to invoke close-out netting and
settlement was intended to reduce the risks of market
disruption. Because financial firms play a central role in the
intermediation of credit and liquidity, tying up these
functions in the bankruptcy process would be particularly
destabilizing. However, during periods of economic instability
this rush-to-the-door can overwhelm the market and even depress
market prices for the underlying assets. This can further
destabilize the markets and affect other financial firms as
they are forced to adjust their balance sheets.
By contrast, the powers that are available to the FDIC
under its special resolution authority prevent the immediate
close-out netting and settlement of financial contracts of an
insured depository institution if the FDIC, within 24 hours
after its appointment as receiver, decides to transfer the
contracts to another bank or to an FDIC-operated bridge bank.
As a result, the potential for instability or contagion caused
by the immediate close-out netting and settlement of qualified
financial contracts can be tempered by transferring them to a
more stable counterparty or by having the bridge bank guarantee
to continue to perform on the contracts. The FDIC's resolution
powers clearly add stability in contrast to a bankruptcy
proceeding.
For any new resolution regime to be truly ``credible,'' it
must provide for the orderly wind-down of large, systemically
important financial firms in a manner that is clear,
comprehensive, and capable of conclusion. Thus, it is not
simply a matter of ``perception,'' although the new resolution
regime must be recognized by firms, investors, creditors, and
the public as a mechanism in which systemically important
institutions will in fact fail.
Q.4. Firms Subject to New Resolution Regime--Chairman Bair, in
your testimony, you continuously refer to ``systemically
significant entities,'' and you also advocate for much broader
resolution authority. Could you indicate how a ``systemically
significant entity'' would be defined? Will the list of
systemically significant institutions change year-to-year? Do
you envision it including nonfinancial companies such as GM?
Would all financial and ``systemically significant
entities'' be subject to this new resolution regime? If not,
how would the market determine whether the company would be
subject to a traditional bankruptcy or the new resolution
regime?
Why do we need a systemic risk regulator if we are going to
allow institutions to become ``systemically important''?
A.4. We would anticipate that the Systemic Risk Council, in
conjunction with the Federal Reserve would develop definitions
for systemic risk. Also, mergers, failures, and changing
business models could change what firms would be considered
systemically important from year-to-year.
While not commenting on any specific company, nonfinancial
firms that become major financial system participants should
have their financial activities come under the same regulatory
scrutiny as any other major financial system participant.
Q.5. Better Deal for the Taxpayer--Chairman Bair, you advocate
in your testimony for a new resolution mechanism designed to
handle systemically significant institutions. Could you please
cite specific examples of how this new resolution regime would
have worked to achieve a better outcome for the taxpayer during
this past crisis?
A.5. A proposed new resolution regime modeled after the FDIC's
existing authorities has a number of characteristics that would
reduce the costs associated with the failure of a systemically
significant institution.
First and foremost, the existence of a transparent
resolution scheme and processes will make clear to market
participants that there will be an imposition of losses
according to an established claims priority where stockholders
and creditors, not the Government, are in the first loss
position. This will provide a significant measure of cost
savings by imposing market discipline on institutions so that
they are less likely to get to the point where they would have
otherwise been considered too-big-to-fail.
Also, the proposed resolution regime would allow the
continuation of any systemically significant operations, but
only as a means to achieve a final resolution of the entity. A
bridge mechanism, applicable to the parent company and all
affiliated entities, would allow the Government to preserve
systemically significant functions. Also, for institutions
involved in derivatives contracts, the new resolution regime
would provide an orderly unwinding of counterparty positions as
compared to the rush to the door that can occur during a
bankruptcy. In contrast, since counterparties to derivatives
contracts are exempt from the automatic stay placed on other
contracts under the Bankruptcy Code, they will exercise their
rights to immediately terminate contracts, net out their
exposures, and sell any supporting collateral, which serves to
increase the loss to the failed institution.
In addition, the proposed resolution regime enables losses
to be imposed on market players who should appropriately bear
the risk, including shareholders and unsecured debt investors.
This creates a buffer that can reduce potential losses that
could be borne by taxpayers.
Further, when the institution and its assets are sold, this
approach creates the possibility of multiple bidders for the
financial organization and its assets, which can improve
pricing and reduce losses to the receivership.
The current financial crisis led to illiquidity and the
potential insolvency of a number of systemically significant
financial institutions during 2008. Where Government assistance
was provided on an open-institution basis, the Government
exposed itself to significant loss that would otherwise have
been mitigated by these authorities proposed for the resolution
of systemically significant institutions. A new resolution
regime for firms such as Lehman or AIG would ensure that
shareholders, management, and creditors take losses and would
bar an open institution bail-out, as with AIG. The powers of a
receiver for a financial firm would include the ability to
require counterparties to perform under their contracts and the
ability to repudiate or terminate contracts that impose
continuing losses. It also would have the power to terminate
employment contracts and eliminate many bonuses.
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RESPONSES TO WRITTEN QUESTIONS OF SENATOR REED
FROM SHEILA C. BAIR
Q.1. You discussed regulatory arbitrage in your written
statements and emphasized the benefits of a Council to minimize
such opportunities. Can you elaborate on this? Should standards
be set by individual regulators, the Council, or both? Can a
Council operate effectively in emergency situations?
A.1. One type of regulatory arbitrage is regulatory capital
arbitrage. It is made possible when there are different capital
requirements for organizations that have similar risks. For
instance, banks must hold 10 percent total risk-based capital
and a 5 percent leverage ratio to be considered well-
capitalized, while large broker-dealers (investment banks) were
allowed to operate with as little as 3 percent risk-based
capital. Thus for similar assets, a bank would have to hold $5
for every $100 of assets, a broker dealer would only be
required to hold $3 of capital for every $100 of the same
assets. Obviously, it would be more advantageous for broker
dealers to accumulate these assets, as their capital
requirement was 40 percent smaller than for a comparable bank.
The creation of a Systemic Risk Council with authority to
harmonize capital requirements across all financial firms would
mitigate this type of regulatory capital arbitrage. Although
the capital rules would vary somewhat according to industry,
the authority vested in the Council would prevent the types of
disparities in capital requirements we have recently witnessed.
Some have suggested that a council approach would be less
effective than having this authority vested in a single agency
because of the perception that a deliberative council such as
this would need additional time to address emergency situations
that might arise from time to time. Certainly, some additional
thought and effort will be needed to address any dissenting
views in council deliberations, but a vote by Council members
would achieve a final decision. A Council will provide for an
appropriate system of checks and balances to ensure that
appropriate decisions are made that reflect the various
interests of public and private stakeholders. In this regard,
it should be noted that the board structure at the FDIC, with
the participation of outside directors, is not very different
than the way the council would operate. In the case of the
FDIC, quick decisions have been made with respect to systemic
issues and emergency bank resolutions on many occasions. Based
on our experience with a board structure, we believe that
decisions could be made quickly by a deliberative council while
still providing the benefit of arriving at consensus decisions.
Q.2. What do you see as the key differences in viewpoints with
respect to the role and authority of a Systemic Risk Council?
For example, it seems like one key question is whether the
Council or the Federal Reserve will set capital, liquidity, and
risk management standards. Another key question seems to be who
should be the Chair of the Council: the Secretary of the
Treasury or a different Senate-appointed Chair. Please share
your views on these issues.
A.2. The Systemic Risk Council should have the authority to
impose higher capital and other standards on financial firms
notwithstanding existing Federal or State law and it should be
able to overrule or force actions on behalf of other regulatory
entities to raise capital or other requirements. Primary
regulators would be charged with enforcing the requirements set
by the Council. However, if the primary regulators fail to act,
the Council should have the authority to do so. The standards
set by the Council would be designed to provide incentives to
reduce or eliminate potential systemic risks created by the
size or complexity of individual entities, concentrations of
risk or market practices, and other interconnections between
entities and markets.
The Council would be uniquely positioned to provide the
critical linkage between the primary Federal regulators and the
need to take a macroprudential view and focus on emerging
systemic risk across the financial system. The Council would
assimilate information on economic conditions and the condition
of supervised financial companies to assess potential risk to
the entire financial system. The Council could then direct
specific regulatory agencies to undertake systemic risk
monitoring activities or impose recommended regulatory measures
to mitigate systemic risk.
The Administration proposal includes eight members on the
Council: the Secretary of the Treasury (as Chairman); the
Chairman of the Federal Reserve Board; the Director of the
National Bank Supervisor; the Director of the Consumer
Financial Protection Agency; the Chairman of the Securities and
Exchange Commission; the Chairman of the Commodities Futures
Trading Commission; the Chairman of the FDIC; and the Director
of the Federal Housing Finance Agency.
In designing the role of the Council, it will be important
to preserve the longstanding principle that bank regulation and
supervision are best conducted by independent agencies. For
example, while the OCC is an organization within the Treasury
Department, there are statutory safeguards to prevent undue
involvement of the Treasury in regulation and supervision of
National Banks. Given the role of the Treasury in the Council
contemplated in the Administration's plan, careful attention
should be given to the establishment of appropriate safeguards
to preserve the political independence of financial regulation.
Moreover, while the FDIC does not have a specific
recommendation regarding what agencies should compose the
Council, we would suggest that the Council include an odd
number of members in order to avoid deadlocks. One way to
address this issue that would be consistent with the importance
of preserving the political independence of the regulatory
process would be for the Treasury Chair to be a nonvoting
member, or the Council could be headed by someone appointed by
the President and confirmed by the Senate.
Q.3. What are the other unresolved aspects of establishing a
framework for systemic risk regulation?
A.3. With an enhanced Council with decision-making powers to
raise capital and other key standards for systemically related
firms or activities, we are in general agreement with the
Treasury plan for systemic risk regulation, or the Council
could be headed by a Presidential appointee.
Q.4. How should Tier 1 firms be identified? Which regulator(s)
should have this responsibility?
A.4. As discussed in my testimony, the FDIC endorses the
creation of a Council to oversee systemic risk issues, develop
needed prudential policies and mitigate developing systemic
risks. Prior to the current crisis, systemic risk was not
routinely part of the ongoing supervisory process. The FDIC
believes that the creation of a Council would provide a
continuous mechanism for measuring and reacting to systemic
risk across the financial system. The powers of such a Council
would ultimately have to be developed through a dialogue
between the banking agencies and Congress, and empower the
Council to oversee unsupervised nonbanks that present systemic
risk. Such nonbanks should be required to submit to such
oversight, presumably as a financial holding company under the
Federal Reserve. The Council could establish what practices,
instruments, or characteristics (concentrations of risk or
size) that might be considered risky, but would not identify
any set of firms as systemic.
We have concerns about formally designating certain
institutions as a special class. Any recognition of an
institution as systemically important, however, risks invoking
the moral hazard that accompanies institutions that are
considered too-big-to-fail. That is why, most importantly, a
robust resolution mechanism, in addition to enhanced
supervision, is important for very large financial
organizations.
Q.5. One key part of the discussion at the hearing is whether
the Federal Reserve, or any agency, can effectively operate
with two or more goals or missions. Can the Federal Reserve
effectively conduct monetary policy, macroprudential
regulation, and consumer protection?
A.5. The Federal Reserve has been the primary Federal regulator
for State chartered member institutions since its inception and
has been the bank holding company supervisor since 1956. With
the creation of the Consumer Financial Protection Agency and
the Systemic Risk Council, the Federal Reserve should be able
to continue its monetary policy role as well as remain the
prudential primary Federal regulator for State chartered member
institutions and bank holding companies.
Q.6. Under the Administration's plan, there would be heightened
supervision and consolidation of all large, interconnected
financial firms, including likely requiring more firms to
become financial holding companies. Can you comment on whether
this plan adequately addresses the ``too-big-to-fail'' problem?
Is it problematic, as some say, to identify specific firms that
are systemically significant, even if you provide disincentives
to becoming so large, as the Administration's plan does?
A.6. The creation of a systemic risk regulatory framework for
bank holding companies and systemically important firms will
address some of the problems posed by ``too-big-to-fail''
firms. In addition, we should develop incentives to reduce the
size of very large financial firms.
However, even if risk-management practices improve
dramatically and we introduce effective macroprudential
supervision, the odds are that a large systemically significant
firm will become troubled or fail at some time in the future.
The current crisis has clearly demonstrated the need for a
single resolution mechanism for financial firms that will
preserve stability while imposing the losses on shareholders
and creditors and replacing senior management to encourage
market discipline. A timely, orderly resolution process that
could be applied to both banks and nonbank financial
institutions, and their holding companies, would prevent
instability and contagion and promote fairness. It would enable
the financial markets to continue to function smoothly, while
providing for an orderly transfer or unwinding of the firm's
operations. The resolution process would ensure that there is
the necessary liquidity to complete transactions that are in
process at the time of failure, thus addressing the potential
for systemic risk without creating the expectation of a
bailout.
Under a new resolution regime, Congress should raise the
bar higher than existing law and eliminate the possibility of
open assistance for individual failing entities. The new
resolution powers should result in the shareholders and
unsecured creditors taking losses prior to the Government, and
consideration also should be given to imposing some haircut on
secured creditors to promote market discipline and limit costs
potentially borne by the Government.
------
RESPONSE TO WRITTEN QUESTIONS OF SENATOR MENENDEZ
FROM SHEILA C. BAIR
Q.1. A recent media article (New York Times, June 14th) states
there have been strong disagreements between the FDIC and the
OCC over whether the proposal to impose new insurance fees on
banks is unfair to the largest banks, with the FDIC arguing
that the largest banks contributed to the current crisis and
should have to pay more. Can you elaborate on your rationale
for requiring big banks to pay more than community banks?
A.1. The New York Times article referred to the emergency
special assessment, adopted on May 22, 2009, which imposes a 5-
basis point special assessment rate on each insured depository
institution's assets minus Tier 1 capital as of June 30, 2009.
The Federal Deposit Insurance Reform Act of 2005 requires
the FDIC to establish and implement a restoration plan if the
reserve ratio falls below 1.15 percent of insured deposits. On
October 7, 2008, the FDIC established a Restoration Plan for
the Deposit Insurance Fund. The Restoration Plan was amended on
February 27, 2009, and quarterly base assessment rates were set
at a range of 12 to 45 basis points beginning in the second
quarter of 2009. However, given the FDIC's estimated losses
from projected institution failures, these assessment rates
were determined not to be sufficient to return the fund reserve
ratio to 1.15 percent. On May 22, 2009, therefore, the FDIC
Board of Directors adopted a final rule establishing a 5 basis
point special assessment on each insured depository
institution's assets minus Tier 1 capital as of June 30, 2009.
The special assessment is necessary to strengthen the Deposit
Insurance Fund and promote confidence in the deposit insurance
system.
The adoption of the final rule on the special assessment
followed a request for comment that generated over 14,000
responses. The final rule implemented several changes to the
FDIC's special assessment interim rule, including a reduction
in the rate used to calculate the special assessment and a
change in the base used to calculate the special assessment.
The assessment formula is the same for all insured
institutions--big and small. However, it produces higher
assessments for institutions that rely more on nondeposit
liabilities. These institutions do tend to be the larger
institutions. The FDIC considers this appropriate as in the
event of the failure of institutions with significant amounts
of secured debt, the FDIC's loss is often increased without any
compensation in the form of increased assessment revenue.
The amount of the special assessment for any institution,
however, will not exceed 10 basis points times the
institution's assessment base for the second quarter 2009 risk-
based assessment. We believe that the special assessment
formula provides incentives for institutions to hold long-term
unsecured debt, and for smaller institutions to hold high
levels of Tier 1 capital--both good things in the FDIC's view.
------
RESPONSES TO WRITTEN QUESTIONS OF SENATOR BUNNING
FROM SHEILA C. BAIR
Q.1. Many proposals call for a risk regulator that is separate
from the normal safety and soundness regulator of banks and
other firms. The idea is that the risk regulator will set rules
that the other regulators will enforce. That sounds a lot like
the current system we have today, where different regulators
read and enforce the same rules different ways. Under such a
risk regulator, how would you make sure the rules were being
enforced the same across the board?
A.1. The significant size and growth of unsupervised financial
activities outside the traditional banking system--in what is
termed the shadow financial system--has made it all the more
difficult for regulators or market participants to understand
the real dynamics of either bank credit markets or public
capital markets. The existence of one regulatory framework for
insured institutions and a much less effective regulatory
scheme for nonbank entities created the conditions for
arbitrage that permitted the development of risky and harmful
products and services outside regulated entities.
We have proposed a Systemic Risk Council composed of the
principal prudential regulators for banking, financial markets,
consumer protection, and Treasury to look broadly across all of
the financial sectors to adopt a ``macroprudential'' approach
to regulation. The point of looking more broadly at the
financial system is that reasonable business decisions by
individual financial firms may, in aggregate, pose a systemic
risk. This failure of composition problem cannot be solved by
simply making each financial instrument or practice safe.
Rules and restrictions promulgated by the proposed Systemic
Risk Council would be uniform with respect to institutions,
products, practices, services, and markets that create
potential systemic risks. Again, a distinction should be drawn
between the direct supervision of systemically significant
financial firms and the macroprudential oversight and
regulation of developing risks that may pose systemic risks to
the U.S. financial system. The former appropriately calls for
the identification of a prudential supervisor for any potential
systemically significant holding companies or similar
conglomerates. Entities that are already subject to a
prudential supervisor, such as insured depository institutions
and financial holding companies, should retain those
supervisory relationships. In addition, for systemic entities
not already subject to a Federal prudential supervisor, this
Council should be empowered to require that they submit to such
oversight, presumably as a financial holding company under the
Federal Reserve--without subjecting them to the activities
restrictions applicable to these companies.
We need to combine the current microprudential approach
with a macroprudential approach through the Council. The
current system focuses only on individual financial instruments
or practices. Each agency is responsible for enforcing these
regulations only for their institutions. In addition, there are
separate regulatory schemes used by the SEC and the CFTC as
well as the State level regulation of insurance companies. The
macroprudential oversight of systemwide risks requires the
integration of insights from a number of different regulatory
perspectives--banks, securities firms, holding companies, and
perhaps others. Thus, the FDIC supports the creation of a
Council to oversee systemic risk issues, develop needed
prudential policies, and mitigate developing systemic risks.
Q.2. Before we can regulate systemic risk, we have to know what
it is. But no one seems to have a definition. How do you define
systemic risk?
A.2. We would anticipate that the Systemic Risk Council, in
conjunction with the Federal Reserve would develop definitions
for systemic risk. Also, mergers, failures, and changing
business models could change what firms would be considered
systemically important from year-to-year.
Q.3. Assuming a regulator could spot systemic risk, what
exactly is the regulator supposed to do about it? What powers
would they need to have?
A.3. The failure of some large banks and nonbanks revealed that
the U.S. banking agencies should have been more aggressive in
their efforts to mitigate excessive risk concentrations in
banks and their affiliates, and that the agencies' powers to
oversee systemically important nonbanks require strengthening.
As discussed in my testimony, the FDIC endorses the
creation of a Council to oversee systemic risk issues, develop
needed prudential policies, and mitigate developing systemic
risks. For example, the Council could ensure capital standards
are strong and consistent across significant classes of
financial services firms including nonbanks and GSEs. Prior to
the current crisis, systemic risk was not routinely part of the
ongoing supervisory process. The FDIC believes that the
creation of a Council would provide a continuous mechanism for
measuring and reacting to systemic risk across the financial
system. The powers of such a Council would ultimately have to
be developed through a dialogue between the banking agencies
and Congress, and empower the Council to ensure appropriate
oversight of unsupervised nonbanks that present systemic risk.
Such nonbanks should be required to submit to such oversight,
presumably as a financial holding company under the Federal
Reserve.
Q.4. How do you propose we identify firms that pose systemic
risks?
A.4. The proposed Systemic Risk Council could establish what
practices, instruments, or characteristics (concentrations of
risk or size) that might be considered risky, but should not
identify any set of firms as systemic. We have concerns about
formally designating certain institutions as a special class.
We recognize that there may be very large interconnected
financial entities that are not yet subject to Federal
consolidated supervision, although most of them are already
subject to such supervision as a result of converting to banks
or financial holding companies in response to the crisis. Any
recognition of an institution as systemically important,
however, risks invoking the moral hazard that accompanies
institutions that are considered too-big-to-fail. That is one
reason why, most importantly, a robust resolution mechanism, in
addition to enhanced supervision, is important for very large
financial organizations.
Q.5. Any risk regulator would have access to valuable
information about the business of many firms. There would be a
lot of people who would pay good money to get that information.
How do we protect that information from being used improperly,
such as theft or an employee leaving the regulator and using
his knowledge to make money?
A.5. The FDIC, as deposit insurer and supervisor of over 5,000
banks, prides itself on maintaining confidentiality with our
stakeholders. We have a corporate culture that demands strict
confidentiality with regard to bank and personal information.
Our staff is trained extensively on the use, protection, and
disclosure of nonpublic information as well as expectations for
the ethical conduct. Disclosure of nonpublic information is not
tolerated and any potential gaps are dealt with swiftly and
disclosed to affected parties. The FDIC's Office of Inspector
General has a robust process for dealing with improper
disclosures of information both during and postemployment with
FDIC.
These ethical principles are supported by criminal statutes
which provide that Federal officers and employees are
prohibited from the disclosure of confidential information
generally (18 U.S.C. 1905) and from the disclosure of
information from a bank examination report (18 U.S.C. 1906).
All former Federal officers and employees are subject to
the postemployment restrictions (18 U.S.C. 207), which prohibit
former Government officers and employees from knowingly making
a communication or appearance on behalf of any other person,
with the intent to influence, before any officer or employee of
any Federal agency or court in connection with a particular
matter in which the employee personally and substantially
participated, which involved a specific party at the time of
the participation and representation, and in which the U.S. is
a party or has a direct and substantial interest.
In addition, an officer or employee of the FDIC who serves
as a senior examiner of an insured depository institution for
at least 2 months during the last 12 months of that
individual's employment with the FDIC may not, within 1 year
after the termination date of his or her employment with the
FDIC, knowingly accept compensation as an employee, officer,
director, or consultant from the insured depository
institution; or any company (including a bank holding company
or savings and loan holding company) that controls such
institution (12 U.S.C. 1820(k).
------
RESPONSES TO WRITTEN QUESTIONS OF SENATOR CRAPO
FROM SHEILA C. BAIR
Q.1. I appreciate the FDIC's desire to provide clarity around
the process of private investors investing in failed banks that
have been taken over by the FDIC. We need to make sure that the
final rule doesn't deter private capital from entering the
banking system, leaving the FDIC's insurance fund and,
ultimately, the taxpayers with the final bill. Are you open to
modifying some of the proposed requirements, such as the 15
percent capital requirement?
A.1. The Federal Deposit Insurance Corporation is aware of the
need for additional capital in the banking system and the
potential contribution that private equity capital could make
to meet this need. At the same time, the FDIC is sensitive to
the need for all investments in insured depository
institutions, regardless of the source, to be consistent with
protecting the Deposit Insurance Fund and the safety and
soundness of insured institutions.
In light of the increased number of bank and thrift
failures and the consequent increase in interest by potential
private capital investors, the FDIC published for comment on
July 9, 2009, a Proposed Statement of Policy on Qualifications
for Failed Bank Acquisitions (Proposed Policy Statement). The
Proposed Policy Statement provided guidance to private capital
investors interested in acquiring the deposit liabilities, or
the liabilities and assets, of failed insured depository
institutions. It included specific questions on the important
issues surrounding nontraditional investors in insured
financial institutions including the level of capital required
for the institution that would be owned by these new entrants
into the banking system and whether these owners can be a
source of strength. We sought public and industry comment to
assist us in evaluating the policies to apply in deciding
whether a nontraditional investor may bid on a failed
institution.
On August 26, 2009, the FDIC's Board of Directors voted to
adopt the Final Statement of Policy on Qualifications for
Failed Bank Acquisitions (Final Policy Statement), which was
published in the Federal Register on September 2, 2009. The
Final Policy Statement takes into account the comments
presented by the many interested parties who submitted
comments. Although the final minimum capital commitment has
been adjusted from 15 percent Tier 1 leverage to 10 percent
Tier 1 common equity, key elements of the earlier proposed
statement remain in place: cross-support, prohibitions on
insider lending, limitations on sales of acquired shares in the
first 3 years, a prohibition on bidding by excessively opaque
and complex business structures, and minimum disclosure
requirements.
Importantly, the Final Policy Statement specifies that it
does not apply to investors who do not hold more than 5 percent
of the total voting powers and who are not engaged in concerted
actions with other investors. It also includes relief for
investors if the insured institution maintains a Uniform
Financial Institution composite rating of 1 or 2 for 7
consecutive years. The FDIC Board is given the authority to
make exceptions to its application in special circumstances.
The Final Policy Statement also clearly excludes partnerships
between private capital investors and bank or thrift holding
companies that have a strong majority interest in the acquired
banks or thrifts.
In adopting the Final Policy Statement, the FDIC sought to
strike a balance between the interests of private investors and
the need to provide adequate safeguards for the insured
depository institutions involved. We believe the Final Policy
Statement will encourage safe and sound investments and make
the bidding more competitive and robust. In turn, this will
limit the FDIC's losses, protect taxpayers, and speed the
resolution process. As a result, the Final Policy Statement
will aid the FDIC in carrying out its mission.
------
RESPONSES TO WRITTEN QUESTIONS OF SENATOR VITTER
FROM SHEILA C. BAIR
Q.1. Chairwoman Bair, you recently released a proposal which, I
believe, asks private equity to maintain a 15 percent Tier 1
capital ratio while well-capitalized banks only maintain a 5
percent ratio and newly established banks an 8 percent ratio.
In May, the FDIC announced the successful purchase of Bank
United which allowed almost $1 billion of private investment
come in and successfully take over the bank's management. By
all reports this has been a successful arrangement for both the
FDIC and private investment company. Although I understand your
policy concerns, I think that the current proposal goes too far
in several respects. I am concerned that the FDIC's proposed
policy deters private capital from entering the banking system,
leaving the FDIC's insurance fund and, ultimately, the
taxpayers with the final bill. With bank failures mounting this
year, I would have liked see more private investment able to
participate in cleaning up these troubled banks.
What can the FDIC do to ensure that more private equity
comes in to stem the tide of bank failures?
A.1. On August 26, 2009, the FDIC's Board of Directors voted to
adopt the Final Statement of Policy on Qualifications for
Failed Bank Acquisitions (Final Policy Statement), which was
published in the Federal Register on September 2, 2009. The
Final Policy Statement takes into account the comments
presented by the many interested parties who submitted
comments. Although the final minimum capital commitment has
been adjusted from 15 percent Tier 1 leverage to 10 percent
Tier 1 common equity, key elements of the earlier proposed
statement remain in place: cross-support, prohibitions on
insider lending, limitations on sales of acquired shares in the
first 3 years, a prohibition on bidding by excessively opaque
and complex business structures, and minimum disclosure
requirements.
Importantly, the Final Policy Statement specifies that it
does not apply to investors who do not hold more than 5 percent
of the total voting powers and who are not engaged in concerted
actions with other investors. It also includes relief for
investors if the insured institution maintains a Uniform
Financial Institution composite rating of 1 or 2 for 7
consecutive years. The FDIC Board is given the authority to
make exceptions to its application in special circumstances.
The Final Policy Statement also clearly excludes partnerships
between private capital investors and bank or thrift holding
companies that have a strong majority interest in the acquired
banks or thrifts.
In adopting the Final Policy Statement, the FDIC sought to
strike a balance between the interests of private investors and
the need to provide adequate safeguards for the insured
depository institutions involved. We believe the Final Policy
Statement will encourage safe and sound investments and make
the bidding more competitive and robust. In turn, this will
limit the FDIC's losses, protect taxpayers, and speed the
resolution process. As a result, the Final Policy Statement
will aid the FDIC in carrying out its mission.
Q.2. Are you concerned that without attracting private capital,
the FDIC's deposit insurance fund and, ultimately, taxpayers
will foot the entire bill for the looming bank failures?
A.2. We do not see a taxpayer exposure as a result of upcoming
bank failures. Our latest publicly released information shows
that the FDIC ended the second quarter of 2009 with a DIF
balance of $10.4 billion and an additional $32 billion reserve
for expected future failure losses. Updates to these numbers
show the FDIC estimates that it ended the third quarter of 2009
with a negative fund balance. The contingent loss reserve for
expected future losses from failures has grown, however.
To date, the FDIC has required a special assessment to
rebuild the DIF and we recently issued a notice of proposed
rule making to require the prepayment of assessments for 3
years. Current projections are that assessment income will
exceed expected losses from bank failures over the next several
years. However, there is a timing problem as the bulk of bank
failures are expected to occur in 2009 and 2010, while most
assessment income will be booked in later years. Therefore,
although the prepayment of assessments will not immediately
rebuild the fund balance, it will provide the FDIC with the
liquidity needed to fund projected bank failures. Further, even
if it became necessary for the FDIC to borrow from the U.S.
Treasury, any potential borrowing would be repaid by insured
depository institutions.
Q.3. If private equity does come in, what could the savings be
to the deposit insurance fund?
A.3. If, as expected, the FDIC increases the overall number of
potential bidders for failed financial institutions by
including more private equity firms, it would increase
competition and potentially improve the quality of the bids.
Q.4. Do you agree with the Secretary's assessment that the FDIC
was created to address resolving small banks and thrifts and
does not have the appropriate resources to deal with the
failure of a major bank?
A.4. The FDIC has substantial experience resolving large,
complex, internationally active insured depository
institutions. Continental Illinois National Bank and Trust,
which required FDIC assistance in 1984 was the seventh largest
commercial bank in the country at the time. More recently, in
September 2008, the FDIC dealt with the failure of Washington
Mutual Bank which had total assets of $307 billion. This was
the fifth largest bank in the country at that time.
This experience with conservatorships and receiverships has
significant parallels for systemically important holding
companies and for other types of financial companies, enabling
the FDIC to take advantage of its experience in acting as
receiver for thousands of insured depository institutions.
Also, much of the Administration's special resolution authority
proposal is based on the FDIC's current statutory authority.
Therefore, expanding the FDIC's activities to systemically
significant institutions will be consistent in many respects to
its current scope of activities.
Q.5. If there are limits on the FDIC's expertise and resources
would keep the FDIC from resolving the biggest banks in the
country, what are they?
A.5. We believe the FDIC is prepared to handle the resolution
of an insured depository institution of any size and
complexity. Our testimony outlines limitations of our current
resolution authority and recommends, on page 7 [see Page 66 of
this hearing], principles to guide Congress in adopting a
process that ensures an orderly and comprehensive resolution
mechanism for systemically important financial firms.
Q.6. What are the impediments, if any, that the FDIC would face
in resolving the depository institutions associated with Bank
of America or Citi?
A.6. Although I cannot comment on supervisory matters involving
open institutions, any large depository institution can pose
special challenges. They typically have extensive foreign
operations, higher-than-normal levels of uninsured deposits,
expansive branch networks that can span multiple time zones and
usually are heavily involved in derivative financial
instruments. Further, the largest insured depository
institutions are owned by holding companies that own other
related entities. These holding companies manage operations by
business line with little regard to the legal entities
involved. The intertwined nature of the operations of a large
bank holding company will present its own set of challenges.
This is one reason it is important for the FDIC to have
receivership authority over the entire financial services
holding company, not just the insured depository institution.
------
RESPONSES TO WRITTEN QUESTIONS OF SENATOR SHELBY
FROM MARY L. SCHAPIRO
Q.1. Identify Systemic Risk in Advance?--I believe we can all
agree that very few if anyone was able to effectively identify
where the systemic risk resided in our economy prior to our
current financial difficulties. While we had regulatory efforts
in effect to combat these risks in commercial bank and thrift
institutions, the real risk was shown to be outside of this
area.
Chairman Schapiro, what about the structure proposed by the
Obama administration gives you confidence that this new
regulatory body will succeed where so many others failed?
A.1. While there is no guarantee, the one proposed by the
Administration represents a number of improvements over the
current regulatory landscape in terms addressing gaps in
regulatory oversight and minimizing incentives for regulatory
arbitrage. For example, the Administration's proposal seeks to
address the importance of and strengthen consolidated
supervision of large financial conglomerates, including
supervision of previously unregulated subsidiaries.
Critical elements of a successful systemic risk regulation
program also include strong support of functional regulators.
The Council and SRR should complement and augment the role of
functional regulators by leveraging their specialized knowledge
and expertise and should take action in contravention of
functional regulators' standards if necessary when those
standards are less stringent than those advocated by the
Council or SRR. Indeed, functional regulators' standards are
the first line of defense, as functional regulators understand
the markets, products and activities of their regulated
entities.
The effective implementation of a systemic risk regulation
program is critical to its success. Because the process of
identifying emerging risks heavily relies on the analysis of
significant amounts of information and reporting gathered from
firms and regulators, a successful program must be
appropriately resourced, employing an adequate number of staff
with appropriate skill sets. It is important that the
competencies of monitoring and inspection staff are equal to
those of the firm's personnel regarding the relevant topic.
Having a staff that is multidisciplinary and equipped with the
proper skill sets to review and analyze the information
obtained is critical. Generalists with substantial experience
across the breadth of issues and firm relationships should
complement their skills with those of experts in relevant
quantitative specialties.
Q.2. SEC as Systemic Risk Regulator--Chairman Schapiro, the
SEC's Consolidated Supervised Entity program, a program that
existed without the benefit of statutory authorization,
collapsed as its firms failed, were taken over, or shifted to
regulation as bank holding companies.
How does the SEC's experience with the CSE program inform
the model for regulation of systemic risk that you are
advocating today?
A.2. Between 2004 and 2008, the SEC was recognized as the
consolidated supervisor for the five large independent
investment banks under its Consolidated Supervised Entity or
``CSE'' program. The CSE program was created as a way for U.S.
global investment banks that lacked a consolidated holding
company supervisor to voluntarily submit to consolidated
regulation by the SEC. In connection with the establishment of
the CSE program, the largest U.S. broker-dealer subsidiaries of
these entities were permitted to utilize an alternate net
capital computation (ANC). \1\ Other large broker-dealers,
whose holding companies are subject to consolidated supervision
by banking authorities, were also permitted to use this ANC
approach. \2\
---------------------------------------------------------------------------
\1\ In 2004, the SEC amended its net capital rule to permit
certain broker-dealers subject to consolidated supervision to use their
internal mathematical models to calculate net capital requirements for
the market risks of certain positions and the credit risk for OTC
derivatives-related positions rather than the prescribed charges in the
net capital rule, subject to specified conditions. These models were
thought to more accurately reflect the risks posed by these activities,
but were expected to reduce the capital charges and therefore permit
greater leverage by the broker-dealer subsidiaries. Accordingly, the
SEC required that these broker-dealers have, at the time of their ANC
approval, at least $5 billion in tentative net capital (i.e., ``net
liquid assets''), and thereafter to provide an early warning notice to
the SEC if that capital fell below $5 billion. This level was
considered an effective minimum capital requirement.
\2\ Currently six broker-dealers utilize the ANC regime and all
are subject to consolidated supervision by banking authorities.
---------------------------------------------------------------------------
Under the CSE regime, the holding company had to provide
the Commission with information concerning its activities and
exposures on a consolidated basis; submit its nonregulated
affiliates to SEC examinations; compute on a monthly basis,
risk-based consolidated holding company capital in general
accordance with the Basel Capital Accord, an internationally
recognized method for computing regulatory capital at the
holding company level; and provide the Commission with
additional information regarding its capital and risk
exposures, including market, credit and liquidity risks.
It is important to note that prior to the CSE regime, the
SEC had no jurisdiction to regulate these holding companies.
\3\ Accordingly, these holding companies previously had not
been subject to any consolidated capital requirements. This
program was viewed as an effort to fill a significant gap in
the U.S. regulatory structure. \4\
---------------------------------------------------------------------------
\3\ The Gramm-Leach-Bliley Act had created a voluntary program for
the oversight of certain investment bank holding companies (i.e., those
that did not have a U.S. insured depository institution affiliate). The
firms participating in the CSE program did not qualify for that program
or did not opt into that program. Only one firm (Lazard) has ever opted
for this program.
\4\ See, e.g., Testimony by Erik Sirri, Director of the Division
of Trading and Markets, Before the Senate Subcommittee on Securities,
Insurance and Investment, Senate Banking Committee, March 18, 2009.
http://www.sec.gov/news/testimony/2009/ts031809es.htm.
---------------------------------------------------------------------------
During the financial crisis many of these institutions
lacked sufficient liquidity to operate effectively. During
2008, these CSE institutions failed, were acquired, or
converted to bank holding companies which enabled them to
access Government support. The CSE program was discontinued in
September 2008. Some of the lessons learned are as follows:
Capital Adequacy Rules Were Flawed and Assumptions
Regarding Liquidity Risk Proved Overly Optimistic. The
applicable Basel capital adequacy standards depended heavily on
the models developed by the financial institutions themselves.
All models depend on assumptions. Assumptions about such
matters as correlations, volatility, and market behavior
developed during the years before the financial crisis were not
necessarily applicable for the market conditions leading up to
the crisis, nor during the crisis itself.
The capital adequacy rules did not sufficiently consider
the possibility or impact of modeling failures or the limits of
such models. Indeed, regulators worldwide are reconsidering how
to address such issues in the context of strengthening the
Basel regime. Going forward, risk managers and regulators must
recognize the inherent limitations of these (and any) models
and assumptions--and regularly challenge models and their
underlying assumptions to consider more fully low probability,
extreme events.
While capital adequacy is important, it was the related,
but distinct, matter of liquidity that proved especially
troublesome with respect to CSE holding companies. Prior to the
crisis, the SEC recognized that liquidity and liquidity risk
management were critically important for investment banks
because of their reliance on private sources of short-term
funding.
To address these liquidity concerns, the SEC imposed two
requirements: First, a CSE holding company was expected to
maintain funding procedures designed to ensure that it had
sufficient liquidity to withstand the complete loss of all
short term sources of unsecured funding for at least 1 year. In
addition, with respect to secured funding, these procedures
incorporated a stress test that estimated what a prudent lender
would lend on an asset under stressed market conditions (a
``haircut''). Second, each CSE holding company was expected to
maintain a substantial ``liquidity pool'' that was composed of
unencumbered highly liquid and creditworthy assets that could
be used by the holding company or moved to any subsidiary
experiencing financial stress.
The SEC assumed that these institutions, even in stressed
environments, would continue to be able to finance their high-
quality assets in the secured funding markets (albeit perhaps
on less favorable terms than normal). In times of stress, if
the business were sound, there might be a number of possible
outcomes: For example, the firm might simply suffer a loss in
capital or profitability, receive new investment injections, or
be acquired by another firm. If not, the sale of high quality
assets would at least slow the path to bankruptcy or allow for
self-liquidation.
As we now know, these assumptions proved much too
optimistic. Some assets that were considered liquid prior to
the crisis proved not to be so under duress, hampering their
ability to be financed in the repo markets. Moreover, during
the height of the crisis, it was very difficult for some firms
to obtain secured funding even when using assets that had been
considered highly liquid.
Thus, the financial institutions, the Basel regime, and the
CSE regulatory approach did not sufficiently recognize the
willingness of counterparties to simply stop doing business
with well-capitalized institutions or to refuse to lend to CSE
holding companies even against high-quality collateral. Runs
could sometimes be stopped only with significant Government
intervention, such as through institutions agreeing to become
bank holding companies and obtaining access to Government
liquidity facilities or through other forms of support.
Consolidated Supervision Is Necessary but Not a Panacea.
Although large interconnected institutions should be supervised
on a consolidated basis, policy makers should remain aware of
the limits of such oversight and regulation. This is
particularly the case for institutions with many subsidiaries
engaging in different, often unregulated, businesses in
multiple countries.
Before the crisis, there were many different types of large
interconnected institutions subject to consolidated supervision
by different regulators. During the crisis, many consolidated
supervisors, including the SEC, saw large interconnected,
supervised entities seek Government liquidity or direct
assistance.
Systemic Risk Management Requires Meaningful Functional
Regulation, Active Enforcement, and Transparent Markets. While
a consolidated regulator of large interconnected firms is an
essential component to identifying and addressing systemic
risk, a number of other tools must also be employed. These
include more effective capital requirements, strong
enforcement, functional regulation, and transparent markets
that enable investors and other counterparties to better
understand the risks associated with particular investment
decisions. Given the complexity of modern financial
institutions, it is essential to have strong, consistent
functional regulation of individual types of institutions,
along with a broader view of the risks building within the
financial system.
Q.3. SEC's Endorsement of Treasury's Approach--Chairman
Schapiro, you chose to testify today on your own behalf. I
suspect that if you had submitted your testimony for a
Commission vote, you might have met some resistance since you
endorse an approach that envisions the creation of a systemic
risk regulator that will have authority over firms within the
SEC's jurisdiction. Although cast as a second set of eyes to
back up the front line financial regulators, the systemic risk
regulator could complicate the SEC's job.
Are you concerned that the addition of a new regulatory
body will water down your regulatory authority over firms that
you oversee?
A.3. While a SRR should play a critical role in assessing
emerging systemic risks by setting standards for liquidity,
capital and risk management practices, in my view it is vital
that its role be complemented by the creation of a strong and
robust Council. I believe the Council should have authority to
identify institutions, practices, and markets that create
potential systemic risks, and also should be authorized to set
policies for liquidity, capital and other risk management
practices at firms whose failure could pose a threat to
financial stability due to their combination of size, leverage,
and interconnectedness. The Council also would provide a forum
for analyzing and recommending harmonization of certain
standards at other significant financial institutions.
In most times, I would expect the Council and SRR to work
with and through primary regulators of systemically important
institutions. The primary regulators understand the markets,
products and activities of their regulated entities. The SRR,
however, can provide a second layer of review from a
macroprudential perspective. If differences arise between the
SRR/Council and the primary regulator regarding the capital or
risk management standards of systemically important
institutions, I strongly believe that the higher (more
conservative) standard should govern. The systemic risk
regulatory structure should serve as a ``brake'' on a
systemically important institution's riskiness; it should never
be an ``accelerator.''
In emergency situations, the SRR/Council may need to
overrule a primary regulator (for example, to impose higher
standards or to stop or limit potentially risky activities).
However, to ensure that authority is checked and decisions are
not arbitrary, the Council should be where general policy is
set, and only then to implement a more rigorous policy than
that of a primary regulator. This should reduce the ability of
any single regulator to ``compete'' with other regulators by
lowering standards, driving a race to the bottom.
Q.4. SEC as Systemic Risk Regulator--Chairman Schapiro, under
the plan the Administration set forth, a so-called ``Tier 1
Financial Holding Company'' (Tier 1 FHC) and its subsidiaries
would be subject to examination by the Federal Reserve. Thus, a
broker-dealer subsidiary of a Tier 1 FHC would be subject to
examination by the Fed and the SEC.
Should we be concerned that, rather than clarifying
regulatory responsibility, this arrangement could blur lines of
regulatory responsibility?
A.4. A similar arrangement exists today for broker-dealers
subsidiaries within a Bank Holding Company. At its core, the
mission of the SEC is to protect investors, maintain fair,
orderly, and efficient markets, and facilitate capital
formation. Accordingly, rigorous financial responsibility
requirements apply to all U.S. broker-dealers, which are
designed to ensure that broker-dealers operate in a manner that
permits them to meet all obligations to customers and
counterparties. The first of these requirements is the net
capital rule, which, among other things, requires the broker-
dealer to maintain a level of liquid assets in excess of all
unsubordinated liabilities to enable the firm to absorb
business losses and, if necessary, finance an orderly self-
liquidation. The second is the customer protection rule, which
requires the firm to safeguard customer cash and securities by
segregating these assets from its proprietary business
activities. The third prong is comprised of recordkeeping and
financial reporting requirements that require the broker-dealer
to make and maintain records and file reports that detail its
net capital positions and document the segregation of customer
assets.
To ensure an equal playing field among the large and small,
all broker-dealers should be subject to the same regulation,
but additional review and holding company supervision can also
take place. The SRR/Council could serve as a second set of eyes
upon those larger institutions whose failure might put the
system at risk, with the mandate of monitoring the entire
financial system for systemwide risks and forestalling
emergencies.
Q.5. Too-Big-To-Fail--Chairman Schapiro, your testimony
correctly recognizes that one type of systemic risk is that we
create a system that favors large institutions over their
``smaller, more nimble competitors.'' Your testimony also
suggests that a Financial Stability Oversight Council could
prevent the formation of institutions that are too-big-to-fail.
How would this work in practice?
A.5. The Council, SRR, and primary regulators all should have a
role in addressing the risks posed by large interconnected
financial institutions. One of most important regulatory
arbitrage risks is the potential perception that large
interconnected financial institutions are too-big-to-fail and
will therefore benefit from Government intervention in times of
crisis. This perception can lead market participants to favor
large interconnected firms over smaller firms of equivalent
creditworthiness, fueling greater risk. To address these
issues, policy makers should consider the following:
Strengthen Regulation and Market Transparency. Given the
financial crisis and the Government's unprecedented response,
it is clear that large, interconnected firms present unique and
additional risks to the system. To minimize the systemic risks
posed by these institutions, policy makers should consider
using all regulatory tools available--including supplemental
capital, transparency and activities restrictions--to reduce
risks and ensure a level playing field for large and small
institutions. A strong Council could provide a forum for
examining regulatory standards across markets, ensuring that
capital and liquidity standards are in place and being enforced
and that those standards are adequate and appropriate for
systemically important institutions and the activities they
conduct. The Council and SRR would be primarily responsible for
setting standards at the holding company level.
Establish a Resolution Regime. In times of crisis when a
systemically important institution may be teetering on the
brink of failure, policy makers have to immediately choose
between two highly unappealing options: (1) providing
Government assistance to a failing institution (or an acquirer
of a failing institution), thereby allowing markets to continue
functioning but creating moral hazard; or (2) not providing
Government assistance but running the risk of market collapses
and greater costs in the future. Markets recognize this dilemma
and can fuel more systemic risk by ``pricing in'' the
possibility of a Government backstop of large interconnected
institutions. This can give such institutions an advantage over
their smaller competitors and make them even larger and more
interconnected.
A credible resolution regime can help address these risks
by giving policy makers a third option: a controlled unwinding
of a large, interconnected institution over time. Structured
correctly, such a regime could force market participants to
realize the full costs of their decisions and help reduce the
``too-big-to-fail'' dilemma. Structured poorly, such a regime
could strengthen market expectations of Government support,
thereby fueling ``too-big-to-fail'' risks.
------
RESPONSES TO WRITTEN QUESTIONS OF SENATOR REED
FROM MARY L. SCHAPIRO
Q.1. You discussed regulatory arbitrage in your written
statement and emphasized the benefits of a Council to minimize
such opportunities. Can you elaborate on this? Should standards
be set by individual regulators, the Council, or both? Can a
Council operate effectively in emergency situations?
A.1. Establishing a robust and multidisciplinary Financial
Services Oversight Council (Council) would be an important step
toward closing regulatory gaps. Because financial participants
currently can use different vehicles or jurisdictions from
which to engage in the same activity, participants can
sometimes ``choose'' their regulatory framework. This choice
can sometimes result in a race to the bottom among competing
regulators and jurisdictions, lowering standards and increasing
systemic risk.
A strong Council could provide a forum for examining and
discussing regulatory standards across markets, ensuring that
adequate and appropriate capital and liquidity standards for
financial institutions in the marketplace and the activities
they conduct are in place and being enforced. In addition, the
Council would have the role of identifying risks across the
system, harmonizing rules to minimize systemic risk, and
helping to ensure that future regulatory gaps--and arbitrage
opportunities--are minimized or avoided. In general, all
regulatory tools available should be considered, including
strong enforcement, additional measures to improve
transparency, and appropriate activities restrictions. The
Council should set policy if necessary to ensure that more
rigorous standards than those of a primary regulator and/or the
systemic risk regulator (SRR) are implemented. The Council
should provide a different, impartial perspective relative to a
single regulator having a daily oversight role.
In general, I would expect the Council and SRR to work with
and through the primary regulators. The primary regulators
understand the markets, products, and activities of their
regulated entities. The SRR can provide a second layer of
review over the activities, capital, and risk management
procedures of systemically important institutions from a
macroprudential perspective, considering risk to the system as
a whole. If differences arise between the SRR/Council and the
primary regulator regarding the capital or risk management
standards of systemically important institutions, I strongly
believe that the higher (more conservative) standard should
govern.
In emergency situations, the SRR/Council may need to
overrule a primary regulator (for example, to impose higher
standards or to stop or limit potentially risky activities).
However, to ensure that authority is checked and decisions are
not arbitrary, general policy should be set by the Council, and
only then to implement a more rigorous policy than that of a
primary regulator.
The Council's responsibilities, lines of authority, and
consultations with other regulators during both emergency and
nonemergency situations should be explicitly delineated.
Voting, quorum, and other governance requirements, including
consultations with other regulators, should be carefully
considered in advance for exigencies such as the ability to
invoke resolution authority or overrule a primary regulator--as
well as for designating systemically important institutions or
setting policies as a matter of course.
Q.2. What factors should Congress consider as it weighs the
benefits and drawbacks of expanding the Federal Reserve's
authority to oversee the safety and soundness of systemically
important payment, clearing, and settlement systems? Would it
interfere with the SEC's authority over any of these systems?
A.2. While we believe it is appropriate for Congress to
establish a single SRR to focus on macroprudential oversight
and to identify systemic risk, it is important for Congress to
consider the existing framework for the regulation and
oversight of clearing agencies under the Exchange Act.
Accordingly, we believe that any expansion of the Federal
Reserve's authority should supplement rather than replace the
existing regulatory framework for clearing agencies.
Confidence that the financial markets are both safe and
fair is promoted by the risk management standards applicable to
clearing agencies under Section 17A of the Exchange Act,
including that clearing agencies must provide for the
safeguarding of securities and funds and for the prompt and
accurate clearance and settlement of securities transactions.
The current risk management procedures for clearing agencies
have shown remarkable robustness and resiliency both
historically and through the recent period of financial stress.
For example, no clearing agency incurred a loss following the
Lehman bankruptcy last year. Furthermore, in the event of a
participant default, one of a clearing agency's primary lines
of defense is its substantial collateral pool, or clearing
fund, that is comprised of substantial contributions from its
participants. As a result, participants have a strong incentive
to ensure the clearing agency maintains highly effective risk
management policies and procedures.
In addition to the requirements regarding risk management,
Section 17A also imposes a number of requirements to facilitate
a national system for clearance and settlement of securities
transactions. The regulation of the securities markets is
inextricably tied to the regulation of the entities that
provide clearance and settlement services. Clearance and
settlement has an effect on almost every facet of the
securities markets, including: characteristics of the products
traded, trading partners, competition among trading venues,
proxy and dividend distributions, and collaterization of
ongoing transactions such as repurchase agreements and stock
lending. In addition, regulation of many aspects of the
securities market, such as the monitoring and regulation of
``short selling,'' is accomplished through use of the clearance
and settlement infrastructure. The standards that promote
fairness and innovation in the securities markets have elements
related to risk management, such as participant eligibility for
clearing services, and could be compromised if another
regulator could simply ignore the investor protections
available under Section 17A or other laws. For these reasons,
there should be a coordinated approach between the Council,
functional regulators, and SRR in order to fully utilize the
expertise and experience of all regulators and maintain the
existing standards that are crucial to supporting the
securities markets.
Q.3. What do you see as the key differences in viewpoints with
respect to the role and authority of a Systemic Risk Council?
For example, it seems like one key question is whether the
Council or the Federal Reserve will set capital, liquidity, and
risk management standards. Another key question seems to be who
should be the Chair of the Council, the Secretary of the
Treasury or a different Senate-appointed Chair. Please share
your views on these issues.
A.3. Please see my response to your first question.
Q.4. What are the other unresolved aspects of establishing a
framework for systemic risk regulation?
A.4. The Administration's white paper on Financial Regulatory
Reform and recent legislation extensively address the
additional supervisory, capital, leverage, and other
requirements to which Tier 1 Financial Holding Companies (FHCs)
would be subject. Consistent with the need to minimize
regulatory arbitrage and close regulatory loopholes, attention
is also due to firms that would not be considered Tier 1 FHCs
and are not supervised as bank holding companies but
nonetheless have a substantial presence in the securities
markets or carry substantial customer assets. The failure of
such ``Tier 2'' firms could have a disruptive or harmful impact
on orderly and efficient markets and on customers, even if not
necessarily at a global level. Moreover, it may be appropriate
to impose graduated limits and capital charges, as well as
increased supervisory attention, on these financial
institutions as they grow.
Q.5. How should Tier 1 FHCs be identified? Which regulator(s)
should have this responsibility?
A.5. The Council should have the authority to identify Tier 1
FHCs whose failure would pose a threat to the financial system
due to their combination of size; leverage; interconnectedness;
amount and nature of financial assets; nature of liabilities
(such as reliance on short-term funding); importance as a
source of credit for households, businesses, and Government;
amount of cash, securities, or other types of customer assets
held; and other factors the Council deems appropriate. One
possible way to identify Tier 1 FHCs would be to use a process
similar to that used to select participants in the Treasury
Department and Federal Reserve's Supervisory Capital Assessment
Program, or stress tests, conducted in 2009.
Q.6. One key part of the discussion at the hearing is whether
the Federal Reserve, or any agency, can effectively operate
with two or more goals or missions. Can the Federal Reserve
effectively conduct monetary policy, macroprudential
regulation, and consumer protection?
A.6. I believe the approach laid out above, where policy is set
by a strong Council and implemented through functional
regulators with a SRR overlay, would help address limitations
associated with any individual regulators' mission or
expertise.
Q.7. Under the Administration's plan, there would be heightened
supervision and consolidation of all large, interconnected
financial firms, including likely requiring more firms to
become financial holding companies. Can you comment on whether
this plan adequately addresses the ``too-big-to-fail'' problem?
Is it problematic, as some say, to identify specific firms that
are systemically significant, even if you provide disincentives
to becoming so large, as the Administration's plan does?
A.7. Large financial institutions may enjoy a competitive
advantage in the form of a lower cost of capital because the
possibility of a Government backstop has been priced in.
Accordingly, some have suggested that appropriate financial and
risk management requirements be imposed on these large
institutions to level the playing field for smaller competitors
and to provide additional protection against their failure. I
agree with the effort to establish a mechanism for
macroprudential oversight and consolidated supervision of
systemically important firms. Moreover, to minimize the
systemic risks posed by these institutions, policy makers
should consider using all regulatory tools available--including
supplemental capital, transparency, and activities
restrictions--to reduce risks and ensure a level playing field
for large and small institutions.
A credible resolution regime can also help address these
risks by giving policy makers the option of a controlled
unwinding of a large, interconnected institution over time.
------
RESPONSES TO WRITTEN QUESTIONS OF SENATOR BUNNING
FROM MARY L. SCHAPIRO
Q.1. Many proposals call for a risk regulator that is separate
from the normal safety and soundness regulator of banks and
other firms. The idea is that the risk regulator will set rules
that the other regulators will enforce. That sounds a lot like
the current system we have today, where different regulators
read and enforce the same rules in different ways. Under such a
risk regulator, how would you make sure the rules were being
enforced the same across the board?
A.1. Any risk regulator's role should be in conjunction with a
strong Financial Services Oversight Council (Council). The
Council would promote greater uniformity by providing a forum
for examining and discussing regulatory standards across
markets, ensuring that capital and liquidity standards are in
place and being enforced, and that those standards are adequate
and appropriate for systemically important institutions and the
activities they conduct. In addition, the Council would have
the role of identifying risks across the system, harmonizing
rules to minimize systemic risk, and helping to ensure that
future regulatory gaps--and arbitrage opportunities--are
minimized or avoided. The Council would set policy if necessary
to ensure that more rigorous standards than those of a primary
regulator and/or the systemic risk regulator (SRR) are
implemented. Such an approach would provide the best structure
to ensure clear accountability for systemic risk, enable a
strong, nimble response should adverse circumstances arise, and
benefit from the broad and differing perspectives needed to
best identify developing risks and minimize unintended
consequences.
Q.2. Before we can regulate systemic risk, we have to know what
it is. But no one seems to have a definition. How do you define
systemic risk?
A.2. In my view, systemic risk is the concentration of risk in
a single firm or a collective accumulation of risk across firms
that creates a risk of sudden, near-term systemic seizures in
markets or cascading failures of other entities. In addressing
systemic risk it is important that we are careful that our
efforts to protect the system from near-term systemic seizures
do not inadvertently result in a long-term systemic imbalance
that unintentionally favors large systemically important
institutions over smaller firms of equivalent creditworthiness,
fueling greater risk.
Q.3. Assuming a regulator could spot systemic risk, what
exactly is the regulator supposed to do about it? What powers
would they need to have?
A.3. A systemic risk regulator should be empowered, among other
things, with broad information-gathering authority to obtain
adequate reporting from firms that are or may pose a risk to
the financial system and from other regulators. Using the
information obtained, the systemic risk regulator would
identify emerging risks--whether market-oriented,
infrastructure-related, or entity-specific. For example,
concentrations in particular businesses or asset classes and
off-balance sheet or other activities that may not be readily
transparent to the public or primary regulators should be of
particular concern.
Given the breadth of the task, however, the Council, SRR,
and primary regulators all have a role in identifying and
addressing such risks. The Council and the SRR would need to
rely heavily on primary regulators to implement policies. In
that regard, the Council should play a key role in facilitating
and emphasizing coordination among the SRR and primary
regulators.
Moreover, while a consolidated regulator of large
interconnected firms is an essential component to identifying
and addressing systemic risk, a number of other tools must also
be employed. These include more effective capital requirements,
strong enforcement, and transparent markets that enable
investors and other counterparties to better understand risks,
established and maintained in coordination with primary
regulators. Given the complexity of modern financial
institutions, it is essential to have strong, consistent
functional regulation of individual types of institutions,
along with a broader view of the risks building within the
financial system.
Q.4. How do you propose we identify firms that pose systemic
risks?
A.4. The Council should have the authority to identify firms
whose failure would pose a threat to the financial system due
to their combination of size; leverage; interconnectedness;
amount and nature of financial assets; nature of liabilities
(such as reliance on short-term funding); importance as a
source of credit for households, businesses, and Government;
amount of cash, securities, or other types of customer assets
held; and other factors the Council deems appropriate. One
possible way to identify these firms would be to use a process
similar to that used to select participants in the Treasury
Department and Federal Reserve's Supervisory Capital Assessment
Program, or stress tests, conducted earlier in 2009.
Q.5. All of the largest financial institutions have
international ties, and money can flow across borders easily.
AIG is probably the best known example of how problems can
cross borders. How do we deal with the risks created in our
country by actions somewhere else, as well as the impact of
actions in the U.S. on foreign firms?
A.5. Globally active financial services firms may be
geographically dispersed, but as we saw during this financial
crisis, the holding company can become crippled by the failure
of any one of its many material subsidiaries. Our experience
has confirmed the need for cross-border coordination and
dialogue, as well as for sound regulatory regimes for principal
subsidiaries of international holding companies. These
regulatory regimes should of course include capital and
liquidity standards that are adequate, appropriate, and
enforced for the type of financial institutions affected, as
well as measures to address operational and reputational risks.
The global nature of financial conglomerates such as AIG makes
capital and liquidity standards appropriate topics for
international coordination and cooperation. In general, the
financial crisis has highlighted the need for regulators to
work more closely together to better understand the risks posed
by international financial companies and global market risks.
Q.6. Any risk regulator would have access to valuable
information about the business of many firms. There would be a
lot of people who would pay good money to get that information.
How do we protect that information from being used improperly,
such as theft or an employee leaving the regulator and using
his knowledge to make money?
A.6. This same issue exists in our current regulatory regime
and there is an established framework of regulation to
safeguard against the misuse of confidential information. It is
a criminal violation to disclose confidential information
generally. See 18 U.S.C. 1905, Disclosure of confidential
information generally, which provides that any officer or
employee of the United States or any of its department or
agency who, in the course of his employment or official duties,
discloses confidential information (unless authorized by law)
will be subject to fines, imprisonment, or both and will be
removed from office or employment.
There also are express standards of ethical conduct for
employees or executives of any executive agency of the United
States (such as the Securities and Exchange Commission) that
provide, among other things, that an employee shall not engage
in financial transactions using nonpublic Government
information or allow the improper use of such information to
further any private interest. See 5 CFR Section 2635.101(b)(3);
see also 5 CFR Section 2635.703(a), which states that ``[a]n
employee shall not engage in a financial transaction using
nonpublic information, nor allow the improper use of nonpublic
information to further his own private interest or that of
another, whether through advice or recommendation, or by
knowing unauthorized disclosure.''
------
RESPONSES TO WRITTEN QUESTIONS OF SENATOR CRAPO
FROM MARY L. SCHAPIRO
Q.1. Thank you for responding back to my letter that was signed
by Senators Bunning, Martinez, Vitter, and Enzi about the need
to make sure that any decision on short selling will be made
based on empirical data. Has the SEC Office of Economic
Analysis undertaken any independent analysis to determine if
there would be a net benefit from imposing an additional short-
selling restriction so that any final decision will be able to
withstand scrutiny and cost-benefit analysis?
A.1. The Commission's Office of Economic Analysis (OEA), now
part of the newly created Division of Risk, Strategy, and
Financial Innovation, has performed independent analysis of the
uptick rule and various other types of short sale restrictions.
For example, OEA analysis includes (1) a major empirical study
based on a pilot rule change prior to the elimination of Rule
10a-1 in 2007; (2) subsequent analyses to determine how various
forms of uptick rules would have operated during the financial
crisis; and (3) numerous studies of how Regulation SHO and its
subsequent amendments have impacted delivery failures. OEA also
has reviewed and analyzed many other publicly available
empirical studies of short sale restrictions, including studies
conducted both before and after the recent financial crisis.
Collectively, these studies provide a wealth of empirical
evidence relevant to understanding the costs and benefits of
short sale regulation. In addition, the public has had many
opportunities to present additional commentary, analysis, and
empirical evidence bearing on short sale restrictions as a part
of the rule-making process. OEA has assisted the Commission in
reviewing studies and evidence raised through the public
comment process.
------
RESPONSES TO WRITTEN QUESTIONS OF SENATOR VITTER
FROM MARY L. SCHAPIRO
Q.1. Ms. Schapiro, in recent months, you stated that the SEC is
undertaking a comprehensive reexamination of rule 12b-1 fees.
Can you please explain why, when the SEC has so many other
important issues facing it, you are directing the SEC's
resources to a review of these fees which exist to help
millions of small investors have access to ongoing professional
financial advice and service?
A.1. I have directed the staff to undertake a comprehensive
reexamination of rule 12b-1 to help the Commission better
understand the impact the rule has on investors and funds and
to make recommendations to the Commission regarding the rule.
Rule 12b-1, which permits funds to use their assets to pay for
distribution costs, was adopted 30 years ago and has not been
substantively revised since that time. As a result, certain
provisions of the rule likely are outdated and no longer
relevant to the way the rule is used today.
The amount of 12b-1 fees that shareholders pay through
mutual funds has risen from a few million dollars per year in
the early 1980s to over $13 billion in 2008. The expanded use
and amount of the fees paid pursuant to rule 12b-1 have been a
source of concern and controversy for many years. As you note,
supporters of the rule argue that 12b-1 fees help small
investors to access ongoing professional financial advice and
services, and help spur innovation and fund growth. Others,
however, have argued that the rule has, among other concerns,
led to complex fee structures that make it difficult for
investors to evaluate and compare overall costs and services.
The results of the staff's reexamination of rule 12b-1 will
better inform the Commission as it considers potential updating
and reform of this rule that has a substantial impact on fund
investors.
------
RESPONSE TO WRITTEN QUESTIONS OF SENATOR SHELBY
FROM DANIEL K. TARULLO
Q.1. AIG--Governor Tarullo, I am very concerned that the Fed
currently has too many responsibilities. The Fed's bail out of
AIG has put the Fed in the position of having to unwind one of
the world's largest and most complex financial institutions.
Resolving AIG without imposing losses on the U.S. taxpayer is
proving to be a time-consuming and difficult task. It could
even potentially distract the Fed from its core mission of
monetary policy.
Approximately how many hours have you personally dedicated
to overseeing the Fed's investments in AIG?
How does this compare with the number of hours you have
spent on monetary policy issues?
What assurance can you provide that the Fed is devoting
enough time and attention to both AIG and monetary policy?
A.1. I joined the Board at the end of January 2009 and thus was
not involved in matters involving the American International
Group, Inc. (AIG) before that date. While we do not have
records of the exact number of hours I have spent addressing
AIG matters since I joined the Board, these matters do not
occupy a significant part of my ongoing workload and do not
detract from my other responsibilities as a member of the
Board, including the conduct of monetary policy.
The oversight of the Federal financial assistance provided
to AIG is shared by the Federal Reserve, which has provided
several credit facilities designed to stabilize AIG, and the
Treasury Department, which holds equity interests in the
company. The day-to-day oversight of the Federal Reserve credit
facilities is carried out by a team ofstaff at the Federal
Reserve Bank of New York and the Board of Governors, assisted
by expert advisers we have retained. In our role as a creditor
of AIG, the Federal Reserve oversight staff makes sure that we
are adequately informed on such matters as funding, cash flows,
liquidity, earnings, risk management, and progress in pursuing
the company's divestiture plan, so that we can protect the
interests of the System and the taxpayers in repayment of the
credit extended. With respect to the credit facilities extended
to special purpose entities that purchased assets connected
with AIG operations, the staff's oversight activities consist
primarily of monitoring the portfolio operations of each of the
entities, which are managed by a third-party investment
manager. The Federal Reserve staff involved in the ongoing
oversight of AIG periodically report to the Board of Governors
about material developments regarding the administration of
these credit facilities.
The Federal Reserve oversight staff for AIG works closely
with the Treasury staff who oversee and manage the Treasury's
relationship with AIG. As the holder of significant equity
interests in the company, Treasury plays an important role in
stabilizing AIG's financial condition, overseeing the execution
of its divestiture plan, and protecting the taxpayers'
interests.
With respect to time expended by the Reserve Bank members
of the Federal Open Market Committee, the President of the New
York Reserve Bank devotes significant attention to AIG.
However, as noted above, day-to-day responsibility for
overseeing the Bank's interests as lender to AIG has been
delegated to a team of senior Bank managers. The President
regularly consults with the AIG team--in particular he receives
a daily morning briefing on AIG as well as other significant
Bank activities, receives updates throughout the day on an ad
hoc basis circumstances warrant, and occasionally intervenes
personally on particular issues. The President believes that he
is able to adequately balance the time and resources he
allocates to AIG with the other Bank activities that warrant
his personal attention, including his responsibilities as a
voting member of the FOMC.
Q.2. Safety and Soundness Regulation--Governor Tarullo, in your
testimony you state that there are synergies between monetary
policy and systemic risk regulation. In order to capture these
synergies, you argue that the Fed should become a systemic risk
regulator. Yesterday, Chairman Bernanke testified that he
believed there are synergies between prudential bank regulation
and consumer protection. This argues in favor of establishing
one consolidated bank regulator.
In your judgment, is it on the whole better to have
prudential supervision and consumer protection consolidated in
one agency, or separated into two different agencies?
A.2. There are important connections and complementarities
between consumer protection and prudential supervision. For
example, sound underwriting benefits consumers as well as the
relevant financial institution, and strong consumer protections
can add certainty to the markets and reduce risks to the
institutions. Moreover, the most effective and efficient
consumer protection requires the in-depth understanding of bank
practices that is gained through the prudential supervisory
process. Indeed, the Board's separate divisions for consumer
protection and prudential supervision work closely in
developing examination policy and industry gnidance. Both types
of supervision benefit from this close coordination, which
allows for a broader perspective on the quality of management
and the risks facing a financial organization. Thus, placing
consumer protection rule writing, examination, and enforcement
activities in a separate organization that does not have
prudential supervisory responsibilities would have costs, as
well as benefits.
Achieving the synergies between prudential supervision and
consumer protection does not require that responsibility for
both functions and for all banking organizations to be
concentrated in a single, consolidated bank regulator. Under
the current framework for bank supervision, the Board has
prudential supervisory responsibilities for a substantial
cross-section of banking organizations in the United States, as
well as rule-writing, examination, and enforcement authority
for consumer protection. Likewise, the other Federal banking
agencies all have both prudential supervisory authority for
certain types of banking organizations and consumer protection
examination and enforcement responsibilities for these
organizations.
Moreover, as I indicated in my July 23rd testimony to the
Committee, the United States needs a comprehensive agenda to
contain systemic risk and address the problem of ``too-big-to-
fail'' financial institutions. We should seek to marshal and
build on the individual and collective expertise and resources
of all financial supervisors in the effort to contain systemic
risks within the financial system, rather than rely on a single
``systemic risk regulator.'' This means new or enhanced
responsibilities for a number of Federal agencies and
departments, including the Securities and Exchange Commission,
the Commodity Futures Trading Commission, and the Federal
Deposit Insurance Corporation.
One important aspect of such an agenda is ensuring that all
systemically important financial institutions--and not just
those that own a bank--are subject to a robust framework for
supervision on a consolidated or groupwide basis, thereby
closing an important gap in the current regulatory framework.
The Federal Reserve already serves as the consolidated
supervisor of all bank holding companies, including a number of
the largest and most complex banking organizations and a number
of very large financial firms--such as Goldman Sachs, Morgan
Stanley, and American Express--that became a bank holding
company during the financial crisis. This expertise, as well as
the information and perspective that the Federal Reserve has as
a result of its central bank responsibilities, makes the
Federal Reserve well suited to serve as consolidated supervisor
for all systemically important financial firms.
As Chairman Bernanke recently noted, there are substantial
synergies between the Federal Reserve's role as prudential
supervisor and its other central bank responsibilities. Price
stability and financial stability are closely related policy
goals. The benefits of maintaining a Federal Reserve role in
supervision have been particularly evident in the recent
financial crisis. Over the past 2 years, supervisory expertise
and information have helped the Federal Reserve to better
understand the emerging pressures on financial firms and to use
monetary policy and other tools to respond to those pressures.
This understanding contributed to more timely and decisive
monetary policy actions and proved invaluable in helping us to
address potential systemic risks involving specific financial
institutions and markets. More broadly, our supervisors'
knowledge of interbank lending markets and other sources of
bank funding contributed to the development of new tools to
address financial stress.
------
RESPONSES TO WRITTEN QUESTIONS OF SENATOR SHELBY
FROM VINCENT R. REINHART
Q.1.a. Removing Bank Regulation From the Fed--Dr. Reinhart,
Governor Tarullo claims that there are synergies between
systemic risk regulation and monetary policy.
As the former Director of the Division of Monetary Affairs
at the Fed, do you believe that the Fed's ability to conduct
monetary policy would be compromised if the Fed no longer
regulated any financial institutions?
A.1.a. Absolutely not. The Fed's monetary policy responsibility
requires a high-level understanding of the aggregate economy.
Fed officials need an expertise in the workings of markets,
industries, and sectoral behavior. They can get an aggregate
understanding without being a supervisor. As for markets, no
one wants to strip the Fed of its responsibility of managing
the Fedwire and book-entry systems--the backbone to how funds
and Treasury securities are transferred. As long as it provides
those fundamental market utilities, the Fed will always have a
window into markets and large firms, independent of its
supervisory responsibilities. Fed officials frequently boast
that their lending involves little risk because it is highly
collateralized. If so, why do they need the information that
comes from being the regulator of those firms? The Fed should
focus on its core responsibility and work with the Congress to
protect the information flows it deems essential.
Q.1.b. Would banking regulation improve if it was consolidated
under one regulator?
A.1.b. Absolutely yes. Financial firms are too complicated to
supervise or for markets to discipline. One reason is that they
can search among multiple regulators for the most conducive
(i.e., lax) environment. Eliminate regulatory arbitrage by
consolidating regulators.
Q.2. Politicization of the Fed--Dr. Reinhart, Professor Meltzer
asserts in his testimony that the Administration's proposal to
make the Fed responsible for systemic risk would ultimately
sacrifice the independence of the Fed. As the primary Federal
regulator, the Fed's views would have great sway over whether a
firm facing insolvency is rescued. Professor Meltzer points out
that banks, future Administrations, and Congress will therefore
seek to exert political influence over the Fed's decisions on
which firms receive bail outs.
Do you agree with Professor Meltzer that making the Fed
responsible for systemic risk regulation may cause the Fed to
become politicized?
A.2. Monetary policy is abstract and about the national
economy. Aiding a failing firm is concrete and about specific
States and districts. All politics is local. If the Fed is
responsible for systemic risk, it will be enmeshed in politics
and its core responsibility will suffer.
------
RESPONSES TO WRITTEN QUESTIONS OF SENATOR BUNNING
FROM VINCENT R. REINHART
Q.1. I doubt we can create a regulator that will be able to see
and stop systemic risk. It seems to me a more practical and
effective way to limit the damage firms can do is to limit
their size and exposure to other firms. That also has the
benefit of allowing the free markets to operate, but within
reasonable limits. Do you agree with that?
A.1. Financial firms have gotten too complicated and too
interconnected. This is related to, but not completely
explained by, the size of a firm. In March 2008, for instance
and much to my regret, financial authorities were unwilling to
let market forces determine the fate of the mid-sized
investment bank, Bear Stearns, because of concerns about its
interconnectedness. My preferred solution is to combat
complexity directly by enforcing strict consolidation of
balance sheets and requiring different activities within a
holding company to be chartered and capitalized separately. If
a firm's balance sheet is transparent, then the market can
exert meaningful discipline.
Q.2. Many proposals call for a risk regulator that is separate
from the normal safety and soundness regulator of banks and
other firms. The idea is that the risk regulator will set rules
that the other regulators will enforce. That sounds a lot like
the current system we have today, where different regulators
read and enforce the same rules different ways. Under such a
risk regulator, how would we make sure the rules were being
enforced the same across the board?
A.2. Management by committee never works well. Introducing
layers of supervision invites turf wars among the regulators,
the search for regulatory gaps among the regulated, and mutual
finger-pointing after the fact of failure.
Q.3. Before we can regulate systemic risk, we have to know what
it is. But no one seems to have a definition. How do you define
systemic risk?
A.3. Systemic risk refers to the possibility that there will be
a widespread withdrawal from risk taking that does not
discriminate across borrowers.
Q.4. Assuming a regulator could spot systemic risk, what
exactly is the regulator supposed to do about it? What powers
would they need to have?
A.4. Systemic risk is a contagion. The most effective response
is to isolate the source. Before the fact, regulated entities
should be required to keep a simple balance-sheet structure
that limits interconnections. This reduces the risk of
contagion. In the event, weak firms should be allowed to fail.
If there are activities of the firm that pose system risk, they
should be isolated and protected--after sufficient haircuts--
and the rest of the firm left to fail.
Q.5. How would we identify firms that pose systemic risks?
A.5. A systemic threat is posed by any firm with large gross
exposures, relative to its capital, to many different firms
with no effective netting regime.
Q.6. All of the largest financial institutions have
international ties, and money can flow across borders easily.
AIG is probably the best known example of how problems can
cross borders. How do we deal with the risks created in our
country by actions somewhere else, as well as the impact of
actions in the U.S. on foreign firms?
A.6. We can best protect our national interest by requiring
that any firm operating in the United States have a transparent
balance sheet and sufficient capital for each of its
independent lines of business.
Q.7. As you probably have heard, many are calling for an audit
of the Fed. Chairman Bernanke and others are opposed to that
idea because they fear it will lead to Congressional
interference with monetary policy. What can be done to improve
transparency at the Fed? What should not be done? Is there any
information on Fed discussions and the data that goes into them
that would compromise the Fed's independence or ability to do
its job if made public?
A.7. There are limits to transparency. A requirement that the
Fed disclose more information sooner would probably push
decision making more outside organized meetings, to the
detriment of openness. There are two areas where the Fed could
volunteer improvement. First, it could make a numeric summary
of its staff forecast public with its minutes. The forecast is
influential among FOMC participants. If they find it useful,
would not the public? Second, the transcripts could be released
sooner than the current 5-year lag, and probably substantially
so.
Q.8. Do you have any suggestions for ways to improve the Fed's
ability to carry out its core mission of monetary policy? Do
you have any other comments about the Fed generally?
A.8. The Fed would be far better off if it focused on its core
responsibility of monetary policy and hardened the wall of
independence around it. Shed bank supervision, which it did not
do well. Collect and share more data to compensate for the lack
of supervision. Articulate a long-run inflation goal to anchor
the public's understanding. The Fed's unwillingness to engage
the Congress in a meaningful dialogue about the appropriate
role of the central bank is a mistake.
------
RESPONSE TO WRITTEN QUESTIONS OF SENATOR SHELBY
FROM PAUL SCHOTT STEVENS
Q.1. Creating a New Systemic Regulator--Mr. Stevens, your
testimony pointed out the importance of clearly defining the
relationship between any new systemic regulator and existing
primary financial regulators.
What are the potential consequences of failing to draw
clear lines?
A.1. Failure to clearly delineate the relationship between any
systemic risk regulator and the existing primary financial
regulators could have several adverse consequences,
particularly if the systemic risk regulator is not constituted
as a council of existing primary regulators. It would increase
the chances that the systemic risk regulator and one or more
primary regulators might find themselves working at cross
purposes with respect to a given issue. If each believes that
it has responsibility over a particular area, each could adopt
regulations that are inconsistent, particularly if the
regulators have distinct regulatory philosophies and different
types of expertise. If the respective responsibilities of the
systemic risk regulator and the primary regulators are not
well-defined, there will be no clear avenue for resolving these
sorts of conflicts. As a result, there could be delays in
addressing the issue at hand.
Alternatively, the absence of clear lines could result in
the systemic risk regulator and primary regulators duplicating
each other's efforts, which would be inefficient and
potentially create additional regulatory burdens for financial
institutions. Or, the systemic risk regulator and relevant
primary regulator may each mistakenly believe that the other is
responsible for a particular matter, and the identification and
resolution of issues could fall through the cracks.
A related point is the need to place explicit limits on the
authority granted to the systemic risk regulator and to
identify areas in which the systemic risk regulator and the
primary regulators should work together. I believe it would be
most unfortunate if the systemic risk regulator were to
marginalize the primary regulator, thus potentially leading to
the loss of specialized expertise that the primary regulator is
in the best position to offer.
Q.2. Tier 1 Financial Holding Companies--Mr. Stevens, as you
noted, the Administration's proposal would vest the Federal
Reserve with the ultimate authority to designate a firm as a
Tier 1 Financial Holding Company (Tier 1 FHC). A Tier 1 FHC is
defined as a firm the failure of which would pose a threat to
financial stability due to its size, leverage, and
interconnectedness. Some of your larger members could
potentially be swept up by that definition.
How do you anticipate that could change the way in which
large mutual funds are regulated and could the designation of a
large fund complex as a Tier 1 FHC create an uneven playing
field for smaller firms without that designation?
A.2. As a threshold matter, it is useful to note the potential
range of financial firms that could be designated as Tier 1
Financial Holding Companies (Tier 1 FHCs). In its white paper
on financial services regulatory reform, and in the ``Findings
and Purposes'' section of its draft legislation, the
Administration describes a Tier 1 FHC as a firm the failure of
which would pose a threat to financial stability due to its
size, degree of leverage, and interconnectedness. Elsewhere in
the draft legislation is a standard that governs Tier 1 FHC
designations, and it is much more expansive. In particular, the
Federal Reserve need not find all three factors to be present
in order to determine that a firm should be designated a Tier 1
FHC--rather, the legislation would require that the Federal
Reserve consider these and other enumerated factors, in
addition to any other factors that the agency in its discretion
deems appropriate.
The degree of discretion that the Administration seeks to
vest in the Federal Reserve is further illustrated by the
Administration's proposal to authorize that agency to require
certain financial companies to submit ``such information as
[the Federal Reserve] may reasonably require'' for purposes of
making Tier 1 FHC designations. Under the draft legislation,
this authority would extend to any financial company having (1)
$10 billion or more in assets, (2) $100 billion or more in
assets under management, or (3) $2 billion or more in gross
annual revenue. These thresholds are low enough to capture
potentially a wide array of companies in the fund industry.
Under such an open-ended framework, it is certainly
possible that a large mutual fund (typically organized as a
corporation or business trust under state law) or a family of
such funds collectively could be designated a Tier 1 FHC. The
same might be true for a mutual fund investment adviser and its
affiliated companies. Perhaps most likely, a mutual fund
adviser that is part of an integrated financial services firm
could be swept into the Tier 1 FHC regime. These scenarios are
discussed below.
Mutual funds
Designating a large mutual fund or family of funds as a
Tier 1 FHC would not, in my view, be likely to serve the stated
purposes of the Administration's proposal. Mutual funds are
already subject to comprehensive regulation under the Federal
securities laws including, in particular, the Investment
Company Act of 1940 (ICA). Perhaps most relevant for this
purpose are the ICA's strict limitations on leverage to which
mutual funds must adhere. Other core areas of fund regulation,
including daily valuation of fund shares, separate custody of
fund assets, affiliated transaction prohibitions,
diversification requirements, and extensive disclosure and
transparency requirements, are part of an extensive regulatory
framework that has protected fund investors and proven
resilient in difficult market conditions.
Importantly, the Federal Reserve has long viewed a mutual
fund as being controlled by its independent board and not by
its investment adviser or by a company that provides the fund
with administrative, brokerage, and other services. Consistent
with this longstanding view, the Federal Reserve would
presumably need to conclude that the relevant risk
characteristics of a mutual fund or fund family themselves
warrant designating the fund or fund family as a Tier 1 FHC,
and it would not take into account the activities of the fund
adviser and/or the adviser's affiliates in making this
determination. As discussed above, designating a fund or fund
family as a Tier 1 FHC would appear unnecessary given the
comprehensive ICA regulatory scheme, including its strict
limits on leverage.
Under the Administration's proposal, Tier 1 FHC status
might be applied to certain kinds of funds such as money market
funds, which seek to offer investors stability of principal,
liquidity, and a market-based rate of return, all at a
reasonable cost. These funds have been comprehensively
regulated by the Securities and Exchange Commission (SEC) not
only under the ICA provisions outlined above, but also through
a specialized and highly prescriptive rule, Rule 2a-7, for 30
years. For the reasons described below, any concerns that a
large money market fund or family of such funds could present
the potential for systemic risk should be addressed by SEC
reforms and other pending initiatives, and not by designating
such fund(s) as a Tier 1 FHC.
In March, ICI's Money Market Working Group issued a
comprehensive report outlining a range of measures to
strengthen the liquidity and credit quality of money market
funds and ensure that money market funds will be better
positioned to sustain prolonged and extreme redemption
pressures. \1\ Consistent with the Working Group's
recommendations, the Administration, in its white paper,
specifically directed the SEC to move forward with plans to
strengthen the money market fund regulatory framework to reduce
the credit and liquidity risk profile of individual money
market funds and to make the money market fund industry as a
whole less susceptible to runs. In so doing, the Administration
recognized that the SEC, as the primary regulator for money
market funds, is uniquely qualified to evaluate and implement
potential changes to the existing scheme of money market fund
regulation. The SEC already has proposed such amendments, many
of which are similar to the Working Group's recommendations,
and is currently reviewing the comments it has received from
ICI and others on the proposal. \2\ In addition, the
President's Working Group on Financial Markets is considering
whether any other reforms are needed to further strengthen the
resiliency of money market funds to certain short-term market
risks.
---------------------------------------------------------------------------
\1\ See ``Report of the Money Market Working Group'', Investment
Company Institute (March 17, 2009), available at http://www.ici.org/
pdf/ppr_09_mmwg.pdf.
\2\ See ``Money Market Fund Reform'', SEC Release No. IC-28807
(June 30, 2009), 74 FR 32688 (July 8, 2009), available on the SEC's Web
site at http://sec.gov/rules/proposed/2009/ic-28807.pdf.
---------------------------------------------------------------------------
Finally, whether the designation of a large fund or fund
family as a Tier 1 FHC could create an uneven playing field for
smaller funds without that designation is difficult to say. It
is conceivable that investors might perceive such a designation
as providing some kind of assurance or advantage and, thus,
that a Tier 1 designation could have a positive influence on
their investment decisions, especially in times of market
stress. But it seems more likely that a Tier 1 FHC
designation--and its potential effects on how funds are
regulated--would put those funds at a competitive disadvantage
as compared to their peers that are not so designated.
Investment Advisers
Bringing a mutual fund investment adviser--most likely, one
that is part of an integrated financial services firm--within
the proposed supervisory and regulatory scheme for Tier 1 FHCs
would impose an additional layer of substantive regulation on
the adviser that would be fundamentally different from, and
could be at odds with, the regulatory schemes to which fund
advisers have long been subject.
Generally speaking, a Tier 1 FHC and its subsidiaries--
regardless of whether those subsidiaries are already regulated
by a ``functional'' regulator such as the SEC--would be subject
to supervisory and regulatory authority of the Federal Reserve.
Such supervision is intended to be ``macroprudential'' in
focus, combining ``enhanced forms'' of the Federal Reserve's
normal supervisory tools that are focused on safety and
soundness with rigorous assessments of how the firm's overall
activities and risk exposures potentially impact other Tier 1
firms, critical markets, and the broader financial system. A
firm designated as a Tier 1 FHC would need to meet strict
prudential standards, including risk-based capital standards,
leverage limits, liquidity requirements, and overall risk
management requirements. Following a transition period, the
firm also would have to conform to the restrictions on
nonfinancial activities in the Bank Holding Company Act, even
if the firm did not control an insured depository institution.
In a sharp departure from current law, the Federal Reserve
would be given authority to impose and enforce prudential
requirements on a fund adviser, upon consultation in some cases
with the SEC. This would be true regardless of whether the
adviser is named a Tier 1 FHC in its own right or is part of an
integrated financial services firm that is designated as a Tier
1 FHC. In either case, it is not clear how prudential
requirements such as capital standards, which make considerable
sense in ensuring the safety and soundness of an insured
depository institution and its holding company, would be
applied to investment advisers. There would be other ways in
which prudential regulation by the Federal Reserve may conflict
with the regulatory requirements to which investment advisers
already are subject, and it is unclear at this point how such
differences in regulatory requirements would be reconciled.
Lastly, it is important to recognize that, unlike the SEC,
the Federal Reserve does not have an investor protection
mandate. Instead, its bottom-line objective is to promote the
safety and soundness of financial institutions. In pursuing
their respective missions, the two agencies follow distinct
regulatory approaches, they have different regulatory tools at
their disposal, and each has its particular areas of expertise.
The difficulties likely to result from superimposing Federal
Reserve supervisory and regulatory authority onto comprehensive
SEC regulation of mutual fund advisers should not be
underestimated.
Q.3. Independent Board Versus Independent Council--Mr. Stevens,
you argue that the creation of an independent board, as opposed
to a council of existing regulators, could lead to incentives
to justify its existence by finding systemic risks even where
they do not exist.
What aspects of the Council's design would prevent its
staff from falling prey to the same pressure to justify the
Council's existence?
A.3. I believe that several aspects of the design of a Systemic
Risk Council (as I have described it in my written testimony)
would make it highly unlikely that the Council or its staff
would feel pressured to find systemic risks merely to justify
the Council's existence.
As the leaders of the core financial regulatory agencies,
all standing members of the Council would already have critical
``day jobs,'' ones that make them ultimately responsible for
the regulation of financial firms, activities, and markets
within their spheres of expertise. It is precisely these
roles--as Secretary of the Treasury or as Chairman of the SEC,
for example--that would well position the Council members to
distinguish between regulatory matters best handled by the
appropriate primary regulator(s) and those matters that cut
across regulatory lines and present the potential for harm that
could spread throughout the financial system. In these latter
cases, the Council would be required to make a formal
determination that the matter is of such nature and import as
to require the Council's involvement, both in developing a
series of responses to the identified risks and in directing
the appropriate primary regulator(s) to implement those
responses. I do not believe that the Council members would come
to such a conclusion lightly.
Moreover, the Council would not just be tasked with the
prevention and mitigation of systemic risk--it would also be
the body responsible for policy coordination and information
sharing across the various federal financial regulators. The
time and energies of the Council and its independent staff, and
in particular the knowledge gleaned from their continuous
monitoring of conditions and developments in the financial
markets, would be leveraged for both purposes. This is
significant because not all of the issues and risks that they
identify will involve threats to overall financial stability.
Through the collaborative Council process, these ``lesser''
issues and risks can get the attention that they deserve,
presumably by the appropriate primary regulator(s).
Finally, as regards the staff, I have proposed that a small
but diverse group of highly experienced individuals should be
sufficient to support the work of the Council. Many of these
individuals should be seconded from the financial regulatory
agencies represented on the Council and thus, like the Council
members themselves, be well positioned to identify risks that
are truly systemic in nature. And the staff, while independent,
will follow an agenda that is determined by the Council. All of
these factors, in my view, would appropriately focus the
staff's efforts.
------
RESPONSE TO WRITTEN QUESTIONS OF SENATOR SHELBY
FROM ALICE M. RIVLIN
Q.1. Super Regulators--Ms. Rivlin, you state in your testimony
that it would be ``a mistake to give the Federal Reserve
responsibility for consolidated prudential regulation'' of
systemically important institutions as the Obama administration
has proposed. You note that if the Fed acquires this additional
responsibility it will need leaders with regulatory skills--
lawyers, not economists like Volcker, Greenspan, and Bernanke.
Is it realistic to expect that any one person can be an
expert in all of the areas falling under the Fed's
jurisdiction?
As a former Vice-Chair of the Fed, do you think that the
Fed was an effective bank regulator in the run up to this
crisis?
A.1. Answer not received by time of publication.
------
RESPONSE TO WRITTEN QUESTIONS OF SENATOR BUNNING
FROM ALICE M. RIVLIN
Q.1. I doubt we can create a regulator that will be able to see
and stop systemic risk. It seems to me a more practical and
effective way to limit the damage firms can do is to limit
their size and exposure to other firms. That also has the
benefit of allowing the free markets to operate, but within
reasonable limits. Do you agree with that?
A.1. Answer not received by time of publication.
Q.2. Many proposals call for a risk regulator that is separate
from the normal safety and soundness regulator of banks and
other firms. The idea is that the risk regulator will set rules
that the other regulators will enforce. That sounds a lot like
the current system we have today, where different regulators
read and enforce the same rules different ways. Under such a
risk regulator, how would we make sure the rules were being
enforced the same across the board?
A.2. Answer not received by time of publication.
Q.3. Before we can regulate systemic risk, we have to know what
it is. But no one seems to have a definition. How do you define
systemic risk?
A.3. Answer not received by time of publication.
Q.4. Assuming a regulator could spot systemic risk, what
exactly is the regulator supposed to do about it? What powers
would they need to have?
A.4. Answer not received by time of publication.
Q.5. How would we identify firms that pose systemic risks?
A.5. Answer not received by time of publication.
Q.6. All of the largest financial institutions have
international ties, and money can flow across borders easily.
AIG is probably the best known example of how problems can
cross borders. How do we deal with the risks created in our
country by actions somewhere else, as well as the impact of
actions in the U.S. on foreign firms?
A.6. Answer not received by time of publication.
Q.7. As you probably have heard, many are calling for an audit
of the Fed. Chairman Bernanke and others are opposed to that
idea because they fear it will lead to Congressional
interference with monetary policy. What can be done to improve
transparency at the Fed? What should not be done? Is there any
information on Fed discussions and the data that goes into them
that would compromise the Fed's independence or ability to do
its job if made public?
A.7. Answer not received by time of publication.
Q.8. Do you have any suggestions for ways to improve the Fed's
ability to carry out its core mission of monetary policy? Do
you have any other comments about the Fed generally?
A.8. Answer not received by time of publication.
------
RESPONSES TO WRITTEN QUESTIONS OF SENATOR SHELBY
FROM ALLAN H. MELTZER
Q.1. Lessons of Fed History--Professor Meltzer, you are in the
process of completing your book on the History of the Federal
Reserve. I understand that you have been working on this
project for more than a decade. This research gives you a
unique perspective about the strengths and weaknesses of the
Fed.
In your examination of its history, has the Fed
demonstrated that it is inherently better at identifying
systemic risks than any other regulator?
A.1. No. If anyone could forecast crises, they would either be
very rich or they could prevent them. We need to choose
policies that reduce the risk of crises. My answers to some of
Senator Bunning's questions suggest some ways of reducing
failures and the public's cost of failures.
Q.2. What are the problems that are likely to occur if the Fed
is given authority to regulate systemic risk?
A.2. The Fed will not be able to do much because we do not know
how to forecast systemic risks. The Fed will be more engaged in
political decisions than is consistent with independence.
------
RESPONSES TO WRITTEN QUESTIONS OF SENATOR BUNNING
FROM ALLAN H. MELTZER
Q.1. I doubt we can create a regulator that will be able to see
and stop systemic risk. It seems to me a more practical and
effective way to limit the damage firms can do is to limit
their size and exposure to other firms. That also has the
benefit of allowing the free markets to operate, but within
reasonable limits. Do you agree with that?
A.1. Yes, very much. I propose to limit size by making banks
increase their reserves (capital) more than in proportion to
the increase in the size of assets. That shifts the cost from
the public to the stockholders, changes bankers' incentives,
and protects the public. That should accompany an end to ``too-
big-to-fail'' and a lender of last resort rule that Congress
and the Federal Reserve agree to follow.
Q.2. Many proposals call for a risk regulator that is separate
from the normal safety and soundness regulator of banks and
other firms. The idea is that the risk regulator will set rules
that the other regulators will enforce. That sounds a lot like
the current system we have today, where different regulators
read and enforce the same rules different ways. Under such a
risk regulator, how would we make sure the rules were being
enforced the same across the board?
A.2. Again, you are right. The central point of difference
between a risk regulator and increased bank capital lies in who
bears the residual risk. You and I want it to be management and
stockholders. Those favoring a risk regulator leave the public
bearing the risk.
Q.3. Before we can regulate systemic risk, we have to know what
it is. But no one seems to have a definition. How do you define
systemic risk?
A.3. I don't think there is an all-purpose definition. I do not
need to define it because I do not want a risk regulator to
decide. If costs are borne by the banks, they will have an
incentive to be more prudent. We cannot prevent all failures
because banks lend long and borrow short. We can prevent
failures from becoming crises.
The lender of last resort should lend only to those that
have quality collateral. That puts the incentives where they
should be.
Q.4. Assuming a regulator could spot systemic risk, what
exactly is the regulator supposed to do about it? What powers
would they need to have?
A.4. See above. I can't see how we can get a definition. If the
opportunity arises every member of congress would claim that a
large failure in their district is systemic. And their
constituents would expect that.
Q.5. How would we identify firms that pose systemic risks?
A.5. I would not. I would make them hold capital to safeguard
the rest of us.
Q.6. All of the largest financial institutions have
international ties, and money can flow across borders easily.
AIG is probably the best known example of how problems can
cross borders. How do we deal with the risks created in our
country by actions somewhere else, as well as the impact of
actions in the U.S. on foreign firms?
A.6. Yes, a big problem. We allow failures of the companies we
charter. If foreign governments want to rescue the subs in
their jurisdiction, why is that a problem for us?
Q.7. As you probably have heard, many are calling for an audit
of the Fed. Chairman Bernanke and others are opposed to that
idea because they fear it will lead to Congressional
interference with monetary policy. What can be done to improve
transparency at the Fed? What should not be done? Is there any
information on Fed discussions and the data that goes into them
that would compromise the Fed's independence or ability to do
its job if made public?
A.7. Independence of central banks began under the gold
standard. Fed actions were restricted and no one expected long-
term inflation. These restrictions have gone away. We need new
restrictions that Congress can monitor. That means we must
adopt a quasi-rule that allows limited discretion. The Fed
should announce its inflation and unemployment targets. If it
misses the target substantially, it should offer an explanation
and a resignation. The President can accept the explanation or
the resignation. My proposal relates responsibility to
authority. Several countries have adopted variants of it.
Congressman Paul's proposal is too much concerned with
procedure. More important is outcome--inflation and
unemployment. From about 1985 to 2003, we had low inflation and
good growth. The Fed must be made to repeat or improve on that
performance.
Q.8. Do you have any suggestions for ways to improve the Fed's
ability to carry out its core mission of monetary policy? Do
you have any other comments about the Fed generally?
A.8. See the previous question. We need to limit discretion
without putting the Fed in a straight jacket. We need to end
``too-big-to-fail.'' We need to agree on lender of last resort
policy. We need better--more effective--Congressional
oversight.